Wash Sale Adjustments: Impact on Cost Basis Reporting

Transcription

1 Adjustments: Impact on Basis Reporting Author Gudaru Anand Rao Domain Consultant, Wipro Technologies

2 Contents 2 Introduction... Scope... Rule... Key assumptions... Transactional Analysis with Lots, Sublots... 4 Transactional Analysis Holding Period and Potential Loss... 7 : Complexities and Ambiguities... 9 Conclusion... 0 References...

3 Introduction In this paper, we will focus on the cost basis adjustments due to wash sale rules with respect to Emergency Economic Stabilization Act of 08 (also known as U.S. bailout package) in general, and the wash sale complexities with accounting systems or cost basis reporting engine, in particular. This bailout rescue package of the U.S. financial system, legislated a new requirement of Basis Reporting. Effective from //, the reporting burden will shift to financial intermediaries such as brokers, transfer agents, custodians, investment banks, mutual funds and issuers to report accurate, adjusted cost basis to investors and the IRS (Internal Revenue Service). basis of the securities is one of the key drivers to determine the realized gains and losses for tax reporting, which can be exclusively impacted by events (like wash sales, corporate actions, transfers, gifts and inheritance) and exempt distributions. All the above stated factors, which can swing the cost basis, need to be tracked and reported during the life of the securities. Therefore, based on complexities of different asset categories, the following timelines are enforced on financial intermediaries for implementation and reporting: To report realized gain/loss information to the IRS for Equities purchased on 0/0/ or later. To report realized gain/loss information to the IRS for Mutual Funds and Dividend Reinvestment Plans (DRIPs) from 0/0/2. To report realized gain/loss to the IRS for all other securities such as debt instruments, options and other covered securities from 0/0/ (yet to be finalized). sale adjustment is one of the key components of cost basis adjustments. The author has used transactional analysis to explain the complexities, reconciliation techniques and recommendation of wash sale adjustments. In this paper, the concept of sublot is introduced to track wash sale adjustments of high volume. This will facilitate reconciliation between the broker and taxpayer, identification of wash sales adjustments and will help to provide explanation to IRS (Internal Revenue Service) inquiries. Also, this paper deals with the complexities faced by accounting products and cost reporting engines and helps to build simulations and illustrations for complex securities.

4 Scope Key Assumptions In this paper, the ability of current accounting/reporting engines to track and reconcile the wash sales is highlighted, so that the cost basis reporting engines or accounting products can generate the desired output; which would also help the IRS in tax assessment with respect to cost basis adjustments and determination of long and short term gains. The wash sales on options, straddles, DRIPs, mutual funds and other fixed income securities are out of scope and the focus here is primarily on transactional analysis of equities. As per proposed IRS regulation dated 6th December 09, the identification of substantially identical stocks or securities is complex because stocks or securities of one corporation cannot be considered substantially identical to the stocks or securities of another corporation (even within the same industry or sector). But certain corporate actions and convertible options of the securities, justify the identification of substantially identical stocks or securities for wash sale rules. All the facts and circumstances should be considered in determining whether the shares are substantially identical. Therefore, in order to simplify the computation of new cost basis, the proposed regulation (REG089609) of IRS dated 6th December 09, highlights the key assumptions related to brokers with respect to wash sales: Rule As per IRS Rule (IRC Section 09), an investor is deferred for claiming a loss, if the economic position of the asset is retained. This economic position can be retained either when the investor buys a substantially identical security in case of a long position or sells a substantially identical security in case of a short position. In simple terms, the wash sale rule prohibits an investor from claiming a loss, if the investor sells a security and buys a substantially identical security within 0 days before or after the sale. The IRS publication 5 (Investment income and expenses) states that in a wash sale, losses cannot be claimed from the sale or trade of stocks or securities. It also states the following four conditions, which trigger wash sale when traded at loss and within 0 days before or after the sale, the taxpayers: substantially identical stocks or securities, Acquire substantially identical stocks or securities in a fully taxable trade, Acquire a contract or option to buy substantially identical stocks or securities, or Acquire substantially identical stocks for taxpayer s individual retirement account (IRA) or Roth IRA For instance, this rule will be applicable if an investor sells a security X at a loss of $ and immediately purchases the same security or a substantially identical security within 0 days. In this case the loss cannot be claimed and the same should be added to the cost basis of the remaining pool of securities of X or substantially identical security (except in case of point 4 above). 4 sale adjustments should be done at identical CUSIP level, rather than at substantially identical securities. sale is applicable on account by account basis, which means that all wash sale transactions/adjustments are applicable within account (even with same broker). However, the above stated key assumptions can create ambiguity and an escape route for tax evasion. Let s discuss the implications of wash sale adjustments at identical CUSIP level and not at substantially identical securities level. In case of economic disasters, stocks or securities of the same industry or sector have similar or cascading negative impact (even if the other stocks or securities of the same industry or sector have good performance report). The investors can sell the stocks or securities of corporation A and buy the stocks or securities of corporation B (of the same industry and indicative data with similar attributes of stocks or securities of corporation A and B). In case of corporate action, events like reorganization or CUSIP changes would bypass the wash sale adjustments. The second assumption of wash sale adjustments applicable on account by account basis had simplified the reporting (adjusted cost) for brokers, but not for taxpayers. For instance, the taxpayer can open multiple accounts and trade the identical stocks or securities with one or multiple brokers to avoid wash sale rules by acquisition in one account and disposition in another account. The onus lies with the taxpayers to report the wash sale adjustments at identical CUSIP level, but any inaccurate reporting in form 040 (Schedule D) cannot be easily reconciled on account by account basis with single broker or multiple brokers.

