Dividends are payments made by a corporation to one or more of its shareholders with respect to its stock. It is the portion of corporate profits paid out to stockholders. The distribution by the corporation must be in the ordinary course of the corporation’s business. A dividend is a taxable income. The dividend is most often referred to in terms of the dollar amount each share receives (dividends per share). It can also be quoted in terms of a percent of the current market price, referred to as dividend yield.
Normally, dividends are how owners of the company receive income from their ownership. In those private corporations in which the owners are also employees or officers, quite often much of the income of the company is paid out in salary, fringes and bonuses to the owner-employees. If one is neither an officer nor employee of a company, the only way the company can pay out sums to you is if dividends are declared or the company sold and the proceeds of sale paid to the owners.
This article shall briefly describe the types of dividends, the tax treatment of same, and some practical considerations to keep in mind if one buys into a company hoping for regular payment of dividends.
The Basics of Dividends:
Dividends are usually settled on a cash basis, store credits and shares in the company (either newly-created shares or existing shares bought in the market.) Moreover, many public companies offer dividend reinvestment plans, which automatically use the cash dividend to purchase additional shares for the shareholder. Generally, the more secure and stable companies offer dividends to their stockholders. Their share prices might not move much, but the dividend attempts to make up for this. High-growth companies rarely offer dividends because all of their profits are reinvested to help sustain the higher-than-average growth.
Regular cash dividends are those paid out of a company’s profits to the shareholders. A property dividend is when a company distributes property to shareholders instead of cash or stock. Property dividends can literally take the form of railroad cars, cocoa beans, pencils, gold, silver, salad dressing or any other item with tangible value. Property dividends are recorded at market value on the declaration date.
In addition to cash dividends and property dividends, there are times a company may pay a special one-time dividend. A special onetime dividend can take the form of cash, stock, or property dividends. These payments are not a payout of the company’s profits but instead a return of money which shareholders have invested in the business.
A stock dividend is a pro-rata distribution of additional shares of a company’s stock to owners of the common stock. A company may opt for stock dividends for a number of reasons including inadequate cash on hand or a desire to lower the price of the stock on a per-share basis to prompt more trading and increase liquidity.
Mutual funds pay out interest and dividend income received from their portfolio holdings as dividends to fund shareholders. In addition, realized capital gains from the portfolio’s trading activities are generally paid out (capital gains distribution) as a year-end dividend.
Taxation of Dividends:
The term dividend means any distribution of property made by a corporation to its shareholders out of its earnings and profits of the taxable year, without regard to the amount of the earnings and profits at the time the distribution was made. 26 USCS § 316 (a)
Dividends are taxable income. But not all distributions from a corporation to its shareholders are dividends. For taxation, of corporate distributions that portion of the distribution which is a dividend is included in gross income. 26 USCS § 301. Gross income means all income from whatever source derived. 26 USCS § 61. Pursuant to 26 USCS § 61, gross income includes dividend.
Corporate earnings may constitute a dividend even if the formalities of a dividend declaration are not observed, the distribution is not recorded on the corporate books as such, it is not in proportion to stockholdings, or even that some of the stockholders do not participate in its benefits. Paramount-Richards Theatres, Inc. v. Commissioner, 153 F.2d 602 (5th Cir. La. 1946).
Pursuant to 26 USCS § 301, the amount of dividend is the sum of the amount of money received and the fair market value (FMV) of the other property received, reduced (but not below zero) by (a) the amount of any liability of the corporation assumed by the shareholder in connection with the dividend distribution, and by (b) the amount of any liability to which the property distributed is subject.
When a shareholder receives a distribution of property from a corporation with respect to its stock, the portion of the distribution that’s a dividend is included in the shareholder’s income.
Dividends are taxable to the person who has the right to receive them. If a dividend is paid after stock is sold, whether the buyer or seller includes the dividend in gross income depends on when the sale took place.
A shareholder generally is taxed on a dividend in the year it is unqualifiedly made subject to his demand. Thus, dividends are taxable income for the year received or unqualifiedly made subject to the shareholder’s demand.
