What Is the Tax Treatment of an Extraordinary Dividend?
Learn the distinct tax rules for large dividends, which require corporate shareholders to reduce their stock basis while individuals are typically unaffected.
An extraordinary dividend represents a significant, and often non-recurring, distribution from a corporation to its shareholders. It carries distinct tax implications that differ substantially from those of regular dividends. These rules, found in Section 1059 of the Internal Revenue Code, are designed to prevent certain tax-motivated strategies, particularly by corporate shareholders. The tax treatment hinges on whether a dividend meets the specific criteria to be classified as “extraordinary,” which triggers special requirements for corporations that receive such payments.
Identifying an Extraordinary Dividend
A dividend is identified as extraordinary through specific quantitative tests based on the shareholder’s adjusted basis in the stock. For common stock, a dividend is extraordinary if its value equals or exceeds 10% of the stock’s adjusted basis. For preferred stock, the threshold is lower, at 5% of the stock’s adjusted basis. The adjusted basis is generally the stock’s original purchase price, adjusted for events like stock splits.
Aggregation rules prevent circumventing these tests with multiple smaller dividends. All dividends with ex-dividend dates within an 85-day period are treated as a single dividend. Furthermore, all dividends with ex-dividend dates within a 365-day period are treated as extraordinary if their combined total exceeds 20% of the shareholder’s adjusted basis.
As an alternative to using the stock’s basis for these tests, a corporate shareholder can elect to use the stock’s fair market value as of the day before the ex-dividend date. The ex-dividend date is the cutoff day that determines who is entitled to receive a declared dividend.
Tax Consequences for Corporate Shareholders
The tax consequences are most significant for corporate shareholders due to the Dividends-Received Deduction (DRD). The DRD allows a corporation to deduct a percentage of dividends received from another corporation, preventing the same earnings from being taxed multiple times.
If a corporate shareholder receives an extraordinary dividend on stock held for two years or less, it must reduce its basis in that stock. The reduction equals the “nontaxed portion” of the dividend—the amount shielded from tax by the DRD. For example, if a corporation with a $1,000 stock basis gets a $150 extraordinary dividend and a 50% DRD ($75), it must reduce its basis by $75 to $925.
This lower basis increases the taxable gain or decreases the loss when the stock is sold. The rule prevents a corporation from buying stock just before a dividend, receiving it largely tax-free, and then selling the stock at a loss to offset other gains.
If the nontaxed portion of the dividend exceeds the stock’s basis, the excess amount is immediately treated as a taxable gain in the year the dividend is received. This prevents the DRD from creating an artificial tax loss.
Tax Consequences for Individual Shareholders
The tax treatment for individual shareholders is much simpler than for corporations. The complex basis reduction rules do not apply to non-corporate shareholders. For an individual investor, an extraordinary dividend is taxed just like any other dividend they might receive.
The dividend will be classified as either “qualified” or “non-qualified” based on established rules. Qualified dividends are taxed at the more favorable long-term capital gains rates, while non-qualified dividends are taxed at an individual’s regular marginal income tax rates.
The Holding Period Requirement
An exception to the extraordinary dividend rules for corporate shareholders is tied to the stock’s holding period. The basis reduction requirement does not apply if the corporation has held the stock for more than two years before the “dividend announcement date.” This date is the earliest of when the corporation declares, announces, or agrees to the dividend payment.
This long-term holding exception recognizes that a corporation holding a stock for a significant period is more likely a genuine investor rather than one engaging in a short-term tax arbitrage strategy. However, the two-year holding period can be suspended, or “tolled.” The period is paused if the shareholder diminishes its risk of loss on the stock, such as by having an option to sell or entering into a short sale of similar securities.