Cost Basis Reporting: What You Need to Know for

Transcription

1 Cost Basis Reporting: What You Need to Know for 2014 Next Phase Covers Fixed Income and Options Executive Summary Starting in 2014, Phase III of the new cost basis reporting requirements will be implemented for less complex securities. The phase will expand to cover more complex securities in This paper details the changes and points out areas that require particular attention from advisors. You will need to explain to clients which securities will be covered under each reporting deadline. In particular, clients need to know the default amortization methods for bond premiums. The new rules for options, stock rights, and warrants require brokers to report adjusted cost basis and proceeds for closing transactions. You will need to help clients adjust to the changes and understand the difference between broker reporting requirements and taxpayer requirements. The new broker reporting rules will align more closely with taxpayer reporting requirements for clients securities transactions. This paper can help you distinguish yourself and your firm by communicating clearly with clients throughout the transition. 2 INTRODUCTION 2 OVERVIEW OF REGULATIONS 3 FIXED INCOME: TWO REPORTING PHASES 4 AMORTIZATION RULES 5 OPTIONS: WHAT TO EXPECT IN 2014 AND FORMs: LOOK FOR additional MODIFICATIONS IN BACKUP WITHHOLDING CHAnGES 7 TRANSFER REPORTING DELAYED ONE YEAR 7 SCHWAB CAN HELP YOU AND YOUR CLIENTS PREPARE FOR THE NEW REQUIREMENTS 8 CONCLUSION Cost Basis Reporting: What You Need to Know for

2 Introduction By now advisors, brokers, and clients have experienced Phases I and II of the new tax reporting rules for cost basis. The first phase took effect on January 1, 2011, and addressed equities. The second phase, which began January 1, 2012, expanded to mutual funds, exchange traded funds, and dividend reinvestment plans (DRIPs). Now advisors must prepare their clients for Phase III, which will cover fixed income securities and options. Given the complexity of these investments, the Internal Revenue Service (IRS) will stagger the reporting requirements to cover: Less complex fixed income and options securities acquired on or after January 1, 2014 Overview of Regulations The Emergency Economic Stabilization Act of 2008 included new tax reporting requirements that dramatically changed the way investors and advisors think about cost basis. The Act s goal is to ensure that investors accurately report investment gains and losses in their annual tax filings. To achieve this objective, custodians and brokers are required to report the adjusted cost basis of covered securities (including whether the gain or loss is short term or long term) to taxpayers and the IRS on Form 1099-B. The requirements were originally scheduled to be phased in from 2011 to 2013, but the varying complexities of the affected securities caused the IRS to extend the time frame through January 1, More complex fixed income securities and options issued as part of a fixed income instrument acquired on or after January 1, 2016 You have already helped your clients navigate many of the tax reporting changes. Now you can use these new regulations as an opportunity to further strengthen client relationships. Cost Basis Reporting Effective Dates by Security Type Equities Mutual funds, ETFS, AND DRIPS Acquired on or after Less complex fixed income and options securities More complex fixed income and options issued as part of a fixed income instrument January 1, 2011 January 1, 2012 January 1, 2014 January 1, 2016 Cost Basis Reporting: What You Need to Know for

3 Fixed Income: Two Reporting Phases Properly accounting for the cost basis of fixed income securities is considerably more complex than it is for equity securities. Cost basis can be affected by accruals of income and by elections made by the holder of the instrument. To bring consistency to the process, the IRS made changes to the final regulations that help align what broker-dealers report on Form 1099-B with what clients report on their tax returns. The IRS also divided fixed income securities into two categories less complex and more complex and set different dates for their coverage by the new requirements. A Note About Terminology The IRS uses the term debt instruments rather than fixed income. When searching for information regarding fixed income on the IRS website, use the term debt instrument. Schwab will continue to use fixed income except when using debt instruments adds clarity. Covered Fixed Income Instruments Less Complex Fixed Income: Subject to 1/1/14 Reporting More Complex Fixed Income: Subject to 1/1/16 Reporting Fixed Income Excluded From Reporting Taxable and tax-exempt bonds that have a fixed rate, fixed maturity, and fixed payment schedule, even if callable by the issuer. These include: Treasury notes and bonds Fixed-rate corporate bonds Fixed-rate municipal bonds 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 the broker 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) Some 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 yields may be affected by prepayments Short-term fixed income securities with fixed maturity dates not more than one year from the date of issue Cost Basis Reporting: What You Need to Know for

