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July 14, 2011

Congress recognized that incorrect basis reporting for capital gains cost the government an estimated $6 billion to $9 billion per year in lost tax revenue. To help close the "tax gap," Congress recently implemented new cost basis reporting rules for securities, which essentially shift the cost basis tracking chores from individual taxpayers to brokers and corporate issuers.

In today's complex business environment, it is increasingly difficult for individuals to maintain the proper records and navigate the confusing maze of corporate transactions in order to correctly calculate their cost basis in a stock and subsequently the resulting tax liability. Congress recognized that incorrect basis reporting for capital gains cost the government an estimated $6 billion to $9 billion per year in lost tax revenue. To help close the "tax gap," Congress recently implemented new cost basis reporting rules for securities, which essentially shift the cost basis tracking chores from individual taxpayers to brokers and corporate issuers.

These new requirements have often been referred to as the new "broker rules." While it is true that much of the responsibilities landed on brokers, corporate issuers also have many new required tasks that have been overshadowed by the broker requirements. Companies should not overlook these rules and assume their brokers have this covered. The new corporate issuer requirements will demand resources from numerous departments within a company as well as a coordinated approach across the organization.

The new cost basis reporting requirements were enacted as part of the Energy Improvement and Extension Act of 2008 under the Emergency Economic Stabilization Act of 2008 (EESA) as a revenue raiser to offset other provisions by improving taxpayers' disclosure of cost basis, thereby presumably leading to increased taxable gains being reported. Taken together, these new reporting requirements create a web of basis reporting that starts with the issuance of a share of stock, covers all the transfers of that share from issuer through brokers, and includes the quantitative effect of corporate actions on the basis of the share. The culmination of this process is the reporting of the basis of that share on the Form 1099-B issued by the broker reporting the sale transaction.

Once fully implemented, these new rules should make taxpayers' tax preparation easier because their brokers (with basis information gathered from corporate issuers and transferees) will now be responsible for the tedious task of tracking cost basis for them, although the ultimate responsibility of reporting information correctly to the IRS still lies with the taxpayer. Final regulations were released on October 11, 2010, and phase one of the rules went into effect on January 1, 2011. Additional guidance is still being released regularly, including Notice 2011-56 applicable for average basis method stock, which was just issued on June 22, 2011.

Overview of the Law
These new reporting requirements are divided into three main categories:

  • Expanded Form 1099-B reporting requirements for brokers — Section 6045(g)
  • Information statements for transfers of securities — Section 6045A
  • Issuer requirements for organizational actions affecting basis of securities — Section 6045B

Form 1099-B Broker Requirements
The first main requirement under the new cost basis rules is that “brokers” must now include on the appropriate Form 1099-B the customer’s adjusted basis for “covered securities” and whether the resulting gain or loss from the sale is long term or short term.

A broker is any person who, in the ordinary course of a trade or business, stands ready to effect sales to be made by others. This includes the typical brokerage house, but also companies that regularly redeem their own stock. Accordingly, some issuers like smaller private companies could be considered brokers subject to these burdensome rules.

These new rules are being phased in mainly through the definition of "covered security" each year. The timeline below summarizes when various security types fall into the definition of "covered security" and subsequently become subject to these rules.

To correctly calculate the adjusted basis in the security, brokers will now need to track not only what a customer paid for covered securities, but also any wash sale transactions or organizational actions that occur while the covered security is in an account managed by the broker. This is quite a shift of the recordkeeping responsibilities from taxpayers to brokers, and the cost of this change will undoubtedly be passed on to consumers at some point.

Also, brokers may be required to provide multiple 1099-B forms to an individual for a single sale as a result of multiple tax lots being sold together with different basis amounts, holding periods and acquisition dates (i.e., some tax lots may be subject to these rules while others may not). Accordingly, these new rules may be administratively challenging for brokers and potentially confusing for individual taxpayers because of the increased paperwork and required tax forms.

The penalties for non-compliance can be stiff under Sections 6721 and 6722 (up to $1.5 million per section, for a total of $3 million; unlimited if failure is due to intentional disregard) if brokers fail to correctly provide all required 1099-B forms for a calendar year by February 15 of the following year.

Transfer Statements
The second main requirement comes into play when an applicable person transfers custody of a covered security to a receiving broker. An applicable person must now provide within 15 days a transfer statement that allows the receiving broker to satisfy the cost basis reporting requirements.

An applicable person is a broker, a person who acts as custodian of securities in the ordinary course of business, an issuer of securities, a trustee or custodian of an individual retirement arrangement (IRA), or any agent of these persons, including administrators of employee stock purchase plans.

The transfer statement must include items such as the original acquisition date, contact information for the receiving broker and applicable person, CUSIP, adjusted basis and other information necessary to correctly calculate basis. Applicable persons must also reflect the quantitative effect of any organizational actions on basis reported by issuers while the covered securities were in their possession.

Thankfully, the IRS granted some relief from these rules for 2011 through Notice 2010-67, which waives the penalties for failure to furnish a transfer statement by brokers and other custodians in 2011 for transfers that are not incidental to the stock’s purchase or sale. Such transfers may be treated as a non-covered security by the receiving broker. However, absent any further guidance, these provisions will be in full effect January 1, 2012, so applicable persons should get prepared.

