A nightmare." "A bugaboo." "The bane of our existence." Those are among the kinder, gentler remarks expressed by financial planners when asked about cost basis reporting just after the April tax filing deadline.
"We probably get over 100 calls each year from clients' accountants," says Lee Rosenberg, president of American Investment Planners in Jericho, N.Y. "They call us at the last minute, and they want immediate answers to questions about their clients' basis in securities that were sold that year."
Not surprisingly, government tax collectors aren't happy about it, either. "The IRS has estimated that it loses $11 billion a year in misreported capital gains," says Mal Makin, president of Professional Planning Group in Westerly, R.I.
Sales proceeds on securities transactions are of course reported to the IRS. But there has been no instantaneous way of verifying whether a $10,000 sale, for example, resulted in a $1,000 gain, a $100 gain or a capital loss.
"The tax code in this country is an honor system in some ways," says Dan Galli, a financial planner in Norwell, Mass. "Cost basis is often supplied by the client without any kind of proof."
To help close the capital gains tax gap, lawmakers in 2008 approved new reporting requirements for brokers and other financial institutions. Starting this year, those firms must report the adjusted cost basis of securities that were sold, and also indicate whether the trade was short or long term. The IRS and investors will receive the information on a revised Form 1099-B.
LETTER OF THE LAW
As might be expected from a federal law set to take effect three years after passage, the details are devilish. They apply to stock sales in 2011; mutual funds, most ETFs and dividend reinvestment plans in 2012; and other securities, such as bonds and options, in 2013. Galli points out that the requirements are a non-issue for sales in tax-advantaged retirement accounts.
The newly effective law is likely to produce two results. First, the IRS may be much more vigilant about tax compliance because it will receive much more information about capital gains. Second, there still will be lots of securities held by investors for which cost basis information is not readily available. That means financial planners will likely be under increasing pressure to calculate cost basis for clients, paticularly when tax time rolls around.
"These reporting requirements have put a great burden on custodians and financial advisors," says Ginny Stanley, a principal at REDW Stanley Financial Advisors in Albuquerque, N.M. "We had one person here working with investment custodians practically all last year to make sure our records matched their records. The new requirements have caused us to add some procedures to our daily reconciling to make sure we stay current with custodial records."
Her firm's quarterly client newsletter also explained the rules. "Most clients don't know what cost basis is, while other, more sophisticated clients just expect that we will track cost basis, tell them and put it on their tax return because we do most of the tax preparation anyway," Stanley says.
FIRST MAY NOT BE BEST
But that job gets particularly difficult, for example, when there is a partial sale from a position accumulated at different times. Makin explains this to clients by giving them a simple example of an investor who pays $4,000, plus commission, for 100 shares of a stock at $40. Later on, the investor pays $5,000, plus commission, for another 100 shares at $50.
Suppose this investor eventually decides to sell 100 shares when they trade at $45, receiving $4,500 before the commission. "Depending on which lot was sold, there would be a $500 gain or a $500 loss on the sale," Makin says. In most cases, investors will prefer the capital loss to a taxable capital gain.
Frequently, though, clients make many different purchases of the same security, and partial sales may be preferable for rebalancing or for tapping a portfolio in retirement. How are such sales taxed?
"FIFO [first-in, first-out] is our default," Stanley explains. That is, the first shares acquired are assumed to be the first ones sold. However, if Stanley can identify another lot that is better for the client for tax purposes, she will use that lot. For mutual funds, an average-cost method may be used as the default.
As far as taxes are concerned, selling a newer, high-cost lot typically may produce a better result than an old, low-cost lot. But if selling the highest-cost lot will result in a short-term capital gain, which are taxed at a higher rate, it might be better to sell a lower-cost lot that qualifies for the lower, long-term capital gains tax rate.
"We've had some particular occasions where it paid to specify a low-basis lot for a better tax result," Galli recalls. "There might have been remaining capital losses we wanted to use up, or a gift of stock to a graduate student who could take the gains and owe 0%." Current law allows couples filing jointly to report up to $69,000 of taxable income ($34,500 for single taxpayers) and owe nothing on long-term capital gains and qualified dividends.
