What Are Accrued Dividends and How Are They Taxed?
Understand the critical timing difference between when a company owes a dividend and when an investor is actually taxed on the income they receive.
Accrued dividends represent earnings that a company owes to its shareholders but has not yet distributed. This concept is associated with cumulative preferred stock, where a company promises that dividends will be paid. If the company cannot make these payments as scheduled, the obligation does not disappear. Instead, the owed payments accumulate over time, which has specific accounting and tax consequences.
The Dividend Accrual Process
The dividend payment process is marked by four dates that define the transaction.
- Declaration date: The company’s board of directors officially announces its intention to pay a dividend, which creates a legal liability for the company.
- Ex-dividend date: The first day a stock trades without the value of the next dividend payment. An investor must own the stock before this date to be entitled to the payment.
- Record date: The day the company reviews its records to identify all shareholders eligible to receive the dividend.
- Payment date: The date when the dividend is actually paid to eligible shareholders.
This process is significant for cumulative preferred stock, which guarantees payment of all owed dividends before any can be distributed to common stockholders. If a company misses a dividend payment to its cumulative preferred shareholders, that unpaid amount becomes a “dividend in arrears.” These arrears continue to accumulate for every missed payment period.
Calculating Accrued Dividends
To calculate the total accrued dividends on cumulative preferred stock, multiply the stock’s par value by its stated dividend rate, and then multiply that result by the number of missed payment periods. The par value is a nominal value assigned to the stock, while the dividend rate is the fixed percentage used for the annual payment.
For example, a company has issued cumulative preferred stock with a par value of $100 per share and a 5% annual dividend rate. This means each share is entitled to a $5 dividend each year. If the company is unable to make payments for two consecutive years, the accrued dividends are calculated for that period.
The calculation is the $100 par value multiplied by the 5% dividend rate, which equals $5 per year. Since payments were missed for two years, this annual amount is multiplied by two, resulting in a total of $10 in accrued dividends per share.
Reporting on Financial Statements
A company does not record dividends in arrears as a formal liability on its balance sheet. This is because the legal obligation to pay is only triggered when the board of directors officially declares the dividend. Until a declaration is made, the arrears exist as a potential future obligation.
Even though they are not a formal liability, U.S. Generally Accepted Accounting Principles (GAAP) require companies to disclose this information. The total cumulative amount of unpaid dividends must be reported in the footnotes to the financial statements. This disclosure ensures transparency for investors and other stakeholders.
Tax Implications for Investors
For federal tax purposes, investors pay tax on income when it is received, not when it is accrued. This is known as the cash basis of accounting. An investor who holds cumulative preferred stock with dividends in arrears will not owe any tax on those unpaid amounts until they are paid.
The tax obligation is deferred until the company declares and pays the dividends. When the company distributes the payment for past-due dividends, a taxable event occurs. The full amount received, including payments for prior periods, is considered taxable income in the year of receipt.
The company that pays the dividend must report the payment to the investor and the Internal Revenue Service (IRS) on Form 1099-DIV, “Dividends and Distributions.” The investor uses this form to report the income on their personal tax return for the year the payment was received.