Dividends and Distributions
As dedicated tax and business attorneys here at Mackay, Caswell & Callahan, we know that it’s important that we gain and maintain a firm command over certain financial concepts. Doing so allows us to best serve our clients. In many cases, this isn’t an easy task. That’s because many concepts in tax, business and finance are complex and require significant research and intensive analysis. Dividends and distributions are two concepts which are routinely used inaccurately. That’s true even for established professionals. Though unfortunate, this is actually not too surprising. Given that these terms share many characteristics and have a very similar basic functionality, confusion abounds. However, as this article will point out, it’s important to not conflate these two concepts. There are several significant differences between them. Let’s take a look at these concepts in detail. We’ll try and point out some of their similarities and dissimilarities.
Dividends Belong to C Corporations
Dividends are payments to shareholders in a C Corporation. They’re reported by the corporation on a particular form, Form 1099-DIV, when received. Dividend payments are usually made in cash. Usually, but not always. They can also be made in stock or other types of property. Think of them as pieces of the profits created by a corporation. Notably, they’re paid out in accordance with the respective ownership percentage of each shareholder. In a sense, then, they represent a “slice of the pie” to which each shareholder is entitled. The income which is received in the form of a dividend is taxed twice. First, at the corporate entity level. Secondly, at at the individual shareholder level. This is known as “double taxation” and is one of the characteristics which most deter business people from selecting the C Corporation structure.
No Resultant Basis Reduction
When a shareholder receives a dividend, it doesn’t reduce his or her cost basis in the underlying stock. This tax treatment is one of the critical differences between dividends and distributions. Unlike dividends, distributions decrease the cost basis in the receiver’s investment. The decrease equals the distribution amount.
They type of dividend received by a shareholder is largely dependent on corporate performance. It also depends on both the future goals of the corporation and its ability to reach those goals. In some instances, a corporation may issue a stock dividend in order to preserve its cash. Although this reduces the face value of individual shares in the short-term, the expectation is that the stock price will eventually climb. It’s at that time that shareholders will ultimately be able to realize the financial benefits of the dividend.
Distributions Belong to Other Business Entities
In contrast to dividends, distributions are payments made to co-owners in a pass-through (or “flow-through) entity. That means that distributions are not subject to the double taxation like dividend income. Co-owners receive distributions in certain entities. These include S Corporations, partnerships, limited liability companies (or LLCs), trusts and estates. These distribution payments are recorded on a Schedule K-1. The Schedule K-1 is an attachment to to the pass-through entities tax return. The individual shareholder (or co-owner) pays tax on the distribution. He or she does so in accordance with the applicable tax rate for their personal income tax return for the corresponding tax year.
Schedule K-1 and Form 1099-Div Similarities
The Schedule K-1 is very similar to the 1099-DIV form issued by C Corporations for dividends. In fact, there’s even a line on the K-1 to report dividend earnings. That isn’t because any of these pass-through entities issue dividend income. Rather, it’s there only because, in rare instances, S Corporations may receive dividends from C Corporations. The line reference on the Schedule K-1 is for that type of situation. Though all pass-through entities use a Schedule K-1, they attach this form to different tax returns. For instance, S corporations file Form 1120-S. Partnerships, in contrast, file Form 1065. LLCs file either Form 1065, or Form 1120-S, depending on their tax status. Trusts and estates each file Form 1041.
Distributions do affect a shareholder’s basis in the underlying investment. That’s unlike the case with dividends. Accordingly, the shareholder’s basis is reduced by the amount of the distribution. Distributions are also only taxable when the shareholder’s basis falls to zero. That’s because only after the basis reaches zero would the shareholder have taxable gain.
Why Dividends and Distributions Matter
All of these tax disinctions can get a bit overwhelming. But again, that’s precisely why it’s a smart idea to work through tax issues of this type with a capable and reputable professional. The tax attorneys in NYC at Mackay, Caswell & Callahan, P.C., have taken the time to understand the difference between dividends and distributions. We work diligently to master yet more difficult material so that you don’t have to. You can rest easy knowing that your issue, no matter how complicated, is in safe hands with our professionals. If you have a complex tax or financial matter please don’t hesitate to reach out. One of our people will be on your case immediately.
Image credit: CreditDebitPro