A capital dividend, also known as a "return of capital," is the return of a portion of an initial investment. A capital dividend is distributed when a company pays a dividend using money from an account other than profits or earnings. Capital dividends generally arise from non-normal company business interests. The company may own a wasting asset or they may choose to sell an asset.
Some capital dividends are liquidating dividends. When a company is being dissolved entitled stockholders receive a liquidating dividend after the company's debts, liabilities and bills have been settled. Both capital and liquidating dividends reduce cost basis. Returns on capital are not taxed because they do not represent a monetary gain or a loss.
What this means for you: in general investors prefer that the dividends they receive come from profits or earnings because that is what said company is in business to do. When in doubt about whether or not you owe taxes on a particular dividend consult a certified public accountant and make sure their name goes on your income tax forms in the prepared by section. This affords you legal protection in the event of an IRS audit.
Sources: The Motley Fool. www.fool.com, www.investopedia.com.