New Cost Basis Reporting Challenge for Hedge Funds, Partnerships and Corporations: IRS Form 8949 & New Form 1065 Schedule D
By Stevie D. Conlon, Senior Director & Tax Counsel, Wolters Kluwer Financial Services
On December 31, 2012, the IRS released Schedule D for reporting capital gains and losses for calendar year 2012 by partnerships filing federal income tax returns on Form 1065 (2012 Partnership Schedule D). Significantly, the 2012 Partnership Schedule D adopts the format first used for calendar 2011 for individuals filing IRS Form 1040 in that such Schedule D no longer reports the details for capital gains and losses but instead merely summarizes and references IRS Form 8949 for reporting capital gain and loss details.
On January 20, 2013, the instructions to Form 8949 (dated January 17, 2013) were released. The instructions note that the use of Form 8949 by partnerships and corporations (including S corporations and corporations that file specialized federal corporate income tax returns such as REITs and RICs) is new, and that many transactions that would have utilized Schedules D or D-1 are now reported on Form 8949. Although the instructions permit the use of a separate attachment to list multiple transactions, the instructions are explicit that the same level of detail must be provided in the attachment and that “available on request” notations or merely including summary totals on the attachment is not permitted. The instructions also list the various codes to be used to indicate the reason for adjustments to the amounts reported on a Form 1099.
IRS Form 8949
IRS Form 8949 requires taxpayers to detail and segregate capital gains and losses on a transaction-by-transaction basis (rather than by summarizing and referencing an attachment) and into separate categories for those short-term gains and losses for which Form 1099-Bs are received that report both gross proceeds and cost basis, those for which Form 1099-Bs are received that report gross proceeds but not cost basis and those for which no Form 1099-Bs were received. Similar segregation is required for long-term gains and losses.
IRS Form 8949 is formatted so that each transaction that is reported separately on Form 1099-B is reported on a separate line of the Form (additional pages of the Form are used if the number of transactions exceeds the number of lines on the Form). The Form includes the following series of columns: (a) description of property; (b) date acquired; (c) date sold or disposed; (d) proceeds (sales price); (e) cost or other basis; (f) adjustment codes; (g) adjustment amount; and (h) gain or loss. Importantly, the instructions provide that the proceeds and cost or other basis amounts reported for each transaction in columns (d) and (e) must equal the amounts reported by brokers on Form 1099-B, and the taxpayer reports adjustments from such amounts in its calculation of gain or loss in column (g) with the reason code listed in column (f).
Forced Reconciliation of Taxpayer Calculations with Broker Form 1099-B Reported Amounts
IRS Form 8949 essentially forces taxpayers to reconcile the amounts reported on Form 1099-Bs with their own calculations of gain or loss and to explicitly identify and explain the reason for any differences with broker Form 1099-B reporting in a systematic manner that is designed to facilitate IRS review either upon processing or audit.
Of critical concern to taxpayers—particularly hedge funds and investment partnerships that conduct their investment and trading activities through more than one broker and more than one brokerage account—is that brokers’ calculations of cost basis do not necessarily accurately reflect the calculations of cost basis that taxpayers (including hedge funds and partnerships) are required to make in computing and reporting their capital gains and losses on their tax returns (IRS Form 1040 and 1065 for example).
There are several reasons why cost basis reported by a broker might differ from the calculations taxpayers are required to make in computing and reporting their capital gains and losses on their tax returns. The most significant reason why cost basis reported might likely differ is due to simplifying assumptions that brokers are permitted to make in calculating cost basis adjustments relating to wash sales.
Internal Revenue Code (IRC) Sec. 1091 essentially provides that a taxpayer cannot take a loss on the sale of a stock or certain other types of securities and financial contracts if the taxpayer acquires substantially identical stock or securities within a 61-day period that begins 30 days before the date of such sale and ends 30 days after such sale. Losses from wash sales are deferred rather than permanently disallowed because there is an upwards basis adjustment applied to the stock or security acquired that triggers the wash sale disallowance (and there is a related holding period adjustment to the newly acquired stock or security). Taxpayers have been required to track wash sales and apply these loss deferrals and related basis and holding period adjustments for more than 90 years.