Issuer Statements for Organizational Actions
The third main requirement involves issuer statements for organizational actions. This reporting requirement, along with the transfer statement requirement, squarely applies to corporate issuers. Issuers of specified securities must disclose to the IRS and their certificate holders:

  • When an organizational action occurs;
  • Descriptions of the organizational action; and
  • Quantitative effect on basis of the specified security resulting from the organizational action.

Organizational actions include stock splits, reverse stock splits, mergers, acquisitions or any other corporate action that affects the basis of the security. In today’s world of complex and complicated transactions, it is no small task to determine the quantitative effect of transactions on a stock’s basis. Issuers should be mindful of these provisions when contemplating extraordinary corporate events.

Issuers can choose to disclose the required information by either:

  • Preparing and submitting a return designated by the IRS (yet to be released); or
  • Posting required information on an area of the company’s primary public website that is in a readily accessible format and accessible for at least 10 years.

Issuers must disclose the information to the IRS on or before the earlier of:

  • The 45th day following the organizational action; or
  • January 15 of the year following the calendar year in which the organizational action occurred.

Issuers must notify their certificate holders on or before January 15 of the year following the calendar year in which the organizational action occurred. We think most issuers will simply choose to post the information on their websites within 45 days to satisfy both the IRS and certificate holder requirements.

It is easy to see that multiple departments within a corporation may be affected by these new reporting requirements. Calculating the quantitative effect on basis of an organizational action will most likely fall to the corporate tax department, although the legal department and investor relations may also be stakeholders in the corporation’s compliance with these new reporting obligations.

Pursuant to Notice 2011-18, the IRS granted some temporary relief by stating it will not assess any penalties for missing the deadline for 2011 organizational actions as long as the issuer files the return with the IRS or makes it publicly available by January 17, 2012 (i.e., the first business day after the January 15 deadline).

Employee Compensation Implications
The new cost basis reporting requirements have some confusing implications for issuers’ employee equity compensation arrangements due to some technical wording and the way the rules are phased in during 2011, 2012 and 2013.

Due to the requirement that stock be "acquired for cash," only certain compensatory stock awards are considered "covered securities" for purposes of the cost basis reporting rules as noted below:

Accordingly, if an issuer grants a mix of options and other awards to its employees, as many companies do, confusion may arise when employees do not understand why they have an adjusted basis reported on a Form 1099-B for their stock options but not for their other awards.

To add to the confusion, at least until 2013, brokers are not required to include in the reported cost basis the compensation amount already included in ordinary income by the issuer. Accordingly, brokers only have to report the exercise price for stock options and the purchase price for employee stock purchase plans.

The result could be the underreporting of basis (and overpayment of taxes) by employees unless they understand that their Form 1099-B is incomplete (but compliant with the reporting requirements) because of the exclusion of the compensation element of their awards. This will prove to be a challenging communication effort for human resource and tax departments when they inevitably receive calls and emails from their puzzled colleagues.

Brokers may voluntarily comply with these rules and report the correct adjusted basis for covered and non-covered securities. However, this additional service will probably only be provided at an added cost to issuers and individuals.

Alvarez & Marsal Taxand Says:
Although the new rules greatly affect brokers, several critical responsibilities will affect tax departments, investor relations departments and other departments of corporations:

  • If a company is also considered a broker, it needs to ensure that its systems are in place to capture the necessary information for compliance. The rules are extensive and cross many functional teams at a company, so coordination across the organization is key.
  • Companies should check to be sure that all of their service providers are communicating. This process involves numerous third parties, such as transfer agents, stock plan administrators, brokers, etc., so it is easy for a disconnect to occur.
  • It is also worthwhile for companies to look at their broker arrangements and the associated fees. These new requirements have required significant system upgrades and additional costs to brokers, which will probably be passed on to issuers and individuals in some manner.
  • Prior to contemplating any organizational actions, companies should have a coordinated team dedicated to the cost basis implications of the transaction. This team should include representatives from tax, finance, accounting, treasury, human resources, investor relations and others.
  • Companies should talk to their brokers about how they will handle the cost basis reporting and communication around employee equity awards, including the inclusion or exclusion of the compensation component of equity awards as well as non-covered equity awards.
  • HR, tax and finance/accounting departments need to be ready to address questions posed by confused employees because of the inconsistent treatment for covered and non-covered securities, as well as the compensation component of the covered equity awards. Communication efforts should begin prior to the 2012 tax season to minimize any confusion before it is out of control.

As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.

The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.

About Alvarez & Marsal Taxand
Alvarez & Marsal Taxand, an affiliate of Alvarez & Marsal (A&M), a leading global professional services firm, is an independent tax group made up of experienced tax professionals dedicated to providing customized tax advice to clients and investors across a broad range of industries. Its professionals extend A&M's commitment to offering clients a choice in advisors who are free from audit-based conflicts of interest, and bring an unyielding commitment to delivering responsive client service. A&M Taxand has offices in major metropolitan markets throughout the US., and serves the U.K. from its base in London.

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