IRS, why force taxpayers to reconcile securities-broker 1099-Bs to tax returns, when your rules are apples vs. oranges?

March 20, 2012 | By: Robert A. Green, CPA

See our Cost-Basis Reporting area in our Trader Tax Center for more content, blogs, Webinars, Video and our Petition to Congress.

Green’s Forbes blog version: Who Can’t Count, The IRS Or Your Broker?.

Contrary to public perception, securities brokers’ cost-basis reporting on 1099-Bs rarely matches taxpayers’ net trading gain or loss generated from their trade accounting program. This is because the IRS gives brokers one set of rules for preparing 1099s and gives taxpayers an entirely different set of rules.

Why the difference? The IRS does not ask securities brokers to report net taxable gain or loss on 1099-Bs, but they require taxpayers to do that on the new Form 8949 for 2011 tax returns.

The apples and oranges in the rules are counterintuitive to taxpayers, causing great confusion and extension filings. Historically, the IRS led taxpayers to believe the idea of 1099s was to confirm a taxpayer’s income or loss and to provide a means for IRS computers to check up on taxpayer compliance. Sometimes, the IRS matches net income — one example is with Section 1256 contracts. And other times it reconciles with proceeds — such as with securities. But the new 2011 rules require brokers to report cost basis on 1099-Bs, too.

Some of the problem is due to phase-in and transition. Securities brokers report 2011 cost basis on stocks only. (A few brokers elected to report 2010 cost basis on 2011 1099-Bs, too, even though it wasn’t required.) In doing so, brokers’ systems left out wash-sale deferral cost basis from 2010. That means out of the gate, 1099-B 2011 wash sale reporting is incorrect. If 1099-Bs botch wash sales, how can cost-basis reporting be correct for 2011? It can’t. This issue may be better in 2012, when brokers report 2011 and 2012 cost basis.

A wash sale example
If you bought and sold stock symbol X on Dec. 22, 2010 for a material loss, and you repurchased that same stock symbol on Jan. 18, 2011, it’s a wash sale. But, your broker probably did not report the deferred wash sale loss cost basis; it likely only reported the actual purchase price on Jan. 18, 2011. If you report on your taxes the figures from your broker’s 1099-B, you will overstate your 2011 capital gains and that wash sale loss from 2010 will be lost forever.

1099Bs were rushed out too early, yet too late for tax season
Proper wash-sale reporting must have a cut-off date of the end of January, which is 30 days after year-end. How else can you tell if there is a wash sale on Dec. 31? 1099-Bs must be issued by Feb. 15. That leaves just 15 days to do the accounting, make corrections, send PDFs to printers, mail them on time, and deal with great confusion on the new cost-basis reporting rules.

For 2011 1099-Bs, many brokers filed for a 30-day extension until March 15. But S-Corps file by March 15, and there’s only one month left until the April 15 individual tax deadline. Sure, individuals can file extensions, but they owe 90 percent of their taxes on that date for valid extensions. Otherwise, they are subject to penalties.

There simply isn’t enough time to get this all right. Something has to give.

Corrected 1099s are not the answer
Some brokers issued their 1099-Bs by Feb. 15, knowing they will likely have to issue corrected 1099-Bs later on. It takes more time to figure out wash sales and income allocations — like return of capital vs. dividends. We don’t like this practice, since corrected 1099-Bs cause confusion with taxpayers. Too many taxpayers wind up using the wrong 1099-Bs on their tax filings. Some taxpayers rush to file early for refunds, and have to return the money later on with amended tax returns.

Who is at fault? 
Cost-basis reporting is a major new initiative from the IRS, and a new demand on securities brokers. In prior blogs, I pointed out many discrepancies on Form 8949 trying to reconcile trade accounting with 1099-Bs. The differences are large, and I was quick to blame securities brokers for botching some reporting, especially wash sales. But, many of the differences are attributable to brokers following one set of rules written for 1099-Bs, and taxpayers dealing with another set of rules. Plus, the IRS causes more confusion with “covered” vs. “non-covered” securities and brokers confuse things by including some non-covered items in covered. In retrospect, I think it’s more the fault of the IRS system than the brokers, who themselves are struggling with these new demands. It’s one thing to make an error and another to follow the rules and then have problems over apples and oranges.

While the IRS may have a laudable goal in mind, due to the phase-in transition, mixed-up cut-off dates, and apples and oranges between brokers and taxpayers, it’s a minefield of confusion. Instead of improving taxpayer compliance, it could get worse for 2011 with these new rules.

IRS, please don’t require taxpayers to reconcile differences
The IRS caused this mess, so it should not force taxpayers to explain the line-by-line differences on Form 8949. We ask that the IRS simply accept trade accounting as is, and only match proceeds on securities as it has done in prior years. Don’t try to match the unmatchable cost basis for 2011. If the IRS doesn’t waive matching, it will send hundreds of thousands of nasty tax notices to taxpayers. That will lead to great expense and very upset taxpayers. Perhaps, matching will get easier for 2012 tax returns, so we can reassess at that time.