5 The cost reporting engine or accounting products should create adequate provision to plug the loop holes, as IRS can reconsider the above two assumptions at a later stage or should provide additional service to the clients (at least with identical CUSIP in multiple accounts with same broker). : Transactional Analysis with Lots, Sublots & Allocation Ratio In the following transactional analysis, the adjusted cost basis is explained with lots and sublots. In case of multiple lots, recomputation and reconciliation issues, the introduction of sublots are important to identify the wash sale adjustments on proportionate basis. Now, let s focus on the transaction complexities with wash sale adjustments. The key challenges associated with wash sale rules are the identification of lots and determination of new cost basis. It is important to identify the wash sale adjustments in the proportionate basis of the remaining lots, as these adjustments and recomputation (cancellation/rebook of trades) can trigger further wash sales. This process can go in loop due to high volume of trading (resulting in realized loss). The proportionate adjustment of wash sale loss can defer in the same lot, else the adjustment should be deferred in the subsequent lots. Therefore, it is important to identify the wash sale adjustments within lots on proportionate basis to facilitate reconciliation, accurate accounting and tax assessment. The table below explains the wash sale loss movement from the same lot to the next lot and also depicts the complexities involved with recomputation or reconstruction of trades due to incorrect price, rate, units, principal or income. We will further continue the analysis of the wash sale with illustrations, which will highlight the reconciliation techniques and methods of tracking wash sale adjustments with lots and sublots. In table below, the shares of company are traded in multiple lots. In lot, the broker has purchased 95 shares of company on /8/ and subsequently purchases more shares at different point of time on (to take advantage of the falling price). Therefore, shares in lot 2, 75 shares in lot and shares in lot 4 were purchased for same identical securities (shares of company ). In this illustration, the total shares purchased are 240 and all these shares are sold within 0 days wash sale rule on and /22/. In table 2 below, based on broker s default basis, the lot disposition is on FIFO basis (FIFO stands for firstin, firstout, meaning that the oldest shares are recorded as sold first). In this table, the lot disposition is illustrated without the wash sale rules and no adjustment is made to the cost basis. Table : sale loss movement Lot # Trade Trade /8/ 2 Shares CUSIP Price Total Total /22/ /22/

6 Table 2: Lot disposition on FIFO basis Lot # Trade Type Shares Price # Lot Acq Lot Disp s or other basis Gain (or loss) /8/ $,6.00 $, $ /8/ $,90.00 $, ($5.00) 5 5 /8/ $ $ ($0.00) 2 4 $,6.00 $, ($.00) 60 8 /22/ $2, $, $ /22/ $ $ $ /22/ $ $ $40.00 $8, $8,40.00 $ Totals Table : sale rule analysis with FIFO and SubLot Lot # Sub Lot # Trans Type Shs # Alloc Ratio Lot Acq Lot Disp s basis Adj to cost New cost New cost 45 /8/ (5) A 5 /8/ B 5 /8/ Adj /8/ $, A.2 Adj 0.57 $ A.2 Adj 5 $ B A.2 Adj $ /22/ /22/ $8,600 $8,40 $460 A. 2 2A Totals (45) (5) 85 5

