Corporate Dividend Policy Under the Revenue Act of 1936


THE Revenue Act of 1936 will affect in varying degrees the financial policies of practically every incorporated business in the country. It will, furthermore, materially limit the discretion that corporate directors have heretofore had in the formulation of their dividend policy, which formerly was a matter of individual business expediency. The Federal Government has by means of the new Act largely transferred unto itself one more function of private management — that of corporate dividend policy.

A new factor has therefore been brought to bear on corporate management, yet the statements of various officials which have appeared since the passage of the Act have indicated a bewilderment and a lack of full understanding of the implications contained in the Act. This is only natural in view of its complexities and of the completely untried experimental theory of the surtax on undistributed earnings, which has been aptly termed a ‘pressure tax.’ Many corporate directors have failed to appreciate how really effective the pressure will be and have appeared to accept uncritically the philosophy that dividend policy, notwithstanding the Act, is still a question of individual business expediency. Some corporations, in fact, have recently set up reserves for the surtax on undistributed earnings, which, of course, may merely have been set up until dividend policies become more fully crystallized. In their own interests the directors of these companies should become fully aware of the consequences which may face them if they put themselves in a position where they will have to pay a substantial surtax on undistributed earnings.

The law is on the statute books, and most corporation directors are now faced with the definite problem of a change in dividend policy before the end of this year to conform with the Act. To date there have been only a very few companies which have adopted the policy called for — in fact, dictated — by the philosophy of the Act. Many directors have apparently felt that the reinvestment of earnings is a luxury which now can be enjoyed only at the expense of sharply increased taxes. This is not true. It will be enlightening to trace the way in which the Act applies, and to develop the argument as to why, except for certain special or technical conditions, the payment of any substantial surtax on undistributed earnings is generally indefensible.

In addition to the normal tax of approximately 15 per cent, the new law imposes a surtax at graduated rates upon ‘undistributed net income,’ as follows : —

Percentages of Adjusted Net Income Retained Rates of Surtax
First 10 percent 7 per cent
10 to 20 ” ” 12 ” ”
20 to 40 ” ” 17 ” ”
40 to 60 ” ” 22 ” ”
Over 60 ” ” 27 ” ”

The effective rates of surtax, expressed in terms of the amount of earnings retained and of earnings available for distribution, follow: —

Percentages of Adjusted Net Income Paid in Dividends Ratios of Surtax to Undistributed Net Income' Ratios of Surtax to ‘Adjusted Net Income’
100 per cent None None
90 ” ” 7 .0 per cent 7 per cent
80 ” ” 9.5 ” ” 1.9 ” ”
70 ” ” 12.0 ” ” 3.6 ” ”
00 ” ” 13.25 ” ” 5 .3 ” ”
50 ” ” 15.0 ” ” 7.5 ” ”
40 ” ” 16.16 ” ” 9 7 ” ”
30 ” ” 17.71 ” ” 12.4 ” ”
20 ” ” 18.87 ” ” 15.1 ” ”
10 ” ” 19 77 ” ” 17.8 ” ”
None 20.5 ” ” 20.5 ” ”

It will be seen that a corporation which retains all of its earnings is subject to a surtax amounting to 20.5 per cent.

Over the past several years, according to the testimony of treasury experts, corporate dividend policies have resulted in the distribution of between 65 per cent and 70 per cent of earnings on the average. Under the 1936 Act, this would mean a corporate surtax of over 12 per cent of the earnings retained, which is more than 8 per cent higher than the individual 4 per cent normal tax on dividends. It would also mean an increase of over 40 per cent in corporate federal income taxes over the rates contained in the 1934 Act, if corporations in general continue their past policy of distributing only about 65 per cent of earnings. Unless dividend policies are changed, therefore, corporate earnings are going to be very adversely affected by the new Revenue Act.


