There has been a flurry of special dividend announcements recently. Many from companies that don’t normally pay a dividend. Which shouldn’t be surprising really. Which leaves shareholders with a nice end of the year dividend payment. Of course, even special dividends are taxed. But how is it viewed for tax purposed?
Regularly scheduled dividend payments are considered an earnings distribution. Because of this the payments are viewed as ordinary income and taxed accordingly. However, special dividends are not always viewed the same way. Which complicates things. Any tax implications will depend on how the company classifies the special dividend.
What Is A Special Dividend?
A special dividend is a one time dividend payment to shareholders outside of any regularly scheduled dividends, if there are any. Companies usually declare a one time dividend because of very strong earnings or if there is an excessive amount of cash on the balance sheet. But it can be issued for a number of other reasons too.
The Tax Possibilities
When a company announces a special dividend it must classify the distribution. Shareholders will receive Form 1099-DIV breaking down the one time distribution into three categories: return of capital, capital gain, or ordinary income.
Return Of Capital
The majority of special dividends are classified as a return of capital and lowers your cost basis. Which is just the original value of the shares when purchased.
What this means is, your cost basis is reduced by the amount of the distribution. It’s not a taxable event until you sell the shares. You will eventually pay capital gains on the difference between the selling price and the new cost basis. The exact tax implications will depend on the tax code and price of the stock at the time of the sale.
Ordinary Income
Most quarterly dividend payments are viewed as ordinary income and taxed at your marginal tax rate. Special dividends can also fall under this classification as long as the distribution is considered ordinary income. If the dividend meets the requirements of a qualified dividend you’ll be taxed at the more favorable long-term capital gains rates.
This is the crux of many special dividend payments with the possible elimination of the Bush tax cuts and qualified dividend rates in 2013.
A Capital Gain
The last possibility is a capital gain. Which is likely due to a sale of an asset and then passed down to the shareholders. If the 1099-DIV shows the distribution as a capital gain, you’ll pay the capital gains tax rate on that amount in the current tax year.
While the idea of a special dividend might sound great. Your tax implications will depend on how the company eventually classifies that distribution. It’s one more thing to be aware of when tax season starts.