Cost Basis RepoRting: What You need to KnoW foR 2014 1
Cost Basis RepoRting:
What You need to KnoW
foR 2014
Next Phase Covers Fixed Income and Options
executive summary
Starting in 2014, Phase III of the new cost basis reporting requirements will be implemented for less complex securities. The phase will expand to cover more complex securities in 2016. This paper details the changes and points out areas that require particular attention from advisors. You will need to explain to clients which securities will be covered under each reporting deadline. In particular, clients need to know the default amortization methods for bond premiums.
The new rules for options, stock rights, and warrants require brokers to report adjusted cost basis and proceeds for closing transactions. You will need to help clients adjust to the changes and understand the difference between broker reporting requirements and taxpayer requirements. The new broker reporting rules will align more closely with taxpayer reporting requirements for clients’ securities transactions. This paper can help you distinguish yourself and your firm by communicating clearly with clients throughout the transition.
2
INTRODUCTION
2
OVERVIEW OF REGULATIONS
3
FIXED INCOME: TWO REPORTING PHASES
4
AMORTIZATION RULES
5
OPTIONS: WHAT TO EXPECT IN 2014 AND 2016
6
1099 FORMS: LOOK FOR ADDITIONAL MODIFICATIONS IN 2014
6
BACKUP WITHHOLDING CHANGES
7
TRANSFER REPORTING DELAYED ONE YEAR
7
SCHWAB CAN HELP YOU AND YOUR CLIENTS PREPARE FOR THE NEW REQUIREMENTS
8
introduction
By now advisors, brokers, and clients have experienced Phases I and II of the new tax reporting rules for cost basis. The first phase took effect on January 1, 2011, and addressed equities. The second phase, which began January 1, 2012, expanded to mutual funds, exchange traded funds, and dividend reinvestment plans (DRIPs). Now advisors must prepare their clients for Phase III, which will cover fixed income securities and options. Given the complexity of these investments, the Internal Revenue Service (IRS) will stagger the reporting requirements to cover: • Less complex fixed income and options securities
acquired on or after January 1, 2014
• More complex fixed income securities and options issued as part of a fixed income instrument acquired on or after January 1, 2016
You have already helped your clients navigate many of the tax reporting changes. Now you can use these new regulations as an opportunity to further strengthen client relationships.
overview of Regulations
The Emergency Economic Stabilization Act of 2008 included new tax reporting requirements that dramatically changed the way investors and advisors think about cost basis. The Act’s goal is to ensure that investors accurately report investment gains and losses in their annual tax filings. To achieve this objective, custodians and brokers are required to report the adjusted cost basis of covered securities (including whether the gain or loss is short term or long term) to taxpayers and the IRS on Form 1099-B. The requirements were originally scheduled to be phased in from 2011 to 2013, but the varying complexities of the affected securities caused the IRS to extend the time frame through January 1, 2016.
Cost Basis RepoRting effeCtive dates BY seCuRitY tYpe
EquItIEs Mutual FuNds, EtFs, aNd dRIPs lEss COMPlEx FIxEd INCOME aNd OPtIONs sECuRItIEs
MORE COMPlEx FIxEd INCOME aNd OPtIONs IssuEd as PaRt
OF a FIxEd INCOME INstRuMENt aCquIREd ON OR aFtER
Cost Basis RepoRting: What You need to KnoW foR 2014 3
CoveRed fixed inCome instRuments
lEss COMPlEx FIxEd INCOME: subJECt tO 1/1/14 REPORtINg
MORE COMPlEx FIxEd INCOME: subJECt tO 1/1/16 REPORtINg
FIxEd INCOME ExCludEd FROM REPORtINg
Taxable and tax-exempt bonds that have a fixed rate, fixed maturity, and fixed payment schedule, even if callable by the issuer. These include:
• Treasury notes and bonds • Fixed-rate corporate bonds • Fixed-rate municipal bonds
• Variable-rate bonds • Stepped-rate bonds • Convertible bonds • Stripped bonds
• Certain tax credit bonds • Contingent payment bonds
• Inflation-indexed fixed income securities • Foreign-issued bonds or bonds that pay
in foreign currency • Payment-in-kind bonds
• Fixed income securities issued as part of an investment unit
• Fixed income securities for which terms are not reasonably available to the broker within 90 days of acquisition by client
• Fixed income securities evidenced by a physical certificate not held by a custodian or clearing agent (physical debt)
• Some specific interests in or mortgages held by a real estate mortgage investment conduit (REMIC)
• Certain other fixed income securities with payments subject to acceleration
• Pools of fixed income securities whose yields may be affected by prepayments
• Short-term fixed income securities with fixed maturity dates not more than one year from the date of issue
a note about terminology
The IRS uses the term “debt instruments” rather than “fixed income.” When searching for information regarding fixed income on the IRS website, use the term “debt instrument.” Schwab will continue to use “fixed income” except when using “debt instruments” adds clarity.
