The Emergency Economic Stabilizaton Act of 2008 consists of a tax provision which requires brokers to report extensive cost basis information to the IRS and investors. Investors who received past gain/loss statements from their brokers should realize that these statements were not reported directly to the IRS. As a result, this provision brings cost basis reporting for tax purposes to an entirely new level.
In just over two years, starting on January 1, 2012, brokers and their transfer agents will be required to track and report gains/losses for mutual fund transactions in much greater detail than currently required. The deadline for stock transactions is actually one year earlier: January 1, 2011. Experts in the industry are saying that any brokerage which has not started planning for the systems impact is already behind schedule.
There is no shortage of articles highlighting the need to take action and vendors touting potential solutions. One major class of solutions aims to import data from existing transaction processing systems and compute the required cost basis information for investors and the IRS. Approaching the problem as only a reporting challenge has its appeals, probably foremost for cost and expediency. Recoding a transfer agency system during a recessionary period (or anytime, for that matter) ranks up there with persuading Americans to agree on healthcare reform.
With respect to mutual funds, transfer agency shareholder recording systems ("TA systems"), from vendors such as DST, PNC, SunGard, and Envision, generally follow fundamental rules when tracking sharelots. (For those wondering, assume a sharelot to represent the most basic level of tracking an investment in a stock, ETF, mutual fund, bond, etc. on a TA system.) The following such rules apply to a single account ("account-level processing").
1. When an investor purchases shares in a mutual fund, a sharelot is created on the trade date of the investment. If for some reason multiple purchase orders for the same fund occur on the same trade date, the TA system might consolidate those orders under one sharelot.
2. When an investor sells/redeems shares in a mutual fund, the balance of an existing sharelot is reduced by the size of the sell order as of trade date. The choice of which existing sharelot to reduce depends on various rules, usually chosen by the mutual fund (hopefully disclosed in the corresponding Prospectus or Statement of Additional Information.)
3. When an investor reinvests a dividend into a mutual fund (not necessarily the same fund which paid the dividend), the balance of a sharelot created specifically for reinvested dividends is increased. Generally, every reinvestment trade does not create a new sharelot (but, as with everything related to transaction processing, exceptions may exist).
4. The purchase or sale of mutual fund shares as part of an exchange (selling one fund and using proceeds to purchase another) is handled no differently. Sharelots are reduced and created accordingly. However, other rules may take into account special redemption fees, front-end loads, or commissions, for which additional sharelots might be required in order to facilitate computations.
5. Moving shares from one account to another (i.e. changing brokers) generally has no impact on the sharelots, should not result in a taxable event, and should not change the cost basis. However, brokers need to be certain to transfer the sharelot data properly across systems. A surprising portion of account transfers require human intervention, such as sending/receiving faxes and manual data entry.
What might the new cost basis reporting requirements mean for mutual fund transactions and share balances recorded on TA systems, and their users? Here are a few potential repercussions to consider.
1. Systems which follow certain rules for processing sell orders might need to accommodate other rules required under the tax provision.
Simple FIFO or LIFO no longer suffices. Investors will have the option to select which rules to
follow, even change selections over time.
2. The reinvestment of dividends may require the creation of more sharelots in order to track each individual reinvestment transaction. The IRS will require brokers to compute the gain/loss for each set of shares purchased, regardless of whether an investor used cash or dividend distributions to fund the purchase.
3. Wash sales occur when identical shares (the true meaning of which may be pending clarification) are purchased within 30 days before or after being sold. If a taxable loss is realized when shares are sold, the corresponding purchase would require an adjustment to the sharelot cost basis. Not all TA systems may handle this adjustment automatically.
These are only a few considerations, and future postings on this blog may introduce more. Keep in mind that the impact on TA systems might be minimal if adopting the new cost basis reporting requirements is defined as a reporting challenge. As brokers plan various solutions in coordination with technology vendors, will the underlying data architecture and trade processing code in TA systems remain largely insulated?
Check future postings for an ongoing assessment of operational considerations and hopefully some quantitative simulations of the potential tax impact.