A non-taxable distribution is a payment made to shareholders, analogous to a dividend, but it reflects a share of a company’s capital rather than its earnings. Contrary to what the name suggests, it isn’t entirely non-taxable; it’s simply not taxed until the investor sells the company’s stock from which the distribution originated. These distributions reduce the basis of the stock.
Stock received from a corporate spinoff can be transferred to stockholders as a non-taxable distribution. Additionally, dividends paid to cash-value life insurance policyholders fall under this category.
Non-taxable distributions are also known as non-dividend distributions or return of capital distributions.
Key Takeaways
- A non-taxable distribution may take the form of a stock dividend, a stock split, or a distribution from corporate liquidation.
- It’s taxable only upon the sale of the issuing corporation’s stock.
- The non-taxable distribution is reported to the IRS as a reduction in the stock’s cost basis.
Exploring Non-Taxable Distributions in Detail
A non-taxable distribution to shareholders is considered a return of capital rather than a payout from a company’s earnings or profits. Essentially, investors get back part of their initial investment in the company.
Examples of Non-Taxable Distributions
Examples include:
- Stock dividends
- Stock splits
- Stock rights
- Distributions from a corporate liquidation (both partial and complete)
These events are non-taxable when disbursed but will become taxable upon the sale of the underlying stock. Shareholders must adjust the cost basis of their stock accordingly. When selling the stock later, capital gains or losses will be calculated based on the adjusted basis.
Practical Example
Consider an investor who purchases 100 shares of a stock for $800. During the fiscal year, they receive a non-taxable distribution of $90 from the company. The cost basis is now adjusted to $710 (initial purchase price minus distribution). In the subsequent year, if they sell the shares for $1,000, the capital gain is $290 ($200 profit + $90 from the non-taxable distribution).
In rare cases where the non-dividend distribution exceeds the investor’s basis, they must reduce their cost basis to zero and report the excess as a capital gain on IRS Form Schedule D.
For instance, assume the same investor receives $890 in non-taxable dividends. The first $800 reduces the cost basis to zero, while the remaining $90 is reported as a capital gain. This gain might be considered short-term or long-term based on whether the shares were held for more than a year.
Non-taxable distributions are generally indicated in Box 3 of Form 1099-DIV under the “Non-Dividend Distributions” column. Investors might receive this form from the dividend-paying company. If not, the distribution might be reported as an ordinary dividend. Refer to IRS Publication 550 for detailed information on reporting requirements for investment income and non-dividend distribution income.
Related Terms: Stock Dividend, Capital Gain, Cost Basis, Tax Strategy.
