If you own shares of corporate stock, you may receive dividends and other distributions over the course of a tax year. Distributions come in many flavors, each with its own treatment on your tax return. The most common type of distribution is the cash dividend, which will be either an ordinary or a qualified dividend, in tax terms. A less-common type of distribution -- also paid as cash -- is the nondividend distribution, or return of capital, which is also sometimes confusingly referred to as a "tax-exempt dividend." You rarely need to report a tax-exempt dividend on your tax return, and when you do, treat it differently from regular cash dividends.
The United States income tax law taxes income, but not every amount of cash you receive is considered income. All wages or other compensation received for labor are taxed as income, but when it comes to your business revenues or investment proceeds, only your profits or increase are income. For example, if you own shares of stock, regular cash dividends are income, because they reflect the profits that your investment generates for you over the business period. If you sell that stock, however, only your gain is considered income; that is, the amount of the sales proceeds that exceed the amount of your investment (in tax terms, your "basis").
Tax Exempt Dividends
Nondividend distributions may seem similar to cash dividends when you receive the proceeds. They both come to you as cash, the amount of which depends on the number of shares of stock you own. However, they are quite different from a tax perspective.
A regular cash dividend occurs when a corporation pays out to its shareholders a portion of the business profits it has earned. Sometimes, however, a company may pay cash out to its shareholders even if there are no current profits and no retained earnings. This might occur if the company has liquidated a division, sold a subsidiary or an investment, or if the company has generated additional capital (e.g., through a new stock offering). When a company makes this type of distribution, it is considered a return of the shareholder's capital or investment, rather than ordinary taxable income.
General Tax Treatment
At the end of the tax year in which you receive a dividend or distribution, the company or your broker should send you either a Form 1099-DIV or the equivalent information in a consolidated 1099 statement. Nondividend distributions appear in Box 3 on the 1099-DIV. In a consolidated statement, they may be referred to as nondividend distributions, tax exempt dividends, or returns of capital.
Because this type of distribution is a return of capital, you generally do not need to report it on your tax return. However, you do need to keep track of your basis in the stock and reduce that basis by the amount of each nondividend distribution you receive. This is because when your capital is returned to you, the amount of your investment in the stock is reduced. You will not be taxed on tax-exempt dividends unless and until your basis reaches zero.
Tax Treatment at Zero Basis
If and when your basis reaches zero, you need to report and pay taxes on any additional tax-exempt dividends. Unlike ordinary and qualified dividends, however, tax-exempt dividends are not reported on Schedule B, but on Schedule D. This is because any return of capital above and beyond your investment is a capital gain.
Identify these distributions on Schedule D by entering the initials NDEB ("Nondividend distribution exceeding basis"), followed by the company name, in column a) "Description of Property." Enter the amount of the distribution that exceeded your basis in column d) "Sales Price." Whether the entry should go in the short-term or long-term section is determined by how long you have owned the stock shares.
Patricia DeWitt is a CTEC-registered tax professional, a member of the California State Bar and a graduate of Harvard Law School, J.D. class of 2000. Her writing appears on a range of business and finance websites.