Conflicting tax information creates 'nightmares' for some investors

Brokerage tax statements don't always reflect all of an investor's accounts or original costs

May 6, 2019 @ 10:41 am

By Bloomberg News

Brokerage firms are sending tax statements to clients and the IRS with information that differs from the taxes investors ultimately owe, leading some filers to appear to owe tax on profits they never made.

The federal tax code contains two sets of IRS rules — one that defines what information on taxable gains and losses that brokerages must report to their clients and the IRS, and another that defines how individual taxpayers report those gains and losses on their returns.

Those conflicting rules mean that the brokerage statements — known as 1099-Bs — don't always reflect all of an investor's accounts or original costs. It's caused some investors to inadvertently draw the attention of government auditors.

That the statements can cause problems for unwary investors "is a dirty little secret," said Robert Green, an accountant and chief executive at GreenTraderTax, an accounting and consulting firm in Ridgefield, Conn. "Brokers don't want this publicized."

Edward Zollars, a certified public accountant, said his firm, Thomas Zollars & Lynch in Phoenix, had a client who'd exercised $135,000 in stock options granted for $39,000. The client's recent statement, from ETrade, showed those figures but another one as well: a $96,000 "realized gain," or the difference between the two figures.

Taxes withheld

While the statement made it look like the client owed ordinary taxes of around $35,000 on that gain, he didn't. The statement didn't reflect that the client's employer had already withheld tax when the options were exercised. ETrade didn't respond to requests for comment.

"You can get in trouble just following the 1099," Mr. Zollars said, adding that it can create tax-season "nightmares."

In most cases, brokerages are simply following IRS rules — which in this case predate, and weren't changed by, the 2017 federal tax overhaul.

But nine clients of accountant Mark Fichtenbaum this year received 1099-B forms from online broker and wealth manager TD Ameritrade with incorrect values for their investments in options tied to the S&P 500 stock index.

(More: Taxes, investment returns and the new Form 1040)

Mark-to-market

Under an accounting system known as mark-to-market, the statements are supposed to reflect values as of the last business day of the year, usually Dec. 31; instead, they showed the reflected values on the last day the options traded. Due to the stock market's volatility last December, the different dates made the investors look to the IRS like they'd made millions more in taxable profits than they actually had.

In an April 3 letter to one client, TD Ameritrade said that GainsKeeper, the trade-accounting software company it uses to prepare the statements, deploys its own methodology to track the values.

"GainsKeeper has informed us that they use their methodology consistently," TD Ameritrade said in the letter, adding that it "cannot amend" the document. "Unfortunately, this is what occurred." The letter counseled that under special IRS rules for the contracts, the customers would get the tax back in the following year, when the amounts reversed.

Looking for 'reality'

"So we're going to give the government $1 million for tax on phantom gains and get it back the next year? Seriously?" said Mr. Fichtenbaum, counsel to Twenty-First Securities Corp., a brokerage and financial services firm in New York. He provided some of his clients' statements for review.

Had GainsKeeper used that same methodology on all open S&P 500 contracts as of Dec. 31, it would have distorted clients' gains by $6 billion, he said. "I am not looking for perfection, just reality."

Rebecca Niiya, a TD Ameritrade spokeswoman, said the brokerage was merely following the rules.

Stevie Conlon, a tax and regulatory counsel for the Wolters Kluwer's unit that oversees GainsKeeper, said that due to murkiness in IRS rules on computing values for assets like options contracts, the firm relies on separate rules in estates and gift tax laws.

"There's no explicit guidance that tells us how to do it," she said, adding that another broker "could come up with a different price."

Even though individual investors receive separate account statements from brokerages that correctly show their gains and losses, many individual investors rely on the 1099-Bs to tell them how much tax they owe on profits and losses in stocks, commodities, regulated futures contracts and options, among other securities, as well as on barter transactions.

(More: Do you know how to calculate after-tax returns?)

Finding cheaters

The IRS in theory matches the statements to federal returns to root out cheaters. But even though a copy goes to the IRS, "you can't rely on the 1099-B for your return," said Muhammad Akram, an accountant and the founder of Akram & Associates in Cary, N.C., which caters to small hedge funds.

Since 2011, the statements must track and disclose an investor's cost basis, or amount paid, for an asset bought that year or later — a requirement that prohibited the earlier practice of self-reporting profits. Brokers have to send the previous tax year's statements by Jan. 31, but routinely issue corrected statements without warning, sometimes more than once, after they receive details on distributions from mutual funds, real-estate investment trusts and other assets.

Smaller brokerages are more likely to issue statements that misreport basis or dates, Mr. Akram said, because they invest less in the technology required to generate the reports and often don't use third-party software to tally values. But even Wall Street brokerages have inconsistencies, especially with reporting dividend income, he said.

Complex holdings

"It's systemic," Mr. Akram said.

The statements can be a particularly unreliable tax guide for investors with complex assets like futures, options and exercised stock options, accountants say. Also left in the dark are investors who have multiple accounts at a single brokerage, or have portfolios across multiple wealth managers, and taxpayers who've inherited portfolios, said Charles Sarowitz, an accountant and founder of Sarowitz Milito & Co. in Brooklyn, New York.

Statements also can't detail instances across multiple brokerage accounts in which investors sell securities at a loss and purchase the same asset or one "substantially identical" before or after 30 days, known as a wash sale.

And for investors in master limited partnerships, common in the oil and gas industry, "there's never a correct basis" in the brokerage statements because the partnerships typically issue final performance data weeks after the brokerage issues the 1099-B, Mr. Sarowitz said.

Software solution

Big hedge funds routinely use third-party trade software from firms like TradeLog to reconcile brokerage statements and trading logs "because they know" the statements "are screwed up," Mr. Green said. But individual investors and smaller funds typically don't.

So what's an investor to do?

An IRS spokesman said that an investor could ask his or her brokerage for a corrected statement — something Mr. Fichtenbaum said had worked for only one of his many clients with mis-dated options. And while taxpayers can enter adjustments onto their returns, that pits the statements against those entries and creates something he said no one wants: "a good chance somebody at the IRS is going to audit the return."

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