4 Amortization Rules Under the final regulations, brokers cost basis reporting will assume that clients have elected to amortize bond premiums. To conform to the new reporting rules, Schwab is making changes to the amortization rules in our cost basis engine. If amortization is currently turned off on a client s account, we will enable it for the 2014 tax year. We will also make changes to our amortization and yield methods, but not until after April 15, This will ensure that 1099 Composite Reporting for 2013 is issued with current account defaults. The chart below illustrates the broker default amortization elections Schwab will be implementing. Elections: Brokers will support up to five different client elections upon request. Clients must make their elections for the 2014 tax year by December 31, They can elect to: Accrue market discount using constant yield Include market discount in income currently Treat all interest as OID Turn off bond premium amortization Use the spot rate for interest accruals if currency is denominated in non-u.s. dollars (this will not become effective until 2016) In 2014, Schwab will provide specific instructions about how to make client elections Amortization Settings Bonds Amortization Method Yield Apply De Minimis Rule 1 Original Issue Discount (OID) No Call or Put Feature Constant Yield Yield to Maturity Yes Market Discount Straight-Line N/A Yes OID Call Feature Constant Yield Yield to Worst (Lowest Yield) Yes OID Put Feature Constant Yield Yield to Best (Highest Yield) Yes OID With Acquisition Premium Constant Yield Original Yield to Maturity, Then Apply Acquisition Premium Yes Bond Premium No Call or Put Feature Constant Yield Yield to Maturity No Bond Premium Call Feature Constant Yield Yield to Best (Highest Yield) Taxable Bonds Yield to Worst (Lowest Yield) Tax-Exempt Bonds No Bond Premium Put Feature Constant Yield Yield to Best (Highest Yield) No 1. Under federal tax laws and regulations, for the original issue discount rules to apply to a security, the discount at issue must be at least 0.25% of the stated redemption price of the bond at maturity, multiplied by the number of full years from the date of original issue to maturity. Otherwise, the discount at issuance is considered to be zero. Cost Basis Reporting: What You Need to Know for

5 Options: What to Expect in 2014 and 2016 The Phase III regulations change the landscape for reporting cost basis for options on stocks, indexes, 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 be required to report adjusted cost basis and proceeds for closing transactions on options, warrants, and stock rights that are acquired on or after January 1, If options contracts are exercised or assigned, brokers will be 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 Schwab will continue to perform wash sale adjustments on options with the same CUSIP that have disallowed losses. Other custodians may handle wash sales differently, so confirm that you understand their policies. Suggest that clients consult with their tax advisors regarding their particular situations. 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. Check the policies of other custodians you may use. 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. 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, Covered Options Options Subject to 1/1/14 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 Options Subject to 1/1/16 Reporting Investment units in which options, stock rights, or warrants are issued together with a fixed income security Options Excluded From Reporting Incentive stock options Foreign currency options Commodity options Cost Basis Reporting: What You Need to Know for

