"Money For Nothing" is not only the title of a song by Dire Straits in the '80s, but also the feeling many investors get when they receive a dividend. All you have to do is buy shares in the right company and you'll receive some of its earnings. How exciting is that? However, despite the advantage, there are several implications involved in the paying and receiving of dividends that the casual investor may not be aware of. This article will explain several of these. But first, let's begin with a short primer.

What Are Dividends?
Dividends are one way in which companies "share the wealth" generated by running the business. They are usually a cash payment, often drawn from earnings, paid to the investors in a company - the shareholders. These are paid on an annual or, more commonly, a quarterly basis. The companies that pay them are usually more stable and established, not "fast growers". Those still in the rapid growth phase of their life cycle tend to retain all the earnings and reinvest them into the business. (For more details, see How Dividends Work For Investors and The Importance of Dividends.)

Price Implications
When a dividend is paid, several things can happen. The first of these is what happens to the price of the security and various items tied to it. On the ex-dividend date, the stock price is adjusted downward by the amount of the dividend by the exchange on which the stock trades. For most dividends this is usually not observed amidst the up and down movement of a normal day's trading. However, this becomes easily apparent on the ex-dividend dates for larger dividends, such as the $3 payment made by Microsoft in the fall of 2004, which caused shares to fall from $29.97 to $27.34. (To read more, see Declaration, Ex-Dividend and Record Date Defined and Why don't investors buy stock just before the dividend date and then sell right afterward?)

The reason for the adjustment is that the amount paid out in dividends no longer belongs to the company and this is reflected by a reduction in the company's market cap. Instead, it belongs to the individual shareholders. For those purchasing shares after the ex-dividend date, they no longer have a claim to the dividend, so the exchange adjusts the price downward to reflect this fact.

Historical prices stored on some public websites, such as Yahoo! Finance, also adjust the past prices of the stock downward by the dividend amount. Another price that is usually adjusted downward is the purchase price for limit orders. Because the downward adjustment of the stock price might trigger the limit order, the exchange also adjusts outstanding limit orders. The investor can prevent this if his or her broker permits a do not reduce (DNR) limit order. Note, however, that not all exchanges make this adjustment. The U.S. exchanges do, but the Toronto Stock Exchange, for example, does not. (For related reading, check out The Basics Of Order Entry.)

On the other hand, stock option prices are usually not adjusted for ordinary cash dividends unless the dividend amount is 10% or more of the underlying value of the stock.
  
Watch: Dividend


Implications for Companies
Dividend payments, whether they are cash or stock, reduce retained earnings by the total amount of the dividend. In the case of a cash dividend, the money is transferred to a liability account called dividends payable. This liability is removed when the company actually makes the payment on the dividend payment date, usually a few weeks after the ex-dividend date. For instance, if the dividend was $0.025 per share and there are 100 million shares outstanding, retained earnings will be reduced by $2.5 million and that money eventually makes its way to the shareholders. (For more insight, see Retained Earnings: What Gets Kept Counts.)

In the case of a stock dividend, though, the amount removed from retained earnings is added to the equity account, common stock at par value, and brand new shares are issued to the shareholders. The value of each share's par value does not change. For instance, for a 10% stock dividend where the par value is 25 cents per share and there are 100 million shares outstanding, retained earnings is reduced by $2.5 million, common stock at par value is increased by that amount and the total number of shares outstanding increases to 110 million.

This is different from a stock split, although it looks the same from a shareholder's point of view. In a stock split, all the old shares are called in, new shares are issued, and the par value is reduced by the inverse of the ratio of the split. For instance, if instead of a 10% stock dividend, the above company declares an 11-to-10 stock split, the 100 million shares are called in and 110 million new shares are issued, each with a par value of $0.22727. This leaves the common stock at par value account's total unchanged. The retained earnings account is not reduced either. (To read more, check out Understanding Stock Splits.)

Implications for Investors
Cash dividends, the most common sort, are taxed at either the normal tax rate or at a reduced rate of 5% or 15% for U.S. investors. This only applies to dividends paid outside of a tax-advantaged account such as an IRA.

The dividing line between the normal tax rate and the reduced or "qualified" rate is how long the underlying security has been owned. According to the IRS, to qualify for the reduced rate, an investor has to have owned the stock for 60 consecutive days within the 121-day window centered on the ex-dividend date. Note, however, that the purchase date does not count toward the 60-day total.

Cash dividends do not reduce the basis of the stock. (To read more, see How do I figure out my cost basis on a stock investment?)

  
Watch: Dividend Yields
Capital Gains
Sometimes, especially in the case of a special, large dividend, part of the dividend is actually declared by the company to be a return of capital. In this case, instead of being taxed at the time of distribution, the return of capital is used to reduce the basis of the stock, making for a larger capital gain down the road, assuming the selling price is higher than the basis. For instance, if you buy shares with a basis of $10 each and you get a $1 special dividend, $0.55 of which is return of capital, the taxable dividend is $0.45, the new basis is $9.45 and you will pay capital gains tax on that $0.55 when you sell your shares sometime in the future. (To read more about this, see A Long-Term Mindset Meets Dreaded Capital-Gains Tax.)

There is a situation, though, where return of capital is taxed right away. This happens if the return of capital would reduce the basis below $0.00. For instance, if the basis is $2.50 and you receive $4 as a return of capital, your new basis would be $0 and you would owe capital gain tax on $1.50.

Basis is also adjusted in the case of stock splits and stock dividends. For the investor, these are treated the same way. Taking our 10% stock dividend example, assume that you hold 100 shares of the company with a basis of $11. After the payment of the dividend, you would own 110 shares with a basis of $10. The same would hold true if the company had a 11-to-10 split instead of that stock dividend.

Finally, as with everything else regarding investment record keeping, it is up to the individual investor to track and report things correctly. If you have purchases at different times with different basis amounts, return of capital, stock dividend and stock split basis adjustments must be calculated for each. Qualified holding times must also be accurately tracked and reported by the investor, even if the 1099-DIV form received during tax season states that all paid dividends qualify for the lower tax rate. The IRS allows the company to report dividends as qualified, even if they are not, if the determination of which are qualified and which are not is impractical for the reporting company.

Conclusion
Many investors see dividends as "money for nothing", but the implications surrounding paying and receiving dividends can mean a lot of work for both the company and the investor. If you reinvest your dividends through a dividend reinvestment plan (DRIP) or equivalent, the paperwork and tracking of basis can become quite tedious. There is no such thing as a free lunch. As with every other aspect of investing, accurate records are important and it would probably behoove you to use a spreadsheet or similar tool to track such details.

More information can be found in various publications available from the IRS, especially Publication 550.