2014 Cost Basis Legislation and Tax Reporting

Transcription

1 2014 Cost Basis Legislation and Tax Reporting Fixed Income and Options Advisor Toolkit

2 Table of Contents Introduction Cost Basis tax reporting requirements for fixed income securities....4 Letter of Authorization (LOA) to Change Fixed Income Amortization & Accretion Settings form...18 FAQs Where and how your clients will see changes to cost basis....8 Options: what to expect in 2014 and Examples to help explain the changes to your clients Forms Sample communications...12 Glossary...27 How clients will see the changes displayed on their statements and schwaballiance.com

3 Introduction The most recent phase of cost basis legislation requires brokers/ custodians to begin reporting cost basis information on select fixed income positions and options for the 2014 tax year. A significant impact of the 2014 legislation will be on covered fixed income holdings where the IRS has stipulated specific rules for calculating the cost of the bond that in turn will affect the basis for that holding. Depending on the reporting preferences you ve selected for your clients, they may see changes in cost basis, realized gain/loss, and unrealized gain/loss information on schwaballiance.com and reported on their monthly statement. Your clients may begin to see changes in the unrealized gain/loss values in August 2014 displayed online as they are made and in August statements, which will be mailed and also available online the first week of September. All changes to realized gain/loss information are planned for November and will be retroactive to January We ve created this Advisor Toolkit to help you understand the IRS direction on this next phase of the legislation, as well as which securities the legislation covers. We also want you to know Schwab s plans for implementing these requirements and the upcoming changes that may affect your clients. You may want to explain to your clients which fixed income securities will be covered at each reporting deadline and the changes to cost basis calculations. An Overview of IRS Regulations The Emergency Economic Stabilization Act of 2008 included new tax reporting requirements that dramatically change the way advisors and their clients manage cost basis and realized gain/ loss reporting. The Act s goal is to ensure that investors accurately report investment gains/losses in their annual tax filings. To achieve this objective, custodians and brokers are required to report the cost basis of sold covered securities (including whether the gain or loss is short-term or long-term) to taxpayers and the IRS on Form 1099-B. An important definition Please note that the IRS uses the term debt instrument in place of fixed income securities in its publications online. When looking for information regarding fixed income on the IRS website, use debt instrument as the search term. Schwab will continue to use fixed income securities, except when debt instrument or using both terms provides more clarity. The IRS defines debt instrument as any instrument or contractual arrangement that constitutes indebtedness under the general principles of federal income tax law, including notes, bonds, debentures, or other evidence of indebtedness. 3

4 2014 Cost Basis tax reporting requirements for fixed income securities Properly accounting for the cost basis of a fixed income security is considerably more complicated than for an equity security, ETF, or mutual fund. Cost basis can be affected by accruals of income as well as tax instructions the holder of the instrument makes. Many of the changes made by the IRS align broker reporting on Form 1099-B with taxpayer reporting requirements. Fixed income securities subject to January 1, 2014 cost basis reporting Starting in 2014, the IRS cost basis reporting requirements will be implemented for less complex fixed income securities acquired on or after January 1, The less complex fixed income securities in the accompanying chart generally have a single fixed payment schedule for which a yield to maturity can be determined under the general original issue discount (OID), the alternate payment, and demand loan rules. Fixed income securities subject to January 1, 2016, cost basis reporting Another phase of the cost basis reporting requirements is planned for January 1, This phase will cover the implementation of more complex fixed income securities. The IRS has identified more complex fixed income securities as having features that make calculating cost basis even more complicated than it is for those classified as less complex. Less Complex Fixed Income: Subject to 1/01/14 Reporting Taxable and non-taxable bonds that have a fixed rate, fixed maturity, and fixed payment schedule, even if they are callable by the issuer. These include: Treasury notes and bonds Fixed-rate corporate bonds Fixed-rate municipal bonds More Complex Fixed Income: Subject to 1/01/16 Reporting The IRS will address fixed income securities that are more complex in terms of calculating adjusted cost basis in These include: Variable-rate bonds Stepped-rate bonds Convertible bonds Stripped bonds Certain tax-credit bonds Contingent-payment bonds Inflation-indexed fixed income securities Foreign-issued bonds or bonds that pay in foreign currency Payment-in-kind bonds Fixed income securities issued as part of an investment unit Fixed income securities for which terms are not reasonably available to brokers within 90 days of acquisition by client Fixed income securities evidenced by a physical certificate not held by a custodian or clearing agent (physical debt) Fixed Income Excluded from Reporting The IRS specifically excluded fixed income securities described in Section 1272(a)(6) of the IRS regulations from cost basis reporting requirements: Certain specific interests in or mortgages held by a Real Estate Mortgage Investment Conduit (REMIC) Certain other fixed income securities with payments subject to acceleration Pools of fixed income securities whose yield may be affected by prepayments Short-term fixed income securities (with a fixed maturity rate not more than one year from the date of issue). 4

