First: Congratulations on the successful merger of Kansas City Southern (KSU) and Canadian Pacific Railway (CP). Second: It’s no fun to receive a surprise tax bill related to the December 2021 merger, so we’ll try to outline the specifics.

Here are the rules around gain recognition when cash/property is received as part of an otherwise non-taxable merger/transaction: Your original cost basis is first applied or transferred to the shares of the acquiring company’s stock. If your cost basis is greater than the value of the acquiring company’s stock received, then the remaining cost basis is applied to the cash portion of the transaction. If your cost basis is less than or equal to the acquiring company’s stock received, any cash or property received in addition to the stock is taxed as a gain.

Case Study #1

You originally bought stock for $10,000 that was later acquired by another company for a total merger consideration of $20,000 ($15,000 for the acquiring company’s stock and $5,000 cash). In this case, your new cost basis in the acquiring company’s stock is $10,000 (where you now have an unrealized $5,000 gain as it’s worth $15,000) and $5,000 realized capital gain (since your cost basis was less than or equal to the stock received of the acquiring company).

Case Study #2

KSU and CP merger details: KSU shareholders received 2.884 shares of CP stock and $90 cash for each share of KSU stock in December 2021.

Now how would this transaction be reported on your 2021 tax return if you owned 1,000 shares of KSU at the time of the merger?

• Original KSU cost basis: $65,000.00 or $65.00 per share purchased > 1 year ago.
• Merger consideration: $298,657.40 total value received between CP stock and cash:
  • CP stock: 2,884 shares of CP stock worth $208,657.40 (1,000 shares of KSU * 2.884 shares of CP shares at $72.35 on the date of the transaction)
  • Cash: $90,000 (1,000 shares of KSU * $90 cash received per share)
  • Cash in lieu of fractional shares: Since the stock conversion part of the transaction led to a whole number (i.e., 2,884.00 shares versus 2,884.50 shares), no extra cash was distributed for fractional CP shares.
• New CP cost basis: $65,000 or $22.54 per share ($65,000 KSU cost basis / 2,884 new shares of CP). The cost basis remained unchanged (explained below).

Capital gain: Long-term capital gain of $90,000 realized and reported in tax year 2021. Per the example above, the cash received is treated as a capital gain in the year of receipt since this individual’s cost basis was less than the stock received of the acquiring company (CP in this case). This also left the new cost basis in CP to be unchanged from KSU.

Case Study #3:

Now what if the conversion of KSU shares to CP shares led to fractional CP shares? How would that impact the tax calculation? What if you owned 1,150 shares of KSU instead of 1,000 shares?

• Original KSU cost basis: $65,000.00 or $56.52 per share purchased > 1 year ago.
• Merger consideration: $343,456.01 total value received between CP stock and cash:
  • CP stock: 3,316 shares of CP stock worth $239,912.60 (1,150 shares of KSU * 2.884 shares of CP shares at $72.35 on the date of the transaction—see below for how the 0.6 of 3,316.60 shares is treated)
  • Cash: $103,500 (1,150 shares of KSU * $90 cash received per share)
  • Cash in lieu of fractional shares (result of 3,316.60 CP shares conversion to 3,316.00 CP shares): $43.41 (CP shares at $72.35 * 0.60) of which $31.65 will be treated as a capital gain in 2021.
    • Capital gain calculation: $31.65 [$43.41 cash received for a fractional share of CP stock – ($19.60 new CP cost basis per share * 0.60 shares)]. The new CP cost basis is calculated by dividing the original KSU total cost basis by the new CP shares received including fractional shares (i.e., $65,000 KSU cost basis / 3,616.60 CP shares).
  • New CP cost basis: $64,988.24 or $19.60 per share. The new CP cost basis is the KSU cost basis less the $11.76 cost basis used up when calculating the capital gain in the cash received in lieu of fractional shares.

Capital gain: Long-term capital gain of $103,531.65 realized and reported in tax year 2021 ($103,500 cash + $31.65 cash in lieu of fractional shares). Per the example above, the cash received is treated as a capital gain in the year of receipt since this individual’s cost basis was less than the stock received of the acquiring company (CP in this case).

Case Study #4:

What if you didn’t have as large of a gain on the position when the transaction happened? What if your cost basis was $280,000 instead of $65,000 for 1,150 shares?

• Original KSU cost basis: $280,000.00 or $243.48 per share purchased > 1 year ago.
• Merger consideration: $343,456.01 total value received between CP stock and cash:
  • CP stock: 3,316 shares of CP stock worth $239,912.60 (1,150 shares of KSU * 2.884 shares of CP shares at $72.35 on the date of the transaction—see below for how the 0.6 of 3,316.60 shares is treated)
  • Cash: $103,500 (1,150 shares of KSU * $90 cash received per share)
  • Cash in lieu of fractional shares (result of 3,316.60 CP conversion to 3,316.00 CP): $43.41 of which $0.00 will be treated as a capital gain in 2021.
    • Capital gain calculation: $0.00 [$43.41 cash received for a fractional share of CP stock – ($72.35 cost basis per share * 0.60 shares)]
  • New CP cost basis: $239,912.60 or $72.35 per share. The new CP cost basis equals the price of CP shares on the date of the transaction because the KSU cost basis was greater than the amount of CP stock received in the merger.

Capital gain: Long-term capital gain of $63,456.01 realized and reported in tax year 2021 [$103,500 cash – ($280,000 original KSU cost basis – $239,956.01 CP stock received, based on CP share value at $72.35 applied to 3,316.60 shares)]. Per the example above, only part of the cash received is treated as a capital gain since the $280,000 original KSU cost basis is greater than the amount of CP stock received. As such, the remaining cost basis is applied to the cash received until used up; then the remainder is treated as a capital gain.

Case Study #5:

What if you bought the KSU stock less than 1 year prior to the stock and cash merger transaction with CP? The only difference is that any gain realized would be treated as a short-term capital gain that is taxed at ordinary income tax rates for Federal income taxes. Per Case Study #4, the $63,456.01 gain would be treated as a short-term capital gain instead of a long-term capital gain.

Estimated taxes: Please be aware that you may need to make an estimated tax payment(s) for Federal and State (depending on what state you live in) income taxes to account for the realized capital gain portion of these transactions to avoid any penalties.

If you have any questions about the KSU and CP cash and stock merger or about any other financial planning topics, please contact the Merriman team.

Useful resources:

• https://www.irs.gov/pub/irs-pdf/p550.pdf (page 46)

Disclosure: The material is presented solely for information purposes and has been gathered from sources believed to be reliable. However, Merriman cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. It is not intended to serve as a substitute for personalized investment advice or as a recommendation or solicitation of any particular security, strategy or investment product. Nothing in these materials is intended to serve as personalized tax and/or investment advice since the availability and effectiveness of any strategy is dependent upon your individual facts and circumstances. Merriman is not an accounting firm- clients and prospective clients should consult with their tax professional regarding their specific tax situation.  Merriman does not provide tax, legal, or accounting advice, and nothing contained in these materials should be relied upon as such.