What is Liquidating Dividend?
The term liquidating dividend refers to residual payment in the form of cash or other forms of assets to the shareholders after all the creditors and lender’s obligations when the business is closed entirely. They are often paid to the shareholders when they believe that the business is no longer going concern and 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 this is an indication that the company is about to liquidate its assets which means that business sells not only inventory but also every asset including building, machinery it is in the possession of. The only objective to liquidate the assets is to pay off the debts obligations to the secured and unsecured creditors and distribute the residual amount to the shareholders as liquidating dividends.
A company could shell out such dividends to the shareholders in one or more instalments. In the United States, it is a regulatory requirement for the company paying liquidating dividends to refer Form 1099 Div with required detail as size and form of payment.
When the shareholder receives it, the amount being paid is reported in form 1099 – DIV. The extent of the amount which exceeds shareholder’s basis is the capital which taxed as capital gain in the hands of shareholders. The capital gain is taxed as short term or long term depending on the duration for which the shareholders hold the same. The capital gain is considered as long term if they are held more than a year and short term if they are held for less than 1 year. If shareholders have bought shares in different periods of time then the dividend should be divided into short term or long term accordingly based on the group of shares when they were bought.
To illustrate liquidating dividend let’s assume that on 1st March 2018 company X has declared $4 as dividend per share and 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 dividend ($800,000 – $300,000) = $500,000 will be absorb 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).
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 dividend 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 on the basis of 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 partial liquidating the business. They are 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 is in the possession of 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 prior to the record date because of the T+3 system of settlement in financial markets being used in the United States.
In 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 while 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 essentially envisaged as repayment of invested capital and it is basically made from capital base therefore the tax requirement also differs between traditional dividend and liquidating dividend.
The retained earnings (accumulated profits) are deducted from the total dividend and 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 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 –