The dispute arose when more than 30 mutual life insurance companies became publicly traded corporations in the late 1990s and earlier this decade, in a process known as “demutualization.”

Mutual companies are owned by their policyholders, so the companies provided stock and cash to compensate them for the loss of their ownership interests when they went public.

All told, roughly 30 million policyholders received distributions, Ulrich estimates. MetLife Inc. provided over $7 billion of stock to about 11 million policyholders when it went public in 2000, while Prudential distributed $12.5 billion in stock to another 11 million.

The IRS held that the recipients hadn’t paid anything for the shares and owed taxes on the full amount when the shares were sold. Cash distributions also were fully taxable, the IRS said.

That didn’t sound right to Ulrich, 72, an accountant for 49 years. He began researching the issue in 2001, when he received shares from two companies, Prudential and Indianapolis Life.

Ulrich concluded that policyholders had paid for their ownership rights through their premiums so the distributions should have been tax-free.

Funny, a family member gave me some shares he inherited from Met Life’s demutualization just last night to help him with. The man is a hero in my book. The IRS’s position was illogical, but they often make calling them on such matters too burdensome for most to fight. Good for him.

Technorati Tags Charles Ulrich, demutualization, IRS, Life Insurance, MetLife, Taxes

Treasury and Justice Department officials say the protester ranks are growing and now include white-collar professionals. And they are costing the government millions of dollars.

“Too many people succumb to the fallacy, the illusion, that you don’t have to pay any tax under any set of conditions,” Assistant Attorney General Nathan Hochman told Bloomberg. “That is a growing problem.”

The movement has been energized by the Snipes trial:

According to the Bloomberg report, in addition to the Snipes verdict in which he was cleared of tax conspiracy charges, the tax protester movement has been given a boost by the faltering economy and politicians’ vilification of the Internal Revenue Service.

And, no surprise here, the promotion of “kooky” avoidance plans has been aided by the Internet, where many firms sell strategies online and believers encourage others to join the anti-tax efforts.

“Any kooky tax protester can put up their theories,” said Jonathan R. Siegel, a professor at George Washington University’s law school. “It is much easier to get their message before a mass audience.”

You can read the full Bloomberg story on the coming tax enforcement activities here.

You also should check out Siegel’s collection of tax protester myths here.

And the official U.S. word on such efforts can be found at this special Web page dedicated to debunking frivolous tax arguments.

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Technorati Tags IRS, tax deniers, tax policy, tax protesters, Taxes, Wesley Snipes

So what should investors, especially those of us allocating across asset classes rather than picking individual stocks, think about claims that share buybacks are a big positive:

• Announcements do seem to be a short term positive, because investors and many in the media believe they are important, but long term many never occur! Hence the article I linked to. Pumping up the attractiveness of the stock market based on announcements ignore this fundamental problem.
• Share repurchase programs are often a shell game. Generally new share issuance exceeds repurchases. The repurchase plans are announced to great fanfare, the issues of stock, and options on stock, are quietly distributed. While for any one company that may not be true, for the market as a whole it is. Let us quote Bill Bernstein and Rob Arnott :

[M]any investors believed that stock buybacks would permit earnings to grow faster than GDP. The important metric is not the volume of buybacks, however, but net buybacks-stock buybacks less new share issuance, whether in existing enterprises or through IPOs. We demonstrate, using two methodologies, that during the 20th century, new share issuance in many nations almost always exceeded stock buybacks by an average of 2 percent or more a year.

[...]

Investors were told the following:

[...]

When earnings are not distributed as dividends and not reinvested into stellar growth opportunities, they are distributed back to shareholders in the form of stock buybacks, which are a vastly preferable way of distributing company resources to the shareholders from a tax perspective. True, except that over the long term, net buybacks (that is, buybacks minus new issuance and options) have been reliably negative.

Why does this happen?