In the case of a well-established corporation which has a satisfactory working-capital position, there would appear to be only three logical reasons which could cause corporate directors to retain substantially any of its adjusted net income (except for certain technical and special situations). First of all, it might be considered advisable, in the case of a corporation having a few wealthy shareholders who were in very high individual surtax brackets, to retain earnings even at the expense of a surtax on undistributed earnings. Second, it might be argued that in view of Mr. Landon’s pledge to eliminate the ‘cock-eyed’ tax on undistributed earnings, if he is elected, the directors may feel that it is a reasonable assumption that the Revenue Act of 1936 will never take effect, just as the Revenue Act of 1935 never took effect. Finally, there is the third possible argument which has been advanced many times, that it is necessary to keep some of the earnings in the business for expansion, more working capital, or some other legitimate corporate purpose, or for further building up reserves against future contingencies.

The first of these reasons has already been suggested by a leading oil company, with the thought that the penalty of a corporate surtax amounting to 20 1/2 per cent might in itself seem large, but relative to the 70 per cent individual surtax rate on net incomes in excess of $500,000 a year it seems small. To be sure, from the point of view of the shareholders who are in such high surtax brackets, there would be a net saving. This saving would most certainly be at the expense of other shareholders who were in very much smaller surtax brackets or who w ere subject to only a 4 per cent normal tax. Such a procedure, moreover, would most certainly be contrary to the spirit of the Act and would probably leave the corporation open to a further 25 per cent penalty under Section 102 of the Act, which provides, among other things, that ’if a corporation however created or organized is formed or availed of for the purpose of preventing the imposition of the surtax upon its shareholders or the shareholders of any other corporation through the medium of permitting earnings or profits to accumulate instead of being divided or distributed’ it shall be subject to a further surtax. It would seem, moreover, that if there were any minority stockholders who suffered by such a policy the directors might be subject to suits. Regardless of these legal factors, however, there is a fine moral question as to where the dividing line should be. Obviously, in the case of a corporation which is owned completely by one shareholder who is in a 75 per cent surtax bracket, it would be sound and logical to retain 100 per cent of its earnings even at the expense of being subject to both surtax on undistributed earnings and the penalty surtax of Section 102. In the aggregate those corporate taxes would not equal the individual taxes of the shareholder if all the earnings were to be distributed to him. On the other hand, if all the shareholders of the corporation were subject only to a normal tax of 4 per cent, any retention of earnings would cost the company and its shareholders more than complete distribution.

In general, those companies with a number of wealthy shareholders would be more inclined to the temptation of retaining earnings than other companies. The number of shareholders in this country, however, who are in high enough surtax brackets to make this argument a real one is relatively small compared to the numbers of stockholders in lower brackets in the large corporations. Certainly the formulation of the dividend policies of any of the leading companies listed on the New York Stock Exchange to benefit the individual tax situation of these relatively few shareholders who have large individual surtaxes would be both legally and morally indefensible if there were any great number of shareholders in a relatively low surtax bracket or who were subject only to the normal 4 per cent tax on dividends. In practically all of these cases there would be a net saving to the corporation and its shareholders if all earnings were distributed. In the few instances where there may be a net loss because of the existence of a majority of wealthy shareholders, there may be considerable doubt as to the protection of the interests of minority shareholders of moderate means.

The treasurer of a well-known company recently remarked that because of the fact that over 50 per cent of the stock of his corporation, which included 40,000 shareholders, was owned by less than 1 per cent of the stockholders the directors would probably retain a substantial proportion of earnings, since there would be a net saving to this small group who had working control and who were in higher individual surtax brackets. Let us examine for a moment the superficiality of this line of thought. First of all, it will be well-nigh impossible for the directors of this company, as well as those of any company with a substantial number of shareholders, to ascertain the individual surtax brackets in which their stockholders will fall. Let us assume that the large stockholders in this company are in the maximum surtax bracket of 75 per cent and that the corporation retains all of its earnings. It would therefore be subject immediately to the surtax on undistributed earnings of 20.5 per cent. It might furthermore be subject to the surtaxes under Section 102 of the Act for permitting earnings to accumulate in order to prevent the imposition of the surtax upon its shareholders. This would mean total corporate surtaxes (in addition to the 15 per cent normal tax) of approximately 45 per cent.

