Tax planning for stock rights and warrants.

Editor's note: This case study has been adapted from PPC's Guide to Tax Planning for High Income Individuals, 5th Edition, by Anthony J. DeChellis, Douglas L. Weinbrenner, Catherine A. Roeder and Patrick L. Young, published by Practitioners Publishing Company, Ft. Worth, TX, 2004 ([phone]; ppc.thomson.com).

A stock right or warrant is a right to acquire a stock at a set price within a specified period. Stock rights normally have short exercise periods; stock warrants may have periods that extend several years. A stock right is generally issued to existing shareholders and can either be exercised or traded on the open market. The exercise price is typically set at an amount less than the stock's current trading value, to induce shareholders to exercise rights and acquire more shares.

A stock warrant is generally available to the public on the open market, where it can be exercised or traded. These rights or warrants can be exercised by purchasing the stock, or the rights or warrants can be sold or allowed to expire. The sale of stock rights or warrants will generate capital gain or loss.

When stock rights or warrants are included as part of an investor's portfolio, the tax adviser should help the taxpayer determine whether return will be maximized by selling the rights or warrants, or by exercising them and subsequently selling the stock.

Planning for Nontaxable Stock Rights

A taxpayer is generally not taxed on the receipt of stock rights. This rule has certain exceptions, including situations in which the taxpayer has the option to receive cash or other property in lieu of such rights; see Sec. 305(a) and (b). If, on the date the stock rights are distributed, their fair market value (FMV) is 15% or more of the stock's FMV on the distribution date, the adjusted basis of the taxpayer's old stock must be allocated to the stock and stock rights. The allocation is made using a ratio of the FMV of each to their total FMV on the distribution date, according to Regs. Sec. 1.307-1(a).

If the stock rights' FMV is less than 15% of the stock's FMV, the basis of the rights is zero, under Regs. Sec. 1.307-2. However, a taxpayer can elect to allocate the basis of the stock between the stock and the rights in relation to their relative FMVs on the date the rights were distributed. The election is made by attaching a statement to the taxpayer's return for the tax year the rights were received.

Holding period: Nontaxable stock rights take the same holding period as the underlying stock (i.e., the related stock's holding period "tacks on" to the stock right, under Sec. 1223(5)). However, if the rights are exercised and additional stock is acquired, such shares' holding period begins on the date the rights are exercised and the new shares are acquired, according to Sec. 1223(6).

Making the Election

The election to allocate stock basis to the rights should be considered when the taxpayer plans to (1) sell only the rights, (2) exercise the rights and sell the acquired stock within one year or (3) exercise the rights and sell both the old and new shares within one year if the old shares will generate long-term capital gain, as this would maximize the long-term gain and reduce the short-term gain.

Example: Thomas Henderson purchased 200 shares of ABC Energy Corp. in 2005 for $50 a share. Later that year, he received 200 stock rights in a nontaxable transaction, enabling him to purchase an additional 200 shares. At the time he received the stock rights, the stock was trading for $75 a share; the rights were valued at $10 each (less than 15% of $75). Thomas plans to sell the stock rights in 2005, but hold the stock for the long-term.

Thomas can elect to allocate stock basis to the stock rights, because the rights' FMV was less than 15% of the stock value at the time of receipt. Making the election would benefit Thomas, because it reduces the short-term gain he will realize on the rights when they are sold in 2005 and, assuming the stock is sold in the future at a gain, increases the future long-term gain. (The sale of the stock rights would be a short-term transaction, because they have the same holding period as the stock, which was acquired in 2005.)

Under the election, Thomas allocates $1,176 of his stock basis to the stock rights, and reduces his current-year short-term gain from the sale of the rights by the same amount; see the exhibit below.

Exhibit: Allocation of basis to stock rights

Thomas' basis in ABC Energy Carp. slack
  (200 shares @ $50/share) = $10,000
At the date of the stock rights distribution:
Stock's FMV (200 shores @ $75/share)             15,000
Stock rights' FMV (200 rights @ $10/right)        2,000
Total                                           $17,000

Allocation of basis to stack rights: $10,000 x ($2,000/$17,000)
= $1,176

Planning for Taxable Stock Rights

The basis of taxable stock rights received by a taxpayer is their FMV at the time of distribution. The old stock's basis does not change. The holding period begins on the date of distribution.

If the taxpayer exercises the stock rights, the new stock's basis is its cost, plus the basis of the stock rights exercised. Under Sec. 1223(6), the new stock's holding period begins on the date the rights are exercised.

Planning for Stock Warrants

Taxpayers may purchase stock warrants outright on the market. It is generally advisable to purchase warrants that have a remaining life of at least three years, to allow time for appreciation in the underlying stock. On the purchase date, the warrant's price should be low in relation to the common stock's. Also, the common stock should have growth potential and be paying small dividends (if any), because dividends generally limit significant price appreciation.

The basis of a stock warrant is its original cost. On exercise, the new stock's basis is its cost, plus the warrant's basis. The new stock's holding period begins on the date the warrants are exercised; see Sec. 1223(6) and Rev. Rul. 72-71.

Finally, stock investors may want to consider using stock warrants in their portfolios. These warrants cost less than the outright purchase of the stock, which limits the investor's loss to the warrant's price if the stock declines in value. In addition, the warrant preserves the upside potential if the stock appreciates in value.

Albert B. Ellentuck, Esq.

Of Counsel

King & Nordlinger, L.L.P.

Arlington, VA