This article will discuss the tax implications for wash sales stock rights, gifts, small business stock, non-business bad debts, and inheritances. This is a the second article in a series of three focusing on gains and losses. (Read Part I here)
A wash sale occurs when the same securities are purchased 30 days before or after the sale. If a loss results, all or part of the loss is disallowed. If an equal or greater number of the same securities that were sold are purchased, the entire loss is disallowed. If fewer shares are purchased than were sold, part of the loss is disallowed. The disallowed loss is added to the basis of the securities purchased. The holding period for the repurchased securities begins on the date they were purchased.
Example 1 – Total Loss Disallowed
On February 15, 2016, Joe sold 200 shares of Microsoft for $7,000 that he purchased on July 15, 2010 for $8,500. On March 10, 2016, he re-purchased 300 shares for $13,500. Joe’s has a $1,500 long-term loss ($8,500 – $7,000) on the sale. But, since he purchased more shares than he sold within 30 days of the sale, the $1,500 loss is disallowed. The basis of the new shares will be $15,000. ($13,500 + $1,500). The basis per share will be $50 ($15,000/300) and his holding period begins on March 10, 2016.
Example 2 – Partial Loss Disallowed
On February 15, 2016, Joe sold 200 shares of Microsoft for $7,000 that he purchased on July 15, 2010 for $8,500. On March 10, 2016, he purchased 150 shares for $7,500. The loss disallowed is the ratio of new shares purchased to the number sold multiplied times the loss. In this case, the loss disallowed is $1125 (150/200 x $1,500). The basis of the new securities will be $8,625. ($7,500 + $1,125). The basis per share will be $ 58,750 ($8,625/150) and his holding period begins on March 10, 2016.
A stock right gives the holder the privilege of buying additional shares of the same stock owned. When stocks sell with the right attached, this is called “rights on”. If you purchase shares during the “rights on” period, you automatically receive the rights. After the “rights on” period expires, the stock does not come with rights. After that date, the stock trades “ex-rights”. If you want to buy stock with rights after the ex-rights date, you have to purchase the rights on the open market (this topic is discussed below).
When rights are received for the same shares owned and are proportional (same number of rights for each share owned), the rights are not taxable. A taxpayer now has two securities-rights and stock. When a stock trades “ex-rights, the rights are traded in the market just as shares of stock are. If the value of the rights at ex-rights date, is less than 15% of value of the stock, you can elect to allocate part of the stock cost to the rights. If the value of the rights at ex-rights date is 15% or more of the stock value, you are required to allocate part of the stock cost to the rights. The allocation is based on the formula: fair value of rights divided by (fair value of rights + fair value of stock) multiplied by the cost of stock.
Joe owns 1,000 shares of Yum common stock purchased five years ago for $20 per share (total cost of $20,000). On July 1, 2016, he receives one right per share owned allowing him to purchase additional shares of Yum stock at $5 per share exercisable until December 31, 2016. It takes one right to buy one additional share. On July 2, 2016, the rights had a value of $5 each (total value of $5,000) and the stock has a value of $37.50 per share (total $37,500). The value of the rights are 13% of the stock value ($5,000 / $37,500). Since the rights value are less than 15% of the stock value, no allocation is required.
Assume the same facts as example 1 but the value of the stock is $27.50 per share ($27,500 total). The value of the rights are $5,000, which is 18% of the value of the stock ($5,000 / $27,500). Since the rights have a value of more than 15% of the stock value, an allocation is required. The stock cost allocated to the rights will be: $3,000 [$5,000 / ($5,000 + $27,500) x $20,000 ]. The adjusted cost of the stock will be $17,000 ($20,000 – $3,000) or $34 per share ($17,000 / 500). Each right has a basis of $3.00 ($3,000 / 1,000). The holding period of the rights begins on July 1, 2016, the date they were received.
Exercise of Rights
When rights are exercised, the basis of the stock purchased is the purchase price of the stock plus the amount allocated to the rights. The holding period of the additional shares begins on the acquisition date.
Sale of Rights
If non-taxable rights are sold, a capital gain or loss is realized. The amount depends on whether there was an allocation of the stock cost to the rights. The holding period for the rights sold begins on the stock acquisition date.
Example 1 – No Allocation Made
Assume the facts in example 1 above. On November 26, 2016, Joe sell all the rights for $5,750. Since the rights have no basis, he has a long-term capital gain of $5,750.
Example 2 – Allocation Made
Assume the facts in example 2 above. On November 26, 2016, Joe sell all the rights for $5,750. Since the rights have a basis of $3,000, he has a long-term capital gain of $2,750.
Sale of Stock with Allocation of Rights
Assume that on December 30, 2016, Joe sells 400 shares of stock for $45 per share (total $18,000) of the stock purchased with rights that were allocated to the stock in example 2 above. He will have a short-term gain of 4,400 [18,000 – 13,600 (34 x 400)]
Assume Joe sells the shares for $30 per share ($12,000 total) He has a short-term loss of $1,600 [12,000 – 13,600 (34 x 400)].
Stock rights are a capital asset. Their basis is the purchase price and the holding period begins on the date of purchase. If any of the rights are exercised, the basis of the stock purchased is the stock purchase price plus the amount allocated to the rights (see example above). The holding period of the stock begins on the acquisition date. If the purchased rights are sold, the short-term or long-term gain or loss is determined the same way as shares of stock sold.
If the rights lapse, and no allocation of cost was made, there is no gain or loss. If there was an allocation of cost to the rights, then the allocated amount is a capital loss. The holding period begins on the date the rights were acquired and ends on the date the rights expired.
If the purchased rights become worthless during the year, the holding period ends on the last day of the tax year they became worthless.
Small Business Stock (Sect. 1244)
Definition of Section 1244 stock
To qualify as Section 1244 stock, the following requirements must be met [J.K. Lasser’s 2016 Your Income Tax].
(1) At the time the stock is issued, the corporation’s equity may not exceed $1,000,000, including the stock issued.
(2) The stock must be issued for money or property (other than stock and securities).
(3) The corporation, for the five years preceding the loss on the sale, must have derived more than half of its gross receipts from business operations and no passive income. The five year period is waived if deductions, other than dividends received or NOL exceed gross income. If the corporation has been in existence for less than five years before the loss on the sale, the time period of existence is used for the gross receipts test.
Character and Amount Deductible
Even though small business stock held by a taxpayer is a capital asset, the loss on the sale or worthlessness is treated as an ordinary loss but a gain will be capital gain. The loss deduction is limited to $50,000 ($100,000 on joint return, even if only one spouse has a Section 1244 loss). The loss is reported on form 4797, Part II. Any loss in excess of $50,000 ($100,000) is a capital loss reported on form 8949 (the section used depends on whether it is a short-term or long-term). An ordinary loss is preferable to a capital loss because there is no limit (other than AGI before the loss deduction). Capital losses in excess of capital gains can offset ordinary income up to $3,000 but the excess can be carried forward indefinitely. The loss can be claimed only by the original owner of the stock.
If a partnership sells the stock, each partner who was a partner when the stock was issued, will report their proportionate share of the gain or loss as explained above. If the partnership distributes the stock to its partners, the partners must treat it as a capital loss when they sell the stock. The Tax Court ruled that shareholders of S corporations must treat the loss as a capital loss when they sell the stock.