Stocks split for a variety of reasons, but the most common reason is to increase the liquidity of a company and make the share price affordable for smaller investors. Although the price of a stock may become volatile around the timing of a split, the company is worth no more or no less as a result of the split. The market capitalization (number of shares outstanding times the price of a share) remains unchanged. Instead of owning one share worth $100, two shares are owned worth $50 each.
Even though the fundamental business metrics don’t change due to a stock split, many investors view it as a positive sign. Psychologically, a perception is created that the lower price is more affordable, and as a result, more attractive to investors. Since a 2-for-1 split gives every shareholder an additional share, investors may feel as though they own more of the company, even though the value of their position is unchanged.
While a stock split may not impact the value of a company or its shares, it does have meaningful tax basis implications. Basis is defined as the cost paid for an asset plus adjustments, and is used to calculate gain or loss. A stock split is treated as a non-taxable stock dividend, which investors do not include in reportable income for tax purposes. The old basis is apportioned pro rata between the shares. The accounting adjustment is fairly simple if stock has been purchased only once, but is more complicated when multiple purchases of the same stock occurred over time. Let’s take a look at some examples:
John owns 10 shares of ABC, which he purchased for $100 each. ABC completes a 2-for-1 stock split, which results in John owning an additional 10 shares. He now has a total of 20 shares worth $50 each. His new basis is $50/share.
That’s a straight-forward example. But what if John had purchased 8 shares for $90 each and 2 shares for $140 each before the split? In this case, John owns 10 shares that have an average cost of $100 each. However, individual stocks can’t use an average basis calculation, and so the additional shares must be allocated as illustrated in the following example:
John purchased eight 8 shares of ABC for $90, and two shares a year later for $140. ABC completes a 3-for-1 stock split. John allocates the new shares pro-rata, resulting in 24 shares with a basis of $30 ($90 divided by 3) and 6 shares with a basis of $46.67 ($140 divided by 3).
In both cases, John has a total cost of $1,000 before and after the stock split, but in the second example, tracking the different purchases becomes more difficult.
If you have investments in taxable accounts, many financial firms will track cost basis for you. However, financial firms were not required to track transactions made before January 1, 2011, which has left many investors with incomplete basis history. Always keep good records of your transactions. It will reduce stress and cost in future tax seasons.