Brokers Update Basis Reporting Tools for IRS Compliance

We all bear the burden of taxes, some more than others. In April the IRS increased the burden of brokers, pushing their cost basis calculations to new levels.

April's ruling by the IRS tax code held some big surprises for debt, and regulations include a requirement to support holder elections that affect how basis is computed. According to the IRS, "To minimize the need for reconciliation between information reported by a broker to both a customer and the IRS and the amounts reported on the customer's tax return, a broker is required to take into account certain specified elections in reporting information to the customer."

In other words, an individual may generally have about 5-6 choice in how they choose to realize income or loss from debt securities. These elections have been around for a long time but brokers have never actually had to support them.

When you do start supporting them, as the IRS is requiring, it starts affecting all other kinds of income reporting. "We're not just calculating on 1099-B's we're impacting how interest is reported, all kinds of income," explains Bob Linville, director of product management at Scivantage. He is working on requirements for basis reporting for fixed income and options for 2014 and 2016 and supporting some of the clients that are transitioning from Broadridge to Scivantage for cost basis accounting.

"It's complicated stuff, and brokers have to support it and they have to figure out how to explain how it all works to their clients. That's a difficult decision for them, but from our perspective we're providing the tech to support all of that basis tracking and the election that affect how they report."

Broker's Burden

When you buy a bond you may buy at a discount or premium, and when you sell the bond the brokers would report the proceeds and the tax payers would figure out if it was a gain or loss and what other income might be realized. Now the brokers need to figure that out too. And because trades and taxes are unique to each client and each position, there's a lot of extra calculation they didn't have to do before.

"This means they spend a few months going through researching tax laws - they have to do a lot of calculations, and even more disruptive I think was that many brokers were actually doing this calculation, but not all of them, or not all according to tax code," says Linville. "In building a system to support this it was easy to say, the tax code gives us two methods for calculating, let's just pick one and do that all the time. That was an easy decision ten years ago… Now the IRS is saying to the brokerage, you have to do the calculations according to the code. And now the enterprise reports to the IRS and the IRS can compare client's report and broker's report."

Basis reporting is a much higher standard of calculations, with more scrutiny on the accuracy of those calculations, and it requires a lot of investment to get all of that working properly.

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In response to the challenges, clients are electing to buy solutions rather than build. In line with that trend, Scivantage's tech solution is deeply integrated with the back office books and records to automate the calculations. "The accountants are going to be very happy, in theory, that they don't have to do that anymore," jokes Linville.

"We integrate deeply so there's a seamless presentation of data always in sync with whatever service [typically third parties] is presenting the books and records to the brokerage. We're presenting a clear picture in sync with back office as well."

Client Benefits

With brokers taking the reigns of tax reporting, clients will have a much better chance of collecting cost basis calculations than having an accountant figuring it out for you. During the course of the year, you have a much better idea what your income is going to be. Traditionally, it's an end of the fiscal year surprise.

What's more, by providing cost basis functionality investors have more options that are easier to apply. For example, an investor choosing the minimum tax option. In the past this was handled by an accountant or a third party, presumably with a significant waiting period, but if a brokerage is reactive enough these options become much more available and easy to apply to end users.

Breaking Down Silos

On a final note, collecting all of the relevant data to produce exact calculations requires no small skill in data collection. A lot of these rules that govern calculations of basis depends on the specific characteristics of the security (e.g. accrual calculations will be different for yield and variable rates).

"There's a lot of data requirements and some of this data hasn't necessarily been tracked closely in the past because brokers didn't particularly need it. Now to do the calculations they need data they weren't capturing before," says Linville. As a result, a shared challenge for broker and solution provider has been the gathering data from the back office and putting it into a spot the system can access.

Siloing of information has often been a hurdle, and Linville says many firms have made the effort to build new systems and make modifications to whatever data they are getting to the solution provider.

"One good of example of siloing in brokerages is the different kind of income reporting, including interest, dividends, OID, and each one of those is in a separate silo. In the past it was pretty easy, people go to Books and Records, do some math, and there you go. But in basis reporting there are now conditions where we have to adjust that interest because even if you got $2,000 in interest you might also have some accrued premium that would reduce that. The broker may only be supposed to report $1,800. In the world of interest reporting, it's all integrated, so all of those silos have to talk to each other and coordinate the amount."

Linville concludes, "It's our ability to break down silos and partner with back office and tax vendor and build necessary communications and process between those independent groups. As we successfully break those down we're able to deliver. All three parties are incumbents to work well together to create a clean 1099 process." Becca Lipman is Senior Editor for Wall Street & Technology. She writes in-depth news articles with a focus on big data and compliance in the capital markets. She regularly meets with information technology leaders and innovators and writes about cloud computing, datacenters, ... View Full Bio