What Is a Capital Dividend?
A capital dividend, also called a return of capital, is a payment that a company makes to its investors that is drawn from its paid-in-capital or shareholders' equity.
Regular dividends, by contrast, are paid from the company's earnings. A company generally will only pay a capital dividend when its earnings are insufficient to cover a required dividend payment, possibly indicating that a company is in trouble as its business operations are not generating a significant amount of earnings or any earnings at all.
Key Takeaways
- A capital dividend is a type of dividend that is drawn from a company's capital base, as opposed to its retained earnings.
- Regular dividends are paid from earnings, representing a share of the profits, and are a sign of good financial health as the company has the ability to distribute additional earnings.
- Capital dividends are often seen as a signal that a company lacks spare cash to pay dividends, indicating possible financial trouble.
- Companies that pay dividends and that are struggling financially sometimes have the option of stopping dividends until their finances are back on track.
- Capital dividends are not taxed as they are seen as a return of a portion of the money that investors paid when they bought shares.
Understanding a Capital Dividend
Payment of capital dividends is seen as a warning sign that a company is struggling to generate earnings and free cash flow. In fact, by paying out dividends from its retained earnings, the company may be exacerbating its troubles by shrinking its capital base and limiting its future investment and business opportunities. Dividends are only meant to be paid when a company is on a strong financial footing.
On the plus side, a capital dividend is typically not taxable for the shareholder who receives it in the U.S. and Canada. It is viewed as a return of a portion of the money that investors paid in when they bought shares. In fact, a capital dividend payment reduces the adjusted cost basis of the stock when it is reported to the IRS.
A capital dividend can also refer to a dividend paid through the sale of an appreciating asset, which is more often a term used in Canada. For example, if a company sells an asset that has appreciated, it would have to pay capital gains tax. The amount that is not taxed is placed into a capital dividend account from which shareholders are paid a capital dividend.
Capital dividends are drawn from a company’s shareholders' equity, which is a firm's total assets minus its total liabilities.
Shareholders' equity represents a company’s net value. If all the company's assets were liquidated and all its debts were repaid, shareholders’ equity would be the amount that would be returned to shareholders.
Capital Dividend vs. Regular Dividend
Traditional dividends are considered a share of a company's profits but they may be issued as cash payments, additional shares of stock, or another form of property.
A company’s board of directors decides on the type of payout, the amount of the payout, and the timing of it, generally monthly or quarterly. The board may also distribute special dividends separately or together with a regularly scheduled dividend.
Dividends are a form of profit-sharing and a reward for a shareholder purchasing a stake in the company. A dividend payment usually indicates that a company is well established and is generating consistent free cash flow.
Startup companies and high-growth companies rarely offer dividends, preferring instead to put any profits back into research and development to continue that growth. In fact, startups, particularly in the technology sector, often report losses in their early years and are not able to pay out dividends.
Dividend Payers
In contrast, larger and better-established companies that enjoy consistent and predictable profits often pay the best dividends, such as 3M (MMM) and Coca-Cola (KO). The dividends are an incentive for investors to buy and hold their shares since their stocks are rarely big gainers (or big losers) in the markets.
Investors that choose stocks that pay dividends are typically pursuing a dividend investing strategy as opposed to a growth strategy. Historically, these dividend payers are found in sectors including utilities, basic materials, oil and gas, financials, healthcare, and pharmaceuticals. Many blue-chip companies pay dividends and witness little stock appreciation.
Master limited partnerships (MLPs) and real estate investment trusts (REITs) are also top dividend payers.
FAQs
A capital dividend is a type of dividend that is drawn from a company's capital base, as opposed to its retained earnings. Regular dividends are paid from earnings, representing a share of the profits, and are a sign of good financial health as the company has the ability to distribute additional earnings.
What is the difference between a capital dividend and a regular dividend? ›
A capital dividend is a type of payment a firm makes to its shareholders. The payment is taken out from paid-in capital, and not from the company's retained earnings as is the case with regular dividends.
