Back to Basis

by Denise Davidson and Beth Steele

From Financial Planning Magazine, November 2000. Reprinted with permission.

n exciting planning opportunity exists for wealthy clients thanks to the new, lower, long-term capital gains rate that takes effect January 1st. Since the term "basis" may not be on the tip of your client's tongue, you may find yourself counseling clients regularly about the planning opportunities available to investors who are interested in the concept of basis and willing to use it to their advantage. In addition, basis always seems to be a popular topic around April 15 of each year when your clients need to determine their capital gains or losses for the past tax year. So, as the end of the year approaches, it's a good time to review some basics about basis with your clients, as well as to discuss a new rule that all investors should be aware of.

There are three core basis concepts your clients need to know to invest wisely: 1) why they need to know about basis, 2) what basis is, and 3) how basis works. Finally, how basis and the new "longer long-term" capital gains rate, which kicks in at the beginning of 2001, can be used to their advantage. For simplicity, we've geared the following discussion toward the basis of stock held as a capital asset, although the basic rules also apply to other capital assets.

Let's start with why those you advise need to know about basis. Knowing about basis can:

Reduce Taxes.

If your clients don't understand basis, they may very well pay too much tax - more than the Internal Revenue Code requires. We're not talking fancy tax tricks here, but something very fundamental. If one of your clients reports too little basis, he or she will pay too much tax. Consider an investor that reinvests his or her mutual fund dividends instead of taking the dividends in cash. Reinvested dividends are taxed in the year received. It's as though the investor received the cash and then immediately bought more shares of the fund with that cash. Since tax has already been paid on those dividends, the amount of the dividend should be added to the basis of the stock when the investor later sells and needs to determine the gain or loss on the sale. Doing so will either decrease a gain or increase a loss. Investments who fail to adjust their basis by the amount of the reinvested dividends will be taxed twice on the same dividend.

Prevent a Crisis on April 15.

If your clients (or you on their behalf) keep track of all adjustments to basis, tax planning will be a lot easier. Suppose your client wants to sell a stock that has appreciated and over the years, due to an initial low cost basis and subsequent stock splits (which require the investor to adjust his or her per-share basis downward), current adjusted basis in the stock is very low. A sale in this situation would generate a large tax obligation for the client. However, that client may also have other stocks in his or her portfolio that are currently valued at less than their basis, thereby generating losses upon sale. With knowledge of basis, your client can sell the underachievers in order to offset those losses against their large gain. Result: Lower tax liability.

Enhance Wealth by Lowering Taxes.

Here are a few additional examples of when knowing your security's basis becomes essential:

Selling stock received as a gift (which was originally purchased 40 years ago by the donor). As the donee, your client takes on the donor's basis.

Determining which stock (e.g., highly appreciated, low basis) to donate to charity in order to provide your client with a dual benefit: 1) a charitable deduction and 2) preventing a high tax liability upon a sale of that stock.

Re-balancing an investor's stock portfolio when market dips make him or her queasy.

Maximizing the benefits of the new, lower, long-term capital gains rate that takes effect January 1, 2001.

Now, let's get down to what basis is. When an investor purchases stock, he or she is making a capital investment and this investment becomes the investor's initial "cost basis." Since after-tax dollars were used to purchase the stock, it is only fair that that amount not be taxed again when the stock is sold. (Yes, the Internal Revenue Code can be fair!)

While many investors will stick with you through this part of the explanation, getting them to pay attention to or understand the impacts of ongoing changes to basis can be a bit trickier. Subsequent corporate transactions such as stock splits, mergers, spin-offs or distributions will necessitate adjustments to that initial cost basis. Keeping track of all the corporate transactions that affect the basis of your client's shares and doing the math necessary for some of those adjustments is not an easy task and may be beyond the level of involvement your client wants in managing his or her portfolio -- hence, another added service you can provide your client.

A couple of examples will illustrate a few "ins and outs" of basis. Suppose that several years ago your client bought 10 shares of ABC Co. at $50 per share, for a total cost of $500. Your client's total cost basis is $500 for the 10 shares; the per-share basis is $50. Your client decides to sell the 10 shares which are now valued at $100 per share; ABC Co. did not yet have a stock split or other capital change that would affect the basis. Your client will not be taxed on the entire $1,000 received. Rather, your client's gain is calculated by subtracting his or her basis in the shares sold from the amount realized on the sale ($1,000 - $500 = $500 gain). Remind the client that the cost basis represents the investment he or she made with after-tax dollars, and that investment comes back to him or her tax-free.

The above illustrates "cost basis." Now, let's go on to "adjusted basis," which is best understood using the example of a stock split.

