by Ed McCarthy, CFP®
It’s early April 2012. A client’s accountant calls to ask you about the tax treatment of a stock sale from February 2011. Your internally generated capital gains and losses report for the client, which you gave to the accountant as you have every year, showed the transaction generating a long-term loss. That’s not what the custodian reported on the client’s Form 1099-B, the accountant tells you. That form is showing a short-term gain—what happened?
It’s a hypothetical but plausible scenario. Brokers currently report the year’s sales proceeds on Form 1099-B to the investor and the IRS. (“Broker” in this usage also includes custodians.) Some firms supplement the form with a gain/loss report, but the data sent to the IRS do not include cost basis. That practice is about to change with the implementation of the Emergency Economic Stabilization Act of 2008’s (the “Act”) cost-basis reporting provisions. Starting on a staggered basis on January 1, 2011, brokers must report sold securities’ adjusted cost basis and holding periods to the IRS and the investor.
The Act’s requirements apply to firms involved in the transaction: brokers, custodians, transfer agents, etc. Although the legislation does not address financial advisers’ role directly, the new regulations nonetheless will influence advisers’ workflow and change the reports their clients receive from custodians. Failing to prepare for the changes could lead to some unpleasant surprises for clients and advisers, as well as missed planning opportunities. Here’s what you need to know and do.
The Key Dates
The new rules phase in from January 1, 2011, through January 1, 2013, depending on the security’s type. Securities acquired before their class’s specified starting date are considered “uncovered” securities and brokers aren’t required to track cost basis for these securities. Securities acquired on or after their class’s specified date are “covered” securities and their basis and holding period must be tracked and reported. Broadly speaking, the starting dates are reported in Table 1.
What’s Changing?
The new regulations cover several topics, including:
Default cost-basis assumptions and lot specification. Brokers will use default lot identification methods for covered securities’ basis calculations and apply those defaults to sales unless the client requests an alternative method. For example, in the absence of other instructions, the broker may assume FIFO (first-in, first-out) for stocks and average cost for mutual funds.
The client can request a different method, such as LIFO (last-in, first-out), low cost, or high cost, assuming the broker permits those methods. Advisers will be able to specify an alternative default method as well, again depending on what the broker offers. There’s an important new requirement, though: investors using an alternative method must specify that method before the covered security’s trade settles. Once the trade settles, for example, T + 3 (trade date plus three business days) for stocks, the method used for the trade can’t be changed.
Brokers must provide cost-basis information for covered securities when transferring assets. When brokers transfer assets to another broker, the sending broker must provide numerous details including acquisition date, covered or uncovered status, cost basis, and holding period.
Gifted and inherited shares transferred between accounts must be identified and gain/loss must be accounted for. According to Charles Schwab, these shares and their gain or loss must be identified: “For gifted shares, this includes capturing the date of the gift and the donor’s adjusted cost basis and the fair market value (FMV) of the shares on the date of the gift. If, when the gift is made, the donor’s adjusted basis exceeds the FMV, special rules apply that limit the loss the gift recipient can claim when the shares are sold. Inherited shares will be uncovered by the legislation until instructions from the estate executor are received on how to adjust basis. The broker is required to make one attempt to obtain applicable instructions from the estate executor.”1
Brokers must account for wash sales within single accounts. Clients are still responsible for reporting wash sales across their holdings. Brokers must apply wash sale rules’ basis adjustment when applicable, but they’re required to consider identical securities only within a single account. Investors must apply the rule across all of their accounts.
Advisers’ Concerns
The advisers contacted as prospective sources for this article gave a range of responses to the upcoming changes. Some did not anticipate any problems or changes to their operations: “It’s the custodians’ and brokers’ problem, not ours.” Other advisers, particularly those currently generating internal gain-loss reports for clients and those working with multiple custodians, foresee a possibility that the custodians’ reports would conflict with theirs.
Connie Wyllie, director of client services and operations with TFC Financial Management in Boston, Massachussetts, notes that for many years her firm has provided clients with year-end gain/loss reports from its Advent Axys® software. She’s concerned that the new regulations could cause conflicts if the firm’s information does not match that provided to the IRS by the custodian. “In some cases the custodian is missing a lot of (historical basis) information,” she says. “The challenge for us is getting the custodian’s information updated and providing accurate information that’s using separate accounting methods.”
Steve Holdsworth, MBA, CFP®, CLU®, director of client services and financial planning with Legacy Wealth Management Inc. in Memphis, Tennessee, expresses similar thoughts. His firm also provides a realized gain/loss report in its annual tax report to clients.
“We use a high-cost, long-term tax-minimization strategy that is tracked through our portfolio accounting system, which is Advent Axys,” Holdsworth says. “It is not the traditional FIFO or average cost, single category method that the vast majority of the custodians use for their default methodology.”
