This article describes a variety of distributions to the shareholders or partners in “C” and “S” corporations, as well as partnerships, and their varying treatment under the tax laws.
A return of capital to shareholders in a “C” corporation is first offset against the shareholders’ basis in their stock, resulting in no taxable gain. If the return of capital exceeds the shareholders’ basis, then the excess amount is taxed as a capital gain. If the distribution is part of a corporate liquidation, and the amount returned is less than the shareholders’ basis, then the difference can be claimed as a capital loss.
If a corporation issues a dividend to its shareholders, it must be recorded as ordinary income by the shareholders, on the grounds that it is the result of earnings within the short-term, and so has no reason to be considered a long-term capital gain. If the company also has a dividend reinvestment plan available under which shareholders can purchase more shares with their dividends, then any discount on the purchase of additional dividends must be reported as ordinary taxable income in the current period.
If an entity sells stock prior to the payment date of a dividend but after the date when it was declared, then the entity to whom the dividend check is addressed must include the amount of dividend in its taxable income.
A company may distribute a stock dividend to its shareholders. If so, there is no immediate taxable income to the recipient. However, the shareholder must allocate his or her basis in the existing stock between it and the newly acquired stock dividend in direct proportion to the fair market value of each one on the date when the stock dividend was issued.
If an “S” corporation distributes its current or retained earnings to shareholders, it is treated as a nontaxable reduction in one’s basis in the stock. Distributions in excess of one’s basis are treated as a gain. All current-year income or loss experienced by an “S” corporation is passed directly through to its shareholders, and must be reported by them in proportion to their ownership shares in the business. One’s current-year share of income in an “S” corporation will increase one’s basis in the corporation.
Mutual funds and real estate investment trusts are allowed to make capital gain distributions to their shareholders, which will be taxed under the reduced long-term capital gains tax.
If a distribution is made to a partner in a partnership in the form of marketable securities, the partner need only recognize taxable income to the extent that the current market value of the securities on the day of the distribution exceeds the basis of the partner’s interest (which is the money and adjusted basis of any property that the partner originally contributed to the partnership).