In Part 1 of our examination, we looked at four myths surrounding the understanding of dividends. Here, we look at the last three -- two of them discuss what defines a dividend, and the third, in a related topic, looks at how buying and selling right around an ex-dividend date can affect your tax situation through capital gains or losses.

Myth 5: Everything called a dividend is really a dividend.
Considering how many meanings we attach to words, it should not surprise you that this is not true.

The word "dividend" is often used to cover several different types of payments that companies make to their shareholders. These include the sharing of earnings, payment of certain types of interest, and returns of capital. Only the first is truly a dividend.

Consider TD AmeriTrade Holding's (NASDAQ:AMTD) recently paid special dividend of $6 per share. According to the company's website, only a portion, to be determined at a later date, will actually constitute a real dividend. The rest of the payment will be a return of capital to shareholders.

These definitions have very serious tax consequences and affect how you will report this money to the IRS. The former, true dividends, are reported as part of your income and are taxed at either your normal tax rate or the lower qualified dividend tax rate, depending on how long you held the shares. (See Myth 3 in Part 1 of our discussion.) Interest is taxed as normal income. Return of capital is taxed as a capital gain at the time you sell. (See Myth 7 below for details.)

Fortunately, the vast majority of "dividends" that companies pay are actually real dividends. The above situation usually happens only in circumstances involving "special" dividends and payments made by real estate investment trusts -- situations that don't affect as many people. However, if you have a question about whether the dividends you receive are true dividends, contact the company's investor relations department.

Myth 6: Stock splits are not dividends
It depends on how the company decides to handle things. This doesn't much matter to you, but it does to the company.

In a true stock split, the company technically calls in all of its outstanding shares and issues new shares totaling more than it called in. For instance, if there are 1 million shares outstanding and the company declares a 3-for-2 stock split, it calls in all 1 million shares and then issues 1.5 million new ones. The effect to the stock's par value -- the carrying value of each share of stock found on the balance sheet -- is to change it by the inverse of the split ratio. For this example, the par value would be 67% of the original par value.

What you are concerned about is your basis. This is also reduced by the same ratio. If you had 100 shares at $60 each before, you would have 150 shares at $40 each afterward, using the example of the 3:2 split.

Often, though, the company actually issues new shares in the form of a stock dividend. In the above situation, it would be in the form of a 50% stock dividend. The difference from the company's point of view is in the accounting. Here, it transfers retained earnings into an account called "common stock at par value." In the above situation, if par value were $5 per share, then there would be a $2.5 million decrease in retained earnings and a corresponding increase in common stock at par value. Unlike with a stock split, there is no change in par value.

Some stock dividends are accounted for slightly differently, but the net effect is a movement of money from retained earnings into other accounts within the equity portion of the balance sheet. There's no effect for you, but the details matter to the company.

In this situation, your basis is adjusted downward depending on the amount of new stock received and the original basis of the stock originally owned. For instance, for a 20% stock dividend, if you had 100 shares at $30 and 200 shares at $40, your new basis would be $25 for 120 shares ($3,000/120) and $33.33 for 240 shares ($8,000/240).

Unless you receive cash in lieu of fractional shares of stock, neither stock splits nor stock dividends are taxable events to you until you sell the stock. However, you do need to keep track of the new basis for your shares. For more information, see Publication 550, Chapter 4, from the IRS. (Link opens a PDF file.)

Myth 7: I can buy just before the ex-dividend date, catch the drop in price, and record a capital loss.
This one is iffy, since it depends on what price you bought at. Let's take Ameritrade's special dividend as an example. Suppose Ameritrade determines that $2 of the $6 special dividend will be a true dividend, while the remaining $4 will be return of capital. Also suppose that you bought at any one of three prices before the stock went ex-dividend and sold at $19.50 afterwards. Whether you have a capital gain or loss depends on the selling price, because the effect of the return of capital is to lower your basis.

Original basis

Adjusted basis

Selling price

Gain or loss




$7.50 gain




$2.50 gain




$1.50 loss

There is one odd situation worth mentioning. Suppose your basis is $3.50 and you continue to hold the stock. If there is a $4 return of capital, your new basis would be $0 and you would have to report an immediate 50-cent capital gain, even though you have not sold a share.

The take-home lesson from this is to not speculate and try to buy a stock just before the ex-dividend date on a large special dividend, in hopes for a capital loss. It all depends on your basis and how the company handles the dividend, something you might not learn for months. Besides, you will still owe taxes on any portions declared to be a "dividend," and if you don't hold long enough, it will be taxed at the highest rate possible. Not very Foolish.

You have made it to the end. Now you know as much about dividends as many people and more than most. So show off your Foolish knowledge at parties and impress your friends. If you have any questions, though, do not hesitate to contact the investor relations departments of your companies, or look at publications from the IRS website.

Fool contributor Jim Mueller is a customer of Ameritrade, but not a shareholder. The Fool always wants you to understand its disclosure policy.