Stock Splits - Part I

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Stock Splits, Part I
Stock Dividends

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By Roy Lewis

We receive questions all the time about stock splits (and other corporation capital transactions, such as spin-offs and split-ups). So, let's discuss these issues in a bit more detail, starting with stock splits.

Stock Dividends

In "tax speak," stock splits are really called stock dividends. As a general rule, when a corporation distributes its own stock or a right to acquire its stock to its shareholders, the shareholders are not required to include the fair market value of the stock or stock right in their gross income. The following five categories of stock dividends, however, do not fall within this general rule and are taxable to the shareholders:
  1. Distributions in which any shareholder has the option to receive cash or other property instead of stock or stock rights;

  2. Disproportionate distributions, (i.e., distributions in which some shareholders receive cash or other property and other shareholders receive stock or stock rights);

  3. Distributions of common stock to some common stock shareholders and preferred stock to other common-stock shareholders;

  4. Certain distributions on preferred stock; and

  5. Distributions of convertible preferred stock that result in a disproportionate distribution.
It is unlikely that you will run across these types of transactions in your investing life, but understand that they are out there... and remember that not all stock dividends are tax free. If you find yourself with a taxable stock dividend that falls into one of these special categories and need additional assistance with the tax issues surrounding the taxable distribution, please post your question in the Tax Strategies discussion folder, and I'll be happy to provide additional information.

All that being said, the vast majority of stock dividend transactions you encounter will be of the tax-free variety. So, let's take a closer look at how they work from a tax standpoint.

A distribution of stock that does not fall within any of the exceptions discussed above is not included in your gross income. In general, your adjusted basis in the stock is determined by spreading the old cost basis amount evenly over both the old and new shares. The holding period of the "new" stock received in a nontaxable distribution includes the period during which the old stock was held.

EXAMPLE: You bought 100 shares of XYZ Corp. for $30 per share. So, your cost basis is $30 x 100 shares or $3000, plus any broker commission paid to buy the shares.

Sometime after your purchase, the Board of Directors of XYZ Corp. voted to issue a stock dividend to the shareholders. The board authorized a stock dividend in the amount of one "new" share for each "old" share held. In your case, you will receive 100 "new" shares. This type of transaction is commonly know as a "2-for-1" stock split, and you now have 200 shares of XYZ Corp.

You decide that you now want to sell 50 shares of this stock for $25 per share. But, you scratch your head and wonder. Which shares are you selling the "old" shares or the "new" shares? And, what is your cost basis in those shares for tax purposes? Would it be zero, since you paid nothing for your "new" stock? How would you figure the gain?

While this seems like a complicated transaction, it is really very easy. As the above paragraph tells you, "your adjusted cost basis in the stock is determined by spreading the old cost basis amount evenly over both the old and new shares."

Using the facts presented, we computed your total basis in the "old" shares as $3,000 (100 shares at $30 per share). Let's also say that you paid a $20 broker commission. This would make your tax basis in the old shares $3,020. Now that you have 200 shares, you are required to spread the cost basis over all of your shares. This means that your new "per-share" cost basis would be $3,020 divided by 200 shares (because you now have 200 shares total), or $15.10 per share... for each and every share that you own. See how easy this is?

Please Note: Spreading the basis over all of the shares is neither an election nor an option. It is something that must be done, according to Uncle Sammy. You may not simply elect to treat the "new" shares as having a zero-dollar cost basis and the "old" shares as having all of the cost basis. It just doesn't work like that.

Remember also that your holding period for the "new" shares includes the period for which the "old" shares were held. This simply means that your holding period for all of your shares would begin on the date you first purchased the original 100 shares. While you may have held the "new" shares for only a few days or weeks, they will be considered "long-term" as long as the original shares were considered "long-term" when the sale is made. With this knowledge, let's complete the example.

Using the same facts as above, let's say you sold 50 of your shares at a price of $25 per share two years after your original purchase of the first 100 shares. As noted above, your "per-share" cost basis in these 50 shares would be $15.10. So, your total basis for 50 shares would be 50 shares times $15.10, or $755.

You sell these shares for $25 per share, and pay a $20 sales commission, for a net sales price of $1,230. Simple subtraction ($1,230 - $755) tells you that your gain on the sale of these 50 shares is $475.

And, your holding period for these shares is the two-year period starting with your first 100-share purchase, which means that you receive long-term capital gains tax treatment for these shares, and the preferred tax rate that goes along with it.

Pretty easy, eh? But, what if you had "odd lot" shares and your "split" didn't turn out even and you were forced to sell fractional shares? How does that all work? The theory is the same, but the math is a bit more complicated. We review that in more detail in Part II.
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