With less than six months to go, the brokerage community is under intense pressure to prepare for the new cost basis reporting law, which was enacted in October 2008 and takes effect Jan. 1, 2011. While there have been a number of broad challenges facing the financial services industry related to the new law, it is important to note specific areas that are causing the most confusion in preparing to comply.
The cost-basis reporting law obligates brokerages to report the cost basis of securities sold by customers to the IRS and taxpayers on Form 1099-B. As a rule of thumb, cost basis reporting applies to brokers who currently file Form 1099-Bs. However, new transfer reporting rules will also apply to custodians, transfer agents and securities issuers. The law applies to stock acquired on or after Jan. 1, 2011; mutual fund and dividend reinvestment plan (DRP) shares acquired on or after Jan. 1, 2012; and debt instruments and options acquired on or after Jan. 1, 2013.
Brokerages have faced many challenges in preparing. For example, at the time the law was passed, the financial markets were in turmoil and many brokerage firms were faced with budget cuts, freezes and restrictions. As a result many firms delayed cost-basis preparation during 2009.
Another significant challenge is that cost-basis calculation and Form 1099 tax reporting is technology intensive. That means programming and other system changes are necessary for brokerages to provide this new information. In general, significant technology projects comparable to cost-basis reporting often take a minimum of one year to complete. That means that if a broker-dealer's cost basis project was not underway by the beginning of 2010, it is probably behind the eight ball and may have a difficult time getting ready by the deadline.
Additionally, many firms had planned for the IRS guidance on the law to serve as a “roadmap” in their development efforts relating to cost-basis reporting. However, proposed cost-basis regulations were not released until December 2009 and final cost basis regulations will likely not be released until the summer of 2010 at the earliest. This has essentially delayed the start date of firms' technology projects, further compressing the available time frame for preparing.
While the industry may hope that the IRS will delay the effective date for cost-basis reporting because of the delayed release of the IRS regulations, it seems unlikely because the effective date for cost-basis reporting was set forth in the law itself. The IRS does not have the authority to delay it.
As brokerages race against the clock to get ready, here are three specific issues that may require the most attention:
The cost-basis law requires an “applicable person” (broadly defined as a brokerage, transfer agent, custodian, issuer of securities or agent of any of these institutions) to provide a “transfer statement” to the receiving brokerage when a customer's securities are transferred from one to the other. This must happen within 15 days of the date of transfer and must include detailed information regarding the transferor, the customer, and the securities being transferred, with details about the tax cost and holding period.
Transfer reporting is new, so brokerages must build systems to meet this requirement from scratch — a time-intensive task. The transfer reporting rule does allow the IRS some discretion in terms of an effective date. But because the development work related to transfer reporting is so significant, brokerages should continue to work at full speed on transfer reporting efforts — regardless of whether the effective date is delayed.
The new law requires brokerages to provide cost-basis reporting for foreign stock, effective for shares acquired on or after Jan. 1, 2011. A significant issue with foreign stock relates to properly adjusting cost basis for corporate actions. Under the law, a brokerage must adjust cost basis for corporate actions if the issuer of the security provides a new IRS filing called an “issuer statement.”
Within the brokerage community there is concern that this will be very difficult due to the lack of corporate action information that's readily available for foreign stocks. Although a brokerage may not be obligated to make a basis adjustment if a foreign stock issuer doesn't provide the new IRS issuer statement, a brokerage may decide to provide adjustments as a value add to the customer. The difficulty for brokers will not only be obtaining the issuer statements, but also determining the cost basis impact of foreign corporate actions when issuer statements aren't available. This is a significant challenge that could require much time and resources on the part of the brokerage community.
Another difficult — and likely unexpected — challenge for brokerages involves wash sales. The cost-basis law requires brokerages to account for wash sales, which impact the cost basis reported on both Form 1099-B and on transfer statements. But to determine whether a transaction has created a wash sale deferral, brokerages will need to manage and track tax sub-lots. Most brokerages' current systems aren't equipped to process this significant increase in data volume. As firms test their readiness for the law's effective date, it is critical to make sure new or enhanced systems are in place to handle more wash sale calculations.
Cost basis reporting is just one example of how brokerages must adapt to ever-increasing regulatory requirements. And while it is never an easy transition, paying close attention to detail and anticipating the most difficult challenges will prove beneficial to the firms and their clients in the long run.
Stevie D. Conlon is senior director and tax counsel for Wolters Kluwer Financial Services' Securities Tax Solutions line of business, which provides tax lot accounting technology and corporate actions data and analysis to brokerage firms, investment managers and active investors. For more information about the cost basis reporting law, visit www.costbasisreporting.com.