The report-matching challenge could be compounded for firms that use automated rebalancing software. Adam Leone, CFP®, ChFC®, financial adviser with Modera Wealth Management in Westwood, New Jersey, says that the iRebal program generates most of the firm’s trade tickets using a-highest-cost lot method as its default; the firm also uses that default method with its custodians. Occasionally, however, a client’s tax-planning needs dictate the use of an alternative method.
“In New Jersey, we can’t carry forward losses, so the last couple of years we’ve actually realized some gains intentionally at the end of the year,” he says. “When we change that, we ignore what the custodian has right now—we don’t tell them because they don’t really track it. Once the transaction comes down into Advent, we go in and change the lot accounting method and that’s fine. When we report to clients, we give them the detailed realized gains and loss report. Going forward, we’re going to have to enter in that cost and specify the cost-basis method at the time of trade if it deviates from the default, and that’s just from an operational standpoint. How is that going to manifest itself? Is that going to be in iRebal for us? How does it show up on an order per se? It will be interesting.”
Leone’s comment highlights a key point about the need for accurate basis information to flow through with the transaction. Tax-sensitive investing requires accurate basis values and the flexibility to sell targeted lots. If the new regulation makes it more difficult for advisers to fulfill alternative-basis trades, it could produce unintended tax consequences. See sidebar.
“I think it’s going to force financial advisers to provide a little bit more tax advice about which securities are selected,” says Stevie Conlon, senior director and tax counsel for the Securities Tax Solutions Group at Wolters Kluwer Financial Services. “Under the cost-basis regulations, the taxpayer is supposed to select the security at the time they sell the security. You’re going to need that information, not at the end of the year but at the time of the sale and so there’s going to be a demand for real-time information. I can see situations where a customer would say, you told me to sell securities, why didn’t you tell me which ones to sell? There might be frustration because they might say, I sold them and the 1099 I’m looking at says I sold the wrong ones. Maybe I sold a security and I generated a wash sale and don’t even get to take a loss. You should have known that.”
Custodian Responses
Because the Act’s requirements have been known for some time, custodians and software vendors have been actively preparing for it, although the final regs were still pending as of mid-June 2010. Despite the long lead time, the new rules put advisers in a tight spot if they’re not pleased with how their custodian or software vendors are responding to the new rules, because changing those affiliations is a drastic step. Fortunately, the major custodians appear to be making substantial efforts to prevent post-January 1 snafus. John Tovar, managing director of brokerage services with TD AMERITRADE Institutional (TDAI) in Fort Worth, Texas, says the firm’s post-January 1 trading processes will be flexible.
“Our defaults are going to be FIFO for equities and average cost for mutual funds,” Tovar says. “However, the adviser will be able to set up a default based upon their firm level and at the individual account level and then also at the time of trade, they’ll be able to change the default for that specific transaction.”
TDAI has working groups interacting with advisers on the coming changes. The firm also meets regularly with an operations panel composed of the operations managers of a large swath of advisers on the TDAI platform.
“We just had a meeting two days ago and this was a big topic,” says Tovar. “So we’re taking in much feedback from the adviser community and what they need for us to assist them because this is a big change for everybody.”
Tovar says that TDAI is working with all the portfolio management software companies to establish a process that will allow advisers to upload their cost-base information from their systems to TDAI. Data reconciliation among all the participants is critical, he notes, and post-January 1, TDAI will provide its affiliated advisers a download of the cost-base information that the firm is tracking.
“[This is] a big effort to ensure that there is that continuity for the end-client between the data we show and what they show,” says Tovar.
Brian Keil, director of cost basis and tax reporting with Charles Schwab in San Francisco, California, says that the cost-basis legislation “is of the highest priority at Schwab.” The firm’s focal point is ensuring compliance with the regulations as a broker-dealer. But advisers’ needs are also a top priority, he says, including the capability for advisers to download cost-basis information and to send specified lot instructions electronically for equity trades for next year.
“We’re also looking at how is this going to impact the new 1099 that is going to have this new information on that,” says Keil. “If you step back and think of it, every one of Schwab’s clients that receives a 1099 today, of which there are approximately three million, will have a new experience come January 2012. You imagine three million clients getting a new document and the potential tsunami of calls that may come in as a result of that.”
According to Keil, Schwab is working with several accounting and reporting technology providers, including Schwab Performance Technologies.
“We are working directly with them to ensure that as we deliver cost-basis information to the adviser on a daily basis, they’re able to take that data and import it into their portfolio management system as seamlessly as possible,” says Keil.
Michael Kim, senior vice president, practice management, for Fidelity Institutional Wealth Services, says that the firm plans to offer as many different basis assignment choices to its advisory clients as possible. These choices will include continued use of FIFO as a default, LIFO, specific lot identification, high cost, and average cost. Kim says that Fidelity interfaces with multiple portfolio accounting systems and the firm is working to inform advisers about the need and the importance of reconciling that data with the custodian’s data.
