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Mark Washburn

Investors Beware: IRS Is on the Hunt for Cost Basis Information

Tax gap may create more demanding reporting standards both for taxpayers and brokerage firms.

December 13, 2007
by Mark Washburn, CPA/MST

At one time or another, almost every tax preparer has had to use an estimate for the cost basis of a security sold by a client. The client may have neglected to keep accurate records from the time they originally purchased the security, or the taxpayer may have simply lost the required information. Regardless of why a cost-basis estimate was used, the effect could have been a substantial underreporting of taxable income or income improperly characterized as long-term subject to favorable capital gains tax rates.

Taxpayers Beware

Congress is considering a proposal that would force brokerage firms to keep track of their client’s cost basis (what they paid for securities) and holding period (determined by the date they purchased those securities) and provide this information to investors.

The implication to the paid tax professional should be clear. No more estimating these numbers to the taxpayers’ benefit, whether unintentional or not. With accurate historical cost information, many transactions that might otherwise have been recorded as long-term, and thus benefiting from the favorable long-term capital gains rates, would be properly recorded as short-term transactions, subject to ordinary tax rates. These holding period changes can significantly affect the outcome of a taxpayer’s tax return.

Tax Gap

Shoring up cost-basis calculations for securities is one of several recent IRS proposals to close the tax gap. The tax gap is the difference between the amount of taxes owed to the IRS and the amount of taxes actually collected by the Service. One of the key elements used in describing the tax gap is the underreporting of income. The Congressional Joint Committee on Taxation, a nonpartisan committee established by the Senate Finance Committee, was charged with the responsibility of identifying areas of opportunity for closing the tax gap. This expression of the amount of uncollected taxes was estimated at $290 billion in 2001. Russell George, who is the Department of Treasury Inspector General, estimated the current tax gap at $400 billion. Other sources, such as the Bureau of Economic Analysis, estimate the tax gap to be as much as $1 trillion.

Inaccuracies of Accurate Reporting

The issue of more accurate reporting is directly related to underreported income. The premise of the problem is that a larger tax liability exists than taxpayers report. This is due in part to inaccurate information used to report Schedule D transactions. At present, there is no reporting of cost basis and holding period information by brokerages to the IRS. This allows taxpayers to exaggerate their actual cost basis as well as possibly manipulate the character of the sale, changing what should be reported as short-term gains subject to ordinary tax rates into long-term gains subject to the more favorable capital gains rates.

It can be argued that whenever taxpayers have the burden of substantiation, more accurate tax returns are filed. At present, there is no requirement for brokerage firms to report cost basis and acquisition date information on Form 1099-B. Form 1099-B is an informational document prepared by brokerage firms. A copy of the document goes to the taxpayer and a copy goes to the Internal Revenue Service. Currently, brokerage firms use Form 1099-B to report only the sale date and the proceeds received by the taxpayer. Firms which do provide cost basis and acquisition date information to the taxpayer do not provide such information to the IRS at this time.

Since it is the compliant taxpayers who also routinely pay their tax liabilities, the taxes declared by compliant taxpayers are collected with less effort from the Internal Revenue Service. This cost of collection is lower with compliant taxpayers; higher with noncompliant taxpayers.

Key Characteristics of Tax Gap

In a report titled A Comprehensive Strategy for Reducing the Tax Gap issued by the U.S. Department of the Treasury’s Office of Tax Policy, the IRS identified several key characteristics of the tax gap. One of these key characteristics is noncompliance among taxpayers whose income is not subject to third-party information reporting. When taxpayers know the IRS has access to information from third-parties which has to be reported on their tax returns, higher compliance occurs. For example, years ago when it became mandatory to report Social Security numbers of persons claimed as dependents, as many as 5 million “dependents” vanished from tax returns.

However, requiring brokerages to report cost basis information to the IRS does not solve all the problems associated with this thorny issue. To begin with, many investors start with one brokerage company and later switch to a different brokerage firm, sometimes switching several times. The subsequent firms are rarely provided cost basis information from the original firm. In some cases, investors can report this information to the new brokerage company and the new company will then track it. However, since this is self-reported information without independent verification by the new brokerage company, the opportunity for incorrect reporting is available.

Next, many investors chose to reinvest their dividends rather than receive them as cash payments. For tax purposes, these dividends are taxed as if the investor had in fact received the dividends. The fractional shares purchased with the dividends must be tracked as well as the amount of the dividend reinvested in order to accurately compute holding period and cost basis.

Finally, inherited or gifted shares of securities represent major challenges for the beneficiary taxpayer as well as a brokerage company. Generally, taxpayers are not well informed of their responsibilities as they relate to inherited or gifted property. Unless the original owner somehow provides cost basis and acquisition date to the intended beneficiary or gift recipient, such information can be lost. Procedures for obtaining cost basis exist, but the rules used to determine the holding period can be more difficult, especially for gifted property.

Conclusion

Until these proposed changes actually become law, it remains the burden of the tax professional to obtain accurate information from taxpayers. Educating clients whose tax returns include Schedule D transactions as to proper documentation techniques will reduce the burden. Taxpayers bear the responsibility for maintaining accurate records of transactions that have tax implications. CPAs, as tax professionals, bear a responsibility to better educate our clients. The issues identified above must be clearly discussed with clients who are active investors. CPAs must provide sound guidance as to their recordkeeping responsibilities so they are seen as part of the solution to such issues and not part of the problem. Using such issues provides CPAs the opportunity to enhance their ethical image, both to the clients they serve as well as the tax system they are pledged to uphold.

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Mark Washburn is a Senior Lecturer in Accounting at The University of Texas at Tyler. He teaches both Individual and Corporation tax courses at the undergraduate level. He is a certified public accountant licensed in Texas and holds a Master of Science in Taxation from The University of Texas at Arlington.