7 Let s analyze table above with wash sale rules and its impact on the cost basis. In conjunction with lot disposition method (FIFO), the concept of SubLot is introduced. The first sale of 45 shares on, contributes short term gain of $45 with lot and wash sale rule does not apply. The second sale of 5 shares also applies to lot, but contributes to loss of $5. As wash sale rules are applicable, therefore the sublot of A. is identified to defer the loss or add the loss incurred to the cost basis of remaining lot in proportionate basis. The loss of $5 incurred due to the sale of 5 shares is added in proportionate ratio to cost basis of lot with $5 (as 5 shares remain in lot and cost moves from basis of $525 to New Adjusted basis of $540) and is identified with sublot A.. Next the remaining loss of $ ($5$5) for shares, which is identified with sublot A.2, should be added to the cost basis of remaining lot. Now, the third sale of 65 shares is applicable to the cost of 5 shares in lot and shares in lot 2. In case of lot, the remaining 5 shares contribute to loss of 45 ( Proceeds minus New Adjusted basis ), which is identified with sublot B. and triggers wash sale rules for the remaining lots. Now, lot 2 requires cost basis adjustments for sublot A.2 and B. for $ and $45 respectively, which moves cost from basis of $700 to New Adjusted basis of $765. The remaining third sale of shares with lot 2, contribute to a loss of $5. This loss further triggers wash sale rules and is identified with sublot 2A., which adds the loss to the cost of the remaining lot. It is also observed that in table above, the Allocation Ratio is introduced to determine the proportionate ratio of the loss allocated to the remaining lot of the identical securities. It means that if the wash sale loss is exhausted, the total of sublots is equal to. For instance, in table# above, the wash sale allocation ratio for sublot A. and sublot A.2 is 0.4 and 0.57 respectively. The total of sublot A. and A.2 is equal to ( ), which indicates that wash sale loss ($5) triggered on sale of sublot A is fully allocated and no potential loss remains to be claimed. On the other hand, if the wash sale allocation ratio is less than, then it implies that wash sale loss is not fully allocated. Therefore, when the allocation ratio for sublot B. is, it means that wash sale loss ($45) triggered with respect to sale of sublot B is completely allocated. Similarly, the allocation ratio for sublot 2A. is, indicating that wash sale loss ($5) triggered with respect to sale of sublot 2A is completely allocated. 7 : Transactional Analysis Holding Period and Potential Loss The wash sales can also trigger potential loss and impact the holding period of the existing lot. The potential loss can be identified at the end of the fiscal year; if the same identical security is not purchased within 0 days of the wash sale rules or residual loss exists after the proportionate allocation of loss to the cost of the remaining lots. On the other hand, the holding period determines the long or short term gain/loss. However, wash sale loss adjustment impacts the holding period of the existing lot, which takes the acquisition date of the security disposed as the acquisition date of the existing lot. In the following table 4 and table 5, the determination of holding period and potential loss is explained. In the below table, securities of company are purchased in three lots of 90, and 25 shares respectively and first lot is sold entirely. Table 4: Transactional Analysis with holding period Lot # Trade Trade Shares CUSIP Price /4/ /4/ Total 2/5/ Total 90 90

8 Table 5: Transactional Analysis with potential loss Lot Sub Trans # Lot # Type A 2 A. Shs # Lot Acq Alloc Ratio New Lot Disp 90 2/4/ Adj /4/ A.2 Adj As illustrated in the above table, wash sale loss of ($90) is triggered and this loss is adjusted in proportion to the remaining lots. In table 5 above, the wash sale allocation ratio for sublot A. and sublot A.2 is 0.56 and 0.28 respectively. The total of sublot A. and A.2 is not equal to, which indicates that wash sale loss ($90) triggered with respect to sale of sublot A is not fully allocated. Therefore, the scope of potential loss increases, if neither subsequent same identical securities are purchased nor enter into a contract or option to acquire stocks within the 0 days rule. The deferred loss is adjusted to the cost basis to the extent of $75, i.e., proportionate loss of $ is added to the cost basis of lot 2 (as the cost moves from $400 to $4) and proportionate loss of $25 is added to the cost basis of lot (as the cost moves from $0 to $225). The remaining loss of $5 ($90 $ $25) is considered as potential loss, if the same identical stocks are not purchased within 0 days. For the tax year end adjustments, the potential loss can be claimed as loss. But if the same identical stocks are purchased within 0 days, then the prior year tax reporting should be revised with correct data and form 099B and 040 (Schedule D) should be resubmitted. Apart from potential loss, the holding period changes with the wash sale adjustments, as the lot acquisition date of the remaining lot (to which the wash sale adjustment is applied) will take the acquisition date of the sale transactions (which triggered wash sale loss). In the above illustration, the lot acquisition date changed from 2/4/ to for lot 2 and, which is significant to determine the holding period. After /9/2, if lot 2 is sold at gain then such gains will be treated as long term capital gains. Else, such gains will be attributed to short term capital gain. 8 Lot Disp s basis 2/5/ $900 $990 Adj to cost $400 New cost Gain (or loss) Deferred Loss ($90) ($90) $ ($40) $25 ($5) $4 $ $0 $225 $25 The suggestions to track wash sale adjustments are listed below: Adjusted cost basis with lots that trigger wash sale loss and sublots that identify the wash sale adjustments. Determination of holding period, as the holding period for the replacement stocks includes the holding period of the stocks sold at loss for the applicable wash sale rule. In case of full sale (if all lots are sold), the cumulative gain/loss without wash sale rules should reconcile with wash sale rules and as per above mentioned illustration, a gain of $460 matches with table# 2 and table#. In case of partial sale (if lots remain), the wash sale allocation ratio is less than and it implies that wash sale loss is not fully allocated. If the substantial security is not purchased within 0 day rule, then potential loss can be recognized and claimed. sale allocation ratio helps to identify the potential wash sale loss and to determine whether the wash sale loss is allocated in full or in part. At present, most of the accounting products cannot handle wash sale adjustments, therefore cost reporting engines are integrated to compute adjusted cost basis and meet the tax reporting requirements. If accounting products and cost reporting engines maintain different lot disposition method, then the tracking of wash sale adjustments is complex and cumbersome.

