Cost Basis Challenges Industry

Terry Flanagan

IRS rules mandate tracking of wash sales and cost-basis changes.

Cost-basis accounting rules imposed by the Internal Revenue Service are having a far-reaching impact on broker-dealers, mutual funds, prime brokers and custodial firms.

The cost-basis legislation states that brokers, custodians and banks have three years to implement system upgrades to track and capture the adjusted cost-basis information for securities transactions that occur for those securities acquired on or after January 1, 2011 for form 1099-B reporting.

The legislation presents new challenges in the form of technology, operations, tax, and legal issues. At the same time, it provides opportunities to offer tax optimization and other services.

As a result, they are deploying purpose-built software for cost-basis reporting and tax accounting.

“Most firms have a cost basis system in place by now. On the other hand, they’re just now learning how good those systems are,” Cameron Routh, senior vice president of strategic products at Scivantage.

In many cases firms will determine their current solution is not sufficient due missing core functionality, such as wash sales or automated corporate actions, or due to the inability to carry accurate functionality through a complex series of events, said Routh.

For example, class conversions and average cost revocation may both work, but revocation following a class conversion may not.

“In general, cost basis reporting has been viewed entirely from a cost perspective,” said Routh. “This has resulted with firms’ selection of low-cost options which will lead to greater expense in the form of operating costs and client satisfaction.”

Firms tend to focus solely on the reporting of basis, rather than the strategic value of pre-trade tax management that real-time cost basis data in the hands of investors offers.

Scivantage provides front- and middle-office technology, covering trade order processing, event notification management, as well as portfolio tax reporting.

Scivantage’s Maxit platform provide cost basis analysis as well as advanced tax management to help investors avoid wash sale deferrals, harvest tax losses, suggest short-term versus long-term sales and identify the most advantageous tax lot relief methods.

A key opportunity for forms using cost basis reporting systems is in tax management, according to a report by Celent.

For example, an investor may hold 20 lots of a given stock, and tax management tools provide the ability to analyze which lots have the best tax implications, according to Celent.

Under the law, cost basis must be adjusted for a variety of corporate actions, such as spinoffs, mergers, and splits. In addition, in order to accurately account for wash sales, firms must manage tax lots for the shares repurchased after selling.

There will be significant confusion by investors over which securities are being reported, how the mechanics of cost basis work, and understanding cost basis adjustments to individual tax lots.

“There are gaps in the rules for firms and investors,” said Routh. “For example, firms are only required to report wash sales that occurred in individual accounts, while investors are required to calculate wash sales across all of their accounts.”

Shadow Financial Systems has included new functionality that handles cost-basis accounting in its ShadowSuite real-time clearing platform. ShadowSuite’s cost-basis functionality provides the automation that streamlines the tax reporting requirements for cost-basis accounting for these financial intermediaries, according to Don Marino, CEO of Shadow Financial Systems.

Cost-basis accounting represents one of the most complicated tax reporting challenges facing the industry, Marino said.

ShadowSuite is a real-time, exceptions based solution for middle and back-office post-trade multi-currency, multi-asset class and multi-entity securities processing, reconciliation, clearance, settlement, treasury and accounting.

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