Emergency Economic Stabilization Act Reporting Requirements

Prior to 2011, some investment firms voluntarily provided historic cost basis information on securities holdings and reported this data on consolidated statements or special year-in summaries. However, there was no federal requirement to maintain or report this data. The only requirement, under IRS Code Section 6045, was to report gross proceeds from the sale of securities.

That changed with enactment of Section 403 of the Emergency Economic Stabilization Act of 2008. The act requires every brokerage firm to file an annual return with the IRS reporting:

• Gross proceeds from the sale of a "covered security"
• The date securities were acquired
• The customer's adjusted cost basis in the security
• Whether gain or loss in the security is short-term or long-term

If accounts are transferred to a different investment firm, the historic cost basis data of holdings must migrate with the account, so the receiving firm can meet these requirements.

When a stock split or stock dividend made in 2011 or after affects the cost basis of securities, the issuer must file a return with the IRS and provide a statement to securities holders explaining the impact on cost basis. For example, Citigroup completed a 1-for-10 reverse split of its common stock on May 9, 2011. Citicorp must notify all holders of the stock, through their brokerage firms, that the cost basis in each share of stock has multiplied by 10 times.

What Is a Covered Security?

Brokerage firms must report to the IRS historic cost basis on covered securities, upon sale. Any security bought before 2011 is uncovered, so there is no cost basis reporting requirement.

• Beginning in tax year 2011 – Covered securities include purchases of common and preferred stock (except shares purchased through Dividend Reinvestment Plans, DRPs), exchange-traded funds, real estate investment trusts.
• Beginning in tax year 2012 – Covered securities include mutual fund shares, closed-end funds, and shares purchased through DRPs acquired after 1/1/12.
• Beginning in tax year 2013 – Covered securities include purchases of bonds and other fixed income securities, master limited partnerships, unit investment trusts and other tradable securities acquired after 1/1/13.

Until now, the U.S. tax system has put the burden for tracking cost basis on the taxpayer. Most affluent investors, in turn, have delegated this chore to their CPAs or financial advisors. Although the legal burden for accurate tax reporting still falls on the taxpayer, the law has shifted the tracking burden for covered securities to brokerage firms, transfer agents and custodians. These entities now have reporting responsibilities (on covered securities) similar to those that employers have for reporting W-2 wages.

It will be easier for the IRS to scan and compare data each taxpayer submits on 1040 Schedule D with brokerage firm reports on Form 1099-Bs, and this will make taxes more costly for investors who under-report liabilities. For reasons discussed later in this article, the change also could increase reporting errors, IRS inquiries and audit risk. Your clients should expect that data reported on 1099-Bs may not be consistent with the reporting methods they have previously used. Mismatched data may generate automatic IRS deficiency notes, which taxpayers should be prepared to address with personal records.

The Joint Committee on Taxation has estimated that increased 1099-B reporting and enforcement activities will raise $6.7 billion in additional tax revenue over the next decade.

Other Tax Reporting Changes

The IRS published final regulations for tax basis reporting on November 22, 2010, as IR Bulletin 2010-47. You can read details online here: www.irs.gov/irb/2010-47_IRB/ar08.html

Other key points that financial advisors may want to communicate to clients and their CPAs include the following:

Wash Sales – A wash sale is a transaction in which an investor sells a security at a loss to create a tax-loss event, and then repurchases the same or substantially identical security within 30 days before or after the sale.  The IRS disallows a current tax loss on wash sales. Starting in 2011, broker-dealers are required to adjust share cost basis for wash sales, but only if the acquired securities are identical (rather than substantially identical) to those sold. Matching CUSIPs will be the test of "identical."

Short Sales – Before tax year 2011, brokerage firms reported gross proceeds from short sales for the year in which the short sale was entered. Beginning in 2011, short sales will not be reported until the position is closed.

Transfer Statements – When clients transfer ("ACAT") accounts between brokerage firms, the transferring broker must give the receiving broker tax cost basis data on all covered securities transferred not later than 15 days following the transfer date.  At minimum, the transfer statement must include:

• Identity of the security
• Total adjusted basis of securities
• Original date of acquisition
• Transfer date
• Settlement date for the transfer

Share Reporting Methods – Investors often acquire shares of the same security through multiple purchases, such as through DRPs or mutual fund dollar cost averaging. When they then sell a partial holding, the IRS allows taxpayers an option of cost basis accounting methods:

• Average cost – Each sale uses the average cost basis of all remaining shares.
• First in, first out (FIFO) – The first shares acquired are sold first.
• Last in, first out (LIFO) – The last shares acquired are sold first.
• Highest in, first out (HIFO) – The shares with the highest cost basis are sold first.
• Specific share identification – The customer specifically identifies tax lots to be sold.

It is each investor's responsibility to choose one of these methods with the help of their financial advisors or CPAs. For partial sales of securities other than mutual funds or DRP shares, the new law requires brokerage firms to follow the following order, for IRS 1099-B reporting:

1. If the customer identifies a specific cost basis method or specific tax lots to be sold on an "adequate and timely basis," the broker must report the tax cost basis according to instructions.
2. In other cases, the firm must first report as sold any shares for which it does not have cost basis data.
3. Next, it must report as sold the first shares purchased – i.e., using a FIFO basis.

