Only seven months remain until new rules from the Internal Revenue Service on cost-basis reporting take effect.

Are mutual fund companies ready?

A new research report just issued by Celent claimed that mutual funds likely are more prepared than broker-dealers were the same time last year, when they had to prepare for the changes. However, fund operators still aren't in the clear.

"Mutual funds still have to make plenty of technological adjustments to their middle- and back-office systems, change customer interfaces and be prepared for an onslaught of calls from potentially unhappy or confused investors." said Cameron Routh, senior vice president of SciVantage, a Jersey City, N.J., provider of Web-based front- and middle-office technology, which commissioned the report from Celent.

SciVantage is one of a handful of technology firms providing cost basis reporting services. Others include Wolters Kluwer Financial Services, NetWorth Services and Broadridge Financial.

Here are the basic challenges which mutual funds must now address:

* Can the right data be procured reliably, to support the necessary calculations on the original cost of a security?

* Have systems been adjusted to accommodate so-called "wash" sales, where a security is sold at a loss and then substantially the same amount of the same stock is repurchased to create a tax loss?

* Can their systems accommodate the choices that investors are allowed to make in the method of calculating the cost basis of their securities, from average cost to first-in first-out to last-in first-out to specific identification of lots?

* Will there be enough staff will be on tap to answer the flood of questions that will come in from customers as they make those choices?

Beginning Jan. 1, 2012 mutual fund companies for the first time will be required to track and report the cost of a mutual fund transaction to both the Internal Revenue Service and investors. The rule became effective for regular stock acquired on or after Jan. 1, 2011.

Investors in both mutual funds and equity accounts can select the method of cost basis reporting they want-first in-first out accounting or specific identification approach which allows them to first sell the lots of securities that means paying the least amount of taxes. Only investors in mutual funds and dividend reinvestment plans are allowed to use the average cost methodology and an investor selecting average cost methodology cannot change his or her mind.

"Mutual funds are still struggling to deal with the IRS' restriction in average cost methodology and how to treat the average cost of shares covered by the new rule when uncovered shares bought before the effective date are part of the average cost basis pool," said Nico Willis, chief executive of Nettworth Services in Phoenix, Ariz.

The good news: Mutual funds are less likely than broker-dealers to be starting from scratch. "Many mutual fund companies have been providing cost basis reporting as a customer service using average cost as the methodology," said Stevie Conlon, senior director and tax counsel with Wolters Kluwer Financial Services in Boston. "However, because it was not legally required, mutual funds aren't certain the data was accurate."

Correct data would include the dates when the investor purchased initial shares in the fund, any additional purchases were made and the prices at which the trades were executed. Not all order management systems or customer account systems retained that information.

The lack of accurate historical data could end up creating a customer service problem. Here's why: As a rule of thumb, the IRS will allow investors to decide which methodology they wish the mutual fund company to use when it come to covered shares-all of the shares purchased after the effective date.

This method can be applied for each 100 shares, known as a tax lot. However, mutual fund companies don't have to agree to allow the investor to combine covered shares and shares purchased before the effective date into a single account when using the average cost methodology. All the mutual fund company has to say is that it can't find accurate data on legacy accounts and it's off the hook. The IRS is allowing the mutual fund company to decide whether the single account election is available and as a result include shares purchased before the effective date as covered shares.

If the mutual fund can't provide cost basis accounting for legacy accounts as a single account, investors will receive two statements: one calculating the cost basis of covered shares and the other not doing so. "Mutual funds may not be prepared to have their staff handle the customer frustrations that will take place," Conlon said.

Even the most basic decisions on whether to buy or build technology won't be easy; each of the choices poses operational challenges of its own. "Mutual funds which rely on home-grown systems and licensed systems will need to make certain they can account for wash sales and other reporting methodologies while those outsourcing to their transfer agents must make certain their systems are up to par to comply with the new rules," said Isabella Fonseca, director of wealth management research at Celent. "Larger fund companies will likely either adapt their current platform or license a new one while small to mid-sized firms will be turning to their transfer agents and custodian banks for help."

Routh warned that mutual funds which rely on their transfer agents and custodian banks to do the work may not know whether or not they are prepared until the end of the year when they are given access to their new systems.

But that might not given them enough breathing room to detect any defects around complicated cost basis scenarios such as switching out of or revoking using average cost methodology or accommodating shares received from gifts or inheritance.

"Mutual funds should start asking their service providers for access to platforms and begin testing now for complicated cost basis scenarios and shareholder facing tools," Routh said.

Like broker dealers, mutual funds looking to license a tax lot reporting system must consider its functionality and ease of use. Licensing a platform will require customization and integration with multiple internal applications such as corporate actions, portfolio accounting, customer onboarding and security master files " Licensed packages don't come with turnkey programming interfaces. So a firm must budget for programmers to help out with interfacing work, Conlon said.

Mutual funds also want to ensure customer support after the shares in a fund do get sold, according to Fonseca. Among the necessary post-sale functionality: interfaces which will allow the customer to electronically select which tax lot methodology to apply to each lot.

Mutual funds can select a "default" method for calculating the cost of an account if the investor doesn't do pick its own but investors can ask the fund company to change that method when they redeem some of their shares or within a year after the mutual fund has made its decision.

The most difficult regulatory nuance to track: wash sales. "It will require coding changes on tax reporting systems to classify a transaction as a wash sale and additional data from order management, customer account and portfolio recordkeeping platforms to make the calculation," Conlon said.

If the sale of securities falls under what the IRS considers a wash sale, the investor will not be allowed to take a tax loss even if he or she sold the shares at a lower price than what they bought them. Wash sales can easily be triggered through the sale of fractional shares and shares from automatic dividend reinvestment accounts.

