Chairman Camp Agrees: Too Many Choices Burden our Tax System

By :: January 28th, 2013

Last week’s draft plan by House Ways & Means Committee Chair Dave Camp (R-MI) to reform the taxation of financial products includes two key changes that would simplify rules, reduce manipulation, minimize compliance burdens, and improve tax administration.

The first would require investors to use the “mark-to-market” method of accounting for all derivatives, other than business hedges. The second would require them to use average basis to calculate gains and losses from the sale of stock or mutual fund shares, and not first-in-first-out (FIFO), specific identification, or any other method.

Camp has proposed a unified approach to the taxation of derivatives: the mark-to-market method of accounting. Derivatives are contracts that are valued by reference to other assets or indices. They include swaps, forward contracts, futures, options, structured notes, security lending, and many other arrangements.

The current taxation of derivatives is complicated and inconsistent. There are different rules for different derivatives, for different uses of the same derivative, and for different taxpayers. As a result, two derivatives that are economically the same may be taxed quite differently. Investors often use these tax differences to manipulate the character, timing, or source of their income to reduce their tax liability.

For tax purposes, Camp would treat each derivative (other than business hedges) as if it were sold at the end of each year, and require any gains or losses to be recognized annually. Returns would be taxed as ordinary income. As a result, the taxation of derivatives would become straightforward—and most opportunities to manipulate income from derivatives would disappear.

Second, Camp would require taxpayers use average basis (for each account separately) to calculate the gains and losses from their actual sales of stock and mutual fund shares. Gains and losses still would be taxed at lower capital rates and would continue to be treated as short- or long-term, depending on how long the investment is held (which is determined on a FIFO basis). Camp would eliminate the many other methods for figuring gains and losses.

Currently, brokers must help taxpayers calculate their gains and losses from the sale of stock and mutual fund shares (for stock and mutual fund shares purchased on or after Jan. 1, 2011 and Jan. 1, 2012, respectively).

However, brokers must accommodate customer requests for multiple methods to calculate gains and losses. For example, suppose an investor purchased 100 mutual fund shares at $10/share on Feb. 1, 2012, 100 shares for $10.50 on April, 1, 2012, and 100 shares for $11 on June 1, 2012. If the investor sells 100 shares for $12/share on Mar. 1, 2013, she could recognize $200 of gain on a FIFO basis, $150 on an average basis, or $100 on a specific identification basis (if she specified the last lot).

These multiple methods encourage tax planning, undermine the simplicity of basis reporting, and confuse taxpayers. For example, for mutual fund shares, taxpayers must now decide whether to provide standing instructions to determine the order in which their shares should be sold (for example, 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.

Camp would eliminate that babel of calculations and allow only average cost basis. This would reduce complexity for brokers, cut costs, and make life simpler for investors. Customers would receive standardized reports with no confusing choices, which relatively few investors pursue (how many of you have responded to the requests by your brokers to make basis elections?). Finally, in a rising stock market, taxes are lower with average cost than FIFO.

Last year, Camp tackled international tax reform. His latest proposal to simplify financial taxes is another big step forward. Next, perhaps Camp could propose streamlining tax-favored retirement plans, where savers confront well over a dozen different vehicles (Roth IRAs, traditional deductible IRAs, 401(k)s, individual 401(k)s, SEPs, etc.). The road toward tax reform will be long, but kudos to Camp for what he has done so far.





  1. Vivian Darkbloom  ::  2:50 pm on January 28th, 2013:

    Over the weekend I prepared a spreadsheet to identify the specific ETF shares I would direct my broker to sell if the market gets too frothy (which we are likely now on the cusp of). Naturally, that list identifies the shares in which I have the highest cost basis. Camp’s proposal would no longer enable me to do this. However, I have to admit that as a matter of tax policy there’s not too much to complain about the proposal as it relates to fungible assets— except for the cost basis, every share is indistinguishable from the other.

    Rosenthal is right. This is what sensible tax policy proposals are about and Camp deserves credit for proposing sensible reforms. But,

    “Camp would require taxpayers use average basis (for each account separately) to calculate the gains and losses from their actual sales of stock and mutual fund shares.”

    suggests to me that there is a possible way around the proposed rule. I’m not going to tell you what it is, but drafters beware.

  2. Michael Bindner  ::  3:02 pm on January 28th, 2013:

    Kudos to Chairman Camp and his staff, as well as any Administration officials who helped with this. Hopefully this can pass without rancor.

  3. Tax Roundup, 1/29/2013: The best tax proposal ever. Also: tax season delayed for students and parents. « Roth & Company, P.C  ::  9:35 am on January 29th, 2013:

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  4. AMTbuff  ::  2:57 pm on January 29th, 2013:

    I saw that loophole too, Vivian. It’s more trouble that it’s worth for small assets, and it takes time to execute during which the market could move against you. I don’t think the drafters need to worry too much about the small resulting revenue loss.

    If this becomes law the standard tax advice will be to maintain multiple accounts and only purchase a given company’s stock once from each account. If you want to put yourself through that tax reporting headache to save a few bucks, knock yourself out. I don’t see many people actually doing that, especially people who pay tax preparers whose extra effort can eat up any tax savings.

  5. Vivian Darkbloom  ::  3:14 pm on January 29th, 2013:

    “If this becomes law the standard tax advice will be to maintain multiple accounts and only purchase a given company’s stock once from each account.”

    That’s not exactly what I had in mind.

  6. Steve Rosenthal  ::  9:02 am on March 16th, 2013:

    OK, Vivian, now is your chance to contribute to tax policy. I have been asked to testify before Congress on Chairman Camp’s financial products package on March 20th. If you share your loophole, I can point it out (in my testimony or to staff on background). The drafters have long been aware of the planning that would be available for multiple accounts. But are there other planning opportunities, perhaps unintended? (At your instigation, I have been playing around with various examples of buying more stock in order to increase average basis before selling stock. There are some anomalies, some of which would be addressed by the wash sale rules.) Thanks for sharing your views, and now is your chance to share more.

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