Dividends are distributions of corporate earnings and can be paid on both common and preferred stock. There are two types of dividends: ordinary dividends and qualified dividends. The most common types of corporate distributions are ordinary dividends, capital gain distributions, and non dividend distributions. It is to be noted that stock dividend distributions, liquidating distributions, reorganization exchanges, and corporate distribution are treated as:
- the portion of a distribution that is a dividend is included in gross income 26 USCS § 301(c)(1);
- the portion of a distribution that is not a dividend is applied and reduces against the stockholder’s adjusted basis in the stock 26 USCS § 301(c)(2);
- If a portion of a distribution that is not a dividend has reduced the stockholder’s adjusted basis in his stock to zero, then any remaining excess over the adjusted basis is treated as a capital gain;
- That portion of the distribution which is not a dividend, to the extent that it exceeds the adjusted basis of the stock and to the extent that it is out of an increase in value accrued before the date prescribed by the statute, will be exempted from tax. 26 USCS § 301(c)(3)
If any distribution made by a corporation to its shareholders is not out of an increase in value of property accrued before the specified date and is not a dividend, then the amount of such a distribution will be applied against and reduce the adjusted basis of the stock. If there is any excess of such basis, such excess will be taxable in the same manner as a gain from the sale or exchange of property. Koshland v. Commissioner, 1943 Tax Ct. Memo LEXIS 65 (T.C. 1943)
Dividend income from stocks and mutual funds are reported on taxes. Generally, one can use either Form 1040 or Form 1040A to report the dividend income. Ordinary dividends are reported on Form 1040 Line 9a. Some dividends qualify for reduced tax rates and these are called Qualified Dividends. These dividends are reported on Form 1040 Line 9b. Form 1040, line 9b(2009) p.22
Individual taxpayers generally use either Form 1040 or Form 1040A to report dividend income. However, Form 1040 must be used if the taxpayer is reporting qualified dividend income or receives a nontaxable distribution required to be reported as capital gains. Form 1040A (2009) p 12 (Instructions)
Constructive or Disguised Dividends:
A constructive dividend is an undeclared dividend by the Corporation’s Board of Directors. It can be defined as any payment to a shareholder which is not classified as a dividend by the company. These payments are considered dividend and are taxable. For instance, when a company rents its offices from a shareholder and pays in excess of the office’s fair market value, the company’ s rent is considered a constructive dividend. As a result, rent becomes a taxable expense and the company cannot write off the rent. Borrowed funds, lease payments, rental payments, or the personal use of corporate assets of a shareholder is characterized as a constructive dividend.
It is well established that when a corporation uses its funds to pay personal expenses of its shareholders or members of shareholder’s families, which bear no relation to the economic interests of the corporation, such payments constitute constructive dividends to the shareholders to the extent of earnings and profits. To constitute a constructive dividend, a corporate distribution to a shareholder must be both nondeductible to the corporation and must confer some economic benefit or gain to the shareholder. Each corporate expenditure conferring an economic benefit to the shareholder is not a constructive dividend. The deciding factor is if the expenditure was primarily for the shareholder’s benefit and there was no expectation of repayment. NOBLE v. COMMISSIONER, T.C. Summary Opinion 2002-68 (T.C. 2002)
When a corporation confers an economic benefit upon a shareholder, in his or her capacity as such, without an expectation of reimbursement, that economic benefit becomes a constructive dividend, taxable to the respective shareholder. This benefit is taxable to the shareholder whether or not the corporation intended to confer a benefit upon him. Loftin & Woodard, Inc. v. United States, 577 F.2d 1206 (5th Cir. La. 1978)
Note that the tax ramifications can be serious to the company. A corporation cannot take a deduction for the constructive dividend and the shareholder must report the amount of the constructive dividend on his or her tax return. The constructive dividend is usually an adjustment made by an IRS Revenue Agent during an audit of a C Corporation. This term used by the IRS will re-characterize an item that has been deducted on the corporate tax return to a non-deductible dividend. In other words, constructive dividends are “double-taxed”, first at the corporate level and again at the shareholder level. This is because the item is non-deductible on the Corporation Tax return and then included on the recipient or shareholder’s individual tax return as taxable dividend income.
Excessive Compensation and Dividends:
26 CFR 1.162-7 provides that among the ordinary and necessary expenses paid or incurred in carrying on any trade or business is a reasonable allowance for salaries or other compensation for personal services actually rendered, which may be allowed as a deduction. Nevertheless, the Internal Revenue Service (IRS) has systematically interpreted the “reasonable allowance” provision to apply only to closely held corporations, effectively concluding that a publicly held corporation can deduct an unlimited amount of executive compensation.
Pursuant to 26 CFR 1.162-8, in the case of ostensible payments by corporations, if such payments correspond or bear a close relationship to stock holdings and are found to be a distribution of earnings or profits, the excessive payments will be treated as a dividend. It further provides that in the absence of evidence to justify other treatment, excessive payments for salaries or other compensation for personal services will be included in the gross income of the recipient. The income tax liability of a recipient of an amount excessively paid as compensation, but not allowed to be deducted as such by the payor, will depend upon the circumstances of each case.
