Dividends are corporate profits distributed to shareholders. A company can use profits in a variety of ways, but it must consider the effect of its decisions on shareholder value. A cash dividend is money in shareholders’ pockets, but it might produce a smaller net benefit than other means of enhancing shareholder value.
How a Company Can Use Profits
In addition to paying dividends, a company can use corporate profits to expand, or to buy back shares of its stock. Profit growth might result in a higher stock price. A stock buyback makes the remaining shares more valuable to investors, which also might lead to higher stock prices.
Assuming a 15 percent income tax bracket, an investor will keep 85 cents of every dollar he receives in dividends. The same $1 reinvested in the business or used to repurchase company shares could push up the stock price by several dollars, producing a greater net benefit to the shareholders.
Corporate profits paid out to shareholders are effectively taxed twice: first at the corporate level, and then at the individual investor level. Profits reinvested in the business or used to buy back stock are not taxable to the shareholders.
A shareholder must pay income tax on cash dividends in the year received; stock price appreciation is not taxed until the stock is sold. So an investor can choose when to pay tax, and even how much, by deciding when to sell his shares and how many. If a shareholder does not need current income, cash dividends can push him unnecessarily into a higher tax bracket.
Shareholders who do not need current income can choose to reinvest dividends in additional shares of stock. Dividend reinvestment can compound growth but might also cause problems. Reinvested dividends are still taxable in the year received. The problem is compounded when a stock declines in value: An investor would owe income tax on the reinvested dividends even though her investment would be worth less.
Some investors fail to factor reinvested dividends into the cost basis when they sell their shares. If an investor has been reinvesting dividends for several years, calculating the cost can be a challenge. If she does not include the reinvested dividends in the cost basis, she will end up paying more capital gains tax than she should.