Corporate Distribution vs. Dividend: What’s the Difference?

A corporate distribution is a payment made by a corporation to an individual who holds its stock, often in the form of cash or additional shares. These payments represent a transfer of the company’s value to its owners. The way a distribution is categorized has significant implications for how it is treated for tax purposes. Because these payments are not all treated equally, understanding the differences can substantially affect an investor’s tax liability.

Tax Treatment of Shareholder Distributions

The tax implications for a shareholder depend on how the distribution is classified. The Internal Revenue Service (IRS) has distinct rules for different types of distributions, which can range from income taxed at standard rates to payments that are not taxed at all in the year they are received.

An ordinary dividend is considered income to the shareholder and is taxed at the individual’s regular income tax rates. These rates, which range from 10% to 37%, are the same ones that apply to wages and other forms of ordinary income.

For a dividend to be “qualified,” it must be paid by a U.S. or qualifying foreign corporation, and the shareholder must meet a holding period requirement. The shareholder must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. Qualified dividends are taxed at the lower long-term capital gains rates of 0%, 15%, or 20%.

A payment classified as a nondividend distribution is treated as a return of capital and is generally not taxable when received. Instead, it reduces the shareholder’s cost basis in their stock. For example, if an investor paid $50 for a share and receives a $2 return of capital, their new cost basis for that share becomes $48.

This basis reduction defers the tax impact until the stock is sold, at which point the lower basis will result in a larger capital gain or smaller capital loss. If return of capital distributions reduce a shareholder’s basis to zero, any subsequent nondividend distributions are taxed as a capital gain.

The Source of Corporate Distributions

The classification of a distribution as a taxable dividend or a nontaxable return of capital is determined by its source, a tax accounting measure known as “Earnings and Profits” (E&P). E&P measures a company’s ability to make distributions from its earnings rather than from the capital invested by owners.

E&P differs from the “retained earnings” figure on a company’s financial statements because it is calculated according to tax rules, not accounting principles (GAAP). The calculation starts with taxable income and makes adjustments, such as adding back certain tax-deductible expenses, to better reflect the company’s capacity to pay dividends.

E&P is divided into two categories: current and accumulated. Current E&P is calculated annually, reflecting that year’s performance. Accumulated E&P is the sum of all prior years’ current E&P, reduced by any distributions made in those years.

An ordering rule determines the source of distributions. Payments to shareholders are first considered to come from current E&P. If distributions exceed current E&P, they are then sourced from accumulated E&P. Any remaining portion of the distribution is treated as a nontaxable return of capital only after both E&P accounts are depleted.

For instance, consider a corporation with $10,000 in current E&P and $20,000 in accumulated E&P. If this company makes a total distribution of $40,000 to its shareholders, the ordering rule dictates the classification. The first $10,000 is a dividend from current E&P, and the next $20,000 is a dividend from accumulated E&P. The remaining $10,000 is classified as a return of capital.

The Dividend Payment Process

The process of paying a dividend follows a standardized timeline. Once a company’s board of directors decides to distribute earnings, it sets a sequence of events in motion to ensure dividends are paid in an orderly manner to all entitled shareholders.

The first event is the declaration date, when the board of directors formally announces its intention to pay a dividend. The announcement specifies the amount of the dividend per share, as well as the record date and payment date. Once declared, the dividend becomes a legal liability of the company.

Next is the record date. To receive the dividend, an investor must be registered as a shareholder on the company’s books on this specific date. The ex-dividend date is set by the stock exchange, typically one business day before the record date, and an investor who purchases the stock on or after this date will not receive the upcoming dividend.

The final step is the payment date, when the corporation sends the dividend payments to the eligible shareholders. The payment is made either by mailing a check or by directly depositing the funds into brokerage accounts. This date typically occurs a few weeks after the record date.

Reporting Distributions on Form 1099-DIV

Shareholders receive Form 1099-DIV, “Dividends and Distributions,” from their financial institutions after the year ends. This form details the amounts and types of distributions paid during the year. Each box corresponds to a specific distribution classification for tax purposes.

Box 1a reports the total amount of ordinary dividends a shareholder received. This figure represents the full amount of distributions potentially subject to ordinary income tax rates.

Box 1b, “Qualified dividends,” shows the portion of the amount in Box 1a that is eligible to be taxed at the lower long-term capital gains rates. Shareholders report this amount separately to receive the preferential tax treatment.

Box 3, “Nondividend distributions,” reports the return of capital portion of a payment. This amount is not taxed in the current year but instead reduces the shareholder’s cost basis in the stock. This figure is used to adjust the investment’s basis for future tax calculations.