On December 16, 2009, the Internal Revenue Service (IRS) issued proposed regulations (REG-101896-09) regarding the reporting of tax basis by stockbrokers and mutual fund companies to investors and the IRS. The proposed regulations reflect new rules enacted in 2008 by the Energy Improvement and Extension Act (part of the Emergency Economic Stabilization Act, Public Law 110-343) (the Act). IRS Commissioner Douglas Shulman stated that “this important reporting change will improve tax compliance while reducing the recordkeeping and paperwork burden for millions of investors. These taxpayers will now receive the information they need to more easily report their gains and losses correctly.”1
The proposed regulations describe, among other things, who is subject to the applicable reporting requirements, which transactions are reportable, and what information needs to be reported. Some of the key aspects of the proposed regulations are:
Reporting Requirements
Section 6045 generally provides that brokers must provide to customers and the IRS certain information, such as the gross proceeds from the disposition of securities.2 For these purposes, the term “broker” includes not only those persons one might associate with the term, such as a stockbroker or real estate broker, but includes any U.S. or foreign person that in the ordinary course of a trade or business stands ready to effect sales (including redemptions and terminations) to be made by others. Section 6045(g), as amended by the Act, expands the broker reporting requirements, and provides that brokers must report to customers and the IRS the customer’s adjusted tax basis in “covered securities” sold, and whether any gain with respect to such securities is long-term or short-term.
Pepper Point: The new Section 6045(g) reporting requirements are effective for dispositions of most corporate shares that are covered securities starting January 1, 2011. The new rules are effective for regulated investment company (RIC) shares or dividend reinvestment plan (DRP) shares that are covered securities starting January 1, 2012.
The information required by Section 6045 must be reported on Form 1099-B, Proceeds from Broker and Barter Exchange Transactions, which will be modified under the proposed regulations. Section 6045(b), as amended by the Act, extended the due date by which brokers must provide Form 1099-B to customers from January 1 to February 15.
The proposed regulations generally maintain the rule that brokers must report the activities within an account in a single information return. However, the IRS pointed out in the preamble to the proposed regulations that brokers must report covered securities separately from non-covered securities, and must report gain on covered securities as short-term or long-term gain. Thus, the IRS noted that a single sale in an account could necessitate as many as three returns if the sale included covered securities held more than a year, covered securities held one year or less, and non-covered securities.
Covered Security
Section 6045(g)(3)(A), as enacted under the Act, provides that a “covered security” is any “specified security” acquired on or after the applicable date, as discussed above, if the security (1) was acquired through a transaction in the account in which the security was held, or (2) was transferred to that account from an account in which the security was a covered security, but only if the broker receiving custody of the security receives an information statement with respect to the statement. Section 6045(g)(3)(B) provides that a “specified security” is any (1) share of stock in a corporation, (2) note, bond, debenture, or other evidence of indebtedness, (3) commodity, or a contract or a derivative with respect to a commodity, and (4) other financial instrument as determined by the IRS.
Determining Adjusted Tax Basis
The proposed regulations provide rules regarding how a broker should calculate the adjusted tax basis of securities held in a customer’s account. The proposed regulations clarify that, generally, a taxpayer’s adjusted basis in securities held in his or her account is the amount paid, adjusted for commissions and certain other transactions. Brokers must adjust the basis reported on Form 1099-B to take into account certain information available to the broker, including information received on a transfer statement in connection with the transfer of a security or information received from the stock issuer about corporate actions affecting basis. On the other hand, brokers are generally not required to adjust the reported basis for transactions or events occurring outside of the customer’s account and without the broker’s direct actual knowledge.
Pepper Point: The proposed regulations adhere to the general rule under Section 6045(g)(2)(B)(i)(I) that with respect to corporate stock in a customer’s account, a broker must determine and report basis using the FIFO (first-in, first-out) method for determining what shares were sold. In situations in which a customer does not sell all shares of a particular corporate security held in an account, the customer may request that the broker use a permissible method other than FIFO, and the selling broker must follow the customer’s instructions to identify the specific shares sold. Thus, customers may specifically identify the shares to be sold or request that another method, such as average basis, be used.
In contrast to the rule for most corporate stock held in an account, the general rule under Section 6045(g)(2)(B)(i)(II) with respect to RIC and DRP shares provides that basis must be calculated based on the broker’s default method. The default method is not prescribed by statute or regulation, and the broker may choose any permissible method as its default method. Once again, however, the customer is permitted to notify the broker that he or she has elected an alternative permitted method and, if so, the broker must adhere to such elected method.
Average Basis Method
The proposed regulations would eliminate the “double-category method” for determining average basis. Under current rules, Treas. Reg. Section 1.1012-1(e)(3) and (4) provide that taxpayers may compute average basis by choosing one of the two available methods. The “double-category method” divides stock by the holding period and averages long-term shares separately from short-term shares. The “single-category method,” on the other hand, ignores the short-term versus long-term distinction and averages all shares together.
