Buyout Turns Long-Term Investment Into Short-Term Tax Problem

What happens when a corporation agrees to a cash merger before a shareholder is ready to cash out? And what happens to the value of a bond you are holding when interest rates rise?

We'll tackle those questions and a Roth IRA issue in this week's Tax Forum.

If you have any other questions, please send them along to [e-mail]. Don't forget to include your full name.

Cashing Out Prematurely

A company I'm long, Corporate Express, recently was bought by an Amsterdam company (Buhrmann) which does not trade on any U.S. boards. My shares will be liquidated at the buyout price of $9.70, but I have not yet held them for 12 months, as I had intended to. Am I stuck with the 28% capital-gains tax? Is there an alternative? The shares will be liquidated roughly two months this side of 12.

-- Michael Pagelsdorf

Michael,

If you are a shareholder in a company being acquired in a cash deal, you have to sell your shares to the acquiring company.

Unfortunately, the day you sell your shares to Buhrmann is the day you must use to determine whether your gain or loss is long term or short term. If you have a gain, you'll owe capital-gains tax at your ordinary income tax rate rather than at the long-term preferential rate of 20% (there's no longer a 28% capital-gains rate). Sorry. It doesn't matter that your intent was to hold this stock for the long haul.

Unfortunately, it is probably too late to give the stock away to avoid incurring these gains. Thanks to a recent court case, there is a point in the merger process where the stock essentially becomes cash, even though you haven't received money for it yet. This late in the game, if you donated the shares, the tax court might claim that you're actually donating the cash from the swap. So you still would owe the capital-gains tax.

For more details on cash mergers, see this previous Tax Forum. Also check out the Corporate Express Web site. If you click "About us" and go to the investor relations Q&A section, there is more detail on your particular transaction.

Roth Double Shot

Tony Chen asks, "If I convert this traditional IRA to a Roth IRA in 1999, can I still contribute $2,000 to a Roth IRA for 1999?" Steve Chiang asks whether the after-tax IRA contributions he made in years past could be rolled over into a Roth.

Let's tackle both questions together to create one big Roth reminder.

Tony and Steve,

Total contributions to all your IRAs cannot exceed $2,000 annually. It does not matter how you split that amount up. So if you already made a $2,000 contribution to your traditional IRA for 1999, you can't put more money into a Roth.

But depending on the level of your adjusted gross income, you may be able to split your contribution between the two accounts, suggests Rande Spiegelman, a senior manager in KPMG's investment advisory services group in San Francisco.

For instance, if your adjusted gross income is around $35,500, only $1,000 will count as a deductible contribution to your traditional IRA because there is a phase-out of the $2,000 limit when your AGI is between $31,000 and $41,000 (assuming you are single and you are covered by a retirement plan at work). In that case, you can convert the IRA to a Roth and make another $1,000 contribution for 1999.

All your IRA contributions can be rolled into a Roth IRA. Whether they were deductible or nondeductible will determine how much tax you owe at the time of the conversion.

You will not owe tax on any after-tax (nondeductible) contributions -- otherwise you'd be paying tax twice on that money. Just report those nondeductible contributions on Line 1 of Form 8606 - Nondeductible IRAs to alert Uncle Sam.

Be sure to check out our big Roth IRA story from earlier in the year.

Bond Bewilderment

Here's what my feeble little mind doesn't understand: If I buy a $1,000 10-year bond with a coupon or interest rate of 6%, I think I will get $30 twice a year for the 10 years.

What if I decide to sell that bond with the fixed rate of 6%? This is where I get a little lost. That 6% is never going to change, right? But after three years, let's say the interest rate has gone up to 6.5%, nobody's is going to pay a $1,000 for my 6% bond, right? So how does the yield fit in?

My 6% bond yields always $60 annually, right? So if I want to sell it competitively with the later issue that has a 6.5% coupon, will I have to sell it cheaper? So if I sell my $1,000 bond for $990 and the person who bought it will still get $60 annually, his yield is now greater at 6.06%, right?

But when the Fed goes to a tightening bias, do bond prices shoot up in anticipation of higher interest rates? And which bonds are the Fed raising interest rates on -- long, short or intermediate? Help!

-- Jay Trueba

Jay,

Your mind is hardly feeble. You've pretty much got your facts straight.

First, let's assume we're discussing Treasury bonds.

Second, here's a bond basic: Interest rates go up, bond prices go down. Interest rates go down, bond prices go up.

The coupon rate never changes. It's always, in your case, 6%. But depending on prevailing bond prices, the interest rate will change.

Let's use a $1,000 bond with a 6% ($60) coupon that matures in November 2027 as an example.

If bond prices go down, or a later issue comes out with a higher coupon, you're right, you're not going to be able to sell your bond for $1,000 when others can get the same bond for, say, $990.

If you sell your bond for $990, remember, the coupon rate won't change. But because interest rates go up when bond prices go down, that $60 will now equate to around 6.07% (interest rate up) because the bond's price was $990 (bond price down).

Check out SmartMoney.com's bond calculator to determine the yield on different bond prices.

But note that, after the sale, you'll have a $10 loss to report on your Schedule D - Capital Gains and Losses because you originally paid $1,000 for the bond.

On the flip side, if bond prices increase, your bond is a hot commodity. Let's say you sell for around $1,070. The $60 coupon rate will bring the yield down to 5.5%. And you'll have a $70 capital gain to report and pay tax on.

On Tuesday, the Federal Reserve increased interest rates. But that was the federal funds rate -- the rate banks charge each another for overnight loans. The Fed also controls the discount rate -- the interest rate charged by the Fed for short-term loans to banks.

But it does not directly control the rates on bonds. The bond market is affected in the same way the stock market is affected -- news and rumors move prices.

For more detailed bond info, check out our series, Buying Bonds: A Primer.