Five Challenges for the IRS’s New Capital Gains Reporting Rules

By :: May 1st, 2012

Sellers of stocks and other assets have always had to calculate their cost basis (generally, what they paid for the investment) in order to figure their taxable capital gains. In the past, this was often a hit-or-miss experience that required lots of tedious research (occasionally with help from brokers) and more than a bit of guesswork. This year, for the first time, Congress required stock brokers to report cost basis to both the IRS and taxpayers.  Next year, mutual funds must report.  The reporting will apply only to newly-purchased stock, so there will be a long transition to the new system.

The goal is to make things easier for taxpayers and improve compliance (that is, reduce mistakes, deliberate or not).

This is a laudable aim, but the IRS faces a number of challenges to make this initiative work. Here are five, excerpted from a new article I wrote for Tax Notes, Basis Reporting:  Lessons Learned and Direction Forward.   

  1. Congress standardized the information that brokers and mutual funds must report.  It also required taxpayers to either select a basis method (e.g., first-in-first-out (FIFO), average basis, or identification of the specific securities sold) in advance or accept the default choices made by their brokers or mutual funds.  These steps improve the quality and consistency of the information, which in turn will facilitate information matching by the IRS, but they greatly confuse taxpayers, at least in the near term.
  2. Taxpayers are permitted too many choices to calculate their gains and losses, which greatly complicates reporting.  So, for mutual fund shares, taxpayers must now decide whether to provide standing instructions to determine the order in which their shares should be sold (e.g., highest basis first), whether to identify specific lots of shares to be sold at the time of sale, whether to elect average basis for their shares (separately for each of their accounts), and whether to revoke or change their average basis elections.   And the mutual funds must capture, maintain, transfer, and report these basis choices.
  3. By law, taxpayers are responsible for reporting their gains and losses correctly on their tax returns, regardless of the numbers they received from their brokers.  So, for example, the IRS expects taxpayers to adjust cost basis to reflect tax rules, such as wash sales, which the brokers might not have reflected.   In practice, however, most taxpayers will simply transfer the numbers reported to them by their brokers to their income tax returns, and hope for the best.
  4. The IRS expects to match the new information reports to taxpayer returns to identify misreporting.  Whether the IRS can distinguish taxpayer misreporting from system errors in matching is unclear.  However, the mere threat of information matching is likely to improve taxpayer compliance.
  5. Technology advances, such as information reporting and tax preparation software (like Turbo Tax), shield taxpayers from the tax determination process, which is both helpful and harmful.  It’s helpful if taxpayers can save time and effort by using the information provided, but harmful if taxpayers cannot confirm or understand the information they have received.

With all of these problems, is basis reporting worth it?  I believe the answer is yes, but the transition will be painful.

(Full disclosure:  I advise Wolters Kluwer Financial Services--the publisher of GainsKeeper tax software.  The views I express are my own and not those of Wolters Kluwer Financial Services.)

9Comments

  1. Michael Bindner  ::  10:49 pm on May 1st, 2012:

    If we can track a package for overnite delivery, you would think we could track individual shares of stock and their purchase prices. Another wrinkle is inherited stock. There is an argument that if a stock is sold and it was inherited, that the first dollar of value, regardless of gains, should be taxable above a certain filing threshold. In a world of employee ownership, where sales to an ESOP are tax free (and might be for inherited stock), eventually capital gains taxes won’t apply because there will be no outside market or anyone paying income taxes on huge wealth.

  2. Tax Roundup, 5/2/2012 « Roth & Company, P.C  ::  9:00 am on May 2nd, 2012:

    […] Are the new broker basis reporting rules worth it? “Five Challenges for the IRS’s New Capital Gains Reporting Rules“(TaxVox) […]

  3. Ralph H  ::  12:18 pm on May 2nd, 2012:

    I bet you never sold a mutual fund or stock in a dividend rewinvestment program. You are at the mercy of the fund/broker.

    Also, is it fair to charge CG if the investment lost money compared to inflation? I think not.

  4. Ginter Vurlicer  ::  3:07 pm on May 2nd, 2012:

    All this is OK for short term investments, but when you get into long term investments all investors, regardless of the accuracy of their original cost basis, get screwed by the IRS’s ignoring the changes in the consumer price index over long time periods (read as inflation and the decreasing value of the dollar). In many cases of small savers and investors, the current value of their investments is about the same as their original investments when changes in dollar values are taken into account — so no tax should be paid, because there is no net profit or net income. Congress and the IRS assume all dollars to be equal in value over an infinite number of years. This is patently ignoring financial realities and just inflates the amount of taxes due, commensurate with the rate of inflation over the given years. When is Congress and the IRS going to accept the fact that the United States is NOT on the gold or silver standard and all dollars are NOT equal?

  5. Vivian Darkbloom  ::  4:41 pm on May 2nd, 2012:

    This is yet another example of the IRS delegating its compliance and enforcement function to private parties. Other examples include (increased) tax advisor and preparer penalties. This puts the private sector at the forefront in preventing tax fraud and abuse. Perhaps that is how it should be, but at what cost? The cost here seems pretty high. Also, it is not clear to me that these proposed rules will result in increased accuracy, particularly if the current rules on determining the cost basis of capital assets is preserved. The false sense of accuracy these reporting rules may create could actually result in a decrease in the accuracy of gains reporting as reflected in returns filed.

    One possible solution (other than reducing the options for selecting which assets are sold) would be for the IRS to require (allow) reporting per a default rule (say, FIFO). If a taxpayer wishes to deviate from this, the taxpayer would be required to so indicate on the return and substantiate the actual method used. That may logically increase the chances of audit.

    A couple of commenters have raised the issue of inflation and the calculation of taxable gain on capital assets. That is a legitimate concern, but it does not specifically relate to the reporting issue discussed here. Since raising the CG rates is a serious campaign issue, I would suggest a reform that should make most people happy. Granted, inflation is an issue for assets held over a longer period of time. However (other considerations aside such as multiple level taxation) I have never understood why an asset held just over one year should be given much more favorable treatment than one held 364 days and potentially much more favorable treatment (due to the effects of inflation) of an asset held, say, more than ten years. This is a rule that needlessly lacks any nuance. Serious consideration should be given to adjusting the holding period such that favorable tax treatment requires a longer holding period than merely one year, and that the rate of tax (or the gain recognized) gradually decreases the longer the asset is held as an investment. Lengthening the holding period requirements should also silence the largely rhetorical objections that the favorable rates for long term capital gains merely rewards “speculators”.

  6. Michael Bindner  ::  5:59 pm on May 3rd, 2012:

    In a tax advantaged 401(k), IRA, Roth or 403(b) these are not issues. Irregardless, brokers can still keep track for you. As far as inflation, the impact of the gain is offset to some extent by indexing. Adjusting for inflation is only viable if you tax (or write off) changes in value every year, rather than when the stock is sold.

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