It’s not uncommon for publicly-traded companies to restructure based on changing market conditions or their stock price. When companies merge, acquire competitors, or split their stock, it can raise the question of how to consolidate or restructure the company’s outstanding shares.
If such a corporate action generates fractional shares for investors, the company’s leadership has a few options for how to proceed: They could distribute the fractional shares to shareholders, round up to the nearest whole share, or pay cash in lieu of fractional shares. Investors need to be aware of cash in lieu because it can affect a portfolio and taxes.
What Is Cash in Lieu?
Cash in lieu is a type of payment where the recipient receives money instead of goods, services, or an asset.
In investing, cash in lieu refers to funds received by investors following structural company changes that unevenly disrupt existing stock prices and quantities. Instead of receiving fractional shares after a stock split or a merger, investors receive cash.
Following corporate actions like a stock split or a merger, the newly-adjusted stock supply can be uneven and often results in fractional shares. Rather than holding or converting fractional shares to whole shares, some companies opt to aggregate and sell all of the partial shares in the open market. After the sale of these shares, the company will pay cash to the investors who did not get fractional shares.
The company’s board ultimately determines how the company will maintain or return value to investors. Opting to distribute cash in lieu is a company’s method of disposing of fractional shares and returning the cash balance to investors that’s proportionate to prior holdings.
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Why Investors Receive Cash in Lieu
Investors can receive cash in lieu for various reasons involving company restructuring that affects the number of outstanding shares, stock price, or both.
The following events can lead to investors receiving cash in lieu of fractional shares.
A stock split occurs when a company’s board of directors determines that the company’s high share price may be too high for new investors. The company will then execute a stock split to lower the stock’s price by issuing more shares at a fixed ratio while maintaining the company’s unchanged value. Companies will often approve a stock split so its share price looks more attractive to more investors and gains more liquidity and marketability.
Depending on the predetermined ratio, a stock split could generate fractional shares. For example, a 3-to-2 stock split would create three shares for every two shares each investor holds. If you own five shares of the stock, you would have 7.5 shares after the split. Thus, a stock split would cause any investor with an odd number of shares to receive a fractional share.
However, suppose the company’s board isn’t keen to hold or deal with fractional shares. In that case, they will distribute investors’ whole shares and liquidate the uneven remainders, thus paying investors cash in lieu of fractional shares.
Conversely, a company may execute a reverse stock split because its stock price is too low, and they want to raise it. If stock prices get too low, investors may become fearful of buying the stock, and it may risk being delisted from exchanges.
When a stock undergoes a reverse stock split, investors usually receive one share for a specific number of shares they own, depending on the reverse split ratio. For example, a stock valued at $3.50 may undergo a reverse 1-for-10 stock split. Every ten shares are converted into one new share valued at $35.00. Investors who own 33 shares, or any number not divisible by ten, would receive fractional shares unless the company decides to issue cash in lieu of fractional shares.
Companies may notify their shareholders of an impending stock split or reverse 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 publicly-traded companies combine or are bought, investors will often receive stock as part of the deal using a predetermined ratio. These stock purchase deals often result 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 full shares to investors, sell fractional shares, and disburse cash in lieu to investors.
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Suppose an investor owns shares of a company that spins off part of the business as a new entity with a separately-traded stock. In that case, shareholders of the original company may receive a fixed amount of shares of the new company for every share of the existing company held. Depending on the structure of the spinoff, investors may receive cash in lieu of fractional shares of the new company.
How Is Cash in Lieu of Fractional Shares Taxed?
Like many other forms of investment profits, cash in lieu of fractional shares is taxable, even though the payment occurred without the investor’s endorsement or action. Investors will pay a capital gains tax on the payment.
However, if you have a tax-advantaged account, like a 401(k) or individual retirement account (IRA), you do not have to worry about reporting or paying taxes on the gains of cash in lieu payment.
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
As noted above, if you receive cash in lieu of fractional shares, you’ll have to pay capital gains taxes on the windfall. To ensure you’re paying the right amount of tax, you’ll have to take a few extra steps to determine your cost basis and accurately report the cash in lieu payment.
Gather Your Documents
Investors may receive the cash through their investment broker and an IRS Form 1099-B at year-end with a “cash in lieu” or “CIL” notation. To accurately report your cash in lieu payment, you’ll need the Form 1099-B, your original cost basis, the date you purchased the stock, the date of the stock split or other corporate action, and the reason why you received the cash in lieu of fractional shares.
Calculate Your Cost Basis
Calculating the cost basis for cash in lieu of fractional shares is a little tricky due to the share price and quantity change. 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)
• The investor’s 15 shares have a $7.00 per share cost basis ($105 total cost basis)
• Company X declares a 1.5-to-1 stock split
After the stock split, the investor is entitled to 22.5 shares (1.5 x 15 shares = 22.5 shares) valued at $6.67 each ($150 value / 22.5 shares = $6.67 per share), but the company states they will only issue whole shares. Therefore, the investor receives 22 shares plus a $3.34 cash in lieu payment for the half share ($6.67 x 0.5 = $3.34 per 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 $4.77 per share cost basis ($105 total cost basis / 22 shares = $4.77 cost basis) and a $2.39 fractional share cost basis.
Finally, the taxable “net gain” for the cash payment received in lieu of fractional shares equates to:
$3.34 cash in lieu payment – $2.39 fractional share cost basis = $0.95 net gain.
So, rather than paying capital gains taxes on the $3.34 payment, you pay taxes on the $0.95 gain. You report this figure on the IRS Form 1040’s Schedule D.
It’s not always possible to anticipate a company’s actions, like a merger or stock split, and how it will affect shareholders’ stock. If the company doesn’t wish to deal with fractional shares, shareholders need to understand the alternative payments, such as cash in lieu of fractional shares, and how it affects them. While cash in lieu can be burdensome, knowing the nuances of the payment and how it is taxed may benefit your portfolio.
Though you may receive cash in lieu of fractional shares, investors may still consider fractional shares to add to their investment portfolio. For individuals looking to invest in fractional shares with the help of a simple account setup, opening an online brokerage account with SoFi Invest® can help. With the SoFi app, you can trade stocks, exchange-traded funds (ETFs), and fractional shares with no commissions for as little as $5.
Is cash in lieu of fractional shares taxable?
If you receive cash in lieu of fractional shares, the cash is taxable. The payment can be taxed as a short-term or long-term capital gain, depending on how long you’ve held the stock.
Is cash in lieu a dividend?
Investors can receive cash in lieu of fractional shares for a dividend payment. However, cash in lieu is not a dividend and is not taxed like a dividend.
Is cash in lieu a capital gain?
Cash in lieu is treated as a capital gain because the IRS considers it a stock sale. When you receive cash in lieu of fractional shares, you may have to pay capital gains taxes on the payment.
What is a cash in lieu settlement?
A cash in lieu settlement is an agreement between two parties in which one party agrees to pay the other party an agreed-upon amount of cash instead of some other form of payment or consideration.
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