There could only exist a net saving to this corporation and its shareholders, therefore, if the average surtax rate of the entire group of 40,000 shareholders amounted to at least 45 per cent, which is extremely improbable. There would, of course, be a tax saving to the small group in high surtax brackets, but at the expense of the remaining large group of small shareholders. This minority group would presumably have grounds for protest, and it is quite probable that their protest would take the form of suits against the directors who formulated such a dividend policy.

It is unfortunately true that the Act will develop a powerful conflict of interests as between different classes of stockholders. It is also true that, regardless of the common-sense fairness of the situation, the spirit of the Act and of its probable administration will favor the protection of the stockholders of moderate means.

Some corporations have indicated that they would withhold dividend decisions until after the presidential election, on the basis that the election of Mr. Landon would mean the repeal of the Revenue Act of 1936 before next March 15 and that therefore the Act would go the way of the 1935 Act and never be in effect. It is questionable whether directors should indulge in this line of reasoning, for it is nothing more than forecasting what Congress may do next year toward eliminating a present liability of corporations. By no stretch of the imagination could this be considered conservative or sound corporate policy. Mr. Landon is probably sincere in his pledge to revise the tax on undistributed earnings, but it is Congress who enacts the Revenue Act and not the President. The consensus of most tax authorities, moreover, seems to favor the view that it is very unlikely that another Revenue Act will replace the Revenue Act of 1936 for the year 1936. After all, much of the criticism of the 1936 Act was the haste with which it was enacted. To enact a new Act to supplant it between January and March 15 would not seem consistent with this criticism. The only conservative attitude with respect to dividend policies for this year would seem to be the assumption that a corporation will be subject to the Act, as, in fact, it now is.


Finally we come to the argument that a corporation needs to retain a substantial part of its earnings for one corporate purpose or another. The whole problem actually resolves itself into the question of the relative cost of retaining earnings in order to get the necessary cash as against the cost of getting the money from some other source. Federal income taxes represent an expense of doing business, and corporation officers should be just as interested in reducing this cost as they are in reducing expenses in other directions, if they are to carry out their duty to their shareholders. The directors can compute what it will cost the company to retain whatever percentage of earnings they deem it advisable to retain for any purposes they have in mind. This cost ranges from 7 per cent to 27 per cent of the amount of earnings retained, and, to put it mildly, this is an expensive way of obtaining money. Of course, within somewhat narrow limits it could be argued that it would be perfectly sound to retain, let us say, 10 per cent of earnings and pay a surtax of 7 per cent, since, if this amount were distributed, every shareholder (if he paid any federal taxes) would pay a normal tax of 4 per cent, so that the net cost to the company and its small shareholders of retaining this 10 per cent would only be 3 per cent, which is probably not much more than the cost of raising money in other ways. In the event that more than 10 per cent of earnings are retained. however, no such argument is valid.

There are several ways in which a corporation can retain a portion of its earnings. In the first place, Section 115 of the Act provides that an optional stock dividend is considered as a taxable distribution, and the law defines an optional stock dividend as follow: ’Whenever a distribution by a corporation is at the election of any of the shareholders payable either (a) in its stock or in rights to acquire its stock, or (b) in money or any other property, then the distribution is constituted a taxable dividend in the hands of all shareholders regardless of the medium in which paid.’

Under this section, if the directors of a corporation desire to retain a portion of earnings, they could give the shareholders an optional stock dividend, feeling that enough shareholders would elect to take stock so that their purpose could be accomplished.

Another alternative would be for the corporation to pay a dividend on the common stock in stock of another issue, such as preferred stock, or in obligations of the corporation. Under a recent decision (Koshland versus Helvering) the United States Supreme Court ruled that a dividend on a preferred stock payable in common stock represents a taxable dividend in the hands of stockholders. There has apparently been no such decision with respect to the reverse of this process of paying a dividend on common stock in preferred stock. Both of these methods would result in retaining cash in the corporation.

