How to Allocate Cost Basis After a Spin-Off

When a parent company distributes shares of a subsidiary to shareholders as a spin-off, the IRS requires shareholders to split their original cost basis in the parent between the parent shares they keep and the new spun-off shares they receive. The split is not 50-50; it uses the relative fair market value of each security on the distribution date. A shareholder who bought the parent at $100 per share now owns two public companies, and must calculate how much of that $100 basis belongs to each.

Why cost basis matters in a spin-off

A spin-off is a non-taxable corporate reorganization. The shareholder doesn’t owe federal income tax when the spun-off shares are distributed. But the shareholder’s later gain or loss on each stock depends critically on the cost basis they assigned to it on day one.

Imagine a shareholder bought 100 shares of Parent Co. at $100 per share, building a $10,000 cost basis. Parent spins off Child Co., and the shareholder now owns 100 Parent and 50 Child. The market prices them at $60 (Parent) and $80 (Child) on distribution day. The shareholder must allocate the original $10,000 basis between the two securities, not arbitrarily but by a strict IRS formula.

Get this wrong, and you’ll either overpay tax when you sell, or face IRS audit and penalties. The calculation is straightforward, but the tax filing can be fiddly.

The fair-market-value ratio method

The IRS mandates that shareholders use the relative fair market value on the distribution date to split basis. The formula is:

Parent cost basis = (Parent FMV on distribution date ÷ Total FMV of both) × Original basis

Spun-off cost basis = (Spun FMV on distribution date ÷ Total FMV of both) × Original basis

Worked example:

• Original investment: 100 shares at $100 = $10,000 basis
• Distribution: 100 Parent + 50 Spun-off
• Prices on distribution day: Parent $60, Spun $80
• Parent FMV: 100 × $60 = $6,000
• Spun FMV: 50 × $80 = $4,000
• Total FMV: $6,000 + $4,000 = $10,000

Parent basis = ($6,000 ÷ $10,000) × $10,000 = $6,000 Spun basis = ($4,000 ÷ $10,000) × $10,000 = $4,000

Now suppose the shareholder sells all Parent shares at $70 each:

• Proceeds: 100 × $70 = $7,000
• Basis: $6,000
• Gain: $1,000

And sells all Spun at $90 each:

• Proceeds: 50 × $90 = $4,500
• Basis: $4,000
• Gain: $500

Total gain on both sales: $1,500. That gain, combined with any gains or losses from other transactions, goes on Schedule D, and the shareholder owes capital gains tax.

Where to find the fair market value on distribution day

Most brokers will report the distribution FMV automatically on the customer’s tax statement. The spun-off company typically releases an estimated FMV per share in the prospectus, and the SEC files that with the form S-1 or form 10. Financial data providers like Bloomberg, FactSet, and Yahoo Finance also publish the distribution-day prices.

However, the formal IRS requirement is that fair market value should reflect “the price at which the stock would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.”

In practice, this is usually the closing price on the distribution date. If the stock gapped wildly on opening or closed near the session extremes, a shareholder could argue for a different price—but the burden of proof is on the taxpayer, and the IRS typically defers to closing prices.

Cost basis for fractional shares

Some spin-offs result in fractional shares. If a shareholder receives 0.5 or 2.3 shares of the spun company, the broker may offer a cash payment in lieu or allow the shareholder to buy or sell fractional shares to round out a whole number.

If the shareholder receives cash for the fractional share, that cash is treated as proceeds of a sale, and the basis allocable to that fractional share must be computed. This can be fiddly but follows the same ratio logic.

Example:

• 100 shares at $100 = $10,000 basis
• Spin results in 100 Parent + 49.5 Spun
• Broker sends $40 for the 0.5 fractional Spun share
• Parent FMV = $6,000; Spun full amount would be $3,960; Spun fractional = $40
• Total FMV = $10,000

Spun fractional basis = ($40 ÷ $10,000) × $10,000 = $40

• Proceeds from cash-in-lieu: $40
• Basis: $40
• Gain on fractional: $0

The remaining Spun shares (49.5) would carry basis of ($3,960 ÷ $10,000) × $10,000 = $3,960.

Holding period for the spun-off shares

An important tax point: when you receive spun-off shares in a non-taxable distribution under IRC Section 355, your holding period for those shares includes the time you held the parent. If you owned Parent for 3 years before the spin, the spun shares are deemed held for 3 years as well.

This matters for long-term capital gains tax rates. If you sell the spun shares immediately after distribution, you may qualify for long-term rates because your holding period is tacked from the original purchase.

Reporting on Form 8949 and Schedule D

When you later sell shares from a spin-off, you report the transaction on Form 8949 (Sales of Capital Assets) or on Schedule D directly if using simplified reporting. You must include:

• Description of the spun security (e.g., “Spun Inc., 50 shares”)
• Date acquired (original spin distribution date)
• Date sold (when you liquidated)
• Cost basis (the amount calculated using the FMV ratio)
• Proceeds of sale
• Gain or loss

The IRS cross-checks long-term vs. short-term treatment, so accuracy matters. Many brokers now automatically populate this data from their internal records, but if you traded after the spin or if your broker has older systems, you may need to input the basis manually.

What if the spin-off is not IRC Section 355 compliant?

Most well-structured spin-offs meet the requirements of IRC Section 355 and are non-taxable to shareholders. But in rare cases, a spin-off might fail to qualify—perhaps because the parent retains too much control of the spun company, or the transaction’s principal purpose is tax avoidance rather than business purposes.

If Section 355 doesn’t apply, the distribution is taxable as a dividend and subject to dividend tax rates. In that case, the cost basis of the spun shares is their fair market value on distribution, not an allocation of the parent basis. This is a far worse outcome and is why companies spend heavily on tax counsel to ensure Section 355 compliance.

A shareholder in doubt should consult a tax professional or review the proxy statement or prospectus, where the company will discuss the tax treatment of the spin.

See also