5 What Schwab is doing when and why Here s when you ll see changes: August 2014 System changes that may affect unrealized gain/loss values on Schwab Advisor Center, schwaballiance.com, monthly statements with cost basis information included, and advisor cost basis data files November 2014 System changes that may affect fixed income positions that were sold from January 1, 2014, up to the time we make changes in August These changes may result in changes to clients realized gain/loss values and will be visible on Schwab Advisor Center, schwaballiance.com, and advisor cost basis data files Q New IRS Form 1099-B and changes to the 2014 advisor 1099 tax file download Schwab is making adjustments to its amortization settings Amortization/accretion affects the calculation of whether a bond purchased at a premium or a discount has a gain or loss at disposition. Schwab is required to make changes to these settings in our cost basis system to conform to the new IRS reporting rules on certain bond types in taxable accounts. We plan to implement the following changes to our system settings in August 2014 retroactive to January 1, Following is a summary of changes Schwab will make: Enable amortization/accretion for all taxable accounts. Calculate market discount using the straight line accounting method (this is parallel to the IRS default for taxpayers). Exclude market discount in current income and adjust and report cost basis at disposition. Until now, we assumed clients included market discount in current income provided that the amortization/accretion system settings were enabled. Use other methods to calculate the amortization/accretion amount depending upon whether a bond is an original issue discount or was purchased at a premium or market discount, and if there is a call or put feature aligning with taxpayer requirements (see table at right). Note that the method for taxable bonds purchased at a premium with a call feature will be operational in November and should impact few clients. Amortization changes Following is a summary of the enabled versus not enabled amortization scenarios for taxable and non-taxable accounts. Account Type Taxable Account With Amortization Enabled Taxable Account With Amortization Not Enabled Non-Taxable Account With Amortization Enabled Non-Taxable Account With Amortization Not Enabled Change Effect Amortization settings changed to the new required broker IRS defaults potential impact to adjusted cost Amortization enabled with new required broker IRS default settings adjusted cost value provided and cost basis calculated using adjusted cost Amortization settings changed to the new required broker IRS defaults potential impact to adjusted cost No change Schwab is not required to enable amortization settings for these accounts 5

6 How the new amortization settings may impact you and your clients For clients with amortization/accretion enabled on their accounts both taxable and non-taxable Schwab will calculate cost basis, bond premium, and market discount using different methods (refer to the table below). This may result in a different adjusted cost basis. For clients with amortization/accretion not enabled on their taxable accounts, Schwab will begin calculating adjusted cost basis, including market discount and bond premiums, using these same methods. These changes will be reflected on both Schwab Advisor Center and schwaballiance.com and in the unrealized cost basis data files we currently make available via Schwab Data Delivery on Schwab Advisor Center. These files will begin to include adjusted cost values for all fixed income positions for which amortization/ accretion has been recently enabled. Previously enabled accounts adjusted basis will be based on the new broker guidelines. Since the setting changes are retroactive to January 1, 2014, there will be adjustments to realized/gain loss values that will be reflected in the files in November Note: In the past, advisors could choose whether or not to adjust cost basis for amortization/accretion. What happens when amortization is enabled Schwab uses the constant yield methodology. The adjusted cost basis (price) on a specific date is determined by the yield to maturity (call) when the security was acquired and the remaining cash flows until maturity (or call) date. Schwab adjusts on a daily basis generally, the price at any point in time (for example, the date of the client s statement) is adjusted so the yield calculated from the remaining cash flows is the same as the original yield to maturity calculated at the time of purchase. method changes Following is a summary of amortization methods that will be modified for taxable/non-taxable accounts with amortization currently enabled. Bonds A/A Rule Type Previous Schwab Settings Method* Apply de Minimus Rule? A/A Rule Type NEW 2014 Schwab Settings Method Apply de Minimus Rule? Original Issue Discount No Call or Put Feature to Maturity Yes to Maturity Yes Market Discount to Maturity Yes Straight Line N/A Yes OID Call Feature to Maturity Yes to Worst (Lowest ) Yes OID Put Feature to Maturity Yes to Best (Highest ) Yes OID with Acquisition Premium to Maturity Yes Original to Maturity, then apply acquisition premium Yes Bond Premium No Call or Put Feature to Maturity No to Maturity No Bond Premium Call Feature to Maturity No to Best (Highest ) Taxable Bonds to Worst (Lowest ) Tax-Exempt Bonds No Bond Premium Put Feature to Maturity No to Best (Highest ) No 6 * Previously this was " to Maturity" unless it was a pre-refunded bond. Then Schwab calculated to the first call date.

7 Schwab Advisor Center screen shots Advisors will see two values on schwabadvisorcenter.com: original cost basis and adjusted cost basis. On the Unrealized Gain/Loss tab of the Cost Basis screen, the position-level cost value will display adjusted cost. The Cost Basis Details screen will display the original cost basis as well as the adjusted cost basis. Schwab Data Files Advisors will also see changes to values included in their cost basis unrealized gain/loss data files. If amortization/ accretion was just enabled on the position, the data will include the adjusted cost. If amortization/accretion was previously enabled, the adjusted cost value may have changed with the implementation of the new required amortization/accretion settings. Adjusted Cost Basis You can view the Original Cost Per Share, Original Cost Basis, and additional Adjusted Cost Details on the Lot Detail screen. Beginning in August 2014, the Cost Basis value will reflect the adjusted Cost Basis based on new IRS default amortization/ accretion methods, and will be displayed on the Unrealized Gain/Loss screen. Original Cost Basis details Adjusted Cost Basis details 7