• Amongst other factors there is this. In research conducted by the Center for Financial Research & Analysis and the Corporate Library a disturbing, if predictable, pattern was noticed. They looked for companies with share repurchase programs while basing compensation of executives on earnings per share. Not earnings overall, but per share. They also wanted to see how many of these companies had negative cash flows over the two previous years. How many were in the S&P 500? 78. Worse, none of this was disclosed in their proxies. Warren Buffet described this practice in his usual witty style in 2005 (pdf .).
• Management also often conducts stock repurchase programs while busily selling their own stock.
• Repurchases only make sense if that is the best alternative for the cash used. When is that? – Only if the shares are undervalued. If not we should want the dividend. The unfortunate truth is that companies generally buy their shares back when they are going higher and on a run. Historically they have done a poor job of making that key investment decision. Recent history is instructive, buybacks kept picking up steam even as this current correction was approaching. Momentum investing is fine if that is what you want to do, but you hardly need management to do it for you.
• The announcements often are accompanied by a bump in the price, causing the company to pay a higher price than otherwise.
• The sheer size of the buyback programs can move the market, destroying some of the value.
• Of course management which profits from stock options often doesn’t care. They want per share appreciation, the options don’t qualify for dividends.
• Much of the recent binge of repurchase plans was carried out through debt. When this is done the entire effect is really one of leverage. The proper amount of leverage on the balance sheet is certainly open to discussion, but let us always be aware that leverage increases potential gains and losses. Higher risk should therefore mean a lower multiple on those earnings as well, diluting the expected boost to the stock. Given this leverage is often diluted by the factors above, but the cost of servicing that debt remains, we are left with reason to question repurchases as a productive strategy even more. If things get tight companies may need that cash. Dividends can be cut, cash can be drawn down, but the interest cost of that debt may remain.
• But Buffett likes them! If Warren is on my board and has real power I have some faith in the decision on whether dividends, stock buybacks, or reinvesting cash flows makes sense. Generally I have far less faith in management or boards. He seems to feel the same way. Dividends don’t provide shares to send out the back door as compensation. Repurchases do.

Stock repurchases can be a good thing for an individual company, so can leverage, but we are asset allocators, and the total level of stock repurchases tells us nothing about whether that is a wise use of our capital of a diversified selection of stocks. In aggregate it should makes no difference to the value of an index. John Hussman explains that well here .

While there are tax benefits, given the issues surrounding them in practice, an explosion of repurchases as we saw in 1999 and this year, is a bad sign, not a good one. It shows irrational exuberance and carelessness with capital.

Even if it did not, it is certainly no positive to be preferred above paying a dividend or reinvesting cash flows. In aggregate the value of the companies stays the same. It can only increase returns (leaving aside taxes) by increasing leverage with all the risk that entails.

Update: I received some feedback from a couple of people, good friends Tim Randolph and Dale Franks. Both feel the agency feels the agency problem I discuss above is a major contributor. Here is an excerpt from Dale’s e-mail:

Once tax law shifted compensation from direct salary to stock options and other incentive types of pay, it really served to do little more than magnify the agency problem., i.e., executives gaming the agency relationship between managers and owners for thier own profit. I think repurchase programs are often little more than back door for executive to increase their compensation based on EPS.

At every step of the way since moving away from direct compensation, we’ve seen increasing agency problems, and corporate boards have just been abysmal at reigning in executives. Allowing executives to actually sit on the board–or practically as bad, nominate board members of their choosing–has resulted in all sorts of corporate governance failures.

I’d actually be interested now in looking at some research on the timing of repurchase programs and following re-issuance, because I suspect that a signifigant fraction of repurchases are nothing more than a scheme to puff up EPS–and perhaps stock prices–in the short term, then pay off the repurchases through a re-issue. But, to my mind, that only seems to work reliably if the stock price rises or at least remains stable betwen repo and reissue. If it doesn’t, then you either lose cash, increase debt, or issue new shares at a rate that’s dilutive.

