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Cost Basis Reporting Disclosure

In January 2011, implementation of the initial phase of new tax reporting standards will commence. Hilliard Lyons' systems will be prepared and ready to meet this new regulatory challenge.

COST BASIS REPORTING REGULATIONS

Changes coming to Broker 1099 reporting standards

In January 2011, implementation of the initial phase of new tax reporting standards will commence. Hilliard Lyons' systems will be prepared and ready to meet this new regulatory challenge. Cost basis information becomes subject to 1099 reporting beginning with the 2011 tax year. In prior years, only sale proceeds appeared on your Form 1099-B – (Proceeds From Broker and Barter Exchange Transactions). Commencing with the 2011 tax year, reporting on 1099-B will include Cost Basis data for "covered" securities.

"Covered" securities are certain shares acquired on or after January 1, 2011 (more below). According to the regulations, sales of "covered" securities will be subject to the heightened reporting standards to include the related cost basis and holding period. The cost basis reporting regulations can be viewed at the following link: http://www.irs.gov/irb/2010-47_IRB/ar08.html

The terms "covered" and "non-covered" securities will be referenced frequently under the new rules. To understand the reporting framework, it will be important to have a solid understanding of what these terms mean. Securities subject to basis reporting are referred to as "covered" under the regulations. Basis for "Covered" securities becomes subject to 1099 reporting on a phased implementation schedule spanning at least three years:

  • Phase I Securities - Stocks acquired on or after Jan. 1, 2011;
  • Phase II Securities - Mutual funds and dividend reinvestment shares acquired on or after Jan. 1, 2012; and
  • Phase III Securities - Financial instruments as determined by Treasury, such as debt securities and options, acquired on or after Jan. 1, 2013.

The new rules specifically exclude "Non-Covered" Securities from the reporting requirements. Hilliard Lyons will continue providing year-end gain/loss information on "non-covered" securities as in the recent past. Basis information for "non-covered" securities will not be transmitted by Hilliard Lyons to the IRS.

Our tax reporting for the 2011 tax year will be your first exposure to the new reporting formats. Systems design and implementation are ongoing to accommodate capture and storage of information subject to the new standards on January 1, 2011.

Reconciliations between your 1099 and your individual income tax return (Form 1040 Schedule D – Capital Gains & Losses) could be impacted. In the past, Hilliard Lyons has only reported the Sale Proceeds of your Capital Gains activity. The new regulations will require that we begin reporting on the basis and the holding period of "covered" securities. Remember, if it's on your 1099, it means we're also sending that information to the IRS. When we begin reporting your basis to the IRS, it is likely that you will be motivated to ensure the basis you report on Form 1040 Schedule D is consistent with the basis information we will transmit to the IRS. Mismatches, if any, are likely to generate IRS deficiency notices to which you will be obligated to respond.

Hilliard Lyons default tax lot relief method is FIFO. Note that unless you instruct your Financial Consultant otherwise, we'll relieve your tax lots on a First-in, First-out (FIFO) basis. The regulations provide that you will be unable to assign another tax lot to your sale after Settlement Date which is usually 3 days after Trade Date. If you do not intend to sell your oldest shares first, be sure you have communicated this information to your Financial Consultant at the time your trade instructions are placed.

We will report basis for "covered" securities generally as the "adjusted basis" of the asset. The adjusted basis is the total amount paid to acquire property adjusted for commissions and the effects of other transactions such as corporate splits, spins, mergers, etc.

Reporting for Non-Covered Securities? Not every investment is subject to the regulations. Reporting infrastructure for "non-covered" securities is already in place; this is the type of tax reporting to which you have become accustomed. Future tax reporting formats may change depending on further guidance from the IRS, but in overall terms the output will be substantially similar to the year-end packages with which you are familiar. Sales of "non-covered" securities will be reported in substantially the same format you have experienced in the past.

According to the regulations, you will continue to carry the reporting and reconciliation obligation for maintenance of adequate supporting documentation with respect to the basis of your "non-covered" assets. We will continue to support you in this respect in the manner to which you have become accustomed. Beginning with the 2011 tax season, taxpayers should prepare for heightened reconciliation efforts between income tax returns and 1099's for "covered" securities.

Related Information:

Basis Overview

What is the basis for your investments?

