Companies can choose to do several things with their profits. They can retain some or all of their earnings within the business to:

  • Expand their operations organically or via acquisition
  • Pay down debt
  • Build up a stockpile of cash

They can also return a portion of it to shareholders by:

  • Repurchasing stock to reduce the outstanding share count
  • Paying it out via dividends, which can be in cash, shares, or a combination of the two

Here's a closer look at the last option.

Example of dividend income

Dividend income is defined by the Internal Revenue Service (IRS) as any distribution of an entity's property to its shareholders. While usually cash, dividends can also be stock or any other property. 

Usually dividend income is the distribution of a company's taxable income to its investors. For example, say a company made $1 billion in net income last year. It chose to reinvest $750 million of that money to grow its business, buying a competitor for $500 million and investing $250 million in a new location. Since it already had a strong balance sheet with an adequate cash cushion, it opted to return its excess income to shareholders by paying out $250 million in dividends.

However, the IRS also considers the following situations as resulting in dividend income:

  • The corporation pays the debt of its shareholder.
  • The shareholder receives services from the corporation.
  • The shareholder is allowed to use the corporation's property without adequate reimbursement to the company.
  • A shareholder provides services to a corporation but gets paid more than what the company would have paid a third party for the same services.
$100 bills with the word "Dividends" on a piece of paper.

Image source: Getty Images.

Are dividends considered income? 

The IRS considers most dividend payments to be taxable income. There are two types of taxable dividend income:

Qualified dividends 

These payments must meet certain IRS requirements to qualify for a lower tax rate. The payee must be a U.S. corporation or a qualified foreign corporation (incorporated in a U.S. possession, located in a nation covered by an income tax treaty with the U.S., or with shares readily trading on a U.S. stock market exchange). Further, a recipient must hold the underlying stock for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date.

Nonqualified or ordinary dividends 

These payments do not meet those requirements to qualify for a lower tax rate. As a result, the IRS taxes them based on the recipient's ordinary income tax rate.

However, not all distributions from a company or investment are taxable dividend income. Special cases include:

  • Return of capital: A repayment of some or all of an investor's investment in a company's stock. These payments reduce an investor's adjusted cost basis in the investment. A distribution usually qualifies as a return of capital if the company doesn't have any accumulated or current-year earnings.
  • Capital gains distributions: Several entities, including regulated investment companies (i.e., mutual funds, exchange-traded funds, and money market funds) and real estate investment trusts, may pay a capital gains distribution. These payments get taxed as long-term capital gains.
  • Spinoffs: Companies can spin off a portion or all of their ownership interest in a business unit through a stock dividend to existing shareholders, which can be tax-free or taxable depending on the structure. 
  • Stock dividends: When companies issue and distribute a new share class to shareholders, they'll often call it a stock dividend. However, unlike dividends paid with stock in lieu of cash, these are similar to those issued in a stock split, in which investors receive an equal amount of the new shares based on the proportion of existing stock they already own. 

Tax treatment of dividend income

As mentioned earlier, taxable dividend income comes in two forms: qualified and nonqualified. Investors will receive a Form 1099-DIV from each payer of distributions of at least $10, though most brokerage accounts provide a consolidated 1099-DIV that puts them all into one form. This form tells an investor how much qualified and nonqualified dividend income they earned that year.

The IRS taxes ordinary (i.e., nonqualified) dividends at the recipient's ordinary income tax rate. For the 2020 tax year, the income tax brackets are as follows:

Income tax rate

Income Bracket: Singles

Income Bracket: Heads of Household

Income Bracket: Married Joint Filers

Income Bracket: Married Separate Filers

10%

$0 to $9,875

$0 to $14,100

$0 to $19,750

$0 to $9,875

12%

$9,875 to $40,125

$14,100 to $53,700

$19,750 to $80,250

$9,875 to $40,125

22%

$40,125 to $85,525

$53,700 to $85,500

$80,250 to $171,050

$40,125 to $85,525

24%

$85,525 to $163,300

$85,500 to $163,300

$171,050 to $326,600

$85,525 to $163,300

32%

$163,300 to $207,350

$163,300 to $207,350

$326,600 to $414,700

$163,300 to $207,350

35%

$207,350 to $518,400

$207,350 to $518,400

$414,700 to $622,050

$207,350 to $311,025

37%

Above $518,400

Above $518,400

Above $622,050

Above $311,025

Data source: IRS.

Meanwhile, qualified dividends get taxed at the long-term capital gains tax rate. Those rates and income brackets for 2020 are as follows:

Long-Term Capital Gains Tax Rate

Taxable Income: Single Filers

Taxable Income: Married Filing Jointly

Taxable Income: Heads of Household

Taxable Income: Married Filing Separately

0%

 $0-$40,000

$0-$80,000

$0-$53,600

$0-$40,000

15%

 $40,000-$441,450

$80,000-$496,600

$53,600-$469,050

$40,000-$248,300

20%

 Over $441,550

Over $496,600

Over $469,050

Over $248,300

Data source: IRS.

Because the IRS taxes nonqualified dividends at higher rates, investors should consider owning them in a tax-advantaged account like an individual retirement account (IRA). Though for higher-income individuals, there's certainly no harm in owning qualified dividend payers in tax-advantaged accounts to defer or avoid taxes on that income.

Dividend revenue in business 

It's worth noting that there are different tax rules for dividends received by corporations. For example, the dividends received deduction (DRD) allows a company that receives a dividend from another company to deduct that payout from its income, which would reduce its income tax. However, several rules apply, and potential deductions range from 70% of the dividend to 100%. 

Interest and dividend income 

The IRS deems dividend and interest payments received by investors as taxable income. However, there is a notable difference between the two. Dividends aren't an expense to a company, but instead a distribution of its earnings to its investors. On the other hand, interest payments on a company's bonds or other debt are an expense; thus, these payments reduce its taxable income. 

For individuals, the IRS treats interest income similar to nonqualified dividends, taxing both at the ordinary income tax rate. However, instead of a Form 1099-DIV, recipients will receive a 1099-INT to report this income on their taxes.   

Dividend income doesn't have to be taxable

The IRS considers most distributions of cash, stock, or property from a company to its shareholders to be taxable income. The tax rate varies depending on the type of dividend and an investor's tax rate. However, investors can defer or avoid taxes on this dividend income if they hold the investment in a retirement account, which is why it often makes sense to consider keeping dividend stocks in a tax-advantaged account.