With tax shelters under pressure from the Internal Revenue Service, lower inflation, and the possibility of tax reform, some investors are finding shelter in an unexpected place: the stock market. Common stocks share many of the same characteristics with investments that are more often thought of as tax shelters, says William O. H. Freund, vice-president and financial planner with Prescott, Ball & Turben, a Cleveland brokerage.
For both stocks and traditional tax shelters, income can be either tax free or tax deferred, ordinary income can be converted to long-term capital gains where the tax bite is lower, and any losses become tax deductible. Also, common stocks can be used for income-splitting, where tax liability is transferred from a high-bracket person to someone in a lower bracket.
``Tax shelters have come under greater scrutiny from the tax department,'' Mr. Freund says of investments like oil and gas programs, real estate, equipment leasing, and movies. ``But they also have to face up to greater scrutiny from investors. As the top tax rates have dropped from 70 to 50 and maybe to 35 percent, it takes the tax benefit out of these investments.''
Many of the tax shelters that were created when the top personal tax rate was 70 percent ``often had very little in the way of economics,'' he adds. Since the top rate was dropped to 50 percent in 1982, shelters relying heavily on tax writeoffs have either disappeared or have become more investment-oriented rather than tax-oriented.
In so doing, Mr. Freund says, they have come to look more like common stocks and more investors are applying the same standards to them as they would to stocks. Unless an investment pays out more than you put in -- apart from any tax benefits -- it isn't a good investment, he argues.
One of the first tax advantages to common stocks comes with the dividend, which, when it is paid, is in addition to any gain you might make on the sale of the stock. Of this dividend income, $100 is free of federal taxes. On a joint return, that doubles to $200 and is equivalent to $333 of fully taxable income for someone in the 40 percent bracket.
Until this year, investors in public utilities have also had the advantage of being able to deduct $750 ($1,500 on a joint return) of utility dividend income. But since this aspect of the 1981 tax act was not extended past Dec. 31 of this year, Mr. Freund says it will probably die and should not be a factor in any decision to purchase utility stocks.
Common stocks, on the other hand, will continue to offer the same tax advantages they have always had, plus some other advantages over interest-paying investments. When a company makes a profit, Mr. Freund notes, it rewards investors in two ways, both of which are tax-advantaged. First, it takes part of the earnings and pays out a dividend, $100 of which, as noted, is deductible.
Those earnings not paid out as dividends are plowed back into the company as retained earnings. This reinvestment in the company builds equity or book value, somewhat like equity is built up in real estate investments. The total yield on stocks, then, is a combination of partially deductible dividends and equity buildup, which is not subject to taxes until the stock is sold.
When that time comes -- as long as the stock has been held at least six months -- any profit is subject to long-term capital gains treatment, where 60 percent of it is excluded from taxes.
On the other hand, if the stock is sold at a loss, whether long- or short-term, there are tax benefits here, too. Losses can be deducted against other income, such as salary, dividends, and interest. However, you cannot take more than $3,000 of these losses each year to offset noncapital-gain income.
Then there is income splitting. Instead of keeping stock in your name and then selling it to pay college tuition bills, for example, Mr. Freund recommends making a gift of the stock to the child and letting him or her sell it. The child will be credited with your original cost and your holding period, which will qualify the child for the 60 percent exemption for long-term gains. The tax on the remaining 40 percent will be assessed at the youngster's lower rate.
How much stock you give is determined by the rules on gifts. The law allows a taxpayer to give up to $10,000 a year to any individual. Married couples can give an individual $20,000 a year.
Before handing over this much stock or cash, however, you probably should check with your financial adviser. Instead of an outright gift, you may prefer a custodial account or some sort of trust arrangement.
In deciding which stocks to buy for tax savings, you should think long term, Mr. Freund advises. He prefers buying ``good quality stocks with sound fundamentals when they're relatively cheap.'' The companies should have a history of consistent dividend payments and, even if they're not doing so well now, show promise of doing better in the future.
``Eastman Kodak is one example,'' he says. ``It's clearly going through a long-term restructuring of its business. It's now at its lowest price in a decade.''
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