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    Tracking Basis in Mergers, Splits and Other Corporate Actions

    by Stevie D. Conlon

    For many individual shareholders, tax issues are an annual consideration during the preparation of their tax return. Often, it’s a rush to calculate cost basis in order to report capital gains and losses. Unfortunately, a last-minute, once-a-year approach results in lost tax planning opportunities.

    Many times, individuals hold back making decisions simply because the tax rules affecting basis are so complicated—particularly those that apply to many mergers and other corporate actions, such as stock splits and stock dividends.

    However, tracking basis is necessary to compute recognized gains and losses, and to assess tax strategies that must be implemented before the end of the current year in order to reduce an investor’s tax liabilities.

    This article summarizes some of the rules for calculating cost basis, and it provides some related tax tips. Keep in mind, however, that since it is a summary, some rules have been intentionally omitted, and this article is not a substitute for seeking professional tax advice. This article also does not address tax issues relating to investments in securities other than stock or special rules applicable to certain types of corporations (such as real estate investment trusts, S corporations, etc.).

    Lower Taxes by Keeping Track

    When a holder sells his or her stock, gain or loss is generally recognized for tax purposes. Such gain or loss is typically a capital gain or loss, but in some cases the gain is treated as ordinary income (for example, if the market discount rules apply). The amount of gain or loss is computed by comparing the amount realized from the sale (generally, cash received) with the holder’s basis in the stock surrendered. The higher a holder’s basis, the smaller the amount of gain (or the larger the loss) recognized.

    What Is Basis?
    A stockholder’s basis equals the cost paid for the stock, subject to certain required adjustments. When a holder purchases the same stock on different dates and typically at different prices, the shares or instruments purchased on particular dates are referred to as separate “lots.” U.S. tax law requires that taxpayers must separately account for each lot purchased. So, holders must keep track of each lot they buy. The tax law further provides that, for purposes of computing gain or loss, if a holder does not specifically identify which lot of stock is sold, the applicable lot is determined under a “first-in, first-out” or “FIFO” method. This method is generally disadvantageous for stockholders who are selling some shares but not their entire holding, because presumably the earliest lot of stock has the lowest basis and therefore will result in the greatest taxable gain (or smallest loss). Holders can avoid this treatment by specifying the lot sold.

    Adjusting Basis
    A holder’s basis in stock for purposes of computing gain or loss on disposition is not necessarily “cost.” Basis may change from the initial amount of cash paid by the holder because the tax law requires that basis must take into account certain specified adjustments. And, in some cases, a holder receives stock, or stock rights as a distribution or as part of an exchange and doesn’t pay any cash.

    There are a number of routine corporate actions that require basis adjustments. For example, a tax-free stock split or stock dividend generally requires that the basis of old shares held must be allocated between the old shares and the new shares received as part of the split or as part of the dividend. Typically, a simple fraction or percentage is used for the allocation.

    However, it becomes more complicated if there have been a series of tax-free stock splits and stock dividends. And, the allocations must be made on a lot-by-lot basis, so accurate record keeping is critical.

    The good news is that careful tracking of tax basis is generally advantageous because when the holder only sells some of their shares, they can identify the shares with the highest basis as having been sold, thereby minimizing gain recognized (or maximizing their loss).

    To illustrate the tax savings that can be obtained through the proper allocation of basis, consider Abbott Laboratories. On April 30, 2004, Abbott distributed 0.1 share of Hospira for each share of Abbott. Assume that an investor paid $40 for 10 shares of Abbott and after receiving one share of Hospira, the investor sold Hospira for $5.

    If Hospira’s basis was not properly tracked, it may appear to yield a gain of $5. However, for tax purposes the gain is $2.60. The reason is that approximately 6% of Abbott’s $40 cost basis is allocated to Hospira. Table 1 shows the information needed to properly allocate basis, which is based on information provided from a basis tracking tool for the professional market [CCH Capital Changes Reporter]. However, you can perform calculations on your own based on stock prices on the date of the distribution and using the equation shown in Table 1.

    TABLE 1. Allocating Basis: Abbott Stock Dividend
    CCH basis allocation (date of distribution): 1 share Abbott common: 93.54766%; Hospira common 6.45234%. Based on average high/low trading prices NYSE Composite 4/30/2004, date of distribution: Abbott common ($44.63/$44.02) $44.325 and Hospira common ($29.00/$28.20) $28.60

    Source: CCH Capital Changes.

    Calculating Hospira’s basis allocation: 28.60 (0.1) ÷ 44.325 = 6.45234%

    Distributions Taxable as Dividends
    Not all stock dividends and stock splits are tax-free. If such a transaction doesn’t qualify as tax-free, it is instead treated as a “distribution” and is taxable as an ordinary dividend to the extent of the issuer’s current and accumulated earnings and profits.

