Advisers gear up for cost basis rule change

Financial advisers are bulking up their resources — and bracing for client complaints — as they prepare for the Jan. 1 deadline to begin complying with new cost basis rules.

Some advisers already have added staff in preparation for the new rules of the Emergency Economic Stabilization Act of 2008, which requires broker-dealers to report the cost basis of equity holdings to account holders and the Internal Revenue Service starting Jan. 1. Rules governing other investment types will be phased in over three years.

Advisers fear that the methodology that they use to compute cost basis may differ from the methodology used by their custodian. If that is the case and a client reports a cost basis number obtained from the adviser while the broker-dealer reports a different figure on Form 1099-B, the IRS may take action.

“If a client gets one number from an adviser and the custodian gives the IRS another number, there’s going to be a lot of push-back from clients,” said adviser Scott Neal, president of D. Scott Neal Inc., which manages $125 million in assets.

“The clients are going to get mad at their adviser,” he said. “It’ll paint us in a bad light potentially because we’ve been the ones working with them.”

Even though advisers aren’t required to report cost basis data to the IRS, clients expect accurate information from them, said Brian Keil, the director of cost basis reporting at Charles Schwab & Co. Inc. He said that a “few thousand advisers” among the 6,000 who use Schwab’s custodian services have begun implementing the new systems, but the remaining advisers still need to make changes.

“It’s in their best interest to make sure their data is in sync with what we’re reporting to the IRS, because those client calls are going to go to the adviser,” Mr. Keil said.

To avoid these pitfalls, advisers said that they are trying to bulk up on staff members and work closely with their custodians to ensure that their custodians are using a similar method to track cost basis.

“You can either wait for the problems to happen or be ahead of it. It’s the right strategy to be forward-thinking,” said Randall Richard, president of Richard Brothers Financial Advisors, which manages $250 million.

His firm has hired two staff members to help oversee the day-to-day issues that will arise with the change.

Cost basis rules will be extended to mutual funds, exchange-traded funds and dividend reinvestment plan shares in 2012; fixed income, options and other securities will be added in 2013.

In passing the 2008 law, Congress sought to capture millions of dollars in lost tax revenue from investors who don’t correctly report cost basis and underestimate their gains. Investor reporting errors, however, may be due more to the difficulty in calculating cost basis than to investor deception.

Calculating cost basis is complex due to the variety of ways to perform the calculation and because many changes can occur to an investment over time, including several kinds of splits and dividends.

FIRST-IN, FIRST-OUT

One common method of determining cost basis is first-in, first-out, which assumes that an investor sells shares in the order in which they were purchased. This is the default method that broker-dealers are required to use.

This so-called FIFO method can lead to steeper taxable gains, advisers pointed out. Advisers often use other methods, such as selling a particular number of shares and then waiting until year-end to decide which lot (based on purchase price) was sold.

This method is allowed under the new rules, but after Jan. 1, the deadline for specifying the particular lot sold — and locking in the purchase price — becomes the settlement date of the trade.

In preparation for the change, many advisers have had to go through their systems to ensure that they and their custodian have reported trades the same way. One staff member at Reynders McVeigh Capital Management LLC, for example, has spent six months checking the data and has discovered several discrepancies, said Charlton “Chat” Reynders III, chief executive of the firm, which advises on $4 billion in assets.

“We’re taking this very seriously,” he said.

“For us, this is a very big deal. We’ve been working very hard to get the correct tax basis, because in some ways, it could be an advantage to our clients and it needs to be correct,” Mr. Reynders said.

Another challenge that some advisers face is ensuring that their operating systems with regard to cost basis are in sync with their custodians’.

At Ronald Blue & Co. LLC, many clients use gifting strategies to minimize taxes, said Larry Korchan, director of investment operations. Each custodian may have a different code for such strategies, he said.

“If the custodians don’t have the same default, you have to match and marry two codes,” said Mr. Korchan, whose firm manages $5 billion in assets. “For the most part, though, our codes match up.”