Pepper Point: Only the single-category method would be permitted under the proposed regulations. Brokers must use a FIFO ordering rule when determining the holding period of stock to which the single-category basis method applies.
The proposed regulations extend to DRP stock the average basis method of Treas. Reg. Section 1.1012-1(e) that is already available for RIC stock. Thus, taxpayers would be permitted to elect the average basis method for DRP shares acquired after December 31, 2010. DRP shares are eligible for the average basis method only if they are identical. The proposed regulations define identical shares of stock as stock with the same Committee on Uniform Security Identification Procedures (CUSIP) number. Shares acquired through a DRP are not considered identical to shares not acquired through a DRP even if the shares have the same CUSIP number. Certain corporate actions, such as mergers, consolidations, spin-offs, or split-offs, will not cause the underlying shares to be ineligible for averaging; the stock of a successor entity following such a corporate action is identical to the stock of the predecessor entity.
Pepper Point: Commentators had suggested to the IRS that even if a customer requested a broker to do so, brokers should not be required to compute basis for a DRP using the average basis method. The IRS rejected this suggestion. The broker must use the average basis method if elected by the taxpayer; otherwise, the broker must use its default method. The proposed regulations do not mandate a broker default method for RIC or DRP shares, and the broker may determine its own default method.
Taxpayers should elect the average basis method on the income tax return for the first year when the taxpayer desires the method under Treas. Reg. Section 1.1012-1(e)(6). The taxpayer must notify his or her broker of the election in writing in order to request the broker to follow the method. The proposed regulations provide that a taxpayer may change from the average basis method to another permissible method at any time, and that such a change is considered a change in method of accounting subject to Sections 446 and 481.
Wash Sales
Under the proposed regulations, brokers must report the effect of wash sales under Section 1091 only if the purchase and sale transactions occur with respect to covered securities in the same account with the same CUSIP number. The broker must report the amount of the disallowed wash sale loss in addition to the adjusted basis and gross proceeds for the sold security. Then, upon the subsequent sale of the purchased security, the broker must adjust the basis of the purchased security by the previously disallowed loss.
Pepper Point: The IRS did not incorporate into the proposed regulations certain wash sale reporting exceptions as requested by commentators for certain de minimis items and for high frequency traders. The IRS still appears to be considering the matter and has requested additional comments about the treatment of high frequency traders under this rule, including comments on the inter-relatedness of the Section 475 mark-to-market rules, which generally exempt traders from the Section 1091 wash sale rules.
Sales by S Corporations
Recently enacted Section 6045(g)(4) requires brokers to report sales by S corporation customers of covered securities acquired on or after January 1, 2012. This rule is an exception to the general rule under Treas. Reg. Section 1.6045-1(c)(3)(i)(B)(1) that a broker is not required to report sales of securities by a corporation. The proposed regulations clarify the new rule, and provide that the broker is not permitted to rely solely on the customer’s name to determine whether it is a corporation exempt from reporting, since a corporate name does not generally distinguish a C corporation from an S corporation. If a broker does not have actual knowledge that a corporation is a C corporation exempt from reporting, the broker must either request a Form W-9 exemption certificate from the corporation or else make and deliver to the corporate customer and the IRS a return of information with respect to such corporation for sales of covered securities acquired on or after January 1, 2012.
Transfers of Gifted or Inherited Securities
Under the proposed regulations, gifted or inherited securities would retain “covered security” status when transferred from the account of the donor or decedent to the recipient’s account. In both instances, a transfer statement should accompany the gifted or inherited shares. For inherited shares, the transfer statement must indicate (i) that such securities are inherited, (ii) the acquisition date (date of death), and (iii) the adjusted basis in accordance with instructions and valuations from the estate’s authorized representative. The selling broker must then take this information into account when the shares are disposed by the recipient on a subsequent sale. For gifted shares, the transfer statement must indicate (i) that such securities are gifted, (ii) the adjusted basis in the hands of the donor, (iii) the donor’s original acquisition date, (iv) the date of the gift (if known), and (v) the fair market value of the gift (if known) on the transfer date. Similarly, the selling broker must then take this information into account when the recipient disposes of the shares in a subsequent sale.
Comments on the Proposed Regulations
The IRS has requested comments by February 8, 2010 on the proposed regulations and its preliminary draft of the new Form 1099-B. In addition, a public hearing on the proposed regulations is scheduled for February 17, 2010.
For more information, please contact Gregory J. Nowak at nowakg@pepperlaw.com, 215.981.4893 or 212.808.2700, or Bryan Keith at keithb@pepperlaw.com or 202.220.1220.
ENDNOTES
1 IRS News Release, IR-2009-118 (Dec. 16, 2009).
2 Unless otherwise stated, all references to “Section” are to the Internal Revenue Code of 1986, as amended, and all references to the “Regulations” or to “Treas. Reg.” are to the Treasury Regulations promulgated thereunder.
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