Congress Targets Capital Gains to Close Tax Gap

Securities brokers are preparing for a new layer of reporting regulations as Congress takes steps to close the $349 billion tax gap.

A bill in the Senate finance committee and widely expected to pass with little controversy will require securities brokers to begin reporting cost basis for securities transactions to the IRS in order to more accurately report taxpayer capital gains and losses.

A General Accounting Office report in June 2006 estimated misreporting of cost basis for capital gains and losses accounted for $11 billion of the gap in 2001 and concluded 38 percent of taxpayers did not report their capital gains accurately.

With raising taxes a political third rail heading into the 2008 election cycle and the Democratic majority in Congress lacking the power to override a presidential veto even if it were so inclined to attempt a tax hike, closing the tax gap is a generally agreeable method to shrinking the budget deficit.

Securities brokers are now only required to report to the IRS the gross proceeds of sales of stocks, bonds, mutual funds and options as well as distributions from mutual funds. There are no regulations requiring documentation of what price a security was purchased for and that has allowed taxpayers – either through deliberate malfeasance or ignorance – to underreport gains and overreport losses based on inaccurate cost basis.

“Currently, the IRS can match what you say you sold it for, but they can’t match what you say you paid for it,” said Bill MaGee, senior tax partner of BKD LLP in Little Rock. BKD is the largest CPA firm in Arkansas and the 10th largest in the nation.

MaGee said brokers believe the measure will pass in time to take effect in 2009. Upon the advice of the industry experts they consulted, finance committee members have included a provision that will give brokers 18 months from the date it is enacted to implement the new reporting mechanisms.

The law will require brokers to keep records of cost basis for all securities purchased from that day forward as well as take measures to make transferring the information between brokers a more routine process when taxpayers move accounts from one firm to another.

“The obligation will shift from the taxpayer to the broker,” MaGee said.

There are a number of obstacles to overcome, chief among them designing new software or modifying existing programs to track cost basis, not to mention the expense in labor hours brokerage houses will face as they prepare to comply with the new regulations.

James Bell, vice president and assistant portfolio manager, and tax director Nathan Dunham at Garrison Financial Corp. in Fayetteville, said they see three major issues for brokers:

• Transferring records between brokers as well as determining cost basis for securities that are either gifted or inherited.
• If a taxpayer has purchased a security more than once at different prices, the cost basis for the specific lot sold will have to be determined.
• Complex capital transactions within the security such as mergers, spin-offs and stock splits. Determining the cost basis for sales of those securities will be difficult to automate.

Garrison, a wealth management firm, already tracks cost basis for its clients using Advent software but the cost to brokerage firms to adapt will easily run in the millions.

“It will be less than Y2K, but something similar with it all coming at the same time,” Bell said.