Tax planning for stock rights and warrants.

• Author: Ellentuck, Albert B.

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 ((800) 323-8724; 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...