Industry Struggling to Meet New Cost-Basis Demands

May 4, 2009
Chris Kentouris

Financial firms are voicing concerns about the operational and systems changes required to accommodate the Internal Revenue Service's new cost-basis reporting mandate, which will be phased in beginning in 2011.

To prepare, broker-dealers, banks, mutual funds and transfer agents will need to update an array of front- and back-office client interfaces, securities masterfiles, tax-lot accounting systems and reporting platforms.

When a firm's client buys a security, the shares are assigned a tax-lot number. Under the new rules, "major IT changes will be required for firms to capture the tax lots of securities purchased through trading and dividend reinvestment plans and keep them appropriately updated," said Robert Enz, SVP of Broadridge Financial Solutions' securities processing unit, at the Securities Industry & Financial Markets Association's (Sifma) Operations Conference last week.

The new policies, which require firms to report customers' cost basis when selling financial products, were included in the Oct. 3 Emergency Economic Stabilization Act as a revenue-generating provision. In February, the IRS sought industry comment on the new demands to help the agency prepare guidance, though no timetable has been set for its issuance.

Firms, who hope to see the guidance by year-end, caution that they might not have enough time to make the necessary alterations. "We are not prepared and may not be able to fully do so until the IRS comes out with its guidance," said Shahira Knight, managing director of Sifma. "We are faced with a 'now what' situation."

Passing the Burden

Currently, some the largest brokers, funds and transfer agents offer cost-basis accounting to their high-net-worth investors, but they only have to report the gross proceeds of their clients' stock and mutual fund sales on 1099 forms. The IRS has relied largely on investors to produce their own cost-basis numbers on Schedule D forms, which may differ from those of their financial intermediaries.

Financial firms will be on the hook for tracking investors' cost basis for stocks acquired after Jan. 1, 2011; mutual fund shares and dividend reinvestment plans bought beginning in 2012; and debt instruments, options and other securities in 2013. If a client switches accounts to a new firm, that information will need to be transferred.

To ensure that cost-basis calculations are correct, firms must tightly couple their order management systems, corporate actions platforms and other applications to their tax-lot accounting software. "The details of the trade need to be captured accurately, then the tax-lot information stored and recorded on the confirmation," said Enz of New York-based Broadridge, which offers tax-lot accounting. "The year-end tax system must also be linked to the tax-lot system so identical results can be produced on 1099B forms and the customer's Schedule D."

Organizations will need to expand their database capacity for all the extra data. And because different instruments will fall under the legislation at various dates, securities masterfiles will have to reflect whether a security is eligible for cost-basis reporting.

"We are talking about storing billions of tax-lot files and making the information accessible to investment advisers, operations executives and their clients," said Randy Barnes, product manager for Thomson Reuters' Beta Systems division, which provides front-to-back-office processing. "Firms must maintain efficient and scalable systems to make billions of calculations that were not previously required."