IRS Provides Interim Guidance On Stock Basis And Character Reporting Requirements

Notice 2011-56, 2011-29 IRB

In a Notice, IRS provides interim guidance under Code Sec. 1012 relating to stock basis issues stemming from the complex basis and character reporting requirements for most stock acquired after 2010, for shares in a regulated investment company (RIC, i.e., a mutual fund) or stock acquired in connection with a dividend reinvestment plan (DRP) after 2011, and other specified securities acquired after 2012. IRS provides a preview of how proposed regs will address these issues and indicates that taxpayers may rely on the guidance in the Notice pending the regs' publication.

Background on broker reporting requirements. Under the Emergency Economic Stabilization Act of 2008 (EESA, P.L. 110-343), every broker required to file an information return reporting the gross proceeds of a “covered security” must include in the return the customer's adjusted basis in the security and whether any gain or loss with respect to the security is short-term or long-term under Code Sec. 1222. (Code Sec. 6045(g))

A covered security is any specified security acquired on or after the applicable date if the security: (1) was acquired through a transaction in the account in which the security is held, or (2) was transferred to the account from an account in which the security was a covered security, but only if the broker received a statement under Code Sec. 6045A regarding the transfer. (Code Sec. 6045(g)(3)(A))

A specified security is: (a) any share of stock in a corporation (including RIC shares), (b) any note, bond, debenture, or other evidence of indebtedness, (c) any commodity, or contract or derivative with respect to the commodity, if IRS determines that adjusted basis reporting is appropriate, and (d) any other financial instrument with respect to which IRS determines that adjusted basis reporting is appropriate.

For purposes of broker reporting, the adjusted basis of RIC or DRP stock is determined by a broker's default method (identified in legislative history as the first-in, first-out method, the average cost method, or the specific identification method, see Notice 2011-56) unless the taxpayer elects otherwise. (Code Sec. 6045(g)(2)(B)(i)(II)) Similarly, under Reg. §1.1012-1(e)(2)(i), unless a taxpayer elects otherwise, the basis of the RIC or DRP is determined by the broker's default method.

In October of 2010, IRS issued final regs on the basis reporting requirements.

New guidance. In Notice 2011-56, IRS addresses three specific stock basis issues relating to the basis and character reporting requirements that were raised in response to the final regs and are expected to be clarified by proposed regs. IRS says that, pending the publication of the proposed regs, taxpayers may rely on the guidance provided in the Notice.

“Average basis” method. Taxpayers may elect, by notifying their broker in writing, to use the “average basis” method to determine the basis of stock in a RIC and stock acquired after Dec. 31, 2010 in connection with a DRP. (Reg. §1.1012-1(e), Code Sec. 1012(d)) When this election applies, the basis of a customer's stock is computed by averaging the basis of shares of identical stock acquired before, on, and after Jan. 1, 2012, and all the shares are treated as covered securities. A taxpayer that does not use the average basis method determines the basis of stock under Code Sec. 1012(a) by its cost.

Under Reg. §1.1012-1(e)(9)(iii), a taxpayer that wants to revoke its average basis method election must do so within the earlier of (1) one year after making the election, or (2) the date of the first disposition of the stock. A broker may extend the one-year period, but not beyond the first disposition of the stock. After a revocation, the basis of the stock reverts to the cost basis.

If a taxpayer fails to revoke its average basis election within the revocation period, the taxpayer may change from the average basis method to the cost method at any time, but only for stock acquired after the date of the change. The basis of the stock that was averaged remains so following the change. (Reg. §1.1012-1(e)(9)(iv))

Reg. §1.1012-1(e)(9)(i) provides that a taxpayer has not made a basis election if (1) he fails to choose a basis determination method, and (2) basis is determined by a broker's default method. Under Reg. §1.1012-1(e)(9)(v), Example 2, because averaging under a broker's default method is not a taxpayer's election, a taxpayer's change from a broker's default averaging method to the cost method is prospective, and stock acquired before the change retains the averaged basis.

To provide consistency between revoking a taxpayer's average basis election and changing from a broker's default average basis method, the proposed regs are expected to provide that, when a taxpayer changes from a broker's default averaging method for RIC or DRP stock to the cost basis method, the basis of the stock reverts to the cost basis if the taxpayer requests the change by the earlier of (1) one year after receiving notice of the broker's default method, or (2) the date of the first sale, transfer, or other disposition of the stock. A broker may extend the one-year period, but not later than the date of the first sale, transfer, or disposition of the stock.

Observation: In other words, the same timing rules and basis consequences apply regardless of whether the taxpayer is revoking an election or changing from a broker's default method.

To determine the beginning of the one-year period, a broker using the average basis method as a default method must use reasonable means (such as mailings or circulars) to notify taxpayers. The notice must identify the securities subject to the broker's default average basis method.

Qualification as a DRP—the 10% reinvestment requirement. Under Reg. §1.1012-1(e)(6)(i), a plan, arrangement, or program qualifies as a DRP if the written plan documents require that at least 10% of every dividend on any share of stock is reinvested in identical stock. However, a commenter raised the issue of whether a plan that pays cash in lieu of fractional shares (i.e., if the dividends are some shareholders' stock are insufficient to acquire at least one whole share of identical stock) fails to meet the 10% requirement.

The proposed regs are expected to clarify that a DRP does not fail the 10% reinvestment requirement because it pays cash in lieu of fractional shares when the amount of a dividend is insufficient for some shareholders to acquire stock.

Lot selection methods. In the case of the sale, exchange, or other disposition of a specified security on or after the applicable date, for determining which specific lot of stock is to be sold, Code Sec. 1012(c)(1) provides that the “conventions” prescribed in the Code Sec. 1012 regs apply on an account-by-account basis. These conventions are identified in EESA's legislative history as first-in, first-out (FIFO), specific identification, and average basis. However, Reg. §1.1012-1(e) only provides account-by-account rules for averaged stock.

The proposed regs are expected to clarify that the lot selection methods, such as FIFO and specific identification, also apply on an account-by-account basis.

Comments requested. IRS requested comments on issues arising under Notice 2011-56. Comments should be submitted by mail or email on or before Aug. 8, 2011.

References: For the basis and character reporting rules, see FTC 2d/FIN ¶S-3740; United States Tax Reporter ¶60,454.08; United States Tax Reporter ¶60,45A4; TaxDesk ¶814,200; TG ¶60215.