Many corporations may provide corporate stock distributions or stock rights to employees. When a corporation distributes its stock, this would be referred to as a stock dividend, and when a corporation grants stock rights, these are typically referred to as stock options. When individuals receive stock dividends and stock options, they generally will ask or inquire as to whether or not these dividends or stock options are taxable. Generally, the answer is no; stock dividends and stock options are not taxable and thus not reported on an income tax return. However, the stock dividends or options can be taxable under certain circumstances. These circumstances are discussed in this article prepared by a Denver business attorney and tax attorney. Please always consult directly with your business and tax advisors regarding your specific circumstances.

Taxation of Corporate Stock Distributions

Section 305 provides rules governing the taxation of certain types of corporate distributions. Specifically, Section 305(a) states that distributions of stock are taxable to the distributee as ordinary income. However, there are several exceptions to this general rule. One exception occurs when the taxpayer distributes his or her stock to another person according to a written agreement that requires the recipient to pay the taxpayer a sum equal to the stock’s fair market value immediately before the issuance of the stock. In addition, Section 305(b) allows taxpayers to defer the recognition of gain realized upon the sale or exchange of stock held for more than six months. Finally, Section 305(d) permits taxpayers to deduct dividends paid on stock held for more than three years if those dividends represent compensation for services rendered within Section 162(a) of the Internal Revenue Code.

5 Taxable Stock Distributions Situations

A distribution of stock dividends and stock rights or stock options is taxable if any of the following apply:

1) The corporation distributes cash or other property to certain shareholders. It provides other shareholders with an increase in their interest percentage in the corporation’s assets, earnings, and profits.

2) The shareholder can convert the distribution into preferred shares.

3) Any shareholder can choose cash or other properties to be received as opposed to the stock or stock rights.

4) The distribution is a distribution of preferred stock. It should be noted, however, that such a distribution would not be taxable if it is solely an increase in a conversion ratio of convertible preferred stock, which has been made strictly due to a stock dividend, stock splitting, or similar action that would result in reducing the overall conversion rate.

5) The distribution allows for preferred stock to be issued to some common stock shareholders and common stock of the corporation to be issued to other shareholders.

Constructive Stock Distributions

When taxpayers receive a taxable stock dividend or stock rights, they would include the fair market value at the time of the distribution in their income. It is also essential for shareholders to be aware of constructive distributions. A shareholder may have to treat certain transactions that increase their proportionate share or interest in the corporation’s earnings and profits or assets as if a stock or stock options were distributed if the result is the same as items 1, 2, 4, or 5 above. This treatment would apply to a shareholder’s conversion ratio or redemption price change, a difference between the stock’s redemption price and issue price. This redemption is not treated as the sale or exchange of the applicable stock and other transactions whereby a similar effect is realized on the shareholder’s interest in the corporation. An example of a taxable distribution would be the receipt of preferred stock with a redemption price higher than the price the stock was issued for. This difference is considered the redemption premium, and generally, the redemption premium would be regarded as a constructive distribution and taxable.

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The above article has been prepared by John McGuire, a Denver business attorney and tax attorney at the McGuire Law Firm, for informational purposes. It should not be considered tax or legal advice. John is a tax attorney and business attorney in Denver, Colorado, and Golden, Colorado serving clients in Colorado and nationwide on specific tax matters.