What Is an Extraordinary Dividend and How Is It Taxed?

An extraordinary dividend is a dividend large enough, measured against a corporate shareholder’s stock basis, to trigger the basis-reduction rules of Internal Revenue Code Section 1059. When those rules apply, the shareholder must reduce its basis in the stock by the untaxed portion of the dividend, and if that reduction is bigger than the basis, the excess becomes capital gain in the year the dividend is received. The rule exists to shut down a specific move: a corporation buys stock, collects a big dividend that is mostly sheltered by the dividends received deduction, then sells the stock at an artificial loss built out of basis the shareholder never really had at risk.¹

When a Dividend Crosses the Threshold

The test is a ratio: dividend amount divided by the shareholder’s adjusted basis in the stock. Common stock is extraordinary at 10% of basis. Preferred stock is extraordinary at 5%.¹

Two aggregation rules keep shareholders from slicing a large distribution into small ones to duck the test. All dividends on the same stock with ex-dividend dates inside any 85 consecutive days are combined and tested as a single dividend against the 10% or 5% line. Separately, all dividends on the same stock with ex-dividend dates inside any 365 consecutive days are treated as extraordinary in full once the running total passes 20% of adjusted basis. The 365-day rule doesn’t just aggregate for testing; crossing the line automatically classifies the whole batch. Both denominators use the original adjusted basis, ignoring any reductions Section 1059 itself would cause.¹

The Fair Market Value Election

Long-held, appreciated stock can trip the test on a dividend that is modest by market standards. Section 1059(c)(4) lets a shareholder substitute the stock’s fair market value on the day before the ex-dividend date for adjusted basis in the threshold calculation, if the shareholder can establish that value to the IRS. A $5 dividend on stock with a $40 basis is 12.5% and extraordinary; the same $5 dividend on that stock, now worth $200, is 2.5% and clears both thresholds. The election works for the standard test and for the 365-day aggregation test.¹

How the Basis Reduction Works

Once a dividend is extraordinary, the corporate shareholder reduces its basis by the “nontaxed portion.” That is the piece sheltered by the dividends received deduction: the dividend minus the taxable amount left after the DRD is applied.¹

The size of that nontaxed portion tracks ownership under Section 243:

Less than 20% ownership: 50% DRD, so 50% of the dividend is the nontaxed portion.
20% to less than 80%: 65% DRD, so 65% is nontaxed.
80% or more: DRD can reach 100%, and the entire dividend reduces basis dollar for dollar.²

For foreign-source dividends from a 10%-or-more-owned foreign corporation, Section 245A can provide a 100% deduction on the foreign-source portion, so the whole dividend can be nontaxed for basis-reduction purposes.³

Timing is specific. The reduction takes effect at the beginning of the ex-dividend date, not on the payment date and not when the return is filed.¹ A shareholder who sells on or after that date uses the reduced basis when calculating gain or loss on the sale.

When the Reduction Turns Into Current Gain

Basis cannot go below zero. Any nontaxed portion above the shareholder’s basis is treated as capital gain from the sale of the stock, recognized in the tax year the dividend is received, even though the shareholder still owns the stock.¹

Take Corporation A holding common stock in Corporation B at a $100,000 adjusted basis. Corporation B pays a $120,000 dividend that qualifies as extraordinary. If A owns less than 20% of B, the 50% DRD applies and the nontaxed portion is $60,000. Basis drops to $40,000. No current gain.

Change one fact. A owns 25% of B, so the 65% DRD applies and the nontaxed portion is $78,000. If A’s basis was $100,000, the basis simply falls to $22,000. If A’s basis was only $50,000 going in, the $78,000 nontaxed portion exceeds basis by $28,000. Basis goes to zero and A recognizes $28,000 of capital gain that year. The gain is reported on Form 8949 and flows to Schedule D on the corporate return.⁴

The Two-Year Holding Period Exception

The whole regime steps aside if the corporate shareholder held the stock for more than two years before the dividend announcement date. The announcement date is the earliest of when the distributing corporation declares, announces, or agrees to the amount or the payment.¹ The endpoint is the announcement date, not the ex-dividend date and not the payment date. A shareholder who is a day short of two years gets no relief.

