At the very minimum it should be taxed the same as dividends. Essentially tax buybacks are a tax loophole for giving money back to the shareholder.
Simple case with a corporation worth $200 with two equal shareholders, who each paid $100 for their half of the company and are in 20% capital gains tax bracket, ignoring net investment tax of 3.8%:
Dividends:
Corporation pays $100 in qualified dividends, $50 to each shareholder. Each shareholder pays their capital gains tax rate on the $50. If that rate is 20% for each, then a total of $20 is collected by the US Treasury. Each shareholder then reinvests or spends the remaining $80 in the economy, while the government puts the $20 to work.
Buy Back Case:
Corporation buys back $100 of shares from 1 shareholder. No taxes were due there as there were no capital gains for shareholder 1. Shareholder 2 now owns 100% of the corporation, so their investment is now, all other thing equal, worth $200. When shareholder 2 sells, a bill for $20 is due ( $100 in capital gains x capital gains rate ). Shareholder 1 reinvests/spends $100 in economy, government gets no additional cash now, but will eventually when Shareholder 2 sells.
In the end, government gets the same $20 in tax. Benefits of the buy back are that investors are able to choose whether or not they want to cash out, whereas a dividend forces it on all investors. Downside is that government has to wait for the $20 in capital gains taxes. However, if shareholder 1 owed capital gains on the buy back ( perhaps they bought their share for $50, so would owe $10 in the $50 it made on the sale ), the government would get $10 from that sale + $20 down the road when shareholder 2 sold.
Maybe I don't understand how stock works, but wouldn't shareholder 2 still own only 50%, with the corporation still owning 50% of itself?
Think about it like ... the opposite of an IPO. Instead of dividing up the firm into n shares and selling them to investors for cash; it's buying back n/m shares and effectively canceling them.
After the buy back, there are fewer shares of the company which are proportionately more valuable assuming the market capitalization has remained the same.
How is that legal? It doesn't make sense to me that if a share is worth x% of a company that said company can just decide "Nah, you actually now only own half of that" and sell more shares.
Fake edit: I googled "how is stock dilution legal" and found this [0] which explained it well and now it makes sense to me. The diluted stock might be a smaller % ownership, but since the company gained value because of money coming in, the dollar value of the shares stays the same.
[0] https://money.stackexchange.com/questions/58391/why-is-stock...
To say nothing of the fact that the stock might never be sold. Or the fact that capital losses can offset a gain from a buyback, unlike dividends.
If you are the seller from whom the company buys back shares, you pay taxes on your gain. If you’re a shareholder who doesn’t sell, you haven’t realized any gain.
Taxes for all shareholders are deferred until they sell. Taxes for all retail businesses are deferred until they sell their product. Taxes for all homeowners are deferred until they sell their house. Taxes for all art/collectible investors are deferred until they sell.
It’s a matter of practicality and fairness. (Don’t make someone sell an investment solely to raise the cash to pay taxes on an unrealized gain. Don’t create paperwork that’s unnecessary. The government is a patient investing partner. They’re willing to wait to take their cut when you sell. They can borrow arms-length money in the meantime far more cheaply than you can anyway.)
Sorry, but this is plain out wrong. If you are shareholder and get dividends, you pay taxes. Even before you sell.
My apologies if my text was somehow confusing to suggest that I believed shareholders didn’t pay taxes on dividends when received as income.
Would you tax the entity buying the stock (in case always a company since it's a buyback; which I think would be the only example of taxing a stock purchase), or the entity selling the stock (either an individual or a company, which is already potentially taxed as capital gains)?
If the goal is to tax it similar to dividends you would tax the person selling the stock but it's already taxed as capital gains, either long term (0%/15%/20%) or short term (marginal bracket rate).
does the company get a tax break if it buys its shares back at less than it sold them for?
Furthermore, whenever shareholders sell shares after the buyback, their shares are generally worth more, so they pay increased capital gains, too.
I don't know which yields more tax revenue in the long run, but buybacks definitely generate some tax income.
The only time I could see a "buyback" influencing share price without taxation is if the buyback has a price cap, and every shareholder believes that the company is worth more, so they don't sell any shares back. This is exceedingly unlikely unless the company is very thinly traded.
