 Hello and welcome to the session in which we will discuss the taxation of stock dividend. What is the big idea for the taxation of stock dividend? Let's assume you own 500 shares in my company, Farhat Lectures. And the total number of shares outstanding for Farhat Lectures is 5,000. So you own 500 out of 5,000 shares. This means you own currently 10% of Farhat Lectures. But let's assume as the owner of the company I decided to issue additional shares and specifically I want to issue an additional 1,000 share in form of stock dividend. What does that mean? It means I want to reward my shareholders. You're one of them. You're a 10% owner. So I said I'm going to issue new shares to reward you. I don't want to give you cash. I need the cash. I need to preserve the cash for the business. Therefore I'm going to give you more shares of the company. So I issue 1,000 shares, new ones. How much will you get? You're going to get 100 shares of the new 1,000 shares. Now when you get 100 shares, you're going to have a total now of rather than 500, you're going to have a total shares of 600. And the total number of shares now becomes 6,000. You are still a 10% owner. So you are still a 10% owner. Why? Because this dividend is proportional dividend, prorata. That means you own 10%. You're going to get 10% of this transaction. Well, the question becomes here. Is this transaction taxable? What do we need to know about stock dividend? Does it affect earnings and profit for the corporation? So on and so forth. So this is what we're going to be discussing in this session. Let's go ahead and get started. Before we proceed any further, I have a public announcement about my company, lectures.com. Forehead Accounting Lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions as well as exercises. Go ahead, start your free trial today. Is stock dividend taxable or not? Well, it's excluded from income if it's a pro-rata distribution of stock or stock rights, which we'll talk about stock rights shortly separately. If it's a pro-rata distribution, it means everybody, like if you own 10%, you're getting 10%, that's a pro-rata. There are exceptions to the non-taxable treatment. It's when that distribution is this proportional. This proportional means not everyone getting the same amount of shares. So you're a 10% owner, you're getting 15% or you're a 10% owner, you're only getting 5% of the distribution. This is what this proportional, as long as it's a pro-rata proportional distribution, it's excluded from income. What about the effect on the corporation on the earnings and profit? Well, if the distribution is not taxable, well, we don't reduce earnings and profit. So if it's non-taxable, so if it's a proportional, we don't reduce. If it is taxable, we will treat like any other taxable property distribution. And we talked about taxable property distribution in a separate recording. So what are the basis of stock received for the shareholder? When the shareholder receives the new stocks, what's their basis? If the transaction is non-taxable, well, when is it non-taxable? It's a proportional distribution. And if the shares are identical, what does it mean? Shares are identical. Let's assume you own common stock class A and we gave you common stock class A. What's going to happen is this. Your basis, you're going to take the cost of the old shares, how much you invested in the old shares, and you divide this by the new numbers. Why the new numbers? The new number of shares, remember, they are giving you additional shares. That's all what you do. So you did not pay more. When you receive a tax dividend, you did not pay for those. When you received a stock dividend, you did not pay for these stocks. So you take the old amount of money that you invested initially, but you have to spread, divide by the total number of shares, the total number new of shares. If the shares received are not identical, for example, you have class, they gave you class B, well, you have class A. Then we have to make an allocation. You would allocate basis of old stock because you did not pay any money for the new stock between the old on the new shares based on the relative fair market value. Now, if you don't know what relative fair market value is, you really want to learn this as an accounting student. We'll work an example, but something you should be familiar with, relative fair market value, because we use it in many, many different concepts. How about your holding period? Well, the holding period includes holding period or a formally held stock, because the new stocks are a continuation of the old stock. If the transaction is taxable, basis of new share received is the fair market value if it's taxable. And the holding period start on the date of the receipt if the transaction is taxable. Let's take a look at an example. Olive Enterprises announces a 15% stock dividend when its shares are trading at 150. Following the stock dividend, the per share value reduced to 130,043 cent. Now, obviously, because we issued more shares, the market price will go down, but the company is still worth the same. All what we did is we took the value of the company and we spread it over more shares, the value is the same, the value of the company. Thomas, who happens to be an owner of this company and happens to own 200 shares, happens to own 200 