In short, it’s the kind of thing you can do in a bull market without anyone noticing, but which becomes very noticeable in a bear market.

The thing is, if you do it through leverage, while it does bad things to your debt ratio, most investors just aren’t geeks enough to run your debt ratio, quick ratio, inventory turnover ratio, etc., etc. So, the risk isn’t as obvious. But most investors are least attentive enough to notice if you cut the dividend yield from 3% to 1%. They notice that real quick.

Tim posited that it was also a way for some executives to load the company up with debt, increase compensation and make them less attractive for LBO’s. Dale is skeptical. I’ll put it in the hopper as one issue.

Dale throws in that he is planning on posting some of his work on corporate governance reform. Looking forward to it.

Thanks to Abnormal Returns and Barry Ritholtz for linking! While you are here check out the Harley Report, worries about the unseen frauds, our collection of recommended links and musings about them, or the various odds and ends about Baton Rouge, LSU, history and other topics scattered around.

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Technorati Tags Asset Allocation, Buybacks, dilution, dividends, investing, management, repurchases, research, Risk, stock options, stocks, Taxes

Suppose that every day, ten men go out for beer and the bill for all ten comes to $100. If they paid their bill the way we pay our taxes, it would go something like this:

The first four men (the poorest) would pay nothing.
The fifth would pay $1.
The sixth would pay $3.
The seventh would pay $7.
The eighth would pay $12.
The ninth would pay $18.
The tenth man (the richest) would pay $59.
So, that’s what they decided to do.

The ten men drank in the bar every day and seemed quite happy with the arrangement, until one day, the owner threw them a curve. “Since you are all such good customers,” he said, “I’m going to reduce the cost of your daily beer by $20.” Drinks for the ten now cost just $80.

The group still wanted to pay their bill the way we pay our taxes so the first four men were unaffected. They would still drink for free. But what about the other six men – the paying customers? How could they divide the $20 windfall so that everyone would get his ‘fair share?’ They realized that $20 divided by six is $3.33. But if they subtracted that from everybody’s share, then the fifth man and the sixth man would each end up being paid to drink his beer. So, the bar owner suggested that it would be fair to reduce each man’s bill by roughly the same amount, and he proceeded to work out the amounts each should pay. And so:

The fifth man, like the first four, now paid nothing (100% savings).
The sixth now paid $2 instead of $3 (33%savings).
The seventh now pay $5 instead of $7 (28%savings).
The eighth now paid $9 instead of $12 (25% savings).
The ninth now paid $14 instead of $18 (22% savings).
The tenth now paid $49 instead of $59 (16% savings).

Each of the six was better off than before. And the first four continued to drink for free. But once outside the restaurant, the men began to compare their savings.

“I only got a dollar out of the $20,” declared the sixth man. He pointed to the tenth man,” but he got $10!”

“Yeah, that’s right,” exclaimed the fifth man. “I only saved a dollar, too. It’s unfair that he got ten times more than I!”

“That’s true!” shouted the seventh man. “Why should he get $10 back when I got only two? The wealthy get all the breaks!”

“Wait a minute,” yelled the first four men in unison. “We didn’t get anything at all. The system exploits the poor!”

The nine men surrounded the tenth and beat him up.

The next night the tenth man didn’t show up for drinks, so the nine sat down and had beers without him. But when it came time to pay the bill, they discovered something important. They didn’t have enough money between all of them for even half of the bill!

And that, boys and girls, journalists and college professors, is how our tax system works. The people who pay the highest taxes get the most benefit from a tax reduction. Tax them too much, attack them for being wealthy, and they just may not show up anymore. In fact, they might start drinking overseas where the atmosphere is somewhat friendlier.

This is an old one, which I have read before, but I can’t remember where. Authorship is unknown at this point, hopefully Jonathan Chait won’t lambaste me as he did Bill Buckley.

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Technorati Tags beer, Economics, government, Humor, Taxes, Wealth