Accurate Cost Basis Would Help Close Tax Gap (Market Forecast)

In late 2006, the U.S. Treasury’s Office of Tax Policy issued a report that calculated the tax gap at $345 billion for 2001 tax receipts.
The tax gap is defined as the “difference between the amount of tax that taxpayers should pay under the tax law and the amount they actually pay on time.”
The report pegs the 2001 compliance rate at 83.7 percent.
Given the changes in Congress and the renewed focus on a ‘pay-as-you-go’ policy for spending or tax cuts, the federal government will be looking for additional revenue wherever it can find it.
Expect a push to narrow this tax gap in the coming years.
The IRS estimates that $11 billion of the tax gap is due to underreporting of capital gains.
Custodians are now required to send a 1099-B form to the IRS reporting the gross proceeds of securities sales in taxable accounts, but maintaining cost basis information, needed to calculate the net gain or loss for tax purposes, is still the responsibility of the individual taxpayer.
Obviously there are taxpayers who intentionally overstate cost basis in an effort to pay less tax, but the IRS is also focused on investors who unintentionally overstate cost basis due to either the complexity associated with preparing tax returns or the difficulty of maintaining accurate cost basis.
So what are some steps to prepare for IRS scrutiny of capital gains?
First, be sure to keep copies of statements and confirmations.
These provide direct evidence of the date and cost of securities positions.
Second, keep a journal, spreadsheet, or personal finance software record of your securities transactions.
Having all this information updated and in one place should help in tax return preparation.
Third, start right away. Even if you don’t have accurate information for your existing positions you can develop good habits for tracking new positions while you track down the old information.
Garrison Asset Management offers cost basis maintenance, statement and confirmation record keeping, cost basis research on existing positions, and gain and loss reporting as part of our investment management services.
I’m sure that every CPA or investment adviser has a good story about researching cost basis.
I recall a client who had participated in a dividend reinvestment plan through AT&T beginning in the early 1980s.
By the late 1990s she had accumulated significant shares of AT&T, several of the regional Bells created in the breakup of AT&T in 1984 (some of whom had re-merged by then), Lucent and NCR (later spinoffs from AT&T), all of which had dozens of separate lots due to purchases through dividend reinvestment.
Like many companies, AT&T does a good job of assisting investors with determining cost basis through information on their website, but you still need the original cost to do the math.
Fortunately, the client had kept every statement from nearly two decades in a cardboard box, which she brought into the office.
So we rolled up our sleeves and put every purchase, stock split, spinoff, and merger into a spreadsheet and were able to determine her accurate cost basis.
There are a number of misconceptions about cost basis.
One is that shares received due to a stock split have zero basis while the original shares keep their full basis.
In fact, the total cost paid for the original lot is now spread over the higher number of shares, and the purchase date remains the basis date for all the shares.
If you own multiple lots of the stock, repeat that calculation for each lot.
Another transaction that can be tricky is a return of capital.
These transactions are common in real estate investment trusts and limited partnerships, but do occur in other parts of the stock market.
A return of capital looks like a dividend in that it is a cash flow from the company to the shareholder, but the tax treatment is different.
Instead of being taxed as income (qualified or otherwise) like a dividend, the cash flow is not taxed at the time it occurs; instead the cost basis of the position should be reduced by the amount of the return of capital, resulting in a larger capital gain if and when the position is sold in the future.
Another complex basis issue arises when an existing position is exchanged for cash and stock in an acquisition. In this situation a complex formula known as the ‘boot rule’ applies.
The boot rule determines how much of the original cost stays with the new stock versus how much, if any, gets netted against the cash portion of the deal for a realized gain.
Potential realized losses are not allowed to be reported under the boot rule.
Because the tax treatment is dependent on the cost basis, it is possible for two investors with similar size positions bought at different times to have dramatically different tax consequences.
An investor with a low basis may owe capital gains tax while a high basis investor owes none.
Clearly, accurate cost basis reporting can be a complicated but important process.
No investor wants to pay more taxes than she legally owes, nor less than she legally owes, especially in an era of potential higher scrutiny.
James B. Bell is a certified financial adviser with Garrison Asset Management of Fayetteville. E-mail him [email protected].