Business Entities · Corporations in general

Shareholder dividends, distributions, and recognition requirements

Four separate questions have to be answered about any corporate distribution, and each has its own provision. How much was distributed — IRC § 301(b). What is it to the shareholder — IRC § 301(c). What basis does the shareholder take — IRC § 301(d). And what does it do to the corporation — IRC § 311. Getting one of these right does not help with the others, and the asymmetry built into the fourth is the part that most reliably surprises.

The rule

The amount. the amount of a distribution is the money received plus the fair market value of the other property received, determined as of the date of the distribution, reduced but not below zero by any liability of the corporation assumed by the shareholder in connection with the distribution and by any liability to which the property received is subject immediately before and immediately after it (IRC § 301(b))^TY2026

What it is to the shareholder. the portion of a distribution that is a dividend as defined in IRC § 316 is included in gross income; the portion that is not a dividend is applied against and reduces the adjusted basis of the stock; and the portion that is not a dividend and exceeds that basis is treated as gain from the sale or exchange of property (IRC § 301(c))^TY2026

And what is a dividend. a dividend is any distribution of property made by a corporation to its shareholders out of earnings and profits accumulated after 28 February 1913, or out of the earnings and profits of the taxable year computed as of the close of that year without diminution by reason of distributions made during it and without regard to the amount on hand when the distribution was made. Every distribution is made out of earnings and profits to the extent thereof, and from the most recently accumulated earnings and profits (IRC § 316(a))^TY2026

The shareholder’s basis in property received. the basis of property received in a distribution to which IRC § 301(a) applies is the fair market value of the property — so a shareholder takes a stepped-up basis with no carryover from the corporation (IRC § 301(d))^TY2026

What it does to the corporation. no gain or loss is recognised to a corporation on a distribution with respect to its stock of its own stock or of property, except that where it distributes property other than its own obligation whose fair market value exceeds its adjusted basis, gain is recognised as if the property had been sold to the distributee at fair market value. Loss on depreciated property distributed is not recognised (IRC § 311(a), (b))^TY2026

And to its earnings and profits. where a corporation distributes property other than its own obligation whose fair market value exceeds its adjusted basis, earnings and profits are first increased by that excess and the reduction is then measured by fair market value rather than adjusted basis (IRC § 312(b))^TY2026

Stock dividends. gross income does not include a distribution by a corporation of its own stock to its shareholders with respect to their stock — unless the distribution is payable at any shareholder election in stock or in property, is disproportionate, distributes preferred to some common shareholders and common to others, is on preferred stock, or is convertible preferred, in which case IRC § 301 applies (IRC § 305(a), (b))^TY2026

Rate on the shareholder’s side. qualified dividend income means dividends received during the taxable year from domestic corporations and qualified foreign corporations, excluding dividends from corporations exempt under IRC § 501 or § 521 for the year of distribution or the preceding year, amounts deductible under IRC § 591, IRC § 404(k) dividends, and dividends on stock failing the IRC § 246(c) holding period. It is added to net capital gain and so taxed at capital gain rates (IRC § 1(h)(11))^TY2026

With a holding period. 45 days — the holding period condition is failed where the share is held for 45 days or less during the 91-day period beginning 45 days before the date the share becomes ex-dividend, or to the extent the taxpayer is under an obligation to make related payments on substantially similar or related property. For preference dividends attributable to a period exceeding 366 days the test becomes 90 days within a 181-day period (IRC § 246(c)(1), (2))^TY2026

Current figures

How it works in practice

Take the shareholder’s side first because it is the mechanical part. The amount is money plus the fair market value of other property, valued at the date of distribution, and reduced — but never below zero — by liabilities the shareholder assumes or that encumber the property received. That reduction is where the net economic transfer is captured: a shareholder who receives a mortgaged building has received the equity in it, not the building’s gross value.

Then the three tiers, in order and without discretion. Dividend to the extent of earnings and profits; return of capital reducing stock basis; gain from the sale or exchange of property beyond that. Note that the third tier is gain, not a dividend at a capital rate — the character comes from the deemed sale, so holding period matters and the amount is not qualified dividend income.

The corporation’s side is where the asymmetry lives, and it is worth stating starkly. Distributing appreciated property triggers gain to the corporation as though it had sold the property to the shareholder at fair market value (IRC § 311(b)). Distributing depreciated property triggers nothing — IRC § 311(a) denies recognition and IRC § 311(b) applies only where value exceeds basis. So a corporation distributing property at a loss destroys the loss permanently: it is not recognised, and the shareholder takes fair market value as basis under IRC § 301(d), so nobody ever deducts it.

That combination has a straightforward planning implication and it is one of the few in this area. A corporation intending to distribute depreciated property should generally sell it, recognise the loss, and distribute the cash. A corporation intending to distribute appreciated property gains nothing by selling first, since the gain arises either way.

The shareholder’s basis rule completes the picture and is easy to state wrongly. It is fair market value — full stop. Not the corporation’s basis, not the amount treated as a dividend, and not reduced by liabilities. The liability reduction operates on the amount distributed for the purpose of the three tiers, not on the basis of what was received.

