IRC 1248: CFC Gain Recharacterized as Dividends, Limits, Exceptions

When a U.S. shareholder sells stock in a controlled foreign corporation at a gain, Section 1248 of the Internal Revenue Code can convert part or all of that capital gain into ordinary dividend income. The amount recharacterized equals the foreign corporation’s post-1962 earnings and profits attributable to the shares you sold, capped at your actual gain. Anything above that ceiling stays capital gain. The rule keeps shareholders from cashing out accumulated foreign earnings at capital gains rates instead of the ordinary rates that would have applied to a dividend.

Who the Rule Reaches

Section 1248 applies to a U.S. person who sells or exchanges stock in a foreign corporation and recognizes gain, provided two ownership conditions are met during the five-year period ending on the sale date: the person held at least 10% of the total combined voting power at some point in that window, and the corporation was a controlled foreign corporation (CFC) during at least part of it.¹

A foreign corporation is a CFC when U.S. Shareholders together own more than 50% of either the voting power or the value of its stock. Meeting either test is enough.² Ownership is measured directly, indirectly through foreign entities, and constructively through certain family members.³

One wrinkle matters for people close to the line. The Tax Cuts and Jobs Act added a value-based 10% test for U.S. Shareholder status, so a person owning 10% or more by value but less than 10% by vote qualifies as a U.S. Shareholder for Subpart F and GILTI.⁴ Section 1248 itself was not updated the same way. Its trigger still keys off the 10% voting-power test within the five-year window. A shareholder who only crosses the 10% line by value is not pulled in by the statute’s own language.¹

The five-year look-back is an anti-avoidance measure. Dropping below the ownership threshold or arranging for the corporation to lose CFC status shortly before a sale doesn’t unwind the rule, because the statute reaches back through that window to test both conditions.

How the Recharacterization Is Calculated

The recharacterized amount is the lesser of your gain or the earnings and profits (E&P) attributable to the stock you sold.¹ Only post-1962 E&P counts, and only E&P from periods during which the corporation was a CFC and you held the shares.

A short example: gain of $1,000 with $600 of attributable E&P produces $600 of ordinary dividend income and $400 of capital gain. If the attributable E&P were instead $1,200, the entire $1,000 gain would be recharacterized as a dividend and nothing would remain as capital gain. The dividend treatment cannot exceed the actual gain.

The attributable amount depends on how many shares you sold, how long you held them, and which years the corporation qualified as a CFC. In tiered structures, E&P of lower-tier foreign subsidiaries can be included in the calculation for the shares actually sold.¹

Earnings That Do Not Count

Section 1248(d) excludes several categories of E&P from the recharacterization pool. The most important exclusion is earnings already taxed to you. E&P attributable to Subpart F amounts previously included in your gross income under Section 951 is excluded, to the extent those inclusions haven’t already been distributed tax-free under Section 959. E&P previously included under the passive foreign investment company rules of Section 1293 is also excluded, along with earnings from income effectively connected with a U.S. trade or business.¹

Basis Adjustments Reduce the Gain Itself

The E&P exclusion is only one side of the double-taxation protection. The other side runs through your stock basis. Section 961(a) increases your basis in CFC stock by the amount of Subpart F income you were required to include in gross income; GILTI inclusions under Section 951A produce a similar basis increase.⁵ A higher basis means a smaller gain, which in turn caps how much Section 1248 can recharacterize.

Basis then decreases when the corporation distributes those previously taxed earnings to you tax-free under Section 959. If you made a Section 962 election to be taxed as a corporation on your Subpart F inclusions, the basis increase is limited to the actual tax you paid on those inclusions, not the full inclusion amount.⁵

Corporate Sellers Face a Different Outcome

Corporate shareholders selling CFC stock run the same Section 1248 mechanic, but the after-tax result can look very different. A domestic C corporation that receives a foreign-source dividend from a specified 10-percent-owned foreign corporation can generally deduct 100% of that dividend under Section 245A, provided a one-year holding period is met.⁶

For an individual, converting capital gain to dividend income is costly because ordinary rates exceed long-term capital gains rates. For a corporate seller eligible for the Section 245A deduction, the same conversion can eliminate tax on the recharacterized portion entirely, while the capital gain portion would have been taxable. The interaction depends heavily on the specific facts and on anti-abuse rules in the Section 245A regulations.

Transactions That Don’t Trigger the Rule

Section 1248 only bites when gain is recognized. Tax-free stock transfers under Section 351, reorganizations under Section 368, and subsidiary liquidations under Section 332 don’t produce recognition at the time of the transaction. The E&P generally carries over to the recipient, so the exposure is deferred rather than erased; a later taxable sale will still be tested.

A look-through rule under Section 1248(e) closes one workaround. If you sell stock in a domestic corporation that was formed or used principally to hold foreign corporation stock, the sale is treated as though you sold the underlying foreign stock directly for Section 1248 purposes.¹ Inserting a U.S. holding company between yourself and the CFC does not defeat the rule.

And if the gain is already ordinary income or a dividend under another provision, Section 1248 has nothing to recharacterize.

You Have to Prove the Numbers

Section 1248(h) puts the burden of establishing the foreign corporation’s earnings and profits on the taxpayer. If you cannot document the E&P to the IRS’s satisfaction, all gain from the sale is treated as a dividend.¹ Not just the portion that would have been recharacterized on the merits. The entire gain. The same problem applies to foreign tax credits meant to offset the dividend: fail to substantiate the foreign taxes paid, and the credit is lost.

Reconstructing a foreign corporation’s E&P history after the sale, across multiple years and often multiple accounting standards, is expensive and sometimes impossible. Shareholders who kept incomplete records can end up with a much larger bill than the statute would have produced with clean documentation, because they cannot show which earnings were already taxed or which exclusions apply.

U.S. Shareholders of CFCs must also file Form 5471 each year to report ownership and the corporation’s financial data.⁷ When a Section 1248 transaction occurs, a statement showing the gain calculation, the attributable E&P, and the amount recharacterized as a dividend goes with the return. The information return obligation runs alongside the tax computation itself, and failure penalties are assessed separately from the tax at stake.

1
Office of the Law Revision Counsel. 26 U.S. Code 1248 – Gain From Certain Sales or Exchanges of Stock in Certain Foreign Corporations
2
Office of the Law Revision Counsel. 26 U.S. Code 957 – Controlled Foreign Corporations
3
Internal Revenue Service. IRC 958 Rules for Determining Stock Ownership
4
Office of the Law Revision Counsel. 26 USC 951 – Amounts Included in Gross Income of United States Shareholders
5
Office of the Law Revision Counsel. 26 USC 961 – Adjustments to Basis of Stock in Controlled Foreign Corporations and of Other Property
6
Internal Revenue Service. Section 245A Dividends Received Deduction Overview
7
Internal Revenue Service. About Form 5471