8 Where and how your clients will see changes to cost basis Depending on the cost basis reporting preferences you have chosen for your client accounts, clients may see changes on schwaballiance.com and/or their monthly statements beginning with August statements. Please contact Client Reporting to identify your chosen preferences, or click on the Subscription/ Status link on the Cost Basis tab in Schwab Advisor Center to view the reporting preferences for accounts linked to your master accounts. Bond premium Clients who previously did not have the bond amortization preference enabled will see changes to their cost basis as we enable bond amortization for all taxable accounts. Clients will now see two values on schwaballiance.com: original cost basis and adjusted cost basis. The position-level cost value will display adjusted cost. The Lot Details window will contain both. See Example A. Any basis change calculations will also be reflected on monthly client statements that report unrealized gains/losses. Market discount Clients who have purchased bonds at a discount will see a change in the cost basis value of their unrealized gains/losses because cost basis is no longer adjusted daily for market discount accruals. It will now be adjusted at disposition. In addition, clients realized cost basis value may differ if they sell their bonds prior to maturity due to a change in the rule type from constant to straight line yield for the market discount calculation. See Example C. Clients will see two values on schwaballiance.com: original cost basis and adjusted cost basis. The position-level cost value will display adjusted cost. The Lot Details window will contain both. Any basis change calculations will also be reflected on monthly client statements that report unrealized gains/losses. Since some yield methods used in the cost basis calculation have changed, clients who had previously enabled the amortization/ accretion settings may still see a change in their adjusted cost basis depending on the type of bond. See Example B. 8

9 Examples to help explain the changes to your clients Example A: Taxable bond purchased with bond premium On April 1, 2014, you purchased $10,000 original face value (par of 100) of a 10% annual coupon-rate corporate bond issued on 4/01/05, with maturity on 4/01/15, at a price of $105. Cost basis displays as: Purchase 4/01/14 Before Change in Tax Reporting No Amortization After Change in Tax Reporting to Maturity Amortization Cost Basis $10,500 ($10,000 x $105/100) $10,500 ($10,000 x $105/100) On October 1, 2014 (midway between purchase and maturity), the unrealized gain/loss displays cost basis as: Unrealized Gain/Loss 10/01/14 Before Change in Tax Reporting No Amortization After Change in Tax Reporting to Maturity Amortization Cost Basis $10,500 $10, (Adjusted) On April 1, 2015, at maturity, the realized gain/loss displays the following: Maturity 4/01/15 Before Change in Tax Reporting No Amortization After Change in Tax Reporting to Maturity Amortization Proceeds $10,000 $10,000 Cost Basis $10,500 $10,000 (Adjusted) Realized Gain (or Loss) ($500) $0 Proceeds $10,000 $10,000 Cost Basis $10,000 (Adjusted) $10,000 (Adjusted) Realized Gain (or Loss) $0 $0 9

10 Example B: Taxable bond with call feature purchased at premium On April 1, 2014, you purchased $10,000 original face value at a price of $105 of a 10% annual coupon-rate corporate bond issued on 4/01/05, with a call date of 12/01/14, at a call price of $102, and maturity on 4/01/15. Cost basis displays as follows: Purchase 4/01/14 Before Change in Tax Reporting Using to Maturity After Change in Tax Reporting Using to Best (Call, Put, or Maturity) Cost Basis $10,500 ($10,000 x $105/100) $10,500 ($10,000 x $105/100) On October 1, 2014 (midway between purchase and maturity), the unrealized gain/loss displays cost basis as: Unrealized Gain (or Loss) 10/01/14 Before Change in Tax Reporting Using to Maturity After Change in Tax Reporting Using to Best (Call, Put, or Maturity) Cost Basis $10, (Adjusted) $10, (Adjusted) On April 1, 2015, at maturity, the realized gain (or loss) displays the following: Maturity 4/01/15 Before Change in Tax Reporting Using to Maturity After Change in Tax Reporting Using to Best (Call, Put, or Maturity) Proceeds $10,000 $10,000 Cost Basis $10,000 (Adjusted) $10,000 (Adjusted) Realized Gain (or Loss) $0 $0 Note: -to-best functionality will not be available until later in

11 Example C: Taxable bond purchased at market discount On April 1, 2014, you purchased $10,000 original face value (par value 100) of a 10% annual coupon-rate corporate bond issued on 4/01/05, with maturity on 4/01/15, at a price of $50. Cost basis displays as: Purchase 4/01/14 Before Change in Tax Reporting Accretion, Adjusted Daily After Change in Tax Reporting Straight Line Accretion, Adjusted at Disposition (Sale or Maturity) Cost Basis $5,000 ($10,000 x $50/100) $5,000 ($10,000 x $50/100) On April 2, 2014 (one day after purchase), the unrealized gain/loss displays cost basis as: Unrealized Gain (or Loss) 4/02/14 Before Change in Tax Reporting Accretion, Adjusted Daily After Change in Tax Reporting Straight Line Accretion, Adjusted at Disposition (Sale or Maturity) Cost Basis $5, (Adjusted) $5,000 If on October 1, 2014, you sell the bond, the realized gain (or loss) displays cost basis as: Realized Gain (or Loss) 10/01/14 Before Change in Tax Reporting Accretion, Adjusted Daily After Change in Tax Reporting Straight Line Accretion, Adjusted at Disposition (Sale or Maturity) Cost Basis $7,000 (Adjusted) $5,000 Market Discount $0 $2,500 However, if you hold the bond to maturity, on April 1, 2015, the realized gain/loss displays the following: Maturity 4/01/15 Before Change in Tax Reporting Accretion, Adjusted Daily After Change in Tax Reporting Straight Line Accretion, Adjusted at Disposition (Sale or Maturity) Proceeds $10,000 $10,000 Cost Basis $10,000 (Adjusted) $5,000 Market Discount $0 $5,000 Realized Gain/Loss $0 $0 11

