Definition: A liquidating cash dividend is a distribution to that returns some of the original investment to the owners. In other words, a liquidating cash distribution gives some of the investors’ investment back to them. In effect, it shrinks the size of the company by reducing the capital accounts or equity by distributing it to the shareholders.
What Does Liquidating Cash Dividends Mean?
To understand how a liquidating dividend works, you have to understand how a regular dividend works. A regular dividend is the distribution on profits or retained earnings for a period. This is the amount of money the company has earned in addition to the original amount of money the shareholders invested to start the business. In other words, this is a return on the investors’ investment in the company. The business must be profitable or have a positive retained earnings account in order to make a regular dividend.
A liquidating cash dividend, on the other hand, occurs when the company doesn’t have enough profits or built up retained earnings to fund a cash distribution. It’s called a liquidating dividend because it takes money out of the company without sufficiently replenishing it with profits. This is no different than a company going into bankruptcy and liquidating its assets to pay off creditors. In this case, the company is paying investors back their original investments.
A traditional dividend is recorded by debiting retained earnings and crediting cash for the amount paid to the shareholders. A company that declares a liquidating dividend doesn’t have enough retained earnings to declare a regular dividend. In this case, the contributed capital account is debited on the date of declaration.
Many states have laws that restrict liquidating dividends in order to protect creditors. Companies that are thinly capitalized offer little recourse for even secured creditors in a bankruptcy situation.