When a corporation makes a distribution to a shareholder, the tax consequences depend on whether the distribution is a dividend. Under § 301(c), there are three tiers:
First, the distribution is a dividend to the extent of the corporation’s current and accumulated earnings and profits (E&P). The shareholder includes this amount in gross income as a dividend. Under current law, qualified dividends are taxed at capital gains rates for individuals. § 1(h)(11).
Second, if the distribution exceeds E&P, the excess reduces the shareholder’s basis in his stock. This is a tax‑free return of capital. The shareholder doesn’t recognize income, but his basis goes down.
Third, if the distribution exceeds both E&P and the shareholder’s basis, the excess is treated as gain from the sale or exchange of property. This is usually capital gain.
The shareholder’s basis in property received as a dividend is its fair market value. § 301(d). So even if the property has built‑in gain, the shareholder gets a stepped‑up basis.
Here’s an example from the casebook: Myrna owns stock with a basis of 10,000 in Hannibal Corp. Hannibal has accumulated E&P of 4,000 and current E&P of 10,000, value
7,000 from E&P, even though the property is worth only
10,000. Her basis in her stock remains $10,000 because the distribution didn’t exceed E&P.
If the property had been worth 7,000 dividend,
8,000, still $7,000 dividend. The key point: the amount of the dividend is measured by E&P, not by the value of the property.
This article is for general informational purposes only and is subject to change. Tax laws are complex and vary by situation. You should consult a qualified professional for advice specific to your circumstances. For questions, contact Alan Goldstein.
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