The IRS will soon be looking over the shoulders of tax return preparers and their clients when they report stock sales on Schedule D, Form 1040.
For stock acquired and sold after 2010, the IRS will receive information returns from security brokers reporting the adjusted basis of the stock sold and whether the capital gain or loss on the sale is short-term or long-term. These information returns will allow the IRS to double check what you report for your clients on Schedule D.
The silver lining for your clients is that they will have some control over what their brokers report in certain situations. Your clients should receive information and advice from their brokers about the new rules. However, if there are slip-ups, you are going to have to explain to your clients why their tax bill is higher than they expected.
The IRS recently issued proposed regulations governing the new reporting rules [REG-101896-09]. Let’s take a closer look at the new rules in question-and-answer form to see how they will impact your clients’ returns.
Which sales are subject to the new broker-reporting requirements?
The new requirements generally apply to a sale of a “specified security” that was acquired on or after an “applicable date.” Specified securities generally include
- Shares of corporate stock.
- Notes, bonds, debentures, or other evidences of indebtedness.
- Commodities, or contracts or derivatives connected with commodities.
Graduated Phase-In. The applicable date is January 1, 2011, for shares of corporate stock; January 1, 2012, for mutual fund shares and stock shares acquired through a dividend reinvestment plan; and January 1, 2013 (or another date set by the IRS) for other specified securities [IRC Sec. 6045(g)].
(Note: The IRS’s proposed regulations deal only with stock and mutual fund sales because of the earlier effective dates for these sales. The IRS will issue additional guidance on other specified securities in the future.)
How will brokers report the new information?
Brokers will report the information to the IRS and sellers on a revised Form 1099-B. Form 1099-B is currently used to reported the gross proceeds of security sales; under the new requirements, it will also provide the adjusted basis and long-term/short-term information.
The proposed regulations provide that brokers report a sale of securities on one return, even if the sale involves multiple acquisitions (and multiple adjusted bases).
However, because brokers must report whether any gain or loss on the sale of a security is short-term or long-term, and because securities not covered by the new rules must be reported separately from those that are in order to maintain their status, your clients could receive as many as three Form 1099-Bs for a single sale.
How will the broker determine a client’s adjusted basis?
The basis reported by a broker is the total amount paid by the client or credited against a client’s account as a result of the acquisition of the securities, adjusted for commissions and the effects of other transactions occurring within the account. The proposed regulations also require brokers to adjust the basis they report to take into account the information received on a transfer statement in connection with the transfer of securities into the account (see below) [Prop. Reg. 1.6045-1(d)(6)].
When a client sells less than the entire position of a security in his or her account, the client can provide the broker with instructions as to which shares are being sold. The proposed regulations require the broker to follow adequate instructions in determining the basis and capital gain holding period of the shares when completing Form 1099-B [Prop. Reg. 1.6045-1(d)(2)]. This gives a client the power to identify the shares being sold as the ones that provide the best tax results.
To qualify as an adequate instruction, a client must generally identify the shares in writing (e-mails qualify) no later than the settlement date. The proposed regulations provide that a standing order or instruction for the specific identification of stock will be treated as an adequate identification.
Mutual funds and shares acquired through dividend reinvestment plans. In the case of mutual funds and dividend reinvestment shares acquired at different prices, the proposed regulations allow sellers to use an “average basis” method for computing the basis amount to be reported to the IRS as long as the shares being averaged are identical. The broker must compute basis for 1099-B purposes using the average basis method if the taxpayer so elects [Prop. Reg. 1.6045-1(d)(2)(v)]. The holding period of stock to which the average basis method applies is determined on a first-in, first-out or FIFO basis (the first shares being sold are deemed to be those held the longest).
Example. Client D enters into an agreement with W Custodian establishing an account for the periodic acquisition of shares of L Company, a mutual fund. W acquires for D’s account shares of L Company stock on the following dates in the specified amounts:
At D’s direction, W sells 40 shares from the account on January 15, 2013, for $10 per share or a total of $400. D elects to use the average basis method for the shares of L Company. The average basis for the shares sold on January 15, 2013, is $8.99 (total cost of shares, $800, divided by the total number of shares, 89), resulting in a gain of $1.01 per share on the sale. The shares sold are deemed to be the shares first acquired.
Thus, D realizes $25.25 ($1.01 x 25) long-term capital gain for the 25 shares acquired on January 8, 2012, and $15.15 ($1.01 x 15) short-term capital gain for 15 of the shares acquired on February 8, 2012.
Your client can elect the average basis method by notifying the custodian or other agent for the account in writing. The client must make a separate election for each account holding mutual fund and dividend reinvestment shares. The proposed regulations provide that the average basis method can be elected at any time, effective for sales after the date of the election.
How does the broker determine basis if a seller does not identify which shares are being sold?
Absent a valid instruction from the seller, the proposed regulations clarify that a broker must report basis of a security (other than stock eligible for averaging) using the FIFO method when completing Form 1099-B. In the case of mutual fund and dividend reinvestment shares, a broker must report basis by using a default method selected by the broker.
How does a broker get the information needed to determine basis and holding period if the broker was not connected with the original acquisition of the security?
Under the proposed regulations, any “applicable person” is required to furnish a broker with a transfer statement when transferring securities to the broker on or after January 1, 2011 [Prop. Reg. 1.6045A-1]. Applicable persons include another broker, any person that acts as a custodian of securities in the ordinary course of a trade or business, any issuer of securities, and any agent of these persons. In the case of securities subject to the new reporting requirements, the statement must give the receiving broker the information needed to meet the new requirements. If securities are not subject to the new rules, the transfer statement must so specify.
Do the new basis reporting rules apply to securities received by a client as a gift or inheritance?
Yes. Under the proposed regulations, gifted and inherited securities that were subject to the new rules in the account of the donor or decedent remain subject to the new rules when transferred to the recipient’s account, and “applicable persons” must prepare transfer statements for the securities.
With gifts, the transfer statement must indicate that the transfer consists of gifted securities and state the adjusted basis of the securities in the hands of the donor and the donor’s original acquisition date of the securities. The transfer statement must also report the date of the gift (if known when furnishing the statement) and the fair market value of the gift on that date (if known or readily ascertainable). Upon the subsequent sale, the selling broker must apply the relevant basis rules for gifts when reporting adjusted basis.
With inherited securities, the transfer statement must indicate that the securities are inherited and also report the date of death as the acquisition date and report the adjusted basis in accordance with the instructions and valuations provided by the executor or other authorized representative of the estate. The selling broker must use this information when preparing Form 1099-B.
How do the new reporting rules apply to “wash sales?”
Under Code Section 1091, a sale of securities is considered a wash sale if the seller acquires “substantially identical” securities within 30 days before or after the sale. Any loss on a wash sale is not currently deductible, but the basis of the reacquired securities is adjusted to reflect the disallowed loss. The proposed regulations provide that a broker is required take the wash sale rules into account on Form 1099-B only if both the purchase and sale transactions occur in the same account with the sameCommittee on Uniform Security Identification Procedures (CUSIP) number. If a broker is required to apply the wash sale basis adjustments, the broker must report the amount of the disallowed loss in addition to the adjusted basis for the sold security. The broker must adjust the basis of the purchased security by the amount of the disallowed loss when reporting the eventual sale of the purchased security.