What Is Section 1059? Extraordinary Dividend Rules
Understand IRC Section 1059, a rule that adjusts a corporate shareholder's stock basis to offset the tax benefit of receiving an extraordinary dividend.
Section 1059 of the Internal Revenue Code is a rule designed to address a tax strategy involving corporate shareholders and large dividends. It is not a tax form but a provision that prevents corporations from using a particular deduction to artificially reduce the taxable gain on a stock sale. The purpose of this rule is to stop what is known as “dividend stripping,” where a corporation buys stock just before a large dividend is paid, receives the dividend with a significant tax deduction, and then sells the stock at a loss for a tax benefit.
This regulation ensures that the economic reality of such a transaction is properly reflected for tax purposes. It targets situations where the combination of a large dividend and a corresponding drop in the stock’s market price could otherwise create an unfair tax advantage. By adjusting the tax basis of the stock, the provision neutralizes the artificial loss that would have been generated. The rule applies specifically to corporate shareholders because they are eligible for the Dividends Received Deduction (DRD).
Identifying an Extraordinary Dividend
Determining whether a dividend is “extraordinary” involves two primary tests that work in conjunction. The first is a holding period requirement. These rules apply only if the corporate shareholder has held the stock for two years or less before the “dividend announcement date,” which is the date the distributing corporation declares, announces, or agrees to the payment of the dividend.
The second part of the analysis is the dividend threshold test, which measures the size of the dividend relative to the shareholder’s investment. A dividend is considered extraordinary if its amount equals or exceeds a specific percentage of the shareholder’s adjusted basis in the stock. For common stock, this threshold is 10 percent, and for preferred stock, a lower threshold of 5 percent is used.
To illustrate, if a corporation holds common stock with an adjusted basis of $50,000, any single dividend payment of $5,000 or more would be classified as an extraordinary dividend, assuming the stock was held for two years or less. Similarly, if the investment was in preferred stock with the same $50,000 basis, a dividend of $2,500 or more would trigger the rule.
Calculating the Stock Basis Reduction
Once a dividend is identified as extraordinary, the direct consequence is a mandatory adjustment to the shareholder’s tax basis in the stock. The rule requires the corporation to reduce its stock basis by the “nontaxed portion” of the dividend. This non-taxed portion is the amount of the dividend that is offset by the Dividends Received Deduction (DRD). The DRD allows a corporation to deduct a percentage of dividends received from other domestic corporations.
For a practical example, consider Corporation X, which purchases stock in Corporation Y for $20,000. Within two years, Corporation X receives a $3,000 dividend that qualifies as extraordinary. Assuming Corporation X is eligible for a 50% DRD, it can deduct $1,500 of the dividend from its taxable income. This $1,500 is the non-taxed portion, and Corporation X must reduce its basis in the Corporation Y stock by this amount, resulting in a new adjusted basis of $18,500.
When the required basis reduction exceeds the shareholder’s existing basis in the stock, the basis is first reduced to zero. The excess amount is then treated as a taxable capital gain recognized in the year the extraordinary dividend is received. For instance, if Corporation X’s basis in the stock was only $1,000, the $1,500 non-taxed portion of the dividend would first reduce the basis to $0. The remaining $500 would be reported as a capital gain for that tax year.
Special Rules and Elections
Beyond the primary tests, the tax code includes provisions for more complex situations. One rule involves the aggregation of multiple smaller dividends. All dividends received by a shareholder that have ex-dividend dates within an 85-day consecutive period are treated as a single dividend for purposes of the 10% or 5% threshold test.
A broader aggregation rule applies for dividends with ex-dividend dates within a 365-day period. If the total of these dividends exceeds 20% of the shareholder’s adjusted basis, they are all treated as extraordinary.
Taxpayers have some flexibility under a special election. A corporate shareholder can elect to test a dividend’s status using the stock’s fair market value (FMV) on the day before the ex-dividend date, instead of its adjusted basis. Using a higher FMV makes it less likely that a dividend will meet the percentage threshold, potentially avoiding an extraordinary dividend classification and the corresponding basis reduction.
Certain dividends are exempt from these rules entirely. An exception applies to “qualified preferred dividends” on certain preferred stock. If a dividend is fixed and the corporate shareholder holds the underlying stock for more than five years, the distribution is not subject to this provision.