fixed income: two Reporting phases
Properly accounting for the cost basis of fixed income securities is considerably more complex than it is for equity securities. Cost basis can be affected by accruals of income and by elections made by the holder of the instrument. To bring consistency to the process, the IRS made changes to the final regulations that help align what broker-dealers report on Form 1099-B with what clients report on their tax returns. The IRS also divided fixed income securities into two categories—“less complex” and “more complex”—and set different dates for their coverage by the new requirements.amortization Rules
Under the final regulations, brokers’ cost basis reporting will assume that clients have elected to amortize bond premiums. To conform to the new reporting rules, Schwab is making changes to the amortization rules in our cost basis engine. If amortization is currently turned off on a client’s account, we will enable it for the 2014 tax year. We will also make changes to our amortization and yield methods, but not until after April 15, 2014. This will ensure that 1099 Composite Reporting for 2013 is issued with current account defaults.
The chart below illustrates the broker default amortization elections Schwab will be implementing.
Elections: Brokers will support up to five different client
elections upon request. Clients must make their elections for the 2014 tax year by December 31, 2014. They can elect to:
• Accrue market discount using constant yield • Include market discount in income currently • Treat all interest as OID
• Turn off bond premium amortization
• Use the spot rate for interest accruals if currency is denominated in non-U.S. dollars (this will not become effective until 2016)
In 2014, Schwab will provide specific instructions about how to make client elections.
2014 amoRtization settings
bONds aMORtIzatION MEthOd yIEld aPPly dE MINIMIs RulE1
Original Issue Discount (OID)—
No Call or Put Feature Constant Yield Yield to Maturity Yes
Market Discount Straight-Line N/A Yes
OID Call Feature Constant Yield Yield to Worst (Lowest Yield) Yes OID Put Feature Constant Yield Yield to Best (Highest Yield) Yes OID With Acquisition Premium Constant Yield Original Yield to Maturity, Then Apply
Acquisition Premium
Yes Bond Premium—
No Call or Put Feature
Constant Yield Yield to Maturity No
Bond Premium—Call Feature Constant Yield Yield to Best (Highest Yield)— Taxable Bonds
Yield to Worst (Lowest Yield)— Tax-Exempt Bonds
No
Cost Basis RepoRting: What You need to KnoW foR 2014 5
CoveRed options
OPtIONs subJECt tO 1/1/14 REPORtINg OPtIONs subJECt tO 1/1/16 REPORtINg OPtIONs ExCludEd FROM REPORtINg• Options on a single security
• Options on more than one specified security, including an index in which the components are considered covered securities
• Options on financial attributes of specified securities, such as interest rates or dividend yields
• Warrants or stock rights
• Investment units in which options, stock rights, or warrants are issued together with a fixed income security
• Incentive stock options • Foreign currency options • Commodity options
options: What to expect in
2014 and 2016
The Phase III regulations change the landscape for
reporting cost basis for options on stocks, indexes, single stock futures, stock rights, and warrants. Although these instruments are not currently subject to gross proceeds or cost basis broker reporting on Form 1099-B, brokers will be required to report adjusted cost basis and proceeds for closing transactions on options, warrants, and stock rights that are acquired on or after January 1, 2014.
If options contracts are exercised or assigned, brokers will be required to adjust the cost basis or proceeds of the underlying positions. Schwab has been reporting the adjusted cost basis on option exercises and assignments since 2011.
Wash sales
Schwab will continue to perform wash sale adjustments on options with the same CUSIP that have disallowed losses. Other custodians may handle wash sales
differently, so confirm that you understand their policies. Suggest that clients consult with their tax advisors regarding their particular situations.
Cost Basis Reporting
There are several adjustments that brokers will not be permitted to make when reporting the adjusted cost basis of stock rights, options, and warrants:
• Schwab will not take into account the impact of option purchases or sales in determining disallowed losses on sales of the underlying securities. Check the policies of other custodians you may use. You should explain to clients that this treatment differs from taxpayer requirements.
• Brokers may not apply straddle rules on options in reporting adjusted cost basis to the IRS.
• Brokers will no longer be able to report the income component of stock acquired through the exercise of incentive stock options granted after January 1, 2014.