Wash Sale Calculations Across All Accounts and Brokers By Taxpayers
Taxpayers must apply the wash sale rule and compute the related loss deferrals and basis and holding period adjustments across all of their accounts and holdings. For example, if a taxpayer sells Acme stock at a loss that was held in an account with Broker A and then buys Acme stock in a different account with Broker A or in an account with Broker B within the 61 day period, a wash sale has occurred and the taxpayer must treat the loss as disallowed in computing and filing its tax return, adjust the basis and holding period of the stock acquired and reflect those adjustments in reporting gain or loss when the newly acquired stock is subsequently sold. This example describes a “cross-account wash sale.”
Simplified Wash Sale Adjustments by Brokers for Cost Basis Reporting
The cost basis reporting law (IRC Sec. 6045(g)(2)(B)(ii)) provides that although brokers must make basis and holding period adjustments relating to wash sales, brokers are permitted to make two key simplifying assumptions and ignore: (1) transactions occurring in other accounts (cross-account wash sales); and (2) transactions that do not involve identical securities. Such simplified wash sale reporting by brokers makes policy sense because of computer system limitations (determining whether stocks or securities are substantially identical to one another can be problematic and highly factual under the tax law) and limitations on access to data. For example, a broker would not generally have reason to know about transactions in accounts held by other brokers. Additionally, even different accounts held by the same broker might be administered on different back-office systems that might not readily share information.
Straddles and Constructive Sales
The IRS regulations relating to cost basis reporting provide that brokers are not required to make cost basis adjustments for deferred losses and holding period adjustments relating to straddles under IRC Sec. 1092, constructive sales under Sec. 1259 or mark-to-market tax reporting under Sec. 475.
Taxpayers including hedge funds and investment funds are not subject to such exceptions and must apply the straddle and constructive sales rules, if applicable. They must also take into account adjustments under the mark-to-market rules of IRC Sec. 475, if applicable. As a result, these special rules could also result in differences between calculations of basis and holding period between brokers and taxpayers.
Problems for Hedge Funds and Investment Partnerships
Hedge funds and investment partnerships often conduct their investment strategies through multiple accounts with more than one broker. Their level of investment activity can result in a significant number of wash sales and the potential application of other rules such as the straddle or constructive sales rules. As a result, the simplified wash sales adjustments (and ignorance of cross-account wash sales, the straddle, constructive sale and IRC Sec. 475 mark-to-market rules) that brokers are permitted to make in computing cost basis reporting on Form 1099-B could potentially result in significant differences that Form 8949 will force hedge funds and other investment partnerships to detail and explain to the IRS. The large number of stock or securities transactions that a hedge fund or investment partnership might typically generate further complicates the calculation and reconciliation process due to limitations in typical cost basis reporting systems and computing power. Similarly, corporations with significant investment portfolios and activity may also have these issues.
Hedge funds and other investment partnerships are likely to be surprised at the additional tax reporting burden that newly applicable IRS Form 8949 triggers for the preparation of their IRS Form 1065 federal partnership tax returns. Because they are likely to have a significantly greater level of stock and securities transaction activity, along with the probable reliance on multiple investment accounts with multiple brokers, the likelihood of cross-account wash sales increases greatly. The resulting significant differences between fund and broker Form 1099-B reported computations of cost basis will need to be reconciled on newly applicable IRS Form 8949. This new burden will likely come as a surprise to many investment partnerships and corporations with active investment portfolios.
DISCLAIMER: The information and views set forth in GainsKeeper Tax Topics are general in nature and are not intended as legal, tax, or professional advice. Although based on the law and information available as of the date of publication, general assumptions have been made by GainsKeeper Tax Topics which may not take into account potentially important considerations to specific taxpayers. Therefore, the views and information presented by GainsKeeper Tax Topics may not be appropriate for you. Readers must also independently analyze and consider the consequences of subsequent developments and/or other events. Readers must always make their own determinations in light of their specific circumstances.