A stock dividend is a form of equity distribution in which the company’s profits are paid as a stock dividend to its shareholders. The company distributes dividends on its earnings after paying all costs and expenses, such as compensation payments and capital expenditures.
Stock dividends are taxable income to the shareholder at the ordinary tax rates since they are considered regular income rather than capital gains or dividends. The value of a stock dividend is determined by how much income it generates for a given amount of risk taken.
Examples of Stock Dividend
1. A company’s board of directors declares one dividend for each company’s outstanding share. One shares dividend that has been paid out will reduce the number of existing shares by a specific proportion.
2. A company’s board of directors issues one right per outstanding share, which entitles the shareholders to buy a new share at the exact cost of an existing share. These rights are called right shares or “shares by call.”
3. A company’s board of directors issues bonds with a cash payout at maturity equivalent to a stock dividend on each outstanding bond that has been paid out, reducing the number of bonds due in a specific proportion.
4. A company’s board of directors reinvests surplus cash into the company by issuing preferred shares with a dividend rate equal to the prime rate.
5. A company’s board of directors reinvests surplus cash into the company by issuing bonds with a cash payout at maturity equivalent to the prime rate.
6. A company’s board of directors reinvests surplus cash into the company by acquiring another business and issuing new stock in proportion to that business’s earnings before interest and tax.
7. A company’s board of directors reinvests surplus cash into the company by acquiring another business and issuing a new debt instrument with a maturity date equal to that of the most recently published debt, an interest rate equivalent to the prime rate, and an option for early repayment. No dividend is declared during the term of this new debt, but additional new debt is issued after five years at a lower interest rate based on a lower interest rate.
Benefits of Stock Dividend
1. Hedge against inflation- A stock dividend is a form of inflation hedging. It reduces your overall risk on investment. When inflation increases, the value of a stock will also increase, and vice versa. If the value of a stock decreases, the company can reduce its outstanding shares accordingly.
2. growth potential- Some investors believe that gains from investing in the “undervalued” companies would be better than their potential losses from investing in other sectors, significantly when their sources of cash flow have been compromised by poor management or overleverage.
3. Opportunity to invest in high-growth companies – Several small and medium-sized companies are struggling financially but have tremendous potential for growth. They can offer investors extraordinary opportunities, including capital appreciation and residual income from their free cash flow.
4. Preferential tax treatment- The stock dividend is given preferential tax treatment as it is not included in the cost basis of the shares. The cost basis may be defined as the fair market value of the shares at the time of the transaction (potential profit).
5. Stock dividend is not taxable-If a stock is held for more than one year, and there is no indication of an active market for the store, the gain on the sale of a stock received as a stock dividend will not be taxable. However, if there are indications that the company’s shares are actively traded in an open market, then gains from selling any stock dividends will be subject to capital gains tax.
6. Payback on a tax-deferred basis- A stock dividend should be included in the amount of a shareholder’s cost basis in their shares held for at least one year (or 120 days). This will result in a reduction in taxable income. If for some reason, a stock dividend is not included in the cost basis and is included in taxable income, then the total amount will be subject to tax.
7. Potential for capital gains- The stock dividend can be turned into capital gains or dividends if sold after 12 months (4 months for special bonuses). If the business has been inactive for a more extended period, this may indicate potential losses from operations and may warrant further investigation.
8. Preferred stock dividends can be better-The dividends will be deferred at least until the preferred shares are converted. The dividend amount will be included in your cost basis when the stakes are converted to common stock, reducing your tax liability. If you sell the shares before they are converted, you will have to pay income tax on that dividend portion. Some investors may prefer this form of payment over a cash distribution because it reduces their current taxable income on a dollar-for-dollar basis.
Stock dividends can potentially increase financial security when invested in the right company. The shares are valued in liquid markets and can be distributed to shareholders without paying capital gains tax. Stock dividends can also be used for income protection. Stock dividends have a higher return on investment than an equity mutual fund and have an opportunity for growth due to low risk. However, this is conditional on being diversified.