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A dividend is any distribution to a shareholder in a company that is paid by that company from its net income or retained earnings, which are earnings held in reserve by the company for reinvestment or to repay debt. Some companies choose to pay a stock dividend, where the shareholder receives additional stock in the company rather than cash, but most pay cash dividends. There are two primary types of cash dividend: ordinary dividends and qualified dividends. The difference between an ordinary dividend and a qualified dividend is how they are treated for federal income tax purposes. Ordinary dividends are considered ordinary income and are taxed at the taxpayer’s normal tax rate, and a qualified dividend is taxed at a lower, preferred tax rate.
Shareholders provide companies with capital. When a company’s profits exceed its operating, reserve and expansion needs, most companies elect to pay a dividend to shareholders. Companies most likely to pay a dividend, whether it is an ordinary dividend or a qualified dividend, generally are larger, more established companies. Smaller, less established companies, known as “growth” companies, generally reinvest earnings into the company’s core operations to grow the company and its market share rather than pay a dividend.
Dividend-paying companies typically pay these dividends on a quarterly basis, though some pay dividends on an annual basis. At the end of the calendar year, a company that pays dividends to its shareholders typically must provide each shareholder with a form that shows the total dividends paid out. Unless otherwise noted, all dividends are considered ordinary dividends for income tax purposes.
There are several criteria that must be met for a dividend to be considered a qualified dividend and, thus, to receive preferential tax treatment. First, the dividend must be paid out by a qualifying company. Second, the shareholder must have held the stock for at least 60 of the 120-day period that begins on the last date for which the shareholder was eligible to receive the upcoming dividend. Finally, the dividend cannot be listed as a disallowed qualified dividend by the government agency that controls taxes, such as the Internal Revenue Service in the United States.
Qualified dividends are reported as part of the reported ordinary dividends. It is up to the shareholder to determine what, if any, portion of the reported ordinary dividends paid meet the criteria to be considered qualified dividends. When in doubt, the surest way for an investor to determine whether a dividend is an ordinary dividend or a qualified dividend is to check with the company’s investor relations representative.