Investing in stocks can be an exciting yet confusing endeavor, especially when you start receiving payments like dividends and distributions. You may have heard these terms used interchangeably before, but they are quite different! Understanding the distinction between dividends and distributions is key to making informed investment decisions and properly reporting income on your taxes.
This comprehensive guide will explain everything you need to know about dividends and distributions in simple, easy-to-understand language. We’ll cover the definition of each, how they are taxed, how to report them, and most importantly – the key differences between dividends and distributions.
Whether you’re a new or experienced investor, you’ll walk away with clarity on this critical investing concept. Let’s dive in!
What Are Shareholders?
Before understanding dividends and distributions, it’s helpful to cover shareholders. When you purchase stock in a company, you become a partial owner or shareholder of that company. The number of shares you own represents your stake in the company.
As a shareholder, you have certain rights such as the ability to vote on key corporate actions. You also stand to benefit if the company performs well, as the stock value may rise. Shareholders may also receive payments known as dividends, which we’ll explore next.
When you invest in a company’s stock, you’re betting on its future performance. But companies also reward shareholders more immediately by issuing dividend payments.
A dividend is a portion of the company’s profits paid out to shareholders, usually in the form of cash. For example, if a company earns $1 million in profits, it may distribute $200,000 of that to shareholders as dividends.
The most common type of dividend is a cash dividend, but dividends can also be paid as additional shares of stock. Ultimately, dividends provide a tangible return regardless of fluctuations in the stock price.
Unlike a paycheck however, dividends are not guaranteed. They are only paid if and when a company chooses to distribute profits. So dividends can vary year to year based on profitability. When business is good, dividends tend to increase, providing a nice bonus for shareholders.
The Taxman Cometh for Dividends
There is an important caveat when it comes to dividends – they are taxed at both the corporate and individual level. This is known as “double taxation.”
First, the company pays corporate income tax on its profits. Then, the already taxed profits are distributed to shareholders as dividends and taxed again on their personal returns.
Occasionally dividends fall into the “qualified” category, which means they are taxed at the lower long-term capital gains rate rather than ordinary income rates. But either way, you can expect to pay taxes on dividends you receive.
Like dividends, distributions are also payments made to shareholders from company profits. However, distributions are only issued by specific types of corporations known as S-corps or LLCs.
An S-corp is a small business structure that allows income, deductions and tax credits to “pass through” to the personal tax returns of its shareholders. This avoids double taxation.
Shareholders of an S-corp pay income tax on their share of company profits, whether or not profits are actually distributed to them. When distributions are made, they simply receive the profits that have already been taxed at the individual level.
This means S-corp shareholders have more access to company profits without incurring additional taxes. Distributions are often made frequently and regularly.
Key Differences Between Dividends and Distributions
Now that you understand the basics of dividends and distributions, let’s break down the key differences:
- Corporate Structure: Dividends are paid by C-corps whereas distributions come from S-corps.
- Predictability: Dividends can vary unpredictably while distributions tend to be consistent.
- Tax Treatment: Dividends are taxed twice under double taxation; distributions avoid this.
- Reporting: Dividends are reported on a 1099-DIV form; distributions on a K-1.
- Dividends are bonus payments from C-corp profits taxed twice.
- Distributions are more frequent, regular disbursements of S-corp income taxed only once.
Navigating the Tax Implications
Understanding the tax implications is crucial when weighing dividends against distributions. Let’s take a closer look:
As mentioned earlier, dividends are subject to double taxation – once at the corporate level and again on your personal tax return. Public companies typically pay corporate tax of 21%.
After paying 21% tax on profits, the company then forwards the remainder to you as a dividend. You’ll owe taxes on this dividend at either ordinary income or capital gains rates, depending on whether it’s a “qualified dividend.”
For example, if a company earns $1 million and pays 21% or $210,000 in corporate tax, the remaining $790,000 can be distributed to shareholders. An investor who receives $10,000 of this would owe tax based on their personal rate.
With S-corp distributions, company profits are only taxed once when the shareholder files their personal return. The corporation itself does not pay tax. Any distributions then come tax-free since they’ve already been accounted for.
However, if you receive distributions exceeding your tax basis, that portion may be taxed as a capital gain. Basis represents your investment in the company. So work with a tax professional to ensure sufficient basis when receiving distributions.
Reporting Dividends and Distributions
Properly reporting dividends and distributions on your taxes is also essential. Misreporting could lead to penalties from the IRS.
For dividends, you will receive a Form 1099-DIV stating dividend income. This amount gets reported on your personal tax return.
For S-corp distributions, your share of company income is reported annually on Schedule K-1. Any cash distributions should match what is shown in Box 16 on your K-1.
Before filing your return, collect all necessary paperwork including 1099s, Schedule K-1, and your basis information. If unsure how to report anything, it never hurts to consult a tax professional.
Dividends and distributions both offer ways for companies to reward shareholders, but do not let the similar names fool you – they have distinct differences you should understand.
Dividends from C-corps are bonus payments subject to double taxation, while S-corp distributions are tax-free disbursements of already taxed income. Distributions also tend to be more consistent than dividend payments.
As your investment portfolio grows, this guide will help you differentiate between dividends and distributions for proper tax reporting. And of course, work with a financial advisor or accountant to navigate any questions. Here’s to growing your wealth in the stock market!