It’s not uncommon for publicly-traded companies to restructure based on changing market conditions or share prices. When companies merge, split their stock, or acquire competitors, it can raise the question of how to consolidate or restructure the company’s stock.
If such a corporate action generates fractional shares, the company’s leadership has a few options for how to proceed: They could distribute the fractional shares, round up to the nearest whole share, or pay cash in lieu of fractional shares.
What is Cash In Lieu?
With cash in lieu, one party elects an exchange of value to be settled in cash as opposed to the underlying asset or services rendered. In investing, cash in lieu refers to funds received by investors following structural company changes that unevenly disrupts existing stock prices and quantities.
Following a corporate action, the newly-adjusted stock supply can be uneven and often results in fractional shares. When the stock’s exchange ratio does not equal a whole number of new shares, rather than holding or converting fractional shares to whole shares, some companies opt to aggregate and sell all of the fractional shares in the open market.
After the sale, the funds are paid to investors in cash in the form of a check or account deposit. The company’s board ultimately determines how the company will maintain or return value to investors and how that value will be distributed. Opting to distribute cash in lieu is a company’s method of disposing of fractional shares and returning the cash balance to investors, proportionate to prior holdings.
Why Investors Receive Cash in Lieu
Investors can receive cash in lieu for a variety of reasons involving company restructuring that affects the number of outstanding shares, stock price, or both.
There are several company events that can lead to investors receiving cash in lieu of fractional shares.
A stock split occurs when a company’s board of directors determines that their company’s strongly performing stock price may be too high for new investors. To make the stock price look more attractive to more investors and gain more liquidity and marketability, a stock split is executed to artificially lower the stock’s price by issuing more shares at a fixed ratio while maintaining the company’s unchanged value.
Depending on the predetermined ratio, a stock split could cause fractional shares to be generated. For example, a three-for-two stock split of a stock worth $111 would create three shares for every two shares each investor holds. Thus, a stock split would cause any investor with an odd number of shares to receive a fractional share.
However, if the company’s board isn’t keen to hold or deal with fractional shares, they will distribute investors’ whole shares and liquidate the uneven remainders, thus paying investors cash in lieu of fractional shares. The ratio or cash rate as set by the company performing the stock split can be located on the company’s corresponding SEC 8-K document.
Conversely, a company may execute a reverse stock split because a stock’s prices are too low and they want to artificially raise them. If stock prices get too low, investors may become fearful to buy and the stock risks being delisted from exchanges.
When a stock undergoes a reverse stock split, each share is converted into a fraction of a share but higher-priced shares are issued to investors according to the reverse split ratio . For example, a stock valued at $3.50 may undergo a reverse one-for-10 stock split. Every 10 shares is converted into one new share valued at $35.00. Investors who own 33 shares or any number indivisible by 10 would receive fractional shares unless the company decides to issue cash in lieu of fractional shares.
Companies may notify their shareholders of an impending reverse stock split on Forms 8-K, 10-Q, or 10-K as well as any settlement details if necessary.
Merger or Acquisition
Company mergers and acquisitions (M&As) can also create fractional shares. When companies combine or are absorbed, they combine new common stock using a predetermined ratio, which often results in fractional shares for investors in all involved companies.
In these cases, it’s rare for the ratio of new shares received to be a whole number. Companies may opt to return whole shares to investors, sell fractional shares, and disburse cash in lieu to investors.
If an investor owns shares of a company that spins off part of the business as a new entity with a separately-traded stock, shareholders of the original company may receive a fixed amount of shares of the new company for every share of the existing company held.
How Is Cash in Lieu of Fractional Shares Taxed?
Just like many other forms of investment profits, cash in lieu of fractional shares is taxable , even though it was acquired without the investor’s endorsement or action. The stock’s company may send investors a check followed by an IRS Form 1099-B at year-end with a “cash in lieu” or “CIL” notation.
Some investors may simply report the payment on the IRS Form 1040’s Schedule D as sales proceeds with zero cost and pay capital gains tax on the entire cash settlement. However, the more accurate and tax-advantageous method would apply the adjusted cost basis to the fractional shares and pay capital gains tax only on the net gain.
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How to Report Cash in Lieu of Fractional Shares
Calculating the cost basis for cash in lieu of fractional shares is a little tricky due to the change of share price and quantity. The new stock issued is not taxable nor does the cost basis change, but the per-share basis does.
Consider the following example:
• An investor owns 15 shares of Company X worth $10.00 per share ($150 value).
• Investor’s 15 shares have a $7.00 per share cost basis ($105 total cost basis).
• Company X declares a 1.5 stock split.
The investor is entitled to 22.5 shares valued at $6.67 each but the company states they will only issue whole shares. Therefore, the investor receives 22 shares plus a $2.73 cash in lieu payment for the half share.
The investor’s total cost basis remains the same, less the cash in lieu of the fractional shares. However, the adjusted cost basis now factors in 22 shares instead of 15, equaling a $4.66 per share cost basis and a $2.33 fractional share cost basis. Finally, the taxable “net gain” for the cash payment received in lieu of fractional shares equates to $2.725 – $2.33 = $0.39.
It’s not always possible to anticipate a company being restructured and how it will affect shareholders’ stock. In the event the company doesn’t wish to deal with fractional shares, it’s important for shareholders to understand the alternatives such as cash in lieu of fractional shares, and how it affects them. While cash in lieu can be burdensome, investors can be made whole and can then proceed on their own accord.
There are many reasons investors consider fractional shares worth buying to add to their investment portfolio. For individuals looking to invest in fractional shares with the help of a simple account setup and no fees, SoFi Invest® can help.
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