Key takeaways:
- A liquidating dividend is a capital distribution among shareholders that is made during the full or partial corporate liquidation.
- Such a dividend payment represents a return of capital rather than a distribution of profits. Consequently, it is not generally subject to taxation.
- Companies pay liquidating dividends in the form of cash and liquid and semi-liquid assets.
The article will explain what a liquidating distribution is and how to report it in your tax return.
Table of Contents
Understanding Liquidating Dividends
Liquidating dividend is a capital distribution that has previously been invested in the company. During a complete liquidation, a considerable amount of time is taken up by the payout process. The board of directors is responsible for deciding on corporate dissolution, conducting asset liquidation, and carrying out other winding up operations.
Despite this, not all funds obtained from the sale of assets will be distributed to shareholders. The primary holders of these funds are:
- creditors;
- the government (if there are tax debts);
- employees (if there are wage arrears).
The company can perform a partial liquidation, in which they only close the unprofitable part of their business. Despite this, some of the proceeds from the asset liquidation will still go toward paying off debts.
There is also another answer to the question, which is: ‘What is liquidating dividend?’ This term can be used to refer to any dividend that goes beyond the accumulated profit as of the distribution date.
Differences Between Regular and Liquidating Dividends
Regular dividends represent either the current year earnings distribution or retained earnings from previous years. A liquidating dividend, on the other hand, is a capital return, i.e. the amount originally invested in the company’s shares. Different income tax treatment is applied to such payments, depending on the circumstances.
Profit distribution in the form of dividends entails tax implications. Depending on the type of investment, holding period, and investor’s income, the rate will vary. The paid amounts can be found in sections 1a and 1b of Form 1099-DIV.
The return of capital is not subject to taxation until the initial cost of the asset falls to zero. Sections 9 and 10 of Form 1099-DIV contain information on liquidating distributions.
How Liquidating Dividends Work
Liquidating dividend works as follows. First, the company’s board of directors makes a decision on corporate dissolution. Then, management:
- Notifies shareholders and government authorities.
- Conducts an asset sale from which the book value is derived.
- Initiates the distribution process of the proceeds. First, financial obligations are fulfilled. The company pays off debts relating to secured loans and other obligations, including taxes and wages. Additionally, expenses for liquidation activities are deducted from the amount received.
- Pays out the remaining shareholder equity from previous phases.
The duration of the cash distribution waiting period depends on the established liquidation order and market conditions, as well as how quickly the company sells its assets.
In some cases, a decision may be made for the distribution of remaining assets as property liquidation dividends. In other situations, payments may be made over several years.
Calculation of Liquidating Dividends
The formula used for calculating liquidating dividends is as follows:
Liquidating Dividend = Total Assets Sold – Total Liabilities – Costs of Liquidation
Sale proceeds from the company’s assets are first used for debt settlement. Any remaining equity is then distributed among the holders of outstanding shares, with preference given to holders of preferred shares over common shares.
One of the parameters that investors consider when choosing a company is the per-share distribution resulting from liquidation. It is calculated based on the liquidation value. To determine this, an asset valuation is conducted. Intangible assets (such as patents) are not included in this valuation.
Tax Implications of Liquidating Dividends
The tax treatment of liquidation dividends differs from that of regular dividends. A final distribution is a return of capital. This reduces the cost basis of the investment.
If a company pays liquidating dividends and completes its operations in full, two situations are possible:
- The amount distributed exceeds the shareholder’s initial investment. In this case, taxable income arises and is subject to capital gains tax rates.
- The amount received is less than the initial investment. In this case, the investor records a capital loss. They may be able to reduce their future taxes using this loss.
Tax Reporting Requirements
A company that pays a liquidating dividend must send its shareholders a Form 1099-DIV. According to IRS regulations, the reporting threshold for tax filing purposes is $600. For amounts below this threshold, tax documentation may not be provided to investors. For property dividends, the calculation is based on the fair market value of the assets distributed.
After receiving a liquidating distribution from an ongoing company, the investor makes a cost basis adjustment to the asset. The investor must provide a capital gain (or loss) reporting if the company has completed its activities.
Here is an example to help you better understand the answer to the question what a liquidating distribution is? Let’s say an investor bought shares for $10,000. Then after a while, the company decided to cease operations. In the first year, the payout was $2,000. The investor does not incur any tax obligations, but their initial cost basis decreases to $8,000.
The following year, the liquidation distribution amounted to $3,000. At this point, the company finalised its activities. The investor does not have any tax obligations again. Their tax return shows a capital loss of $5,000 (the initial investment of $8,000 minus the $3,000 received in the second year).
If there were to be a partial liquidation, the investor would adjust their cost basis to $5,000 instead of recognising a loss.
