What is Liquidating Dividend?
It refers to residual payment in cash or other forms of assets to the shareholders after reducing all the creditors and lender’s obligations when the business closes entirely. They are often paid to the shareholders when they believe that the business is no longer going concern. I.e. the business is not in a position to survive due to external or internal factors for which management is about to liquidate the business. This is the reason it is also known as liquidating distribution.
When a company decides to dissolve the business, it is an indication that the company is about to liquidate its assets. It means that the business sells the inventory and every asset, including building, machinery it owns. The only objective to liquidate the assets is to pay off the debts obligations to the secured and unsecured creditors. Finally, the company distributes the residual amount to the shareholders as liquidating dividends.
A company could shell out such dividends to the shareholders in one or more installments. In the United States, it is a regulatory requirement for the company to pay liquidating dividends. They refer Form 1099 Div with required detail as size and form of payment.
When the shareholder receives it, the amount paid is reported in form 1099 – DIV. The extent of the amount which exceeds shareholder’s basis is the capital, taxed as capital gain in the hands of shareholders. The tax on capital gain is short term or long term depending on the duration for which the shareholders hold the same. Capital gain is considered a long term if they held for more than a year. Capital gain is short term if held for less than 1 year. If shareholders have bought shares in different periods, then the dividend divide into short term or long term. It happens according to the group of shares with respect to their date of purchase.
To illustrate liquidating dividends, let’s assume that on 1st March 2018, company X has declared $4 as dividend per share. The company’s outstanding shares are 200,000. In addition, the retained earnings are $300,000.00 and paid-up the capital base of $2,000,000.
The Dividend is calculated as follows-
- = $4.00 * 200,000
- = $800,000 shares
The total dividend calculated is $800,000. To pay this dividend, company X will use first the balance in retained earning $300,000.00, and the rest of the dividend ($800,000 – $300,000) = $500,000 will be absorbed from the company’s capital base.
Let’s explain the effect of the above dividend payment with a shareholder’s perspective. Assume shareholder Y own 1,000 shares and expected to receive a dividend payment of $4,000 (1,000 *$4).
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The amount of dividend being represented from the regular dividend is calculated as follows:
- =$300,000 retained earnings/ 200,000 outstanding shares
- =$1.50 per share
The liquidating dividend of the total dividend is calculated as follows:
- =$4.00 – $1.50
- = $2.50 per share
Liquidating Dividend vs. Liquidating Preference
When a company or business decides to pay to liquidate dividends, then the business is supposed to make it clear the order and the form in which the shareholders would receive the dividends. The companies would decide to liquidate the business when it is not in the position to clear the legal obligations, or it becomes insolvent and about to face bankruptcy. As business is in the process of liquidation, the residual assets would flow to the shareholders and creditors. The payment is made according to the preferential order.
Secured creditors are the ones who will receive payments in priority over others, followed by unsecured creditors, bondholders, government for unpaid taxes, and employees in case there are pending salaries and wages. Preferred shareholders and equity stockholders will receive the residual assets, if any.
Liquidating Dividend and Ordinary Dividend
The liquidating dividend is paid from the company’s capital base to the shareholders based on their respective invested capital. Its return on capital is exempted from tax, and therefore it is not taxable for the shareholders. It is different from an ordinary dividend, which is paid to the shareholders only when the business is doing well and is being paid from current profit or retained earnings.
It is being made with the intention of fully or partially liquidating the business. It is not considered as income by an investor as far as accounting treatment is concerned; instead, they are recognized as a reduction in carrying the value of the investment. Any person who owns the common stock on the ex-dividend date is supposed to receive the distribution irrespective of who currently holds the security. The ex-dividend date is usually fixed for 2 business days before the record date because of the T+3 system of settlement in financial markets being used in the United States.
In the case of ordinary dividends, the board of directors declares the dividend on a particular date, which is termed as declarations data, and the same is received by the owners on payment date when officials mail the check and credit the investor’s account with distribution amount.
With the context of dividends, it is required to distinguish between liquidating dividends and ordinary dividends the reason being both follow different accounting treatments as per regulatory requirements. In the case of traditional dividends, they are recorded as income from investments. In contrast, liquidating dividends are not recorded as income, but the reduction in carrying value of investment or, in other words, they are recorded as a return of the investment. The liquidating dividend is necessarily envisaged as repayment of invested capital, and it is made from a capital base; therefore, the tax requirement also differs between the traditional dividend and liquidating dividend.
The retained earnings (accumulated profits) are deducted from the total dividend. Then this amount is supposed to be divided by the total number of outstanding shares to get the conventional dividend. Once this dividend is paid out, the remaining balance is what we call liquidating dividends.
In our example, shareholder Y would receive a regular dividend of $1,500 ($1.5*1000) and liquidating dividend of $2,500. It is a return on shareholder’s investment; therefore, they are not taxable in the hands of shareholders when they receive the same.
This article has been a guide to Liquidating Dividend. Here we discuss how liquidating dividends work along with examples and its differences from preference and ordinary dividend. You can more about finance from the following articles –