12 Sample communications Let your clients know in advance about the new fixed income reporting requirements You may wish to adapt these sample communications as either letters or s to your clients. If you have enabled cost basis reporting preferences for their accounts, your clients may see changes on schwaballiance.com and/or on their monthly statements beginning with their August 2014 statements. Please note that these sample communications are relevant only if cost basis is displayed on schwaballiance.com or your clients statements. For confirmation of your current reporting preferences, view your settings under the Cost Basis tab on schwabadvisorcenter.com. Go to the Subscription/Status link for the applicable master account to view schwaballiance.com and statement settings. You may also contact Client Reporting at or to obtain this information. While Schwab will be communicating to your clients via an insert included with their August statements, you may want to prepare them in advance with your own communications. To help you begin, we ve provided these sample communications you can use or modify. 12

13 Letter or #1 For clients with amortization/accretion settings that are currently enabled Re: 2014 IRS Rule Changes to Fixed Income Securities Purchased at a Premium or Discount We re writing to let you know that new IRS legislation requires that brokers and custodians (like Schwab) begin reporting cost basis information on select fixed income positions for the 2014 tax year. Beginning in August 2014, Schwab will make changes to the amortization settings in its cost basis system to conform to the new IRS reporting rules. The changes will be implemented over a several-week period in August and will be retroactive to January 1, Below is a summary of the changes Schwab will implement for taxable and non-taxable* accounts beginning in August 2014: The methods used to calculate amortization and accretion will be updated depending on whether a bond is purchased at a premium, original issue discount, or market discount, and/or if there is a call or put feature. Market discount on a bond purchased on the secondary market will be calculated using the straight line accounting method (this is parallel to the IRS default for taxpayers). The amount of the market discount will not be incorporated into current income or adjusted cost basis until the position has been sold, has matured, or has been called. Prior to this change, Schwab assumed that you included market discount in your current income and adjusted cost basis daily. These changes will affect all open bond holdings in your accounts. As a result, you may see changes to the cost basis information reported online and on your monthly statements beginning with your August statement, which will be mailed and available online the first week of September. It s important to note that the changes don t affect bonds that were purchased and sold prior to the beginning of this year. In addition, bonds that closed in 2014 up to the August implementation date will be updated this fall. If you have any questions or would like to schedule time to discuss the changes, please don t hesitate to call to set up a time to talk. Sincerely, [Advisor Name] *For all accounts (taxable and non-taxable) that currently have amortization enabled, Schwab will amortize positions using the new methods. Independent investment advisors are not owned by, affiliated with, or supervised by Schwab. 13

14 Letter or #2 For clients with amortization/accretion settings NOT currently enabled Re: 2014 IRS Rule Changes to Fixed Income Securities Purchased at a Premium or Discount We re writing to let you know that new IRS legislation requires that brokers and custodians (like Schwab) begin reporting cost basis information on select fixed income positions for the 2014 tax year. Beginning in August 2014, Schwab will make changes to the amortization settings in its cost basis system to conform to the new IRS reporting rules. The changes will be implemented over a two-week period in August and will be retroactive to January 1, Below is a summary of the changes Schwab will implement for taxable accounts beginning in August 2014: Enable amortization settings. The methods used to calculate amortization and accretion will be based on whether a bond is purchased at a premium, original issue discount, or market discount, and/or if there is a call or put feature. Market discount on a bond purchased on the secondary market will be calculated using the straight line accounting method (this is parallel to the IRS default for taxpayers). The amount of the market discount will not be incorporated in current income or adjusted cost basis until the position has been sold, has matured, or has been called. Prior to this change, Schwab assumed that you included market discount in your current income and adjusted cost basis daily. These changes are effective January 1, 2014, and will affect all open bond holdings in your accounts. As a result, you may see changes to the cost basis information reported online and on your monthly statements beginning with your August statement, which will be mailed and available online the first week of September. It s important to note that the changes don t affect bonds that were purchased and sold prior to the beginning of this year. In addition, bonds that closed in 2014 before the August implementation date will be updated this fall. If you have any questions or would like to schedule time to discuss the changes, please don t hesitate to call to set up a time to talk. Sincerely, [Advisor Name] Independent investment advisors are not owned by, affiliated with, or supervised by Schwab. 14

15 How clients will see the changes displayed on their statements and schwaballiance.com Your clients will see changes in their August 2014 statements if the cost basis display is enabled for their statements: Reflects the Adjusted Cost Basis per new IRS default Note: If you haven t subscribed your client accounts to cost basis display on their Statements, there won t be a change in their experience after August We ll continue to suppress cost basis information for these clients. 15

16 If you have enrolled your client accounts to view cost basis value online, the new adjusted Cost Basis value reflecting the new IRS default amortization/accretion methods will display in the Unrealized Gain/Loss and Lot Details screens. Clients who use schwaballiance.com and have accounts enabled to view cost basis data will see these changes: Adjusted Cost Basis Adjusted Cost/Share Adjusted Cost Basis 16

