Why You Need to Understand the New IRS Cost Basis Reporting Rules

The Internal Revenue Service (IRS) has imposed new cost basis reporting rules for securities sales. The rule change allows the IRS to better track your capital gains – i.e., is the IRS getting all the money they can. Getting the correct basis recorded is important because it will set the “bar” for how much you pay on future gains. Given that tax rates across the board are expected to increase, do you want to pay more than you are required on your capital gains? Since the reporting rules were announced, they have not been getting the press they warrant. Too many taxpayers will be at the mercy of their broker’s record keeping, and ultimately making a “donation” to the IRS by using an incorrect basis for their securities.

We believe that all individual, partnership, trust or other taxable entities that have custodian or broker accounts should take the time to review their cost basis. We have found many custodial institutions were not proactive in planning for the cost basis reporting changes and ultimately, it is up to you, the tax payer, to ensure your cost basis elections are reviewed and properly documented before your 2011 tax returns are filed. Understand that setting the correct cost basis will determine how much you will pay on future capital gains and changing the cost basis will be a cumbersome process.

New reporting requirements for financial institutions were passed three years ago as part of The Emergency Economic Stabilization Act of 2008. Final regulations were issued by the Treasury Department in October, 2010. The purpose of the changes is to better track your cost basis in investments, which may be “lost” or not reported properly when securities are transferred between entities or individuals. When the IRS says “better track your cost basis”, you can read that as – they want to make sure they are getting all the money they are entitled to. The new rules also require reporting the cost basis of the securities sold, allowing the IRS to “match” information reported on tax returns to
information supplied by brokers and custodians. Again, “match” can be translated as “making sure the IRS gets all they are entitled to”. The rule change will further increase the amount of data the IRS can electronically match and audit on tax returns. Brokers and custodians will be required to report cost basis for “covered” securities based on the date the security was acquired, in accordance with the following schedule:

Securities are considered covered if acquired on or after:

Date Type of Security
January 1, 2011           Stocks and other equities
January 1, 2012          Mutual funds, ETFs, and shares in a qualified dividend reinvestment plan
January 1, 2013          Fixed income securities, options and other securities

In prior years many brokers and custodians provided cost basis information as a convenience to investors but without the detailed rules which now govern the determination of cost basis, including certain assumptions and elections which can apply to both the broker, custodian and the investor. Effective for stocks acquired on multiple dates starting January 1, 2011 a general default rule of FIFO (first in, first out) may be applied by the broker or custodian unless the investor designates another method to be used. The default method for mutual funds (effective January 1, 2012) is the average cost method.

An investor may choose another allowable cost basis method rather than the default, but must advise the broker or custodian of their choice for a specific trade or by way of a “standing order”, to be applied to future trades. The investor can change the method at any time, but must indicate to the broker or custodian the chosen method before the settlement date of a particular trade. Many of our clients choose a high cost method in order to minimize taxable gains, as the shares with the highest cost are deemed to be sold first (which creates a larger loss or smaller gain). Another example is the LIFO (last in, first out) method, where the last shares acquired are sold first. As will be discussed further in an upcoming article, this lot selection method can have significant ramifications, including its effect on whether a particular sale in 2011 or after will involve “covered” securities (subject to cost basis reporting) or non‐covered securities.

There are a number of cost basis tracking and reporting changes in the act. One additional reporting responsibility in the legislation includes the requirement that any security transferred between brokers or custodians include a transfer of the cost basis within 15 days. Historically, it has been the investor’s responsibility to track cost basis and provide such information to the new broker or custodian.

Identification of cost basis on gift and inheritance transfers is also now required. There are numerous rules related to the cost basis of securities received via gift or inheritance and the broker or custodian may not be aware of all the decisions made by the estate or individual making the gift. Careful analysis of the cost basis calculations may be warranted to ensure it is properly reported and transferred to the recipient of the gift or inheritance.

Brokers and custodians are now required to adjust cost basis for certain corporate actions (mergers, acquisitions, spin offs, stock splits, etc). Domestic corporations are also required to provide necessary tax reporting information to the applicable financial institutions. Often the structure of the corporate action dictates the cost basis treatment. The corporation is the entity with the knowledge of the structure of the deal and must now provide that information to the financial institutions.

In the past it has been the responsibility of the investor to monitor and maintain cost basis in their securities. Some taxpayers have done a better job of recordkeeping than others; however it should not be assumed that the broker or custodian has the correct basis. Previously, when securities were transferred between different institutions, if cost basis was not transferred to the broker or custodian they may have used the date of transfer as the purchase date and cost, an estimate of the cost basis or, in many cases, nothing at all. It was also common for numerous lots, acquired on different dates at different costs, held at one broker or custodian to be changed to one large lot when transferred to a new broker or custodian, resulting in incorrect cost basis records. There are also many stocks with corporate actions each year. If those transactions were not properly reported or tracked in the past, the cost basis may be misallocated between either different lots or different securities in the event of a buyout or spin off.

You may be thinking: “If only covered securities are included in the new legislation, I just have to make sure my current lot selection agrees with my broker or custodian – right?” Well, no. Under the new reporting rules only covered securities have to be reported with cost basis. Differences in a non‐covered security’s basis can lead to different lots being selected in a sale by the broker or custodian than you intended. This could result in differences in the cost of those securities being considered covered or non‐covered between your records and your broker or custodian’s records in future years.

It is important to make sure that the December 31, 2011 cost basis of all of your securities agrees between the records used for tax preparation and your broker or custodian. We evaluated all of our clients’ cost basis data to ensure their custodian uses the correct data for tax reporting. It was a long, detailed process but we felt it was necessary to ensure proper reporting going forward.

 

DISCLOSURE

To ensure compliance with Treasury Circular 230, we are required to inform you that any advice concerning tax issues contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of avoiding any penalties that may be imposed by any governmental taxing authority or agency.