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Tuesday, 04/15/2003

The DRIP Investor and the Spin-off
by Steve Gail

Now and then, a funny thing tends to happen to DRIP investors. They run into a small event called a Spin-off. Yes, a spin-off occurs where you receive a specific number of shares of one of the companies that your original DRIP company owns and has decided to spin it off and let it publicly trade on its own. As a hypothetical example, lets take a fictitious company, which we will call GHI Corporation. And again, for the sake of example we will assume that you own 500 shares of GHI. Now GHI has just made an announcement that for every shareholder who owns 100 shares of GHI on or before record date (remember that term from a prior article), will be entitled to 10 shares of the spin-off company called JKL. So in essence, you receive for your 500 shares 50 shares of JKL. Now let's say that this spin-off tradess for an initial value of $20 a share on the open market and will then fluctuate based on market conditions of supply and demand. The issue that you as a DRIP investor has to take into consideration, is the ramifications of the spin off, for tax consequences. Unlike, your dividends, which are treated and taxed as ordinary income, your stock spin-off has to be considered in a completely different light and here are the reasons why.

First, a holding period must be determined for the new spin-off of stock. Secondly, a cost basis has to be determined if and when the stock is eventually sold. Unlike you dividends, which are taxed in the year you received them, stock spin-offs are treated differently. First of all, their holding period is determined by the date you owned the original shares you purchased your DRIP security (in this case the GHI Corporation). once again, for the sake of example let's say we purchased our shares on November 15, 2002 (last year), then your holding period starts on November 15, 2002 of last year. Now let us say you sold your spin-off on April 14, 2003. you would have a holding period from November 15, 2002 until April 14, 2003. In this case you would have a short term holding period and your spin-off stock JKL corporation would have a short term gain of whatever you sold the stock for. What ever I sold the stock for? How come. Well the reason is simple, when you were given the stock as a spin-off, the spin-off of JKL Corporation had a ZERO cost basis, which simply means you treat its purchase price as zero and when you sell it ALL the proceeds become taxable no matter what the net price of the stock is at its sale. The only exception is if the stock goes bankrupt, then you would have a zero gain from a zero basis. The other situation, that could occur, is that your original DRIP purchase of your GHI Corporation, had been purchased over a year and a day before. (for example instead of buying your GHI DRIP stock on November 15, 2002, you made the purchase before April 13, 2002.) Then your spin-off, after it was sold on April 14, 2003, would be a long term capital gain, with a cost basis of zero, instead of a short-term capital gain with a cost basis of zero. Seems simple enough. Unfortunately, there are a few other factors that we have to consider if this spin-off happens and we ever decide to sell our shares of JKL Corporation. Can anyone guess? That's correct! we have to keep record of all the shares of GHI corporation that we purchased and designate to which date the spin-off shares came from. Once again, Murphy has appeared in the form of paperwork and record keeping. Unfortunately, there isn't much we can do as DRIP advisors to prevent these situations, however as long as you keep accurate records of your cost basis and purchase dates, the job will be a lot less TAXING! (Pardon the bad pun)

Until Next Time,


Copyright 2003

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