From my perspective, the key difference with a buyback is the winnowing of shareholders to those who believe more-strongly in the company's future. With a dividend, every shareholder gets a small amount of cash. With a buyback, some shareholders get cash for their shares, and every other shareholder gets a bigger slice of a company that is worth less (total) money.
If the market is efficient (and it isn't, but it can be) then following a buyback, one would expect the market capitalization of the company to be smaller, as the company has paid out money. After 6 months, if the market cap of the company, plus the funds expended in the buyback, is greater than the inflation-adjusted pre-buyout market-cap, then the company has created shareholder value through some other mechanism (even if the mechanism is pure psychology).
This doesn't make sense to me. If I spend $X to buy a widget worth $X, I've paid out money, but I haven't net lost anything. I'm worth the same in total. If the widget is a share in a company, even my own, that shouldn't change the fact that the net change in total value is zero.
Look at if from a different angle: the ones selling the shares to the company are the shareholders. In aggregate, the shareholders own the company valued at $B (market cap) before the buyback, and the company valued at $A plus the cash paid $X after the buyback. If $A=$B they are creating $X out of thin air.
Even simpler to grasp: you have a business 50/50 with a partner. There is $1m in the company account, you reach an agreement and he will sell his interest back to the company for $1mn in cash. You are sole owner now. The company doesn’t have the cash anymore. How much was the company worth before? How much is it worth now?
The company's cash flow is the same, but there are fewer outstanding shares, so earnings per share goes up. Earnings per share matters because when it increases that implies that future dividends per share will also increase.
If investors expect higher future dividends, that means that the stock is worth more, so it goes up.
Before the buyback, it is a company with some extra cash. After the buyback, it is just the company.
The mechanism may be called profit, earnings, free cash flow... at least for the old-fashioned companies that bring in more money that they spend over the six-months period.
The right answer isn't to introduce new forms of buyback taxes with unknown second-order effects (who would you tax? if the shareholder is avoiding dividend taxation, taxing the corporation isn't a great solution). The solution is to just improve the way we tax dividends and capital gains.
If only 20 widgetshares exists in the world and we each have 50% (you have 10 and I have 10) and the market for widgetshares is $200.
Should you be taxed for your theoretical $5.26 gain if I destroy 1 widgetshare but you haven't sold any. Buy backs are no different. You will pay taxes if you sell.
Personally, I think you should pay taxes if you take out a loan using the market value of the shares as collateral. This is where everything starts getting funny and companies and individuals start being able to avoid taxes forever.
At the time of death, either make the estate pay capital gains taxes on the market value of the assets, or just don't give the heirs a stepped-up basis. It will catch up eventually.
Simple example: Dividends can be made ad nauseum; Buybacks can only be made as long as there are outstanding shares.
If you think those consequences are unintended, then I have a bridge to sell you.
(All numbers in the following are made up).
Some major company a long time ago was going to pay out a dividend, and then their accountants had a great idea. Instead of a dividend, they would first do 100 for 99 stock split. Then they would do a 1% stock buyback. The shareholders would be taxed at capital gains rates instead of ordinary income rates on this.
Note that for any shareholder, the result afterward is that for every 99 shared they owned before the split and buyback they still own 99 shares. No one's actual percentage ownership of the company has changed--but they have received money from the company.
The code and/or regulations were updated to fix this. But then buybacks that were not hidden dividends were getting classified as ordinary income, too, and so further code and/or regulation changes were made to further refine this.
What it eventually ended up with is rules that looked at how ownership was distributed among the shareholders before the buyback and after the buyback, and decided if it was a disguised dividend or a legitimate buyback based on how that distribution changed.
(I haven't followed tax law for several years. Anyone happen to know if this is still there after the Trump tax changes?)
This sort of thing is a large part of why tax codes and regulations tend to be big and complicated. Even if they start out fairly simple, people find holes like that split/buyback trick, and closing those holes adds complexity. The result is that you only generally will see either very simple tax systems (like sales taxes) or very complex systems. Systems that start out in between end up moving toward very complex.