Investors have long been responsible for determining the tax consequences of their securities trades, but starting next year it will be up to their account custodians—and, indirectly, their financial advisers—to keep them honest.
The Internal Revenue Service is set to implement a new rule that requires custodians to obtain and track the adjusted cost basis—the original purchase price—of client trades and report that information to the agency. Currently custodians only have to send tax information to investors themselves, and it doesn't include the detailed cost-basis information under the new rule.
The change was written into the Emergency Economic Stabilization Act of 2008. Congress estimates that placing the calculation burden on custodians rather than investors should generate nearly $7 billion in tax revenue over 10 years. The rules are expected to take effect Jan. 1 for stock trades, a year later for mutual funds and in 2013 for other securities, such as bonds and options.
Though financial advisers won't be affected directly, they'll need to explain the rule's impact on clients' investment decisions—or be prepared to face clients' wrath when 2011 taxes are due. Among other things, they will have to be able to factor in cost-basis effects when talking to clients about their potential stock trades, and make sure clients who trade online understand the tax ramifications of their trades. They'll also be expected to help clients determine the most appropriate method to account for their investment activity and when it's most tax-advantageous to buy or sell securities.
Investors often leave complicated cost-basis calculations until well after the investment sale or purchase. And because the IRS has had no easy way to verify when trades actually occurred, or the cost basis may have been lost when accounts were transferred to a new custodian, investors often fudge the investment purchase and sale dates, to their tax advantage.
"A lot of decisions have been made in consultation with accountants, after the fact," says Ron Fiske, executive vice president of product development at Fidelity Institutional Wealth Services. But this new rule "will make it crucial that advisers work closely with clients and identify tax strategies and implement them at the point of sale."
Aside from getting up to speed on tax and accounting issues, advisers must also be certain that the custodians holding client assets have upgraded their technology to account accurately for events that could alter an investment's cost basis, such as stock splits, special dividends and, especially, wash sales.
Some major custodians such as Fidelity Investments' National Financial and the Bank of New York Mellon's Pershing unit have already taken proactive steps to alert advisers to the rule. But few have completed the necessary technology upgrades or even made final decisions on how to proceed.
That technology is going to be critical for financial advisers to be on top of the tax consequences of their clients' trades, since as investors' first point of contact they'll have to explain why selling one lot of stock over another has better tax results. Doing those calculations manually for each client simply isn't feasible, and there will no longer be room for error.
"Clients are going to call up their financial advisers and say, 'Correct it—it should be the second lot instead of the first,'" says Stevie Conlon, tax director of GainsKeeper, a division of Wolters Kluwer Financial Services Group.
After the new rule takes effect, however, they won't be able to do that because the dates of stock trades will be etched in the IRS's database.
Wash sales may be particularly problematic for investors who trade actively. They occur when an investor sells a position for a loss and then repurchases the same security within 30 days. The investor can no longer claim a loss on the sale for tax purposes, although that loss can be taken for a subsequent sale.
For example, an investor buys a 100-share lot of Acme Corp. for $120 a share, the price plummets in a broad market sell-off, and he sells the stock at $90 per share, for a $3,000 loss. Four weeks later, Acme reports strong earnings and the stock jumps to $100 a share, the investor jumps back in, and he eventually sells the 100 shares for $140 a share.
The IRS says the $3,000 loss is "disallowed" and can't be taken as a loss for tax purposes, although it can be taken later against the $4,000 gain. Most broker-dealer systems today do not recognize the disallowance and instead show an inaccurate loss, says George Michaels, the chief executive of G2 Systems, which developed software addressing the wash-sale issue.
In the past, investors might not have realized they were within three days of avoiding the disallowance and improperly claimed the loss on their taxes. Under the new rule, savvy financial advisers should alert clients to the potential disallowance before executing the trade and suggest waiting three more days. Advisers should also track the cost basis of the second purchase, so if clients move to sell the shares in less than a year, they can point out the different tax rates for long-term and short-term capital gains.
Pershing, the largest correspondent clearer, services the investment units of banks such as Harris Bank and Dutch giant ING. Kevin McCosker, the director of asset servicing at Pershing, says the clearer's system can already handle most of the new requirements.
Other major brokerages, including Goldman Sachs, UBS, Charles Schwab and Morgan Stanley Smith Barney were mulling how to revamp their accounting systems to accommodate the new rules. Some brokerages may choose to rebuild their accounting systems using in-house or third-party vendors, such as SciVantage, GainsKeeper or Sungard, or attach software to handle specific functions such as wash sales.
Either way, given the complexity of the changes required, time is running out to adjust their systems by yearend, according to David Easthope, a senior analyst at Celent.
Industry experts say the IRS will stamp the final rule this summer.