Cost-Basis Reporting, the New Schedule D, and Form 8949

Gains & Losses

The 2011 tax filing season ushered in the first phase of new basis reporting rules stemming from the 2008 Emergency Economic Stabilization Act, P.L. 110-343. This legislation established a three-phase process for submitting cost-basis information to the IRS (Sec. 6045(b)(2)). The IRS will use this reporting mechanism to match information reported by taxpayers with that reported by third parties.

The first phase of the rules required custodians, broker-dealers, and others to report the cost basis for all equities purchased on or after January 1, 2011, on a new Form 1099-B, Proceeds from Broker and Barter Exchange Transactions. For the 2012 tax year, brokers and others will be required to report cost-basis data for mutual funds, dividend reinvestment plans, and exchange-traded funds acquired on or after January 1, 2012 (Regs. Sec. 1.6045-1(a)(15)). This reporting will include mutual funds held by S corporations (Sec. 6045(g)(4)). In 2013, the reporting requirements will expand to include fixed income and options (Prop. Regs. Sec. 1.6045-1(a)(15)(i)). A result of this information-reporting requirement is a redesign of Schedule D, Capital Gains and Losses, and creation of a new Form 8949, Sales and Other Dispositions of Capital Assets. Form D-1 is no longer in use; Form 8949 replaces it (2011 instructions for Schedule D (and Form 8949)).

The correct preparation of Schedule D and Form 8949 requires the taxpayer to separate transactions into six categories including short- and long-term transactions where broker basis is reported (1) on Form 1099-B and to the IRS, (2) on Form 1099-B and not to the IRS, and (3) not on a 1099-B at all. The six categories are represented by designations “A,” “B,” and “C” in short- and long-term sections on Form 8949. Totals from sale price, cost basis, and adjustment columns on Form 8949 are carried to the appropriate columns and sections of Schedule D (2011 instructions for Schedule D (and Form 8949)).

Given the significant increase in the information being reported, the required reconciliations of broker statements to taxpayer’s records, and the number of new forms that must be completed, it is surprising the IRS’s estimate of average taxpayer burden in number of hours decreased for 2011 from 2010 by one hour.

Schedule D will continue to have lines for direct input of capital gain distributions and for certain gains and losses that cannot be reported directly on Form 1040, line 13—gains and applicable losses from installment sales, like-kind exchanges, involuntary conversions, Sec. 1256 contracts and straddles, and from partnerships, S corporations, estates and trusts, as well as capital loss carryovers. If a taxpayer has capital gains or losses only from a capital gain distribution or one of these other sources, the taxpayer is generally not required to file Form 8949.

The mechanics of reporting on Schedule D and Form 8949 are designed to permit electronic matching of third-party information. As a result, taxpayers may be forced to complete multiple Forms 8949, as only one type of transaction can be reported on a single form. For example, a taxpayer will need one form for A-type transactions where basis has been reported to both the taxpayer and the IRS; a separate form for B-type transactions where basis has been reported by the broker to the taxpayer but not to the IRS; and another form for C-type transactions where no 1099-B was received.

Once the transactions have been properly reported on Forms 8949, these forms must be summarized; only the total is carried to Schedule D (2011 instructions for Schedule D (and Form 8949)). For taxpayers with numerous securities transactions, reporting involves additional work unless the Form 1099-B separates the transactions into A, B, and C categories. To avoid recoding each transaction on a Form 8949, preparers and taxpayers can attach a statement containing the same information in the same format as the form. The totals from the attached statements are then entered into the appropriate sections on Form 8949 from the schedules. If the taxpayer receives multiple Forms 1099-B, each broker’s Form 1099-B totals should be entered on a separate line of Form 8949 to facilitate IRS matching. For e-filed returns that do not include the transaction details, a taxpayer must attach Form 8949 (or a statement with the same information), to Form 8453, U.S. Individual Income Tax Transmittal for an IRS E-File Return, and mail the forms to the IRS.

Perhaps the most difficult parts of this compliance change are Form 8949, Part I, columns b and g. These columns are used to modify the gain or loss reported by the third party on Form 1099-B. The instructions to Form 8949 list 11 codes that can be used to describe the reason for the adjustments recorded in column g. Interestingly, the final category states that, if none of the other 10 reasons apply, the taxpayer should leave columns b and g blank, meaning no adjustment can be made. Preparers will need to again fit adjustments into the prescribed format to facilitate matching. If a preparer makes more than one adjustment to the transaction, only the net amount should be reported in column g with multiple explanatory codes in column b as necessary (2011 instructions for Schedule D (and Form 8949)).

Practitioners also need to be aware of the elections and defaults used by brokers and custodians to determine the basis method for phase 2 of basis reporting for 2012 (mutual funds, dividend reinvestment plans, and exchange-traded funds acquired on or after January 1, 2012). Brokers and custodians all have forms available for investors to select and change methods of identifying cost basis for shares sold. For investors opening new accounts, a method election should be on the account application, and, for existing investors, an election form must be completed. The cost-basis method elected is generally only applicable to shares acquired after January 1, 2012, for mutual funds and January 1, 2011, for individual equities, and can be changed prospectively.

Taxpayers should identify either the default method used by the broker or custodian or the election made by the investor, as retention of this information will be important for planning future transactions and advising on the amount and nature of any gains. Clearly, the next generation of IRS matching notices (CP 2000) will provide interesting feedback as to the ability of the IRS to match, and the taxpayer and broker to report, in the correct box the same information. There may be a lot of time spent writing responses.