“We have transmissions and interfaces that are in place today where we can take in their data systematically to help them tie their cost basis of the security that they are showing on their system with the information that we have in our system,” Kim says.
Technology in the Center
Advisers recognize that their firm’s trading, accounting, and reporting software will play a critical role in the transition. Chris Flynn, vice-president product management in Advent Software’s Investment Management Group, says that the firm hosted a webinar on the cost-basis regs in mid-June that drew more than 400 participants.
Advent works with about 250 custodians, and Flynn says that getting cost-basis data flows aligned among all parties is a substantial challenge.
He cites an example: “In a typical workflow, the investment manager is never talking to the custodian. It [the order] goes to the broker, then goes to DTC (Depository Trust Company), then comes back to the investment manager and through DTC goes to the custodian. So, the challenge is every one of those parties needs to carry this versus-purchase [identification of specific shares] information.”
So, is Flynn comfortable that all these moving pieces will work together smoothly under the new regs? The good news for advisers is that he believes the larger, adviser-oriented custodians understand the issue and are “all over this.” Still, he says, he doesn’t think that “anybody expects that all the custodians are going to be ready to go on January 1. I think there is going to be some conversion going on during the year and that’s what we anticipate.” From Advent’s perspective, Flynn notes, nothing will change within its systems, which will provide the same functionality and lot-identification that they provide currently.
Potential Benefits
During the transition phase it’s understandable to focus on overcoming potential problems with implementing the new rules. But the changes could also lead to business opportunities, notes Nico Willis, president of NetWorth Services Inc. in Phoenix, Arizona. He believes that in several years, client portfolios could be a mix of covered positions with basis data and pre-effective date positions that lack basis information. Advisers who can provide the research needed to assign those missing basis values will be able to add value to their client services through more effective tax planning, says Willis.
Several other developments are likely to benefit advisory firms and their clients. Firms that don’t currently track and report cost-basis figures internally will have access to more detailed data from their custodians. This will enhance their ability to provide tax-efficient investment management. Firms that currently track and report cost basis might consider modifying their internal record-keeping and reporting processes so their records and their custodians’ are aligned. Additionally, advisers and clients will benefit from simplified income tax forecasting and preparation.
What to Do Now
All sources agree that the key to a successful transition is to review workflows and systems and communicate with custodians, tech vendors, and clients. Tovar emphasizes the need for an open dialogue with custodians to ensure reconciliation between the adviser’s and the custodian’s data. Keil recommends that advisers ask at least the following three questions:
- Which of my internal workflows will be affected by this legislation? Trading, reconciliation, and downloads are all going to be affected within the adviser workflow, he says. If you’re using third party vendors to help support any of those flows, you should be contacting those third parties and asking them, “What are you doing to help me to ensure I can be supported with this change in legislation?”
- What is my firm’s communication support plan for this effort? Clients will hear about the changes in the media or they’re going to see the new Form 1099. Undoubtedly, Keil maintains, clients will contact their advisers first for an explanation. Educating clients about the change and the adviser’s role in helping them through the transition is going to be critical. “Additionally, under that communication support plan is training their staff,” says Keil. “How do they ensure their staff is ready, understands the legislation, and that they’re prepared to support those incoming calls or inquiries that may come in?”
- As a result of this legislation, are my clients likely to want to see gain/loss data more frequently and are they going to want to see it from my system or potentially from the custodian’s system? Will they want to see it on monthly statements?
There is no shortage of resources coming out on this topic for advisers. The custodians and tech companies interviewed for this article, for example, are developing informational resources including webinars and white papers for their adviser clients. Interest in the topic is growing and is likely to increase as articles like this one begin to appear later in 2010. Kim has found that as of early summer 2010, most of Fidelity-affiliated advisers are in “learning mode” about the pending changes. He anticipates that the firm’s interaction with advisers will increase as the year progresses. He urges advisers to avoid delay in learning about the issue and its resolution because this is not a problem you want to tackle after it arises.
“Get started as early as possible,” says Kim. “As you can imagine, again, depending on the size and the amount of data we’re talking about, this is not an easy process. What we would ask for is an opportunity to help our [adviser] clients and for our clients to, frankly, leverage all of the resources and the systems that we have in place to help them comply and help them reconcile the cost-basis information between their system and our system. So, to the extent that they can get started as early as possible, I think that would be key.”
Ed McCarthy, CFP®, is a freelance writer in Pascoag, Rhode Island, and longtime contributor to the Journal of Financial Planning.
Endnote
1. Charles Schwab. 2010. Preparing for the New Cost Basis Regulations: 5.