The basis of your investment is used to measure gain or loss on the sale of an investment. Gain or loss is the difference between your adjusted tax basis and the amount your investment sells for.

Basis is normally the original cost. If you did not purchase your investment (you received the asset as a gift, inheritance, or in a tax-free distribution), then your basis is determined by something other than your cost and your asset carries what is known as an "adjusted basis".

Occasionally, it may be necessary to increase or decrease the basis of investments. If the issuer declares a stock split or undergoes merger activity, you may need to begin carrying an adjusted basis for the investment depending on the terms of the event.

You may decide to sell part, but not all, of your position. If you purchased shares at different times and prices, you may have different tax bases for those separate lots. There are different lot selection methods for identifying the basis of what you sold. More on those methods below.

Cost basis

If an asset has a cost basis, it means that the original cost of the asset equals the basis. Thus, if you purchase shares of stock for $10,000, your initial cost basis in those shares is $10,000.

Transferred basis

If an asset has a transferred basis it means that your initial cost basis will be as it was in the hands of the person who transferred the asset to you. Gifted shares are the most common example of property with transferred basis. The value of a gift is not included in the recipient's taxable income, nor may the donor deduct the value of gifts (unless made to a qualified charity). The recipient assumes the donor's basis in the property and uses that amount to measure any applicable gain or loss when the property is sold. (Recipients of gifts generally cannot use transferred basis for the purpose of determining a loss, but rather, would reduce the basis to an amount equal to that realized when sold. Affected taxpayers should consult a qualified tax advisor).

Fair market value (FMV) basis

Applicable to property acquired from a decedent (except for deaths in 2010). Generally assets acquired from a decedent carry an adjusted basis equal to FMV on either the date-of-death or the Alternate Valuation Date as elected on the decedent's Estate Tax Return. The Alternate Valuation Date is six months after the date of death and is a mechanism that can be used to reduce the estate tax liability only if the values of the assets have declined.

Executors (or personal representatives or Successor Trustees) are required by the new regulations to instruct the broker as to the applicable basis amounts for assets acquired from decedents.

Reinvestment

You may have holdings in which you reinvest earnings. If your share quantity increases when you reinvest, then you have purchased a new tax lot which must be carried separately from the tax lot from which it arose. Reinvesting for new shares is equivalent to receiving an income distribution then purchasing new shares with the amount distributed to you.

How splits, stock dividends, stock rights, or consolidations impact your tax basis

A stock split involves a division into more units of the same stock. Generally, the aggregate value of the old and new shares should be the same. A stock dividend is a proportionate distribution of stock to all the shareholders. Similar to a stock split, it essentially subdivides the stock, but tends not to impact the amount known as basis. In both cases, the result is an allocation of the basis proportionally from before the event to the resulting shares after the event.

Open date content for stock received in a split or a stock dividend is the same as the holding period for the original shares. For holdings of multiple lots, basis must be allocated to the related lots proportionally.

Tax Lot Selection

There are occasions when you might sell only part of your position. For most investments, the IRS permits you to use one of the following methods to identify what you sold:

  • Specific identification method
  • FIFO method
  • Average cost method

Specific identification method

This method allows you to select exactly what you sell. One advantage is that you may choose lots which will result in the smallest tax liability. Strategy may involve selection of lots with the highest basis, or may focus on identification of lots only with long-term holding periods. Depending on your needs, you may find it advantageous to select short-term-gain lots if you have losses available to offset the gain.

First in, first out (FIFO) method

The FIFO method deems that the oldest lots in the position are the first sold. This method will more frequently result in long-term gains or losses, but may also carry the greatest amount of taxable gain depending upon the appreciation of the underlying assets.

The FIFO method is applicable to all of your marketable investments (such as stocks, bonds, and mutual funds), and is the rule which generally applies when the specific identification method is not applicable. Most brokers, including Hilliard Lyons, use FIFO as a default method of accounting for your sales unless you specify otherwise.

Average cost method

When you sell shares in an open-end mutual fund, you may also elect use of the average cost method to determine the basis of the shares sold. This allows you to average the basis of all mutual fund shares regardless of how long you have owned the shares. The actual holding period is determined under the FIFO method. Average cost can only be determined if the actual cost and open-date of all of the tax lots are known. If any of your tax lots are missing this information, the average cost basis cannot be calculated for that security.

