From the January 2009 issue of Investment Advisor • Subscribe!

January 1, 2009

New Tax Lot Accounting

Firms should prepare now for rules that take effect in 2011, 2012, 2013

Getting on top of the tax lot requirements put forth by the Internal Revenue Service (IRS), which was rolled into the $700 billion bailout legislation, will consume a pretty sizable portion of brokerage firms' time this year--despite the fact that the rules don't take effect until 2011, 2012, and 2013.

Starting in 2011, the IRS will require brokerages to "start capturing cost basis for equities," says Rob Enz, senior VP and general manager of Broadridge Financial Solutions' Wealth Management Solutions group. In 2012, the IRS rule takes effect for securities that can be processed with an average cost method, which are typically mutual funds, Enz says, but language in the bailout legislation looks "like it's going to allow equities that have dividend reinvest programs to be rolled into that category." Then in 2013, the IRS will begin requiring firms to track the cost basis for fixed income and other types of securities, he says.

So the bottom line premise of this new IRS rule--which is actually a requirement that the IRS has "talked about for years," Enz says--is that starting on January 1, 2011, brokerage firms will need to capture tax lot information when their customers purchase an equity. "When equities purchased in 2011 are subsequently sold, the brokerage firm must submit the original cost basis data to the IRS along with the 1099B gross proceeds information," he explains. So the IRS "wants to keep better tabs on whether people are reporting accurately the cost of the securities they're selling because they charge you long-term or short-term gains depending on how long you've held the securities, and how much you make is directly attributed to what you pay versus how much you sold it for."

Enz notes that it is Section 403 of H.R 1424, which became Public Law 110-343, that holds the relevant sections of the law that relate to reporting cost basis on customer 1099's. The general text of the law can be found at www.Congress.Org.

There are still a lot of explanations needed to be supplied by the IRS about the rule, Enz says, and he's expecting the IRS to release clarifications in the next six months. For example, "you're going to end up with a bunch of securities that were purchased before that requirement and if you do sell you could be liquidating some shares that are before and some that are afterwards." It's unclear, he says, "how the IRS is going to require us to handle those things."

Because tax lot accounting is very complicated, Enz says, it's paramount that brokerage firms get up to speed with the new requirements as soon as possible. Enz says he expects the IRS to change the "wash sale" rule, which says that if an investor sells a security for a loss and then repurchases the same security within 30 days the loss is disallowed. "So you have to track that and know whether you can claim the loss or not."

Enz suspects that most brokerage firms, big and small, are being proactive and becoming compliant. In order to comply with the rule, he says, firms will have to use a system that is scaleable. Since some of the big brokerage firms have "millions and millions of accounts, they have to find a cost effective method for tracking the data and storing it for long periods of time and then reporting it," he says. The bill also makes "mandatory the requirement that brokerage firms transfer cost basis information when accounts transfer."

Will the new requirements be particularly onerous for smaller firms? That, of course, depends on "how are they going to spend their money," Enz says. If they are going to develop their own system, I think the smaller guys don't have the IT shops to do that. So I think they would be out shopping for vendors and then it's the cost of the package you're going to buy."

A Product to Handle the Requirement

Broadridge, a provider of technology-based outsourcing solutions to the financial services industry, is rolling out a new system that will help brokerage firms comply with the new requirements. What's unique about the new system, called Aspire Wealth Performance and Portfolio Accounting System, is that it combines a cost-basis system with a performance system, Enz says.

"We will ingest data from the back-office system and be able to do two things: produce the tax lot accounting for you as well as do performance so you can compare the performance of your account to benchmarks in the industry--the S&P or the Dow or whatever. So it will be a two-for-one offering." Broadridge is "building the application to be scaleable, and we're also making it so it's back-office agnostic--it's not tied to Broadridge's back office."

Broadridge charges on an account basis and that will be tiered based on the size of the firm, Enz notes.

Broadridge's system also helps firms comply with the new rule's mandate that brokerage firms reconcile their data back to the system of record, Enz says. "There has to be built-in reconciliation tools, because if you're a large firm with millions of accounts, the last thing you want to have is the need to hire 100 people to reconcile the data," he says. "We also think we have an edge in this regard."

Enz expects scads of brokerage firms to use Broadridge's system. As it stands now, one large brokerage firm "with five million accounts" will be signing up in the spring to use the performance aspect of Broadridge's portfolio accounting system, he says, and another firm will be using both the tax lot accounting and performance service comes June.

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