    If a taxable distribution exceeds an issuer’s current and accumulated earnings and profits, the excess is treated as a non-taxable return of capital—but only to the extent of the holder’s basis in the particular stock. And, such a distribution reduces a holder’s basis in his or her stock for purposes of applying this rule in the future—which can be an issue for some companies that annually pay out a return of capital distribution and which is necessary for purposes of computing gain or loss when the stock is sold.

    Once the distribution exceeds the holder’s basis, any excess amount is treated as capital gain—and is long term or short term, depending on how long the holder has held the stock.

    When shares are received in a taxable transaction—such as a taxable stock dividend or stock split, a taxable merger, or when a company distributes shares of another company’s stock in a transaction that does not qualify as a tax-free spin-off or split-off—the basis of the shares received equals their fair market value as of the date of distribution. The holding period of the new shares begins the day after the date of distribution. Note that the date of distribution is used, not the ex-distribution date.

    The American Jobs Creation Act enacted in 2004 permits the Internal Revenue Service (IRS) to require Forms 1099 to be filed regarding taxable mergers, effective as of October 23, 2004. This new requirement could place added pressure on the proper shareholder reporting of taxable mergers.

    Determining Basis

    Tax-Free Dividends and Stock Splits
    When shares are received in a tax-free stock dividend or stock split, a holder’s basis in his or her old shares must be allocated between the new shares received and the old shares.

    This allocation must be done on the date of distribution (not the ex-distribution date) based on the relative fair market values of the old shares and the new shares (fair market value on distribution date method). Based on the valuations as of the date of distribution, you can determine the percentage of old basis allocable to the new shares received.

    For example, assume that Jane owns 100 common shares of Washington First Financial Corp. purchased at $2.50 peshare ($250 total). On May 17, 2005, a 20% common stock dividend is paid.

    This allocation is simple because the dividend is paid in the same type and class of stock. Thus, the per share fair market value of the old shares and new shares is the same. The relative value of the old shares is 100/120 or 83.3333%. The relative value of the new shares is 20/120 or 16.6667%. Therefore, $208.33 (83.3333%) of Jane’s $250 basis in the old shares remains with the old shares and $41.67 of basis (16.6667%) is allocated to the new shares.

    Adjustments in Tax-Free Reorganizations When Cash or Other Property Is Also Received
    When a shareholder receives stock and cash or other property for their existing stock in a tax-free reorganization, a special rule applies—known as the “boot rule.” Loss cannot be recognized and gain is recognized in an amount equal to the lesser of:

    1. The amount of cash and fair market value of other property (other than stock) received, or
    2. The amount of gain “realized” on the exchange. The amount of gain realized is determined by subtracting the holder’s basis in shares exchanged from the fair market value of stock received and other property received plus the amount of cash received.
    This special rule is applied on a lot basis for each separate lot of stock the shareholder is exchanging. Typically, the amount of cash received is less than the amount of gain realized on the exchange and, accordingly, the shareholder will typically recognize gain in an amount equal to the full amount of cash or other property received, with no offset or adjustment for the holder’s basis in their exchanged shares. The holder’s basis in the shares received is equal to the basis in the shares exchanged, plus the amount of gain recognized as described above and the amount treated as a dividend (described below), less the amount of cash or fair market value of other property received. Also, the holding period of the exchanged shares carries over. For example, assume that Joe purchased Redwood Empire Bancorp stock on the following dates:
    • 100 shares on 12/10/04 for $26
    • 200 shares on 2/11/05 for $31
    • 100 shares on 12/10/03 for $14
    Then, on 3/1/05, Redwood Empire Bancorp merged with Westamerica Bancorporation. Under the terms of the merger, each share of Redwood is entitled to receive 0.3263 of a share of Westamerica and $11.37 cash. Each share of Westamerica is worth $52.515. The merger is classified as a non-taxable merger.

    The tax implication is illustrated in Table 2.

    TABLE 2. Adjustments in Tax-Free Reorganizations When Cash or Other Property Is Received: Redwood Empire Bancorp
    First Lot
    Fair Mkt Val of property received $ 2,850.56 [(100 × 0.3263 × $52.515) + (100 × $11.37)]
    Tax basis in property surrendered $ 2,600.00 [100 × $26]
    Gain realized $ 250.56 [$2,850.56 – $2,600.00]
    Gain recognized $ 250.56  
     
    Basis in Westamerica $ 1,713.56 [$2,600 + $250.56 – (100 × $11.37)]
     
    Second Lot
    Fair Mkt Val of property received $ 5,701.13 [(200 × 0.3263 x $52.515) + (200 × $11.37)]
    Tax basis in property surrendered $ 6,200.00 [200 × $31]
    Loss realized $ 498.87 [$5,701.13 – $6,200.00]
    Loss recognized $ 0  
     
