Sec. 1059: Adjusting More Than Basis

By Matthew Cotter, Washington

Editor: Annette B. Smith, CPA

Corporations & Shareholders

Sec. 1059 requires a corporate shareholder to reduce the stock basis of its subsidiary when it receives an extraordinary dividend from the subsidiary within the first two years of owning the subsidiary's stock. The procedures for recalculating basis in that scenario are clear, but the effect of these basis adjustments on the corporate shareholder's earnings and profits (E&P) is not as clear.

Earnings and Profits

E&P essentially is a quantitative measure of a corporation's ability to make distributions to its shareholders in excess of distributions considered a return of capital. Although the Code refers to E&P numerous times, nowhere does it provide a comprehensive list of procedures necessary to calculate E&P. Certain Code sections that clearly have some effect on a corporation's E&P, including Sec. 1059, provide little or no guidance for calculating E&P. The lack of clear statutory guidance leads practitioners, as a pragmatic matter, to look elsewhere, including to the legislative history, IRS guidance, and case law, for an appropriate answer.

Economic Reality Problem With the Dividends-Received Deduction

Congress enacted Sec. 1059 in 1984 to prevent corporate shareholders from engaging in "dividend stripping" transactions. The following example illustrates Congress's concern when it passed the section.

Example: Prior to the enactment of Sec. 1059, corporation P purchased 50% of the common stock of corporation S for $500. S has undistributed E&P of $1,000. Shortly thereafter, S declares a dividend, with P receiving a $200 dividend distribution. P , upon receipt of the dividend, properly claims an 80% dividends-received deduction (DRD) under Sec. 243 equal to $160 (80% × $200) and includes the remaining $40 in taxable income. The distribution reduces the total fair value of S by the amount of the distribution, thus reducing the fair value of P' s stock in S .

Under the law in effect prior to the passage of Sec. 1059, P makes no adjustment to the basis in its S stock because the distribution is made out of S' s E&P. When P subsequently sells its devalued S stock for $300 ($500 – $200), P could claim a $200 artificial capital loss ($300 proceeds – $500 basis). Here, P' s $200 capital loss could not be used to offset the $40 of ordinary dividend income, but it could be used to offset P' s capital gain to the extent it had any. Sec. 1059 is designed to prevent corporate shareholders from creating such artificial capital losses to offset capital gains.

Sec. 1059

Sec. 1059 requires a corporation that receives an "extraordinary dividend" on shares of stock to reduce the basis in those shares of stock (but not below zero) by the nontaxed portion of the dividend. Sec. 1059(c) defines an extraordinary dividend as any dividend that exceeds 10% of a corporate shareholder's common stock basis (or 5% for preferred stock). An extraordinary dividend also includes non-pro-rata dividend-equivalent redemptions and dividends arising by operation of Sec. 304.

In the example, S' s $200 dividend distribution to P is considered an extraordinary dividend because it exceeds $50, which is 10% of P' s basis in its S stock ($500 × 10%). Accordingly, P must reduce its basis in the S stock by the nontaxed portion of the dividend, resulting in an adjusted basis of $340 ($500 basis – $160 nontaxed portion of the dividend). When P later sells its S stock, instead of recognizing a $200 loss, as in the pre-Sec. 1059 example, P recognizes a loss of only $40 ($300 – $340), achieving a much closer approximation of the "true" economics of the transactions.

How Is E&P Affected?

When a corporate shareholder receives a distribution out of E&P, the corporate shareholder generally increases its E&P by the full amount of the distribution without regard to Sec. 243 (see Friedel, Galanis, and Allen, BNA Tax Management U.S. Income Portfolio 762-3d: Earnings and Profits , for an in-depth discussion of the E&P rules). However, when a corporate shareholder receives a distribution that is treated as a return of capital-i.e., all or a portion of the distribution is applied directly to reduce the basis of the stock to which the distribution is made-Sec. 312(f)(2) precludes the corporate shareholder from increasing its E&P by the amount of the distribution attributable to a return of capital.

In the example, P receives a $200 distribution out of S' s E&P. Absent the application of Sec. 1059, P ordinarily would increase its E&P by the full amount of the distribution ($200). However, because the distribution is an extraordinary dividend, P is required to reduce its basis in S stock by $160, the nontaxed portion of the distribution. A question arises as to whether, because of the reduction in basis under Sec. 1059, P' s E&P should increase by only the $40 taxable portion of the dividend.

The IRS's view is that P' s E&P should increase by $40 and not by the full $200 dividend distribution (Field Service Advice 868 (10/16/92)). This view is premised on the analysis that a Sec. 1059 basis reduction essentially is economically the same as a return-of-capital distribution governed by Sec. 312(f)(2); therefore, the E&P consequences stemming from an extraordinary dividend should produce the same effect as a return-of-capital distribution under Sec. 312(f)(2).


A dividend distribution usually increases a corporate shareholder's E&P by the full amount of the dividend. However, if the dividend distribution is characterized as a Sec. 1059 extraordinary dividend, the corporate shareholder's E&P increases by only the taxable portion of the dividend. In light of these different rules, corporate recipients of extraordinary dividends that are contemplating a distribution out of E&P should review their E&P calculations to ensure that they have sufficient E&P to fund the distribution.


Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington.

For additional information about these items, contact Ms. Smith at 202-414-1048 or

Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.

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