Congress recently passed the Inflation Reduction Act, which contains a number of provisions. It aims to raise revenue and combat inflation by implementing a 15% corporate alternative minimum tax, allow Medicare to negotiate prescription drug prices, and increase IRS enforcement on high-income taxpayers. And it plans to invest $437 billion in energy security, climate change, and an extension of the Affordable Care Act.
However, there is one tax change that was added at the last minute that could have a major impact on some of the stocks in your portfolio: a 1% excise tax on corporate stock buybacks.
The new tax on stock buybacks
The short version of the new tax is that when most companies buy back shares of their own stock, there will be a 1% tax imposed on the amount spent. In other words, if a company spends $100 million on stock buybacks, it will face a $1 million tax bill. The idea is to discourage buybacks that are solely intended to increase earnings and share prices, and to encourage profits to be spent in other, more productive ways.
There are a few exemptions. For example, REITs (real estate investment trusts) are exempt from the new tax, and the same is true if the repurchased stock is contributed to an employee stock ownership plan or something similar.
Why stock buybacks are a target
Companies buy back shares for a few reasons. As one example, if management thinks its stock is worth more than its current market price, it can be a great use of capital and can help drive long-term value. And from the perspective of earnings, fewer outstanding shares can make it appear that per-share earnings growth is stronger than it actually is.
While stock buybacks certainly have their valid and practical uses, they have been called into question by several key lawmakers in recent years. For example, some in power were hesitant to assist the airlines during the initial COVID-19 shutdowns after it was revealed that these companies had spent billions buying back their own stock instead of building reserves. The general argument from many politicians is that businesses should be spending their profits on their employees, or reinvesting in their growth, rather than simply buying back stock and boosting their share price for investors.
Will your favorite companies stop buying back stock?
This is certainly negative news for companies that buy back stock regularly, but whether it will actually impact the volume of buybacks is another matter.
To be sure, some companies could choose to shift some of their earnings away from buybacks and toward dividends, but it isn't likely to happen on a large scale. After all, the new 1% tax on stock buybacks is the only additional tax due when companies use their profits in this way.
On the other hand, if a company decided to pay dividends instead, investors who own shares in a standard brokerage account could face tax rates as high as 23.8% on that income.
Let's see how this could actually affect a company. Through the first three quarters of its current fiscal year, Apple (AAPL 0.74%) generated $79.1 billion in net income and spent $65 billion on stock buybacks. Under the new tax law, the company would pay a $650 million tax on these buybacks -- 1% of the amount.
That $650 million might sound like a big tax bill, and it is. However, it represents an earnings hit of just $0.04 per share for the tech giant. Plus, consider what would happen if Apple were to pay that $65 billion as dividends instead. Assuming an average tax rate of 15% on qualified dividends, its shareholders could get hit with nearly $10 billion in tax bills.
The bottom line is that while the new tax on stock buybacks could certainly cause your favorite companies' earnings to suffer a bit, it is unlikely to significantly change corporate behavior when it comes to capital allocation. Nor is it likely to result in a major drag on long-term stock performance. In short, investors shouldn't panic.