Quick Answer
Dividends come in three types. Cash dividends are taxable and paid in cash to shareholders of record. Stock dividends are not taxable; they lower cost basis per share while total cost basis stays the same. Return of capital is also not taxable but reduces total cost basis directly.
Now that you understand the components of return, let's look more closely at dividends, one of the most important income components for equity investors.
Cash Dividends
Cash dividends are the most common form of dividend distribution.
- Paid in cash to shareholders of record
- The board of directors must declare the dividend before it can be paid
- Taxed as ordinary income in most cases
- Qualified dividends (from domestic corporations and certain foreign companies, held for a minimum period) may receive preferential tax rates; the same lower rates applied to long-term capital gains
Exam Tip: Gotchas
- Cash dividends are taxable; stock dividends are NOT. This distinction is frequently tested.
- Qualified dividends get preferential tax rates (same as long-term capital gains), but they are still taxable. "Preferential" does not mean "tax-free."
- The board of directors declares dividends. Shareholders do not vote on the amount.
Stock Dividends
Stock dividends distribute additional shares to existing shareholders instead of cash.
- Not taxable when received
- The investor's total investment value stays the same; it is just spread across more shares
- Cost basis per share decreases because the same total cost is divided among more shares
Think of it this way: Picture a pizza cut into 8 slices versus 10 slices. With 10 slices, each piece is smaller, but you still have the same amount of pizza. A stock dividend works the same way: more shares, each worth proportionally less, but your total investment value stays the same.
Example:
- You own 100 shares with a total cost basis of $5,000 ($50/share)
- The company declares a 10% stock dividend
- You receive 10 additional shares (100 x 10%)
- You now own 110 shares with the same $5,000 total cost basis
- Your new cost basis per share: $5,000 / 110 = $45.45/share
Exam Tip: Gotchas
- Stock dividends do not change total cost basis. Only cost basis per share changes (it decreases because the same total cost is spread across more shares).
Comparison Table
| Feature | Cash Dividend | Stock Dividend | Return of Capital |
|---|---|---|---|
| What you receive | Cash | Additional shares | Cash (return of your investment) |
| Taxable when received? | Yes (ordinary income or qualified rate) | No | No |
| Effect on cost basis | No change | Cost basis per share decreases | Total cost basis decreases |
| Source | Company earnings and profits | Company issues new shares | Not from earnings/profits |
Exam Tip: Gotchas
- Stock dividends and return of capital are both non-taxable when received, but they affect cost basis differently. Stock dividends spread the same total basis across more shares (per-share basis drops). Return of capital reduces the total basis itself.
What Should You Check on Exam Day?
- Can you explain why cash dividends are taxable but stock dividends are not?
- Do you know how a stock dividend changes cost basis per share versus total cost basis?
- Can you calculate a new cost basis per share after a stock dividend, given shares and total cost?
- Do you know how return of capital differs from a stock dividend in its effect on cost basis?
- Can you state who declares dividends and confirm shareholders do not vote on the amount?