What Are Corporate Actions?

When a publicly-traded company issues a corporate action, it is initiating a process that will bring actual change to its stock. By understanding these different types of processes and their effects, an investor can have a clearer picture of what a corporate action indicates about a company's financial affairs and how that action will influence the company's share price and performance. This knowledge, in turn, will aid the investor in determining whether to buy or sell the stock in question.

Corporate actions are typically agreed upon by a company's board of directors and authorized by the shareholders. Some examples are stock splits, dividends, mergers and acquisitions, rights issues and spin offs. Let's take a closer look at these different examples of corporate actions.

Stock Splits
As the name implies, a stock split (also referred to as a bonus share) divides each of the outstanding shares of a company, thereby lowering the price per share - the market will adjust the price on the day the action is implemented. A stock split, however, is a non-event, meaning that it does not affect a company's equity, or its market capitalization. Only the number of shares outstanding change, so a stock split does not directly change the value or net assets of a company.

A company announcing a 2-for-1 (2:1) stock split, for example, will distribute an additional share for every one outstanding share, so the total shares outstanding will double. If the company had 50 shares outstanding, it will have 100 after the stock split. At the same time, because the value of the company and its shares did not change, the price per share will drop by half. So if the pre-split price was $100 per share, the new price will be $50 per share.

So why would a firm issue such an action? More often than not, the board of directors will approve (and the shareholders will authorize) a stock split in order to increase the liquidity of the share on the market.

The result of the 2-for-1 stock split in our example above is two-fold: (1) the drop in share price will make the stock more attractive to a wider pool of investors, and (2) the increase in available shares outstanding on the stock exchange will make the stock more available to interested buyers. So do keep in mind that the value of the company, or its market capitalization (shares outstanding x market price/share), does not change, but the greater liquidity and higher demand on the share will typically drive the share price up, thereby increasing the company's market capitalization and value.

A split can also be referred to in percentage terms. Thus, a 2 for 1 (2:1) split can also be termed a stock split of 100%. A 3 for 2 split (3:2) would be a 50% split, and so on.

A reverse split might be implemented by a company that would like to increase the price of its shares. If a $1 stock had a reverse split of 1 for 10 (1:10), holders would have to trade in 10 of their old shares for one new one, but the stock would increase from $1 to $10 per share (retaining the same market capitalization). A company may decide to use a reverse split to shed its status as a "penny stock". Other times companies may use a reverse split to drive out small investors.

Dividends
There are two types of dividends a company can issue: cash and stock dividends. Typically only one or the other is issued at a specific period of time (either quarterly, bi-annually or yearly) but both may occur simultaneously. When a dividend is declared and issued, the equity of a company is affected because the distributable equity (retained earnings and/or paid-in capital) is reduced. A cash dividend is straightforward. For each share owned, a certain amount of money is distributed to each shareholder. Thus, if an investor owns 100 shares and the cash dividend is $0.50 per share, the owner will receive $50 in total.

A stock dividend also comes from distributable equity but in the form of stock instead of cash. A stock dividend of 10%, for example, means that for every 10 shares owned, the shareholder receives an additional share. If the company has 1,000,000 shares outstanding (common stock), the stock dividend would increase the company's outstanding shares to a total of 1,100,000. The increase in shares outstanding, however, dilutes the earnings per share, so the stock price would decrease.

The distribution of a cash dividend can signal to an investor that the company has substantial retained earnings from which the shareholders can directly benefit. By using its retained capital or paid-in capital account, a company is indicating that it can replace those funds in the future. At the same time, however, when a growth stock starts to issue dividends, the company may be changing: if it was a rapidly growing company, a newly declared dividend may indicate that the company has reached a stable level of growth that it is sustainable into the future.

Rights Issues
A company implementing a rights issue is offering additional and/or new shares but only to already existing shareholders. The existing shareholders are given the right to purchase or receive these shares before they are offered to the public. A rights issue regularly takes place in the form of a stock split, and can indicate that existing shareholders are being offered a chance to take advantage of a promising new development.

Mergers and Acquisitions
A merger occurs when two or more companies combine into one while all parties involved mutually agree to the terms of the merge. The merge usually occurs when one company surrenders its stock to the other. If a company undergoes a merger, it may indicate to shareholders that the company has confidence in its ability to take on more responsibilities. On the other hand, a merger could also indicate a shrinking industry in which smaller companies are being combined with larger corporations. For more information, see "What happens to the stock price of companies that are merging together?"

In the case of an acquisition, however, a company seeks out and buys a majority stake of a target company's shares; the shares are not swapped or merged. Acquisitions can often be friendly but also hostile, meaning that the acquired company does not find it favorable that a majority of its shares was bought by another entity.

A reverse merger can also occur. This happens when a private company acquires an already publicly-listed company (albeit one that is not successful). The private company in essence turns into the publicly-traded company to gain trading status without having to go through the tedious process of the initial public offering.Thus, the private company merges with the public company, which is usually a shell at the time of the merger, and usually changes its name and issues new shares.

Spin Offs
A spin off occurs when an existing publicly-traded company sells a part of its assets or distributes new shares in order to create a newly independent company. Often the new shares will be offered through a rights issue to existing shareholders before they are offered to new investors (if at all). Depending on the situation, a spin-off could be indicative of a company ready to take on a new challenge or one that is restructuring or refocusing the activities of the main business.

Conclusion
It is important for an investor to understand the various types of corporate actions in order to get a clearer picture of how a company's decisions affect the shareholder. The type of action used can tell the investor a lot about the company, and all actions will change the stock itself one way or another.

