Cost Basis Reporting
By Richard Moskowitz, Senior Manager, Alternative Investment Group
On October 12, 2010, the Internal Revenue Service issued final cost basis reporting regulations. In general, these provisions are applicable to U.S. non-exempt recipients , which includes Individuals, Partnerships, and Limited Liability Companies, Trusts, and starting in 2012, Subchapter-S Corporations. A “covered” security for which cost basis reporting will be required, will include a sale of stock in either a domestic or foreign corporation acquired after December 31, 2010, stock in a regulated investment company, such as a mutual fund or a dividend reinvestment plan, acquired after December 31, 2011, and debt securities, options or any other specified securities acquired after December 31, 2012. The first 1099-B with cost basis will be received on February 15, 2011.
Although, at first thought, this may seem like a dream come true for tax preparers, who customarily must wait for clients to dig out their trade confirmations for cost basis, the truth is, that this requirement might work for the investor who has one brokerage account, but for a hedge fund or high net worth individual with many accounts, it will cause huge nightmares. Since the Internal Revenue Service receives copies of the 1099’s as well, there is a serious issue of tax lot allocation as well as potential wash sale issues that will not be included on the 1099, yet must be calculated by tax preparers. This will have an impact as to whether the 1099 will match what the taxpayer believes should be reported. In addition, a taxpayer might receive three, or possibly four, 1099’s for a single sale if it involves both short term, long term, covered and non covered securities.
Customers will have to select a tax lot relief method, i.e.: HCFO (highest cost, first out), LCFO (lowest cost, first out) FIFO (first in, first out), Specific identification, etc., no later than the settlement date of the trade. This means that taxpayers must communicate lot relief method for newly acquired stock starting on January 1, 2011. As of now, a transferring broker must provide the new broker cost basis of any transferred stock, 15 days after the date of transfer. The industry has requested a delay in the effective date of transfer reporting.
A taxpayer cannot select a different tax lot than the tax lot reported by the broker on the 1099-B for basis and gain/loss calculation purposes. There is a lot relief method consistency requirement which states that
- A customer must specify a lot relief method at the time the security is sold but no later than the settlement date.
- Selection of method must be made by the taxpayer not the advisor.
- Standing orders are permitted.
- Consistent reporting by the customer and broker is required.
Wash sales and other tax related issues are bound to be confusing and complex in the coming years. Whereas brokers will report wash sales report under two simplified assumptions:
- Within the same account and
- Only with identical securities by CUSIP
Taxpayers and their return preparers will still be required to determine the tax rules in regard to the selling and the non-selling of securities. It should also be noted that short sales will be reported on Form 1099-B when closed rather than when opened. This is a departure from the current practice which is to report a short sale on the day it is opened.
Inherited securities, transferred securities and gifted securities will also have their own set of rules. An example of this is that basis of inherited securities under cost basis regulations will be determined by an authorized representative of the estate.
To provide brokers and transfer agents with needed information to comply with cost basis reporting there are two additional key new rules:
- Transfer reporting-New Internal Revenue Code Section 6045A requires applicable persons including brokers, issuers, custodians, transfer agents or others, to provide cost basis information to a broker when securities are transferred.
- Issuer reporting-New Internal Revenue Code Section 6045B requires issuers of securities to report to the IRS and holders regarding corporate action events.
The Internal Revenue Code imposes a penalty on any transferor that fails to timely furnish a correct transfer statement to the receiving broker. In order to promote industry readiness to comply with the reporting requirements for the sale of covered securities beginning in 2011, the Service will not assert penalties for any transfer of stock in 2011 that is not incidental to the stock’s purchase or sale.
There is bound to be confusion with the new form 1099-B. The differences in the form include Box 3 cost or other basis, Box 5 wash sale loss disallowed, Box 6 covered or non-covered security, Box 7 reported gain or loss and Box 8 which will report whether the gain is short term or long term. A broker will have to correct a 1099-B if any information changes at any time. That means that there is a very high risk of corrected 1099-B’s in the future.
In conclusion, the new reporting requirements, as well as, the differences that will be occurring will make enforcement difficult in the initial stages. We all wait patiently to see the results of Congress’s well regarded intent to lessen the burden of cost basis reporting.