The clock is ticking on the end of the Bush tax cuts, which include the low 15% rate on dividends. If the U.S. Congress and President Obama cannot agree on some type of tax-cut extension before the end of 2012 (111 days away), the rate on dividends will skyrocket from the current 15% to the 39.6% rate for ordinary income. And don’t forget to tack on the 3.8% tax surcharge on investment income to help pay for Obamacare.  Add everything up and the total tax on dividends could rise as high as 43.4%.

As Investing Daily’s dividend expert Roger Conrad has written, “the most likely outcome following November is a post-election compromise with some tax benefits and spending restored and no fiscal cliff.” Even if dividend tax rates do rise, retirees will still need dividends to generate the necessary income for living expenses. Several academic studies have found that long-term performance of dividend-paying stocks is largely unaffected by tax-rate changes.

But over the short term, Ned Davis Research has found that dividend stocks have underperformed non-dividend-paying stocks in the six months after a hike in dividend tax rates. In fact, the worst underperformance occurs in the first three months, with non-dividend payers returning 50% more than dividend payers! The reason for the underperformance is clear: a stock’s value is based on its after-tax cash flows. If taxes rise, after-tax cash flows decline — resulting in less value for the shareholder. A dividend-tax-induced stock selloff would probably affect your portfolio because 402 of the 500 companies in the S&P 500 index currently pay dividends – the highest number since 1999.

Dividend Tax Rates May Rise in 2013

Although a tax compromise may be most likely scenario, partisanship is so intense on Capitol Hill that many investors may not trust politicians to do the right thing and will consequently sell dividend stocks now and ask questions later. As Roger Conrad states, investors would do well to believe in the Boy Scout motto: “Be prepared.” Anything could happen, especially if both parties decide to wait until after the presidential election to start negotiating on a tax-cut extension. U.S. Senator and 2008 Republican presidential candidate John McCain recently warned:

I have never seen a lame-duck session that ended up in anything but a disaster. For us to somehow say, ‘Ok, we’ll wait until after the November election,’ is crazy.

Thanks to the inane and extremist Grover Norquist-inspired “no new taxes” pledge many Republicans have taken, the chances of Capitol Hill actually allowing the Bush tax cuts to expire is higher than it otherwise would be. Democrats simply won’t agree to a tax-cut extension without some leeway on raising revenue elsewhere. Consequently, Congress may let the tax cuts expire by doing nothing (automatically raising taxes) and only afterwards vote on a retroactive tax-cut plan. This strategy – first proposed by Office of Management and Budget (OMB) Director Peter Orzsag — would allow Republicans to stay true to the Norquist pledge and yet let taxes rise.

Of course, the risk of Orzsag’s proposal is that after taxes rise Congress fails to agree on a plan to reduce them, which would result in the dividend tax rate remaining at nosebleed levels. To guard against this nightmare scenario, several companies are likely to announce special dividends during the last months of 2012 to take advantage of the 15% dividend tax rate before it disappears. During the last three months of 2010 – the last time the Bush tax cuts were set to expire before a last-minute deal extended them for two years – more than 150 companies announced special dividends.   

Special Dividend Stocks

Below is a list of companies that are prime candidates to announce a special dividend between now and the end of 2012. Why is this important? After all, don’t stock prices fall by the amount of any dividend payout? Yes, that is true — on the ex-dividend date. But there is evidence that investors bid up the price of a stock significantly between the date a special dividend is announced and the ex-dividend date. Just look at the positive investor reaction to the recent announcements of special dividends by American Eagle Outfitters (NYSE: AEO) and DSW Inc. (NYSE: DSW). The stock pop occurs because investors view cash in their hands as worth more than cash owned but locked inside of a corporation.

Bottom line: special dividends can create trading opportunities! The key is to buy the stock before the special-dividend announcement and that is why the list of stock candidates below should be of interest to investors.

Since corporate executives don’t always have the average shareholder’s financial interest as a top priority (unfortunately), I believe a company is more likely to issue a special dividend if corporate insiders own a large chunk of company stock and would personally benefit from the dividend payout. The company must also generate enough cash to pay a large dividend and not be burdened by a lot of debt. Consequently, using my trusty Bloomberg terminal, I screened for stocks where:

• Insiders own at least 30% of shares outstanding
• Free cash flow is greater than 10% of the stock’s market cap
• Debt-to-capital ratio is less than 30%

The stock screen found seven special-dividend candidates:

7 Special Dividend Stocks?

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