Liquidating DividendA type of dividend that is distributed during liquidation proceedings

When a company declares dividends, it creates a liability on its part to pay a certain amount to its shareholders.

Normally, the source of cash to pay such dividends will come from the company’s net income (a.k.a. net profit).

If a company is unable to make profits for a certain period but still declares dividends, it may source the payment from its reserves.

However, it’s rarely the case that a company would declare and distribute dividends during a period of loss.

That’s because when a company constantly declares and distributes dividends even without profits, it will eventually exhaust all of its funds.

In the worst case, it won’t have enough resources to continue operating.

That said, there’s a certain type of dividend that companies pay out during a partial or liquidation.

We refer to it as the liquidating dividend. Unlike with a regular dividend, the source of payment for a liquidating dividend will mostly come from the company’s capital base.

As such, it’s more of a return of capital rather than a proper dividend.

Also, it is typically not taxable (on the shareholders’ part).

In this article, we will be exploring what a liquidating dividend is.  

What is a liquidating dividend?

What does it mean when a company declares liquidating dividends?

When does a company typically declare liquidating dividends?

We’ll try to answer these questions as we move along with the article.

What is a Liquidating Dividend?

A liquidating dividend is a type of dividend that a company typically distributes to its shareholder during a partial or full liquidation.

Unlike a regular dividend, a liquidating dividend is typically not taxable.

This is because a liquidating dividend is more of a return of the shareholders’ capital rather than a proper dividend.

As such, it typically does not result in the generation of income on the part of the shareholders.

The source of payment for a liquidating dividend usually comes from the company’s capital base.

This is unlike with a regular dividend that typically comes from the company’s income or general reserve funds.

As such, you would typically see a company declare and distribute liquidating dividends when it’s undergoing partial or full liquidation.

In a typical liquidation proceeding, a company will sell all of its assets to pay all of its obligations as much as possible.

The company will prioritize first the payment for all of its creditors.

Then, holders of preferred shares come next.

And finally, any remaining amount will be used to pay the company’s shareholders.

The residual amount that the shareholders receive is a liquidating dividend.

Despite being typically non-taxable, a liquidating dividend usually isn’t enough to cover the initial investment of the shareholders.

This is because when a company undergoes liquidation, it usually comes with the deterioration of its value and quality.

A company that is performing well isn’t likely to cease its operations.

On the other hand, a company that is constantly underperforming and generating losses will eventually have to cease its operations.

Because of such losses, the value of such a company’s share will naturally go down.

We may also refer to a liquidating dividend as liquidating distribution.

Liquidating Dividends in the US

In the US, the payment of liquidating dividends is a regulatory requirement.

If the company is unable to pay it in full immediately, it may opt to make the payments in installments.

The company will have to issue a Form 1099 – DIV to all of its shareholding, which should detail the amount of the liquidating dividend.

If the liquidating dividend exceeds the initial investment of the shareholder, then the excess amount will be subject to tax (on the part of the shareholder).

That said, it rarely happens that a liquidating dividend covers a shareholder’s initial investment, much more exceeds it.

Liquidating Dividends vs Ordinary Dividends

A company will typically only declare and distribute dividends when it is able to generate profits.

As such, the source of payment for a dividend will usually come from the company’s profit for that period.

If the profit is not enough to cover the amount of dividends, the company will have to use its reserves to make up for the excess.

On the part of the shareholder, a dividend is a form of income.

As such, it is subject to tax. Particularly, dividends tax.

On the other hand, a liquidating dividend is more a return of capital rather than a form of income.

It is meant to return the initial investment made by the shareholder. As such, it is typically not taxable.

I say typically because a liquidating dividend can still be taxable under a particular circumstance.

If the amount of a liquidating dividend exceeds the shareholder’s initial investment, then the excess amount will be subject to tax.

This is because the excess amount is technically a form of income.

In the case of partial liquidation, a liquidating dividend acts as a reduction in the carrying value of the shareholder’s investment.

Ordinary dividends can be declared by the board of directors at any given time, though it usually only occurs when the company is performing well.

On the other hand, a company can only declare and distribute liquidating dividends during partial or full liquidation.

To make it short, an ordinary dividend is a form of income on the part of the shareholder.

On other hand, a liquidating dividend is more of a return of the shareholder’s initial investment.

Liquidation Preference

In the event of liquidation, a company will have to sell its assets to pay for all of its obligations.

As much as possible, it would want to pay all its creditors, be they external or internal.

The company must pay its creditors first.

The highest priority belongs to secured creditors.

Next to them are the unsecured creditors which may include bondholders, the government (if the company has unpaid tax liabilities), and employees (who still have unpaid salaries and wages or other obligations).

Finally, any remaining amount will go to the company’s shareholders.

If the company has preferred shareholders, they are typically paid first.

The least priority of payment goes to common shareholders.

With common shareholders having the least priority, it rarely happens that the liquidating dividend will exceed their initial investment.

In most cases, the liquidating dividend isn’t enough to cover the initial investment of the shareholders.