IRS Section 301: Taxing Corporate Property Distributions

Internal Revenue Code (IRC) Section 301 provides the rules for how distributions of property from a corporation to its shareholders are taxed. The term “property” is defined broadly to include money, securities, and any other property, with the exception of the distributing corporation’s own stock or rights to acquire its stock. These regulations establish a framework for determining the tax implications for both the shareholder receiving the assets and the corporation making the payout. For the shareholder, the rules dictate how much of the distribution is income versus a return of investment, while the corporation faces consequences for its financial records and tax liabilities.

Shareholder Tax Consequences of a Distribution

The tax treatment of a corporate distribution for a shareholder follows a three-tiered system based on the corporation’s “Earnings and Profits” (E&P), a tax-specific measure of a company’s economic earnings.

First, the distribution is treated as a taxable dividend to the extent of the corporation’s E&P. This portion is included in the shareholder’s gross income and reported on their tax return. For individual shareholders, these dividends may be “qualified,” which are taxed at lower long-term capital gains rates, provided certain holding period requirements are met. The corporation will issue a Form 1099-DIV to the shareholder, which specifies the portion of the distribution that is taxable as a dividend.

Once the corporation’s E&P is fully depleted, any remaining portion of the distribution is treated as a non-taxable return of capital. This amount is not immediately taxed; instead, it reduces the shareholder’s adjusted basis in their stock, which is the shareholder’s investment cost for tax purposes. This reduction affects the calculation of capital gains or losses when the shareholder eventually sells the stock.

If the distribution amount exceeds both the corporation’s E&P and the shareholder’s stock basis, the excess is taxed as a capital gain. This gain is treated as if the shareholder sold their stock. For instance, if a shareholder with a $2,000 stock basis receives a $6,000 distribution from a corporation with $3,000 of E&P, the tax consequences are: $3,000 is a taxable dividend, $2,000 is a non-taxable return of capital that reduces their stock basis to zero, and the final $1,000 is taxed as a capital gain.

Determining Earnings and Profits

Earnings and Profits (E&P) is a tax concept that measures a corporation’s capacity to make distributions to shareholders that are treated as dividends. E&P is not the same as a company’s retained earnings or its taxable income. Instead, E&P is calculated by starting with the corporation’s taxable income and making specific adjustments to more accurately reflect its economic income.

There are two types of E&P: current and accumulated. Current E&P is calculated annually based on the corporation’s activities during the tax year. Accumulated E&P represents the total of all prior years’ current E&P, reduced by any distributions made in those years.

When a corporation makes a distribution, an ordering rule applies. The distribution is first considered to come from current E&P. If total distributions for the year exceed current E&P, the remaining amount is drawn from accumulated E&P. This distinction dictates the tax treatment for the shareholder.

Corporate Tax Consequences of a Distribution

When a corporation distributes property, the tax implications extend to the corporation itself, governed by IRC Section 311. While cash distributions do not create a taxable event for the corporation, the rules differ for non-cash property distributions, particularly when a corporation distributes appreciated property.

If a corporation distributes property that has a fair market value greater than its adjusted basis (the corporation’s cost), the corporation must recognize a gain. This gain is calculated as if the corporation had sold the property to the shareholder for its fair market value. For example, if a corporation distributes land worth $100,000 that it holds with a tax basis of $30,000, the corporation must report a $70,000 gain.

This recognized gain increases the corporation’s E&P, which in turn affects the tax treatment of the distribution for the shareholder. Following the distribution, the corporation’s E&P is reduced by the fair market value of the property distributed. If a corporation distributes property that has depreciated in value, it is not permitted to recognize a loss on the distribution. This rule creates a system where gains are recognized, but losses are not.

Special Considerations for Property Distributions

Distributions of non-cash property introduce specific considerations. A primary aspect is the shareholder’s basis in the property they receive, which becomes its fair market value (FMV) at the time of the distribution. This “stepped-up” basis is important because if the shareholder later sells the property, their gain or loss will be calculated using this new FMV basis.

A more complex situation arises when the distributed property is subject to a liability, such as a mortgage. In this scenario, the amount of the distribution to the shareholder is reduced by the amount of the liability they assume. For instance, if a shareholder receives property with an FMV of $100,000 but also assumes a $40,000 mortgage, the net distribution amount is $60,000. However, the corporation’s gain recognition is still based on the full FMV, and the FMV is treated as being not less than the amount of the liability.