17 To view the original lot details including original Cost per Share and Cost Basis, your clients can launch the Original Lot Details screen via the View Original Lots link on the top right of the Lot Details screen. Original Cost/Share Original Cost Basis Note: If you haven t enrolled your client accounts to view cost basis information online via schwaballiance.com, there won t be a change to their online experience after August We ll continue to suppress cost basis information including the Unrealized Gain/Loss screen on schwaballiance.com for these clients. 17

18 Letter of Authorization (LOA) to Change Fixed Income Amortization & Accretion Settings form Client instructions The new IRS-designated defaults may not coincide with what your clients have used for tax filing purposes in the past. But the IRS will allow taxpayers to instruct their brokers to use settings for taxable bonds that differ from the defaults. They can choose to: Accrue market discount using constant yield. Include market discount in current income. Disable bond premium amortization. Treat all interest as OID. Please note: Schwab is able to support all the instructions above for the 2014 tax year except the instruction to Treat all interest as OID. We ll provide an update about this instruction in The Letter of Authorization (LOA) to Change Fixed Income Amortization & Accretion Settings form will be available September 1, If your client is considering changes to their default settings, instructions for the 2014 tax year must be submitted in writing to Schwab by December 31, 2014, and will be retroactive to January 1, Schwab will ensure that all forms received by December 31 will be processed in time for 1099 reporting for that tax year. The Letter of Authorization (LOA) to Change Fixed Income Amortization & Accretion Settings form must be signed and completed by the account holder for each affected account. Advisors cannot execute the LOA on their client s behalf. Some instructions are not revocable and others require IRS commissioner approval for revocation. Your clients are also responsible for filing the appropriate instructions with the IRS on their tax returns. To obtain the Letter of Authorization (LOA) to Change Fixed Income Amortization & Accretion Settings form, contact the Client Reporting Services Team at Letter of Authorization (LOA) to Change Fixed Income Amortization & Accretion Settings Use this form to make changes to the IRS broker defaults for fixed income amortization and accretion settings that are currently applied to your Charles Schwab account. Complete, sign, and return this form to: Charles Schwab & Co., Inc E. Lincoln Drive, Phoenix, AZ You may also fax this completed form to (inside the U.S.) (outside the U.S.) (multilingual services) Clients of independent investment advisors, contact your advisor directly or Schwab Alliance at Page 1 of Current Schwab Account Amortization and Accretion Settings as Required by the IRS Broker Defaults Bond premium will be amortized for any taxable bonds in your account. Market discount will be calculated using the straight-line method. Market discount will be included on the 1099-B when the security is sold or matures. 2. Changes to IRS Broker Defaults for Fixed Income Amortization please NOTE THAT SuBMITTING AN INSTRuCTION ON THIS FORM TO CHARLES SCHWAB DOES NOT SATISFY THE IRS REQuIREMENTS FOR MAKING ELECTIONS ON YOuR TAX RETuRN. IT IS YOuR RESpONSIBILITY TO FILE THE AppROpRIATE ELECTION WITH THE IRS. SOME ELECTIONS ARE NOT REVOCABLE AND OTHERS REQuIRE IRS COMMISSIONER AppROVAL FOR REVOCATION. WE STRONGLY RECOMMEND THAT YOu CONSuLT WITH A TAX ADVISOR BEFORE SuBMITTING THIS FORM. Your instructions must be received by December 31 of the current tax year to be applied for that same tax year. Changes for forms received after December 31 will be applied to the following tax year. Review your options below and check the boxes for the broker defaults that you would like to change. This change will be applied to all taxable fixed income positions in the account unless otherwise stipulated. Instructions must be given for each individual account. Account Number Turn Off Taxable Bond Premium Amortization 1 ple Market Discount Use 2 Include Market Discount in Current Income 3

19 FAQs Why is Schwab making adjustments to cost basis and reporting calculations this year? The IRS has issued guidelines for brokers and custodians for the next set of securities they are required to include in their tax reporting. For tax year 2014, brokers and custodians are required to report cost basis on select fixed income securities and options. The guidelines require Schwab to begin amortizing/accreting bonds purchased at a premium/discount and adjust the cost and basis accordingly. While Schwab is not required to make changes that affect gain/loss calculations on options contracts, there are tax withholding and reporting requirements on options that we will be making as a result of this phase of the legislation. What securities and positions will be considered covered and reported to the IRS? This year, the IRS requires custodians and brokers to report cost basis on select fixed income positions and options purchased on or after January 1, With respect to fixed income holdings, the legislation is in effect only for what the IRS is categorizing as less complex bonds. These are bonds that generally have fixed rates and fixed terms, including Treasury notes and bonds, fixed-rate corporate bonds, and municipal bonds. In 2016, cost basis on bonds considered more complex is expected to become reportable to the IRS. Examples of more complex bonds include variable-rate bonds, convertible bonds, contingent payment bonds, or other bonds that make it difficult for brokers to calculate a yield. The full list of bonds that will be reportable in this initial phase is available on page 4 of the Advisor Toolkit. What changes will Schwab be making to cost basis reporting on fixed income holdings? Schwab is required to comply with IRS guidelines for fixed income cost basis accounting. The guidelines require the following changes: Amortizing/accreting covered bonds Updating the amortization yield method (these differ based on bond feature; refer to the appropriate section of the Advisor Toolkit for details) To ensure consistent accounting for all fixed income holdings, the three amortization/accretion setting changes listed at left will be applied to all bond positions with these settings enabled, including both covered and uncovered positions in taxable and non-taxable accounts. NOTE: For the 2014 tax year, Schwab will only be reporting to the IRS adjusted cost basis on covered securities (less complex bonds and options) purchased and sold on or after January 1, Which of my clients will be affected? Clients holding less complex bonds in both taxable and nontaxable accounts may be affected. Clients who have amortization/ accretion currently enabled on their accounts may see a change in cost basis for their less complex bonds. For clients who do not currently have amortization/accretion enabled, there will be adjustments to their cost basis in their taxable accounts (the new settings will only be enabled for taxable accounts). Your clients level of awareness of these changes will depend on the reporting preferences you have chosen for their accounts. If you have enabled your clients to view gain/loss information on schwaballiance.com and/or on their monthly statements, your clients may see the adjusted cost basis values. Will you adjust the cost basis on both open and closed positions? We will enable the new settings per the guidelines above on affected bonds in August Later this year, we will retroactively adjust the settings on bonds that were closed after January 1, 2014, and through the August implementation. We will provide additional information on the changes that will affect closed positions later this year. What will be reported and where? All realized gains/losses for bonds and options in taxable accounts will be included on your clients 2014 Form 1099-B, but only the cost basis for those covered bonds and options purchased and sold on or after January 1, 2014, will be reported to the IRS. Updating the market discount to accrue at disposition Updating the market discount accrual method to straight line 19

