IRC Section 301: Dividends, Basis Recovery, and Capital Gain

Under Internal Revenue Code Section 301, distributions from a C corporation to its shareholders are taxed in a fixed three-step sequence: first as an ordinary or qualified dividend to the extent the corporation has earnings and profits, then as a tax-free recovery of your stock basis, and finally as a capital gain on anything that exceeds both. The label the corporation puts on the payment does not control the outcome. The statute does.¹

What Section 301 Covers

Section 301 applies to any transfer of money or property a corporation makes to you because you own its stock. Board minutes calling the payment a “dividend,” a “return of capital,” or anything else make no difference. The tax treatment follows the statutory framework.¹

“Property” here is broad. It covers cash, securities, real estate, inventory, patents, corporate debt obligations, and essentially any other asset the corporation transfers. One exclusion matters: stock in the distributing corporation itself, and rights to buy that stock, are not “property” for this purpose.² Distributions of the corporation’s own shares fall under a separate provision and are generally not taxable.³

The amount of the distribution is the cash received plus the fair market value of any non-cash property, reduced by liabilities you assume or that come attached to the property. The net figure cannot drop below zero.⁴

Earnings and Profits Set the Ceiling on Dividend Treatment

The whole framework turns on a figure called earnings and profits, or E&P. It is not retained earnings on a balance sheet, and it is not taxable income on the corporate return. E&P is a separate calculation Congress designed specifically to measure how much economic income the corporation has generated and not yet distributed. A distribution qualifies as a “dividend” only to the extent the corporation has E&P to back it up.⁵

E&P has two components. Current E&P is what the corporation generated during the present tax year, measured at year-end. Accumulated E&P is the running total of undistributed E&P from all prior years. The starting point is taxable income, adjusted upward for items that increase economic wealth without being taxable (tax-exempt bond interest, for example) and downward for items that reduce wealth without being deductible (federal income taxes paid).⁶

When a corporation has positive current E&P and a deficit in accumulated E&P, current E&P is spread proportionally across every distribution made during the year. When the two figures point the other way, they are netted on each distribution date to see whether any dividend capacity exists. These ordering rules can shift the tax result significantly if there are multiple distributions in a single year.

The Three-Tier Sequence

Once you know the distribution amount and the corporation’s E&P, the statute forces every dollar through the same three-step test. You cannot skip a step or rearrange the order.¹

Tier 1: Taxable Dividend

The distribution is a taxable dividend to the extent the corporation has E&P to support it, drawing first from current E&P and then from accumulated E&P.⁵ This amount is included in your gross income. Whether it is taxed at ordinary rates or preferential capital gains rates depends on whether it counts as a qualified dividend.⁷

Tier 2: Tax-Free Recovery of Basis

Anything that exceeds total E&P moves to Tier 2 and reduces your adjusted basis in the stock. You owe no tax on this portion now. The catch is that every dollar of basis reduction increases your capital gain when you eventually sell the shares, so the tax is deferred, not eliminated.⁷

Tier 3: Capital Gain

If the distribution exceeds both the corporation’s E&P and your remaining basis, the leftover is treated as gain from a sale of the stock. If you have held the shares more than one year, it is long-term capital gain.⁸ Tier 3 typically only appears when basis has been ground down to zero after years of distributions from a corporation with little or no E&P.

Tax Rates on Each Tier

A Tier 1 dividend taxed at ordinary rates can hit 37%. A qualified dividend tops out at 20%. For a shareholder pulling $50,000 out of a corporation, the difference runs into thousands of dollars.

To qualify, the dividend must come from a domestic corporation or a qualifying foreign corporation (generally one incorporated in a U.S. territory, eligible for a U.S. tax treaty, or with stock traded on a U.S. exchange). You also have to meet a holding period: more than 60 days during the 121-day window that begins 60 days before the ex-dividend date.⁹

The rate itself depends on your taxable income and filing status. For 2026, single filers pay 0% on qualified dividends and long-term capital gains up to $49,450 of taxable income, 15% above that, and 20% once taxable income exceeds $545,500. Joint filers reach the 15% bracket at $98,900 and the 20% bracket at $613,700.

High-income shareholders face another layer. The Net Investment Income Tax adds 3.8% on top, and it applies to both dividends and capital gains from corporate distributions.¹⁰ The surtax hits the lesser of your net investment income or the amount by which your modified adjusted gross income exceeds the threshold: $250,000 for joint filers, $200,000 for single filers, and $125,000 for married filing separately.¹¹ Those thresholds are not indexed for inflation. A shareholder in the 20% qualified dividend bracket who also owes the NIIT effectively pays 23.8% on Tier 1 income.

When the Corporation Distributes Property Instead of Cash

The same three tiers apply when the corporation hands you real estate, equipment, securities in another company, or inventory. Measurement is different, and the corporation has its own tax event to worry about.