Theoretically, however, there is some doubt as to whether these methods, or a combination of them, although allowed by the provisions of the Act, would be legally upheld by a subsequent Supreme Court decision. In the opinion of many lawyers, corporate directors would be taking the risk, if they attempted any of these methods, of having the Supreme Court subsequently hold that such distributions were not taxable in the hands of shareholders and, therefore, were not considered as a distribution of earnings. The corporation would then be liable for a tax on undistributed earnings.

Apparently the surest way in which a corporation can avoid the liability of the surtax on undistributed earnings is by the distribution in cash of its entire earnings. This does not, however, prevent the reinvestment of distributed earnings by shareholders if a corporation has need of capital for expansion, additional working capital, retirement of debt, or other corporate purposes. Probably the easiest method of accomplishing this is through the issuance of rights to shareholders.

At first glance this method may seem somewhat complicated, perhaps costly, and an entirely new thought in the realm of corporate finance. As a matter of fact, it is quite the contrary. The American Telephone & Telegraph Company followed for years, in effect, an identical policy. From 1920 to 1939 this company paid a dividend of $9.00 per share each year on its common stock. Practically every other year the corporation issued rights to its shareholders to purchase additional stock. The amount of money raised by the issuance of rights was considerably in excess of the aggregate amount paid out to its shareholders in the form of dividends. In this instance the company went considerably further than merely getting back from its shareholders a portion of the money which it had distributed to them as dividends. but actually assessed them for additional capital.

Upon analysis, in the case of the great majority of corporations, there will be a net saving to the corporation and the majority of its shareholders if the corporation pays out substantially all of its earnings and gets back whatever cash it needs by issuing rights. The exact saving would, of course, depend upon the cost of the issuance of rights. In the case of large, well-established companies with earnings amounting to many millions of dollars, the percentage cost of this operation should be small, particularly if the issue is not underwritten. The entire operation could be handled in the offices of the company.

Under present market conditions, if rights are offered at a price far enough below the current market, it would seem that the function of underwriting could be dispensed with in the case of large, well-established corporations, since the rights would then have a value great enough to provide shareholders with a definite incentive

to take up their rights, or at least to sell them

to someone who would.


The following example illustrates the savings which will result from this policy:—

Corporation A Corporation B
Net income $11,800,000 $11,800,000
Normal tax (approximately I.V) 1,800,000 1,800,000
Adjusted net income $10,000,000 $10,000,000
Dividends paid 4,000,000(40%) 10,000,000(100%)
Undistributed net income $6,000,000(60%) 0
Surtax on undistributed earnings 970,000 0
Amount available for reinvestment $5,030,000 $5,100,000*
Number of shares outstanding 1,000,000 1,000,000
Earnings per share $9.03 $10.00
Dividend per share $4.00 $ 10.00
Aggregate dividends received by shareholders $4,000,000 $10,000,000
Less normal individual taxes (4%) 160,000 400,000
Less money reinvested by shareholders 0 5,100,000
Net cash return to shareholders $3,840,000 $4,500,000
Normal corporate tax (15% $1,800,000 $1,800,000
Corporate surtax 970,000 0
Individual normal taxes. 160,000 400,000
Total federal income taxes paid $2,930,000 $2,200,000

In the case of Corporation A, where the judgment of the directors leads them to believe that they should retain 60 per cent of their earnings for some corporate purpose or other, the surtax paid by the corporation amounts to $970,000, and the corporation has $5,030,000 available for reinvestment. In the case of Corporation B, the judgment of the directors also leads them to believe that approximately $5,000,000 is needed for some corporate purpose, but in order to avoid the payment of any corporate surtax they distribute the entire $10,000,000 of earnings to the shareholders. The corporation then proceeds to issue rights in the ratio of one new share for every ten shares held to subscribe to stock at a price of $51 per share. If all the rights were exercised, the corporation would have received from its shareholders a total of $5,100,000. If the expenses of the issue of rights amounted to $70,000 (which is probably high), the corporation would have available $5,030,000, or exactly the same amount as in the case of Corporation A.

