When Accrued Dividends Become Capital Gains

Dividends on stock don't accrue the same way as interest on bonds, and that means that the dividends could represent ordinary income to shareholder...
Robert WillensAugust 21, 2002

When a bond is purchased and sold between interest payment dates, the portion of the purchase price attributable to interest that has accrued to the date of purchase is treated as interest income to the seller of the bond.(In these cases, the settlement date, not the trade date is applicable—see Rev. Rul. 66-97). As a result, the buyer treats the payment as an offset to the interest coupon to which the accrued interest is attributable.

However, dividends on stock do not accrue as interest accrues. Instead, the dividends represent ordinary income to the shareholder of record when actually, or constructively, received by the shareholder (see Rev. Rul. 56-211). Thus, there is potential to convert—through a timely sale or disposition of stock—accrued dividends into capital gains.

For instance, if the sale occurs before the date on which the dividend becomes the shareholder’s separate property, the portion of the selling price attributable to accrued dividends would be treated as part of the selling price of the underlying stock. For this purpose, in the case of preferred stock, a dividend becomes the shareholder’s separate property, entirely disconnected from the stock, at the time such dividend is declared.

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Take the case brought to light in Rev. Rul. 69-130, in which a corporation declared a dividend on its preferred stock. Later, the board decided to call the preferred stock for redemption and offered to pay an amount equal to par value, plus the dividend already declared. The ruling concludes that the amount paid to each holder of preferred—to the extent of the dividend declared before the redemption call—was properly treated as dividend income.

The ruling reasons that once a dividend has been declared, the shareholder has an immediate vested right against the corporation in the capacity of a creditor. That is, a declared dividend becomes the shareholder’s separate property, and is therefore entirely disconnected from the stock.

Accordingly, the amounts paid to satisfy the obligation created by the declaration could not be said to be paid in cancellation or redemption of the stock. On the other hand, Rev. Rul. 69-131 states that, if a corporation redeemed its preferred stock for an amount equal to par value plus accrued dividends—none had been declared—the shareholder properly treated the entire amount received. That includes the part attributable to accrued dividends, as proceeds from the sale of stock, or as a capital gain.

The conclusions reached in Rev. Rul. 69-130 were, in Rev. Rul. 75-320, extended to a case in which the corporation, before redeeming its preferred stock, had not formally declared any dividends. The ruling finds, however, that a “constructive” declaration had occurred. There, with respect to a class of cumulative preferred stock, the board: 1) resolved that the funds to pay a quarterly dividend be “set apart” on the books of the corporation; and 2) declared and paid a dividend with respect to the outstanding common stock.

Shortly thereafter, the preferred was redeemed for an amount equal to par value plus the accrued (and “set apart”) dividends. However, the preferred stock agreement required that dividends on preferred be “declared and paid or set apart for payment” before any dividend on the common stock could be declared and paid. The ruling concludes that merely setting aside funds (to defray the dividend) does not satisfy this requirement.

Therefore, because the corporation had performed an act (the declaration and payment of dividends on common stock) that required, as a prerequisite, the declaration of dividends on the preferred stock, the preferred stock agreement had been breached—and the constructive declaration should be viewed as having occurred. Accordingly, the redemption transaction consisted, in substance, of two separate transactions. One being a redemption of the preferred stock. The other, a late payment of the dividend, which through its actions with respect to the common stock, the corporation was obligated to pay.

There is, oddly, one scenario in which a preferred shareholder can be charged with dividend income even though no dividends with respect to the preferred stock have been actually or constructively declared. The scenario involves a recapitalization, in which the old stock is swapped for new stock.

If, in this case, the value or the liquidation preference of the new stock—whichever is greater—exceeds the issue price of the stock surrendered in the recapitalization, the exchanging shareholder will be charged with dividend income in an amount equal to the lesser of the excess, or the amount of dividends, that are in arrears. That’s because the shareholder’s proportionate interest in the issuing corporation is seen as increasing.

Additionally, the holder of the surrendered security will report such dividend income even though no dividends have been declared with respect to the surrendered security.

Curiously, however, as Professors Martin Ginsburg and Jack Levin so aptly point out in Mergers Acquisitions and Buyouts (Aspen Publishing), this rule is confined to a recapitalization. Indeed, in an acquisitive reorganization, a merger for example, in which stock with accrued (but undeclared) dividends is exchanged for stock in the acquirer, no dividend income need be reported by the exchanging shareholder. That’s even though the value (or the liquidation preference) of the stock received exceeds the issue price of the surrendered securities.