"It's likely to happen far more often with mutual funds than equity accounts and the easiest to miss due to additional share purchases and dividend reinvestments," Conlon said. "So mutual funds have to be extra cautious that wash sales are programmed into any platform they use."

Making matters more complicated, the mutual fund will be required to apply the tax loss from the wash sale to the cost basis of the first lot of shares purchased by the investor. If the investor selected the average cost basis methodology to be used for that lot of shares then the cost basis of all of the other lots of shares subsequently purchased by the investor will have to be readjusted to incorporate the tax loss, Willis said. MME

Only seven months remain until new rules from the Internal Revenue Service on cost-basis reporting take effect.

Are mutual fund companies ready?

A new research report just issued by Celent claimed that mutual funds likely are more prepared than broker-dealers were the same time last year, when they had to prepare for the changes. However, fund operators still aren't in the clear.

"Mutual funds still have to make plenty of technological adjustments to their middle- and back-office systems, change customer interfaces and be prepared for an onslaught of calls from potentially unhappy or confused investors." said Cameron Routh, senior vice president of SciVantage, a Jersey City, N.J., provider of Web-based front- and middle-office technology, which commissioned the report from Celent.

SciVantage is one of a handful of technology firms providing cost basis reporting services. Others include Wolters Kluwer Financial Services, NetWorth Services and Broadridge Financial.

Here are the basic challenges which mutual funds must now address:

* Can the right data be procured reliably, to support the necessary calculations on the original cost of a security?

* Have systems been adjusted to accommodate so-called "wash" sales, where a security is sold at a loss and then substantially the same amount of the same stock is repurchased to create a tax loss?

* Can their systems accommodate the choices that investors are allowed to make in the method of calculating the cost basis of their securities, from average cost to first-in first-out to last-in first-out to specific identification of lots?

* Will there be enough staff will be on tap to answer the flood of questions that will come in from customers as they make those choices?

Beginning Jan. 1, 2012 mutual fund companies for the first time will be required to track and report the cost of a mutual fund transaction to both the Internal Revenue Service and investors. The rule became effective for regular stock acquired on or after Jan. 1, 2011.

Investors in both mutual funds and equity accounts can select the method of cost basis reporting they want-first in-first out accounting or specific identification approach which allows them to first sell the lots of securities that means paying the least amount of taxes. Only investors in mutual funds and dividend reinvestment plans are allowed to use the average cost methodology and an investor selecting average cost methodology cannot change his or her mind.

"Mutual funds are still struggling to deal with the IRS' restriction in average cost methodology and how to treat the average cost of shares covered by the new rule when uncovered shares bought before the effective date are part of the average cost basis pool," said Nico Willis, chief executive of Networth Services in Phoenix, Ariz.

The good news: Mutual funds are less likely than broker-dealers to be starting from scratch. "Many mutual fund companies have been providing cost basis reporting as a customer service using average cost as the methodology," said Stevie Conlon, senior director and tax counsel with Wolters Kluwer Financial Services in Boston. "However, because it was not legally required, mutual funds aren't certain the data was accurate."

Correct data would include the dates when the investor purchased initial shares in the fund, any additional purchases were made and the prices at which the trades were executed. Not all order management systems or customer account systems retained that information.

The lack of accurate historical data could end up creating a customer service problem. Here's why: As a rule of thumb, the IRS will allow investors to decide which methodology they wish the mutual fund company to use when it come to covered shares-all of the shares purchased after the effective date.

This method can be applied for each 100 shares, known as a tax lot. However, mutual fund companies don't have to agree to allow the investor to combine covered shares and shares purchased before the effective date into a single account when using the average cost methodology. All the mutual fund company has to say is it can't find accurate data on legacy accounts and it's off the hook. The IRS is allowing the mutual fund company to decide whether the single account election is available and as a result include shares purchased before the effective date as covered shares.

If the mutual fund can't provide cost basis accounting for legacy accounts as a single account, investors will receive two statements: one calculating the cost basis of covered shares and the other not doing so. "Mutual funds may not be prepared to have their staff handle the customer frustrations that will take place," Conlon said.

Even basic decisions on whether to buy or build technology won't be easy; each of the choices poses operational challenges of its own. "Mutual funds which rely on home-grown systems and licensed systems will need to make certain they can account for wash sales and other reporting methodologies while those outsourcing to their transfer agents must make certain their systems are up to par to comply with the new rules," said Isabella Fonseca, director of wealth management research at Celent. "Larger fund companies will likely either adapt their current platform or license a new one while small to mid-sized firms will be turning to their transfer agents and custodian banks for help."

Routh warned that mutual funds which rely on their transfer agents and custodian banks to do the work may not know whether or not they are prepared until the end of the year when they are given access to their new systems. But that might not provide enough breathing room to detect any defects in complicated scenarios such as switching out of or revoking using average cost methodology or accommodating shares received from gifts or inheritance.

"Mutual funds should start asking their service providers for access to platforms and begin testing now for complicated cost basis scenarios and shareholder facing tools," Routh said.

Keeping track of wash sales could end up being the most challenging aspect of either licensing a tax-lot accounting platform or building one in-house.

That's because of the complicated coding changes and data needed to classify transactions as wash sales, said Conlon.

Such events could be far more easily triggered in mutual funds than equity accounts through the sale of fractional shares and shares from automatic dividend reinvestment plans. If the sale of securities falls under what the IRS considers a wash sale, the investor cannot take a tax loss even if the shares were sold at a lower price than purchased. MME

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