What Is a Distribution From Paid-in Capital?

A corporate distribution is a payment made by a corporation to its shareholders. Understanding the origin of these funds is important, as it dictates the tax implications for the shareholder and the accounting treatment by the corporation. The character of a distribution is determined by specific tax and accounting rules that govern how and when shareholders receive value from their investment.

The Source of Corporate Distributions

A corporation has two primary pools of capital from which it can make distributions. The first is its “Earnings and Profits” (E&P), a tax-specific calculation that measures a company’s economic ability to pay dividends. E&P is similar to the accounting figure of retained earnings, as it tracks the accumulated net income of the business with various adjustments required by tax law. When a company makes a distribution, tax rules mandate that it is first sourced from any available E&P.

Only after a corporation has exhausted its E&P can it make a distribution from its other major capital source: paid-in capital. Paid-in capital, often detailed on the balance sheet as “Additional Paid-in Capital” (APIC), represents the money shareholders have invested directly into the company in exchange for stock. This ordering rule is important; a distribution cannot be classified as coming from paid-in capital if any positive E&P balance exists. This ensures distributions are first treated as a taxable sharing of profits before they are considered a return of the shareholder’s original investment.

Shareholder Tax Consequences

When a shareholder receives a distribution from paid-in capital, it is treated for tax purposes as a “return of capital.” A return of capital is not immediately taxable to the recipient. Instead of being reported as income, the distribution reduces the shareholder’s cost basis in their stock. The basis is the shareholder’s investment cost for tax purposes, reflecting that the company is returning a portion of that original investment.

This basis reduction has a direct effect. For instance, if a shareholder initially purchased stock for $50 per share and receives a $5 per share distribution classified as a return of capital, their adjusted basis in the stock becomes $45 per share. This process continues with each subsequent return of capital distribution.

The tax-free nature of these distributions is limited. Once the shareholder’s basis in the stock has been reduced to zero, any further distributions from paid-in capital are no longer treated as a tax-free return of capital. At that point, any additional amount received is taxed as a capital gain. The character of this gain, whether short-term or long-term, depends on how long the stock was held.

Corporate Accounting and Reporting

From the corporation’s perspective, making a distribution from paid-in capital requires a specific accounting entry. The company will decrease its Additional Paid-in Capital account and decrease its Cash account. This entry shows that the source of the payment was the capital contributed by shareholders, rather than profits earned by the business. This is distinct from the accounting for a dividend, which reduces the Retained Earnings account.

Beyond internal accounting, the corporation has a reporting obligation to shareholders and the IRS. The details are communicated using Form 1099-DIV, “Dividends and Distributions.” While taxable dividends are reported in Box 1a, the portion of a distribution that is a non-taxable return of capital is reported in Box 3, titled “Nondividend distributions.” This segregation notifies shareholders of the proper tax treatment.

By receiving a Form 1099-DIV with an amount in Box 3, the shareholder is notified that they have received a return of capital and must adjust their stock basis. The corporation may also be required to file Form 8937, “Report of Organizational Actions Affecting Basis of Securities,” with the IRS to provide further detail about any distribution that affects shareholder basis.