Understanding how corporate dividends are taxed to shareholders.

• Author: Ellentuck, Albert B.

Shareholders recognize a taxable dividend to the extent a distribution is paid out of corporate earnings and profits (E&P). If the distribution exceeds E&P, the excess reduces the shareholder's stock basis. Any amount in excess of the shareholder's stock basis is capital gain (Secs. 301(b)(1) and (c)). The amount of the distribution is decreased (but not below zero) by liabilities assumed by the shareholder (e.g., a mortgage on a distributed piece of real estate).

The tax rates for qualified dividends are (1) 0% for taxpayers with a marginal tax rate on ordinary income of 10% or 15%; (2) 15% for taxpayers with a marginal tax rate on ordinary income of 25% or greater whose taxable income falls below the levels for the 39.6% regular tax rate (2014 inflation-adjusted $457,600 for married filing jointly, $406,750 for single filers, and $228,800 for married filing separately); and (3) 20% for taxpayers with taxable income above those levels.

Individuals with modified adjusted gross income above a certain threshold ($250,000 for married filing jointly, $200,000 for single filers, and $125,000 for married filing separately) may also owe the 3.8% net investment income tax (Sec. 1411). Net investment income includes dividends less expenses properly allocable to the dividends. This means that the tax rate applicable to a redemption taxed as a nonliquidating corporate distribution (taxable dividend to the extent of the corporation's E&P) may actually be 18.8% (15% + 3.8%) or 23.8% (20% + 3.8%).

Taxation of Cash Dividends

A cash distribution to a shareholder is a taxable dividend to the extent of the corporation's current or accumulated E&P. If the current E&P equals or exceeds the amount of the distribution, it is a fully taxable dividend to the shareholder even if the corporation has negative accumulated E&P (Regs. Sec. 1.316-1(a)). In other words, if there is sufficient current E&P to cover all distributions made during the year, all distributions are taxable dividends. Amounts treated as taxable dividends reduce the corporation's E&P balance, but not below zero.

Taxation of Noncash Dividends

When property (rather than cash) is distributed, the amount of the dividend equals the fair market value (FMV) of the property on the date of the distribution, reduced by any liabilities assumed by the recipient or to which the property is subject (Sec. 301(b)). In addition, as is the case with cash dividends, the distribution must be from current or accumulated...