Broker-Dealers Getting to Grips With Cost Basis Reporting

Terry Flanagan

Cost basis reporting (CBR) regulations—which identify the actual cost of a security for income tax purposes—are having a substantial impact on broker-dealers by requiring them to analyze whether a securities transaction is a potential wash sale, and to maintain ‘tax lot’ inventories, or categories of securities by transaction date, in order to comply.

Following the first two of three phases of CBR regulations, financial services firms have experienced challenges with the automation and transfer of data between books and records, cost basis reporting systems and tax reporting systems, according to a recent report by research firm Celent.

In addition, accuracy of calculations for wash sales and corporate actions were also a high priority.

Firms have been given until January 2014 by the U.S. Internal Revenue Service to implement the third phase, involving fixed income regulations, but this could prove the trickiest of all.

“For those struggling with CBR, fixed income has more taxable events than equities,” said George Michaels, chief executive of G2 FinTech, a provider of tax analysis and compliance software for the U.S. and international investment management community.

TaxGopher, G2’s flagship product, is a tax analysis engine for cost basis adjustment, which enables firms to provide accurate information on taxable gains and losses. For a full cost basis reporting system, G2 offers TaxGopher+, which adds a tax lot retirement engine to TaxGopher.

The Internal Revenue Service code provides that a taxpayer cannot take a loss on the sale of a stock or certain other types of securities and financial contracts if the taxpayer acquires substantially identical stock or securities within a 61-day period that begins 30 days before the date of such sale and ends 30 days after such sale—in other words, a wash sale.

Although the code regarding wash sales have been on the books since 1921, the 2008 CBR law allows brokers to ignore transactions occurring in other accounts (cross-account wash sales) and transactions that do not involve identical securities.

“Such simplified wash sale reporting by brokers makes policy sense because of computer system limitations—determining whether stocks or securities are substantially identical to one another can be problematic and highly factual under the tax law—and limitations on access to data,” said Stevie Conlon, senior director and tax counsel at Wolters Kluwer Financial Services, a provider of compliance and risk management solutions, in a blog.

For example, a broker would not generally have reason to know about transactions in accounts held by other brokers. Additionally, even different accounts held by the same broker might be administered on different back office systems that might not readily share information.

“CBR is a watered-down version [of the wash sale restrictions],” said Michaels. “You only have to worry about wash sales in specialized cases.”

Taxpayers, including hedge funds and investment funds, are not subject to such exceptions and must apply the straddle and constructive sales rules, if applicable.

To enable broker-dealers to comply with CBR, G2 FinTech released TaxGopher+, a streamlined version of its flagship product TaxGopher, which is used for cost basis adjustments on taxable gains and losses on constructive sales, straddles and qualified dividends.

“Our original software suite [TaxGopher] was designed for far more complex transactions encountered by the buy side community, such as hedge funds and asset managers,” said Michaels. “To make that software usable for brokers to comply with CBR, we had to turn off some of the more sophisticated functionality.”

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