shares, with the basis of 2,400. In other words, Thomas was part of this company before this dividend, stock dividend. He paid 2,400 and owned 200 shares. Now, Thomas, part of this transaction, received an additional 30 shares, an additional 30 shares. But before we proceed any further, I just wanna show you that Thomas paid $12 per share. So 2,400 divided by 200, his basis in the shares were $2. So what impact does the stock dividend have on Thomas now since he received additional 30 shares? Let's start from both, dividend from corporation and Thomas as well. Well, the stock dividend does not result in gross income. Remember, this is not taxable because he received, we're assuming 15% proportional number of shares. And it has no effect on all of enterprises, taxable income or earnings and profit. Prior to the stock dividend, Thomas' basis were $12. Following the stock dividend, well, Thomas maintained the same total basis. Thomas did not invest more than 2,400. However, now Thomas owns 230 shares rather than 200. Now we're gonna take the 2,400 divided by 230 shares and his basis in the new stock is $10.44. Now let's assume all of enterprises declare 441 stock split. Well, if that's the case, now Thomas will have 800 shares rather than 200 and the basis are the same. In other words, Thomas did not pay for those additional 600 shares. Well, then we'll take 2,400 and we're gonna spread 2,400 over how many shares, over 800 shares. And his stock basis now is obviously $3 per share, $3 per share. Let's take a look at an example where we have both common and preferred stock involved. In other words, you'd receive stock dividend for a different class of stocks. Sophia purchased 2,000 shares of common stock three years ago for 20,000. That's her basis. And the current tax here, Sophia received a non-taxable preferred dividend of 200 shares. So they gave her stocks but of a different class preferred dividend. The preferred dividend has a fair market value of $2,000 and the common stock on which the preferred dividend is distributed has a fair market value of 38. Now we're giving us the fair market value. So the fair market value of common is 38. The fair market value of the preferred is 2,000. The total fair market value is 4,000. Now what is the relative fair market value? We'll take the fair value of each item relative to the total. 38,000 divided by 40. Common stock represent 95% of the fair market value of the total. We multiply this by the original basis. That's gonna give us 19,000 for common stock. We're gonna do the same thing for the preferred stock. 2,000 divided by 40,000 equal to 5% if the relative fair market value is 5% and we're gonna allocate to the basis of the preferred stock, 1,000. So now the basis for the common is 19. The basis for the preferred is 1,000. Let's move on and talk about stock rights. What are they? What are stock rights? I hope you know this from your intermediate accounting. If not, I'm just gonna briefly tell you what they are. So sometime when you buy stocks in addition to the stock, so in addition to buying the stock, you might get a right, basically a right to buy the stock at a certain price. Basically, Delta, if you buy 1,000 shares today, we're gonna give you 100 rights and those rights will give you the right to buy the stock in the future at a certain price. Sometime those rights are issued to keep your proportional ownership. So simply put, they would say, look, now you own 10%, we're gonna give you stock rights and those stock rights will give you the right to buy the new shares. When we issued the new shares, 10% of any new shares issued. It's an evidence of your, of that right, of your something called the preemptive right to keep your ownership at 10%. This is what the rights are. The tax treatment of the tax rights are the same as the stock dividend. Sometime they are taxable, sometime they are not. If stock rights are taxable, income is recognized based on the fair market value of the stock received. So if it is taxable, those rights have a value. So whatever value you got, sometime there's the value for each right, $5, $7, $8. And this becomes your basis. The fair market value of the stock rights becomes your basis because you are taxed on that. Once you are taxed on it, it becomes your basis. If exercised, I mean, I mean, in other words, if exercised means you exchange the right to buy the stock, the holding period begins on the date the rights are exercised. So once you buy the stock, your holding period start on that date. Basis of the new stock. So when you buy, when you take this right and you exercise the right, basis of the rights of the stock equal basis of the rights plus how much you paid for the stock. Don't worry, we'll look at an example. How about if the stock right are not taxable? Well, if the value of the rights received less than 15% of the value of the old stock, basis in the right is zero. Now you have the right. You have the right. The right means you have the election. You have the option, not the right, you have the option. Election is available which allow allocation of some basis of formally held stock to rights. You can make that allocation. If the value is more than is 15% or more of the value of the old stock, if the right has that value and the rights are exercised or sold, you must allocate some basis