Effects of dividends and spin-offs on stock.

Example: J's grandfather died in January 1993, leaving each of his grandchildren 100 shares of Sears stock he had acquired two years earlier. J is considering selling this stock to pay for his daughter's first year of college.

J prepares the following list of the stock's relevant information and any transactions relating to his shares.

1. J's grandfather purchased 100 shares of Sears for $30 per share in 1991.

2. J's grandfather died in January 1993; for estate tax purposes, the Sears' stock was valued at $40 per share.

3. Sears spun off Dean Witter to shareholders of record on June 28, 1993; each shareholder received 0.39031 shares of Dean Witter common stock for each share of Sears owned.

4. Sears announced a stock dividend of Allstate Stock to Sears shareholders of record on June 30, 1995; each shareholder received 0.927035 shares of Allstate for each share of Sears owned.

5. Dean Witter announced a 100% stock dividend on Jan. 17, 1997.

6. In June 1997, Dean Witter and Morgan Stanley announced a name change to Morgan Stanley Dean Witter, Discover & Co.

7. J's brokerage statement now includes 78 shares of Morgan Stanley, 100 shares of Sears and 92 shares of Allstate.

The basis of property received from a decedent is normally the fair market value (FMV) at the date of the decedent's death (Sec. 1014(a)). Because J's bequest had appreciated in value from $3,000 at the time of purchase by his grandfather to $4,000 at the time of his grandfather's death, it followed the normal rule; thus, J's basis in the 100 shares of Sears is $4,000. The holding period of property received from a decedent is always long-term, and the actual holding period of either the decedent or the heirs is disregarded (Sec. 1223(11)).

The IRS ruled that Sears' distribution of Dean Witter stock in 1993 qualified as tax-free under Sec. 355, with the Sears shareholders not recognizing gain. However, J's brokerage statement indicated that he had received $1.10 for a partial share. While the cash received by a Sears shareholder in lieu of any fractional share distribution was to be treated as the sale of such fractional share, J had not bothered with this immaterial capital gain or loss on his 1993 return. However, to properly determine gains or losses, it was mandatory to determine the basis for the Dean Witter shares and the fractional shares. J's original Sears stock basis of $4,000 had to be allocated between the Sears stock and the Dean Witter stock based on relative FMVs on the date of the Dean Witter distribution:

Sears shares           100
Den Witter shares
(100 x 0.39031)     39.031

Sears FMV
  at date of distribution
  ($40.375 x 100) =         $4,037.50    73.56%
Dean Witter FMV
  at date of distribution
    ($37.1875 x 39.031) =   $1,451.47    26.44%

Total                       $5,488.97   100.00%

                     Basis        Sears'
                     allocation   original   Revised     Per-share
Shares               percent      basis      tax basis   tax basis

100 Sears            73.56%       $4,000     $2,942      $29.42
39.031 Dean Witter   26.44%       $4,000     $1,058      $27.11

After adjusting the basis of the Sears shares to reflect the Dean Witter spin-off distribution, J was then required to make a similar calculation to allocate the revised basis of the Sears shares to reflect the Allstate spin-off in 1995. The allocation was based on the FMVs of the Allstate and Sears common shares on the distribution date. The FMV of a Sears share on the distribution date was $32.0625 and the FMV of an Allstate share on that date was $29.6875; this resulted in a basis allocation for Sears of 53.81% and a basis allocation for Allstate of 46.19%:

                   Basis        Sears'
                   allocation   revised   New         Per-share
Shares             percent      basis     tax basis   tax basis

100 Sears          53.81%       $2,942    $1,583      $15.83
92.7035 Allstate   46.19%       $2,942    $1,359      $14.66

J had received $20.78 for a partial share in 1995 but, again, had not calculated the immaterial capital gain of $10 ($20.78 - (0.7035 shares X $14.66)).

The final basis calculation necessary was related to the Dean Witter 100% stock dividend on Jan. 17, 1997. Because the Service had ruled that the stock dividend was nontaxable, the basis of the Dean Witter stock had to be allocated by dividing the basis of the old shares by the total number of shares held after the distribution (Sec. 307(a)). This reduced the basis of a Dean Witter share by 50%, from $27.11 to $13.56. The holding period of the new shares included that of the old, which rendered all shares long-term (since they were initially bequeathed toe) (Sec. 1223(5)).

Finally, the subsequent name change and merger with Morgan Stanley did not affect the basis of the shares; J still owned 78 shares in the new company. J's 100 shares of Sears stock (worth $40 per share at his grandfather's death) now yielded the following results:

                                                          Morgan
                                      Sears    Allstate   Stanley

Per-share tax basis                   $15.83    $14.66     $13.56
Market price on 8/1/97                 62.25    79.375     48.625
Potential gain per share              $46.42   $64.715    $35.065
  Number of shares                       100        92         78
  Total gain                          $4,642    $5,954     $2,735
Less 20% capital gains tax               928     1,191        547
Cash received
  (sale price -- capital gains tax)   $3,714    $4,763     $2,188

From Russell H. Hereth, CPA, Associate professor of accountancy, and John C. Talbott, CMA, professor of accountancy, Wright State University, Dayton, Ohio (not affiliated with AFAI)