The term liquidating dividend refers to the process of providing shareholders with a partial or full distribution of their capital investment in the company. Liquidating dividends are typically paid when a company is going out of business or has sold a portion of the enterprise.
Also known as liquidating distributions, a liquidating dividend is a return of the company's shareholders' capital investment. This concept is different than regular dividends, which are paid from the company's profits or retained earnings.
This difference has income tax implications to shareholders. While regular dividends are taxable, liquidating dividends are not taxable since they are merely the return of the shareholder's investments. Companies will issue IRS Form 1099-DIV, which clarifies the tax implications of the distribution.
Companies will pay liquidating dividends under the following circumstances:
- The company has filed for bankruptcy and decided the best course of action would be to liquidate the net assets of the company.
- The company has decided to exit a business and has sold the operation's assets to another entity.
Distributions can only be made to shareholders after the money owed to creditors has been paid. Cash can only be paid to shareholders if the company's net assets are positive.
The management team at Company A has decided to declare a dividend of $2.00 per share and has 800,000 shares of common stock outstanding. The company balance sheet shows $400,000 in retained earnings and $5,000,000 in paid in capital in excess of par. The following entry is required:
Cash Paid = Shares of Common Stock x Dividend
= 800,000 x $2.00, or $1,600,000
The journal entry to record the transaction would be:
In the above example, shareholders would need to be informed that $400,000 / 800,000, or $0.50 per share were regular dividends, while $1.50 per share represents a liquidating dividend.