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Guidance Backlog Slows Preparation for Cost-Basis Reporting

BOSTON - As tax experts at mutual fund companies hurry to prepare their fund accounting systems before newly mandated changes to federal cost-basis reporting rules take effect, they are finding they could use a little help and guidance from the government.

Instead, they are hearing nothing.

This backlog of regulatory guidance is frustrating these tax experts and nearly every other area in the financial industry that is trying to plan ahead in advance of significant regulatory reforms.

"There has been a high level of awareness over this, but not much progress," said Deanna Flores, a tax principal at KPMG, at the National Investment Company Service Association's East Coast Regional Meeting. "This is potentially very confusing to customers, and confusion costs money."

A recent tax study done on behalf of the Internal Revenue Service discovered widespread underreporting of capital gains and losses. Congress believes that cost-basis information isn't being reported, either because people are being sneaky or a large number are making mistakes.

It's easy to see why so many investors are confused. Calculating gains and losses is extremely difficult if you don't know the original purchase price, as with a gift or inheritance.

Plus, a lot of long-term investors choose to reinvest their dividends, which makes it even more difficult to determine actual gains and losses. Under the new rules, investors who choose to reinvest their dividends must record the purchase price every time they reinvest.

Tax experts say the new legislation is not intended to substantially change existing laws, but instead make the financial industry more accurate and verifiable by the IRS.

"We have an opportunity to simplify the lives of our customers," Flores said. "This all makes perfect sense at 64,000 feet, but it starts to fall apart at 63,999 feet."

Equities acquired after 2011 will be subject to mandatory cost-basis reporting, Flores said. Mutual funds will be subject to the new rules by 2012, while bonds will have to comply by 2013.

Mutual funds are already a little bit ahead of the curve because they already provide cost-basis information. The new rules don't apply to investors in tax-deferred 401(k) retirement accounts.

"We often hear people say, 'We already provide cost-basis reporting,'" Flores said. "This is very different from what we do today. Basically, if you produce a 1099 form, you will be affected by this change."

The industry is awaiting additional guidance from the IRS and Treasury Department, but many expect any guidance to come late and in waves.

"It will be hard to execute these changes with all this uncertainty," said James Foggo, vice president and senior director of investor services at PNC Global Investment Servicing. "Institutions that have cost-basis 'champions' will be fine, but even they will have to start executing sooner rather than later."

With the deadline for mutual funds still more than two years away, some firms may be tempted to keep these new changes on the back burner in order to focus on more immediate needs, but accounting experts warn the new requirements have a long adoption timeline for a reason: The new rules touch every part of a firm's operations and are anticipated to take firms one to two years to implement.

"Hopefully, the IRS will be issuing guidance in the near future," said Jeff Naylor, vice president of business development at SunGard. "That information will address and probably raise additional questions. When the IRS guidance comes out, we may have to go back and revisit every decision."

If the IRS alters the effective date, it will add a whole new dynamic to the process, he said.

Even if it wanted to, it's not in the IRS's power to grant an extension. While it might be possible to waive penalties for non-compliance at first, many experts say Congress intended the clamp-down on delinquent taxpayers to be a revenue raiser.

Flores said the change is estimated to raise $10 billion over 10 years and will help pay for the Troubled Asset Relief Program (TARP).

"We know we have a lot of work to do," Flores said, "but there are still a lot of things we don't know. What will the forms look like? How will we survey customers? This is a 100% customer-facing change. It is as significant as a W-2 form from the customer's perspective."

Congress has decided the best way to close these apparent tax gaps is by taking the burden of computing the tax basis away from the average investor and placing it on the broker.

Investors will have to report the gross any time they do a liquidation, and the entity that initiates the liquidation is responsible for filing the 1099-B. If a customer has a direct account, the mutual fund provides the 1099-B, but if they go through a third-party brokerage firm, the firm must provide the 1099-B.

Under the new rules, customers will need to declare their methodology when they open a new account, rather than when they submit their taxes. Customers can choose from the first-in, first-out methodology, which assumes they will sell their oldest shares first; an average-cost methodology, which calculates the average cost of all their shares; or they can choose to specify which individual shares they want to sell.

The average cost of implementing these changes is impossible to predict because of all the variables. Industry leaders say companies can take this opportunity to vastly improve their value-added customer service or simply outsource to a specialist.

In the absence of timely guidance from the Treasury, firms should adopt a flexible strategy that can cope with any last-minute changes. Because these changes will take at least a year to integrate and a few months to test-run, tax specialists urge companies to get started now.


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