A special dividend is a cash payment made by a company to its shareholders that is separate from any regular dividend the company is currently paying. Special dividends are typically the result of an earnings period in which a company received a windfall profit. Special dividends are also usually larger than a company’s regular dividend
In addition to expanding on the special dividend definition we provided, this article will explain why companies may choose to issue special dividends and review their tax ramifications as well as the affects special dividends have on a company’s share price. Finally, we’ll explain why some analysts can look at a special dividend as a bad signal for investors.
For What Reasons do Companies Pay Special Dividends?
As pointed out in the introduction, the most common reason that a company issues a special dividend is due to exceptional earnings that have left them with excess profit. However, here are other reasons a company may issue a special dividend.
- Selling off a large asset while going through a corporate restructuring - An example of this occurred in 2017 when a utilities sector stock, National Grid (NYSE: NGG) issued a special dividend of $17.2 billion after it sold 61 percent of its United Kingdom gas distribution business.
- Non-recurring capital gains - This type of capital gain can occur when a company has an equity stake in a company it lends to. That is the case of Main Street Capital (NYSE: MAIN). The business development company has been issuing a special dividend of $0.55 cents per share every year since 2013. Although the company believes it will be able to continue to deliver this special dividend for the foreseeable future, it is not considered a regular dividend. One reason for this is so that the company’s payout ratio does not rise to a level that could make investors and shareholders question the sustainability of the regular dividend.
- As part of a hybrid payout plan - In a hybrid payout plan, a company will issue a defined quarterly dividend and issue a special dividend on an annual basis that will bring their dividend payout ratio to the percentage of earnings per share (EPS) that they desire. An example of this is Ford Motor Company (NYSE: F) which for some time had a policy of issuing a regular dividend of 15 cents per share and a special dividend that gave them a payout ratio of 40% to 50% of EPS. Companies whose earnings can be cyclical may choose the flexibility of this dividend strategy as a way to reward long-term shareholders while still being able to have the cash on hand to address the needs of their capital-intensive business.
- To take advantage of a favorable tax policy - In 2012, a record number of companies issued special dividends due to the uncertainty of whether the tax cuts issued by the Bush administration would expire. This raised the tax rate for qualified dividends from 15% to being taxed as regular income.
What Are the Tax Ramifications of Special Dividends?
Special dividends are most commonly treated as a return of capital. For shareholders, having this classification means the income they receive is not taxed as regular income (like it would be for regular dividends). Instead the cost basis for the shares they receive is lower and the shareholders will only be taxed when the shares are sold.
An exception occurs if the money is held in a tax-deferred account, such as a 401(k) or IRA. In this case, the shareholder will miss out on the tax benefit since distributions from the plan after age 59 1/2 are taxed as regular income. Still, a special dividend like a regular dividend does undergo double taxation (the company is taxed as well as the shareholder).
However, there is a particular kind of special dividend arrangement in Australia known as a franked dividend that eliminates the double taxation of dividends. In this case, a shareholder can reduce the taxable amount they will pay.
This is because any dividends are paid out of a company’s profits that have been taxed. This “franking credit” is assessed at a company’s tax rate. Since that tax rate is generally higher than the shareholder’s tax rate, the investor can profit from the difference between the two rates. A fully franked dividend is one in which the company pays tax on the entire dividend thus allowing investors to receive 100% of the tax paid as franking credits.
What Effect do Special Dividends Have on a Company’s Stock Price?
The impact of a special dividend on a company’s stock price is that the company’s stock will fall by approximately the same amount of the special dividend on the day after its ex-dividend date. This is because by choosing to issue a special dividend, a company is electing to use their excess cash to pay shareholders. This reduces the value of the company.
So even though investors generally view a special dividend as a sign of financial health, it can have a negative impact on a company’s stock. For this reason, it’s typically not a sound investment strategy to buy shares of a company in order to capture the extra dividend.
Like a regular dividend, there is an ex-dividend date that applies to special dividends. However, since the amount of a special dividend can be a significant percentage of a company’s stock price, it could lead to market disruption by having a company’s share price fall to the point where it triggers stop-loss orders or margin calls. For this reason, the market adjusts the ex-dividend date using a “due bill” document.
Why Special Dividends Can be a Bad Idea
Many shareholders enjoy getting paid with cash from a special dividend. However, there are reasons why special dividends may not be a good idea for the issuing company.
- Analysts may question a company’s motives for issuing the special dividend – Specifically, analysts may wonder if the business has lost its ability to grow.
- Another reason that many experts don’t think special dividends are a good idea is that they add no long term value to a stock. A regular dividend is part of a company’s capital structure. They are predictable and if they grow it is usually a sign that a company’s earnings and free cash flow are also growing. Over time a quality dividend stock has a stable payout ratio and dividend yield.
- Special dividends can decrease a company’s future cash flow and as a result limit the opportunity for future dividend growth.
The Bottom Line on Special Dividends
Special dividends are one option that a company has to return excess cash to its shareholders. The typical reason for a company to issue a special dividend is because they have had a record earnings season which has put excess cash on their balance sheet. The special dividend is a one-time gift that they give to shareholders.
However, there can be other reasons that companies offer special dividends – particularly if they are involved in a cyclical industry. Although these dividends may be paid on a regular schedule, they are not considered to be regular dividends and do not factor into a company’s recorded dividend per share (DPS) number.
One key difference between a regular dividend and a special dividend is the ex-dividend date. Special dividends may require a large payment to shareholders. This can equal a significant percentage of a company’s share price. With that in mind, the market will adjust the ex-dividend date to help ensure there is no disruption in trading. However, like a regular dividend, the company’s share price will typically decline the day after the ex-dividend date.
Special dividends also enjoy different tax treatment since they typically receive a “return of income” classification. This allows shareholders to avoid taxes until they sell shares. With a regular dividend the money received is taxed as regular income even if the shares are reinvested.
When considering investing in a company that issues special dividends, investors should avoid chasing the dividend. Instead, they should apply the same due diligence that they would and invest in the stock if they see the long-term prospects for the company to be sound. In many cases, a special dividend is a sign that a company is on solid financial footing, but it can also be a caution that the company has no more opportunity for growth since it can’t find any other use for the extra cash.
