Tax Strategies
Tracking Basis in Mergers,
Splits and Other Corporate
Actions
By Stevie D. Conlon and Sanjeev Doss
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.).
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AAII Journal
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
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%
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 inves-
tor 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.
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 taxfree 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 exdistribution 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 per
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Tax Strategies
share ($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.
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
Tax basis in property surrendered
Gain realized
Gain recognized
$ 2,850.56 [(100 × 0.3263 × $52.515) + (100 × $11.37)]
$ 2,600.00 [100 × $26]
$ 250.56 [$2,850.56 – $2,600.00]
$ 250.56
Basis in Westamerica
$ 1,713.56 [$2,600 + $250.56 – (100 × $11.37)]
Second Lot
Fair Mkt Val of property received
Tax basis in property surrendered
Loss realized
Loss recognized
$ 5,701.13 [(200 × 0.3263 x $52.515) + (200 × $11.37)]
$ 6,200.00 [200 × $31]
$ 498.87
[$5,701.13 – $6,200.00]
$0
Basis in Westamerica
$ 3,926.00 [$6,200.00 – (200 × $11.37)]
Third Lot
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Fair Mkt Val of property received
Tax basis in property surrendered
Gain realized
Gain recognized
$ 2,850.56 [(100 × 0.3263 x $52.515) + (100 × $11.37)]
$ 1,400.00 [100 × $14]
$ 1,450.56 [$2,850.56 – $1,400.00]
$ 1,137.00 (lesser of gain realized or cash received)
Basis in Westamerica
$ 1,400.00 [($1,400.00 + $1,137 – (100 × $11.37)]
AAII Journal
The tax implication is illustrated
in Table 2.
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 TorontoDominion 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.
June 2005
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