TIMING IS EVERYTHING
Financial planners can help their clients identify specific shares to sell to realize a smaller gain or larger loss, but that identification must come at or very near the sale date. "We have to be specific within a certain period of time because our custodians will no longer 'look back' and reclassify a lot after their prescribed time limit," Stanley explains.
"It used to be that we could go back and re-identify the lot we wanted as long as it was within the same year," she continues. "But the requirements have become much more strict."
Her firm's quarterly newsletter informs clients about its new policy: "Under the new legislation, we must now identify or specify lots when the trade is executed if we do not want to use FIFO," it says. "If we are not sure which lot to select as the trade is executed, we can only make changes up until the trade settles or until three days after the trade is executed. After the trade settles, FIFO will automatically be used to calculate gains or losses. It is incumbent upon us to make the best decision possible for our clients when we execute stock trades."
Planners should be sure specific instructions are conveyed in writing punctually and that instructions are acknowledged formally. A subsequent check of Form 1099-B will help verify that the proper cost basis is being reported.
Specific identification may be feasible when a financial planner has the necessary information and the authority to sell securities. That might not be the case, however, for clients with separately managed accounts if the account manager has the ability to sell at will. John Anderson, head of practice management solutions at SEI Advisor Network in Oaks, Pa., says planners should always check with their account managers to see whether it's even possible to identify specific lots for tax-efficient selling.
"Instead of FIFO, we have a standing order in our contracts to use 'HIFO,' or highest-in, first out. We sell the highest-cost shares automatically," Anderson says. "However, financial advisors have the ability to initiate the sale of other lots if they wish to."
For financial advisors to make tax-efficient identification of securities to be sold, they should have complete knowledge of a client's cost basis. That includes securities acquired as gifts and inheritances, which are also covered under the new law.
For gifts, the date of the gift, the donor's adjusted cost basis and the fair market value of the gifted shares must be reported. For example, if a woman transfers 100 shares of stock to her daughter, the firm holding the shares must report the relevant information. After a gift and a subsequent sale, the seller typically uses the donor's adjusted cost basis and acquisition date to determine the tax owed on a sale.
For inherited securities, it's up to the estate's executor to provide information on how the cost basis will be adjusted. (Typically, the basis is the date-of-death value.) According to Stanley, the reporting institution is required to make one attempt to obtain applicable instructions from the estate executor.
PLAYING SHERLOCK HOLMES
For many financial planners, the cost basis of securities bought, inherited or received as a gift this year or next, or even in the past few years, is not a major obstacle. "It's the gifts and inheritances from many years ago that may cause problems," Rosenberg says.
Stock splits, dividend reinvestments and migration from broker to broker can also cause cost basis problems. "It's often up to us to poke around and do the required detective work," he adds.
Rosenberg says his firm spends $10,000 to $20,000 each tax season to hire temporary accounting help to deal with cost basis queries. "We gather as much of the data as we can and fill in the gaps to the best of our ability to estimate cost basis."
Such efforts can be crucial for clients. In situations where basis records could not be obtained, the U.S. Government Accountability Office has reported that "IRS examiners considered basis to be zero and treated all gross proceeds amounts as capital gains." Ouch.
The new cost basis rules have even been affecting prospecting. For example, Rosenberg has been reluctant to take some new clients if it appears cost basis will be difficult to track. "It's an added expense, and you have to decide whether a client will be worth it," he says.
In the meantime, Rosenberg's firm has been manually building a system to compile as much cost basis information from clients as it can. Makin says his firm has been gathering cost basis information and keeping the data updated for more than five years.
"It makes plain common sense," he explains. "How can you know what investments you should be selling if you don't know their cost basis? We need the information to make the right decision."
Makin adds that the new law provides financial planners with an opportunity to get in touch with clients and explain the cost basis issue to them. "We can show the work we do for them, paying attention to important things such as new rules on sales of securities," he says.
"This can give clients a sense of comfort, knowing that we've got their back on a complicated subject they're probably not very familiar with," Makin adds. "It deepens the relationship between the advisor and the client."