Why are 1099B rules different? 
Brokers prepare 1099-Bs based on detailed rules from the U.S. Treasury. While these rules might resemble tax-filing rules for taxpayers, they are often very different. In my next blog, I will explain how some forex dealers issue 1099s for Section 1256 contracts on forex forwards. Yet, taxpayers must start with Section 988 ordinary gain or loss and they are only entitled to Section 1256g lower 60/40 tax treatment if they file a contemporaneous internal election, and with other conditions as well. This Section 1256 contract 1099 is prepared by the broker with realized and unrealized gains and losses, but taxpayers only report realized ordinary gain or loss if they remain in Section 988. If you ask brokers about this problem, they will explain they are not responsible for a taxpayer’s tax return filings — they only need to follow detailed 1099-B rules for a default investor, without any regard for their client’s facts, circumstances, tax and accounting treatment, or elections. How would a broker know about internal elections, anyway?

Wash sales are bound to be wrong
When it comes to wash sales, there are a multitude of things that can and will go wrong, and that messes up cost basis and reconciliations for securities traders (unless they use Section 475 MTM and are exempt from wash sales).

First, many brokers are using back-office tax-accounting solutions that may botch wash-sale reporting, since they have not focused on it much in prior years. Second, there is the cost-basis rules transition problem mentioned earlier, with brokers omitting 2010 wash sale cost basis deferred into 2011. Third, most brokers rushed 1099-Bs to the printer before doing an end of January wash sale calculation (covered earlier). Fourth, most brokers report wash sales between “identical positions” (the same symbol only), whereas, taxpayers are required to report wash sales between “substantially identical positions” (such as between stocks and options). How can the IRS ask brokers to calculate wash sales according to identical positions only and taxpayers by substantially identical position? Even if brokers could get all the above right, broker-provided wash sales would still be wrong because brokers only report wash sales in one account, whereas a taxpayer must report wash sale analysis across all taxable accounts, including IRAs.

TradeLog is the answer for tax reporting
Don’t get side tracked with broker-provided 1099-Bs and other reports for your tax return preparation. Securities traders need TradeLog to download and match all their trades. TradeLog generates a Form 8949 attachment, but don’t be alarmed by a large discrepancy between this and your 1099-Bs. Those differences are due to the problems mentioned here and many more not listed in this blog. TradeLog calculates wash sales correctly.

Full disclosure, we sell TradeLog on our site and receive a commission. We sell TradeLog because it’s the only program on the market that our CPAs trust, and we have to sign tax returns, subject to preparer penalties, too. TradeLog works well because it’s a third-party solution that downloads trading transactions directly from your broker through a filter.

Broker accounting
Back-office system providers — like Scivantage Maxit (for ScottTrade and others), Broadridge Aspire (for Penson), and Sunguard — integrate their enterprise solutions into their brokerage firm clients’ platforms. Enterprise solutions are part and parcel with brokerage firm reporting; they’re set up to generate 1099-Bs for the firm, not the taxpayer’s net trading gain and loss reports.

We spoke with Cameron Routh of Scivantage. Mr. Routh has been involved with securities trade accounting software and brokers for a long time, and he is a wealth of knowledge when it comes to these problems. Mr. Routh explained that Scivantage and other enterprise solutions integrate with brokerage data systems to generate brokers’ 1099-Bs and other reporting, based on brokerage firm rules, not a taxpayer’s rules. While traders can retrieve a Sciadvantage utility to generate a 2011 Form 8949, it won’t have 2010 cost-basis information and that means it won’t have wash sale deferral carryovers, either.

Even Mr. Routh agrees that the best solution for a trader in 2011 is TradeLog, run separately from the broker.

Single account election
Mr. Routh pointed out that brokers were given the choice to make a “single account election” to report cost basis more accurately, including prior year cost basis. Most brokers declined this election, because they don’t want to bite off more than they can chew. Brokers don’t have sufficient information on hand for prior year accounting method (FIFO, special identification, average cost basis) and more. With older positions, firms would have to go back a very long time and that’s asking for trouble.

Phase-in problems will continue
More items become covered securities in 2012 (mutual funds) and 2013 (stock options). So, expect the same types of transition problems with these items in the future.

Bottom line
In the spirit of “closing the tax gap,” Congress asked the IRS to do cost-basis reporting. Like all things legislative, it looked much easier on the design board. Regulations were difficult and late, and implementation uncovered the poor design. Like all major undertakings, this one needs some tweaking. But, please IRS, don’t take this out of the hide of taxpayers. Waive the matching for a few more years, until this is in better shape. There shouldn’t be so many huge gulfs; please don’t force taxpayers to be the accountants when dealing with this mess.