Why Would Companies Use Liquidating Dividends?

Liquidating dividends are a special kind of distribution that happens when a business undergoes either a full liquidation or a partial liquidation. As such, these are meant to distribute the business’s remaining assets to either the partners for a partnership or the shareholders for a corporation. Liquidating dividends are very different from normal dividends to say the least, which is why some people choose to call them liquidating distributions instead.

Why Would Companies Use Liquidating Dividends?

The popular image of a business undergoing liquidation is that of a business that is being forced to shut down because it can no longer cover its obligations. However, this can be rather misleading because the term encompasses other businesses shutting down for other reasons as well. Whatever the exact cause, liquidation is the process of bringing an end to a business before handing out its assets to those who have a claim upon them. There is a strict order that determines which claims are prioritized over which claims.

First, secured creditors can claim the assets that were used as collateral. After which, they will sell those assets in an attempt to recover as much of the outstanding balances as possible. In most cases, the proceeds from those sales won’t be enough, meaning that secured creditors will have the right to reclaim the rest from the business’s liquid assets. Second, unsecured creditors can claim the business’s assets for the purpose of recovering their outstanding balances. This can encompass a very wide range of parties. For example, if the business has issued bonds, the bondholders are considered to be unsecured creditors. Furthermore, other examples range from governments if there are unpaid taxes to employees if there are either unpaid wages or other unpaid obligations. Third, either the partners or the shareholders receive the remaining assets of the business in the form of a liquidating dividend. Their claims come last because they are considered to be the owners of the business, meaning that they took on more risk than the other claimants. As such, if there is nothing remaining after the other claimants have been satisfied, there is no liquidating dividend.

One of the Last Steps in the Process

The handing out of liquidating dividends is one of the last steps in the liquidation process. After all, the owners are the claimants with the lowest priority. As a result, once they have received the remainder of the business’s assets after the other claimants have been satisfied, there should be nothing left.

Not Normal Dividends

It cannot be stressed enough that liquidating dividends are not the same as normal dividends. The former happens once when a business is shut down for whatever reason. Meanwhile, the other can happen whenever the corporation has some extra cash that it chooses to hand out to its shareholders rather than spend on something else. This can be seen in how it is normal for established companies to pay normal dividends on a regular schedule because they no longer need to reinvest all of their earnings into their operations.

Return of Capital

In fact, it should be mentioned that liquidating dividends can be considered a return of the owners’ capital to them. Of course, this would be the owners’ capital either plus the remnants of their retained earnings or minus their retained earnings. Generally speaking, if a business is shutting down because it can no longer meet its obligation, chances are very good that the owners aren’t going to be getting anything back. In contrast, if the business is shutting down because the relevant decision-makers have decided to do so, there is a much greater chance of them getting something at the end. After all, a business that is being forced to shut down is a business that isn’t doing so well, meaning a higher likelihood of them not having enough assets to cover everything. Something that is particularly true because the most expensive assets tend to be very illiquid, which is why it is difficult for anyone to get full value for them on short notice.

Tends Not to Be Taxed

Since liquidating dividends can be considered a return of the owners’ capital, they tend not to be taxed. However, interested individuals should look up the relevant rules in their region because making assumptions about financial matters can be very problematic to say the least. In any case, this isn’t a huge consolation because in most cases, most recipients of liquidating dividends won’t get enough to cover their initial investments.

Can Sometimes Refer to Another Scenario

Sometimes, the term liquidating dividends can refer to another scenario. In short, businesses will sometimes choose to sell a part of their operations to an interested buyer. When that happens, businesses have a wide range of options when it comes to uses for the proceeds. For example, they could reinvest the money in their operations, thus enabling them to fuel their growth in the times still to come. In contrast, they could choose to hold on to the money in readiness for the future, whether that means capitalizing on some kind of future opportunity or mitigating some kind of future risk. Suffice to say that having some spare funds on hand can be just as useful for businesses as it is useful for household. Of course, there are also times when businesses will choose to just hand out the proceeds to their shareholders in the form of a special dividend, which is called thus because businesses tend not to sell parts of their operations on a regular schedule. Under those circumstances, it is possible that the special dividend will be called a liquidating dividend. After all, to liquidate something can also mean to sell an asset for either cash or cash equivalents on the open market, thus making it a very appropriate choice of term for such scenarios. In any case, the potential for such terms to be used in very different scenarios is one more reason that interested individuals should always check out the context before making a judgement. Otherwise, they could make an error by failing to understand exactly what they are dealing before rushing in.