Publicly traded companies like to promote their stock to individual investors. One method companies use to generate interest is splitting shares, meaning issuing existing stockholders additional shares. Each stockholder ends up with more shares, although the investment value doesn’t change. This may sound like a smoke-and-mirrors ploy, but stock splits can bring you real benefits.
Stock Splits
When a board of directors decides to split the company’s stock, it issues new shares to all shareholders in the same proportion. If the stock split is 2-for-1, for example, each shareholder gets one new share for each share she owns. In a 3-for-2 stock split, she receives one additional share for every two shares she owns. The value of her investment does not change because the price per share is adjusted to compensate. Suppose she owns 50 shares at $30 per share, worth $1,500. After the 3-for-2 split, she has 75 shares at $20 per share, also equal to $1,500.
Fractional Shares
A 3-for-2 stock split may result in a fractional share. For instance, if you owned 125 shares of a stock, after the split you’d have 187.5 shares. Typically, rather than keep track of fractional shares, a company pays you cash in lieu of the fractional share. If the stock was valued at $30 per share before the 3-for-2 split, the price is $20 after the split. You would receive $10 for the half-share, leaving you with 187 whole shares.
Tax Implications
Because you do not sell any shares and the value of your investment does not change, a stock split does not create a tax liability, meaning the Internal Revenue Service isn’t going to want a cut. In the event you receive cash in lieu of a fractional share, the correct procedure is to allocate a proportional part of your original investment, called your cash basis, to the fractional share and report only your capital gain or loss. Suppose you paid $15 per share for stock that is now worth $30 per share. After a 3-for-2 split, your cost basis is $10 per share and one share is worth $20. If you receive $10 cash in lieu of the half-share, the cash basis for the fractional share is $5 and you report a capital gain of $5.
Significance
Stock splits make shares more affordable for small investors. The announcement of a stock split is generally perceived as a positive event by investors and draws their attention to the company’s stock. Typically, stocks that split tend to perform better than stocks that don’t.
