Dividends and Distributions – Use in the Proper Context
Dividends and distributions refer to the payment of cash to investors. Why are there two separate terms? Well, the term is tied back to the type of entity that makes the payment. Simply stated, regular corporations, i.e. C-Corporations as identified in the Internal Revenue Code use the term ‘Dividends’ and S-Corporations (Small Business Corporations) use the term ‘Distributions’. In addition to S-Corporations, other closely held business use the term ‘Distributions’ to identify amounts disbursed to the respective owners or beneficiaries. These forms of entities include Partnerships, Limited Liability Corporations, Trusts and Estates.
Although it appears relatively simple at first, it is slightly more involved than this and this article addresses the proper definition and context use when using these two similar terms. In addition, there are more differences between the two terms than just the source of the payment. For a full and detailed understanding of the terms, continue reading.
Both terms mean the physical transaction of disbursing value (typically in the form of cash) to the investor. Dividends are most commonly cash disbursements from corporations that file traditional Form 1120 tax returns; whereas distributions are cash disbursements to investors of small business corporations that file a Form 1120-S or some other form identified with closely held entities. The following two subsections describe in more detail the terms origins and why the tax code definition is the proper business definition too.
Traditionally, dividends are a share of the profits generated by a company. The more common thinking is that the payment made to the shareholder reflects the shareholder’s percentage of ownership in a company as his/her share of the entire dividend payout. Typically large publicly traded companies that are more developed and stable in their earnings issue (pay) dividends to shareholders. However, dividends are not always cash. This is one of the minor differences between dividends and distributions.
Dividends can be paid in the form of additional stock. This is done to hold cash for future use and still award value to existing shareholders (investors). Other forms of dividends include property dividends. These include samples of products or most often a prorated share of a legally held investment such as a bond(s) or stock in a subsidiary. In smaller closely held C-Corporations, property distributions are more commonly made in the form of existing equipment or inventory. I have seen this mostly in the form of disposing of vehicles to the owners of the company.
The term was first used back in the 15th century during the early development of the new corporation entity status that appeared in the 1400’s in Northern Europe.
Other distinguishing characteristics of dividends include:
Reporting of payments via Form 1099-DIV (DIV is short for dividends). Dividends DO NOT affect the basis of the stock investment from the shareholder’s perspective. In mutual funds, dividends can be assigned to the owners in the form of capital gains referred to as capital gain distributions (yes I know, this appears confusing but it is an IRS term), again Form 1099-DIV is used to report this information.
In the equity section of the financial reports, the word ‘Dividends’ is used as an offset to Retained Earnings to identify the amount of value transferred to shareholders.
Dividends are usually taxed a second time after the disbursement to the shareholder. Initially the C-Corporation has already paid taxes via an income tax on the company’s earnings and once paid out as dividends, the shareholder claims the dividend as income on their Form 1040. There is an opportunity to have the dividend reported as ‘Qualified’ which reduces the tax rate the shareholder pays on these particular dividends.
As stated above, distribution is a term used in S-Corporations which are small business corporations as classed by the Internal Revenue Service. When an owner of a small business desires an overall lower tax rate he files Form 2553 to request status as a small business corporation. The small business corporation files a Form 1120-S on a calendar year and reports all taxpayer level information via Form K-1 which is attached to the tax return. The K-1 is similar in function as the Form 1099-DIV except it also includes many other pieces of information.
A K-1 is also used by Partnerships (file Form 1065), Limited Liability Companies (file Form 1065 or 1120-S as authorized by the IRS), Trusts (file Form 1041), and Estates (file Form 1041). This is very similar in nature to an S-Corporation K-1 but use block 19 to report the information. As you read about the S-Corporation from here down, just remember, the closely held entity format (partnerships, trusts and limited liability company) is very similar.
S-Corporations are a member of what is referred to as pass-through entities (includes partnerships, LLC’s, Trusts and Estates) and therefore assign their respective net income, interest earned, capital gain issues, and various forms of deductions separately to the shareholder via the K-1. In addition, the K-1 Line 16 reports actual distributions using a letter code of ‘D’ (D is for distributions). The irony of all this is that the K-1 is very similar to the 1099-DIV in that it uses the same terms in the reporting format. It even has blocks to report dividend earnings. Huh? In rare situations, S-Corporations received dividend payments from C-Corporations and therefore assigned this income to the shareholder of the S-Corporation. This doesn’t mean the S-Corporation paid out the dividend to the shareholder, it only means the S-Corporation is assigning the income to the shareholder based on their respective ownership percentage.
Distinguishing characteristics of distributions include:
- Reported via the K-1
- Disbursement of cash to a shareholder via distributions AFFECTS shareholder basis in their investment and is reported on the Form 1120-S in the M-2 Schedule.
- Distributions to shareholders are never taxed. This is because all net income and deductions are assigned to the shareholder and are taxed separately via Schedule E attached to the shareholder’s Form 1040.
The equity section of the balance sheet uses the term ‘Distributions’ as an offset to Retained Earnings to identify those amounts paid out to the owners of the company. An S-Corporation may make property distributions, but not stock distributions.
Dividends and Distributions – Use in the Proper Context (Summary)
After reading the above detailed explanation, you should now understand the two terms relate to the type of tax entity. Dividends are used with the C-Corporation entity format and Distributions are used with closely held entities. However, the words do have other meanings in business. The following are some examples of their correct use:
The benefit derived from some action made by the owner or the business. For example, ‘The hard work has reaped many dividends’. This is usually used in a non-financial context and is really a grammatical issue. I believed the preferred word should be ‘benefits’ and not dividends. When referring to financial gains as a share of a larger group, than the word dividend is appropriate.
A much broader term to describe a benefit received from closely held entities such as the S-Corporation, Partnerships, Limited Liability Company, and Trusts. For more information related to the various types of entities, read: Types of Business Entities. Many estates are held in trust until all assets (cash, investments, and physical assets) are distributed to the heirs. Thus when using this term, the speaker is referring to a tightly (limited number of individuals) held entity. Remember, these entities are authorized by the Internal Revenue Service and have a limited, core set with the number of investors or beneficiaries.
A lot of times this term is used outside of the business world especially in math, specifically statistical analysis.
Depending on the circumstances of the conversation, the terms are similar in referring to a financial gain from a business source. However, they are distinctly different in technical meaning. Act on Knowledge.
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