Suppose another client has 10 shares of ABC Co., which split two-for-one. A two-for-one split means that for every one share held, your client now has two; or, in this case 20 shares (2 x 10 = 20). The original total cost basis of the 10 shares remains $500. However, that $500 initial cost basis is now represented by 20 shares, instead of 10. Consequently, the per-share basis is adjusted to $25 ($500 divided by 20 = $25). If your client sold 10 shares at $100 apiece, he or she would realize $1,000 and the gain would be the difference between $1,000 and the $250 basis (10 x $25), or $750.

The following are two common examples of when a stock's basis would need to be adjusted:

Receipt of stock due to a nontaxable spin-off or distribution by a corporation of which the investor is a shareholder: the basis of his or her original stock must be allocated between that original stock and the new stock.

An investor's shares of a corporation that was merged into another are exchanged for shares of the new, acquiring corporation. Basis of the client's old shares could carry over to the new shares or it may need to be adjusted, depending on the structure of the merger transaction. When he sells his new shares, he must know their basis to accurately determine gain or loss.

Currently, there are two capital gains tax rate classes: short-term (for stocks held one year or less) and long-term (for stocks held more than 12 months). The maximum long-term capital gains rate is 20 percent for taxpayers in the 28 percent bracket or higher and 10 percent for those in the 15 percent bracket.

Generally, for tax years starting after December 31, 2000, the 20 percent and 10 percent rates will apply so long as the 12-month holding period has been met. However, lower long-term capital gain rates may apply if a taxpayer's stock has been held more than five years. The date that the five-year holding period starts is different for taxpayers in the 15 percent bracket than for those in higher brackets. For a taxpayer in the 15 percent bracket, stock does not have to be acquired after December 31, 2000 in order to have the five-year rule apply; such capital gains would be taxed at 8 percent.

For those taxpayers in a bracket higher than 15 percent, the five-year holding period (and lower 18 percent rate) generally will only apply to stocks (or other capital assets) acquired after December 31, 2000. But, an exciting planning opportunity exists for those higher bracket taxpayers who hold stocks acquired in tax years prior to January 1, 2001 that will allow them to make their stock eligible for the five-year holding rule and 18 percent maximum tax rate.

Via a special tax election, taxpayers may treat stocks that were acquired prior to January 1, 2001 as having been "sold" at fair market value (their closing price) on January 2, 2001 and then "re-acquired" on that date. Any income tax due on this deemed sale is recognized and the stock's basis is increased to its fair market value. If a loss is realized, it is not recognized, nor is it preserved through a basis adjustment.

Consider a taxpayer in the 28 percent tax bracket who purchased 100 shares of XYZ Co. stock in 1999 for $5,000, and still holds it on January 1, 2001. The stock has not split and its basis has not been adjusted in any other way prior to January 1, 2001. The taxpayer plans to hold on to the stock for at least five more years and would like to take advantage of the 18 percent special long-term rate when it is later sold. In order to do so, the taxpayer must elect to treat the XYZ shares as having been sold on January 2, 2001 and pay any resulting tax. So, if the stock had a fair market value of $8,000 on January 2, 2001, the taxpayer would pay tax on the $3,000 deemed capital gain when his or her 2001 tax return is filed. The five-year holding period begins on that deemed sale date (on January 2, 2001) and the basis in the stock becomes its fair market value on that date. When the stock is sold more than five years later, the post-2000 appreciation will be taxed at the 18 percent capital gains rate.

Now is a good time to start educating your clients regarding basis and working with them to analyze their stock holdings to determine whether it would be beneficial for them to make the special tax election. Remember, tax will be due even though their "deemed sale" does not generate cash and it could become difficult to pay that tax. You may also want to talk to your clients about adjusting their withholding or estimated taxes to avoid penalties, which also could adversely affect their cash flow. You should also factor in the time value lost on the money used to pay the tax.

Instead of your client's focusing on stocks that already have huge gains - those with a low basis and high market value (and therefore a huge potential tax liability if "sold" on January 2, 2001) - you may want to steer them to think about stocks that have a small amount of gain today, but which they plan on holding for at least five more years. The cloud that's hung over tech stocks this year could actually have somewhat of a silver lining. If stock values remain low on January 2, 2001 and there is only a small amount of gain on which to pay tax, it may be very beneficial to qualify those stocks for the new five-year holding period and lower 18 percent rate.

Whatever your clients' investment goals, a knowledge of basis can help reduce tax, smooth the way to April 15 tax filing and ultimately increase wealth. Basis is basic to all tax planning.

Denise Davidson, J.D., and Beth Steele, J.D., are analysts for CCH INCORPORATED's Capital Changes, providing the information needed to calculate adjusted basis of securities so investors can plan for capital gains impacts. CCH, based in Riverwoods, IL is a leading provider of tax, securities and business law information. For information, visit http://business.cch.com.

Sponsored by James J. Eccleston. This Web site contains material of general interest. It is neither intended to, nor constitutes, either legal advice or investment advice.
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