20 Do I and/or my clients need to take any action to ensure that the required changes are implemented? No. Neither advisors nor their clients need to do anything to ensure that the proper changes are made. Schwab will be implementing changes and updates to its cost basis systems to ensure adherence to the new guidelines issued by the IRS. Will my clients see the adjusted cost basis of fixed income positions for amortization/accretion? Depending on the settings you have chosen, your clients may see the adjusted cost basis on statements and/or schwaballiance.com. You may view your settings in the Cost Basis tab on schwabadvisorcenter.com or call Schwab for this information. Click on the Subscription/Status link for the applicable master account to view these settings, or call Client Reporting Services at What information will Schwab report to the IRS on covered bonds and options for 2014? Schwab will report adjusted cost basis and total market discount at disposition (sale or maturity) on IRS Form 1099-B. Schwab will also report bond premium on an annual basis to the IRS on Form 1099-INT and acquisition premium on Form 1099-OID. From what date will Schwab adjust my clients cost basis? Once adjusted cost is implemented on your clients accounts, Schwab will catch up calculations on all applicable positions from the acquisition of the position to the current day. Will Schwab provide both original and adjusted cost basis figures to me? Advisors will see both original and adjusted cost on schwabadvisorcenter.com and in cost basis data files. If you have selected to include cost basis on your clients statements, the electronic copies of these statements that you have access to through schwabadvisorcenter.com will also reflect the changed values. Will Schwab provide me with my clients market discount and bond premium on an annual basis? Yes, this information on less complex fixed income holdings will appear in the amortization section of the 1099 Composite and Year-End Summary. What if a client reports their bonds differently on their income tax return than the IRS-prescribed defaults? The IRS will allow taxpayers to instruct Schwab to use settings for taxable bonds that differ from the defaults. To do so, clients must sign and complete the Letter of Authorization (LOA) to Change Fixed Income Amortization & Accretion Settings form. For the different settings to be in effect, the form must be submitted prior to the end of this year. The IRS has approved these instructions: Accrue market discount using constant yield. Include market discount in current income. Disable bond premium amortization.* Treat all interest as OID. Please note: Schwab is able to support all the instructions above for the 2014 tax year except the instruction to treat all interest as OID. We will provide an update regarding support for this instruction in What if a client doesn t accrue their market discount using the straight line method? Are you able to calculate it using the constant yield method? Yes, but to do so, your client must complete and return the Letter of Authorization (LOA) to Change Fixed Income Amortization & Accretion Settings form and instruct Schwab to make the change. What if a client holds all their bonds until maturity? Does it matter whether you accrue the discount using the straight line or constant yield method? No, if a bond is held until maturity, the result will be the same regardless of whether we calculate straight line or constant yield. Generally, if a bond is sold prior to maturity, the straight line method may accrue the discount at a faster rate than constant yield. 20 * Schwab will stop amortizing and adjusting cost basis for bond premium for taxable bonds only. We are still required to accrete for market discount and original issue discount for both taxable and non-taxable bonds.

