Stock Splits and Reverse Stock Splits

How they can affect stock value.

When a corporation divides up its authorized and issued shares into a greater number of shares, i.e., two shares for every old one, it is termed a stock split.

From a legal viewpoint, a stock split results in an increase in the number of shares outstanding and a corresponding decrease in the par or stated value (in the case of no par value stock given a stated value) per share. A stock decrease, although it results in an increase in the number of shares outstanding, does not decrease the par or stated value of the shares. Thus, when the board of directors votes to split its stock, it does not change total shareholders' equity but merely increases the number of shares owned by the shareholders.

EXAMPLE The Gin Rummy Playing Card Corporation had 1,000 shares of $10 par value common stock outstanding when its board voted to split the stock in half. This action reduces the par value of the stock to $5 and increases the shares to 2,000 shares outstanding. The corporation's shareholders' equity section both before and after the stock split, assuming retained earnings of $5,000, would appear as follows:

Stockholders' Equity Before Stock Split

Common Stock:

1,000 shares at $10 par $10,000

Retained Earnings 005,000

$15,000

Stockholders' Equity after Stock Split

Common Stock:

2,000 shares at $5 par $10,000

Retained Earnings 005,000

$15,000

A corporation can also declare a reverse stock split where outstanding shares are combined into a lesser number of the same class, i.e., one new share for every three outstanding.

A stock split and a reverse stock split require board action. In some states, it may also require advance shareholder approval. The articles of incorporation must also be amended to change the par value or stated value of the shares.

TAX CONSEQUENCES There are no tax consequences to a stock split except to divide the cost basis of each share in case of a split, or to multiply the basis of the stock in case of a reverse stock split.

EXAMPLE 1 Roy Hamilton bought 100 shares of the Zebra Maintenance Corp. for $1,000. One year later, the corporation votes to split the stock, i.e., two shares for every old one. The old cost basis of $10 per share ($1,000/100 shares) is reduced after the split to $5 per share ($1,000/200 shares). Should Roy later sell 100 shares for $2,000, his capital gain, for tax purposes, would be $1,500 ($2,000 sales price - $500 [100 shares sold Ą $5]).

EXAMPLE 2 Same facts as in EXAMPLE 1, except that Zebra votes a reverse stock split, i.e., one new share for every five shares outstanding. The old cost basis of $10 per share ($1,000/100 shares) is increased to $50 per share ($1,000/20 shares). Should Roy later sell ten shares for $2,000, his capital gain, for tax purposes, would be $1,500 ($2,000 sales price - $500 [10 shares sold Ą $50]).

Note that both a stock dividend and stock split do not involve an expenditure of corporate assets.

Fractional Shares (or Scrip)