6 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 $7. On June 30, 2015, sell for $ B Reporting Box 9 Box B Reporting Box 9 Box 10 Profit or (loss) realized on closed contracts 2014 Unrealized profit or (loss): open contracts December 31, 2013 Profit or (loss) realized on closed contracts 2015 Unrealized profit or (loss): open contracts December 31, 2014 $0 $0 Box 11 Box 12 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) Aggregate profit or (loss) on contracts $4 $6 (proceeds of $9 less premium paid of $3) $4 Box 11 Box 12 Unrealized profit or (loss) on open contracts held in your account on December 31, 2015 Aggregate profit or (loss) on contracts $0 $2 ($6 + $0 $4) 1099 Forms: Look for Additional Modifications in 2014 Schwab anticipates the following changes when the IRS releases draft copies of its 2014 tax forms: Form 1099-B Adjusted cost basis required for all covered securities. Total accrued market discount for covered securities. Proceeds reporting for all principal payments (cost basis reporting is not required). Sales of short-term fixed income securities issued after January 1, 2014, will no longer be reported to the IRS on Form 1099-B. Forms 1099-INT/1099-OID Report bond premium annually for fixed income securities. Report market discount annually as interest if your clients currently make a written election to include income. Backup Withholding Changes Explain to clients that they may be subject to backup withholding on gross proceeds if: They have received B Notices from the IRS due to missing or incorrect name/taxpayer ID number combinations. They have not submitted a W-9. Their W-8 certification has lapsed. Schwab will be required to withhold the federal backup withholding rate, currently 28%, of the proceeds on their options contract, right, and warrant sales, in addition to all other reportable gross proceed transactions. If a client lives in a state subject to state backup withholding on gross proceeds, the current state rate will also apply. Schwab will be modifying our existing process to withhold federal backup withholding on all gross proceeds transactions at the time of trade. State backup withholding will continue to be applied the day after the trade date. Cost Basis Reporting: What You Need to Know for

7 Transfer Reporting Delayed One Year Cost basis reporting on security transfers of 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, 2017 Schwab Can Help You and Your Clients Prepare for the New Requirements In 2014, Schwab will provide additional materials to help you educate your clients about the new phase of the reporting requirements. In addition to explaining to clients how their fixed income and option positions will be affected, you should ensure that clients understand the following details: Amortization rules. Point out to clients that if amortization is currently turned off on their accounts, Schwab will enable it for the 2014 tax year. Reporting. Ensure that your clients understand that under the final regulations, a broker-dealer s cost basis reporting will assume that clients have elected to amortize bond premiums. The election will be retroactive to the beginning of the tax year. Elections. Clients must make their taxable bond elections for the 2014 tax year no later than December 31, The election will be retroactive to the beginning of the tax year. In 2014, Schwab will provide specific instructions for making client elections. Cost Basis Reporting: What You Need to Know for

8 Conclusion As the IRS continues to introduce the cost basis reporting requirements, advisors must remain committed to explaining the changes to clients. Support clients as they prepare for the changes, and include their tax advisors in the conversations. Advisors who communicate well and address client confusion stand to deepen relationships and reinforce their value. Many advisory firms back-office teams have been adjusting to the rules for equities, mutual funds, ETFs, and DRIPs. Beginning January 1, 2014, they will need to do the same for fixed income and options, with a second layer of requirements coming in It is critical to assess how the next phase of the legislation will affect your firm and to begin training staff now. Key Takeaways The third phase of this legislation, particularly the rules relating to fixed income, will likely affect some advisory clients. Be sure your clients know whether they hold less complex or more complex fixed income or both. Further changes to Form 1099-B may create confusion for clients. Plan now to develop a communications strategy to guide clients through these changes in Prepare your back office now for the third phase. Although broker-dealers shoulder most of the burden to comply, your firm should begin to anticipate the workflow changes and client questions that relate to fixed income and options. Staying on top of news from broker-dealers is vital to the successful implementation of the new requirements. Taking steps now to prepare your firm and your clients can lead to stronger client relationships and help avoid difficult workflow issues later. Proactively communicating with clients could uncover potential opportunities. For general informational purposes only. Meant for an institutional audience. Independent investment advisors are not owned by, affiliated with, or supervised by Schwab. This information is not intended to be a substitute for specific individual 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 Charles Schwab & Co., Inc. ( Schwab ). All rights reserved. Member SIPC. HNW ( ) ELC (10/13)