When Is a Stock Dividend Considered Taxable?
Understand the tax implications of a stock dividend. While often nontaxable, the specifics of the distribution determine if you must report income or adjust cost basis.
A stock dividend occurs when a company distributes additional shares of its own stock to existing shareholders. Unlike a cash dividend, which is a direct payment of money, a stock dividend provides more ownership slices in the corporate pie. While cash dividends are taxed in the year they are received, stock dividends are often not taxable upon receipt. There are, however, specific circumstances defined by the Internal Revenue Service (IRS) that can make a stock dividend a taxable event for the shareholder.
The General Rule of Nontaxability
Receiving a stock dividend does not trigger an immediate tax liability in most cases. The IRS views a proportional stock dividend as a restructuring of the shareholder’s existing equity, not as an increase in wealth. For example, a stock dividend is like having a pizza cut into eight slices instead of four. You own more slices, but your total ownership of the pizza has not changed, and you have not realized any economic gain.
This principle affects how the investment’s cost basis is handled. The total cost basis of your holdings remains the same after the dividend, but it must be reallocated across the increased number of shares. For example, an investor who purchased 100 shares for $1,000 has a cost basis of $10 per share.
If the company issues a 10% stock dividend, the investor receives 10 additional shares for a total of 110. The total cost basis is still $1,000, but the per-share basis is recalculated by dividing $1,000 by 110 shares, resulting in a new basis of approximately $9.09 per share. This lower basis is used to calculate capital gains or losses when the shares are sold.
When Stock Dividends Become Taxable
The nontaxable treatment of stock dividends is conditional. The protection is lost if the distribution gives a shareholder an advantage or changes their proportional interest in the company relative to other shareholders. Internal Revenue Code Section 305 outlines several specific situations where a stock dividend becomes taxable income. These rules are designed to prevent companies from disguising what is effectively a cash distribution in the form of stock. These situations include:
- Choice of stock or cash: If shareholders are given a choice to receive the dividend in the form of stock or cash, the distribution is taxable for all shareholders. This applies even for those who ultimately chose to receive additional shares. The logic is that the shareholder had access to the cash and chose to forgo it, which is economically equivalent to receiving cash and then using it to buy more shares.
- Disproportionate distributions: A stock dividend is taxable if the distribution results in some shareholders receiving cash or other property while others experience an increase in their proportionate interest in the company’s assets or earnings. This rule prevents arrangements where one class of shareholders receives a stock dividend while another class receives a cash dividend.
- Distributions of common and preferred stock: If a distribution results in some common stockholders receiving common stock and others receiving preferred stock, the dividend is taxable. This type of distribution alters the nature of the shareholders’ interests in the corporation, as preferred stock carries different rights and privileges than common stock.
- Distributions on preferred stock: As a general rule, most stock dividends paid on preferred stock are considered taxable. The rationale is that dividends on preferred shares are often a substitute for periodic cash dividends that would have been taxable anyway.
- Distributions of convertible preferred stock: A distribution of convertible preferred stock is also presumed to be taxable. This is because it has the potential to create a disproportionate distribution in the future, unless it can be demonstrated that the distribution will not have such a result.
Calculating and Reporting Taxable Stock Dividends
When a stock dividend is determined to be taxable, the shareholder must recognize income. The amount of taxable income from a stock dividend is its fair market value (FMV) on the date of the distribution. This value is based on the trading price of the shares on the day they were issued to you.
For instance, if you receive 20 additional shares as a taxable dividend and the stock’s FMV on that day is $50 per share, you have received $1,000 of taxable dividend income. This $1,000 becomes the cost basis for the new shares.
This income is reported to you by the brokerage or company on Form 1099-DIV, typically in Box 1 as ordinary dividends. You must then transfer this information to your personal tax return, Form 1040. You may also need to complete Schedule B, Interest and Ordinary Dividends.
The dividend will be classified as “qualified” or “non-qualified” on Form 1099-DIV. Qualified dividends are taxed at more favorable long-term capital gains rates (0%, 15%, or 20%) depending on your income. To be qualified, holding period requirements must be met, such as owning the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. Non-qualified dividends are taxed at regular ordinary income tax rates.