Passing on the Business: Data Transit for Cost-Basis Reporting

A US investor decides to switch its account from one broker-dealer or bank to another.

The transition is supposed to be a no-brainer which happens every day on Wall Street. However, when it comes to cost-basis reporting, a simple operational process could easily turn into an administrative and financial nightmare, warn tax operations experts. The ramifications can be serious for both financial firms and investors.

Beginning January 1, 2015, the US Internal Revenue Service will penalize financial firms for any mistakes or delays when it comes to transferring data on accounts for investors in fixed-income securities to another firm. The original sending firm, otherwise called the delivering firm or transferor holding the account has fifteen days to send a ton of information about the account of the investor through a so-called transfer form to the receiving firm or the new firm which the investor has now selected.

Sending or delivering firms that make either a mistake in the information transferred to the new firm or don’t meet the deadline will be whammied with a fine of about US$100 per tax statement, or up to US$1.5 million annually. Investors, in turn, could end up paying either too much or too little tax, because the receiving firm won’t have the correct information to calculate the cost-basis of the account, explains Robert Linville, director of product management for cost basis software vendor Scivantage in Littleton, Colorado.

Such errors in cost-basis reporting, if not corrected, could end up creating a domino effect down the line to other broker-dealers or banks receiving the information in the future. Original discount bonds and bonds purchased in the secondary market at prices that are above or below their par amount are the ripest for errors, according to tax experts.

The IRS wants to ensure that investors pay the correct tax when they sell their stocks, fixed-income securities or options, so they now are holding financial firms responsible for calculating the cost-basis of those accounts. The new requirement was tacked onto a 2008 law — the Energy Improvement and Extension Act, which became effective as of January 1, 2011 for equity accounts and January 1, 2012 for dividend reinvestment and mutual fund accounts. As of January 1, 2014, the IRS’s new cost basis reporting rules became effective for simple debt instruments that were purchased after that date.

Laundry List

An automated system operated by Depository Trust & Clearing Corp. known as CBRS allows financial firms to simply fill in the necessary data fields for transferring account information from one financial firm to another, but it is only as good as the information input into the system, which could be as many as eleven different items for each tax lot for each security covered by the cost-basis reporting rules. They are: the purchase price, the acquisition date, the adjusted issue price as of the transfer date, the original basis, yield to maturity as determined under tax rules, cumulative amortized bond premium to the transfer date, cumulative accreted market discount to the transfer date, adjusted basis as of the transfer date, acquisition date adjusted for holding period rules and wash sales, and the computation cut-off date for all the amounts reported. At the CUSIP level or the level of the individual security, rather than the tax lot, the transferring broker must also provide the issue price, the issue date and the description of payment terms.

If it sounds like a mindboggling list, it is. “The level of detail and complexity of calculation for the required items that must be provided upon transfer of debt securities raises a substantial risk of potential error by the transferring broker or bank,” says Stevie Conlon, senior director and tax counsel in Waltham, Mass. for Wolters Kluwer Financial Services’ Gainskeeper business. “There are also several additional items that are not required to be transferred, but would also be needed to make certain that the receiving broker or bank can make future cost-basis calculations correctly to report cost-basis information on the investor’s Form 1099B when the affected debt security is ultimately sold.”

So just what should a receiving firm do? For one, it should verify it has received the information by the 15-day window and the clock starts ticking from what the IRS says is the “date of settlement for the transfer.” If not, the receiving broker dealer or bank then has to call the sending firm, says Linville. Even if all goes well and the information is received, the receiving broker must confirm it has all the data. Should the transfer form not be delivered on time or the data fields not completed, the receiving broker had better plan on making yet another quick phone call.

The receiving firm and delivering firm will need to check on the accuracy through a sniff test. Translation: do the calculations all over again to see if the figures are the same through a combination of random testing of data points and figures as well as human intervention through tax operations specialists. “The implementation of data management and technology solutions can further help eliminate errors and simplify the process on both sides,” says Linville.

Count on tax operations and tax reporting specialists to be doing some hefty overtime during the 2015 tax season. Granted, there are plenty of software packages, such as those offered by Wolters Kluwers and Scivantage, which do cost-basis reporting calculations. But they rely on accurate data and not all of them may not account for wash sales and any corporate actions. Hopefully, financial firms will also be using standardized data formats through DTCC’s CBRS rather than proprietary emails and faxes to keep the transfer as efficient as possible.

Lots of Worry

Three tax operations specialists at New York-based broker-dealers tell FinOps that they are expecting at least ten percent of transferred accounts in fixed-income instruments to either miss the fifteen-day window, be incomplete, or inaccurate. “The inaccuracies will most likely come from cumulative amortized bond premiums, cumulative accreted bond discounts, and adjusted basis,” says one tax operations director adding that DTCC’s CBRS doesn’t allow for “in-depth information on corporate actions and wash sales.”

Yet another tax operations director was concerned about receiving information through both the CBRS and proprietary emails and faxes. “It will produce a harrowing reconciliation ordeal.” The reason: the receiving firm will have to compare the information received through CBRS with that received through other channels. DTCC officials declined to respond to questions for this article, including the current number of users of the CBRS system and specifics about the information supported by the transfer form.

The IRS does provide the receiving broker or bank with an “out” if it doesn’t receive the information in time from the transferring broker or bank or if it is incomplete, as long as it makes just one request to the sending broker for additional or correct information. Without receipt of that information, the receiving broker is entitled to classify the assets as “uncovered” and the IRS will not require the receiving broker to calculate the cost-basis for those fixed-income securities. Likewise, the receiving broker is not responsible if it does not trust the information from the sending broker, but relies instead on information from the investor or a third party for cost-basis calculations. However, if it relies on its own calculations, the receiving broker or bank is responsible for any errors and can be fined.

Failure to meet the deadline or to provide complete or accurate information can put the sending broker on the hook with the IRS, if problems with the transfer of information turn up in a compliance audit. “Unfortunately the risk of penalties will be hanging over the heads of transferring brokers or banks, so they may send updated corrected transfer statements for securities months or even years after the transfer and upon receipt,” says Conlon. “The receiving brokers or banks must then treat the securities as covered and report on their cost basis when sold.” The end result: corrected Form 1099s to the IRS and unhappy customers.

Common-sense advice for both delivering and receiving broker-dealers and banks: take a good hard look at your readiness to meet these deadlines, if you haven’t already. Even with the use of automation, the massive information requirements are going to burden your staff. The short deadline may seem impossible at first glance, but this is a no-forgiveness mandate from the IRS, and customer relationships may be at risk as well.