What Is a Capital Dividend?

A capital dividend, also called a return of capital, is a payment 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.

Understanding the Capital Dividend

A 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.

Key Takeaways

  • A capital dividend is drawn from a company's capital base, not its earnings.
  • It is seen as a signal that a company lacks spare cash to pay dividends.
  • Regular dividends are paid from earnings, and represent a share of the profits.

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.

Capital Dividend vs. Regular Dividend Payments

Traditional dividends are considered a share of a company's revenues 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 regular scheduled dividend.

Capital dividends paid to shareholders are generally not taxable.

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.

Start-up 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.

Dividend Payers

In contrast, larger and better-established companies that enjoy consistent and predictable profits often pay the best dividends. 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.

Historically, these dividend payers are found in sectors including utilities, basic materials, oil and gas, banks and financial, healthcare and pharmaceuticals.

Master limited partnerships (MLPs) and real estate investment trusts (REITs) are also top dividend payers.

Capital Dividends and Shareholders’ Equity

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.