Ordinary dividend: Meaning, Criticisms & Real-World Uses

What Is an Ordinary Dividend?

An ordinary dividend is a distribution of a company's earnings to its shareholders that is taxed at the investor's ordinary income tax rate. These distributions are the most common type of dividends paid by corporations and fall under the broader category of corporate finance, specifically related to a firm's distribution policy. When a corporation pays out a portion of its earnings per share as an ordinary dividend, it reduces the company's retained earnings.

History and Origin

The practice of distributing corporate profits to owners has existed as long as corporations themselves. In the United States, the taxation of dividends has evolved significantly over time. For many years, ordinary dividends were subject to the same progressive tax rates as other forms of ordinary income, such as wages or interest. A significant shift occurred with the passage of the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA). This legislation, signed into law on May 28, 2003, dramatically reduced the maximum tax rate on qualified dividends from a high of 38% to 15% for most taxpayers, aligning them with long-term capital gains rates¹², ¹³, ¹⁴, ¹⁵. This change aimed to stimulate economic activity by lowering the cost of capital and encouraging more companies to pay dividends¹¹. While the tax cut aimed to stimulate investment, studies have shown that it had no significant impact on business investment or employee compensation after 2003¹⁰.

Key Takeaways

An ordinary dividend is a portion of a company's profits paid to shareholders, typically taxed at regular income tax rates.
Most dividends received by investors are classified as ordinary dividends by the Internal Revenue Service (IRS).
Companies often pay ordinary dividends on a fixed schedule, such as quarterly.
The tax treatment of ordinary dividends can differ from that of qualified dividends.
The payment of an ordinary dividend impacts a company's cash flow and retained earnings.

Formula and Calculation

An ordinary dividend itself doesn't typically have a "formula" for its value, as it's a fixed amount per share declared by the company's board of directors. However, the total ordinary dividend received by an investor is calculated as:

\text{Total Ordinary Dividend} = \text{Dividend Per Share} \times \text{Number of Shares Owned}

For example, if a company declares an ordinary dividend of $0.50 per share and an investor owns 200 shares, the total ordinary dividend received would be:

\text{Total Ordinary Dividend} = \$0.50 \times 200 = \$100

The dividend payout ratio, which indicates the proportion of earnings paid out as dividends, is a related calculation:

\text{Dividend Payout Ratio} = \frac{\text{Total Dividends Paid}}{\text{Net Income}}

Interpreting the Ordinary Dividend

Interpreting an ordinary dividend involves understanding its implications for both the investor and the company. For an investor, receiving an ordinary dividend represents a direct return on their investment in the company, separate from any potential capital appreciation of the stock. It signifies that the company is profitable and willing to share its success with its owners.

From a company's perspective, the decision to pay an ordinary dividend reflects a deliberate strategy regarding capital allocation. A consistent ordinary dividend payment can signal financial stability and maturity, potentially attracting income-focused investors. However, it also means that the company is distributing capital that could otherwise be reinvested in the business for growth, used to reduce debt, or for share repurchases. Investors should consider the company's overall financial health, as reflected in its balance sheet and income statement, when evaluating the sustainability of an ordinary dividend.

Hypothetical Example

Imagine Sarah owns 150 shares of Company ABC's common stock. On January 15, Company ABC announces an ordinary dividend of $0.25 per share, payable on February 15 to shareholders of record as of January 31.

Since Sarah owns 150 shares and the dividend is $0.25 per share, her total ordinary dividend payment will be:

Total Ordinary Dividend = 150 shares * $0.25/share = $37.50

On February 15, Sarah receives a check or direct deposit for $37.50. This amount will be reported to her on Form 1099-DIV and will be included in her taxable income for the year, subject to her ordinary income tax rates. It's important for Sarah to understand the ex-dividend date as well; to receive this dividend, she must have owned the shares before that date.

