Types of dividends and return of capital

What a company can hand over

A dividend is a distribution of a corporation’s earnings and profits to its shareholders, and it is the most common kind of distribution a corporation makes. The board decides whether to pay one at all: unlike a bond’s interest, nothing obliges a company to distribute anything, which is the structural difference between owning a company and lending to one.

Most dividends are paid in cash, and that is the case the exam usually describes. But cash is not the only form. A corporation may pay a dividend in the stock of another corporation — a holding it owns and hands out rather than sells — or in any other property. A property dividend is rare in practice and common in questions, because it tests whether a candidate has learned the definition or only the usual case.

A distribution of the corporation’s own stock is different in kind, and it is called a stock dividend. Nothing leaves the company. The same claim on the same earnings is simply cut into more pieces, so a holder ends up with more shares that are each worth less. That is why a stock dividend is generally not taxable when it is received: no value has been transferred, so there is nothing to tax yet.

The tax consequence lands later, through basis. If the stock dividend is not taxable, the holder divides the basis of the old stock across the old and the new shares together. The total basis does not change; the basis per share falls. When the shares are eventually sold, the gain is measured against that lower per-share figure, which is where the tax that was deferred finally appears.

Cash dividends are taxed when received, and they fall into two classes. Ordinary dividends are included in ordinary income. Qualified dividends are those that qualify to be taxed at the lower capital gain rates, and the payer must identify which of the ordinary dividends are also qualified when it reports them. A holder sees the split on Form 1099-DIV, which a payer sends for distributions of at least $10.

A return of capital is different: it is not a dividend and is not taxed when received while the investor still has basis. It reduces adjusted basis dollar for dollar. If basis reaches zero, any further nondividend distribution is a taxable capital gain. This is a return component named in the SIE outline; the question here is the basic distinction, not detailed tax reporting.

Exam terms

Dividend

A distribution of a corporation’s earnings and profits to its shareholders.

Cash dividend

The usual form: money paid out to the holders on the record list.

Stock dividend

A distribution by a corporation of its own stock, generally not taxable when received.

Property dividend

A dividend paid in the stock of another corporation or in any other property.

Ordinary dividend

A dividend included in ordinary income.

Qualified dividend

A dividend that qualifies to be taxed at the lower capital gain rates.

Form 1099-DIV

The form a payer sends for distributions of at least $10, identifying which dividends are qualified.

Worked example

A holder owns one share bought for $45, and the corporation distributes two new shares for each share held.

1. The distribution is of the corporation’s own stock, so it is a stock dividend rather than a cash or property dividend.
2. It is generally not taxable on receipt, so the holder reports nothing for it this year.
3. The holder now has three shares: the original one and the two distributed on it.
4. The basis of the old stock is divided across all three, so $45 ÷ 3 gives a basis of $15 in each share.
5. Total basis is still $45 and the holding is worth what it was; what has changed is that any future gain will be measured against $15 a share rather than $45.

Check yourself

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Same rule, new context

Related practice

• Total return componentsPractice this