For mutual fund or DRP programs, the brokerage firm must reported cost basis in accordance with its default method, unless the customer chooses a different method. The default method often is average cost basis.

Challenges and Opportunities for Investors

Here are some issues you can discuss with clients and their CPAs to increase preparation for the new reporting requirements.

The Value of Consolidation – The more brokerage accounts clients have, the more problems 1099-B reporting may cause. On each taxpayer's 1040 Schedule D, all gains and losses (from all brokerage firms) are netted in two separate baskets: long-term and short-term.  The problem is that the IRS will be matching bottom-line numbers on the Schedule D against the "roll up" of multiple 1099s provided by different brokerage firms. Theoretically, if identical cost basis data is used by the taxpayer and by all brokerage firms, the end result should match. But even one error made by a brokerage firm will cause the IRS to register a mismatch, and perhaps a deficiency notice. Tracking down that error may take several hours of a CPA's time. Unless clients need multiple brokerage accounts, now is a good time to consolidate.

Documenting Average Basis Method – IRS regulations require taxpayers to notify brokerage firms, custodians or transfer agents in writing, if they wish to use an averaging method for mutual fund shares. According to the regulations, this requirement "ensures that both taxpayers and brokers have a record of the fact and scope of the election." At many brokerage firms, the "written" requirement can be met electronically through an affirmative online "checkbox" choice. Make sure clients who want to use averaging methods for mutual funds document this choice now, and let CPAs know about the requirement.

Business Accounts – Brokerage firms must report tax cost basis for covered securities owned by S corporations and partnerships, but there is no tax cost basis reporting requirement for C corporations. To determine whether a customer is an S or C corporation, the brokerage firm usually will request a Form W-9 exemption certification. However, if there is doubt about the form of organization, the law requires a presumption that it is an S corp. If C corporation clients have brokerage accounts and don't want cost basis reported, they should confirm status with brokerage firms.

Gifted and Inherited Shares – What happens when a covered security is gifted or inherited and then sold? The answer is that the brokerage firm must ascertain the appropriate basis under U.S. tax law and report it on 1099-B.  Complexities can arise when: 1) depreciated securities are gifted; or 2) the basis of inherited securities is "stepped-up" using an alternate valuation date. On gifts or inheritances of covered securities, clients should ask their financial advisors and CPAs to coordinate cost basis information with the brokerage firm. The regulations direct brokers to use the date of death for purposes of stepping up basis on inherited securities, unless the broker receives specific instructions from the estate representative.

Commissions and Fees

Box 2 of the 1099-B usually reports proceeds from securities sales net of commissions and fees. However, there are fee arrangements that some CPAs allocate to individual transactions (as subtractions from gross proceeds), even though they are not attached to any specific transaction. For example, a CPA may allocate the quarterly fee in a fee-based brokerage account among several sales transactions during the same period.

With increased IRS scrutiny, this practice may become a bigger red flag. Unless brokerage firms are including commissions or fees in net proceeds on the 1099-B, taxpayers should claim them separately as miscellaneous itemized deductions, subject to the 2% AGI limit.

Updating Clients Cost Basis Records

Tax experts expect that many IRS mismatches will be generated by discrepancies between the historic cost basis records of brokerage firms and the records clients (or CPAs) maintain. This will become a bigger issue in 2012 reporting, when mutual funds become covered.

In the past, clients often did not tell their brokerage firms which cost basis method they were using. If a client has redeemed shares several times in the past, it's possible the broker's cost basis records will match the client's. Even if the client and firm were both using an average cost method, calculations may not exactly match.

Some brokerage firms are offering to let clients review and update cost basis information on non-covered securities, to allow any differences in cost basis to be corrected. The client (or CPA) will need past brokerage statements, transaction history and tax returns to complete this job.  (Any changes in cost basis will not affect the tax treatment of past transactions.)

If brokerage firms are carrying mutual fund shares at higher cost basis than the client's records show, a review/update can potentially save taxes as well as time spent addressing IRS deficiency notices. At some brokerage firms, the opportunity may not be available after mutual funds become covered securities on 1/1/12.

The Biggest Opportunity in This Change

As clients receive 1099-Bs in January and February, you will have an opportunity to meet with them and their CPAs to proactively determine share reporting methods. You then can help clients communicate their preferred reporting methods to brokerage firms, and perhaps update historic cost basis records held by brokerage firms.

You also will have an opportunity to remind clients that taxable brokerage accounts are becoming more complex and costly. In addition to taxes, sales made in these accounts may trigger increased CPA time and attention in preparing taxes and aligning 1099-Bs with Schedule Ds. If data doesn't align, clients also may face increased audit risk. To avoid these issues, suggest taking advantage of account types that don't require cost basis records or generate 1099-B reporting. They include stable value funds, IRAs, tax-deferred annuities and permanent life insurance. 

Be sure to communicate to clients this number: $6.7 billion. That's the amount of increased revenue the IRS expects to generate over the next decade from tougher 1099-B reporting.

Who's going to be paying $6.7 billion? People who make frequent transactions in taxable brokerage accounts.

Tell you clients: "It never hurts to make tax-smart investment choices, especially when the IRS has painted a $6.7 billion target on your back."