Why Do Companies Issue Non-Dividend Distributions?

A non-dividend distribution is a payment made by a company to its shareholders that is not sourced from the company’s profits. This type of distribution is classified as a “return of capital,” which means the company is returning a portion of the shareholder’s original investment. Unlike a traditional dividend, which represents a share of the company’s earnings, a return of capital is different in its origin and its implications.

These payments are not necessarily a sign of financial trouble, as a profitable company can still issue one. The classification of a distribution hinges on specific tax accounting rules rather than the general financial health of the business.

The Role of Earnings and Profits in Distributions

The distinction between a taxable dividend and a non-dividend distribution is governed by a tax concept known as “Earnings and Profits” (E&P). E&P is not the same as retained earnings or net income found on standard financial statements. It is a measure defined by tax law, under Internal Revenue Code Section 316, to determine a corporation’s capacity to make distributions from its profits.

The calculation of E&P starts with a company’s taxable income and is then adjusted for items treated differently for tax and accounting purposes. For example, a company must add back certain deductions, like the accelerated depreciation of an asset, when calculating E&P.

Under tax law, any distribution is first treated as a dividend to the extent the company has positive current or accumulated E&P. Only after all E&P has been paid out can a subsequent distribution be classified as a non-dividend return of capital. A company could have significant cash but a zero or negative E&P balance, meaning any distribution must be classified as a return of capital.

Issuing Distributions Without Sufficient Profits

A company might issue a return of capital due to its financial circumstances, not a deliberate choice. This occurs when a company has cash to distribute but lacks the E&P to classify the payment as a dividend. This situation can arise from several business scenarios.

For instance, high-growth companies that reinvest heavily to fuel expansion can have low taxable income. These reinvestments, particularly in capital expenditures, can reduce E&P to the point where any distribution is considered a return of capital.

Companies in cyclical industries, like manufacturing, may experience periods of low profitability. To maintain investor confidence, they might make distributions from cash reserves, which will be classified as a return of capital if accumulated E&P has been depleted by prior losses.

A history of significant operating losses can also create a deficit in a company’s E&P. Until the E&P account becomes positive, any distributions will be treated as a return of capital.

Strategic Reasons for Returning Capital

A company may also deliberately structure a payment as a return of capital for strategic purposes. This is often done when a company wants to return a large amount of cash to investors without setting a precedent for future dividend payments. A one-time, special distribution is a common way to achieve this.

A company might find itself with a large cash surplus after selling a major asset or a business division. Instead of reinvesting, the company may return this cash to shareholders. Structuring this payment as a return of capital can be a tax-efficient way to distribute the funds if the company lacks sufficient E&P to cover a large dividend.

A partial liquidation of the business is another strategic reason. In this scenario, a company is winding down a specific part of its operations and returning the capital associated with that segment to its investors.

Finally, using a return of capital helps manage shareholder expectations. Regular dividends create an expectation of consistency, but classifying a payment as a return of capital signals it is a one-off event, giving the company more flexibility.

How Non-Dividend Distributions Affect Shareholders

For shareholders, receiving a non-dividend distribution has specific tax consequences that differ from a regular dividend. A return of capital is not taxable in the year it is received. Instead, it reduces the shareholder’s adjusted cost basis in their shares.

For example, if an investor purchased a share of stock for $50 and receives a $5 non-dividend distribution, the cost basis of that share is reduced to $45. The tax effect is deferred until the shareholder sells the stock. When the stock is sold, the lower cost basis will result in a larger capital gain or a smaller capital loss.

This tax treatment continues as long as the shareholder has a basis in the stock. If the total non-dividend distributions received exceed the shareholder’s original cost basis, the excess amount is treated differently. Once the cost basis is reduced to zero, any further distributions are taxed as a capital gain in the year they are received.

Shareholders will find information about non-dividend distributions on Form 1099-DIV. Nondividend distributions are reported in Box 3 of this form, allowing shareholders to accurately track the reduction in their cost basis.