However, there are many debates on the IRS’s misapplication of Section 162(1)(a) and to render such compensation nondeductible since the IRS allows publicly traded businesses to deduct an unlimited amount of executive compensation for corporate tax purposes. In contrast, IRS frequently applies Section 162(1)(a) to limit corporate deductions for executive compensation paid by closely held corporations.
Poison Pills and Hostile Take Overs via Distribution of Stock Dividends:
Rev Rul 90-11, 1990-1 CB 10 provides that when a publicly held corporation adopts a plan providing shareholders with rights to buy additional stock at less than fair market value to head off any unsolicited take-over attempt, it is termed a “poison pill” plan. Generally, a poison pill is a type of financial or structural maneuver that a company may make to frustrate an attempted takeover by a hostile bidder. An acquiring company will abandon its takeover and allow the target company to remain independent, if the poison pill is effective.
Poison pills have existed in various forms for many decades. They were viewed merely as anomalies in corporate finance. Poison pills typically discourage hostile takeovers by letting companies sell large amounts of stock to existing shareholders at cheap prices. The hostile bidder is not allowed to purchase any of the new stock. His/her holdings in the takeover target become diluted and are worth less.
The most common type of poison pill is the shareholder rights, or “flip-over” plan. It allows a company facing an unwelcome bid to declare a special stock dividend consisting of rights to purchase additional, new shares. In order to make a suitor company spend substantially more to acquire control, the price to these rights is purposely set far above market value. The company may redeem the rights after the bid has been abandoned.
The shareholder rights may be transferred or “flipped over” to the successor firm, if the takeover bid is successful. These rights entitle the shareholders to purchase shares in the surviving firm at a discount of as much as 50 percent. This causes tremendous dilution of the surviving firm.
The “flip-in” plan is a variation of the flip-over plan. It hastens the exit of a suitor with a substantial minority of shares, without affecting a merger. The flip-in offers the company rights to buy additional discounted shares in the target.
Poison pill plans enable a company to thwart everyone except the most determined and deep-pocketed suitors. It allows shareholders to benefit greatly if the suitor succeeds. Moreover, no poison pill or any other type of defense is ever meant to be used. Poison pills indicate to the financial community that the companies using them suffer from some financial or structural weakness and are ready for some form of merger.
Another type of poison pill is “dead hand” poison pill. Dead-hand poison pills can be redeemed only by the incumbent board of directors. Such a plan is designed to keep the existing board and current management in place, at the expense of existing shareholders or in opposition to a majority of shareholders. It eliminates shareholders’ ability to act by written consent. A variation on the dead-hand poison pill is the no-hand poison pill. It cannot be altered for at least one year or some specified time.
No Right to Dividends on Non Public Corporations in California:
A common misconception is that ownership of stock in a closed or private corporation in California entitles one automatically to dividends being declared by the Board. In reality, via salaries and bonuses to employees and officers and creation of a large reserve for the Corporation, it is quite easy for a Board of Directors to avoid paying all or most profits out in dividends to an unfriendly shareholder. See our article Who Has Power When Push Comes to Shove in a California Corporation. Courts will seldom substitute their judgment for the Board in determining appropriate salary or bonus to employees. A claim of excessive salary or constructive dividend can be advanced as described above, but such struggles are an uphill road for the disgruntled shareholder.
A typical “corporate fight” sees a majority shareholder obtaining control of the Board of Directors, electing said shareholder as President, then declaring sizable bonuses and salaries and only token dividends. The minority owner may claim breach of fiduciary duty, but it is a difficult case to prove. The protections that the minority shareholder must seek require advanced planning in most circumstances via employment agreements and requirements for supermajority voting in certain decisions, beyond the scope of this article. What is important to grasp is that the average minority shareholder should not assume that dividends will automatically be paid.
There is one right as to dividends in such corporations that exists in California, however. If a dividend is declared for any shareholder, it must be paid in proportionate amount to all shareholders. (This is not always true for different classes of stock, note.)
In public companies, dividends are the central source of income to owners of stock until a sale occurs. In private companies, salaries and bonuses become the central method of receiving income since most owners work in the company. Those owners not working in the privately held company need to carefully structure the ownership method so as to avoid owning stock with small dividends and to obtain appropriate tax and legal planning before investing. If they find themselves already owning such stock which fails to generate appropriate income, there may be some relief available but it will not be an easy task and they should carefully consider the cost benefit of litigation in such instances.