What Is an Extraordinary Dividend and How Is It Taxed?

An extraordinary dividend is a corporate distribution large enough, relative to the recipient’s stock basis, to trigger Internal Revenue Code Section 1059. When a corporate shareholder receives one, it must reduce its basis in the stock by the portion of the dividend sheltered by the dividends received deduction. If that reduction would push basis below zero, the excess is taxed immediately as capital gain, even though the shareholder still owns the stock. The rule exists to shut down a specific strategy: a corporation buys stock, collects a large dividend that is mostly tax-free thanks to the DRD, and then sells the stock at an artificial loss. Section 1059 removes the basis that would have generated that loss.¹

When a Dividend Is Extraordinary

The test is a ratio: dividend amount divided by the shareholder’s adjusted basis in the stock. A dividend on common stock crosses the line at 10% of basis. For preferred stock, the threshold is 5%.¹

Smaller dividends can still be caught through aggregation. All dividends on the same stock with ex-dividend dates falling within any 85 consecutive days are combined and tested as a single dividend against the 10% or 5% threshold. A separate 365-day rule works differently: once total dividends on the stock during any 365 consecutive days exceed 20% of the shareholder’s adjusted basis, the entire amount is automatically classified as extraordinary. Both windows use the shareholder’s original adjusted basis as the denominator, ignoring any reductions Section 1059 itself has caused.¹

The Fair Market Value Election

Stock bought years ago at a low price can trip the percentage test on a dividend that is modest compared to current value. Section 1059(c)(4) lets the shareholder substitute the stock’s fair market value, as of the day before the ex-dividend date, for adjusted basis in running the threshold calculation. The taxpayer has to establish that FMV to the IRS’s satisfaction.¹

The math shifts quickly. A $5 dividend on stock with a $40 basis is 12.5% and triggers the rule. The same $5 dividend on stock now worth $200 is 2.5%, below either threshold. The election covers both the standard test and the 365-day aggregation test.

How Much Basis the Shareholder Loses

Once a dividend qualifies, the corporate shareholder must reduce basis by the dividend’s “nontaxed portion.” In practical terms, that is the amount sheltered by the dividends received deduction. The statute defines the nontaxed portion as the dividend amount minus the taxable portion, with the taxable portion being whatever remains in gross income after the DRD.¹

The applicable DRD rate depends on how much of the paying corporation the shareholder owns:

Less than 20% ownership: 50% DRD, so the nontaxed portion is 50% of the dividend.
At least 20% but less than 80%: 65% DRD, nontaxed portion of 65%.
80% or more: up to a 100% DRD, meaning the entire dividend can be nontaxed and reduce basis dollar-for-dollar.

These rates come from Section 243.² For dividends from a 10%-or-more-owned foreign corporation, Section 245A can allow a 100% deduction for the foreign-source portion, which can likewise make the whole dividend nontaxed.³

Timing is strict. The basis reduction takes effect at the beginning of the ex-dividend date, not when cash arrives and not when the return is filed. A shareholder who sells on or after the ex-dividend date computes gain or loss using the reduced basis.¹

When the Reduction Creates Immediate Gain

Basis cannot go below zero. When the nontaxed portion exceeds the shareholder’s adjusted basis, the excess is treated as capital gain from the sale or exchange of the stock, recognized in the tax year the extraordinary dividend is received. The shareholder owes tax that year even without selling.¹

An example makes this concrete. Corporation A owns common stock in Corporation B with a $100,000 adjusted basis. Corporation B pays a $120,000 extraordinary dividend. Corporation A owns less than 20%, so the 50% DRD applies. The nontaxed portion is $60,000. Basis drops from $100,000 to $40,000, and no gain is triggered.

Change the ownership to 25% and the DRD rises to 65%. The nontaxed portion becomes $78,000. Basis still absorbs it, falling to $22,000. But if Corporation A had started with only $50,000 of basis, that $78,000 would exceed basis by $28,000. Corporation A would recognize $28,000 of capital gain that year, and the stock basis would be zero going forward.

Any gain triggered this way is reported on Form 8949 and carries to Schedule D of the corporate return.⁴

The Two-Year Holding Period Exception

Section 1059 does not apply at all if the corporate shareholder held the stock for more than two years before the “dividend announcement date.” That date is the earliest of when the paying corporation declares, announces, or agrees to the amount or payment of the dividend.¹

A long-term holder is not running a dividend-stripping scheme, which is the point. The two years run from the acquisition date to the announcement date, not to the ex-dividend date or payment date. A shareholder one day short gets no relief.

Distributions That Are Always Extraordinary

Some distributions are automatically extraordinary regardless of amount and regardless of how long the stock has been held. The two-year exception offers no protection:

Non-pro-rata redemptions. When a corporation buys back stock in a way that shifts the remaining shareholders’ proportional interests, any part treated as a dividend is automatically extraordinary.
Partial liquidations. A distribution tied to partial winding-down that is treated as a dividend falls into the same category.
Certain constructive dividends. Redemptions that would not have been dividends but for the stock attribution rules under Section 318(a)(4), or the related-corporation rules under Section 304(a), are also covered.

When a redemption is caught only by the attribution or Section 304 rules, the basis reduction applies solely to the shares actually redeemed, not to all shares the shareholder owns.⁵

Qualified Preferred Stock

Dividends on “qualified preferred stock” follow their own rules rather than the standard 5% threshold. Qualified preferred stock pays fixed dividends at least annually and was not in arrears when acquired. If the actual rate of return exceeds 15%, the stock loses qualified status and the standard rules return.

For qualified preferred dividends, the holding-period exception stretches to five years. Hold the stock longer than that and Section 1059 does not apply. Sell earlier and the basis reduction is capped at the difference between dividends actually paid during the holding period and the dividends that would have been paid at the stock’s stated rate of return. The cap confines the reduction to the “excess” dividends above the stated yield.¹

What This Means for Individual Shareholders

The basis-reduction machinery of Section 1059 targets corporate shareholders because individuals do not claim a dividends received deduction. There is no nontaxed portion for an individual’s basis to absorb. The definition of “extraordinary dividend” still reaches individuals through a different route, though.

Under Section 1(h)(11)(D)(ii), if an individual receives qualified dividend income that meets the Section 1059(c) thresholds, any loss on a later sale of that stock is treated as a long-term capital loss to the extent of those extraordinary dividends. Long-term capital losses only offset long-term capital gains and up to $3,000 of ordinary income per year, so a loss the taxpayer expected to use against ordinary income at higher rates gets reclassified and loses value.⁶ The mechanism differs from the corporate rule, but the anti-abuse purpose is identical.

Effect on Short Sales

Extraordinary dividends change the arithmetic for short sellers too. When you sell short and the lender collects a dividend, you typically owe a payment in lieu of that dividend to the lender. For ordinary dividends, you can deduct the payment if the short sale stays open at least 46 days. For an extraordinary dividend, the required period jumps to more than one year.

Close the short sale inside that window and the payment in lieu is not deductible at all. It is added to the basis of the stock used to close the position. There is also no exception allowing deduction up to the amount of income earned from lending your collateral; extraordinary dividends are carved out of that relief entirely.⁷

The threshold test uses a different denominator in the short-sale context: the amount realized on the short sale rather than adjusted basis in the stock. A dividend on preferred stock is extraordinary for short-sale purposes at 5% of short-sale proceeds, and 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