What Is a Capital Dividend?

A capital dividend is a dividend that is paid to investors in a stock from a company's paid-in capital, which is the money that comes from the investors themselves. Most dividends are paid from a company's earnings as a reward to investors for their loyalty in owning shares. By contrast, a capital dividend essentially returns the capital of investors to them simply because a dividend payment is due. The company that pays out these dividends is usually in serious financial trouble and may be making a mistake by not saving the money for its own purposes.

Dividends are important to investors who are choosing between stocks. Whereas an investor can't rely on a stock's price rising at all times, he or she can count on dividends from companies that have a proven track record of paying them. In that way, the dividends provide a fixed income to the investors who receive them at regular intervals. A company that can't afford to pay them through its earnings may have to reach into the money that has been invested in the company to pay what's known as a capital dividend.

When a company decides to pay a capital dividend to its investors, it is doing so because its earnings won't allow them to pay normal dividends. Instead, it takes the capital already invested in the company and essentially returns it to the investors. The reason for doing this is that the company might want to keep its schedule of dividend payments intact.

For investors, however, receiving a capital dividend is not as favorable as receiving one from a company's earnings. Since the money for these dividends are coming from what investors have paid, also known as paid-in capital, there is no real gain to be had. The one benefit for investors comes from the tax benefits afforded them in this situation. In many cases, such dividends are not taxable since the transaction is essentially a situation where investors are breaking even.

Companies must also understand the consequences attached to the decision to award a capital dividend. Although such a company might feel it is beholden to investors expecting a dividend, it is also removing much-needed funds that could be used for better purposes. It might actually be more beneficial for a company to skip a few dividend payments and use the paid-in capital to invest in the business. Such a move might reinvigorate the fortunes of a company in danger, possibly even leading to future dividends that can be paid from earnings.