Stock dividends are excluded from income by IRC § 305(a) because nothing has left the corporation and no shareholder’s proportionate interest has changed. The exceptions in IRC § 305(b) all identify situations where one of those two things is untrue — an election between stock and property, a disproportionate distribution, common to some and preferred to others. Where an exception applies, the distribution is treated as a IRC § 301 distribution and runs through the ordinary tiers.

On rate, qualified dividend income is added to net capital gain and taxed accordingly. Two conditions matter in practice: the payer must be a domestic corporation or a qualified foreign corporation, and the shareholder must satisfy the holding period that IRC § 1(h)(11)(B)(iii) borrows from IRC § 246(c) — more than 45 days within the 91-day period beginning 45 days before the ex-dividend date. A shareholder who buys just before the record date and sells shortly after has an ordinary dividend, not a qualified one.

Scenarios

How this has changed

The IRC § 311 asymmetry is the product of a deliberate reversal. Before 1986 a corporation generally recognised no gain on distributing appreciated property, which allowed appreciation to leave the corporate solvent untaxed at the entity level. That was repealed, and IRC § 311(b) now requires recognition as if the property had been sold. The non-recognition of loss in IRC § 311(a) was left in place, so what had been a symmetrical rule became a one-way one. Material describing corporate distributions as generally tax-free at the entity level is pre-1987.

Qualified dividend income is newer than the rest of this topic and is now permanent. Before 2003 all dividends were ordinary income to individuals; the reduced rate was introduced with an expiry date and extended repeatedly before being made permanent. What is worth watching is not the rate but the conditions, which have not moved: the payer requirement and the IRC § 246(c) holding period are the same tests they have always been, and they are where questions are set.

IRC §§ 301, 305 and 316 have not been materially amended in a way that affects this topic. The IRC § 301(c)(3)(B) exemption for distributions out of pre-March 1913 appreciation remains in the Code and is, at this distance, of no practical application whatever — worth noticing only because a candidate reading the subsection will wonder what it is for.

Exam focus

The commonest computation gives earnings and profits, a distribution and a stock basis, and asks for the shareholder’s treatment. Run the three tiers in order and remember that the second is not income and the third is gain rather than dividend.

The second reliable shape gives a corporation distributing property and asks what the corporation recognises. Appreciated: gain, as if sold at fair market value. Depreciated: nothing. Where a question offers a loss deduction to the corporation on a distribution, that option is always wrong.

Where a question gives a mortgage on distributed property, apply it to the amount distributed and not to the shareholder’s basis. Both figures are usually offered.

And where a question turns on the rate, check the holding period before concluding that a dividend from a domestic corporation is qualified.

Check yourself

1. A corporation distributes land worth $600,000 with an adjusted basis of $250,000, subject to a $200,000 mortgage assumed by the shareholder. What is the amount distributed, and what is the shareholder’s basis in the land?

Answer: $400,000 distributed, and a basis of $600,000. IRC § 301(b)(1) measures the amount by fair market value, and IRC § 301(b)(2)(A) reduces it by the liability assumed. IRC § 301(d) gives the shareholder a basis equal to the fair market value of the property, with no reduction for the mortgage — the liability adjustment belongs to the amount distributed, not to basis.

2. On the same facts, what does the corporation recognise?

Answer: $350,000 of gain. Under IRC § 311(b) a corporation distributing property whose fair market value exceeds its adjusted basis recognises gain as if the property had been sold to the distributee at fair market value. The mortgage does not reduce the gain, and the gain increases earnings and profits under IRC § 312(b) before the distribution reduces them.

3. A corporation distributes equipment worth $80,000 with an adjusted basis of $300,000. What does it recognise?

Answer: nothing. IRC § 311(a) denies recognition of gain or loss on a distribution with respect to stock, and the exception in IRC § 311(b) applies only where fair market value exceeds adjusted basis. The $220,000 of loss is not recognised by the corporation, and because the shareholder takes fair market value as basis under IRC § 301(d), it is never deducted by anybody.

4. A corporation with $40,000 of earnings and profits distributes $250,000 to a shareholder whose stock basis is $70,000. What does the shareholder report?

Answer: $40,000 of dividend income, a $70,000 return of capital reducing basis to zero, and $140,000 of gain from the sale or exchange of property. IRC § 301(c) fixes the order, the second tier is not income, and the third tier is gain rather than a dividend — so it is not qualified dividend income even though the shareholder’s rate on it may be the same.

5. A shareholder buys stock in a domestic corporation 20 days before the ex-dividend date and sells it 15 days afterwards. Is the dividend qualified dividend income?

Answer: no. IRC § 1(h)(11)(B)(iii) excludes a dividend on stock that fails the IRC § 246(c) holding period, which requires the share to be held for more than 45 days during the 91-day period beginning 45 days before the ex-dividend date. Thirty-five days is not enough, and the dividend is ordinary income however domestic the payer.