DEFINITION of Nontaxable Distribution
A non-taxable distribution is a type of dividend that is paid to shareholders of a corporation not as a result of earnings, but as a return of capital. Nontaxable distributions can also include stock received from a spinoff. Dividends paid to cash-value life insurance policyholders are also considered nontaxable returns of capital.
Nontaxable distributions are also referred to as nondividend distributions or return of capital distributions.
BREAKING DOWN Nontaxable Distribution
A non-taxable distribution is not paid to investors from a company’s or mutual fund’s earnings or profits. It is a return of capital, meaning investors get back some of the money they invested into the company. Examples of non-taxable distributions include stock dividends, stock splits, stock rights, and distributions received from a partial or complete liquidation of a corporation.
Although the distribution is a non-taxable event when disbursed, it will be taxable when the stock is sold. Shareholders who receive nontaxable distributions must reduce the cost basis of their stock accordingly. Upon the sale of the stock, the resultant capital gain or loss will be calculated from the adjusted basis. For example, an investor purchases 100 shares of a stock for $800. During the tax year, she receives a non-taxable distribution of $90 from the company. Her cost basis will be adjusted to $800 – $90 = $710. The following year, she sells her shares for $1,000. Her reportable capital gain for tax purposes is $1000 – $710 = $290.
the amount of the nondividend distribution is usually smaller than the investor’s basis in the shares. In a case where the distribution is more than the basis, the shareholder must reduce his or her cost basis to zero, and report the excess amount of the distribution as a capital gain in Schedule D. For example, assume the investor in the example above receives a total of $890 in dividends that are non-taxable. The first $800 of the distribution will reduce her cost basis to zero. The remaining $90 will be reported as short- or long-term capital gain, depending on how long the shares were held. She must also report as a long-term capital gain any additional nondividend distribution she receives on the stock in later years.
Nontaxable distributions are generally reported in Box 3 of Form 1099-DIV. Return of capital shows up under the “Non-Dividend Distributions” column on the form. An investor that does not receive this form from the dividend payer must report the distribution to the IRS as an ordinary dividend.
To learn more about nontaxable distributions, refer to IRS Publication 550: Investment Income and Expenses here.