9 Demonstration of Loop Concept Figure : Loop Concept for Adjustment Lo ss Lot X Adjusted 0d ays Lot Y s Long Term Realized Gains Lo s 0 ys da in Lot X The wash sale rules will continue in loop with frequent trading of same identical security, as the cost basis adjustments moves from one lot to another in proportionate basis. This loop will break, if no wash sale loss is incurred or with cancellation and rebook of trades (as a result of recomputation), which will result in gains. This concept is depicted in figure above, which necessitates the implementation of edit checks to perform the following: Short Term Realized Gains : Complexities and Ambiguities The wash sale adjustments create complexities and ambiguities in dealing with following: Replacement Securities In case of dividend reinvestment plans, the replacement shares (reinvested as per the plan prospectus), are considered for cost basis adjustment in the event of wash sale. Also, in the case of corporation stocks as bonus awards and to buy Warrants for common stocks of the same corporation; are all considered as replacement securities and should not be considered as part of wash sale rule. Track wash sale with lots/sublots, which will facilitate easy reconciliation and identification of wash sale losses to the tax authorities and taxpayers. Identification of potential loss for the year end tax calculation (as the same cannot be claimed, if same identical security is purchased within 0 days of wash sale rules). 9 As per IRS Rule 5 Ga Triggers Edit Checks, Recomputation & Reconstruction Lot X Adjusted Holding Period Substantially Identical Securities For instance, the wash sale rules will be applicable, if warrants are sold at loss and common stocks are purchased of the same corporation; provided that warrants and stocks are considered to be substantially identical. All the facts and circumstances should be considered in determining whether the shares

