COST BASIS ó TURNING COMPLIANCE INTO AN OPPORTUNITY TO IMPROVE YOUR BUSINESS

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COST BASIS ó TURNING COMPLIANCE INTO AN OPPORTUNITY TO IMPROVE YOUR BUSINESS

In 2005, the Internal Revenue Service (IRS) attributed the tax gap for 2001 to taxpayers misreporting $11 billion worth of capital gains or losses. The Government Accountability Office (GAO) was asked to analyze the misreporting and the actions the IRS takes and to suggest ways to improve taxpayer compliance. The GAO ultimately recommended that brokers be required to report cost basis information to the IRS.

Historically, firms reported only the gross proceeds from sales of securities on behalf of their clients. However, the accuracy of a reported gain cannot be assured or confirmed if the investmentís base starting point or cost is uncertain, unadjusted or unknown. And as any business or individual who has filed taxes knows, when it comes to tax revenues, accuracy and traceability are essential.

On Oct. 3, 2008, the U.S. Congress passed the Emergency Economic Stabilization Act of 2008, which was signed into law by President George W. Bush. Section 403 of Division B of the Act makes cost basis reporting mandatory for all brokers executing
transactions that involve publicly traded securities. Under this law, firms must track and report the cost basis of stocks, bonds, mutual funds and other securities, using choices that include the first-in, first-out method, specified lot processing, or the average cost method for mutual funds. Firms also need to specify whether gains are long-term or short-term and if the securities are covered or uncovered.

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UNDERSTANDING THE CONSEQUENCES OF NON-COMPLIANCE
Under the new law, cost basis information reporting is no longer considered ìnice-to-haveî or a value-added service on statements. Non-compliance carries penalties that can affect both the firm and the client. Failure to report accurate cost basis information could cost upwards of $100 per Form 1099-B, with a maximum penalty per legal entity of $350,000. Should a firm intentionally fail to report cost basis information, the fine increases to $200 per 1099-B, or 10% of the amount that was required to be
reported (whichever is greater). Moreover, in the case of intentional failure to report, the penalty that can be imposed is limitless.

CONSIDERING THE OUTSTANDING QUESTIONS
Despite the looming deadline for compliance, several aspects of the law remain unclear. For example, while some industry groups believe that Congress intended to exempt gifted and inherited shares from cost basis reporting, the IRS included them in its guidance. Making the correct basis adjustments to coincide with gifts and date of death valuations with inheritance is the main challenge, especially on a
jointly held account where it is unknown if one party has been deceased for years.

Firms also need to know how to deal with rules that vary or contrast across the 50 U.S. states and how to carry fair market value and gifted value ó and then, based upon sale proceeds, determine which to use. In addition, guidance is needed on how to apply fair market value to a security when it is gifted, as well as the differences between individual gifts and charitable gifts.

COST BASIS REPORTING REGULATION IMPLEMENTATION SCHEDULE
Section 403 of Division B of Public Law 110-343 details the legislation that makes cost basis reporting mandatory for all brokers executing transactions that
involve publicly traded securities.  The requirements to report realized gain/loss
information to the IRS for the benefit of clients have the following deadlines:

•  January 1, 2011 ó Equities purchased on 1/1/2011 or later
•  January 1, 2012 ó Mutual funds and DRIPs purchased on 1/1/2012 or later
•  January 1, 2013 (or a date to be determined) ó Fixed income options and any other securities that the IRS decides to include, purchased on 1/1/2013 or later
  

Many industry participants submitted comment letters to the IRS in February 2010. These comment letters focused mainly on requests for additional guidance, particularly regarding:

• Transfer requirements
• Short sales
• Foreign securities
• Wash sales
• Average cost
• ìLikeî securities (including DRIPs)
  

The comment letters also asked for relief, since changes may not be written to the Federal Registry until June or July 2010 at the earliest. Due to the lack of information, many firms are delaying their pursuit of compliance. By doing so, these organizations may not leave enough time to achieve full compliance. They may also miss the hidden
opportunities presented by cost basis projects.

To Be Continued In Part 2...

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