NY Time provides some fresh view of two tax consequences following Microsoft's $3-per-share special dividend.
First, although Bill Gates readily announced to donate the entire $3 billion plus dividend income to his private foundation, he still stands to get up to $600 million tax benefit out of the deal. The reason is dividend will be taxed at 15% but donations can offset ordinary income, which for Bill Gates, is taxed at the top tax bracket of 35%.
The second point the NY Time article brings about is this expected special dividend may bring some arbitrage opportunity for traders. Traders can buy Microsoft stock, hold for more than 61 days, get the special dividend and dump the stock. Because by holding the shares for more than 61 days, traders can receive dividends that will be taxed at the maximum of 15%, while if the stock price theoretically drops $3, the corresponding short-term capital loss is worth a tax benefit of up to 35% if it is used to offset short-term capital gains. For people at 35% tax bracket, these transactions will worth $3 * (35% - 15%) or $0.60 per share purchased, or a little bit more than 2% return over two months. (However, it is not risk free: MSFT may lose more than $3 after the dividend payout.)
The article also points out another important fact people who wants to test their luck in this arbitrage opportunity should consider: according to IRS rules, if investor's cost basis on MSFT is less than $30.81, any corresponding capital loss will automatically be classified as long-term capital loss, which will be used to offset long-term capital gain first (taxed at 15% or less). The IRS publication says:
Loss on stock that paid qualified dividends. Any loss on the sale or trade of stock must be treated as a long-term capital loss to the extent you received, from that stock, qualified dividends (defined in chapter 1) that are extraordinary dividends. This is true regardless of how long you actually held the stock. Generally, an extraordinary dividend is a dividend that equals or exceeds 10% (5% in the case of preferred stock) of your adjusted basis in the stock.
However, for people who does not have long-term capital gains for 2004, these capital losses from MSFT can still be used to offset other short-term capital gains.
For me at 25% tax bracket, the arbitrage will only be worth 1% of the capital invested. Surely I can also short-sell in Roth IRA and buy in after-tax brokerage accounts to hedge against the price change more than $3 during the 61-day period, but this will bring the return on capital to 0.5% and I simply don't see much incentive. The NY Times article nevertheless suggests that there may be people or companies buying before the dividend payout to exploit this opportunity, so I will sit in the sideline to see if the buyers can create an attractive price point to unload some of my Microsoft options.