Ordinary dividends: Meaning, Criticisms & Real-World Uses

What Are Ordinary Dividends?

Ordinary dividends represent the most common form of distribution paid by a corporation to its shareholders out of its accumulated earnings and profits (E&P). These distributions are generally considered taxable income to the recipient in the year they are received and are taxed at an individual's marginal tax brackets for ordinary income. As a key component of investment income, understanding ordinary dividends is fundamental for investors in equity investments and falls under the broader category of corporate finance.

History and Origin

The concept of companies distributing a portion of their profits to owners dates back to early joint-stock companies. In the United States, the taxation of dividends has evolved significantly since the inception of the income tax. Initially, after the passage of the 16th Amendment in 1913, dividends paid to shareholders were largely exempt from federal income tax to avoid what was perceived as double taxation on corporate earnings. However, this changed, with a period from 1936 to 1939 where dividends were taxed at individual income tax rates.,⁹

Following this, various exemptions and credits were introduced, and for an eighteen-year period from 1985 to 2003, dividends were again fully taxed at an individual's income tax bracket. A major shift occurred with the Jobs and Growth Tax Relief Reconciliation Act of 2003, which significantly reduced tax rates on qualified dividends, distinguishing them from ordinary dividends. This legislative history underscores the long-standing debate and changing policy landscape surrounding the taxation of dividend tax.

Key Takeaways

Ordinary dividends are distributions of a company's earnings and profits to shareholders.
They are typically taxed at an investor's ordinary income tax rates.
Unlike qualified dividends, they do not receive preferential tax treatment.
The Internal Revenue Service (IRS) provides detailed guidance on reporting ordinary dividends.
A company's dividend policy dictates how and when these distributions occur.

Formula and Calculation

The calculation of an ordinary dividend per share is straightforward:

\text{Ordinary Dividend Per Share} = \frac{\text{Total Ordinary Dividends Paid}}{\text{Number of Outstanding Shares}}

Where:

Total Ordinary Dividends Paid refers to the total monetary amount distributed by the company as ordinary dividends.
Number of Outstanding Shares represents the total number of shares of a company's stock currently held by investors, including restricted shares.

This formula helps determine the per-share amount a shareholder receives from the total ordinary dividends declared.

Interpreting Ordinary Dividends

Ordinary dividends are interpreted primarily in the context of an investor's tax liability and the company's financial health. When a company declares and pays ordinary dividends, it signals that the company has sufficient earnings and profits (E&P) to distribute to its shareholders. For individual investors, the receipt of ordinary dividends means this income will be added to their other forms of income, such as wages or interest, and taxed according to their applicable federal income tax brackets.

The amount of ordinary dividends received directly impacts an investor's gross income and, consequently, their net income after taxes. Understanding the distinction between ordinary and other types of distributions, such as qualified dividends or non-dividend distributions, is crucial for accurate tax planning and assessing the true after-tax return on an equity investment.

Hypothetical Example

Consider XYZ Corp., a publicly traded company that specializes in real estate investments. Since Real Estate Investment Trusts (REITs) typically pay non-qualified (ordinary) dividends, XYZ Corp. declares an ordinary dividend of $1.00 per share.

Suppose an investor, Sarah, owns 500 shares of XYZ Corp.
When XYZ Corp. distributes its ordinary dividends:

Dividend Calculation: Sarah receives 500 shares * $1.00/share = $500 in ordinary dividends.
Tax Implications: Sarah’s $500 in ordinary dividends will be added to her other income for the year. If Sarah is in the 22% federal income tax bracket, she will owe approximately $500 * 0.22 = $110 in taxes on these dividends.
After-Tax Income: Sarah’s net income from the dividend, after federal taxes, would be $500 - $110 = $390.

This example highlights how ordinary dividends are treated as regular income for tax purposes, directly affecting the investor's after-tax return. Investors receive a Form 1099-DIV from the payer, which details the amount of ordinary dividends and any other distributions.

