Cost basis reporting not as simple as it appears

WASHINGTON — Be careful what you wish for with regard to cost basis reporting, as it might cause a headache of colossal proportions.
The president’s fiscal 2008 budget proposal, presented to Congress last Monday, includes a legislative proposal that would require financial institutions to track investors’ cost bases in stocks, bonds and mutual funds. It also would require them to transfer this information when customers moved their accounts to new firms and to report the cost bases to the customer and the Internal Revenue Service.
Although financial advisers have been hankering for cost basis reporting for years, some are coming to the realization that tracking that information may prove more trouble than it is worth. That is because there are numerous ways to calculate cost basis, each with varying degrees of complexity.
“What it’s going to lead to is a humongous headache for everybody — for advisers, for clients, for brokerage firms and for the IRS,” predicted Robert Moody, a certified financial planner who is president of registered investment advisory firm Compass Advisors LLC of Big Canoe, Ga.
For his clients, he favors the so-called specific-identification method, which involves selling specific shares in order to maximize tax efficiency.
The problem with making financial institutions responsible for cost basis reporting, Mr. Moody said, is that the institutions aren’t likely to be familiar with each investors’ unique tax circumstances and may use a less efficient method of calculating cost basis. Also, it raises the possibility that there could be a discrepancy between what an investor reports as cost basis to the IRS and what the institution does, he added.
“This would generate deficiency letters from the IRS when no deficiency in fact exists,” Mr. Moody said.
Indeed, the proposal in some situations might create scenarios under which taxpayers could create false “audit-proof” cost bases, said Keith Lawson, senior counsel for tax law at the Investment Company Institute in Washington.
“There could be situations where brokers have to rely on information provided by shareholders,” such as when securities are given as gifts to others, he said. “There are a lot of issues here that need to be sorted out.”
Unlike with many other measures in the administration’s budget, Democrats are likely to warm to the cost basis proposal to generate an estimated $6.7 billion over the next 10 years, according to estimates from the Department of the Treasury. The revenue will be realized through reducing cheating and helping taxpayers to compute their capital gains taxes more accurately.
Similar legislation was introduced in the last Congress, and Sen. Evan Bayh, D-Ind., one of its authors, plans to reintroduce it this year, spokeswoman Meghan Keck said.
At the Treasury Department’s budget briefing last week, Eric Solomon, assistant secretary for tax policy, acknowledged: “Details like whether or not one would use the average cost basis or first in, first out … still need to be worked out.”
The brokerage industry appears to be happier with the proposal than it has been with past proposals that would require firms to report customers’ cost bases. “This is very constructive,” said Patricia McClanahan, vice president and director of tax policy at the Washington headquarters of the Securities Industry and Financial Markets Association, which also is based in New York.
The proposal would apply to securities acquired after 2008, so brokerage firms wouldn’t have to provide the information for past purchases. The proposal would give the Treasury Department flexibility to create exemptions where necessary and would ensure that brokers received from issuers information necessary to pass along to investors, Ms. McClanahan noted.
Advisers worry
Advisers like the idea of receiving cost basis information from broker-dealers and mutual fund companies, but they have some worries about how the system would work.
Many clients change advisers, and mistakes could be made by other firms, said G. M. “Buz” Livingston, a CFP and president of Livingston Financial Planning Inc. in Santa Rosa Beach, Fla. “Who’s going to be responsible for that?” he asked.
“I applaud the idea,” Mr. Livingston said. “But the devil is in the details.”
Once a client moves to another firm, CFP and enrolled agent Jane Young wonders whether registered advisory firms such as hers still would be required to provide cost basis information. “This could put a huge burden on some fiduciaries,” said Ms. Young, a co-owner of Pinnacle Financial Concepts Inc. in Colorado Springs, Colo.
Still, she said, requiring broker-dealers and mutual funds to provide cost basis information “is an excellent idea. It’s so hard for us as financial planners to provide the data when we don’t have the tools to do it.”
If the requirement is enacted into law, “it should be easier to advise the client,” said Scott Anderson, a CFP, enrolled agent and registered representative with Newport Advisory LLC in Newport Beach, Calif.

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