What is the difference between capital dividend and eligible dividend? ›
When a shareholder receives a capital dividend they are not taxed on it. Eligible dividends are grossed up by 38% and non-eligible dividends are grossed up by 10%. Devinder took a tax class and is now pretty much a tax expert.
What is the difference between a dividend and a capital distribution? ›
A mutual fund dividend is income earned by the fund from dividends and interest paid by the fund's holdings. A capital gain distribution occurs when the fund sells assets during the year and the gains on those sales exceed the losses.
What is the difference between a dividend and a capital payment? ›
Dividend income is given to shareholders according to the company's policies. It can be on a periodical basis, such as manually, quarter, monthly, or annually. Meanwhile, capital gains are received after selling long-term assets at a higher price.
What is meant by capital dividend? ›
What Is A Capital Dividend? A capital dividend is a dividend that a company pays its investors out of shareholders' equity or paid-up capital. It gives a company's existing investors a second chance to collect dividends even if the organization is not generating enough profits. Thus, it serves as a safety net.
How do I avoid paying tax on dividends? ›
You would not owe tax on dividends from stocks held in a retirement account, such as a Roth IRA or 401(k), or a college savings plan, such as a 529 plan or Coverdell ESA. There are exceptions to this tax immunity, though.
How are capital dividends taxed? ›
Taxes must be withheld under Part XIII of the Income Tax Act if a capital dividend is paid to a non-resident shareholder. A 75% penalty tax is imposed under Income Tax Act, section 184(2), if a capital dividend is paid that is more than the CDA.
What are the different types of dividends for tax purposes? ›
For tax purposes, there are two kinds of dividends: qualified and nonqualified (sometimes called "ordinary").
What are the tax types for dividends? ›
Key Takeaways
Qualified dividends must meet special requirements issued by the IRS. The maximum tax rate for qualified dividends is 20%, with a few exceptions for real estate, art, or small business stock. Ordinary dividends are taxed at income tax rates, which as of the 2023 tax year, maxes out at 37%.
Qualified dividends are taxed at the same rates as long-term capital gains. Long-term (held more than one year) capital gains distributions are taxed at long-term capital gains tax rates; distributions of short-term (held one year or less) capital gains are taxed at the same rates as ordinary income.
Is capital distribution taxable? ›
Long-term capital gain distributions are taxed at long-term capital gains tax rates; distributions from short-term capital gains and net investment income (interest and dividends) are taxed as dividends at ordinary income tax rates. Ordinary income tax rates generally are higher than long-term capital gains tax rates.
Are dividends taxed differently than capital gains? ›
Capital gains and dividends are taxed differently. Dividends are going to be either ordinary or qualified and taxed accordingly. However, capital gains are taxed based on whether they are seen as short-term or long-term holdings.
What is an example of a capital dividend? ›
To provide a clearer understanding of the Capital Dividend Account, let's consider an example. Suppose a private corporation realizes a capital gain of $200,000 from the sale of an asset. Half of this amount, or $100,000, would be taxable income for the corporation, while the remaining $100,000 would be tax-free.
Are dividends taxed as ordinary income? ›
Ordinary dividends are taxed using the ordinary income tax brackets for tax year 2023. Qualified dividend taxes are usually calculated using the capital gains tax rates.
Is return of capital dividend taxable? ›
Return of capital distributions aren't taxable, but they can have tax implications because they might produce additional realized capital gains.
Why would a company pay a special dividend vs a regular dividend? ›
The special dividend, also known as extra or non-recurring dividends, refers to the declaration and distribution of an amount in addition to the regular dividend and is usually given when the company receives a large windfall from asset sales or other one-time events.
What is the difference between types of dividend? ›
Unlike regular dividends that are paid out of a company's profits, liquidating dividends are paid from the company's remaining assets after all debts and liabilities have been settled. It's important to note that liquidating dividends is typically subject to specific legal and regulatory requirements.
Are there different types of dividends? ›
A company can share a portion of its profits with four different types of dividends. Your monthly brokerage statement might show a CASH dividend, a STOCK dividend, a HYBRID dividend or a PROPERTY dividend.
