Dividend Safety

Gregory J. Cook, EA, CPA+ Accredited Tax Advisor Past President Alabama Society of Enrolled Agents Past President Alabama Association of Accountants

How Safe is Your Dividend Income?


As an investor, you buy stock for two basic reasons. You hope to benefit from any gains in the capital value of the stock. Or, you want the steady stream of income that stock dividends can provide. The best of both worlds, of course, is a stock that does both: rises in value and pays a dividend consistently.

Investors, particularly those on fixed incomes for whom safety of principal is important, are more likely to buy common stocks that pay dividends. The potential for regular increases in dividends is attractive when compared to the fixed-income payments bonds and preferred stocks provide.

If you invest in dividend-paying common stocks, you should exercise caution when choosing a stock on the basis of an attractively high dividend. Some companies whose dividends are enticingly high today may not be able to boost those dividends for a long time. They may even have to cut their dividend if earnings are off.

What, then, are the criteria you should use in measuring a particular dividend-paying stock? You want, above all else, to ensure the consistency of your dividend payments. You also want your dividends to increase on a regular basis. Moreover, you would like to see that the company you invest in has reasonable prospects for earnings growth.

There are yardsticks that you can use to give you a better idea of a company's financial health and its continued ability to pay dividends. While not foolproof, they will give you a clearer understanding of what to look for in picking an income stock. When you examine an income stock, you should check if the company has a record of uninterrupted earnings and dividend growth over the years. You should examine the company's prospects for future dividends growth. Be wary where a company pays out as dividends more than it earns.

And look also at the stock's price/earnings (P/E) ratio. The P/E ratio is essentially a measure of investor confidence in a particular stock. Ask yourself where the company stands in terms of current earnings and future prospects. How high or low is the P/E ratio when compared to other stocks in the same industry?

Certain companies have historically performed well on a consistent basis no matter whether the economy is in a boom or a bust cycle. Utilities have been a good example. Gas, electric, telephone, and water companies on the whole have tended to exhibit steady, dependable growth and consistent increases in dividends. You can measure the credit quality of utility and telephone companies by checking how they are rated by ratings services such as Moody's and Standard & Poors.

Many stocks in groups other than utilities pay dividends that increase regularly. Many Fortune 500 firms show steady, reliable earnings growth and provide consistent dividends. Industries that provide basic commodities, products, and services tend to hold their own even during downturns in the economy. However, even Fortune 500 firms are subject to the swings of a volatile stock market.

Inflation and high interest rates are other concerns for investors in dividend-paying stocks. You should know that the prices of income stocks tend to fall in times of high inflation and high interest rates. However, their dividends tend to move up in tandem with the level of inflation. In all, successful investing for income requires time, patience, and good advice.

Dividends are distributions of property (which can include money, stock of another corporation or other property) a corporation pays you because you own stock in that corporation. You also may receive dividends through a partnership, an estate, a trust, a subchapter S corporation or from an association that is taxable as a corporation. Most dividends are paid in cash. A shareholder of a corporation may be deemed to receive a dividend if the corporation pays the debt of its shareholder, the shareholder receives services from the corporation, or the shareholder is allowed the use of the corporation's property. A shareholder may also receive distributions such as additional stock or stock rights in the distributing corporation; such distributions may or may not qualify as dividends.

You should receive a Form 1099-DIV, Dividends and Distributions, from each payer for distributions of $10.00 or more. Also, if you receive dividends through a partnership, an estate, a trust, or a subchapter S corporation, you should receive a Schedule K-1 from that entity indicating the amount of dividends taxable to you. You must report all taxable dividends even if you do not receive a Form 1099–DIV or Schedule K-1.

Ordinary dividends are the most common type of distribution from a corporation. They are paid out of the earnings and profits of the corporation. Ordinary dividends are taxable as ordinary income unless they are qualified dividends. Qualified dividends are ordinary dividends that meet the requirements to be taxed as net capital gains.

Distributions that qualify as a return of capital are not dividends. A return of capital is a return of some or all of your investment in the stock of the company. A return of capital reduces the basis of your stock. For information on Basis of Assets, refer to Topic 703. A distribution generally qualifies as a return of capital if the corporation making the distribution does not have any accumulated or current year earnings and profits. Once the basis of your stock has been reduced to zero, any further non-dividend distribution is capital gain.

Capital gain distributions may be paid by regulated investment companies (mutual funds) and real estate investment trusts (REITs). Capital gain distributions are always reported as long-term capital gains. You must also report any undistributed capital gain that mutual funds or REITs have designated to you in a written notice. Those undistributed capital gains are reported to you on Form 2439 (PDF). Please refer to the Form 1040 Instructions or Form 1040A Instructions for information on how to report qualifying dividends and capital gain distributions.

Form 1099-DIV should break down the distribution into the various categories. If it does not, contact the payer.

You must give your correct social security number to the payer of your dividend income. If you do not, you may be subject to a penalty and/or back-up withholding. Refer to Topic 307 for more information on back-up withholding.

If you receive dividends in significant amounts, you may have to pay estimated tax.