When a corporation pays out its accumulated prior earnings, that distribution is a dividend for federal income tax purposes, and the shareholder owes tax on it. The Internal Revenue Code reaches this result through a concept called earnings and profits (E&P): any distribution a corporation makes to its shareholders out of current-year or accumulated E&P is a taxable dividend, regardless of what the corporation calls the payment.1Office of the Law Revision Counsel. 26 USC 316 Dividend Defined Whether that dividend is taxed at ordinary rates or at the lower qualified-dividend rates depends on the source corporation and the shareholder’s holding period, and the rate gap can exceed 20 points.
Earnings and Profits Is What Makes a Distribution a Dividend
E&P is a tax measure of the corporation’s economic capacity to distribute wealth. It is not retained earnings on the balance sheet and it is not taxable income on the tax return. If a corporation has no E&P, it cannot pay a taxable dividend no matter how large the check.
E&P sits in two pools. Current earnings and profits (CE&P) is what the corporation generates in the current taxable year. Accumulated earnings and profits (AE&P) is the running total of prior years’ earnings that were never distributed. Together those pools decide how every dollar of a distribution is classified.
The Ordering Rule for Every Dollar
Section 301 runs each dollar of a corporate distribution through a fixed sequence. The step where the dollar lands determines the tax.2Office of the Law Revision Counsel. 26 USC 301 Distributions of Property
First, Current Earnings and Profits
A distribution comes first out of CE&P, measured at the end of the taxable year. This happens even if the corporation carries a large accumulated deficit from prior losses. Current profits fund a dividend on their own; an old deficit does not shield them.1Office of the Law Revision Counsel. 26 USC 316 Dividend Defined
Then, Accumulated Earnings and Profits
Any distribution amount that exceeds CE&P comes next from AE&P. This is the accumulated prior-earnings pool. Dollars sourced from either CE&P or AE&P are taxable dividends the shareholder must include in gross income.
The two pools interact when one is negative. Positive CE&P with negative AE&P still produces a dividend to the extent of CE&P. A current-year deficit combined with positive AE&P is netted down to the AE&P balance available on the date of the distribution, and that netted figure sets the dividend amount.
Then, a Tax-Free Return of Capital
After both E&P pools are exhausted, additional distribution amounts stop being dividends. They are treated as a return of capital that reduces the shareholder’s adjusted basis in the stock. No tax is due at the time of receipt. The cost is a lower basis, which produces more gain when the stock is eventually sold, so the tax is deferred rather than eliminated.
Finally, Capital Gain
If the distribution exceeds both E&P pools and the shareholder’s remaining stock basis, the excess is treated as gain from the sale of property. It is a capital gain, long-term or short-term depending on how long the shareholder has held the stock. Reaching this step means the shareholder has recovered the full original investment and is now recognizing economic profit.
How the Dividend Portion Is Taxed
Once a distribution is classified as a dividend, the shareholder’s rate depends on whether it is a qualified dividend or an ordinary dividend.3Internal Revenue Service. Topic No. 404 Dividends and Other Corporate Distributions Ordinary dividends are taxed at the shareholder’s regular income tax rate. Qualified dividends are taxed at the long-term capital gains rates.
What Makes a Dividend Qualified
Two conditions must be met. The dividend must come from a domestic U.S. corporation or a qualified foreign corporation. And the shareholder must hold the stock for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date.4Legal Information Institute. 26 USC 1(h)(11) Qualified Dividend Income Miss the holding period and the whole dividend is taxed as ordinary income. Investors who trade around dividend dates often fail this test without noticing.
2026 Qualified Dividend Brackets
- 0% on taxable income up to $49,451 for single filers or $98,901 for married couples filing jointly.
- 15% on taxable income from $49,451 to $545,500 for single filers, or from $98,901 to $613,700 for joint filers.
- 20% on taxable income above $545,501 for single filers, or above $613,701 for joint filers.
The 3.8% Net Investment Income Tax
High-income shareholders pay an additional 3.8% surtax on net investment income, including dividends. The tax applies once modified adjusted gross income exceeds $200,000 for single filers or $250,000 for married filing jointly.5Internal Revenue Service. Topic No. 559 Net Investment Income Tax Those thresholds are not indexed for inflation, so more filers cross them each year. For a top-bracket shareholder, the combined federal rate on a qualified dividend reaches 23.8%.
When the Corporation Distributes Property Instead of Cash
Non-cash distributions run through the same ordering rules, but they create tax on both sides. The corporation is treated as if it sold the asset at fair market value and recognizes gain accordingly.6Office of the Law Revision Counsel. 26 USC 311 Taxability of Corporation on Distribution Land bought for $100,000 and distributed at $400,000 produces $300,000 of gain at the corporate level.
The shareholder’s distribution amount equals the property’s fair market value, and the shareholder’s basis in the property is that same fair market value rather than the corporation’s basis. If the property is subject to a liability, the liability reduces the amount the shareholder is treated as receiving. That net figure then flows through the CE&P, AE&P, basis, and gain sequence.
Constructive Dividends: Payments That Weren’t Called Dividends
The IRS can recharacterize an economic benefit as a dividend even when the corporation never declared one. This shows up most often in closely held corporations, where personal and corporate lines blur.
Common triggers include the corporation paying a shareholder’s personal expenses, making interest-free or below-market loans to a shareholder, letting a shareholder use corporate property such as vehicles or vacation homes without paying fair rental value, and paying a shareholder-employee compensation that exceeds what is reasonable for the work performed. Excess compensation gets recharacterized as a dividend, which strips the corporation’s deduction and still leaves the shareholder taxed on the amount.
A constructive dividend does not need to be declared by the board, does not need to go pro rata to all shareholders, and does not need to qualify as a dividend under state law. The E&P ordering rules still govern: the recharacterized benefit is taxable as a dividend to the extent of the corporation’s E&P.
S Corporations Carry Old E&P Forward
S corporations do not generate new E&P during years they operate under S status. A corporation that converted from C to S, however, carries its accumulated E&P from the C years forward, and that old balance can sit on the books indefinitely.7Office of the Law Revision Counsel. 26 USC 1368 Distributions
For an S corporation with accumulated E&P, distributions follow a modified sequence. They come first from the Accumulated Adjustments Account (AAA), which tracks post-conversion S corporation income; AAA distributions reduce stock basis and are generally tax-free to the extent of that basis. Once the AAA is exhausted, distributions become dividends to the extent of the carried-over C corporation E&P. Only after both the AAA and the old E&P are used up do distributions return to the standard basis-reduction-then-gain treatment.
Shareholders in a converted S corporation should know the E&P balance the company inherited. A distribution the owner expected to be tax-free can turn out to be a fully taxable dividend.
How the Distribution Shows Up on Your Tax Return
Corporations report distributions on Form 1099-DIV, “Dividends and Distributions,” and must issue one to any shareholder who received $10 or more in dividends or other distributions during the year.8Internal Revenue Service. Instructions for Form 1099-DIV Three boxes carry most of the information the shareholder needs:
- Box 1a, Total Ordinary Dividends, shows the full amount sourced from E&P, including any qualified portion.
- Box 1b, Qualified Dividends, shows the piece of Box 1a that qualifies for the capital gains rates.
- Box 3, Nondividend Distributions, shows the return-of-capital piece that exceeded E&P and reduces stock basis.
The IRS matches these figures against what the shareholder reports, so mismatches generate notices quickly. If Box 3 has an amount, keep it: that dollar amount is what reduces basis, and the reduced basis is what determines gain the day the stock is sold.