To adjust your cost basis after a stock dividend, spread the total basis of your original shares across the combined old and new shares. Your total investment cost doesn’t change. It just gets divided among more shares, which lowers the per-share basis and, in turn, raises the gain you’ll report whenever you sell. Section 307 of the Internal Revenue Code requires this allocation for non-taxable stock dividends, and skipping it means you’ll understate basis and overpay tax on the sale.1Office of the Law Revision Counsel. 26 USC 307 – Basis of Stock and Stock Rights Acquired in Distributions
Same-Class Dividend: Divide and Move On
When the dividend gives you more of the same stock you already own — common shares on common, say — the calculation is a single division. Take the adjusted basis of your original shares and divide it by the total number of shares you hold after the dividend. That’s your new per-share basis.2Internal Revenue Service. Publication 550 – Investment Income and Expenses
An example. You bought 100 shares for $5,000, so your basis is $50 per share. The company declares a 10% stock dividend and issues you 10 more shares. Total basis stays at $5,000, but it now spreads across 110 shares. $5,000 ÷ 110 = $45.45 per share. Sell 50 shares later at $60 each and your per-share gain is $14.55, not the $10 you’d get if you kept using the old $50 figure.
Different-Class Dividend: Allocate by Fair Market Value
If the dividend gives you a different class of stock — preferred distributed on common is the classic case — you split your original basis between the old and new stock in proportion to their fair market values on the distribution date.2Internal Revenue Service. Publication 550 – Investment Income and Expenses
Suppose you paid $100 for one common share. The company then distributes one preferred share for each common share you hold. On the distribution date, the common is worth $150 and the preferred is worth $50, a combined $200. The common gets 75% of your $100 basis, or $75. The preferred gets the remaining 25%, or $25.2Internal Revenue Service. Publication 550 – Investment Income and Expenses You need the fair market values as of the distribution date to run this, and those figures typically come from the company’s Form 8937.
Fractional Shares Paid in Cash
Stock dividends rarely divide cleanly. If you hold 75 shares and receive a 10% stock dividend, you’re entitled to 7.5 shares. Most companies pay 7 whole shares plus cash for the half share.
The IRS treats that cash as if you received the fractional share and immediately sold it. Compute gain or loss by comparing the cash against the portion of your adjusted basis assigned to the fractional share. For most individual investors, whose shares are capital assets, the result is a capital gain or loss.3Internal Revenue Service. IRS Letter Ruling 202531002 – Treatment of Cash in Lieu of Fractional Shares
The Holding Period Carries Over
New shares from a non-taxable stock dividend inherit the holding period of the original stock. Under Section 1223(4), the time you held the original shares tacks onto the new ones, as long as the basis is determined under Section 307.4Office of the Law Revision Counsel. 26 USC 1223 – Holding Period of Property If you’d already crossed the one-year mark for long-term capital gain rates on your original shares, the dividend shares qualify at long-term rates the moment they arrive. The fractional share sold for cash follows the same tacking rule.
Where the Adjustment Numbers Come From
You don’t have to compute fair market values from scratch. Companies whose actions affect shareholder basis — stock dividends included — must file IRS Form 8937 reporting the quantitative effect on basis.5Internal Revenue Service. About Form 8937 – Report of Organizational Actions Affecting Basis of Securities The form must be filed within 45 days of the action or by January 15 of the following year, whichever comes first, and shareholders must receive a copy by that same January 15 deadline.6Internal Revenue Service. Instructions for Form 8937 Keep it. You’ll need those figures the year you sell.
Reporting the Sale
When you eventually sell the shares, report the transaction on Form 8949 and carry the totals to Schedule D.7Internal Revenue Service. Instructions for Form 8949 Check the Form 1099-B your broker sends carefully. Depending on when you acquired the shares and whether the broker correctly processed the stock dividend, the basis reported to the IRS may or may not reflect the adjustment. If the 1099-B basis is wrong, report the correct adjusted basis on Form 8949, put the adjustment amount in column (f), and note the reason with a code in column (g). This is where most basis-adjustment mistakes either get caught or get baked into the return.
When the Rule Doesn’t Apply: Taxable Stock Dividends
Some stock distributions are taxable rather than non-taxable, and the allocation rule doesn’t apply to them. A dividend is taxable, for example, when any shareholder had the option to take cash or other property instead of stock, when the distribution is disproportionate in specific ways, or when it’s paid on preferred stock (with narrow exceptions).8Office of the Law Revision Counsel. 26 USC 305 – Distributions of Stock and Stock Rights
If the dividend is taxable, you leave the basis of your original shares alone. The new shares get their own basis equal to their fair market value on the distribution date, which is the same amount you report as income. Their holding period also starts fresh on the distribution date rather than tacking onto the original shares.
Stock Rights Worth Less Than 15% of the Old Stock
A separate rule applies when the distribution is of stock rights rather than actual shares, and those rights are worth less than 15% of the fair market value of your existing stock on the distribution date. The default is a zero basis for the rights, meaning you don’t reduce the basis of your original shares at all. You can elect to allocate basis using the standard FMV method by making the election on your return for the year you receive the rights, and the election is irrevocable. If the rights are worth 15% or more, allocation is mandatory.1Office of the Law Revision Counsel. 26 USC 307 – Basis of Stock and Stock Rights Acquired in Distributions
What Getting It Wrong Costs
An incorrect basis inflates or deflates the gain you report, and the IRS can assess an accuracy-related penalty of 20% of the underpayment for negligence or a substantial understatement of tax.9Internal Revenue Service. Accuracy-Related Penalty For individuals, a substantial understatement means the tax is understated by the greater of 10% of the correct tax or $5,000. Interest runs on top of the penalty from the original due date. The IRS may waive the penalty for reasonable cause and good faith — reliance on an incorrect 1099-B, for example — but that defense is thin if the company sent you a Form 8937 that laid out the adjustment.