One of your clients owns 500 shares of BCD stock and is concerned with tax consequences associated with their investments. BCD announces a 5% stock dividend on their common stock and your client will be receiving 25 additional shares. The client calls in and asks how this stock dividend will be treated for tax purposes. Which of the following is TRUE?
[A] The stock dividend is not a taxable event for this client at this time.
[B] The stock dividend is taxable as ordinary income, but may qualify for a reduced tax rate because of the client's long-term holding period.
[C] The stock dividend is taxable as a capital gain to the client, but may qualify for a reduced tax rate because of the client's long-term holding period.
[D] The stock dividend is fully taxable as ordinary income to the investor in the year received.

[A] The stock dividend is not a taxable event for this client at this time.

Explanation:

If one of my clients owns 500 shares of BCD stock and is concerned with tax consequences associated with their investments. BCD announces a 5% stock dividend on their common stock and your client will be receiving 25 additional shares.

What is true is that the stock dividend is not a taxable event for this client at this time.

This is referred to as a RIGHTS ISSUE which increases the number of shares an existing share holder owns rather than paying them cash dividends.

Such a benefit is not taxable because stock dividends are not cash dividends rather what happens is like a dilution of ownership of shares since the cost basis of the shares will be adjusted from 500 shares to 525 shares.

The answer depends on the type of account:

1) If BCD stocks are held in a retirement account, then they are not taxed right away ⇒ option A would be correct in this case.

2) But if the investor holds the stocks in a non-retirement account, they they are taxed. They can be taxed in two different ways:

Option D is correct in this case.

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