What Is an Extraordinary Dividend for Tax Purposes?
An unusually large dividend may be treated differently for tax purposes, requiring a reduction in the stock's cost basis instead of being taxed as income.
A dividend is a company’s distribution of its earnings to shareholders. An “extraordinary dividend,” however, is a classification for a distribution that is significantly larger than normal. This designation, defined under Section 1059 of the Internal Revenue Code, triggers unique tax rules with consequences for corporate shareholders. The regulations are designed to prevent specific tax-avoidance strategies.
The Technical Definition of an Extraordinary Dividend
A dividend is classified as extraordinary based on its size relative to the shareholder’s investment. The primary test compares the dividend amount to the shareholder’s adjusted basis in the stock. A dividend is considered extraordinary if it exceeds 10% of this basis for common stock, or 5% for preferred stock. The adjusted basis is the original purchase price of the stock, adjusted for certain events like stock splits.
As an alternative, a shareholder can elect to use the stock’s fair market value (FMV) on the day immediately preceding the ex-dividend date. For example, if common stock has an FMV of $100 per share on the day before the ex-dividend date, a $12 dividend per share would be extraordinary because it exceeds the 10% threshold.
To prevent companies from avoiding these rules, an aggregation rule combines all dividends with ex-dividend dates within an 85-day period and treats them as a single dividend. A separate rule applies if multiple dividends with ex-dividend dates within a 365-day period exceed 20% of the shareholder’s adjusted basis. These rules apply if the receiving corporation has not held the stock for more than two years before the dividend announcement date.
Tax Impact on Corporate Shareholders
The tax consequences of an extraordinary dividend are most pronounced for corporate shareholders because of the dividends-received deduction (DRD). The DRD allows a corporation to deduct a percentage of dividends received from other domestic corporations, which helps prevent corporate earnings from being taxed multiple times. When a corporation receives an extraordinary dividend, these rules limit the benefit of this deduction.
The main consequence for a corporate shareholder is a required reduction in its stock basis. The reduction amount is equal to the “nontaxed portion” of the dividend, which is the part shielded from tax by the DRD. For instance, if a corporation buys stock for $1,000 and receives a $150 extraordinary dividend with a 50% DRD, $75 is the nontaxed portion. The corporation must then reduce its stock basis by this $75 to a new adjusted basis of $925.
This basis reduction defers the tax on the dividend amount until the stock is sold. By lowering the basis, the eventual capital gain upon selling the stock will be larger, or the capital loss will be smaller. If the required basis reduction is greater than the corporation’s basis in the stock, the excess amount is treated as a taxable capital gain in the year the dividend is received.
Tax Impact on Individual Shareholders
The tax treatment of large dividends for individual shareholders is significantly different and simpler than for corporations. The specific basis reduction rules for extraordinary dividends do not apply to individual investors. For an individual, a dividend that might be classified as extraordinary for a corporation is taxed just like any other dividend payment.
The dividend income will be categorized as either “qualified” or “non-qualified.” Qualified dividends are taxed at lower long-term capital gains tax rates, while non-qualified dividends are taxed at the individual’s higher, ordinary income rates. The distinction depends on the dividend’s nature and how long the investor held the stock, not the payment’s size.
The primary consideration for an individual receiving a very large dividend is whether it might be a non-dividend distribution. This occurs if the distributing company does not have sufficient earnings to cover the payment. In such cases, the distribution is treated as a “return of capital,” which reduces the individual’s adjusted basis in the stock. Once the basis reaches zero, any further distributions are taxed as a capital gain.
Issuer Reporting Obligations
When a company pays a dividend that affects the tax basis of its shareholders’ stock, it must report this action. The primary mechanism for this is IRS Form 8937, Report of Organizational Actions Affecting Basis of Securities.
A company must file Form 8937 with the IRS when it undertakes an action, such as paying an extraordinary dividend that results in a basis reduction for corporate shareholders. The company is also required to make this form available to its shareholders, either by posting it on its public website or by providing it upon request.
The form provides details a shareholder needs to adjust their stock basis correctly, including a description of the action, the date, and the quantitative effect on basis. This information allows shareholders to accurately calculate capital gains or losses when they sell the securities.