You measure the distribution at the property’s fair market value on the date of receipt, minus liabilities you assume or that ride with the property. That net figure enters the three-tier analysis. Your basis in the distributed property equals its fair market value at the time of distribution, regardless of what the corporation originally paid. If you sell it later, gain or loss runs from that fresh baseline.⁴

On the corporate side, if the property’s fair market value exceeds the corporation’s adjusted basis, the corporation must recognize gain as though it sold the asset to you at market price. That gain flows into corporate taxable income and increases E&P for the year, which can pull more of the same distribution into Tier 1 treatment. If the property has lost value, the corporation cannot recognize the loss, and you still take a fair-market-value basis. The asymmetry is deliberate; it stops corporations from cherry-picking loss property to distribute for the deduction.¹²

Constructive Distributions

The corporation does not have to write a check or declare a dividend for Section 301 to apply. The IRS routinely reclassifies transactions between a closely held corporation and its shareholders as taxable distributions when the shareholder gets an economic benefit without paying for it. For owner-operated businesses, this is one of the most common audit adjustments.

Common triggers:

Personal expenses paid by the corporation. If the company pays your mortgage, credit card bills, or vacation costs with no expectation of repayment, those payments run through the three-tier framework.
Below-market or interest-free loans from the corporation. Forgone interest is treated as a distribution under a separate statute, with a de minimis exception when the outstanding balance stays at or below $10,000.¹³
Personal use of corporate property. Driving the company car, using a corporate vacation home, or flying on a company plane without paying fair rental value creates a distribution equal to that value.
Bargain purchases. Buying corporate property for less than fair market value produces a distribution equal to the discount.
Excessive compensation to a shareholder’s family member for services, above what the market would pay.

The sting is the double tax. The corporation usually cannot deduct a distribution, so it pays corporate tax on the amount. Then you pay individual tax on the same dollars. Clean documentation of every transaction between you and the corporation is the best defense.

How the Distribution Gets Reported

The corporation issues Form 1099-DIV, breaking the payment into ordinary dividends (Box 1a), qualified dividends (Box 1b), and nondividend distributions (Box 3), among other categories. Ordinary dividends go on line 3b of Form 1040 and qualified dividends on line 3a.¹⁴ Tier 3 capital gains go on Schedule D. Corporations making nondividend distributions (amounts exceeding E&P that fall into Tier 2 or Tier 3) must also file Form 5452.¹⁵

One practical wrinkle: current E&P is measured at the close of the tax year, so the final dividend-versus-nondividend split may not be known until well after the distribution date. Corrected 1099-DIVs sometimes arrive after year-end, and shareholders who filed early may need to amend. Tracking your stock basis year over year is your job, not the corporation’s, and it is the only way to correctly apply Tiers 2 and 3 when a distribution exceeds E&P.

S Corporation Shareholders: Different Rules

If you own S corporation stock, Section 301’s three-tier framework does not apply directly. S corporation distributions run through a separate provision built around the accumulated adjustments account, which tracks previously taxed but undistributed S corporation income. Section 301 re-enters the picture only when an S corporation carries leftover C corporation E&P from a prior period, in which case distributions beyond the AAA are treated as dividends under Section 301 to the extent of those old earnings and profits.¹⁶ If your S corporation converted from C corporation status, the interaction is worth working through carefully.

1
Office of the Law Revision Counsel. 26 USC 301 – Distributions of Property
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Office of the Law Revision Counsel. 26 US Code 317 – Other Definitions
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Office of the Law Revision Counsel. 26 US Code 305 – Distributions of Stock and Stock Rights
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Office of the Law Revision Counsel. 26 US Code 301 – Distributions of Property
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Office of the Law Revision Counsel. 26 USC 316 – Dividend Defined
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Office of the Law Revision Counsel. 26 USC 312 – Effect on Earnings and Profits
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Internal Revenue Service. Topic No. 404 – Dividends and Other Corporate Distributions
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Internal Revenue Service. Topic No. 409, Capital Gains and Losses
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Legal Information Institute. 26 US Code 1(h)(11) – Qualified Dividend Income
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Internal Revenue Service. Net Investment Income Tax
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Internal Revenue Service. Topic No. 559, Net Investment Income Tax
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Office of the Law Revision Counsel. 26 US Code 311 – Taxability of Corporation on Distribution
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Office of the Law Revision Counsel. 26 US Code 7872 – Treatment of Loans With Below-Market Interest Rates
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Internal Revenue Service. 1099-DIV Dividend Income
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Internal Revenue Service. About Form 5452, Corporate Report of Nondividend Distributions
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Office of the Law Revision Counsel. 26 US Code 1368 – Distributions