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What is a Liquidating Dividend?

LIquidating Distribution

Regular dividends happen when corporations choose to hand out some of their cash to their shareholders rather than reinvest it into their revenue-earning operations. Sometimes, this is a routine matter, as shown by the corporations that have managed to pay out dividends on a regular basis for decades and decades. Other times, this is much more exceptional in nature, which might be motivated by the corporation coming into some extra cash through a one-time occurrence. Whatever the case, regular dividends see corporations choosing to pay out some of their retained earnings to their shareholders, which tends to be in the form of cash but can be in the form of other assets as well.

Meanwhile, even though liquidating dividends are called liquidating dividends, they cannot be considered to be such in truth. This is because liquidating dividends are paid out to the shareholders when corporations undergo either a partial liquidation or a full liquidation, thus explaining their name. As such, they are considered to be a kind of return of capital, which is why they tend not to be taxable.

Who Gets a Liquidating Dividend?

It is important to note that liquidating dividends are very much subject to the rules of precedence when it comes to who gets paid before who from the proceeds of a liquidation. As such, it is perfectly possible that shareholders won't be getting liquidating dividends, particularly if the corporation is undergoing liquidation because it has experienced serious financial issues.

For those who are unfamiliar, the entities that are entitled to be paid from the proceeds of a liquidation can be separated into three categories. First, there are secured creditors. Second, there are unsecured creditors. Third, there are shareholders. Secured creditors must be paid before unsecured creditors, who in turn, must be paid before shareholders. Secured creditors are the first to be paid because their cash has been guaranteed by collateral. Once that has been settled, the process moves on to the unsecured creditors. Based on the name, it should come as no surprise to learn that these entities include the creditors whose cash hasn't been guaranteed by collateral. However, they also include entities such as suppliers, employees, and even the government if there are outstanding taxes that must be paid. Shareholders come last for the simple reason that standard shareholders can be considered the owners of the corporation. Due to this, returning their capital is considered to be less important than paying the outstanding balances owed to creditors. In a lot of cases, shareholders won't get any liquidating dividends at all because the proceeds from the liquidation aren't enough to cover what is owed to the creditors. Never mind them.

To an extent, this is because the value of assets are not constant. Yes, accounting says that the value of assets should equal the combined value of liabilities and owner's equity on the balance sheet. However, the value of assets is not a perfect reflection of the fair market value of assets, not least because there is a serious limit to how well accountants can estimate such figures without actually putting those assets up for sale. Besides this, there is the issue of liquidity as well. Basically, it is much easier to buy and sell some assets than others because there are most transactions happening on a regular basis. For example, there are some assets that are so easy to buy and sell that they are considered to be as liquid as cash, which is why they are called cash equivalents. In contrast, there are other assets that are very illiquid in nature, with an excellent example being real estate properties. For these assets, it takes time for interested parties to find someone willing to buy and sell them, whether because the level of interest is low or because the number of entities with both the interest and the means is low. Certainly, it is possible for interested parties to get a figure that is closer to the fair market value by taking more time, but the thing about liquidation is that said process happens on a tight schedule, meaning that there isn't time. As a result, it is very common to see assets being sold for less than what they would be worth under better circumstances, thus further reducing the chances of shareholders getting liquidating dividends.

When Is a Liquidating Dividend Paid Out?

Corporations can undergo liquidation for various reasons. For example, it is possible that the shareholders of a small private corporation will choose to bring their corporation to a conclusion, perhaps because they have fallen out so badly with one another that they can't agree to an arrangement to keep things running. However, the more common scenario is that of the corporation being forced to liquidate because it is no longer capable of meeting its obligations.

As for how that can happen, well, there is a very wide range of potential reasons. Sometimes, a corporation is very reliant on either one customer or a small number of customers in the single industry. As a result, if that one customer or that small number of customers run into financial issues, it is very much possible for the corporation to get dragged down by them. Other times, a corporation has chosen to expand in a bad way. After all, notable expansions tend to consume a lot of resources, which can include a fair amount that has been borrowed if the corporation sees a good chance come up but doesn't have enough money in its bank account to cover it. As such, if the expansion goes poorly, the resulting issues can send the corporation into either a crash or a downward spiral that will culminate in a crash. On top of this, it isn't uncommon for businesses to just read the situation wrong, thus rendering them less capable of standing toe-to-toe against their competitors. Something that is particularly likely in fast-changing fields.

Anyways, liquidating dividends won't be paid out unless the corporation has enough proceeds from the liquidation to cover the full extent of what it owes to both its secured and its unsecured creditors. This is much likelier when the shareholders choose to end the corporation for a reason other than its inability to meet its obligations. In the latter case, shareholders will be lucky if they can actually reclaim the full value of what they put into the corporation.

Allen Lee

Written by Allen Lee

Allen Lee is a Toronto-based freelance writer who studied business in school but has since turned to other pursuits. He spends more time than is perhaps wise with his eyes fixed on a screen either reading history books, keeping up with international news, or playing the latest releases on the Steam platform, which serve as the subject matter for much of his writing output. Currently, Lee is practicing the smidgen of Chinese that he picked up while visiting the Chinese mainland in hopes of someday being able to read certain historical texts in their original language.

Read more posts by Allen Lee

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