Mandatory Cost Basis Reporting

By James Klauber

On October 3, 2008 the Emergency Economic Stabilization Act (H.R. 1424), commonly referred to as the financial-rescue law or ‘bail-out’ law, was ratified by former President Bush. Although primarily enacted to allow the federal government to purchase mortgage-backed securities as a counter-measure to the subprime mortgage crisis, another important aspect of this legislation is that it mandates both mutual fund companies and brokerage firms to track their investors’ cost bases in stocks, bonds and mutual funds. They are then required to report this information to both the customer and the Internal Revenue Service when customers transfer their accounts to other firms and when any securities are sold. Previously, they were only required to report gross proceeds on sale. This is intended to prevent investors from under-declaring profits and over-declaring losses on the sale of securities in their personal tax return.

There is a progressive phase-in time line under the legislation for mandatory cost basis reporting. The brokerage firms and mutual fund companies will have to report on the cost basis for all stock acquired after the first of January, 2011, mutual fund shares and stock eligible for a dividend reinvestment plan acquired after the first of January, 2012 and other securities (debt securities and options) acquired after the first of January, 2013. The deadline for actually filing the cost basis reports (currently drafted as Form 1099-B: Proceeds from Broker and Barter Exchange Transactions) with the Internal Revenue Service is not until February 2012, however in order to meet the reporting requirements the information systems of brokers and fund managers will need to be able to monitor and capture cost-basis information from January 2011 onwards. Implementation of an appropriate system to capture adequate information after January 2011 would potentially make gathering the information necessary to complete the reporting greatly more difficult.

Another implication of this new reporting requirement will be the provision of some tax simplification from the perspective of the investor, as the onus of calculating and reporting the adjusted cost basis shifts to the mutual fund companies and brokerage firms. However, there is additional layer of complexity in the reporting. Not only will the adjusted cost basis for the sold securities be reported, but also the effective intention of the sale; for short-term benefit or for long-term benefit. This is of significant taxation concern to the investor. Any profit made on an adjusted cost basis on securities sold for short-term benefit (generally securities that have been held by the investor for less than twelve months) will be subject to taxation at personal income taxation rates. While any profit made on an adjusted cost basis on securities sold for long-term benefit (generally securities that have been held by the investor for more than twelve months) will be subject to capital gains tax rates, which are higher than ordinary income tax rates.

The taxation consequences are further complicated by the fact that there are a number of ways to calculate cost basis, each potentially calculating a different profit or loss made on a sale, and therefore with different personal taxation outcomes. The legislation stipulates that the adjusted cost basis should be calculated ‘in accordance with the first-in first out method unless the customer notifies the broker by means of making an adequate identification of the stock sold or transferred’. Effectively this means that brokers will, by default, use the first-in first-out method to calculate the adjusted basis unless the investor notifies their broker that they wish the calculation to be made by an alternative ‘adequate identification’ method. It should be noted, that in most cases the investor will not be able to nominate the use of an average basis calculation method, as this method is specifically excluded by the law for most securities. There are a number of such adequate identification alternatives, such as the ‘specific-identification’ method where the sold shares are specifically identified irrespective of their date of acquisition. Different methods will likely yield different adjusted cost basis profits, and therefore different taxation liabilities.

The result is that brokerage firms and mutual fund companies will have to implement effective information systems prior to January 2011 that are capable of capturing adequate information to allow for the calculation of an adjusted cost basis under a range of methods. Provision of multiple calculation methods and advice on the personal taxation effects of each will represent a new and significant differentiator between firms.

About the Author: By James Klauber, sponsored by First American Stock Transfer, Inc., registered with the Securities & Exchange Commission as a Registrar and Stock Transfer Agent – firstamericanstock.com. Please link to this site when using article.

Source: isnare.com

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