Revenue Code 301: Taxing Corporate Distributions
This article explains the tax treatment for corporate distributions. See how a payment's characterization determines the tax consequences for shareholders and the company.
When a corporation provides money or assets to its shareholders, it is making a distribution. The Internal Revenue Code (IRC) dictates the tax treatment for the shareholder, with the guidance for these non-liquidating distributions falling under IRC Section 301. This section establishes the framework for determining how a shareholder must account for the value they receive.
The rules ensure that distributions are properly characterized, preventing the misclassification of a dividend as a tax-free return of an investment. These regulations apply to both cash payments and transfers of corporate property.
The Three-Tier System for Taxing Distributions
The tax treatment of a corporate distribution is governed by a three-tier system. This hierarchy determines the character of the distribution, which dictates how it is taxed based on the corporation’s “Earnings and Profits” (E&P), a tax-specific measure of its dividend-paying capacity.
First, the distribution is a taxable dividend to the extent of the corporation’s E&P. For individual shareholders, these “qualified dividends” are taxed at preferential long-term capital gains rates of 0%, 15%, or 20%, depending on taxable income. This is the most common outcome for distributions from profitable businesses.
Once the corporation’s E&P is depleted, the second tier applies, and any remaining portion of the distribution is a non-taxable return of capital. This amount reduces the shareholder’s adjusted basis in their stock, reflecting that they are receiving part of their original investment back. A shareholder’s basis is what they paid for the stock.
If the distribution exceeds both the corporation’s E&P and the shareholder’s stock basis, the third tier applies. The excess amount is treated as a gain from the sale of property, which is a capital gain.
For example, a shareholder has a stock basis of $2,000. A corporation with $3,000 in E&P distributes $6,000 to this shareholder. The first $3,000 is a taxable dividend. The next $2,000 is a tax-free return of capital, reducing the stock basis to zero. The final $1,000 is taxed as a capital gain.
The Role of Earnings and Profits
Earnings and Profits (E&P) determines the taxability of corporate distributions. E&P is a measure of a corporation’s economic ability to pay dividends and is not the same as retained earnings or taxable income. The calculation starts with taxable income and makes several adjustments for items that are treated differently for tax purposes.
E&P is divided into two categories: current and accumulated. Current E&P is calculated annually based on that year’s financial performance. Accumulated E&P is the sum of all prior years’ undistributed current E&P, going back to the corporation’s inception.
When a corporation makes a distribution, it is considered to come first from current E&P. If total distributions for the year exceed current E&P, then accumulated E&P is used. This distinction is important, as a distribution is only a dividend if paid from either current or accumulated E&P.
Distributions of Property Other Than Cash
The three-tier system also applies when a corporation distributes property, such as land or equipment, instead of cash. While the characterization rules remain the same, two elements are defined differently for the shareholder in a non-cash transaction.
The first element is the amount of the distribution. For a non-cash property distribution, the value is the property’s Fair Market Value (FMV) on the date it is distributed. This differs from the corporation’s internal book value and ensures the shareholder is assessed on the actual economic value received.
The second element is the shareholder’s tax basis in the property they receive. The shareholder’s basis in the distributed property is also its FMV at the time of the distribution. This new basis will be used to calculate any gain or loss if the shareholder later sells the property. For instance, if a corporation distributes land with an FMV of $50,000, the distribution amount is $50,000, and the shareholder’s basis in that land becomes $50,000.
Tax Consequences for the Distributing Corporation
When a corporation distributes property to its shareholders, the distributing corporation itself can face tax consequences. These rules are governed by IRC Section 311, particularly when the distributed property has appreciated in value.
If a corporation distributes property that has an FMV higher than its adjusted basis, it must recognize a gain. The transaction is treated as if the corporation had sold the property for its fair market value. This “deemed sale” forces the corporation to pay tax on the built-in gain, preventing companies from avoiding taxes by distributing appreciated assets.
Conversely, if the distributed property’s FMV is less than its adjusted basis, the corporation cannot recognize a loss on the distribution. This rule prevents corporations from selectively distributing loss-generating assets to create tax deductions. Any distribution also reduces the corporation’s E&P, which affects the tax treatment of future distributions.