Regulations enacted in 2008 require brokers, transfer agents, and issuers to report cost basis information to the IRS and taxpayers. The regulations are effective in three stages, with three effective dates for different types of securities:

• Stocks acquired on or after January 1, 2011
• Mutual fund and dividend reinvestment plan stock acquired on or after January 1, 2012
• Debt instruments (such as bonds, notes, debentures, and other evidence of indebtedness) and options acquired on or after January 1, 2014

As the different portions of the regulations become effective, we find that we run into practical issues in their implementation. One of the issues noted so far centers on the cost relief methodology the broker uses, as opposed to the methodology used by the taxpayer in its books and records. While the two methodologies should theoretically be the same, we find that many times the brokers use a different method of cost relief from what was instructed by the taxpayer. The reason behind this, in many cases, could be that some brokers did not have the systems in place to handle the methodology utilized by the taxpayer. In other instances, there were simply errors or miscommunications between the broker and the taxpayer. But either way, the bottom line is that prior to 2011, it did not matter as the brokers were not required to report cost basis of their clients’ securities sales to the IRS. For that reason, brokers were not motivated to invest the resources necessary to upgrade their systems to capture true cost basis reporting information.

However, since the 2008 regulations became effective, these discrepancies have become serious issues. In addition, brokers are required to report wash sales, and therefore the cost basis reported by the broker will be reflective of wash sales. But brokers are required to report only wash sales within the same account and wash sales between identical securities by CUSIP. This becomes an issue because the taxpayers are required to identify and defer losses on wash sales regardless of whether or not the sale and purchase creating the wash occur in the same brokerage account. In addition, a taxpayer can create a wash sale by acquiring a “substantially identical” security to the one sold at a loss. Such security could have a different CUSIP number. In such a case (admittedly probably a rare case) the broker will not identify the wash sale, given that the reacquired security does not have the same CUSIP as the security sold at a loss. Options and other contracts to acquire “substantially identical” securities, straddles and constructive sales, and the interaction between those rules and the wash sale rules also create the potential for differences between wash sale deferrals required to be identified by the taxpayer and those required to be identified by the broker.

For the reasons mentioned above (and several other potential issues such as partial sub-lot sales, for example), the taxpayer in all likelihood will end up reporting to the IRS a different cost basis from what the broker has reported. In such a case, the burden is on the taxpayer to prove that the cost basis reported on its tax return is accurate and to reconcile the differences to the cost reported by the broker. In many instances, this can be a difficult task. The IRS has released Form 8949, which reconciles differences between the two cost basis figures. Currently the form is available only for individual tax returns- Form 1040- but it is expected that it will be utilized with partnership tax returns as well– Form 1065. Preparing these reconciliation forms will mean that it will require additional time to prepare tax returns and may result in an increase in professional fees.

Given the potential differences between security sale costs identified by the taxpayer and the same reported to the IRS by the broker, what can taxpayers do to protect themselves from errors and unreconciled discrepancies? In the event of an audit, documentation is very important. Taxpayers should clearly direct their brokers on the cost relief methodology to be used and document instructions provided to their brokers as best as possible. In cases where a taxpayer changes the cost relief method during the year, brokers should be notified of such a change in a timely manner. The brokers should be notified no later than the settlement date of each security sale for which the taxpayer intends to apply the new method. The change in cost relief method is not allowed for any particular trades for which the brokers were not notified by the settlement date, and retroactive application of the change is not allowed. The method can be changed on a sale-by-sale basis, so long as the broker is notified by settlement date as discussed herein. Taxpayers should also verify with the broker and document that the broker is actually following the proper cost methodology. Taxpayers should also request confirmations and acknowledgments from their brokers and document them accordingly.