To take advantage of the average cost method, you must make an election on your tax return. Usually this is a default election taken at the time you first report a sale using the average cost basis of accounting. Once this election is made, you are not permitted to switch to another method without approval from the IRS.

Average Cost reporting infrastructure is not in place at this time. When securities eligible for Average Cost reporting become subject to the reporting standards (see phase-in schedule), Hilliard Lyons systems will be capable of supporting those reporting needs.

Hilliard Lyons employs a default tax-lot-relief method of First-in, First-out (FIFO) which is consistent with requirements of the new regulations. As always, clients have the opportunity to identify specifically which tax lot is intended for any sale. According to the regulations, the intended tax lot must be identified no later than settlement date. Settlement date is typically 3 business days after trade date. Be sure to address your tax-lot selection needs at trade date to ensure that your needs are met.

As Phase II securities become covered under these regulations, Hilliard Lyons will begin deploying and offering Average Cost accounting platforms, however, this feature is not expected to become available within our reporting systems until January 1, 2012.

Phase-in Period

The regulations are constructed to accommodate a phasing schedule so that not all securities become subject to standards simultaneously. Certain instruments with escalated technical reporting challenges are scheduled to become subject to the reporting standards later in the phasing period. Examples of those types of securities include bonds, options, mutual funds, DRIP stock and Exchange Traded Funds. The graphic below represents the phase-in period and the related "covered" securities for each phase:

Phase-in Period

Cost Basis Regulations are scheduled to implement in three phases as depicted below. Broker reporting for "Covered" securities is phased in through the implementation period according to this schedule.

Taxpayers should prepare to continue maintaining supporting documentation for all "Non-Covered" securities.
  Covered Securities Non-Covered Securities
Reporting Responsibility Hilliard Lyons reports cost basis to IRS and to taxpayer on Form 1099-B. Taxpayer uses 1099-B content to prepare Form 1040 Schedule D (Capital Gains & Losses). IRS Reconciles taxpayer's Schedule D to Broker's 1099-B Taxpayer reports cost basis to IRS on Form 1040 Schedule D (Capital Gains & Losses).
Phase 1

Equities

Corporate Stock other than Regulated Investment Companies (RIC) and Dividend Reinvestment Program (DRIP) stock, section 6045(g)(3)C(i)

 Acquired on or after January 1, 2011 Acquired before January 1, 2011
Phase 2

Mutual Funds, Dividend Reinvestment Plans (DRIPs) and Exchange Traded Funds (ETFs)

Stock in a RIC or DRIP, section 6045(g)(3)C(ii)

 Acquired on or after January 1, 2012 Acquired before January 1, 2012
Phase 3

Other Securities specified by Treasury Dept. including Fixed Income (Bonds) and Options

Treasury has discretion to alter applicable dates and securities, section 6045(g)(3)C(iii) and 6045(h)(3)

 Acquired on or after January 1, 2013 Acquired before January 1, 2013

 

Dividend reinvestment plans

A dividend reinvestment plan (DRIP) is the automatic reinvestment of shareholder dividends into more shares of the same stock. Some DRIP sponsors absorb much of the applicable brokerage fees, and some will discount the stock price for shares acquired within the DRIP. DRIP's allow shareholders to accumulate capital over the long term using a dollar cost averaging strategy. For issuers, the plans may be leveraged as a means of raising capital without incurring substantial issuance costs.

Unlike equity stock shares acquired otherwise, shares acquired in a DRIP are eligible for Average Cost Basis accounting when or if you sell some or all of your shares. As always, investors should seek guidance from a qualified tax advisor when determining which basis of accounting to use in identifying the cost of disposed shares. Remember, the initial reporting method is equivalent to a default election which the taxpayer must retain for the life of the holding. Be sure your default election is consistent with your needs, in the long term if necessary, with respect to your investment strategy in the DRIP shares.

Wash Sale Reporting

Though nothing new in terms of tax regulation, the prospect of Broker reporting for Wash Sale events may surprise some taxpayers.

Wash sale rules generally involve deferral of losses when the same security is purchased in a 30-day proximity to the sale event. In the scope of year end planning, it is common to harvest losses in order to mitigate tax liabilities on realized gains. When harvesting losses, be aware of the Wash Sale Rules Code Sec. 1091(a); Reg. §1.1091-1).

