On October 3, 2008, President George W. Bush signed the Emergency Economic Stabilization Act of 2008. Tucked away in the Act is a provision that moves the responsibility of basis determination from the shoulders of the taxpayer to the shoulders of the securities industry. After December 31, 2010, every broker that is required to file an information return reporting the gross proceeds of a ‘covered security’ must include in the return the customer’s adjusted basis in the security and whether any gain or loss with respect to the security is short term or long term under Code Sec. 1222, Sec. 403(3)(1)DivB, PL 110-343, 10/3/2008.
There is a three-stage phase-in with the first effective date of January 1, 2011, as follows: Stock acquired on or after January 1, 2011; Mutual fund and dividend investment plan (DRIP) shares acquired on or after January 1, 2012; and Other specified securities [principally debt securities (bonds) and options] acquired on or after January 1, 2013. Because cost basis reporting only applies to securities acquired on or after the applicable effective date, brokers must sort and separate post-effective-date acquired securities from the pre-effective date securities. As customers sell their positions, brokers must have the ability to identify whether pre-effective-date or post-effective-date securities were sold in order to determine whether cost basis reporting is required. The software and accounting system mechanics of such an exercise could be difficult. Similarly, because of the three-stage phase-in of effective dates, brokers’ systems must correctly sort securities into the various categories in order to apply the proper basis rules to each and to determine correctly whether a security is a pre-effective or post-effective-date acquisition.
This effort began with the National Taxpayer Advocate’s report about the tax gap based on the 2001 filing season. The report stated that the tax gap was $345 billion. Of this amount, individual taxpayers accounted for $197 billion, mostly unreported or under reported income rather than overstated deductions or improperly claimed credits. Of that $197 billion, under reported capital gains accounted for $11 billion.
In 2006, the investigative arm of Congress, the General Accounting Office (GAO), estimated that 38 percent of all reported capital gains are erroneous. This was also verified by the work of the IRS in conjunction where 46,000 random taxpayers were audited. Net Basis was used to verify reported cost basis information on the Schedules D for the 2001 National Research Program Random Study. Hundreds of thousands of investment transactions were processed through the NetBasis system. NetBasis not only identified a significant number of Schedules D that yielded improper reporting, but it also identified $11 billion dollars in under reported capital gains taxes, which was then included in the 2006 Tax Gap Report.
Since 2005, a renewed effort has been underway to change the rules to shift this responsibility from the taxpayer to the broker. At the heart of the matter is that cost basis of securities, real estate, or other items sold was not required to be reported to the IRS by anyone except the taxpayer. According to Nina Olson, the National Taxpayer Advocate, “When information is reported to the IRS, the compliance rate is 90 percent. When it’s not reported, only 50 percent shows up on a tax return. In another statement, Olson said, “Where taxable payments are not reported to the IRS by third parties, compliance drops precipitously to a range from about 20 percent to about 68 percent depending on the type of transaction.”
Congress decided to take the responsibility from the shoulders of the individual taxpayer and place the responsibility upon the securities industry primarily brokerage firms which was spelled out in the 2008 Emergency Economic Stabilization Act.
In early 2009, the IRS released Notice 2009-17, Information Reporting of Customer’s Basis in Securities Transaction, requesting comments for guidance with respect to the reporting of a customer’s basis in securities transactions. The notice contained 36 specific issues under 8 categories. The categories included:
1. Applicability for reporting requirements. The IRS addresses concerns about who is a “middleman” subject to the broker reporting and transfer reporting statement requirements and how to minimize duplication of reporting by multiple brokers.
2. Basis method election. There are many basis method elections
(FIFO, specific identification, single-category and double-category averaging for mutual funds, and dividend reinvestment plans (DRIPs) for determining the basis of securities sold. How will these methods be applied uniformly? Will the taxpayer retain the various elections or will the brokers force a single method to simplify their reporting?
3. Dividend reinvestment plans. Can the average cost basis frequently used by mutual funds be expanded to include DRIPs? How will shares of stock acquired prior to the effective date for DRIPs (January 1, 2012) be melded into a suitable report after the effective date of basis reporting for stocks (January 1, 2011)?
4. Reconciliation with customer reporting. How will the taxpayer’s
Form 1040 Schedule D be reconciled by a broker’s basis reporting if the basis method elections are different? If a workable solution is not found, the objectives of taxpayer help and audit administration could be defeated.
5. Special rules and mechanical issues. This category deals with the variety of issues associated with wash sales, options, changes in timing for reporting proceeds from short sales, adjustments to basis for original issue discount (OID), market premium, discount and additional special basis adjustment rules.
6. Transfer reporting. When a taxpayer transfers his or her account from one broker to another, what information is required to be in the customer account transfer (ACAT) reporting? Due to the staggered effective dates, what will be the cost basis computation and reporting obligations for brokers under the law? What is the proper period for furnishing transfer reporting statements? How soon will the transfer information be required to be available to the successor broker?
7. Issuer reporting. When a corporation merges, splits, spins off, etc., there is generally a notice advising the taxpayer of any taxable consequences of the corporate action. Now that brokers are responsible for cost basis information, who will ultimately be responsible for providing the taxpayer with a tax opinion or a tax disclosure statement? How soon?
8. Broker practices and procedures. The cost basis reporting law presents some additional obligations and potential penalties to brokers. What responsibility does a brokerage firm or mutual fund have to make sure that the cost basis numbers they send are as accurate as possible? When does a broker have to start correcting numbers or looking for more information?
What initially appeared to be a simple solution to provide cost basis following the sale of a security really isn’t because the effective dates of the new law are staggered, the fact that acquisitions prior to the effective dates are not part of the solution, and that mutual funds, stocks, and bonds are only a part of the assets that can be acquired or sold.