1099 forms: Look for additional
modifications in 2014
Schwab anticipates the following changes when the IRS releases draft copies of its 2014 tax forms:
Form 1099-B
• Adjusted cost basis required for all covered securities. • Total accrued market discount for covered securities. • Proceeds reporting for all principal payments (cost
basis reporting is not required).
Backup Withholding Changes
Explain to clients that they may be subject to backup withholding on gross proceeds if:
• They have received “B” Notices from the IRS due to missing or incorrect name/taxpayer ID number combinations.
• They have not submitted a W-9. • Their W-8 certification has lapsed.
Schwab will be required to withhold the federal backup
Broad-Based index options (section 1256 Contracts)
Non-equity options that are marked to market under Section 1256—i.e., listed options for non-equity securities and broad-based stock indexes—will be reported under the rules for regulated futures contracts.
2014 1099-b REPORtINg
Box 9 Box 10
Profit or (loss) realized on closed contracts 2014
Unrealized profit or (loss): open contracts—
December 31, 2013
$0 $0
Box 11 Box 12
Unrealized profit or (loss) on open contracts held in your account on
December 31, 2014
Aggregate profit or (loss) on contracts
$4 Fair Market Value (FMV) ($7 less premium paid of $3)
$4
2015 1099-b REPORtINg
Box 9 Box 10
Profit or (loss) realized on closed contracts 2015
Unrealized profit or (loss): open contracts— December 31, 2014 $6 (proceeds of $9 less premium paid of $3) $4 Box 11 Box 12
Unrealized profit or (loss) on open contracts held in your account on
December 31, 2015
Aggregate profit or (loss) on contracts
$0 $2 ($6 + $0 – $4)
Example: Activity
• On March 5, 2014, buy broad-based index options contract for $3.
• On December 31, 2014, options contract is worth $7. • On June 30, 2015, sell for $9.
Cost Basis RepoRting: What You need to KnoW foR 2014 7
transfer Reporting delayed one Year
Cost basis reporting on security transfers of fixed income and options will be required one year later than the date for purchases. The IRS has delayed requirements for reporting cost basis on transfers for an additional year. This will allow brokers the necessary time to change their transfer reporting systems. Any fixed income or options transferred during this time will be treated as uncovered.
1099 REPORtINg tRaNsFER statEMENts
Less complex fixed income January 1, 2014 January 1, 2015
Options January 1, 2014 January 1, 2015
More complex fixed income January 1, 2016 January 1, 2017
Options issued as part of a fixed income instrument January 1, 2016 January 1, 2017
schwab Can help You and Your Clients
prepare for the new Requirements
In 2014, Schwab will provide additional materials to help you educate your clients about the new phase of the reporting requirements. In addition to explaining to clients how their fixed income and option positions will be affected, you should ensure that clients understand the following details: • Amortization rules. Point out to clients that if
amortization is currently turned off on their accounts, Schwab will enable it for the 2014 tax year.
• Reporting. Ensure that your clients understand that
under the final regulations, a broker-dealer’s cost basis reporting will assume that clients have elected to amortize bond premiums. The election will be retroactive to the beginning of the tax year.
• Elections. Clients must make their taxable bond
elections for the 2014 tax year no later than December 31, 2014. The election will be retroactive to the beginning of the tax year. In 2014, Schwab will provide specific instructions for making client elections.
Conclusion
As the IRS continues to introduce the cost basis reporting requirements, advisors must remain committed to
explaining the changes to clients. Support clients as they prepare for the changes, and include their tax advisors in the conversations. Advisors who communicate well and address client confusion stand to deepen relationships and reinforce their value.
Many advisory firms’ back-office teams have been
adjusting to the rules for equities, mutual funds, ETFs, and DRIPs. Beginning January 1, 2014, they will need to do the same for fixed income and options, with a second layer of requirements coming in 2016. It is critical to assess how the next phase of the legislation will affect your firm and to begin training staff now.
Key takeaways
• The third phase of this legislation, particularly the rules relating to fixed income, will likely affect some advisory clients. Be sure your clients know whether they hold less complex or more complex fixed income— or both. Further changes to Form 1099-B may create confusion for clients. Plan now to develop a
communications strategy to guide clients through these changes in 2014.
• Prepare your back office now for the third phase. Although broker-dealers shoulder most of the burden to comply, your firm should begin to anticipate the workflow changes and client questions that relate to fixed income and options. Staying on top of news from broker-dealers is vital to the successful implementation of the new requirements.
• Taking steps now to prepare your firm and your clients can lead to stronger client relationships and help avoid difficult workflow issues later. Proactively communicating with clients could uncover potential opportunities.
