Dividends are distributions of a company’s net income or retained earnings to shareholders. Cash dividends can be ordinary or qualified, with the latter taxed at a lower rate. Established companies are more likely to pay dividends, while growth companies reinvest profits. Qualified dividends must meet certain criteria to receive preferential tax treatment.
A dividend is any distribution to a shareholder in a company that is paid by that company from its net income or retained earnings, which are earnings held in reserve by the company to reinvest or pay down debt. Some companies choose to pay a stock dividend, where the shareholder receives additional shares in the company instead of cash, but most pay dividends in cash. There are two main types of cash dividends: ordinary dividends and qualified dividends. The difference between an ordinary dividend and a qualified dividend is how they are treated for federal income tax purposes. Ordinary dividends are considered ordinary income and are taxed at the taxpayer’s normal tax rate, and a qualified dividend is taxed at a lower preferred tax rate.
Shareholders provide capital to companies. When a company’s earnings exceed its operating, reserve, and expansion needs, most companies choose to pay dividends to shareholders. The companies that are most likely to pay a dividend, whether it is a regular dividend or a qualified dividend, are generally larger and more established companies. Smaller, less-established companies, known as “growth” companies, typically reinvest profits in the company’s core operations to grow the company and its market share rather than pay a dividend.
Companies that pay dividends generally pay these dividends quarterly, although some pay dividends annually. At the end of the calendar year, a company that pays dividends to its shareholders generally must provide each shareholder with a form showing the total dividends paid. Unless otherwise stated, all dividends are considered ordinary dividends for income tax purposes.
There are several criteria that must be met for a dividend to be considered a qualified dividend and therefore to receive preferential tax treatment. First, the dividend must be paid by a qualified company. Second, the shareholder must have held the shares for at least 60 of the 120-day period beginning on the last date for which the shareholder was eligible to receive the next dividend. Finally, the dividend cannot be classified as a qualified dividend disallowed by the government agency that controls taxes, such as the Internal Revenue Service in the United States.
Qualified dividends are reported as part of reported ordinary dividends. It is up to the shareholder to determine what portion, if any, of the reported common dividends paid meet the criteria to be considered qualified dividends. When in doubt, the surest way for an investor to determine whether a dividend is an ordinary dividend or a qualified dividend is to consult with the company’s investor relations representative.
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