Examples of Liquidating Dividends
Real-world examples of bankruptcy liquidation include Kodak, Sears Holdings Corp. and Borders Group Inc. However, business closure is not always the issue. Corporate restructuring is also an option. Kodak, for example, continues to operate in areas such as medical diagnostics and software.
When a company decides to pay a liquidating distribution, it does not always indicate financial goals problems. It could be due to a merger or acquisition, voluntary dissolution, or the execution of a capital return plan for shareholders.
Investment Considerations for Liquidating Dividends
Any investment strategy should include a risk assessment. Investors perform a preliminary calculation of the business’s liquidation value to account for the likelihood of company liquidation and its portfolio impact.
If signs of imminent company liquidation are already present, two options are available to an investor:
- wait for payments from the issuer using the proceeds from liquidating assets;
- sell shares to traders seeking speculation opportunities based on rumours of bankruptcy.
Although shareholder rights are protected by law, capital return is not guaranteed. Payouts may be a small proportion of the initial investment, or may not be made at all if all proceeds from the sale of company assets are used to settle debts.
Liquidating distributions can be an effective exit strategy for company management. Distributing the remaining value provides an opportunity to maintain investor trust and potentially encourage them to participate in future business ventures.
Warning Signs of Impending Liquidation
The following financial distress indicators may suggest a high bankruptcy risk:
- decreasing business activities, fewer clients, and a lack of new contracts;
- declining business performance, falling profits and revenue, and incurring losses;
- deteriorating financial position, increasing debt-to-equity ratio;
- negative market signals;
- management announcements regarding the exploration of strategic alternatives or potential buyers for part of the business;
- technical defaults on issued bonds;
- downgrades in credit ratings, and others.
These signs can be found in the company’s financial statements and analyst reviews, as well as other sources of information.
Liquidating Dividends vs. Other Corporate Actions
Now let’s consider other corporate actions involving shareholder distributions. These are all taxed differently:
- Stock buybacks. These are financed using the company’s profits. Shareholders must pay tax on the difference between the purchase price and the sale price of their shares. If the holding period exceeds one year, capital gains tax rates apply.
- Special dividends: These are paid out when a company makes a one-off profit. They may not qualify as ‘qualified dividends’.
- Corporate restructuring involving spin-offs. Special dividends in the form of shares are usually involved. Such distributions come with tax advantages and do not lead to tax liabilities in the year of receipt. Taxes are only incurred upon the sale of the shares.
- Mergers or acquisitions of companies. Merger considerations are more complex. Shareholders may receive cash payments, shares in the acquiring company or shares in a new company created as a result of the merger.
The Bottom Line: Key Takeaways About Liquidating Dividends
Investor awareness of the potential for liquidation is essential for capital preservation. Liquidating distributions are not considered income. This should be taken into account during the tax planning process. It is also useful to know that US tax treatment enables capital losses to offset capital gains.
It’s crucial to comprehend that the final distribution’s size varies depending on the reasons for its payment. If the corporate dissolution process was initiated after a bankruptcy declaration, the company’s ability to recover all invested funds is doubtful.In such cases, the investor will have no choice but to accept a capital loss.
Therefore, it is necessary to regularly review your companies’ portfolios and balance sheets. This will enable you to quickly identify any declines in shareholder value or increased risks.
FAQ
What is a liquidating dividend example?
Let’s provide an example calculation using the formula. Suppose the company managed to sell its assets for $1 million. Its outstanding debts amounted to $300,000 and its liquidation expenses totalled $50,000. The remaining funds ($650,000) will be allocated to liquidation distributions. If the company has 100,000 outstanding shares, each share will receive $6.50.
What is the difference between liquidating and nonliquidating dividends?
Liquidating distributions are made by reducing the company’s capital base. In the event of bankruptcy, these funds are obtained by selling the company’s assets. Other types of dividends are paid out of current or retained earnings.
Is a liquidating dividend taxable?
In most cases, the answer is no. Tax is only withheld when the amount distributed exceeds the original cost of the stock.
Do shareholders get paid in liquidation?
Shareholders have the right to receive money upon liquidation. In reality, however, this only occurs if profits from asset sales exceed outstanding liabilities. If a company is facing challenging circumstances, it is unlikely that initial investments will be fully recovered.
Article Sources
- Hanlon, M., & Hoopes, J. L. (2014). “What do firms do when dividend tax rates change? An examination of alternative payout responses.” Journal of Financial Economics, 114(1), 105-124.
- Skinner, D. J. (2008). “The evolving relation between earnings, dividends, and stock repurchases.” Journal of Financial Economics, 87(3), 582-609.
- Graham, J. R., & Kumar, A. (2006). “Do dividend clienteles exist? Evidence on dividend preferences of retail investors.” The Journal of Finance, 61(3), 1305-1336.
