Quick Answer
The board of directors declares dividends at its sole discretion; shareholders have no standing right to demand one. Cash dividends are taxable when paid; most stock dividends are not taxed until sold. You must buy before the ex-dividend date to receive the dividend, and cumulative preferred arrearages must be cleared before any common dividend.
Dividends are not guaranteed and are not a contractual obligation, unlike bond interest. Shareholders have a right to receive dividends only if declared, and every dividend is paid from after-tax corporate earnings (retained earnings).
What Types of Dividends Are There?
| Type | Description | Tax Treatment |
|---|---|---|
| Cash dividends | Most common; paid in cash per share | Taxable as ordinary income or qualified dividend rate |
| Stock dividends | Additional shares issued to existing shareholders | Generally not taxable when received; adjusts cost basis |
| Property dividends | Non-cash assets distributed (rare), for example shares of another company that the issuer holds as an investment | Taxable at fair market value (FMV) |
How Do Cash Dividends Work?
- Most common form of dividend
- Paid from after-tax corporate earnings
- Declared by the board of directors; not guaranteed
Qualified vs Ordinary Dividends: Which Tax Rate Applies?
| Type | Tax Rate | Requirement |
|---|---|---|
| Qualified dividends | Favorable long-term capital gains rates (0%, 15%, or 20%) | Must hold stock for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date; must be paid by a U.S. corporation or qualified foreign corporation |
| Ordinary dividends | Taxed as ordinary income | Default treatment if holding period not met |
How Do Stock Dividends Work?
- Shareholders receive additional shares instead of cash, usually pro rata (in proportion to the shares each holder already owns)
- Increases shares outstanding; reduces price per share proportionally
- No change in total shareholder value (more shares at a lower price)
- Generally not taxed when received; only taxed when shares are later sold
- Some stock dividends are taxable when received, for example when any shareholder can choose cash or other property instead of stock, or when the distribution is on preferred stock (apart from a narrow conversion-ratio adjustment on convertible preferred). The new shares from a taxable stock dividend take a basis equal to their fair market value on the distribution date, and the old shares keep their basis
- A nontaxable stock dividend reduces cost basis per share (same total cost spread across more shares)
Example:
- Own: 200 shares at $30/share = $6,000 total value
- 25% nontaxable stock dividend: Receive 50 additional shares
- After: 250 shares at $24/share = $6,000 total value
- New cost basis per share: $6,000 / 250 = $24
Think of it this way: A stock dividend is like cutting a pizza into more slices. You have more pieces, but the same amount of pizza. Your percentage ownership of the company stays exactly the same.
Exam Tip: Gotchas
- Most stock dividends are not taxable when received; cash dividends are. Tax on a nontaxable stock dividend is owed only when those shares are eventually sold. Cost basis per share decreases because the same total cost is spread across more shares.
- Divide the total basis by the new share count; do not subtract the dividend percentage from the per-share price. A 10% nontaxable stock dividend on 100 shares bought at $40 ($4,000 total) leaves 110 shares, so the new basis is $4,000 / 110 = $36.36, not $36.00 ($40 less 10%). The per-share figure falls by less than the dividend percentage.
How Are Property Dividends Taxed?
- A property dividend distributes an asset other than cash or the issuer's own stock, for example shares of another company that the issuer holds as an investment
- Taxable to the shareholder at FMV on the date of distribution, the same timing as a cash dividend
- The dividend is taxed at the same rates as a cash dividend (ordinary or qualified dividend rate)
- The shareholder's cost basis in the asset received becomes that FMV
- A qualifying spin-off is different: when a corporation distributes the shares of a subsidiary it controls and the transaction meets the federal tax requirements for a spin-off, the shareholder generally owes no tax when the shares are received
Example:
- A corporation distributes to its shareholders, as a dividend, shares of another company that it holds as an investment
- Those shares are worth $40 each on the distribution date
- Each shareholder owes tax on $40 per share received, in the year of distribution
Exam Tip: Gotchas
- The test is whose stock you receive, not whether you receive stock at all. More shares of the issuer's own stock is a stock dividend (generally not taxed when received). Shares of a different company that the issuer holds as an investment are a property dividend (taxed at FMV when received); a qualifying spin-off of a subsidiary generally is not taxed on receipt.
What Are the Key Dividend Dates?
Four dates matter when a company declares a dividend:
| Date | Significance |
|---|---|
| Declaration date | Board of directors announces the dividend (amount, record date, payment date) |
| Ex-dividend date | First date a buyer will NOT receive the declared dividend; stock price typically drops by approximately the dividend amount |
| Record date | Shareholders on the company's books as of this date receive the dividend |
| Payment (payable) date | Dividend is actually paid to shareholders of record |
How Does the Ex-Dividend Date Work Under T+1 Settlement?
- Under current T+1 settlement, the ex-dividend date is typically the same day as the record date
- To receive the dividend, you must purchase the stock before the ex-dividend date
- On the ex-date, the stock trades "ex-dividend" and the price typically opens lower by the dividend amount
Think of it this way: Stock trades take one business day to settle (T+1). The ex-date is the record date itself, so buying before the ex-date gives your trade time to settle and register your ownership by the record date.
Example (T+1):
- Record date: Friday. The ex-dividend date is also Friday.
- Buy on Thursday: the trade settles Friday, you are on the books by the record date, and you bought before the ex-date. You receive the dividend.
- Buy on Friday: you bought on the ex-date. The trade settles Monday, after the record date, so the seller keeps the dividend.
Exam Tip: Gotchas
- Buying on the ex-date means no dividend. To receive the dividend, you must buy before the ex-dividend date.
- A question may give only the record date and leave the ex-date for you to work out. Under T+1, the ex-date is the record date, so the last day to buy and still receive the dividend is the business day before it. Older study materials show the ex-date one business day before the record date. That was the T+2 rule, which no longer applies.
How Do Preferred Stock Dividends Differ?
- Cumulative preferred: unpaid dividends accumulate as arrearages; all arrearages must be paid before any common dividends
- Non-cumulative preferred: missed dividends are lost forever; no accumulation
- Participating preferred: receives stated dividend PLUS a share of additional profits beyond a specified threshold
Exam Tip: Gotchas
- Cumulative preferred arrearages must be paid in full before common stockholders receive any dividend. This is the single most tested preferred stock dividend concept.
- Stockholders do NOT vote on dividends; only the board of directors declares them.
What Should You Check on Exam Day?
- Know the declaration, ex-dividend, record, and payment dates. Under T+1, the ex-date and a business-day record date usually coincide; buy before the ex-date to earn a regular cash dividend.
- Separate the two tax rules: cash dividends are taxable on receipt, most stock dividends are untaxed until sold.
- Sort received shares by whose they are: the issuer's own shares are a stock dividend; another company's shares held as an investment are a property dividend taxed at FMV; a qualifying spin-off generally is not taxed on receipt.
- Check whether a qualified-dividend holding period (more than 60 days in the 121-day window) is satisfied before assuming the favorable rate applies.
- Watch for cumulative versus non-cumulative preferred stock; only cumulative arrearages carry forward.