GainsKeeper Blog

IRS Final Cost Basis Regulations – Clarification of Covered Securities Subject to Cost Basis Reporting

WALTHAM, Mass. – Oct. 26, 2010 – On Oct. 12, 2010, the IRS issued the final cost basis reporting regulations (TD 9504) and related Notice 2010-67 (the Final Regs and the Notice—both documents are available at http://www.costbasisreporting.com). The Final Regs do not delay any of the effective dates relating to cost basis reporting and almost all of the key aspects of the proposed rules that create compliance complexities for brokers and cost basis systems were retained. However, some transferors of stock may delay transfer reporting due to IRS penalty relief set forth in Notice 2010-67 (the scope of the penalty relief is discussed in a separate article dated Oct. 15, 2010 available at http://www.costbasisreporting.com).

The cost basis law and the Final Regs include a number of different sets of rules, including rules under Internal Revenue Code Sec. 6045(g) for determining whether securities constitute “covered securities” subject to cost basis reporting. Although brokers, transfer agents, issuers and other financial intermediaries may be required to report information regarding noncovered securities on Form 1099-B, transfer statements and issuer corporate action returns, the key point is that brokers and transferors are not required to report the cost basis of noncovered securities.

Sec. 6045(g)(3) defines stock acquired on or after Jan. 1, 2011, mutual fund and dividend reinvestment plan (DRP) shares acquired on or after Jan. 1, 2012, and options and debt instruments acquired on or after Jan. 1, 2013 as covered securities. The Final Regs only address stock, mutual fund and DRP shares.

Brokers and other securities industry participants raised a number of comments relating to the proposed regulations regarding the definition of covered securities. A particular concern was the classification of hybrid securities and securities units. The Final Regs do not address cost basis reporting for components of securities units. Another was the brokers’ obligation to determine the tax classification of securities in certain cases and whether a broker has a “reason to know” of a security’s proper tax classification. The Final Regs provide some relief here by eliminating the “reason to know” standard.

Set forth below is our top 10 list of covered securities related changes and retained rules in the Final Regs:

1. Clarification that real estate investment trust (REIT) shares, foreign stock and ADRs are treated as stock subject to Jan. 1, 2011 effective date.
2. Clarification that exchange traded fund (ETF) shares treated as stock can also be covered securities.
3. If the issuer has not classified a security as stock but a broker knows that the security is stock, the broker must treat it as stock for covered securities purposes. This is actual knowledge by broker and not a “reason to know” standard (unlike proposed regs). A broker is not bound by another broker’s classification of a security as stock.
4. Clarification of treatment of securities received in a corporate action as covered securities unless basis carried over from noncovered securities.
5. Stock received thru exercise of stock option or issuer rights is covered because it is acquired in a sales transaction.
6. Stock received in an employee grant is not covered because it is not acquired for cash.
7. Stock acquired in 2011 is no longer a covered security if transferred to a DRP during 2011.
8. Security acquired for the account of a foreign person is not a covered security unless broker knows or should have known (per Sec. 1471 or 1472) that customer was not a foreign person at time security was acquired.
9. Stock sold by a domestic partnership is subject to basis reporting.
10. Stock sold by a foreign partnership is exempt for reporting to US partners.

There are a number of other important rules in the Final Regs that address issues such as the rules for lot selection and averaging of basis for mutual fund and dividend reinvestment plan shares, required basis and holding period adjustments that brokers must take into account in reporting basis on Form 1099-B (including wash sale and corporate action adjustments), rules for short sales, transfer reporting, and issuer corporate action reporting. Issues relating to these rules under the Final Regs will be discussed separately.

We will provide additional commentary relating to the Final Regs and other aspects of the cost basis reporting law at later dates.

Stevie

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