Most taxpayers deal with Schedule D when they sell some of their investment holdings. Yet in some situations, you might end up dealing with Schedule D even when you didn't make any investment sales at all. One example involves receiving cash in lieu of fractional shares as part of a merger or spinoff, and reporting that cash correctly can be harder than you might think.
A common situation for cash in lieu
Cash in lieu of fractional shares comes up most frequently when you own stock in a company that goes through a major transformative event. In merger situations, shareholders in the target company often receive shares of the acquiring company in exchange for their existing holdings, and it's rare for the ratio of new shares received to be a round number. Similarly, if a company spins off part of its business as a separately traded stock, shareholders might receive a certain number of shares of the spun-off entity for every share of the existing company they own.
Most companies and brokers don't like handling fractional shares, so if the math works out unevenly, they'll typically just take whatever fraction of a share you would have received under the formula, and essentially sell it automatically, paying you the resulting cash. This cash gets reported on a 1099 form as cash in lieu of fractional shares, and like any sale, you have to account for it on Schedule D.
The hassle of cash in lieu
Unfortunately, many brokers don't do a good job of giving you information about cash in lieu transactions. Technically, you'll have cost basis in whatever fractional shares produced the cash in lieu, and so you won't owe taxes on the full amount of the cash you received. You'll report both the cash and the basis on Schedule D, noting the sale of whatever fractional share resulted from the transaction.
The problem is that the necessary basis information usually isn't available until after the transaction goes through. Therefore, you'll often have to look it up yourself, and correct mistaken information on a 1099.
Also, keep in mind that if you allocate cost basis to the fractional shares, you'll have to reduce your remaining cost basis in the shares you continue to own. Typically, the dollar figures are fairly small, but any disparity in what you report versus what your broker reports could trigger warning flags that the IRS can pick up.
Cash in lieu of fractional shares is generally a nuisance, with the small amounts involved causing more trouble than they're arguably worth. Nevertheless, treating cash in lieu correctly on Schedule D can prevent a much bigger IRS problem down the road.
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