Under the wash sale rules, a taxpayer who realizes a loss upon a sale or other disposition of stock or securities may not take a deduction for the loss. The wash sale rules apply if, within a period beginning 30 days before the date of the sale or disposition and ending 30 days after that date, the taxpayer has acquired, or has entered into a contract or option to acquire, substantially identical stock or securities. Trade date is "Day Zero" when counting days to determine the window for Wash Sale limitations.

Under Cost Basis Reporting regulations, brokers must account for wash sales, including any deferred loss, at the time of sale and for any account transferred to another broker within the wash sale window. The effect of any disallowed loss will be reflected in the adjusted basis of the replacement property purchased inside the wash sale window.

If you have a wash sale, you should expect to see information in your 1099 effectively removing the loss from the amounts reported to you and to the IRS with an allocation of the deferred amount against the basis of the applicable property purchased during the wash sale window.

Short Sale Reporting

A short sale is a contract for sale of property that the seller does not own. The seller borrows shares to deliver to the buyer. At a later date, the seller either purchases similar stock or property necessary to close the sale, and delivers it to the lender, or delivers stock or property which was already held but not transferred at the short-sale date.

In the past, an event of sale proceeds, regardless of whether the sale was closed, appeared on Form 1099-B in the period the proceeds were paid. Cost Basis Reporting regulations require disclosure of the amount of gain/loss and the related holding period for "covered" securities. Accordingly, Short-Sales of "covered" property can only be reported accurately when the short-sale is closed. Unlike Short-Sale reporting in the past, Short-Sales of covered securities can be expected to trigger reporting obligations in the period they are settled under the new regulations.

Be mindful of backup withholding obligations if you are contemplating a Short-Sale of "covered" securities. Financial institutions may be required to capture provisional backup withholding amounts for improperly documented accounts on the proceeds date. Depending on the period of time taken to close the Short-Sale, the withheld amounts may not appear as a credit on the 1099 until the period in which the Short-Sale is closed.

2011 Form 1099-B (Draft)

A draft of the 2011 Form 1099-B is copied below. Note the additional information IRS will seek (Boxes 7 & 8).

1099-B

This document can be viewed at: http://www.irs.gov/pub/irs-dft/f1099b--dft.pdf.

Transfer Reporting

Transfer Reporting provisions requires Hilliard Lyons to:

  • Send and Receive basis information between firms for "covered" securities for clients transferring assets between firms
  • Update basis information for information received from issuers about the quantitative effects of corporate actions (splits, spins, mergers).

Under the Cost Basis Regulations, brokers will begin to provide "transfer statements" when clients transfer from firm-to-firm. The firm from which the transfer originates (the "sending" firm) will be required to send basis information for "covered" securities to the receiving institution generally within 15 days.

The receiving institution must monitor for receipt of the required information and, if the sending firm fails to observe the 15-day reporting obligation, the receiving firm must request that information from the sending firm.

Transfer reporting activity will rely largely on existing infrastructure which supports transfer of the same information. Account Transfer (ACAT) system users, including Hilliard Lyons; have relied upon the Cost Basis Reporting System (CBRS) feature for years as a matter of customer service. Compliance with the transfer reporting regulations will be carried out generally within the scope of the familiar ACAT/CBRS infrastructure.

IRS Notice 2010-67 (issued 10/12/10) provides transitional relief for Transfer Reporting provisions set forth under the final regulations. To accommodate systems design, development, testing and implementation, IRS will not assert penalties for failure to furnish transfer statements under Section 6045A and that transferred stock may be treated as a "non-covered" upon subsequent sale or transfer.

Gifted and Inherited Shares

Under the Cost Basis Regulations, brokers will be required to adjust basis for gifted and inherited shares. Gifted shares generally retain the open date and basis as in the hands of the donor unless the fair value of the shares on date of gift is less. If the donor's basis exceeds fair value on date of gift, special rules apply limitations on the possible loss that can be recognized when sold by the recipient.

Inherited shares are subject to a variety of date of death adjustments depending on the date of the decedent's death. Shares acquired by inheritance are required to be carried by the broker as "non-covered" until adequate instructions are provided by the executor or personal representative regarding how to adjust the basis. Your Hilliard Lyons Financial Consultant will be pleased to assist.

Additional Information on Cost Basis Reporting regulations can be viewed at the following links:

Please contact your Financial Consultant if you have any questions.