When reading about equities, investors seem to assume that dividends and distributions are alike. In many cases, these can mean the same thing. However, when you look beyond the transfer of cash from company to stockholder, you can see huge contrasts between dividends and distributions. By understanding these differences, investors can weigh the tax and ownership effects more easily and maximize the benefits of stock-based cash flows.
When studying many equities, it’s easy to gloss over the differences between dividends and distributions. At first, most income-oriented investors care only about receiving the cash, with little regard for such distinctions. However, issues can appear later, so understanding how the payouts differ matters.
How Dividends Work
Dividends stand out as the most common form of cash payout for C Corporations, the type of company that trades on the major exchanges. In fact, many investors who buy into C-Corporations care little about stock price increases. They buy stocks such as Coca-Cola (NYSE:KO) or Exxon Mobil (NYSE:XOM) simply to receive a dividend that enjoys a history of annual increases.
The dividends also do not figure into the original cost basis of buying the stock. This is because the IRS treats dividends as a share of a company’s profits — as opposed to an equity stake in the company. Also, dividends do not always involve cash. Investors can often receive dividends in the form of shares or other types of property. Some choose to convert their cash payout into shares so they can receive higher dividend payments in future quarters. However, for tax purposes, they are still treated as cash payouts.
They also differ from a tax outlook. Recipients will place these dividends in the 1099-DIV section of one’s tax form. They will pay taxes on the payout, according to rules governing dividends. From the company point of view, they pay dividends with after-tax income. Firms receive no tax deductions for making such payouts.
How Distributions Differ
Distributions work differently. Mutual funds and companies set up as S Corporations (or sometimes partnerships, LLCs, trusts, and estates) make distributions. They make such payouts often to lower a company’s tax burden. Hence, they make payouts with before-tax income.
For this reason, the IRS considers distributions a payout of company equity. As a result, these payouts will figure into an investor’s cost basis. Distributions always come in the form of cash. In the case of S Corporations, entities will report these payouts on IRS Form K-1. Partnerships, LLCs, and other entities will report on a similar form bearing a different name. The recipient treats such payouts as a type of income. This payment will appear on Schedule E of the recipient’s 1040 tax form.
Stock investors will most commonly see distributions within mutual funds. The way funds list these payouts often confuses investors. When people examine funds such as the Vanguard Institutional Index I (MUTF:VINIX) or the American Funds EuroPacific Growth F-1 (MUTF:AEGFX), they might notice a section called “Dividend and Capital Gains Distributions.” As the name implies, the section includes both dividends and distributions.
The payouts consist of dividends in most cases. However, at times, mutual funds will pay distributions. This occurs when the fund sells stocks and earns capital gains. Many choose to pass these through in the form of cash payouts to shareholders. Usually, the IRS will tax this type of payout as a capital gain.
Final Thoughts on Dividends and Distributions
Dividends and distributions often appear the same from the recipient’s perspective. Dividends may or may not involve cash. For tax purposes, companies derive them from a share of their income. In contrast, distributions always come in the form of cash payouts. They come from the equity of the company. As a result, a distribution affects both cost basis and taxation.
This disparity usually makes little difference when recipients get their payout. However, by understanding how each differs, investors can gain a better understanding of their investments and the subsequent tax consequences.
As of this writing, Will Healy did not hold a position in any of the aforementioned stocks. You can follow Will on Twitter at @HealyWriting.