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Communications Key to Working With New Cost-Basis Rules


A principal aim of the impending cost basis reporting law is to enable the IRS to capture lost tax revenues due to inaccurate or underreported filings. Brokers and custodians are now scrambling to ensure their accounting systems will be compliant with the regulations, expected to take effect Jan. 1, 2011. However, the law will impact firms in other ways they may not yet realize.

In particular, brokers distributing managed account products and the investment managers who supply them face unique challenges given the complexity of sharing cost basis information when communicating client service requests.

Control of year-end tax liability is one tangible benefit of managed account products. The ability for a manager to communicate lot information to the sponsor is required for "tax optimized" management, where taking advantage of lower tax rates for long-term capital gains is desirable.

For example, if in the course of the year, a manager has realized $20,000 in gains, the client's adviser will look for a like amount of unrealized losses and may direct the manager to raise losses in the account to offset the anticipated gains.

In addition to tax harvesting, there are other situations where the client or adviser may direct a manager to take specific action regarding the securities in the account. The types of instructions that involve securities where cost basis information may be required include: new account opening, contribution of securities, distribution of cash, distribution of securities and termination or partial liquidation of holdings.

Investment managers will not be required to store cost basis information on their portfolio management systems. But for the majority of managers who use client holdings information from their portfolio management systems to make investment decisions, it will now be necessary to agree with sponsors on how cost basis information is communicated, and how lots are closed when trades are booked.

We recommend the implementation of a four-level approach to sharing cost basis information between managers and sponsors. The four levels represent progressively tighter integration between the sponsor's custodial systems (which must be in compliance with the new law) and the managers' accounting and portfolio management systems (which need not be compliant).

Level 1 - Position-level communication. The manager doesn't receive cost-basis information from the sponsor. When sending trades, the manager communicates at position level only, and doesn't include the cost basis for each lot of a given security.

Level 2 - Lot-level communication. The sponsor provides the manager with cost-basis information for client holdings. The adviser can now instruct the manager which specific lots to sell or deliver when the adviser submits client requests.

Level 3 - Selling rule communication. The sponsor provides the manager with cost basis information, and sponsor and manager also agree upon a "selling rule" for the client account (e.g. FIFO, LIFO, greatest gain, greatest loss). This approach provides further direction to the investment manager, and increases the probability that the lots closed by the manager will be booked as expected by the sponsor.

Level 4 - Two-way communication. The sponsor provides the manager with cost basis information. The manager, when sending trade details to the sponsor, communicates which lots are to be closed. This approach allows the manager to consider the tax impact of a particular trade when managing the client's assets, since the manager now can ensure the sponsor will record the completed trade by closing the expected lots.

Consider the difference between Levels 1, 2, 3, and 4 as an adviser requests a manager to harvest $20,000 in losses from a client's account.

* Level 1: No harvesting. Because the manager may not have complete cost basis information for the account, the manager may not show $20,000 in unrealized losses, requiring additional communication with the adviser before the instructions can be fulfilled.

* Level 2: Unintended consequences. Because the manager has reconciled lots with the sponsor, the adviser can be confident that the manager will be able to raise the requested losses. However, it is possible that the lots closed on the sponsor's books will vary from those intended by the investment manager, realizing a loss greater or lesser than that which was expected by the adviser.

* Level 3: Tax results not optimized. The manager relies on the "selling rule" to close lots. This should allow the manager to execute the adviser's instructions, and have the resulting trades faithfully replicated when being booked by the sponsor. However, the manager's ability to tax-optimize the trades may be limited by the need to adhere to the selling rule.

* Level 4: Optimized tax results. The manager interprets the adviser's request in the context of its tax optimization policy. The lots closed by the manager are specifically communicated to the sponsor, avoiding any potential for variation when booked to the client account.

Brokers, advisory firms, and investment managers that offer managed accounts are likely to find client communications to be significantly impacted by the broker or custodian's new need to report cost basis. Client-specific instructions are commonly communicated by fax or e-mail, which can lead to errors.

Instead, we believe firms will need to adopt industry communications standards for account origination and maintenance requests.