Cost-Basis Reporting: More Than Just a Number
January 11, 2010
At first glance, reporting the cost of a security purchased by an investor to the Internal Revenue Service seems relatively straightforward.
All a bank, brokerage firm, mutual fund, transfer agent or even issuer would have to do is look up how much the customer paid for it at the time it was bought. Right?
Well, if it were that simple financial firms wouldn't be so worried about just how they will comply with new cost-basis reporting rules which are just around the corner. "It's far more than a calculation of a number," explains Jodi Baskin, product manager for SunGard Data Systems' wealth management unit. "Cost-basis adjustments need to be made over the entire life of the account."
The IRS wants financial firms to adjust for losses and gains that are treated as a wash, short sales and the impact of corporate actions. The tax collector also wants them to allow the investor to decide just which methodology for calculating cost-basis reporting he or she wants to use. And if you weren't the bank or brokerage firm who sold the investor the account in the first place you still have to make certain you got the information-accurately-from the original financial firm which hopefully hasn't gone out of business.
The new policies were included in the Emergency Economic Stabilization Act enacted in October 2008, passed by Congress to bail out a financial system that appeared on the verge of breaking down. In February 2009, the IRS sought industry comment to help prepare its guidance.Last month it came out with revised proposals, but even those aren't final. That means firms could easily have less than six months to prepare to follow the rules and establish the cost basis of every eligible security held in their accounts for their customers.
This gives firms just enough time to find and install a tax lot accounting system, but little else. Among the most commonly cited are from Wolters Kluwer Financial Services; Scivantage; DST; SunGard Data Systems; NetWorth Services and Broadridge Financial Services. Pending approval from the Securities and Exchange Commission, the Depository Trust & Clearing Corp. will permit transfer agents, mutual fund companies, custodian banks and broker-dealers which do not currently use its Automated Customer Account Transfer Service (ACATS) to communicate cost-basis data to each other. The expansion would also allow a user of ACATS to transfer cost-basis information to a non-ACATS user. However, the DTCC's cost-basis reporting service (CBRS) will not calculate the cost-basis for the firm receiving the account.
The new regulations will come into effect on January 1, 2011 for equities purchased as of that date. For mutual funds they come into effect on January 1, 2012 and for debt instruments, options and other securities on Jan 1, 2013. Firms may voluntarily decide to follow the rules for securities accounts opened prior to those dates.
Penalties will be steep. Broker dealers, mutual funds and others that provide the IRS and investors with inaccurate 1099 forms will be fined $100 for each mistake, up to a maximum of $350,000 annually. If the IRS considers an error to be international, it will levy even higher penalties.
What's left for a firm to do besides licensing a tax lot accounting software package? Plenty. For starters, that software must be integrated with middle and back office operating systems as well as master records on securities. At the same time, staff must be trained and customers educated on the new regulations.
Bottom line: "Firms which haven't already done so must quickly establish some sort of steering committee which will incorporate IT, operations, tax compliance and customer service staffers," says Baskin.
The cost for preparing will vary. For a large broker-dealer which has already been offering cost basis reporting calculations for some of its customers it might come to $1 million but a firm which doesn't could spend upwards of $5 million, on systems integration, staff training and customer education.
"From a technology perspective alone, firms must link their corporate actions platforms, subaccounting systems, securities master files and front-end order management systems," says Cameron Routh, senior vice president of Scivantage in Jersey City, N.J. "The year-end tax reporting 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."
Such an integration isn't done overnight. It could take at least four to six months, even if the tax lot reporting software offers its own programming hooks, known as Application Programming Interfaces. The long timetable stems from the need to analyze, map and test every data point in a firm's books and records, says Routh.
Organizations will also need to expand their database capacity for all the extra data on the methodology selected by a customer as well as the cost-basis calculations for all of their accounts. Because different instruments will fall under the legislation at different dates, securities master files will have to reflect whether a security is eligible for cost-basis reporting. That means storing billions of tax lot files and making the information accessible to investment advisers, operations executives and their clients.
One of the largest operational challenges will be allowing the customers to decide which tax lot accounting methodology to use. A customer can select first-in, first-out accounting, average cost or the specific identification approach, which lets them first sell the lot of securities that optimizes their tax position.
The investor can also change his or her mind and later select different methodologies for different accounts registered under the same name with the same financial intermediary. The change will require the financial intermediary to recalculate the cost-basis on the 1099 forms.
The flexibility-and duration of the selection process-will add to time and costs involved with adapting IT systems. "Providing various sale methodologies will require lots of coding," says Nico Willis, chief executive of NetWorth in Phoenix.
According to Willis, the new rules, in their current form, will require financial firms to run multiple cost-basis methodologies simultaneously "so they can have the answers ready for when the client makes it decision or even changes its mind," says Willis.
"Customers will start asking which cost-basis methodology to use as well as which of their accounts are covered," says Willis. "The dilemma for firms will be to provide sufficient customer support without providing answers which could be construed as tax advice."
Unclear is whether firms will want to give their customers the results of different cost-basis methodologies or simply allow them access to their websites to do any calculations themselves. Willis recommends the later choice, which will avoid any legal quagmires and help firms score points for superior client service.
