Definition and example of indirect dividends

What is the indirect dividend?

An indirect dividend is a dividend that is announced in one year, but is counted as part of another year’s income for federal tax purposes. This often happens when a dividend is announced near the end of the calendar year. A company could declare in December 2020, for example, that registered shareholders will receive a dividend. Actual payment of the dividend may not occur until January or February 2021. In these cases, the dividend would be accounted for as taxable income in the year it was declared, not the year it was paid.

Key takeaways

  • An indirect dividend is announced in one year, but paid in another.
  • Investors pay tax on the dividend the year it is announced, not the year the dividend is paid to them.
  • For certain business entities, the rules on indirect dividends are more complex.

Understand the indirect dividend

An indirect dividend could be “rolled over” to the following year in terms of payment to shareholders, but in terms of taxes, that liability would remain in the year the dividend was announced. For example, ABC Corporation states that shareholders of record on December 15, 2020 are entitled to receive a dividend of $ 2 for each ABC share they own, with a payment date of January 25, 2021. For the Tax Service Internal (IRS) For purposes, shareholders would have to include the dividend of $ 2 per share when they file their annual tax return for 2020.

For most taxpayers this is not a problem, since they have the dividend in hand when they pay their taxes for the year.

The dividend process

The process of establishing and paying dividends is subject not only to the discretion of the corporation, but also to the rules of the respective stock exchange on which the shares are listed. There are four important dates related to dividends:

  1. Declaration date or announcement date.
  2. Ex-dividend date.
  3. Registration date or owner of the registration date.
  4. Payment date.

The declaration date is when the dividend is announced. The ex-dividend date means that anyone who purchases the shares on or after the ex-dividend date is not entitled to the declared dividend. The registration date is usually the day after the dividend date and is when the company records who receives the dividend. The payment date is when the actual dividend is paid to eligible shareholders.

On the ex-dividend date, the price of the shares should theoretically fall by the amount of the dividend, since the company will allocate that amount to distribute it to the shareholders. For example, if a company has declared a dividend of $ 1, on the ex-dividend day the shares should, theoretically, open $ 1 less than the previous close. In the real world, this doesn’t always happen because there are multiple factors that affect the stock price.

Exceptions to the Indirect Dividend Tax Rules

For some types of entities, the tax rules for indirect dividends are more complicated. For registered investment companies (RICs), such as mutual funds or real estate investment trusts (REITs); or companies that pay taxes like them, such as business development companies (BDC). United States law says that secondary dividends must be declared by the 15thth day of the ninth month after the end of the taxable year.

In addition, shareholders typically pay taxes on dividends in the year in which the actual payment of these dividends is made. The deadline for a RIC to file its tax return is 15th day of the third month of the following financial year. A business can get a six-month automatic filing extension if its Form-7004 is filed before the tax return due date.

Because RICs usually make use of the six-month extension, it means that RICs effectively have the option of declaring indirect dividends as taxable income nine and a half months after the current taxable year.

Example of an indirect dividend

In a given year, an indirect dividend could end up looking like the following graph.

Image by Sabrina Jiang © Investopedia 2021

The company declares a dividend in October. The ex-dividend date is set for December 14. Anyone who wants the dividend must own the shares before the ex-dividend date. Effectively, ex-dividend means that there are no dividends for the people who buy the shares that day. The registration date is for the company and is not of much interest to the investor. However, in this case, because the dividend occurs near the end of the year, the payment date is not until January.

For tax purposes, the dividend must be included on the investor’s tax return for this year, although they will not actually receive the dividend payment until next year.

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Mark Holland

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