    Basis in Westamerica $ 3,926.00 [$6,200.00 – (200 × $11.37)]
     
    Third Lot
    Fair Mkt Val of property received $ 2,850.56 [(100 × 0.3263 x $52.515) + (100 × $11.37)]
    Tax basis in property surrendered $ 1,400.00 [100 × $14]
    Gain realized $ 1,450.56 [$2,850.56 – $1,400.00]
    Gain recognized $ 1,137.00 (lesser of gain realized or cash received)  
     
    Basis in Westamerica $ 1,400.00 [($1,400.00 + $1,137 – (100 × $11.37)]

    Stock Spin-Offs and Split-Offs
    Spin-offs and split-offs involve the distribution of shares of stock in another company to the shareholders of the distributee company. As indicated earlier, these transactions can either be taxable or tax-free.

    If the transaction is tax-free, a shareholder must allocate a portion of basis in their old shares to the new shares received. The allocation is based on the relative fair market values of the stock retained and the new stock received as of the date of distribution.

    For example, Michael owns 100 common shares of GP Strategies Corp. purchased at $6 per share ($600 total). On November 26, 2004, GP distributes to stockholders, in a tax-free spin-off, one common share of National Patent Development Corp. for each GP common share held. On the date of distribution, the average high/low per share price of GP common stock is $7.115, and the average high/low per share price of National Patent is $1.715. The relative value of the old shares is $7.115 ÷ [$7.115 + $1.715] or 80.5776%. The relative value of the new share is $1.715 ÷ [$7.115 + $1.715] or 19.4224%. Therefore, $483.47 (80.5776%) of Michael’s $600 basis in the old shares remains with the old shares and $116.53 of basis (19.4224% of $600) is allocated to the new shares.

    Determining the appropriate date of valuation for allocation purposes and computing the percentage is important and required by the tax law. In addition, if cash or other property is received by a shareholder in connection with the transaction, the special “boot rule” and related basis adjustments discussed above generally apply.

    Making Sense of It All

    In computing gain or loss from sales of stock or other corporate actions that occur during the year—such as stock dividends, splits, mergers, spin-offs and split-offs—shareholders need to track their tax basis in the stock holdings.

    As we have shown, the tax law generally requires you to accurately track the basis of the separate lots of stock you hold for purposes of correctly computing gain or loss. And, if you properly instruct your brokers and account managers, you can designate which particular lots of shares are sold, which can minimize gain or maximize loss recognition to your advantage.

    A recent complex merger involving the merger of Banknorth with Toronto-Dominion Bank illustrates the importance of keeping track of the basis of your holdings, and how complicated it can become.

    On March 1, 2005, Banknorth Group, Inc. merged into Toronto-Dominion Bank, a Canadian company. The transaction involved two steps:

    • The first was a tax-free merger where holders of Banknorth Group, Inc. shares exchanged their shares for shares of Banknorth Delaware, Inc. common (1 for 1).

    • The second step involved the exchange of 51% of the holders’ new Banknorth Delaware shares for Toronto-Dominion Bank common (0.2351 shares per share exchanged) and $12.24 cash (per share) in a taxable merger. Holders retain the 49% interest in Banknorth Delaware shares received in the first step.
    The company noted that the amount of gain or loss recognized by a shareholder in the taxable merger would depend on the tax basis of the shares in the specific lot (or lots) of Banknorth Delaware shares they tendered in the taxable merger (the second step).

    Here, accurate tax basis tracking pays off because the investor with adequate records that identifies his or her high basis shares as sold in the second-step taxable exchange minimizes gain recognized (or maximizes loss recognized!).

    Conclusion

    Waiting until shortly before April 15 to consider tax strategies for an investor’s stock portfolio is generally “too little, too late.”

    Tracking basis throughout the year to permit taking tax losses to offset gains, to make sure you qualify for long-term capital gain rates for stock holdings, and similar tax management can result in meaningful tax savings. But basis tracking can get complicated when it comes to certain corporate actions that may require basis adjustments. Understanding these corporate action issues and how they may affect your own holdings may help you plan your tax strategies more effectively this year and in years to come.


    Stevie D. Conlon, JD, CPA, is senior tax analyst for CCH Capital Changes, Riverwoods, Ill. Sanjeev Doss, LLM, JD, CPA, is tax director for GainsKeeper, Boston, Mass. CCH Capital Changes (www.cap.cch.com) provides basis tracking and tax planning information and GainsKeeper (www.gainskeeper.com) provides Internet-based tax-lot accounting services and portfolio management tools. Both are a part of Wolters Kluwer Corporate & Financial Services division.


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