7512 / How is a shareholder taxed when, as part of a stock dividend, the shareholder receives cash or scrip in lieu of fractional shares?

If a shareholder receives cash in lieu of a fractional share, the regulations state that the shareholder will be taxed as though the shareholder had actually received that fractional share and then the corporation had redeemed it.¹ Unfortunately, it is not clear whether all the redemption rules of IRC Section 302 apply for the purpose of determining whether the cash is treated as having been received in a distribution to which IRC Section 301 applies (i.e., as a dividend to the extent of the corporation’s earnings and profits) or as proceeds from the sale or exchange of the fractional share (i.e., leading to capital gain or loss, depending on the holder’s basis in the fractional share).

But it is clear that if the corporation, with the approval of the shareholders, combines into whole shares the fractional shares due the shareholders, sells them in the market, and distributes the proceeds of the sale, the shareholders who receive the proceeds in lieu of a fractional share are treated as though they had received the fraction and made the sale themselves. Each such shareholder thus has a gain or loss to the extent of the difference between the cash received and the tax basis in the fractional share.² Similarly, if a shareholder is allowed to elect to have the corporation sell scrip certificates that would otherwise be distributed in lieu of a fractional share and pay the proceeds to the shareholder, the shareholder is treated as having sold the scrip for a capital gain or loss to the extent of the difference between the cash received and the tax basis in the scrip certificate.³

If a shareholder does receive scrip certificates in lieu of a fractional share, the shareholder realizes no taxable income on the receipt.⁴ The shareholder will, however, be taxed on the sale or exchange of the scrip in the same manner as when the shareholder sells the whole shares of stock received in the stock dividend, see Q 7509.

The tax basis and holding period of fractional shares or scrip received in a nontaxable stock dividend are determined in the same manner as the whole shares received in that dividend, see Q 7510.

See Q 702 for an explanation of the treatment of capital gain.