Compliance Complexities

Although we have not seen major changes from 2010 on how your 2011 personal income taxes will be calculated, there have been a few changes to compliance that may leave you scratching your head. The changes include sharing more detailed information with the IRS, so that they can then cross-reference your return to third party reporting. The theory is that this will not only encourage taxpayers to be truthful on their returns, but it will also increase the ability for the IRS to find those who are not in compliance.

One of these changes involves a new tax form for reporting capital gains and losses from stocks, bonds, mutual funds and similar investments. Historically, all capital transactions were reported on Schedule D of your tax return. Starting with the 2011 tax year, investment transactions will be reported on the new Form 8949, Sales and Other Dispositions of Capital Assets. This form will list different categories of transactions and will then flow through to a revised Schedule D.

Back in 2008, Congress passed the Emergency Economic Stabilization Act, which required that brokers begin reporting the cost basis of investment products to investors and to the IRS. In theory, having brokers report cost basis along with sales proceeds will greatly reduce burden on individual taxpayers to maintain extensive records on their investments and could simplify the tax reporting process. In practice, this will add compliance time and cost as you must reconcile the information reported on Form 1099-B with other records including basis information.

Brokerage firms send out a Form 1099-B to report the sale of an investment product, such as a stock or mutual fund. Currently, the 1099-B only reports information about the sale of the investment (such as the date of sale and the sale proceeds). Taxpayers then need to supply the purchase date and purchase price to report the transaction on their Schedule D. Many brokers already provide gain/loss reports as supplemental information. Starting in 2011, cost basis information will be included directly on the 1099-B if the broker is required to supply that information. Whether a broker is required to provide cost basis information depends on whether the investment is a “covered security.” Brokers are required to provide cost basis for stocks acquired during 2011 (or later), for mutual funds and stocks in a dividend reinvestment plan acquired during 2012 (or later) and all other investment products acquired during 2013 (or later).

The IRS has substantially revised Form 1099-B to facilitate this cost basis reporting. The IRS has also substantially revised Schedule D and created the new Form 8949. Starting with 2011, Schedule D now functions as a summary of all capital gains transactions. Individual investment sales are to be detailed on the new Form 8949.

Any particular investment sales transaction will fall into one of three categories:

• Sales of covered securities for which cost basis is provided;
• Sales of non-covered securities for which no cost basis is provided on the 1099-B; or
• Sales of investments assets for which no 1099-B is received.

The new Form 8949 reflects this categorization. A separate Form 8949 is required for each type of transaction, with the appropriate check box indicated at the top of the form. Form 8949 is further divided into two pages, with short-term transactions being listed on page 1 and long-term transaction listed on page 2.

To phrase this a different way, there will be one Form 8949 reporting capital gains and losses where cost basis is provided (check box A), with short-term transactions listed on page 1 and long-term transactions listed on page 2. There will be a separate Form 8949 reporting capital gains and losses with cost basis in not provided (check box B), with short-term transactions shown on page 1 and long-term transactions shown on page 2. And there will be a third Form 8949 reporting capital gains and losses where Form 1099-B was not received (check box C).

Totals from these separate Forms 8949 will be summarized on the newly revised Schedule D. The Form 8949 will also include codes that taxpayers can use when they are making adjustments to the reported basis on the Forms 1099-B.

A final item to note is that the default for lot selection is FIFO (first-in-first-out). An example of this is when a taxpayer has purchased various lots of the same stock over time and then sells only a portion of their holdings. The default is for the first lot purchased to be the lot that was sold, which may result in more or less gain/loss than was planned for. Specific lot selection can be made, but must be identified at the time of sale and communicated appropriately with the brokerage house. The average cost method can also be elected for mutual fund transactions and for certain types of real estate investment trusts.

Although historical basis reporting will be handled entirely by the brokerage houses, it is still important to keep your own records to verify their records and to keep track of any basis changes that may not be in the brokerage houses’ database.

If you have any questions or need guidance on these new compliance complexities, please contact me at bforeman@bpw.com or (805) 963-7811.