What Qualifies as a Non Taxable Distribution?
Not all distributions are taxed as income. Understand how certain payments reduce an investment's cost basis, affecting your tax liability when you eventually sell.
A non-taxable distribution is a payment that is not considered part of your taxable income for the year. Unlike typical investment income like dividends or interest, you do not report it as income when filing your annual tax return. Instead of representing a share of profits, this payment often signifies a different type of transaction. However, these distributions have future tax consequences that require careful tracking.
Understanding Return of Capital
The most common form of non-taxable distribution is a “return of capital” from a corporation. Corporations make payments to shareholders, known as dividends, from their accumulated or current-year “earnings and profits” (E&P). This E&P account is a tax-specific measure of a company’s capacity to pay dividends. When a company makes a distribution that exceeds its total available E&P, the excess amount is not classified as a dividend.
This excess portion is treated as a return of capital. Financially, the company is not distributing profits but is returning a portion of the shareholder’s original investment money. This can happen if a company has significant non-cash expenses like depreciation that reduce its E&P for tax purposes but not its cash available for distribution. The paying corporation determines the character of the distribution based on its E&P calculations at year-end and notifies shareholders what portion is a dividend versus a non-taxable return of capital.
Impact on Investment Basis
Receiving a non-taxable distribution directly affects your “cost basis” in the investment. The cost basis is the original value of an asset for tax purposes, typically the purchase price plus any costs of acquisition like commissions. When you receive a return of capital, you must reduce your cost basis in the stock on a dollar-for-dollar basis by the amount of the distribution.
For example, imagine you purchased 100 shares of a stock for a total of $2,000, making your initial cost basis $20 per share. If the company pays a non-taxable distribution of $1 per share, you would receive $100. This $100 is not taxed in the current year, but you must reduce your total cost basis by this amount, from $2,000 down to $1,900. Your adjusted basis per share is now $19.
This basis reduction has a deferred tax consequence. When you eventually sell the shares, your capital gain or loss is calculated as the difference between the sale price and your adjusted cost basis. Using the previous example, if you sell the 100 shares for $2,500, your taxable capital gain would be $600 ($2,500 sale price – $1,900 adjusted basis), rather than the $500 gain you would have had without the basis adjustment.
Non-taxable distributions can reduce your cost basis to zero over time. Once your basis in the stock is $0, any subsequent distributions are no longer treated as a non-taxable return of capital. At this point, any further payments must be reported as a taxable capital gain in the year they are received. The character of that gain, whether short-term or long-term, depends on how long you have held the security.
Common Sources of Non-Taxable Distributions
While returns of capital from corporations are a primary example, non-taxable distributions can arise from several other sources.
- Qualified distributions from a Roth Individual Retirement Arrangement (IRA). Because contributions to a Roth IRA are made with after-tax money, withdrawals in retirement are not taxed, provided the account has been open for at least five years and the owner is over age 59½.
- Distributions from a Health Savings Account (HSA). These are non-taxable when used to pay for qualified medical expenses. Money taken out for non-medical reasons is subject to income tax and a 20% penalty if you are under age 65.
- Gifts and inheritances. In the United States, the recipient of a gift or inheritance generally does not pay federal income tax on the value of the property received. Any tax liability, such as gift or estate tax, is the responsibility of the giver or the decedent’s estate.
- Proceeds from a life insurance policy. Payments paid to a beneficiary upon the death of the insured are generally not included in the beneficiary’s gross income.
Reporting Non-Taxable Distributions
The primary document for reporting corporate distributions is Form 1099-DIV, “Dividends and Distributions.” A return of capital is reported in Box 3, labeled “Nondividend distributions.” This amount is not entered directly onto your Form 1040 as income; its purpose is to alert you to adjust your investment records. The legal obligation for accuracy in tracking cost basis rests with the investor, though brokerage firms may provide supplemental information.
If a distribution exceeds your basis, the excess amount must be reported as a capital gain. This is done using Form 8949, “Sales and Other Dispositions of Capital Assets,” which is then used to fill out Schedule D, “Capital Gains and Losses.” On Form 8949, you would report the excess distribution as if it were proceeds from a sale with a cost basis of zero, resulting in a taxable gain.