Practical Applications

Ordinary dividends have several practical applications across investing, financial analysis, and personal financial planning:

Income Generation: For investors seeking regular income, such as retirees or those on a fixed income, ordinary dividends provide a steady stream of cash flow from their investments.
Company Valuation: Analysts consider a company's ordinary dividend payments and its dividend yield when evaluating its financial health and attractiveness as an investment. Consistent dividend payments can indicate a mature, stable company.
Tax Planning: Understanding the tax treatment of ordinary dividends is crucial for individual investors. The IRS provides detailed guidance on how to report and pay taxes on dividends, primarily through IRS Publication 17, "Your Federal Income Tax for Individuals"⁸, ⁹. Taxpayers typically receive Form 1099-DIV from dividend payers, which classifies the type and amount of dividend⁷.
Shareholder Relations: For companies, maintaining a consistent ordinary dividend can demonstrate a commitment to returning value to shareholders and can enhance investor confidence, contributing to positive corporate governance. Information on dividends and other shareholder-related matters is often found on the Investor.gov website, a resource from the U.S. Securities and Exchange Commission (SEC)⁶.

Limitations and Criticisms

While ordinary dividends offer benefits, they also come with limitations and criticisms:

Tax Efficiency: The primary criticism of ordinary dividends, especially historically, has been their less favorable tax treatment compared to qualified dividends or long-term capital gains. Before certain tax law changes, this could lead to a "double taxation" scenario where corporate profits were taxed at the corporate level and then again when distributed to shareholders as dividends. While the 2003 tax cuts significantly mitigated this by lowering the tax rate on qualified dividends, ordinary dividends still face higher taxation for most investors.
Opportunity Cost: When a company pays an ordinary dividend, it reduces the capital available for reinvestment in the business. Critics argue that retaining earnings for growth opportunities, such as research and development, acquisitions, or expanding operations, could generate higher long-term returns for shareholders than immediate dividend payouts.
No Guarantee: Companies are not obligated to pay dividends. A company can reduce or eliminate its ordinary dividend at any time, which can lead to a decrease in stock price and investor dissatisfaction. For instance, during economic downturns, companies may cut dividends to preserve capital.
Impact on Stock Price: On the ex-dividend date, the stock price is typically expected to drop by the amount of the dividend paid, as the value is being distributed out of the company⁵. This means that the total value of an investor's holding (stock price + dividend) remains theoretically the same immediately after the dividend is paid. This is similar to how a stock split adjusts the share price without changing the total value of an investor's holdings³, ⁴.

Ordinary Dividend vs. Qualified Dividend

The distinction between an ordinary dividend and a qualified dividend is crucial for tax purposes. While both represent distributions of a company's earnings to shareholders, their tax treatment differs significantly in the U.S. tax code.

Ordinary Dividends: These are the default classification for most dividends. They are taxed at the investor's marginal taxable income rates, which can range from 10% to 37% as of recent tax laws. Most dividends from real estate investment trusts (REITs) and money market accounts are examples of ordinary dividends.
Qualified Dividends: These dividends meet specific IRS criteria regarding the type of dividend, the holding period of the stock, and the source of the dividend. If a dividend is "qualified," it is taxed at the lower long-term capital gains rates, which typically range from 0% to 20%, depending on the taxpayer's ordinary income bracket. To be qualified, the dividend must generally be paid by a U.S. corporation or a qualified foreign corporation, and the investor must hold the stock for a minimum period around the ex-dividend date.

The primary confusion arises because all qualified dividends are, by definition, also ordinary dividends. However, not all ordinary dividends are qualified. The payer of the dividend is required to correctly identify each type and amount of dividend on Form 1099-DIV for tax reporting².

FAQs

Are all dividends ordinary dividends?

No, not all dividends are ordinary dividends. Dividends can be classified as either ordinary or qualified. While all qualified dividends are a type of ordinary dividend, only those that meet specific IRS criteria regarding the stock's holding period and the paying company's origin are considered "qualified" for favorable tax treatment.

How are ordinary dividends taxed?

Ordinary dividends are generally taxed at your regular federal income tax rates, similar to wages or interest income. These rates vary based on your total taxable income and filing status.

What is a dividend reinvestment plan (DRIP)?

A dividend reinvestment plan (DRIP) allows investors to use their cash dividends to purchase additional shares or fractional shares of the same company's stock, often without paying brokerage commissions. This strategy can help grow an investment over time through compounding.

Where can I find information about the dividends I received?

Companies that pay dividends are required to send investors a Form 1099-DIV, "Dividends and Distributions." This form details the total dividends received and specifies whether they are ordinary or qualified, helping you properly report them on your tax return. The IRS provides guidance in IRS Topic No. 404, Dividends ¹.