What Is a Non-Taxable Distribution?
Let me explain what a non-taxable distribution is—it's a payment made to you as a shareholder, much like a dividend, but it comes from the company's capital instead of its earnings. Don't let the name fool you; it's not entirely tax-free. You won't pay taxes on it right away, but it will affect your taxes when you sell the stock from the issuing company. These distributions lower your stock's basis.
You might see stock from a corporate spinoff transferred to you as a non-taxable distribution. Also, dividends on cash-value life insurance policies count as non-taxable distributions. Sometimes, they're called non-dividend distributions or return of capital distributions.
Key Takeaways
- A non-taxable distribution can be a stock dividend, a stock split, or a distribution from a corporate liquidation.
- It's only taxable when you sell the stock of the corporation that issued it.
- You report it to the IRS as a reduction in your stock's cost basis.
Understanding Non-Taxable Distributions
When you receive a non-taxable distribution, it's not coming from the company's or mutual fund's earnings or profits—it's simply a return of the capital you invested. You're getting back some of your own money.
Common examples are stock dividends, stock splits, stock rights, and distributions from partial or complete corporate liquidations. The distribution itself is non-taxable at the time you get it, but it becomes taxable when you sell the stock. You need to reduce your stock's cost basis by the distribution amount. Then, when you sell, your capital gain or loss is based on that adjusted basis.
Here's an example to make it clear: Suppose you buy 100 shares for $800. In the tax year, you get a $90 non-taxable distribution. Your basis drops to $710 ($800 minus $90). The next year, you sell for $1,000. Your capital gain is $290—the $200 profit plus the $90 distribution.
Usually, the non-dividend distribution is less than your basis in the shares. But if it's more, you reduce the basis to zero and report the excess as a capital gain on IRS Form Schedule D. For instance, if you receive $890 in distributions on that $800 investment, the first $800 zeros out the basis, and you report the remaining $90 as a gain—short- or long-term based on your holding period.
You'll typically see non-taxable distributions in Box 3 of Form 1099-DIV, under 'Non-Dividend Distributions.' The company might send you this form; if not, it could show up as an ordinary dividend. Check IRS Publication 550 for full details on reporting investment income, including these distributions.
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