Non-Taxable Distribution

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Non-Taxable Distribution: Definition and How It Works

A non-taxable distribution (also called a return of capital or non-dividend distribution) is a payment to shareholders that represents a return of part of their original investment, not a distribution of a company’s earnings. Because it is a return of capital, it is not taxed when received. Instead, it reduces the shareholder’s cost basis in the stock and is taxed later when the stock is sold.

Common Forms and Examples

  • Stock dividends, stock splits, and stock rights (when not paid from earnings).
  • Distributions from a partial or complete corporate liquidation.
  • Stock received in a corporate spinoff.
  • Certain dividends from cash-value life insurance policies.

How Basis Adjustment and Taxation Work

  • When a shareholder receives a non-taxable distribution, the distribution amount reduces the cost basis of their shares.
  • The tax event occurs when the shares are sold; the capital gain or loss is calculated using the adjusted (reduced) basis.
  • If the total non-taxable distributions exceed the shareholder’s cost basis, the basis is reduced to zero and the excess is treated as a capital gain in the year of the distribution.

Example 1:
– Purchase: 100 shares for $800 (basis = $800).
– Non-taxable distribution received: $90 → adjusted basis = $800 − $90 = $710.
– Sale next year for $1,000 → capital gain = $1,000 − $710 = $290.

Example 2 (distribution exceeds basis):
– Purchase: shares for $800.
– Total non-taxable distributions received: $890.
– First $800 reduces basis to $0; remaining $90 is reported as a capital gain (short- or long-term depending on holding period).

Reporting and Forms

  • Non-taxable distributions are generally reported on Form 1099-DIV under “Nondividend Distributions” (Box 3).
  • If not properly identified, a distribution might be reported as an ordinary dividend; consult tax guidance if forms are unclear.
  • Excess distributions over basis must be reported on Schedule D of Form 1040 as capital gains.
  • For detailed reporting rules and examples, refer to IRS Publication 550.

Key Takeaways

  • A non-taxable distribution returns capital to shareholders and is not taxed when received.
  • It reduces the cost basis of the stock; tax is deferred until the stock is sold.
  • If distributions exceed basis, the excess is taxable as a capital gain.
  • Properly track basis adjustments and review Form 1099-DIV and IRS guidance when preparing tax returns.