For the purposes of simplicity, let us ignore the question of individual surtaxes and of state taxes and assume that all the shareholders of the corporation merely pay the normal tax of 4 per cent. The stockholders of Corporation B would have received aggregate dividends amounting to $10,000,000. They would, however, pay the normal tax on dividends of 4 per cent, or $400,000, and they would have reinvested in the company, upon exercising their rights, $5,100,000, so that the aggregate net return to them would amount to $4,500,000, which is $660,000 more than the net return to the stockholders of Corporation A. Furthermore, total federal income taxes paid by Corporation B and its shareholders would amount to only $2,200,000, as against the $2,930,000 paid by Corporation A and its shareholders, or a saving of $730,000.

Many directors apparently feel that the policy followed by Corporation B results in a steady dilution of the shareholders’ equity in their corporation. This is not true. If every shareholder exercises his rights there is no dilution, since each shareholder maintains his proportionate equity in the company. In the above example the issuance of rights is not even an assessment in the case of small shareholders, since the company has distributed enough in dividends to enable t he stockholders to take up their rights. Even in the case of the American Telephone & Telegraph Company, where the amount of money required to subscribe to rights was greater than the dividends paid, stockholders were not diluted if they exercised their rights. Rather they were assessed. In general a stockholder begins to be assessed only when the net dividends received by him in any one year (deducting the individual taxes which he pays on those dividends) are less than the amount of money which he needs to subscribe to his rights. A stockholder is diluted only if he sells his rights and therefore has a smaller pro rata equity in the corporation. It is probably true that many shareholders have a misconception as to the true distinction between capital and income, and are inclined to consider rights as a form of supplementary income because of the fact that these rights during their life have a definite market value and can therefore be sold for cash.


In general, in the case of a majority of corporations, there would seem to be no legitimate reason why the directors should subject the corporation to the surtax on undistributed earnings when there is a perfectly easy and legitimate way in which to avoid such taxes. Of course it is going to be difficult in a great many cases for the corporation directors to determine before the end of the taxable year what earnings actually will be. There arc always such questions as inventories, reserves, and other similar factors which are extremely hard to estimate in advance of the close of the year. In the past, most corporations have not known what their actual earnings have been until many weeks after the close of the year, and in many cases it has been years before the Treasury Department has determined the taxable income of a corporation. It would obviously have been more equitable for the Revenue Act to provide a period of time during which the true earnings of the corporation could be determined. As the Act stands, however, the dividend must be distributed before the close of the taxable year in order to avoid the surtax, and corporate directors are faced with the problem of making the best guess that they can as to what earnings will finally turn out to be.

In conclusion, therefore, the argument would seem to be reasonably clear that most corporations should pay out substantially all of their earnings. If they do not. they are probably laying themselves open not only to criticism but to the liability of the imposition of the penalty tax contained in Section 102 of the Act, and of suits by minority stockholders for paying the surtax on undistributed earnings.

While we have here been interested chiefly in the immediate implications of the new tax bill on corporate policy, it is necessary to suggest that the ultimate influences on American business may be revolutionary. Since the retention of earnings for expansion or other corporate purposes may well be supplanted by various methods of new financing, particularly by the issuance of rights, corporations are by implication forced to put themselves under federal jurisdiction to a far greater degree than heretofore in regard to the reinvestment of their earnings. John Marshall said that the power to tax is the power to destroy. The Revenue Act of 1936 will tend to destroy the discretion which corporate directors formerly had in the formulation of their dividend policies.

  1. The author is vice president of the State Street Research & Management Corporation, Boston, Mass.
  2. By the issuance of rights