10 are substantially identical. For instance, the shares issued by one corporation/mutual fund are not considered to be substantially identical to shares issued by another corporation/ mutual fund in the same industry or sector. Recommendations to the key assumption: At present the wash sale rules are applicable to same identical security at CUSIP level, but the definition of substantially identical securities and identification of replacement securities need further explanation and justification to plug any loopholes. The substantially identical and replacement securities should be tightly defined with appropriate examples by IRS. The accounting and tax reporting application should be designed to accommodate wash sale adjustments for substantially identical securities and other securities identifiers (like ISIN, SEDOL, etc), so that foreign transactions can be reported. Also, the identification of replacement securities still remains a challenge and should be followed in right spirit, which should be based on flexible criteria. However, the onus to prove the intent should lie both with the broker and taxpayer to notify all the substantially identical and replacement securities. Technical In case of prescheduled trades or reclass transactions, the cost reporting engine or accounting systems can trigger wash sale without any intent or action on the part of the taxpayer. In case of DRP (Dividend Reinvestment Plan), a regular scheduled reinvestment can occur within 0 days of wash sale rule, which requires adjustments to cost basis. However, such DRP plans should mention about the technical wash sale adjustments, irrespective of reinvestment limit and preauthorized instructions. Book & Lot Difference The book cost difference in two applications (for instance, if accounting application has GAAP book set and cost basis reporting application has tax book set), will cause incorrect wash sale adjustments and this would be difficult to reconcile. Similarly, the cost basis reporting application can support only particular lot disposition method and is not in synchronization with other lot disposition methods of accounting application. Recomputation (cancellation and rebook) of trades, due to incorrect price or shares or any other indicative/reference data of the trade can increase or decrease wash sale adjustment to arrive at new adjusted cost basis, or convert a wash sale loss to gain or vice versa. Such cancellation and rebook of trades are simple with equities, but the complexities increase for other securities with respect to determination of accurate cost basis (as amortization, corporate action and asset classification require recomputation and reconstruction of trades in right order to arrive at correct cost basis). Exceptions: Loss and gain on the same day Loss from a wash sale of one block of stocks or securities cannot be used to reduce any gains on identical blocks sold on the same day. Another key assumption for brokers is to track wash sale adjustments on account by account basis, which can lead to misleading results. It incentivizes the taxpayer to open multiple accounts with one or multiple brokers to trade identical securities, by which wash sale rules can be avoided and not reported by the broker. This triggers the question, how can IRS verify the wash sale adjustment reported in form 099B and 040, if the taxpayer does not consider wash sale adjustments for identical securities in multiple accounts. Finally, the complexities with respect to substantially identical securities, replacement share in case of corporate actions and technical wash sale with respect to preauthorized repetitive investments need to be clarified by IRS. The subjectivity and ambiguity with cost basis adjustment can impact the accounting/reporting engine s derivation and posting rules, as the objective of wash sale rules is to prevent inappropriate, intentional recognition of loss and cost basis adjustments. Mark to Market election No wash sale rule is applicable to traders, who elect mark to market method, because holdings are valued at year's end market rate and there is no need to account for gains or losses that might occur within the 0day wash sale restrictions. All gains and losses from trading activities should be reported as ordinary gains and losses on Form 4797 (Part II), instead on Schedule D of Form 040. This election should not be applicable to securities held for investment. 0

11 Conclusion The wash sale rule with respect to cost basis gets complex with high volume of trade, accounting adjustments and recomputation, which can cause reconciliation and reporting breaks. In order to ensure compliance and correct cost basis reporting, it is recommended to track wash sale adjustments with lots, sublots and wash sale allocation ratio. The maintenance of lots and sub lots for wash sale adjustments in cost reporting engine is very critical to identify the adjustment of cost basis on proportionate basis and/or on basis of potential loss. This will further facilitate the following: Periodic reconciliation between two regions or versions (with and without cost basis adjustments), as explained in table#2 (pg6) and table# (pg6) previously. Daily feeds and reconciliation between the accounting products and cost basis reporting engines, with respect to different book set, lot disposition methods and manual adjustments. References IRS Publication 5, 09 Investment Income and Expenses IRS Publication 55, 08 Basis of Assets IRS Publication 564, 08 Mutual Fund Distributions Proposed IRS Regulation as of 6th Dec 09 Wipro in Securities & Capital Markets Wipro Banking and Financial Services business unit serves the Top 0 Banks, Top 4 global Insurers and Top 2 brokerages across the globe with more than 85 customers spread across 5 continents, with more than USD billion in revenues. Wipro s Securities and Capital Markets practice serves industry participants across the value chain on buy and sell side. We specialize in serving the top capital markets infrastructure providers including some of the Top 5 customers from industry segments like custodians, data providers, exchanges and market utilities. About Wipro Technologies Wipro is the first PCMM Level 5 and SEI CMMi Level 5 certified IT Services Company globally. Wipro provides comprehensive IT solutions and services (including Systems Integration, IS Outsourcing, Package Implementation, Software Application Development and Maintenance) and Research & Development Services (hardware and software design, development and implementation) to corporations globally. Wipro s unique value proposition is further delivered through our pioneering offshore Outsourcing Model and stringent quality processes of SEI and Six Sigma. About the Author Gudaru Anand Rao is a Domain Consultant with the Securities & Capital Market practice of Wipro Technologies. He has worked on Asset Serving and Wealth Management projects (Investment & Fund Accounting and Administration), with sound knowledge of Securities and Capital Markets, Application Architecture and overall service delivery experience in the financial services industry of USA, UK and Austria. For any questions, the author can be contacted at anand.gudaru@wipro.com. Disclaimer This paper is based on IRS publication of rule 5, 55, 564 and proposed IRS regulations. The contents and illustrations in this paper are author s understanding and interpretation of the IRS rules and do not necessarily represent the views of Wipro Technologies. The content and illustrations used in this paper are indigenous and any resemblance with any material is purely coincidental.

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