Touching All the Basis?

Stocks, mutual funds, even options

By Kaye A. Thomas
Posted June 3, 2007

Congress appears to be getting serious about basis reporting by brokers.

It's coming. We don't know exactly when or in what form, but the idea of basis reporting by brokers is gathering steam. It has bipartisan support, and it's a rare example of a change that will increase revenues but may actually be seen by many taxpayers as a benefit, relieving them of confusion in determining what basis to use in reporting their capital gains and losses.

Brokers and other entities responsible for making these reports won't like it, though. For them it will be a major, expensive headache.

The Problem

Under current law, when you sell stock or mutual fund shares, the broker or mutual fund company prepares Form 1099-B. They send one copy to the IRS and another to you. This form tells the amount of the sale proceeds but doesn't provide the other crucial number needed to determine the amount of gain or loss: your basis for the shares. Generally this is the amount you paid for the shares, but basis can change as a result of various events including gifts, stock splits, spin-offs and mergers.

It's your responsibility to maintain records, figure your basis for the shares you sold and calculate the amount of gain or loss. Major problems can occur when records are lost or destroyed. Meanwhile, the IRS doesn't have this information. They can check to make sure you reported the correct amount of sale proceeds because that number appears on Form 1099-B, but they have no way of knowing if you reported the correct amount of gain or loss unless they audit your return. Similarly, they have no easy way of checking whether you reported the sale in the proper category, short-term or long-term.

The basic idea here is to require reporting of basis as well as sale proceeds, so that Form 1099-B will reflect the amount of gain or loss. The form will also show whether the sale was short-term or long-term.

New Proposal

Legislative proposals for basis reporting have been floating around for years. Mark Everson, who recently left his position as IRS Commissioner, had made it one of the agency's top legislative priorities. The Taxpayer Advocate favored the idea as well, seeing it as a measure that would help ordinary taxpayers comply with the law. President Bush included it in his fiscal 2008 budget proposal.

Now, the two leaders of the Senate Finance Committee (Democrat Baucus and Republican Grassley) have released a new proposal as a draft for comment. It's somewhat more ambitious than other versions that have been floated. For example, it anticipates a requirement that brokers not only record the basis of shares purchased in their accounts, but also get basis information for shares transferred to their accounts — whether the transfer is from another broker or from an account holder that has physical possession of the shares.

One reason for this is concern about avoidance by taxpayers that might take low-basis shares from one brokerage account and then put them into a different account with a broker that doesn't know the basis.

Filling Some Gaps

The proposal would fill some important gaps in the present reporting system. Current law requires brokers to report stock sales by individuals but not stock sales by corporations. That would change under the proposal. Similarly, sales of publicly traded options escape reporting by brokers under current law but not under the proposal.

And here's something that would make many investors (and tax preparers) happy. Corporations that engage in transactions that change the basis of their shares, such as spin-offs, mergers and stock splits, would be required to make basis adjustment information available in a systematic way. Most companies currently provide some form of guidance, but it's often hard to find.

Leaving Other Gaps Unfilled

The proposal falls far short of a comprehensive scheme for basis reporting, however. Realistically, a complete solution isn't possible, at least not without major changes in the substance of the rules for capital gains and losses. Here are some of the issues.

Wash Sales

If you sell shares at a loss and buy the same stock within 30 days before or after that sale, the wash sale rule disallows the loss — and adds it to the basis of the replacement shares. This rule also affects the holding period of the replacement shares. Your broker doesn't necessarily know whether you made a wash sale because the purchase of replacement shares could be in a different account maintained with a different broker. The Senate Finance Committee proposal contains some language about determining basis on an account-by-account method, but if they mean to limit the wash sale rule so it applies only when replacement shares are bought in the same account, they may as well repeal the rule altogether.

Fancy Trading Techniques

Similar issues arise when people use stock options or short sales as part of their investment repertoire. These techniques can give rise to straddles or constructive sales. Here again, activity in one account can affect the basis of shares held in a different account.

Selling Mutual Fund Shares

Current law lets you choose from among four different methods for determining the gain or loss when you sell mutual fund shares. The default method is to treat the first shares purchased as the first ones sold, but you're allowed to identify shares or elect either of two averaging methods. Your basis for the shares sold — and for the remaining shares — depends on the method you use. In theory, the broker or mutual fund company knows whether you've used share identification, but they don't know whether you've elected an averaging method or, if so, which one.

And So On

Beyond these issues, there are lots of little problems in the grimy details of the rules for capital gains and losses. Some would be relatively easy to correct. For example, share identification should be brought into the twenty-first century; the current rules predate the Internet and online trading. Others are intractable. The IRS has never given us a clue how to apply the wash sale rule to stock options, for example, and we're still waiting for regulations providing details on how to apply straddle rules contained in legislation adopted over 20 years ago. How narrow can you make a collar without causing a constructive sale? That's a matter of opinion.

Bottom Line

If basis reporting has to wait for all these problems to be solved it will never happen. More likely we'll end up with a version of basis reporting that covers most common transactions and requires taxpayers to provide an explanation when they use basis that differs from the amount reported on Form 1099-B. Basis reporting could make tax time a lot easier for many investors, but it won't be a comprehensive solution.