and formally held stocks to the rights. Then you have to allocate. Don't worry, we'll work an example illustrating these concepts. Let's take a look at this example. A corporation with a common outstanding stocks announces a non-taxable dividend payable and rights to subscribe to common stock. So what they did, they said this. We're gonna announce a non-taxable dividend payable. So it's a tax dividend and rights to subscribe. So each right gives the holder the option to purchase one share of common stock. So it'll give you a right and each right will give you the right to purchase the stock at 120. And we're gonna give you one right for every two shares. So if you own two shares, you'll get one R, one right. Maggie owns 500 shares of the company and she purchased those three years ago for 20,000. Okay, so how many rights would Maggie receive? Maggie would receive 250 new right. When the right are distributed, the market value of the common stock is 130 and the market value of the rights is $10 per right. So those rights, they have a value. So if Maggie received 250 of them, well, the value of those is 2,500. Maggie received 250. So what Maggie did, she exercised 150 and sells the remaining 100 for actually $11. She got them at 10, she sold them at 11, but what she did, she exercised 150 right. Well, what would that 150 rights give her the right to do? Gives her the right to purchase the stock at 120. So she can buy the stock at 120 and the stock trading at 130 when the rights are distributed. So that's the benefit of the right. Now, Maggie does not have to allocate the cost of the original stock to the rights because the value of the rights is less than 15% of the value of the stock. What we do is we say, okay, Maggie has 500 shares, the value of the stocks on that date, if we take 500 times 130 is 65,000. That's the value of the stock and the value of the rights are 2,500. If we take 2,500 divided by the total, it's less than 15%, way less, it's 3.85. If Maggie does not allocate her original cost basis to the rights, the tax consequences are as follow. The basis of the new stock, basically, is she purchased them at 120, she purchased 150 shares. It's what she paid, 18,000. That's the basis of the stock. The holding period of the new stock begins on the date the stock was purchased. The sale of the right result in a long-term capital gain of 1,100 because remember, she sold them at $11, at $11 times 100 shares. And remember, we're assuming the basis of the rights are zero because we're not allocating anything to the rights. Therefore, the full amount is capital gain. The holding period of the rights start with the date of the original 500 shares of stock were purchased. So also the rights has an old date, the date when the 500 shares were purchased because this is what brought the rights to life as those old purchase of 500 shares. Let's change the scenario a little. Let's assume Maggie chooses to allocate basis to the rights. What would happen? Well, here's what's gonna happen. The basis of the stock, what we're gonna do, we're gonna take, we're gonna look. At the basis, the value of the stock is 65,000. And take the basis of the stock, take the basis of the stock, the value of the stock divided by the value of the stock and the rights. Remember, the value of the stock is 65,000. The value of the rights are 2,500. Together, they'll give you 67,500. Well, if we take 65,000 divided by 67,500, that's 96.29% percentage. We multiply it by 20,000 the original cost. The basis of the stock now is 19,259. The basis of the rights, it's the value of the rights divided by the value of the rights and the stock together. And that's gonna give us the remaining, which is 3.70%. This ratio is 3.70 multiplied by 20. We're gonna allocate to the rights $741. Now, what we did is we establish a basis for the rights. And if we take $741 divided by 250 rights, each right is valued at $2.96. That's what we did. The basis of each right is 296. So when Maggie exercises the rights, her basis in the new stock will be, the basis in the new stock, it's the cost, what she paid, plus the rights value, which is not the rights value, the rights basis, which is 150 rights times 3.96, which is $445. And she paid 18,000 for the stock separately. Therefore, the basis for the new stock is 18,461. Because remember, she paid 120 for 150 shares. But now we added them, since we allocated basis to the rights, we allocate the rights, part of the rights basis to the stock as well. Now, the sale of the rights now would yield a long-term capital gain of only $804. Why only $804? Why? Because the proceeds were $1,100. But now, since we establish basis to the rights, we have 100 times 2.96. We have $296,296 in basis. $1,100 in proceeds minus the basis, we got $804. So in this scenario, what we did, we assumed that Maggie gave the rights some basis, allocated some basis to the rights. And if that's the case, if she chooses to do that, this will be the answers, it'll be totally different. What should you do now? You gotta go to Farhat Lectures, look at additional MCQs, true, false, additional resources that's gonna help you understand the taxability of stock dividends, the taxability of stock rights. Good luck, study hard, invest in yourself whether you're a CPA candidate, an enrolled agent, or an accounting student. Stay safe.