Investors not only seek capital appreciation from the securities they buy, but they sometimes also pick securities for the income they provide. Such income can come in the form of dividends and distributions. Some may think that dividends and distributions are interchangeable terms for these payouts, but they are very different. Understanding where these two forms of income differ can help investors navigate future investment options. Here are some of the main differences between dividends and distributions. A financial advisor can provide valuable insight into which type of fixed-income investments are the best fit for your goals, timeline and risk profile.
What Is a Dividend?
Purchasing a share of a stock makes you the partial owner of a corporation. When that happens, you can earn a payment from the company’s profits, known as a dividend. Generally, dividends are the most typical form of cash payment made by C corporations, typically large businesses whose shares trade on major stock exchanges, such as the New York Stock Exchange and the NASDAQ.
Companies may not always choose to pay out dividends. Instead, they can decide to hold on to the money and put it towards something within the company. That way, it has the opportunity to fund internal growth or future operations.
There are also different forms of dividends. Cash dividends are usually the most popular type, but there are also stock dividends, property dividends, scrip dividends and liquidating dividends.
The IRS views dividends as separate from the actual share of the company. Instead, the IRS treats it as a portion of the company’s profits. So, dividends don’t factor into the stock’s original cost.
What Is a Distribution?
Unlike a dividend, a distribution is a cash disbursement from a mutual fund or small business that is organized as an S corporation. In the U.S. such corporations can have no more than 100 owners or shareholders, all of whom are U.S. residents. Plus, they can only have a single class of shareholder.
S corporations, which are a type of pass-through entity, forward their income, deductions, losses and credits directly through to their shareholders. Those who hold these shares then report the flow-through of income and losses on their own tax returns, where they are assessed at the individual shareholder’s rate. The IRS treats distributions as a payout of company equity and thus are used to calculate the cost basis of an investment.
Distribution vs Dividend: Taxation
Payouts from S Corporations and C corporations are taxed differently.
Dividends from C corporations, which file Form 1120 tax returns, are taxed twice. Firstly, the company’s profits are taxed. Secondly, the disbursement of these profits as dividends is made with after-tax money and shareholders who receive these dividends must pay taxes on the dividends they have received. This is known as double taxation.
Sometimes dividends may become eligible as qualified dividends. In this case, they are up for taxation at a lower capital gains rate. Capital gain dividends also break into two categories: long and short term. Long-term capital gains operate under standard capital gain tax rates. In contrast, short-term capital gains are included under ordinary income.
Generally, S corporations, which file Form 1120-S tax returns (or another form identified with closely held businesses), don’t pay any income taxes. Instead, taxation occurs on the shareholders’ level. So, if you own shares of an S corporation, then you are taxed on your allocated share of the profits from the business, i.e., your distribution.
The particulars of the taxation for the shareholder that receives a distribution depend on the nature of that income. If it’s standard income, then you pay standard income tax rates as part of your individual tax liability. You report this type of income via Form 1040. However, if the distribution is considered capital gains (or dividends accumulated when an S corporations was a C corporation) then the shareholder pays at a lower tax rate.
Distribution vs Dividend: What Is a Yield?
The term “yield” typically refers to the income an investment earns. This is usually expressed as a percentage. Dividend yields are percentages calculated when you divide the overall yearly dividend payments that a shareholder earns by the stock’s current share price. In general, a good dividend yield sits around 2% to 6%, but various factors can sway that number higher or lower. Moreover, those numerous influences can also make it complicated to decide what qualifies as a good dividend yield.
Similarly, a distribution yield also measures the cash payout for a shareholder. For a distribution yield, you annualize the most recent distribution and divide that by the net asset value (NAV) of the investment at the moment of payment.
There are a number of investors who purchase stocks from certain companies regardless of increases in their stock price. They are more interested in the companies’ reliable dividend payout and the history of yearly increases that comes with it. These corporations are called Dividend Aristocrats, and they earn a spot on the S&P 500 index for paying and increasing their base dividend annually for a minimum of 25 consecutive years.
By calculating the yields on these Dividend Aristocrats or any valuable investments for distributions, investors can decide which shares are worth purchasing.
The Bottom Line
A dividend is a payment from a C corporation, usually in the form of cash or additional shares. A distribution, on the other hand, is a payment from a mutual fund or S corporation, always in the form of cash. Dividends are paid with after-tax money – thus they are double taxed; distributions are paid with before-tax money – thus they avoid being double taxed. The IRS treats distributions as a payout of company equity.
Tips on Investing
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If you’re interested in adding dividend income to your investment strategy, you may not know where to start. A financial advisor is one answer to such a dilemma. SmartAsset offers a free matching tool that can help you get in contact with up to three local advisors in only minutes. Once you find the one best suited for your needs and situation, they can help walk you through the process. If you’re ready, get started now.
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While your main goal may be to find the investment with the strongest dividend yield or distribution yield, it’s important to keep in mind the risk level of every investment. Prioritize your pre-established risk tolerance before looking for specific returns. If you want greater returns or more income, consider reevaluating your portfolio, its strategies and goals first.
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