September 30, 2010 / 7:41 PM / 9 years ago

Advisers must gear up for cost-basis angst

NEW YORK (Reuters) - New tax-reporting rules designed to help Uncle Sam capture more investment gains have brokerage firms scrambling to prepare their systems by January and financial advisers bracing for a flood of client questions.

Neil Hutchinson (L), Senior Wealth Manager of HSBC, poses with James Bryan in hedge fund management from Execuzen, outside HSBC headquarters during a promotion ahead of a "Hedge Fund Fight Nite" charity event in Hong Kong September 2, 2009. REUTERS/Bobby Yip

The Internal Revenue Service, the U.S. government’s tax-collection agency, loses hundreds of millions of tax dollars each year from investors who inaccurately report the cost basis of investments, understating gains or inflating losses.

Brokerages and firms that hold assets for independent advisers currently report the proceeds clients receive when they sell securities.

The IRS hopes to raise an additional $6.1 billion over the next decade by forcing brokerages to provide cost-basis data directly to the agency. The data include the price a customer paid for stock and takes into account subsequent actions that affect the stock’s value, such as stock splits.

“There will be some angst among clients. Having the broker-dealer report out to the IRS puts a stronger onus on the end investor to keep accurate records,” said Maggie Serravalli, an executive vice president at Fidelity Institutional, which provides custody services for independent advisers.

Under a new law, brokers will have to report the cost basis for stocks bought on or after January 1, 2011. Firms will also have to tell the IRS whether a client made a short-term gain on a stock sale — for stock held less than a year — and is subject to a tax at the higher ordinary-income rate.

Many firms provided cost-basis information to clients in the past but did not vouch for its accuracy. Now, firms will have to ensure that the correct information is going to the IRS or they could face stiff penalties.

“The industry is really moving on this. Initially, people were paralyzed; now they’re scared but moving forward,” said Brian Keil, the director of cost-basis reporting at Charles Schwab Corp.

While brokerage firms are responsible for providing the information to the IRS, advisers are going to be on the front lines explaining the changes to clients and monitoring systems to ensure the firm’s figures are accurate.

“From an adviser perspective, it’s an opportunity to earn more client trust by clearly explaining the regulations and not shying away from it,” Serravalli said.

Independent advisers who use more than one firm to hold their assets have a bigger challenge to ensure their own portfolio management systems are in sync with those of their custodians.

Advisers are also going to have to take a more active role in tax planning. A client may have bought stock of the same company over the years at different prices.

Some custodians, including Fidelity and Schwab, will by default sell stocks in the order they were purchased if the adviser does not make a specific request. This may not be the most tax-efficient option for clients.

“The legislation is pushing the whole industry in the direction of tax advice,” said Keil.

Under the old rules, financial advisers or accountants could wait until year-end to decide which lot to sell, to minimize the client’s taxes. Now the election has to be made before the trade settles, usually within three days, so more advisers will be expected to make that choice for clients.

Advisers cannot relax once the rules are enacted next year. In 2012, brokerages will also have to provide cost-basis information for mutual funds and stock acquired through dividend reinvestment programs.

A year later, cost-basis rules will be extended to bonds and stock options.

“It’s not like Y2K when everyone prepared and then it was over. This will be ongoing for several years,” said Keil.

Reporting by Helen Kearney; editing by John Wallace

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