Return of capital tax: nondividend distributions and box 3

The three tiers of section 301

A distribution from a corporation to a shareholder is sorted by section 301 into three tiers, in order. The part that is a dividend, as section 316 defines one, is included in gross income [1]. The part that is not a dividend is applied against and reduces the adjusted basis of the stock [1]. The part that exceeds the adjusted basis is treated as gain from the sale or exchange of property [1].

A fund’s own prospectus applies the same rule to itself. One summary prospectus says distributions in excess of the fund’s current and accumulated earnings and profits are treated as a return of capital [8]. That reduces the shareholder’s cost basis, and once basis is reduced to zero, further distributions are treated as capital gain [8].

So a return of capital distribution from an ETF is the second tier. No income this year, and a lower basis in the shares. Nothing in the section says the money is tax-free. It says when the tax comes.

Why nobody knows the split during the year

Section 316 defines a dividend as a distribution out of the corporation’s earnings and profits. One of the two pools it names is the earnings and profits of the taxable year [2]. Those are computed as of the close of the taxable year, without regard to the amount of earnings and profits at the time the distribution was made [2]. Every distribution is deemed to come out of earnings and profits to the extent there are any [2].

That sentence is the mechanism behind every estimate a fund prints. Return of capital is what is left after the year’s earnings are computed at year end. So the split cannot be known in March, or July, or in the notice that came with the payment.

A fund that calls a payment mostly return of capital in July and reports it as mostly income in February did not change its mind. The computation happened at the only time the statute allows it to.

The Publication 550 example

Publication 550 works the cycle with numbers. Stock bought in 2012 for $100 receives a nondividend distribution of $80 in 2015 [3]. The holder does not include it in income and reduces the basis of the stock to $20 [3].

A nondividend distribution of $30 arrives in 2025. Its first $20 applies against basis, which takes it to zero, and the other $10 is reported as a long-term capital gain for 2025 [3]. Any nondividend distribution on that stock in later years is reported as a long-term capital gain [3].

Two things in the example matter for a fund that pays weekly. The basis reduction is cumulative across years, so a position that has received many small return-of-capital payments has a basis well below what it cost. And the gain past zero is a capital gain, reported whether or not the shares were sold.

Box 3, and the date the number is final

The Form 1099-DIV instructions tell the payer where each part goes. Total ordinary dividends go in box 1a, and qualified dividends in box 1b as part of that total [4]. Total capital gain distributions go in box 2a [4]. Nondividend distributions go in box 3, and the instruction says to enter them if determinable [4].

That qualifier is the payer’s side of section 316. The number goes in the box once the year’s computation exists. The general instructions for information returns set the date: a payee statement is due by January 31 for most returns, which includes Form 1099-DIV [5].

So the character of a calendar year’s distributions is on paper by the end of the following January, and not before. A holder who filed from the notices would have filed from estimates.

Form 8937 is the issuer’s final word on basis

When an action affects the basis of a security, the issuer reports it on Form 8937. A return of capital distribution is one. The form states, per distribution, how much of it was return of capital once the year closed.

One issuer’s form for the tax period ended December 31, 2025 reports 44.462767% of each distribution in that period as return of capital [6]. The notices during the year had estimated most of each payment as return of capital [6]. The BTCI page prints that receipt in full.

The form is where a broker’s basis adjustment comes from. It is also where a holder who tracks basis by hand reads the adjustment. It is published after the fact. It is not the notice, and it is not the fund page.

What happens at zero basis

Once the adjusted basis of the shares is zero, section 301 has one tier left. Every further nondividend distribution is treated as gain from the sale or exchange of property [1]. Publication 550 says whether that gain is long-term or short-term depends on how long the stock has been held [3]. The shares do not have to be sold for the gain to be reported.

A fund paying most of its distribution as return of capital moves a position toward zero basis at the rate of those payments. How fast is arithmetic on the payment, the return-of-capital share, and the basis. The ETF income calculator prints it for a range the reader sets.

The estimate on a notice is not an input that can be trusted. The MSTY, YBTC, and YBIT pages print what the estimates were worth.

Inside an IRA

None of the above reaches an IRA. Publication 590-B says distributions from a traditional IRA are taxed as ordinary income, apart from any nondeductible contributions [7]. The account, not the holder, is the shareholder. A return of capital distribution received by the account reduces nothing on the holder’s return.

A qualified Roth distribution is not taxed at all, subject to the 5-year period and the qualifying events Publication 590-B lists [7]. So the basis machinery of section 301 is a taxable-account question. Whether a fund like this sits in one account or another is the holder’s decision, and this page describes the mechanics only.