Distributions That Are Extraordinary No Matter What

Some distributions are extraordinary automatically, without any threshold test and without any holding-period escape:

Non-pro-rata redemptions, to the extent treated as dividends.
Partial liquidations treated as dividends.
Redemptions that would not have been dividends but for the Section 318(a)(4) attribution rules or the related-corporation rules of Section 304(a).

For redemptions caught only by attribution or Section 304, the basis reduction applies only to the shares actually redeemed, not to all shares the shareholder owns. Exchanges treated as dividends under the reorganization rules of Section 356 are tested as redemptions for these purposes.⁵

Qualified Preferred Stock Has Its Own Rules

Dividends on “qualified preferred stock” bypass the 5% threshold test and follow a separate regime. Qualified preferred stock pays fixed dividends at least annually and was not in arrears when the shareholder bought it. If the actual rate of return exceeds 15%, the stock loses qualified status and the standard rules come back.

The holding period exception here runs five years, not two. Hold the stock more than five years and Section 1059 does not apply. Sell earlier and the basis reduction is capped at the excess of dividends actually received during the holding period over what would have been paid at the stock’s stated rate of return. The rate-of-return calculation uses the lesser of adjusted basis or liquidation preference as the denominator, counting only dividends received during the holding period.¹

What Individual Shareholders Should Know

The basis-reduction machinery targets corporate shareholders because only corporations claim the DRD. Individuals don’t have a nontaxed portion, so the core mechanism doesn’t reach them. The label still matters, though. Under Section 1(h)(11)(D)(ii), if an individual receives qualified dividend income that meets the Section 1059(c) definition of extraordinary, any loss on a later sale of that stock must be treated as long-term capital loss to the extent of those extraordinary dividends.⁶

That reclassification hurts. Long-term losses only offset long-term gains and up to $3,000 of ordinary income per year. An individual who planned to take a short-term loss against ordinary income at higher rates ends up with a less flexible long-term loss instead. Same anti-abuse purpose as the corporate rule, different mechanics.

How Short Sales Interact

Extraordinary dividends also change the rules for short sellers. Sell stock short and, if the lender receives a dividend, you owe a payment in lieu of that dividend. Ordinarily the payment is deductible if the short sale stays open at least 46 days. When the dividend is extraordinary, the required holding period jumps to more than one year. Close the short earlier and the payment is not deductible at all; instead, it is added to the basis of the stock used to close the position. The usual relief allowing deduction to the extent of income from lending collateral does not apply to extraordinary dividends.⁷

The extraordinary-dividend test for short sales uses a different denominator: the amount realized on the short sale rather than the shareholder’s adjusted basis. A dividend on preferred stock is extraordinary for short-sale purposes at 5% of the short-sale proceeds, 10% for other stock.

1
Office of the Law Revision Counsel. 26 U.S. Code 1059 – Corporate Shareholder’s Basis in Stock Reduced by Nontaxed Portion of Extraordinary Dividends
2
Office of the Law Revision Counsel. 26 U.S. Code 243 – Dividends Received by Corporations
3
Office of the Law Revision Counsel. 26 U.S. Code 245A – Deduction for Foreign Source Portion of Dividends Received by Domestic Corporations
4
Internal Revenue Service. Instructions for Form 8949
5
Office of the Law Revision Counsel. 26 USC 1059 – Corporate Shareholder’s Basis in Stock Reduced by Nontaxed Portion of Extraordinary Dividends
6
Office of the Law Revision Counsel. 26 U.S. Code 1 – Tax Imposed
7
Internal Revenue Service. Publication 550 (2025) – Investment Income and Expenses