The following article will explain what constitutes a distribution. To learn more about the different kinds of distributions, read The Impact of Distributions on Corporations.
From a tax perspective, distributions may be viewed in one of three possible ways: dividends, return of capital, and gain. Generally, distributions are dividends only to the extent that they do not exceed the corporation’s earnings and profits (E&P).
Specifically, according to Section 301 of the US Internal Revenue Code, a distribution of property (e.g., cash or other property) made by a corporation to its shareholder would be considered a dividend to the extent of the corporation’s current E&P or accumulated E&P after 1913.[1]
Note that Section 301’s definition of property, however, excludes stock in the distributing corporation.
Dividends and Domestic Shareholders
Corporate shareholders are taxed on dividends at the corporate rate, which is currently at 21%.
For individuals, the applicable tax rate would depend on whether the dividends constitute “qualified dividends” which are are taxed at the more favorable long-term capital gains rate, while nonqualified dividends are taxed at the individual regular income rate.
Qualified dividends are generally dividends paid by a US corporation, a corporation in a US possession, a non-US corporation that is eligible for benefits under a tax treaty maintained by its resident jurisdiction with the US, or a non-US company whose stock is traded on a major US stock exchange.
Further, the shareholder must have held the stock for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date (a different holding period requirement applies for preferred stock dividends).
If the dividends are considered qualified dividends, the individual shareholder will be receive such dividends tax-free if they are in the 10% and 12% tax bracket. For those in the 22%/24%/32%/35% bracket, they are taxed at a 15% rate, while shareholders in the 37% bracket will be taxed at a 20% rate.
Dividends & Foreign Shareholders
A dividend paid by a U.S. corporation to a non-US shareholder is usually subject to a withholding tax, where the distributing corporation would withhold an amount of the dividend and remit to the US IRS.
The amount of the withholding tax depends on whether the United States has tax treaties with the non-US shareholder’s country of residence and whether the shareholder is eligible for treaty benefits.
This amount also depends on how much of the U.S. corporation the foreign shareholder owns. See our article on Withholding Taxes to learn more.
Distributions in excess of E&P
To the extent that a distribution exceeds the current year and accumulated E&P, it will be considered a return of capital.[2]
This component is applied against and reduces the shareholder’s adjusted tax basis in the shares and usually represents a tax-free recovery of the taxpayer’s investment in the stock.
To the extent the basis has been reduced to zero, the remaining portion of the distribution would be capital gain to the shareholder. (If the corporation is a US real property holding company (USRPHC) under the FIRPTA rules, consideration must be given to possible FIRPTA withholding tax implications). [3]
Impact of Distributions to the Corporation
If a corporation distributes appreciated property to its shareholders, it must recognize gain in a sum equal to the amount the property has appreciated.
Nimble Dividend Rule
One pitfall that sometimes befalls unwary investors is the “nimble dividend rule.” If an entity has a positive balance in its current year E&P, but has a negative balance in its accumulated E&P account at year end, then the nimble dividend rule would apply to require the dividend to come first out of current E&P account before the accumulated E&P account is touched.
This is designed to prevent a company from using prior year E&P deficits to offset the amount included as a dividend. The nimble dividend rule is of particular importance for investors in areas such as infrastructure investments, which may have long periods of deficits before becoming profitable.
Unfortunately for U.S. investors in foreign corporations, indirect foreign tax credits cannot be claimed for nimble dividends. Generally, an indirect foreign tax credit allows investors to claim a credit on the income taxes paid by the foreign corporation to its government.
Thus, what would have been a tax free return of capital to the shareholder may become taxable as a dividend due to the nimble dividend rule. The adverse effects of this rule may be mitigated with some foresight and careful planning, which might include strategies such as delaying a distribution to a year when both current and accumulated E&P accounts have positive balance sheets.
Conclusion
Understanding how a dividend is taxed is helpful on a fundamental level when approaching mergers and acquisitions. Understanding how different kinds of distributions are taxed can help dealmakers decide which type of merger or acquisition best fits their goals.
Furthermore, buyers and sellers should be aware that distributions impact stock prices and balance sheets.
To learn more about the different kinds of distributions, read The Impact of Distributions on Corporations. Finally, correctly Calculating Earnings and Profits is crucial to correctly distributing dividends.
[1] IRC § 316(a).
[2] IRC § 301 (c)(2).
[3] A corporation is generally a U.S. real property holding corporation if the fair market value of the U.S. real property interests held by the corporation on any applicable determination date equals or exceeds 50 percent of the sum of the fair market values of its: U.S. real property interests, interests in real property located outside the United States, and certain business assets.