Capital Dividend: Definition Vs. Regular Dividend and Taxation

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.