It Pays to Know Your Rights

The Right to Choose

OK, so you have 1,000 shares, plus 1,000 rights to buy 1,000 more shares at 40 cents. (Keep in mind that this is a loose example -- these numbers are similar to Ericsson's plan, but the various scenarios are not specific to Ericsson.) Now there's the question of what to do with those rights.

Investors generally have three options: Hold the right until it expires, sell it on the secondary market (if they're transferable and a market for them develops), or exercise the right and buy the shares.

Holding the right until expiration typically just eliminates your option to buy shares, and any basis that had been allocated to the rights reverts back to your original shares. In the example we've been using, you'd still own 1,000 shares of Ericsson with a $700 basis. If the rights lapse, you don't get to claim a loss.

If you sell the right on the secondary market, your basis in the right would be either zero, if no allocation was necessary, or whatever the allocated amount was determined to be -- in this case, $200. So if you're able to sell those rights for 40 cents each ($400), you'd have a gain of $200. (If no allocation were necessary, the entire $400 would be considered gain.) The holding period of the rights is the same as the holding period of your shares. So if you bought the shares more than a year ago, you'll owe a 20% capital gains tax on your $200 gain. If you bought the shares less than a year ago, the gain from the sale of the rights would be taxed at your ordinary income tax rate.

OK -- we're almost there.

Lastly, if you exercise the rights and purchase the shares, your basis is what you paid for them (40 cents a share) plus whatever basis had been allocated. The holding period begins on the date of exercise, so you'll have to hold off on selling those shares for at least a year from the date of exercise to reap the lower 20% capital gains tax rate.

Every rights plan is somewhat different, and investors should weigh the various options before making any decisions. After all, many companies issuing rights are troubled -- and you will be too if you go through a tax hassle for rights that end up being wrongs.

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