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 so that we can best serve our clients. In many cases, this isn’t an easy task, 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 even by established professionals. Though unfortunate, this is actually not too surprising given that these terms share many characteristics and have a very similar basic functionality. However, as this article will point out, it’s important to not conflate these two concepts because there are several significant differences between them. Let’s take a look at these concepts in detail and point out some of their similarities and dissimilarities.
Dividends Belong to C Corporations
Dividends are payments made to shareholders in a C Corporation and are reported by the corporation on a particular form, Form 1099-DIV, when they are received. Dividend payments are usually made in cash, although they can also be made in stock or other types of property. Dividends are a piece of the profits created by the corporation and are paid out in accordance with the respective ownership percentage held by each shareholder. In a sense, 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, both at the corporate entity level and then at the individual shareholder level; this is referred to as “double taxation” and is one of the characteristics which most deter business people from selecting the C Corporation structure.
When a shareholder receives a dividend, the shareholder doesn’t take a reduction to 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 by the distribution amount.
Whether a shareholder receives a cash dividend or dividend in the form of other property depends largely on the performance of the underlying corporation. It also depends on 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 and shareholders will ultimately be able to realize the financial benefits of the stock.
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, which means that distributions are not subject to the double taxation faced by dividend income. Distributions are therefore made to co-owners in S Corporations, partnerships, limited liability companies (or LLCs), trusts and estates; these distribution payments are recorded on a Form K-1, which is attached to the tax return of the pass-through entity. The individual shareholder (or co-owner) pays tax on the distribution in accordance with his or her tax rate on his or her Form 1040 for the corresponding tax year.
The Form 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 and the line reference on the Form K-1 is reserved for that type of situation. Though all pass-through entities use a K-1 form, they attach this form to different tax returns. For instance, S corporations file Form 1120-S, partnerships file Form 1065, LLCs file either Form 1065 or 1120-S depending on their situation, and both trusts and estates each file Form 1041.
Distributions do affect a shareholder’s basis in the underlying investment, unlike the case with dividends, and so the shareholder’s basis will be reduced by the amount of the distribution. Distributions are also only taxable when the shareholder’s basis has been fully reduced to zero, because only after the basis reaches zero would the shareholder have taxable gain.
Why Dividends and Distributions Matter
All of this can get a bit overwhelming. But again, that’s precisely why it’s a smart idea to contact a capable and reputable professional to assist you with your complex tax and business needs. The tax and business attorneys at Mackay, Caswell & Callahan, P.C., have taken the time to understand the difference between dividends and distributions, and 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 which you need assistance with, don’t hesitate to reach out and one of our people will be on your case immediately.