21 What if a client includes their market discount and pays tax on it in their income tax return every year? Are you able to change their account settings to include market discount in income currently? Yes, but to do so your client must complete and return the Letter of Authorization (LOA) to Change Fixed Income Amortization & Accretion Settings form. This gives us the authority to update the setting on their account to include their market discount in their annual 1099-INT or 1099-OID reporting. We will also adjust their cost basis daily when they select current inclusion. What if a client doesn t want you to calculate their market discount at all? Will you disable market discount reporting? No, if a bond is covered under the cost basis reporting rules, we are required by the IRS to report market discount when a bond is sold or matures. Are you able to stop amortizing bond premium on my clients accounts? Yes, but only for taxable bonds. We are required to make the adjustments and report the premium for non-taxable bonds in alignment with the taxpayer requirements. How can I obtain the Letter of Authorization (LOA) to Change Fixed Income Amortization & Accretion Settings form? You can obtain the form by contacting the Advisor Services Client Reporting Services Team at When will the Letter of Authorization (LOA) to Change Fixed Income Amortization & Accretion Settings form be available? The Letter of Authorization (LOA) to Change Fixed Income Amortization & Accretion Settings form will be available on September 1, Why are you making these changes now rather than in January 2014, when the changes became effective? The IRS released the final cost basis regulations in April The guidelines provided require Schwab to upgrade its cost basis systems. To ensure proper 2013 tax reporting, we needed to wait until tax year 2013 ended before making the required changes. The IRS only requires brokers to make changes on less complex bonds purchased after January 1, 2014, in taxable accounts. Why did Schwab decide to apply the changes to the bonds my clients purchased prior to 2014 and also apply these changes to amortized bond positions in non-taxable accounts? We made this decision because we believe that it will result in a simpler and easier message to communicate to your clients, and that it will deliver a more consistent experience to your clients. How will my clients find out about these changes? Is Schwab communicating information to them directly? You should inform your clients about these changes. We ve provided resources within the Advisor Toolkit to help advisors communicate this information directly to their clients. Schwab will communicate the changes to clients who access cost basis through schwaballiance.com in the Unrealized Gain/Loss tab. In addition, all clients with cost basis on their statements will receive an insert in their August 2014 statements, which will be mailed early in September. Whom should I and/or my clients call with questions? Advisors should contact the Advisor Services Client Reporting Services Team at If your clients want to speak to someone at Schwab, direct them to Schwab Alliance at Can I sign and submit the Letter of Authorization (LOA) to Change Fixed Income Amortization & Accretion Settings form on behalf of my client? No, the IRS requires that the account holder execute the form. 21

22 Options: What to expect in 2014 and 2016 The IRS regulations also change reporting cost basis on options on stocks, indices, single stock futures, stock rights, and warrants. Although these instruments are not currently subject to gross proceeds or cost basis broker reporting on Form 1099-B, brokers will now be required to do so if they are acquired on or after January 1, If option contracts are exercised or assigned, brokers are required to adjust the cost basis or proceeds of the underlying positions. Schwab has been reporting the adjusted cost basis on option exercises and assignments since Wash Sales Cost Basis reporting There are several adjustments that brokers will not be permitted to make when reporting the adjusted cost basis of stock rights, options, and warrants: Schwab will not take into account the impact of option purchases or sales in determining disallowed losses on sales of the underlying securities. You should explain to clients that this treatment differs from taxpayer requirements. Brokers may not apply straddle rules on options in reporting adjusted cost basis to the IRS. Schwab will continue to perform wash sale adjustments on options with the same CUSIP that have disallowed losses. Options Subject to 1/1/14 Reporting Options Subject to 1/1/16 Reporting Options Excluded From Reporting Options on a single security Options on more than one specified security, including an index in which the components are considered covered securities Options on financial attributes of specified securities, such as interest rates or dividend yields Warrants or stock rights Investment units in which options, stock rights, or warrants are issued together with a fixed income security Incentive stock options Foreign currency options Commodity options 22

23 Reporting change for employee stock option exercise Brokers will no longer be able to report the income component of stock acquired through the exercise of incentive stock options granted after January 1, Example: The client is granted an employer s Non-Qualified Stock Option (NQSO) to purchase 100 shares of stock at $10 a share (total cost $1,000). Current Reporting Reporting for grants after 1/01/14 The company s stock price is at $15 a share when exercised (total value $1,500). The client has $500 of ordinary income at the time of exercise reported on W-2. If the client sells the shares at the time of exercise, Schwab reports $1,500 sales proceeds and $1,500 commission cost. There will be a small loss on the transaction. Proceeds = $1,500 Cost = $1,500 commission RGL = $0.00 or loss The company s stock price is at $15 a share when exercised (total value $1,500). The client has $500 of ordinary income at the time of exercise reported on W-2. If the client sells the shares at the time of exercise, Schwab reports $1,500 sales proceeds and $1,000 cost minus commission. There will be a large gain on the transaction. Proceeds = $1,500 Cost = $1,000 commission RGL = $500 or gain The client will now be responsible for adding the $500 of income reported on the W-2 as a basis adjustment on Form

24 Broad-based index options Broad-Based Index Options (Section 1256 Contracts) Non-equity options that are marked to market under Section 1256 i.e., listed options for non-equity securities and broad-based stock indexes will be reported under the rules for regulated futures contracts. Example: Activity On March 5, 2014, buy broad-based index options contract for $3. On December 31, 2014, options contract is worth $ B Reporting Box 9 Profit (or loss) realized on closed contracts 2014 $0 Box 11 Unrealized profit (or loss) on open contracts held in your account on December 31, 2014 $4 Fair Market Value (FMV) ($7 less premium paid of $3) Box 10 Unrealized profit (or loss): open contracts December 31, 2013 $0 Box 12 Aggregate profit (or loss) on contracts $4 On June 30, 2015, sell for $ B Reporting Box 9 Profit (or loss) realized on closed contracts 2015 $6 (proceeds of $9 less premium paid of $3) Box 11 Unrealized profit (or loss) on open contracts held in your account on December 31, 2015 $0 Box 10 Unrealized profit (or loss): open contracts December 31, 2014 $4 Box 12 Aggregate profit (or loss) on contracts $2 ($6 + $0 - $4) 24

