GainsKeeper Blog

WALTHAM, Mass. – Oct. 30, 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. There are a number of special rules concerning cost basis reporting relating to short sales. There is uncertainty whether brokers’ existing back office systems adequately track short sales and related information that will be necessary to comply with the Final Regs, particularly the special rules for short sales relating to transfer reporting. In addition, brokers' cost basis reporting systems may not necessarily provide for the required basis adjustments for short sales including wash sales and special holding period adjustments mandated by the Final Regs.

Under prior law, gross proceeds from short sales were reported at the time a short sale was opened (when the shorted stock was sold). Under the cost basis reporting law, a short sale will be reported when stock is delivered to close the short sale (rather than when they are opened).

There was confusion regarding how the change of reporting of short sales from open to close would be transitioned and the proposed cost basis regulations increased the level of confusion. There were also concerns regarding how a broker would withhold on gross proceeds for backup withholding purposes if short sales are reported on close rather than open because proceeds from short sales are received on open (rather than on close).

The Final Regs provide clarification and relief regarding transition. Under the Final Regs, short sales are only reported on close if the short sales are opened in 2011 or later. Short sales opened before 2011 are not subject to reporting on close. Also, the preamble to the Final Regs clarifies that the Final Regs leave unchanged prior rules permitting backup withholding at the time the short sale is opened or closed.

Set forth below is our top 10 list of short sale reporting related changes and retained rules in the Final Regs:

1. No reporting of short sales on close for short sales opened before 2011. Short sales of a security (note that this rule is not limited to “specified securities” or “covered securities”) opened during 2011 or later must be reported on close. Short sales of covered securities opened during 2011 or later must also report the adjusted basis of the security and whether gain or loss is long-term or short-term on Form 1099-B. If a short sale opened during 2011 or later is closed with a noncovered security, a broker is not required to report (but may with penalty relief) the cost basis or whether gain or loss is long-term or short-term.
2. Backup withholding may be imposed on either open or close of a short sale.
3. Brokers must apply wash sale rule to short sales because there is no exclusion under the Final Regs from wash sale loss deferrals and basis and holding period adjustments relating to short sales applicable under Sec. 1091(a) or 1091(e).
4. Brokers do not need to make holding period adjustments to related lots due to short sales under Sec. 1233(b)(2).
5. Brokers need to make short-term and long-term gain adjustments for short sales under Sec. 1233(b)(1) and (d) because the Final Regs do not provide any exclusion.
6. Brokers do not need to apply constructive sale rule of Sec. 1259 as a result of covered short sales that trigger constructive sales (although taxpayers must still do so and brokers can optionally apply the rule). Similarly, brokers do not need to apply the worthless security gain rule of Sec. 1233(h) in connection with short sales.
7. Final Reg. 1.1012-1(c)(8) permits customer to select the lot used to close the short sale by the settlement date.
8. Final Regs permit the broker to file a Form 1099-B to report backup withholding on a short sale in a year before the year it is closed in addition to reporting it in the year it is closed although the regs permit the IRS to discontinue such permission.
9. Securities delivered to or from a customer that are lent or borrowed in connection with a short sale or securities lending transaction are subject to transfer reporting unless the transferor is acting as principal (exception does not apply if the transfer involves a previously borrowed security transferred to another account of the same customer).
10. Transfer statements for borrowed securities (in connection with short sales or securities lending, for example) must indicate that the transferred security is borrowed if the transferor knows that the security is transferred pursuant to a lending or borrowing arrangement and must not report adjusted basis if the transferor knows it is pursuant to a short sale. The receiving broker may have special transfer reporting obligations that flow back to the transferor if the transferred security is used to satisfy an existing short sale (Reg. 1.6045-1(c)(3)(xi)(C)).

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, the definition of covered securities, transfer reporting and issuer 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

DISCLAIMER: The information and views set forth in GainsKeeper Tax Topics are general in nature and are not intended as legal, tax, or professional advice. Although based on the law and information available as of the date of publication, general assumptions have been made by GainsKeeper Tax Topics which may not take into account potentially important considerations to specific taxpayers. Therefore, the views and information presented by GainsKeeper Tax Topics may not be appropriate for you. Readers must also independently analyze and consider the consequences of subsequent developments and/or other events. Readers must always make their own determinations in light of their specific circumstances.