Practical Applications

Ordinary dividends play a significant role in various aspects of personal finance and investment analysis. For individual investors, they are a source of current investment income that can be used for spending or reinvestment. However, due to their taxation at ordinary income rates, investors often consider the tax efficiency of such income when constructing their portfolios. This is particularly relevant when comparing investments that primarily pay ordinary dividends versus those that pay qualified dividends or offer returns through capital gains.

From a corporate perspective, the decision to pay ordinary dividends is a key aspect of a company's dividend policy and overall corporate finance strategy. Companies must consider their earnings and profits (E&P) and liquidity when determining dividend distributions. Publicly traded companies are also subject to notification requirements regarding dividend actions. For instance, the U.S. Securities and Exchange Commission (SEC) outlines policies requiring companies to provide prompt notice to exchanges regarding dividend declarations or omissions., Th⁸i⁷s ensures transparency and helps maintain a fair and orderly market by making information available to the public.

Limitations and Criticisms

While ordinary dividends provide direct income to shareholders, their taxation at higher, ordinary income rates can be seen as a limitation compared to the preferential tax treatment often given to qualified dividends and long-term capital gains. This difference in tax rates can lead to a phenomenon known as "double taxation," where corporate profits are taxed at the corporate tax level and then again when distributed to shareholders as dividends., Th⁶i⁵s may disincentivize companies from distributing profits, instead opting for strategies like share buybacks that can provide returns through capital appreciation, which might be taxed at lower rates for investors.

Some financial theories, such as the dividend irrelevance theory proposed by Miller and Modigliani, suggest that in a perfect capital market, a company's dividend policy should not affect its shareholder value., Ho⁴w³ever, real-world market imperfections, including tax differentials, can cause deviations from this theory. Critics also point out that high dividend payout ratio might indicate a lack of profitable reinvestment opportunities for the company, potentially limiting future growth.

Ordinary Dividends vs. Qualified Dividends

The primary distinction between ordinary dividends and qualified dividends lies in their tax treatment for individual investors.

Feature	Ordinary Dividends	Qualified Dividends
Tax Rate	Taxed at ordinary income tax rates (marginal rate).	Taxed at preferential long-term capital gains rates (typically 0%, 15%, or 20%).,
²	¹ Eligibility	Most common type of dividend; no specific holding period or issuer requirements for ordinary income treatment.
Form 1099-DIV	Reported in Box 1a of Form 1099-DIV.	Reported in Box 1b of Form 1099-DIV.
Examples	Dividends from REITs, money market accounts, employee stock options.	Most common stock dividends from U.S. corporations, and some foreign corporations, meeting holding period rules.

The confusion often arises because all qualified dividends are also technically ordinary dividends in the broader sense of being a distribution from a company's profits. However, the term "ordinary dividends" is specifically used in tax contexts to refer to those that do not meet the criteria for preferential "qualified" treatment. This distinction significantly impacts an investor's overall taxable income and after-tax returns.

FAQs

How do I know if a dividend is ordinary or qualified?

Your brokerage firm or mutual fund will report the type of dividend you received on Form 1099-DIV. Box 1a shows the total ordinary dividends, and Box 1b shows the portion of those that are qualified dividends. If Box 1b is empty or zero, then all dividends reported in Box 1a are considered ordinary for tax purposes.

Are ordinary dividends subject to federal income tax?

Yes, ordinary dividends are generally subject to federal income tax at your marginal income tax brackets, just like wages or interest income. The specific rate depends on your overall taxable income and filing status. The IRS Publication 550 provides comprehensive information on reporting this type of investment income.

Do ordinary dividends affect my stock basis?

Typically, no. Ordinary dividends are distributions of a company's earnings and profits (E&P) and are taxed as income. They do not reduce your stock basis. Non-dividend distributions, however, can reduce your basis.

Can a company choose whether to pay ordinary or qualified dividends?

The tax classification of a dividend as "ordinary" or "qualified" is based on specific criteria set by tax law, primarily related to the issuer's type (e.g., U.S. corporation vs. REIT) and the shareholder's holding period of the stock. A company decides to pay a dividend and the amount, but the tax treatment for the shareholder is determined by these predefined tax rules, not a choice by the company.