Sellers of stocks and other assets have always had to calculate their cost basis (generally, what they paid for the investment) in order to figure their taxable capital gains. In the past, this was often a hit-or-miss experience that required lots of tedious research (occasionally with help from brokers) and more than a bit of guesswork. This year, for the first time, Congress required stock brokers to report cost basis to both the IRS and taxpayers. Next year, mutual funds must report. The reporting will apply only to newly-purchased stock, so there will be a long transition to the new system.
The goal is to make things easier for taxpayers and improve compliance (that is, reduce mistakes, deliberate or not).
This is a laudable aim, but the IRS faces a number of challenges to make this initiative work. Here are five, excerpted from a new article I wrote for Tax Notes, Basis Reporting: Lessons Learned and Direction Forward.
- Congress standardized the information that brokers and mutual funds must report. It also required taxpayers to either select a basis method (e.g., first-in-first-out (FIFO), average basis, or identification of the specific securities sold) in advance or accept the default choices made by their brokers or mutual funds. These steps improve the quality and consistency of the information, which in turn will facilitate information matching by the IRS, but they greatly confuse taxpayers, at least in the near term.
- Taxpayers are permitted too many choices to calculate their gains and losses, which greatly complicates reporting. So, for mutual fund shares, taxpayers must now decide whether to provide standing instructions to determine the order in which their shares should be sold (e.g., highest basis first), whether to identify specific lots of shares to be sold at the time of sale, whether to elect average basis for their shares (separately for each of their accounts), and whether to revoke or change their average basis elections. And the mutual funds must capture, maintain, transfer, and report these basis choices.
- By law, taxpayers are responsible for reporting their gains and losses correctly on their tax returns, regardless of the numbers they received from their brokers. So, for example, the IRS expects taxpayers to adjust cost basis to reflect tax rules, such as wash sales, which the brokers might not have reflected. In practice, however, most taxpayers will simply transfer the numbers reported to them by their brokers to their income tax returns, and hope for the best.
- The IRS expects to match the new information reports to taxpayer returns to identify misreporting. Whether the IRS can distinguish taxpayer misreporting from system errors in matching is unclear. However, the mere threat of information matching is likely to improve taxpayer compliance.
- Technology advances, such as information reporting and tax preparation software (like Turbo Tax), shield taxpayers from the tax determination process, which is both helpful and harmful. It’s helpful if taxpayers can save time and effort by using the information provided, but harmful if taxpayers cannot confirm or understand the information they have received.
With all of these problems, is basis reporting worth it? I believe the answer is yes, but the transition will be painful.
(Full disclosure: I advise Wolters Kluwer Financial Services–the publisher of GainsKeeper tax software. The views I express are my own and not those of Wolters Kluwer Financial Services.)