How the Inflation Reduction Act's Stock Buyback Tax Could Rattle Portfolios

Some critics worry that discouraging stock buybacks could exacerbate the pains many are feeling amid shaky markets.

Publicly traded corporations often use a stock buyback strategy when they believe that their shares are undervalued. To increase value, they buy their own corporate shares to decrease the number of shares that are available on the market, thus concentrating the value of the remaining shares that are publicly available.

The Inflation Reduction Act contains a new provision that would discourage stock buybacks by imposing a new tax on such transactions. While the provision only applies to large publicly traded companies, the impact on individual investors shouldn’t be overlooked. Discouraging stock buybacks can have a wider impact, further exacerbating the pains felt by investment portfolios that are already in a slump due to today’s shaky market conditions.

Stock Buyback Excise Tax: The Basics

The Inflation Reduction Act of 2022 added a new 1% excise tax on stock buybacks. The tax is imposed on the fair market value of stock that a covered corporation purchases in any given year, less the value of any stock that was issued by the same corporation that year.

The tax only applies to the fair market value of stock repurchased by “covered corporations,” which include domestic corporations whose stock is publicly traded on an established securities market. The tax also applies in cases where a corporation purchases stock of an affiliate (defined as a corporation if more than 50% of its stock is held, directly or indirectly, by the purchasing corporation).

As the law is written, the excise tax would apply broadly to all types of stock that a covered corporation has issued. The new law also allows the Treasury Department to impose the stock buyback excise tax on transactions that are substantially similar to stock buyback transactions.

Exceptions to the New Rule

Not all transactions trigger the new stock buyback tax. The excise tax does not apply if the repurchase is part of a reorganization and no gain or loss on the stock repurchase is recognized. It also does not apply in situations where the repurchased stock is contributed to an employer-sponsored retirement plan, employee stock ownership plan (ESOP) or similar plan (or if an amount of stock equal to the value of the stock repurchased is contributed to such a plan).

Under the law, the following transactions are also exempt:

Impact on Everyday Investors

As an initial matter, stock buybacks have the impact of returning cash that a publicly traded corporation has on hand to investors in the public markets. It also gives corporations a way to use cash in a way that is most efficient in terms of returning value to existing shareholders.

Some also argue that stock buybacks are a more tax-efficient alternative to paying dividends to shareholders — although shareholders will eventually have to pay capital gains taxes on the appreciation in value caused by the buyback.

It’s now possible that more companies will choose to pay special dividends, which may not have the same tax deferral value to investors as stock buybacks.

Conclusion

The full impact of the new stock buyback is still unknown. It will depend largely on whether — and how — large publicly traded corporations change their behavior in response to the tax. However, individual investors should not overlook the potential impact on their portfolios as we watch to see whether this tax causes corporate behaviors to shift away from stock buybacks.

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