I have received shares of Avaya (AV) in my brokerage account due to the spinoff from Lucent Technologies (LU) . My question is: What is the cost basis of those shares? My brokerage account states those shares are a dividend. Is my cost $0, since I did not buy those shares? Or is the basis the price of the shares when they were entered into my account?

-- Don Chrisman

Don,

It's becoming one heck of a family tree.

As a reminder, Lucent was spun off from

AT&T

(T) - Get Report

in 1996, 12 years after AT&T's local phone monopoly was broken up into seven

Baby Bells

.

On Oct. 2, 2000, Avaya, the corporate telecommunications company, was spun off from Lucent. So Avaya is a spinoff from a spinoff -- essentially a grandchild for Grandma Bell.

Because Lucent is the nation's second-most widely owned stock, with about 5.3 million shareholders, there are now almost as many Avaya holders. Avaya becomes the third-most widely held stock, with about 5 million shareholders, including 3 million individual investors. (Note: Lucent shareholders needed at least 12 shares to be eligible for the Avaya stock distribution, so not everyone qualified.)

For every share of Lucent held, shareholders received 0.0833 share of Avaya (or one Avaya share for every 12 Lucent shares). The company is calling the distribution of Avaya a "special dividend," but you're not getting a cash distribution (unless you have fractional shares, and we'll get to that in a minute). You're getting actual shares of Avaya. While this distribution of shares is not a taxable event to you now, those new shares do have a cost to you.

Here's how the math works for the Avaya spinoff and determining cost basis. You must allocate 5.476% of your basis (i.e. the original cost, adjusted for any splits or dividend reinvestments) in a Lucent share to your new Avaya share, says Denise Davidson, editor of

Capital Changes

, a product of

CCH

, the supplier of tax-law information in Riverwoods, Ill. The remaining 94.524% of your cost basis will go to your original Lucent shares. (These percentages are based on the average of both stocks' high and low prices on Oct. 2.)

Let's assume you purchased 100 shares of Lucent back in January for $70 (sorry!). On Sept. 20 of this year -- the date of record -- you qualified for 8.33 (100 x 0.0833) shares of Avaya. (We'll assume you didn't reinvest dividends and that there were no Lucent stock splits.)

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Your cost basis prior to the spinoff was $70 a share. The company has determined that 94.524% of that basis now is attributable to your Lucent shares, and 5.476% should be allocated to your new Avaya shares.

In our example, the cost basis of each Lucent share you bought for $70 now becomes $66.17 ($70 multiplied by 94.524%), and the basis in your new 0.0833 share of Avaya is $3.83 (5.476% of $70). The basis in one whole share of Avaya then becomes $45.98 ($3.83 divided by 0.0833 share). With the Lucent currently trading at $32 and Avaya hovering at $14, that probably won't make you too happy.

Remember, you started with 100 shares of Lucent so you got 8.33 shares of Avaya. But the company is not going to distribute 0.33 share to you. You'll receive the cash equivalent of that fractional share -- either via check in the mail or the amount will be credited to your brokerage account -- by Oct. 31, according to Avaya's

Web site. You always can opt to reinvest that money back into the stock, but you still will owe tax on it.

So that means you're going to owe capital gains tax -- either short term or long term, depending on how long you've held your Lucent stock -- on the difference between the cash you receive and your basis in that fractional share. Your Lucent holding period is carried over to your Avaya stock. In our example, you've held your Lucent shares since January, which is less than a year, so you will not qualify for the long-term capital gains rate.

But you need to determine your cost basis in that fractional share to know what you'll owe in tax. In this example, the basis in that 0.33 share will be about $15.17 ($45.98 multiplied by 0.33 share). You will owe tax on the difference between the cash you receive and $15.17. (Granted, that may be an inconsequential amount of tax, but for illustration purposes, you get the idea.)

Because you'll owe tax on that fractional share, its basis is no longer part of your overall Avaya basis. You're left with eight shares, each with a cost basis of $45.98, so your remaining Avaya basis is $367.84 (383.01 minus 15.17).

A tax-information pamphlet should be sent to all registered Avaya shareholders by Oct. 31, according to its Web site. This pamphlet will provide information on how to calculate the cost basis in full and fractional shares. And Avaya eventually plans to provide a downloadable version of this worksheet on its Web site. If you still need more information, call Lucent's investor relations hot line at (908) 582-6173.

A Roth Reminder

If you converted a regular IRA to a Roth IRA back in 1999, make sure your 1999 adjusted gross income did not exceed $100,000. If -- surprise! -- it did, you have until Oct. 16 to switch your Roth back to a traditional IRA without penalty. For more details, check out our

Roth IRA reporting guide.

Come Chat Away

Don't forget! Martin Nissenbaum, director of income tax planning at

Ernst & Young

, will be here on Thursday, Oct. 12 at 5 p.m. EDT for a

Yahoo!

chat. So come armed with questions! Register for Yahoo! chat at

chat.yahoo.com. It's free!

Send your questions and comments to

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TSC Tax Forum aims to provide general tax information. It cannot and does not attempt to provide individual tax advice. All readers are urged to consult with an accountant as needed about their individual circumstances.