25 A reminder about backup withholding changes Schwab is required to withhold the federal backup withholding rate, currently 28%, from the proceeds of their options contract, right, and warrant sales, in addition to all other reportable gross proceeds transactions. If a client lives in a state subject to state backup withholding on gross proceeds, the current state rate will also apply. Schwab modified its existing process to collect federal backup withholding taxes on all gross proceeds transactions at the time of trade. State backup withholding will continue to be applied the day after the trade date. Explain to clients that if their accounts are subject to backup withholding on gross proceeds, it is because: They received B Notices from the IRS due to missing or incorrect name/taxpayer ID number combinations. They have not submitted a W-9 form. Their W-8 certification has lapsed. Transfer reporting delayed one year Cost basis reporting on security transfers of covered fixed income and options will be required one year later than the date for purchases. The IRS has delayed requirements for reporting cost basis on transfers for an additional year. This will allow brokers the necessary time to change their transfer reporting systems. Any fixed income or options transferred during this time will be treated as uncovered Reporting Transfer Statements Less complex fixed income January 1, 2014 January 1, 2015 Options January 1, 2014 January 1, 2015 More complex fixed income January 1, 2016 January 1, 2017 Options issued as part of a fixed income instrument January 1, 2016 January 1,

26 1099 Forms The IRS released the final cost basis regulations that will result in new reporting requirements for fixed income and options that will impact the Composite, Year-End Summary, and Transfers reports mailed in Q1 of next year. Later in 2014, Schwab will provide advisors with educational tools that describe the changes to the 1099 Composite and other reporting platforms, and share our plans for communicating these changes to your clients. Here is a summary of the changes that will be made to existing tax reports. Form 1099-B Report adjusted cost basis, disallowed loss, holding period, and acquisition date for less complex fixed income, options, stock rights, and stock warrants acquired on or after 1/1/14. Remove sales reporting for short-term debt issued after 1/1/14. Report all principal payments (cost basis reporting is not required). Add a box to report market discount at disposition for covered bonds. Schwab is making system changes in August 2014 and November 2014 to prepare clients accounts for tax reporting that reflects required IRS changes making tax preparation easier for you and your clients. Add four boxes for regulated futures reporting for section 1256 contracts. Forms 1099-INT/1099-OID Add a box for Bond Premium/Acquisition Premium. Add a box for Market Discount (used only if your client currently instructs us to include market discount in their income). 26

27 Glossary 171 Election A taxpayer (a bondholder or client) instruction under Internal Revenue Code Section 171 to amortize bond premium on a taxable fixed income security. Accretion The process of adjusting the purchase price of a bond upward to par. The difference between the price of a bond bought below par and its par value is called the discount. When an investor buys a security in the secondary market at a discount (if the security was purchased below par of 100), the purchase price is adjusted upward to 100 over the remaining life of the security until it reaches par on the maturity date. Acquisition Premium The excess of a fixed income security s adjusted cost basis immediately after purchase, including purchase at original issue, over the fixed income security s adjusted issue price at that time. Amortization The process of adjusting the purchase price of a bond downward to par. The difference between the price of a bond bought above par and its par value is called the premium. When an investor buys a security in the secondary market at a premium (if the security was purchased above par of 100), the purchase price is adjusted downward to 100 over the remaining life of the security until it reaches par on the maturity date. Bond Call Feature Allows the issuer the right to redeem the bond, under specific conditions, prior to its maturity date. Bond Premium Amount by which your cost basis in the bond right after you buy it is more than the total of all amounts payable on the bond after you get it (excluding payments of qualified stated interest). Bond Put Feature Allows the holder to force the issuer to repurchase the security at specified dates before maturity. A method of amortizing bond premium. The constant yield amount is calculated by multiplying the adjusted cost basis by the yield to maturity at issuance and then subtracting the non-qualified stated interest. Debt Instrument or Fixed Income Security De Minimus Fixed Income Security or Debt Instrument Market Discount Original Issue Discount (OID) Qualified Stated Interest Straight Line Amortization to Best to Highest to Maturity to Worst to Lowest The IRS defines debt instruments (also referred to by Schwab as fixed income securities) as any instrument or contractual arrangement that constitutes indebtedness under the general principles of federal income tax law, including notes, bonds, debentures, or other evidence of indebtedness. Under federal tax laws and regulations, for the discount rules to apply to a security, the discount must be at least 0.25% of the stated redemption price for the bond at maturity, multiplied by the number of full years from the date of original issue for OID securities or purchase date for market discount to maturity. Otherwise, the discount is considered to be zero. The IRS defines debt instruments (also referred to by Schwab as fixed income securities) as any instrument or contractual arrangement that constitutes indebtedness under the general principles of federal income tax law, including notes, bonds, debentures, or other evidence of indebtedness. The stated redemption price of a bond at maturity minus your cost basis in the bond immediately after you acquire it. Market discount arises when the value of a debt obligation decreases after its issue date. The amount by which the stated redemption price at maturity of a fixed income security is more than its issue price. In general, qualified stated interest is stated interest that is unconditionally payable in cash or property (other than fixed income securities of the issuer) at least annually over the term of the fixed income security at a single fixed rate (e.g., bond coupon payments). A simple amortization method that spreads out the cost of an asset equally over its lifetime. The yield that would be realized on a callable bond if it were redeemed on the date that would result in the highest yield. The average annual return on a bond, assuming the bond is held to maturity and all interest payments are reinvested at the same rate. The yield includes an adjustment for any premium or discount from the face value. The yield that would be realized on a callable bond if it were redeemed on the date that would result in the lowest known yield to the holder. For general informational purposes only. This information is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner, or investment manager. 27