Get Ready for Stock Cost-Basis Reporting

There will be changes in how your stockbroker reports your stock trades for 2011.

Your broker now has to report the “cost” of your stock trades. This is a new rule for 2011. It came in as part of the 2008 Emergency Stabilization Act, also known as the bank bailout bill. You can anticipate that the purpose of this rule is to raise taxes.

There are three steps to the phase-in of this bill:

(1)    For 2011 (that is, the 2012 tax season), brokers are to report cost on all equity trades, if the equity was bought on or after January 1, 2011.

(2)    For 2012 (the 2013 tax season) brokers will report cost for mutual funds, dividend reinvestment plans and many exchange –traded funds bought on or after January 1, 2012.

(3)    For 2013 (the 2014 tax season), the rule will be extended to bonds and options.

There is a tax trap in here, so let’s go over it. The trap releases if you bought the security at different times and prices. Brokers refer to this as “accumulation.” Each time you buy the stock is called a “lot.”Let’s use the following accumulation as an example:

Let’s say you bought Sirius XM Radio at the following prices:

                January, 2010                     500 shares           $0.70

                May, 2011                           400 shares           $2.31

                August, 2011                      300 shares           $1.71                   

You sell 300 shares today at $1.77 per share. What is your cost for the 300 shares?

The IRS has provided four options:

(1)    First-in, first, out (FIFO).

a.       Under this rule, your cost would be 300 times $0.70 = $210.

(2)    Last-in, first out (LIFO)

a.       Under this rule, your cost would be 300 times $1.71 = $513.

(3)    Highest cost

a.       Under this rule, your cost would be 300 times $2.31 = $693

(4)    Specific identification

a.       You get to pick which shares you sold. All things being the same, you would probably select the May, 2011 lot and use $693 as cost.

Under our example, your answer could vary from a gain of $321 to a loss of $162.  It is quite a swing.

Where is the trap?

You have to tell the broker which method you are using, and you have to tell them before the settlement date of the trade. This is very different from the way it has been, which previously allowed the accountant to decide which method to use when preparing your return. We many times contacted a broker for lot dates, shares and cost when a client had accumulated a position in a stock. We had the luxury (if it could be called that) of doing so when preparing the return. This now has to be done within three business days of the trade date.

There is also another trap. If you do not select a method, the IRS will select it for you. The IRS will decree that you selected the first-in, first-out method. That is a fine method, but if you look back at our example, you will see that it is also the method that reports the least cost, and therefore the most gain, to the IRS. Remember what I said about raising revenue for the government?

 And the final trap? By the time you get to me, there is nothing I – as your tax CPA – can do.

Related Party and Tax Deductions

If you are a partnership, LLC or S corporation and report on the accrual basis, this may apply to you.

You may be aware that there are restrictions on deductions between related accrual-basis and cash-basis entities or individuals. These are the “related party” rules of IRC Section 267 and are well-known to tax accountants. By the way, these rules drive on a one-way street: the effect is to delay the deduction, not to delay the income.

                EXAMPLE ONE:

Sanctuary, Inc is a C Corporation and accrual-basis taxpayer. It owes $34,000 at year-end to Sam (a Schedule C) for the provision of goods or services. Sam is a 51% shareholder.  Sam is on the cash-basis, as most individuals are. Sanctuary, Inc cannot deduct the $34,000 until Sam includes it in income, because more-than-50% ownership triggers the related party rule.

                EXAMPLE TWO:

Sam (a Schedule C) owes Sanctuary, Inc $27,000 at year-end for the provision of goods or services.  Sam (a Schedule C) cannot deduct this until it makes payment. Sam (a Schedule C) is, after all, on the cash-basis. Sanctuary, Inc is quite unruffled by all this. As an accrual-basis entity, it will report the $27,000 in income without waiting for Sam’s (a Schedule C) deduction.

The trap here is the more-than-50 percent rule. The 50% requirement goes away if the transaction is between an S corporation, partnership/LLC and a shareholder or partner/member.

Change Sanctuary to a partnership, LLC or S corporation and the threshold drops to any ownership. As an example, an accrual to a 2-percent S- corporation shareholder would be disallowed under the related party rules.

Why? Here is how I make sense of it. As a pass-through investor, both sets of numbers will wind up on one income tax return. The IRS is therefore stricter than it would be if the numbers wound up on two tax returns, such as between a C corporation and an individual.