October 20, 2010

TO: Distribution

FROM: FROM: Burt, Staples & Maner LLP

RE: Final Cost Basis Regulations

The final cost basis regulations have finally been published, a mere 11 weeks before the statutory effective date of January 1, 2011. Fortunately, the final rules follow the general outline of the proposed regulations published in December 2009, and the changes in many cases soften the requirements for brokers. However, some new and difficult requirements have emerged. Here are the highlights:

• Penalty Relief for Many Transfers During 2011. Notice 2010-67, published simultaneously with the final regulations, states that the IRS will not assert penalties under IRC § 6722 against brokers, custodians and others who make transfers of stock during 2011 and fail to provide a transfer statement if the transfer is not “incidental to the stock’s purchase or sale.” The receiving broker may treat the securities as “noncovered” and therefore not subject to cost basis reporting. Also see “DVP/RVP Transfer Statement Rules” below.
  
  
• Other Penalty Relief Possible. The preamble to the final regulations states that in addition to the transfer statement penalty relief, “the IRS will continue to work closely with stakeholders to ensure the smooth implementation of the provisions in these regulations, including the mitigation of penalties in the early stages of implementation for all but particularly egregious cases.”
  
  
• DVP/RVP Transfer Statement Rules. The final regulations now provide that transfers in connection with DVP/RVP transactions require transfer statements. However, a transfer statement is not required for a sale if that sale was effected by the transferor or the transferor is otherwise required to report the sale on Form 1099-B. Likewise, a transfer statement for a purchase is not required if the broker receiving custody instructed another broker to make the purchase. Because such transfers would appear to be “incidental to the stock’s purchase or sale” they would not be eligible for penalty relief during 2011.
  
  
• Qualified Intermediaries (“QIs”) Generally Need Not Issue Forms 1099-B. The final regulations do not adopt language in the proposed regulations that would have subjected QIs to Form 1099-B reporting, including cost basis reporting, for all sales. Accordingly, a QI is obligated to issue a Form 1099-B only when required by the current QI Agreement. The preamble states that Form 1099-B and FATCA reporting will be coordinated in future guidance.
  
  
• Nonqualified Intermediaries and Flow-throughs. A sale of stock held by a foreign intermediary or foreign flow-through entity (e.g., a foreign partnership) is not subject to cost basis reporting, even if the broker knows that the proceeds are being paid through to a U.S. non-exempt recipient and even if the broker knows the amount of the proceeds paid to that person. However, traditional Form 1099-B reporting without cost basis information continues to be required in that situation. Moreover, foreign brokers who effect sales within the U.S., and who therefore are required to file Forms 1099-B, are subject to the cost basis rules.
  
  
• Major Carve-Out for Exempt and Foreign Customers. Any stock purchased by exempt recipients and “exempt foreign persons” (i.e., those documented or presumed to be foreign) is noncovered. In addition, any stock transferred to an account of an exempt recipient or exempt foreign person is not subject to the transfer statement rules, which should considerably reduce the volume of transfer statements.
  
  
• Securities Lending and Repo Transfer Rules. The rules for transfers in the securities lending and repo contexts have been completely re-written. Now, a transferor who borrows or lends shares as a principal is not required to issue a transfer statement. Moreover, as noted above, transfers to exempt recipients and exempt foreign persons are also excluded from the transfer statement requirement. On the other hand, securities lending transfers to a U.S. non-exempt recipient by a broker acting as an agent are subject to the transfer statement requirement. The final regulations retain the requirement that a broker who receives borrowed shares that are used to close a non-exempt customer’s short position provide information regarding the short sale to the transferring broker, who generally would be responsible for issuing a Form 1099-B for the short sale.
  
  
• Orders Fulfilled With Multiple Trades. If a customer places a single order that is executed in several trades, the broker can effectively elect whether to treat the purchase as a single transaction or separate transactions. If the broker provides the customer a single confirmation, it must average the basis or gross proceeds of the shares; if not, the basis or gross proceeds of each execution must be tracked separately. However, the customer can opt-out of averaging (but not separate treatment) by notifying the broker. The opt-out provision may (to say the least) create serious operational issues for some brokers.
  
  
• Wash Sales. The final regulations clarify that unless the purchase and sale in a wash sale both occur in the same account, no wash sale adjustment is required, so transfers of shares should not affect wash sale calculations. However, the final regulations fail to clarify precisely how to make the holding period adjustments required by IRC § 1091 and how to report that information on transfer statements and Forms 1099-B, stating that such matters “relate to the substantive rules under section 1091 and are outside the scope of these regulations.”
  
  
• S Corporations. Beginning in 2012, corporations that have elected to be S corporations generally are not exempt from Form 1099-B reporting (including cost basis reporting). The proposed regulations would have eliminated the “eyeball” tests which permit a customer to be treated as a corporation exempt from reporting based on its name. The final regulations partially restore the “eyeball” tests, permitting reliance on the names of insurance companies and foreign per se corporations, which are not eligible to be S corporations. Also, a corporation that provides a Form W-8BEN can be treated as exempt.
  
  
• Average Basis Method Changes. The final regulations simplify changes to and from the average basis method for mutual fund and dividend reinvestment plan shares. The proposed regulations had provided that such an alteration would, under some circumstances, be a change in a method of accounting requiring the Commissioner’s consent. Now, a taxpayer can elect into or out of averaging at any time prospectively. In addition, as provided in the proposed regulations, a taxpayer who elects into averaging can revoke that election before the first sale of stock subject to the election (but no later than a year after the election, unless the broker permits a longer time); a revocation restores the separate basis of the shares that were subject to the election.
  
  
• Non-FIFO Sales. Confirmations of sales on a non-FIFO basis may be included in regular account statements, so long as they are provided within a “reasonable time” after the sale. In addition, the preamble confirms that brokers are not required to accept standing orders for lot relief methods.
  
  
• FIFO Sales. If the customer does not specify a different order, the first shares sold should be those for which an acquisition date is unknown. Then shares should be sold in FIFO order.
  
  
• Customers Are Presumed to Be Minority Shareholders. Brokers are permitted to make adjustments to basis related to corporate actions as if the customer is a “minority shareholder,” unless the broker “knows” the customer is a majority shareholder. While this concession is sensible, the basis adjustments for many corporate actions turn not on majority/minority shareholder status, but rather on other facts. For example, in a redemption, the key question is whether the shareholder’s interest in the corporation has been reduced (sale treatment) or not (dividend treatment).
  
  
• Mark-to-Market and Constructive Sales. The final regulations do not require a broker to make mark-to-market adjustments under IRC §§ 475 and 1296, or constructive sale adjustments under IRC § 1259. However, the preamble makes clear that adjustments that are not required are nonetheless permitted. The preamble suggests (but the regulations do not mandate) that customers be informed of any non-required adjustments to avoid duplication of those adjustments.
  
  
• Actual Knowledge vs. Reason to Know. The final regulations ease certain rules by requiring that a broker “know” something, rather than merely have “reason to know” it. For example, a broker must “know” that a security is reasonably classified as stock before being required to treat it as such in the absence of an issuer determination. The minority shareholder rule described above also is based on the “know” standard. On the other hand, in most cases the final regulations retain the “know or have reason to know” standard.