GainsKeeper Blog

WALTHAM, Mass. – Jun. 23, 2011 – On June 22, 2011, the IRS issued Notice 2011-56 (“Notice,” available at http://www.costbasisreporting.com) indicating that the IRS will issue new proposed regulations addressing three issues raised concerning rules set forth in the final cost basis regulations released in 2010. The IRS had issued the final cost basis reporting regulations (TD 9504) on October 12, 2010 (the Final Regs—also available at http://www.costbasisreporting.com).

The Notice states the forthcoming proposed regulations will favorably address three specific problems raised by commentators regarding the Final Regulations.

1. Retroactive Change from Broker Default Method to Customer Selected Lot Relief Method for Mutual Fund & DRP Shares

The cost basis law and the Final Regulations provide that a broker can select a broker default method of lot relief for determining cost basis on the sale of average basis eligible mutual fund and dividend reinvestment plan shares (“CBRIC” and “CDRP” mutual fund and dividend reinvestment plan shares as defined under Treas. Reg. 1.1012-1(e)(5) and (e)(6)). The Final Regulations (Treas. Reg. 1.1012-1(e)(9)(v), Ex. 2) indicated that if a broker had selected a broker default relief method of averaging, a customer’s opt-out of the broker’s default method would only be prospective and would not un-do the calculation of average basis of shares held and acquired prior to the customer opt-out, even if the customer had not sold any shares of CBRIC or CDRP stock prior to the customer opt-out.

For example, assume that a customer started an account in January of 2012, bought shares in the ACME mutual fund and began a series of monthly purchases of additional ACME shares and reinvested dividends received in additional shares throughout the year. Assume also that the broker default relief method was averaging and the customer did not sell any shares of ACME through November 2012. According to the Final Regulations, if the customer contacted the broker in late November 2012 and made a customer opt-out election to a lot relief method other than averaging (such as highest-in, first-out), the election would only be prospective and not retroactive. Therefore, the basis for all the ACME shares purchased through November would be averaged and the customer’s opt-out election would only affect the determination of basis of shares bought after the election was made.

What was particularly disconcerting about this “prospective-only customer opt-out” was that the Final Regulations included a revocation rule that generally permitted a customer to retroactively revoke a customer election (rather than a broker default election) of averaging. However, the rule only applied if the election to average had been made less than one year before the date of revocation (or a longer period if extended by the broker) and no shares had been sold by the customer between the date the election to average was made and the date of the revocation.

Essentially this meant that the Final Regulations included a retroactive right to revoke averaging if a customer had elected averaging. But they did not include a similar retroactive right to revoke averaging if the broker had elected averaging for a customer under the broker default method and the customer wanted to revoke the broker’s election.

The Investment Company Institute (ICI), a mutual fund industry organization, submitted a comment letter to the IRS dated Jan. 13, 2011, requesting that this rule under the Final Regulations be revised. The Notice adopts this request.

As described in the Notice, it is expected that proposed regulations will be issued that permit a customer to retroactively opt-out of a broker’s default method election of averaging provided that the broker’s election to average had been made less than one year before the date of revocation (or a longer period if extended by the broker) and no shares had been sold by the customer between the date the election was made and the date of the revocation. In order to determine the starting date for the one-year period, the Notice indicates that brokers will need to notify a customer by reasonable means of the broker default method. “Reasonable means” may include mailings, circulars, or electronic mail sent separately or included in a taxpayer’s account statement, or other means reasonably calculated to provide actual notice.

The indication in the Notice that proposed regulations will change the prospective-only rule of the Final Regulations is a positive development for the mutual fund industry and dividend reinvestment plans. It may cause some funds to adopt averaging as a broker default method that might not have if the prospective-only rule hadn’t been addressed by the Notice.

2. Clarification of the Treatment of Cash in Lieu of Fractional Shares for Purposes of Determining if Dividend Reinvestment Plans Qualify as CDRPs

Under the Final Regulations, only stock held in dividend reinvestment plans that meet a technical definition set forth in the regulations (Treas. Reg. 1.1012-1(e)(6), a “CDRP”) qualify as eligible for basis averaging for cost basis purposes. One key requirement that a dividend reinvestment plan must satisfy under the Final Regulations to qualify as a CDRP is that the written plan documents must require that at least 10 percent of every dividend on any share of stock is reinvested in identical stock (the 10 percent of every dividend requirement).

Depending on the number of shares a customer held in an account, a customer might not receive a dividend large enough to purchase a share of stock to permit reinvestment. In other words, the amount of the dividend paid, based on the size of the customer’s holdings of the stock, might only account for a fractional share. Commentators were concerned regarding whether the payment of cash in lieu of a fractional share under these circumstances would cause the dividend reinvestment plan to fail to satisfy the 10 percent of every dividend requirement. If this was the outcome, the plan would not qualify as a CDRP and shares held in an account under such a plan would not be eligible for basis averaging under the cost basis law.

The Notice indicates that forthcoming proposed regulations will clarify that a dividend reinvestment plan does not fail to satisfy the 10 percent of every dividend requirement if it pays cash in lieu of fractional shares when the amount of a dividend is insufficient for some shareholders to acquire stock.

This is a welcomed clarification because without it, it was possible that almost no dividend reinvestment plan would qualify as a CDRP and would essentially make dividend reinvestment plans ineligible for basis averaging, in spite of the clear intent of the cost basis law.

3. Clarification that Lot Relief Methods Are Applied Account by Account

Under prior law and the cost basis law, selecting lots sold (“lot relief”) is generally determined on either a first-in, first-out basis or based on specific identification of the lots sold. There are a number of methods (such as highest-in, first-out, lowest-in, first-out, etc.) that are all based on specific identification. The cost basis law clarified that these methods should be applied on an account-by-account basis. This clarification made sense under the new rules requiring cost basis reporting by brokers due to both systems- and technology-related limitations, and the fact that one broker would generally be unaware of holdings of identical securities in accounts held with other brokers or in the customer’s possession.

The Final Regulations did not make this clarification for all accounts and securities. Instead the Final Regulations only included an “account-by-account” clarification for mutual fund and dividend reinvestment plan (CBRIC and CDRP) securities eligible for basis averaging. A comment letter dated October 22, 2010 was submitted on behalf of Wolters Kluwer Financial Services requesting that the Final Regulations be revised to clarify that the account-by-account rule generally applies to all securities and accounts. The Notice indicates that forthcoming proposed regulations will adopt this clarification.

This clarification is a positive development because it would track the broader rule set forth in the cost basis law and would address the technology and broker knowledge concerns described above.

Conclusion

Overall, the Notice favorably addresses three technical concerns raised regarding the Final Regulations and indicates that forthcoming proposed regulations will address these issues. It should be noted that the Final Regulations include many other rules that were not addressed in the Notice, some of which have also been controversial. It is uncertain whether the IRS will issue additional guidance that addresses other concerns in the Final Regulations besides these three specific issues.

Stevie

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