Although taxpayers work to make the money they earn, they can also put their money to work for them. Among the myriad of investment opportunities that help your money make more money, earning dividends is the choice for a lot of investors. Dividends can be a tidy little supplemental income source that helps pay bills, pay for luxury items such as vacations or even pay for your child's education. Whether you're a seasoned and savvy investor or you rely on investment advice from your broker or financial planner, dividend income can be a welcome addition to your investment portfolio.
In a nutshell, dividends are a company's share-of-the-wealth distributions of property to its investors. "Property" is a wide-reaching term that includes cash, additional shares of stock, real estate, physical assets of the company and other items of value. Investors typically purchase stock in a corporation, which gives them part ownership in a share of the corporation. These shareholders earn interest on the stock they purchase as the corporation turns a profit.
Two Types of Dividends
"Ordinary dividends" is the term that describes the total dividends that investments pay its investors. Divided into two parts, ordinary dividends include "qualified" dividends and "nonqualified" dividends.
- Qualified dividends. Most corporate stock, for example, falls under the category of qualified dividends. Because these dividends are typically paid on long-term investments, they are taxed as long-term capital gains, which have tax rates that are lower than ordinary income tax rates. But "long term" doesn't always mean an extended period that's measured in years; a “long” term may be as short as two months. The IRS requires a minimum 60-day holding period for your stock investment during the 121-day period that starts 60 days before the ex-dividend date. The ex-dividend date is the day after a corporation announces its declaration of dividend payments to shareholders.
- Nonqualified dividends. These dividends are taxed at the ordinary income tax rate, which is a higher rate than qualified dividends.
Forms of Dividends
Any association that qualifies as a taxable corporation, as well as a Subchapter S corporation, partnership, trust or estate, can pay dividend distributions. Most corporations generally pay dividends to their investors in cash. But they may use other forms of payment, even stock in another corporation. A company may satisfy its dividend debt to investors if the shareholders receive services from the company, or even if the company allows the shareholders to use the company’s property. And if it’s the shareholder who provides a service to the company, the company may satisfy its dividend debt by paying the shareholder more than it would pay someone else for the same service.
IRS-allowable dividend distributions include:
- Cash dividends. This form of dividend payment is the most common among the different types of distributions. “Cash” may sometimes be paid in the form of actual cash, but it’s more commonly paid by check or electronic funds transfer. You’ll receive a dividend for each of the stock shares that you own in a company, and your payments may be made quarterly, annually or at other periodic intervals, depending on the terms of your investment and the corporation’s board policies.
- Stock dividends. If a company pays dividends in stock, you won’t be taxed on the distributions until you sell the stock, which is a short-term advantage for you. An advantage to the issuing company is their not having to pay cash, which helps if the company is having financial difficulty with its cash flow. Another reason a company may pay dividends in stock is when the company wants to use its available cash for business purposes. Generally, a company issues stock as dividends based on the numbers of stock shares you already own.
- Property/Product dividends. Some types of dividend distributions are nonmonetary dividends. For example, you may receive a property or product dividend. Property includes products that the company makes (or even product samples), services that the company offers or stock from a subsidiary it owns. Product samples dividends are not commonly given, but this is an allowable dividend distribution. Typically, a company does not have to give prior notice to its shareholders when it issues property dividends, and the dividends are taxed based on their value. A company may choose to pay its shareholders in property dividends if they’re experiencing financial difficulty and its cash flow is compromised.
- Scrip dividends. A company that sees it will be unable to pay dividends in the future may issue scrip dividends. Essentially, this is a promissory note, which creates a note payable, with a promise to pay their shareholders. The scrip dividend may or may not carry interest, and the promise to pay may include cash payments or payments in additional shares of stock at a future date. Scrip dividends allow companies to conserve their cash, and they offer investors the tax benefit of not having to pay income tax until they sell their shares.
- Liquidating dividends. When a corporation is in financial trouble, and the board of directors is considering shutting down the business, the board may decide to pay their investors the original capital that the shareholders purchased. But before the corporation can pay liquidating dividends to its shareholders, it must first pay all its other liabilities.
Reporting Dividends as Income
Because all dividends are income, taxpayers must report their dividend income on their tax returns, as long as they receive $10 or more in dividend interest from a single entity. The entity must issue you a Form 1099-DIV with the amount it paid each taxpayer. If your dividend income is from an estate, trust, or S corporation, the issuing entity must also give you a Schedule K-1 with the amount of taxable dividend income they paid you. If you receive more than $1,500 in ordinary dividends, or if you receive someone else’s dividends as a nominee, you’ll also have to file Schedule B with your tax return.
IRS Form 1099-DIV and 1040
Although you should receive a 1099-DIV from each entity that issued you $10 or more in dividend interest, you must still report this income even if you do not receive the 1099-DIV. Through tax year 2017, you'll report dividends on your 1040 or 1040A tax return. But beginning with tax year 2018, you'll report this income on the new Form 1040, which consolidates the current Forms 1040, 1040A and 1040EZ into one streamlined form.