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Beleaguered and cash-strapped companies have hit upon an old tactic for raising some badly needed capital: rights offerings.

In recent months,




Allied Capital



Chartered Semiconductor


have all gained approval from the

Securities and Exchange Commission

to implement their rights plan.

If the past few years have taught us anything, it's that nothing comes easy on Wall Street. Investors need to understand the tax implications of these rights, particularly how any profits will be taxed. Let's work through a few scenarios resulting from a rights grant.

But first, a few basics. A rights offering is when a company offers current shareholders the "right" to buy a fixed number of additional shares for a fixed price within a fixed period. The number of rights is based on how many the investor currently owns, and the rights generally enable the investor to purchase the additional shares at a discount to where they're currently trading.

When rights are transferable -- as they frequently are -- a secondary market often develops in which the rights themselves can be bought and sold on the open market. Investors frequently see these offerings as a boondoggle. Indeed, sometimes they are.

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Companies, such as Allied Capital, often position rights offerings as a "reward" for long-term investors. But that reward can backfire -- as was the case with Ericsson -- if the market reprices all shares to reflect the discount.

The bottom line is that companies issue these rights for their own benefit; it's frequently an easy way to raise cash that requires less effort, and disclosure, than a secondary offering.

Duke Energy

(DUK) - Get Duke Energy Corporation Report

recently took the latter route, selling 54 million shares in a secondary offering expected to raise $1 billion for debt repayment. Both secondary and rights offerings dilute existing shares, although rights offerings can actually serve as something of a boon to existing investors able to pick up additional shares at a discount (or sell the rights).

Rights offerings are also common to closed-end funds, which cannot otherwise issue additional common stock.

As with all investment decisions, investors need to be aware of the tax implications of rights offerings. The various scenarios can prove tricky, so you should consult a tax adviser before making any decisions. Here, though, are the essential topics you'll need to tackle.

Know Your Rights -- and Your Basis

First, establish that the rights themselves are nontaxable, advises Mark Luscombe, a CPA with tax law and research provider CCH. "The declaration of a right is generally not a taxable event," Luscombe says. Rights would be taxable if the offer did not go to all shareholders; if they were offered in lieu of cash; if the distribution of rights was disproportionate among shareholders; if they are distributed for convertible preferred stock, common and preferred stock or dividend and preferred stock. Again, these days most companies issue nontaxable rights.

The second -- and crucial -- step is to determine the cost basis of the right. Cost basis is usually what you've paid for an investment, but in this case part of the cost basis of the shares you already own (the ones that qualified you to receive the rights to buy more) might have to be allocated to the rights.

Determining the proper basis for both the existing shares and the rights is essential, since that's what the Internal Revenue Service needs to know when you eventually sell. The difference between the basis and the selling price is the gain or loss, and gets taxed or deducted accordingly.

If the right is for less than 15% of the fair market value of the stock, no reallocation is necessary. For instance, say Ericsson is trading at $1 per share (that's just a few cents more than the stock's price when the rights offer was announced). If the rights had been discounted so that each right bought one share for less than 15 cents, no basis allocation would be required.

Ericsson's rights, however, were issued at roughly $0.40 -- more than 15% of what Ericsson was trading at the time of issue. Presumably, then, investors would have to transfer some of the basis in their existing shares and attribute it to the rights.

Here's how that works: The basis gets distributed proportionately across your existing shares and the rights. Let's say you owned 1,000 shares of Ericsson, which you bought at 70 cents each. Your basis in the shares is then $700. Multiply that by the current fair market value of the shares -- in this case, $1,000. Now divide that amount ($70,000) by the fair market value of the shares and rights combined -- in this case, $1,400. (That's 40 cents per right multiplied by 1,000, since Ericsson awarded one right per share, plus the $1,000 fair market value of the shares.) The result of ($700 x $1,000) / $1,400 is $500. Therefore, the basis for the existing shares is reduced from $700 to $500.

Next, the same calculation is applied to the rights. The $700 basis in the shares is multiplied by $400, the fair market value of the rights. The result, $280,000, is again divided by the combined fair market value of the shares and rights ($1,400) to arrive at a $200 basis in the rights. Essentially, the $200 of basis that was sliced out of the first calculation is what gets allocated to the rights.


The calculation for determining basis allocation is the same regardless of whether the shares you own can be sold for a profit or for a loss, according to tax attorney Bob Scharin, editor of Warren, Gorham & Lamont/RIA's

Practical Tax Strategies

, a monthly journal written for tax professionals. If you had bought Ericsson for $10 a share instead of 70 cents per share, for instance, the basis would still get allocated the same way, according to the same formula.

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.