Wealthy clients may get excited when their long-held stocks jump in value after a headline corporate deal—but they might also be looking at a nasty tax surprise.
Some mergers that greatly benefit the bottom line of one or two companies can have an impact on the cost basis of stock; managing cost basis can help reduce capital gains.
High-net-worth clients generally have an idea of the importance of cost basis “but don’t always understand it,” said Daniel Morris, a senior partner at Morris + D’Angelo CPAs in San Jose, Calif.
In one recent major deal, the merger of industrial-gas giants Linde AG and Praxair Inc., the shareholders of former Praxair shares were forced to exchange Praxair investments for shares of Linde. “This event created two possible scenarios,” said Katelynn Minott, a CPA and managing partner with Bright!Tax/The Minott Group.
“If the fair market value of the Linde shares in the exchange was higher than their basis in their Praxair shares (the original purchase price of the Praxair shares), they had a taxable gain to recognize on their return. This will also bump up their basis to the fair market value of the new Linde shares,” she said. “If the Linde shares they received were lower in fair market value than their basis in the forfeited Praxair shares, their basis stayed the same.”
“It’s annoying when there’s a large corporate transaction and the client doesn’t tell you,” added Lawrence Pon, a CPA/PFS at Pon & Associates in Redwood City, Calif. “The result can be a large bill plus interest and penalties come filing day—when taxpayers must pay even if they submit an extension to file their return.”
“The bigger issue … is usually the structure of the transaction,” added Todd A. Miller, partner, transaction advisory services-transaction tax, with Ernst & Young. “Certain transactions structured as stock-for-stock exchanges can be taxable to the shareholder, leaving the shareholder with a tax liability without actually selling anything.”
Are there options to avoid the tax bite? “Can gain be deferred? Reduced? What are the holding periods?" Morris said. “What was the type of initial investment? Were the shares acquired from the company or in a secondary market?”
“Does the stock qualify for 1202 treatment,” which allows exclusion of capital gains from select small business stock from federal tax? Pon said.
Miller had the following recommendations:
• Keep tax basis computations up to date so that when a potential transaction is proposed, the taxpayer can evaluate the consequences.
• If the taxpayer has any input into the transaction structure, design the structure as tax-free reorganization.