What Are Extraordinary Dividends and How Are They Taxed?

An extraordinary dividend is a distribution from a company to its shareholders that is significantly larger than normal. While a large dividend payment seems like a straightforward gain, it carries specific tax implications that differ from regular dividends, as outlined in Section 1059 of the Internal Revenue Code. The regulations are particularly complex for corporate shareholders and were established to prevent certain tax-avoidance strategies. Understanding if a dividend qualifies as “extraordinary” is the first step in determining its financial impact.

Criteria for an Extraordinary Dividend

The primary method to determine if a dividend is extraordinary is the percentage-of-basis test, which compares the dividend’s size to a shareholder’s adjusted basis in the stock. A shareholder’s basis is the original purchase price of the shares. A dividend is classified as extraordinary if its value equals or exceeds 10% of the shareholder’s basis for common stock or 5% for preferred stock.

For example, if a corporation owns common stock with an adjusted basis of $200 per share and receives a dividend of $25 per share, that dividend is extraordinary. The $25 payment is 12.5% of the $200 basis, exceeding the 10% threshold.

To prevent shareholders from breaking up a large distribution into smaller ones, aggregation rules apply. Any dividends with ex-dividend dates within an 85-consecutive-day period are combined and treated as a single dividend for the percentage test. This prevents a company from issuing three separate 4% dividends on common stock over a short period to stay under the 10% threshold.

A broader aggregation rule also exists for dividends paid over a longer timeframe. If the total of all dividends with ex-dividend dates within a 365-day period exceeds 20% of the shareholder’s stock basis, those dividends are also treated as extraordinary.

Tax Consequences for Corporate Shareholders

The tax treatment for a corporate shareholder is linked to the dividends-received deduction (DRD). The DRD allows a corporation to deduct a portion of the dividends it receives from other domestic corporations, preventing the same earnings from being taxed multiple times. The rules for extraordinary dividends are designed to limit the benefits a corporation can gain from this deduction.

A corporate shareholder must reduce its basis in the stock by the nontaxed portion of the extraordinary dividend. The nontaxed portion is the amount of the dividend excluded from taxable income because of the DRD. This basis reduction is triggered if the corporation has not held the stock for more than two years before the dividend is announced.

Consider a corporation that owns stock with a $1,000 basis and has held it for one year. It receives a $150 extraordinary dividend and, due to the DRD, does not pay tax on $100 of that amount. The corporation must then reduce its stock basis by that nontaxed $100 portion, resulting in a new adjusted basis of $900, which increases the potential capital gain when the stock is sold.

If the required basis reduction is larger than the shareholder’s existing basis, the basis is reduced to zero. The excess amount is treated as a taxable capital gain in the year the dividend is received. For instance, if the stock basis was only $80, the $100 nontaxed portion would reduce the basis to $0, and the remaining $20 would be recognized immediately as a capital gain.

Tax Consequences for Individual Shareholders

For individual shareholders, the tax rules are much simpler, and the basis reduction requirement does not apply. An extraordinary dividend is generally taxed in the same manner as any other dividend payment.

The main consideration for an individual is whether the dividend qualifies for the lower tax rates for “qualified dividends.” These rates are 0%, 15%, or 20%, depending on the individual’s taxable income. For a dividend to be considered qualified, the shareholder must meet a holding period requirement.

To secure these preferential tax rates, an individual must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. The ex-dividend date is the day on which the stock begins trading without the right to the upcoming dividend payment. If this holding period is met, the dividend is taxed at the favorable qualified dividend rates.

If an individual shareholder fails to meet this holding period, the dividend is considered “unqualified.” An unqualified dividend is taxed at the individual’s higher marginal ordinary income tax rates. This distinction in tax rates is the main consequence for an individual, rather than any adjustment to the cost basis of their shares.

Special Rules and Elections

A special rule applies to dividends paid on “disqualified preferred stock,” which are automatically treated as extraordinary regardless of their size or holding period. Preferred stock is considered disqualified if it has a fixed term, can be redeemed by the issuing company, or has a dividend rate tied to interest rates or similar indices.

A shareholder can also elect to use the stock’s fair market value (FMV) instead of its adjusted basis when applying the percentage test. A shareholder might make this election if the stock has appreciated significantly since its purchase, resulting in a high FMV but a low adjusted basis. This allows the shareholder to use the stock’s FMV on the day before the ex-dividend date to determine if a dividend is extraordinary.

Using FMV can prevent a dividend from being classified as extraordinary. For example, if a stock’s basis is $50 but its market value is $120, a $10 dividend would be extraordinary under the basis test (20%) but not under the FMV test (8.3%). To make this election, the shareholder must attach a statement to their timely filed income tax return for the year the dividend was received. For publicly traded stock, the FMV is its closing price, while for non-publicly traded stock, the value must be established to the satisfaction of the IRS.