What is a Liquidating Dividend?
A liquidating dividend is a type of dividend payment made to shareholders. Unlike other types of dividends, the payment is generated by utilizing assets other than income derived from earnings. In some cases, assets may be sold and the cash generated from those transactions used to issue the payments to shareholders. This means of supplying dividend payments to shareholders is rarely used, except in situations where the business is preparing to shut down or liquidate, or a temporary issue with cash flow has developed.
Since a liquidating dividend is not paid out of the earnings generated by the business during a specific period, the transaction is considered a return of capital rather than a return on profits. This creates a situation where the issuer of the dividend payment does not have to pay taxes on the total amount of dividends paid from the capital, since those payments were funded using assets that presumably were taxed previously. The decision to cover the dividend payments from existing capital assets rather than earnings is not left up solely to the discretion of the company. Many tax agencies have specific regulations that require companies to document that the flow of earnings is insufficient to manage the current dividend payments due to shareholders in order to claim that the payments are tax-exempt.
While compensating shareholders with a liquidating dividend is somewhat rare, there are situations where this strategy is the most prudent course of action. In some cases, the need to use capital assets to make dividend payments may be due to what is known as wasting assets. This is more common with energy companies that provide coal, or various types of petroleum products. Another situation where a liquidating dividend may be issued is when the business itself is in the process of being liquidated. For example, if the owner of the business passes away and the heirs choose to liquidate the company rather than continuing to operate it or sell it to a competitor, this type of payment method may be issued on some type of pro-rated basis.
In general, the issuance of a liquidating dividend is a sign that the company is in some sort of financial difficulty. While there are situations where this measure becomes necessary due to a short-term interruption in cash flow, the strategy more often points to a financial problem that may or may not be easily resolved. For this reason, companies tend to consider all other options in meeting their commitments to shareholders before resorting to issuing a liquidating dividend.
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