Corporate Actions

Definition of a Corporate Action

A corporate action is any material change to a security, including name changes, stock splits, spin offs, and mergers, to name just a few. In many cases, a corporate action will result in a new position or a change to the cost basis of the security. Not surprisingly, it is up to the investor to make all the necessary cost basis adjustments for each security. With over 6,000 corporate actions annually that affect a stock's cost basis, the odds are good that an investor will encounter one sooner or later. Some corporate actions are manageable; however other corporate actions require more laborious calculations. Each corporate action type has its own rules that investors must learn if they are to accurately complete their Schedule D forms.

The arduous task of tracking and adjusting for corporate actions can be further complicated by wash sale activity. GainsKeeper’s wash sale algorithms are synchronized with corporate action activity to alleviate this problem.

Some Types of Corporate Actions

Merger: A merger is a corporate action that results when two companies join together to form one company. Mergers can be taxable or non-taxable. If a merger is taxable an investor will need to realize an "artificial" sale and re-purchase the security. For a non-taxable merger an investor will need to allocate the cost basis to the new security.

Spin Off: A spin off is a corporate action that occurs when a company distributes part of its assets to form a new publicly traded company. When a spin off occurs stockholders of the parent company receive shares of the new company in the form of a stock dividend.

Stock Split: A stock split is a corporate action that occurs when a company changes the amount of shares it has outstanding and then adjusts each share's price accordingly. The number of shares received as a result of a stock split is a ratio of the total shares owned right after the split. Stock splits are usually non-taxable. It is important to note that after a stock split the number of shares owned in the security and the cost basis of those shares will change. Often stock splits are expressed as a fraction. A two for one stock split, where the investor receives one additional share for every share owned in the security, is the most common type of stock split.

Qualified Dividend

Qualified dividends are dividends that are taxed at the lower 5 or 15 percent tax rates instead of at the ordinary income tax rate. The IRS states that in order for dividend income to qualify for the reduced capital gains tax rates two guidelines must be met. Both the company paying the dividend and the holding period relative to the ex-dividend date must qualify.

GainsKeeper's DivTracker product is an easy to use tool that removes the complicated qualified dividend calculations. Taxpayers can use DivTracker to produce a Qualified Dividend Report displaying their ordinary dividend and qualified dividend income - figures required for tax filing in line 9a and 9b of IRS form 1040.

Wash Sale Rule

Definition of Wash Sale Rule

A wash sale is trading activity in which shares of a security are sold at a loss and a substantially identical security is purchased within 30 days. The subsequent purchase could occur before or after the security is sold, creating a 61-day window that must be monitored to identify wash sales.

IRS Explanation of Wash Sales

The IRS defines a wash sale as "a sale of stock or securities at a loss within 30 days before or after you buy or acquire in a fully taxable trade, or acquire a contract or option to buy, substantially identical stock or securities." The wash sale rule under Section 1091 of the Internal Revenue Code (IRC) is intended to prevent investors from generating and recognizing artificial losses in situations where they do not intend to reduce their holdings in the securities that are sold. For purposes of Section 1091 wash sales occur when an investor realizes a loss on the sale of a security and the investor acquires a "substantially identical" security within a 61-day "window" that extends from 30 days before the date of the sale to 30 days after the date of the sale. If an investor sells the stock at a loss, and then buys a "substantially identical" replacement stock within this 61-day window, a wash sale occurs and the loss is deferred until the replacement shares are sold. The pro rata loss is added to the cost basis of the replacement shares purchased, and the holding period of the replacement shares includes the holding period of the original shares sold. However, the deferred loss will eventually be recognized when the replacement shares are sold. For more information about the IRS and the wash sale rule, please see IRS Publication 550.

Wash Sale Example

An investor buys 100 shares of Yahoo stock for $5,000 on October 1. On December 7 the investor sells these 100 shares of Yahoo stock for $4,500. On December 16 the investor buys 100 shares of Yahoo for $4,750. Because the investor bought substantially identical stock within 30 days of the sale of Yahoo, a wash sale occurred and the loss of $500 on the sale of Yahoo cannot be deducted. The loss is deferred and applied to the cost basis of the new tax lot. Therefore, the wash sale in this example would raise the cost basis of the new lot from $4,750 to $5,250.

If you sell a stock and your spouse (if filing jointly) or a corporation you control buys a substantially identical stock, you also have a wash sale. In these cases, the IRC states that losses from the sale of stock can not be recognized at the time of sale, but must be deferred instead.

Wash sales can span tax years. For example, if you sold a stock for a loss in December and repurchased the stock the following January you would have a wash sale. For this reason it is important to include all January trades when calculating your capital gains for the Schedule D.

Wash sales can be very complicated to monitor. To see how GainsKeeper can help investors monitor wash sales, please see the example in "How GainsKeeper Helps Investors Tame Wash Sales."


What the Wash Sale Rule Really Means to Investors

If you are active in a particular stock, it is imperative that you monitor your wash sales period before you re-purchase the stock. After you have taken a loss, you need to be aware of the date you can repurchase a security and still claim the earlier loss on taxes. Investors may find themselves not being able to realize significant losses due to wash sales. Manually tracking the wash sale periods or using a portfolio service such as GainsKeeper that can account for wash sales, will prevent you from purchasing the stock in a wash sale period. Nothing is more frustrating than selling stock at a loss to offset your tax bill only to find out after January 1st that a wash sale disallowed the loss.

While you will eventually realize losses deferred by wash sales, avoiding them in the first place will help you maximize your investment performance.

How to Avoid Wash Sales

Wash sales can be avoided by waiting to repurchase replacement shares until after the 30-day window closes.

You can also avoid a wash sale by purchasing a similar security, rather than an identical stock, to the one you sold for a loss. For example, if you sold Yahoo for a loss and you were interested in investing in another portal stock, then you could buy Google within the 30-day window and not trigger a wash sale.