Question

heather owns 400 shares of diego corporation common stock for which she paid $4,000. she receives a nontaxable stock dividend of 20 shares of preferred stock on her common stock. the fair market values on the date of distribution of the preferred stock dividend are $20 a share for common stock and $100 a share for preferred stock. what is heather's basis in the common and preferred shares?

Answer 1

Heather's basis for her common shares after receiving the preferred stock dividend is $3,200 or $8 per share, while the basis for the new preferred shares is $800 or $40 per share.

Step-by-step explanation:

Heather's initial investment in the Diego Corporation common stock was $4,000 for 400 shares, which gives her a per-share basis of $10 per common share. When she receives the stock dividend of 20 preferred shares, this is a nontaxable event, and therefore the basis of her original investment must be allocated between the common and new preferred shares. Since the fair market value (FMV) of the common shares is $20 each at the time of the dividend, and the FMV of the preferred shares is $100 each, we use these values to allocate the original basis proportionally.

The total FMV of her holdings at the time of the dividend is (400 common shares × $20) + (20 preferred shares × $100), which equals $8,000 + $2,000 or $10,000 in total. The ratio of the FMV of the common shares to total FMV is 80% ($8,000 / $10,000), and the ratio for the preferred shares is 20% ($2,000 / $10,000).

Hence, Heather's adjusted basis for the common stock is now 80% of $4,000, which is $3,200, or $8 per share for the 400 common shares. The basis for the preferred shares is 20% of $4,000, which is $800, or $40 per preferred share for the 20 shares.