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Letters to the Editor

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To The Editors:

Thank you for your article in the June 2004 AAII Journal, “Investing in DRPs: A Guide to Dividend Reinvestment Plans.” However, I want to comment on a matter that recently came to my attention: determining the tax basis upon a partial sale of shares in a dividend reinvestment or direct purchase plan (DRP/DSP).

On page 27, there is a brief overview of the tax considerations which states “When shares are sold, the tax basis is the fair market value as of the date the shares were acquired, plus any brokerage commissions paid….” It is reasonable to assume that long-term investors may wish to sell less than their entire position to rebalance their portfolio, raise cash, or average out of a position that reached a sale trigger.

The ‘average-cost’ method, often used for mutual fund shares, is not permitted for a DRP/DSP sale. I mention this because these plans are especially suited for small, dollar-cost-averaging purchases, which combined with the reinvested dividends, quickly result in numerous purchases of what may be rather small share amounts. Regardless of method of purchase, the share amounts are recorded to several decimal places (not restricted to whole shares), so the pattern of the data looks much like a mutual fund and the amount of data can become unappealing to manage. For this reason, many mutual fund holders find it appealing to use the average-cost method and many of the funds now compute this information for shareholders.

Thus, DRP/DSP tax-basis determination is subject to the same rules as direct ownership of stock or stock held in street name (see IRS Publication 550). One must adopt the first-in/first-out method, which may be a disadvantage when the earliest shares have the lowest basis and their sale creates the maximum taxable gain. The alternative, ‘specific identification,’ lets the investor select which shares are being sold. But to qualify for that method, certain documentation requirements must be met.

If you have left the stock certificates with your broker or other agent, you will make an adequate identification if you:

  1. Tell your broker or other agent the particular stock to be sold or transferred at the time of the sale or transfer; and

     

  2. Receive a written confirmation of this from your broker or other agent within a reasonable time.Do you think any DRP/DSP plan administrators/agents are prepared to assist in this documentation of what otherwise are fungible shares of stock held within a plan?

Mellon Investor Services raised my interest in this topic when they sent me an invitation to transfer the certificate, held directly in my name, to be held in their name in electronic form (along with the DRP shares). They included considerable material on the advantages of holding shares in electronic form. Continuing to hold the certificate had the obvious advantage of segregating the tax basis for those shares from the shares subsequently purchased (at generally higher prices). Since the materials provided by Mellon made no mention of how they might assist a participant with tax documentation at time of sale, I sent them a letter. I thought it would help them respond if I gave them specific scenarios, rather than posing a general question. Their response showed they don’t even have the most basic grasp of the issue. While the letter invited me to call a general contact number if I have further questions, I have not done so. I believe that I should be able to get the most insightful answer by posing the question in writing, so they can think about the answer before responding, rather than catching their customer service staff off guard with a complex inquiry.

I participate in several DRP plans and none of their Web sites, while extensively available for managing plan transactions, provide for the rather routine documentation required by the IRS. I have several brokerage accounts and they also do not provide this feature on their transaction Web sites, so, presumably, one has to enter a broker-assisted trade (generally at a higher commission) in order to arrange for the documentation.

I thought other members would be interested in this topic, and I also wanted to confirm the IRS documentation requirements applicable to a DRP/DSP sale.

Larry Roles
San Francisco, California

Editor’s Note: The documentation requirements outlined are correct.


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