Mandatory reporting guidelines apply to both investment management companies and brokerages. While fund companies are not singled out specifically, security-specific rules and the current state of cost basis offerings create unique, often challenging, problems for mutual fund companies - starting with wash sales and lot relief methods, for instance. Fortunately for investment management firms, legislation doesn’t impact pure mutual fund providers until Jan. 2012 (firms with brokerage arms will be required to cover equities beginning in 2011). 2012 may seem like a long time from now, but considering all the changes basis reporting requires, that effective date is a lot closer than it seems. More over, there are many reasons that investment management firms may not want to wait any longer before implementing a cost basis solution.

Historically, mutual fund providers have used Average Cost as the default lot relief method (LRM). The legislation requires that firms support any lot relief method desired by investors.  This presents two challenges for investment management firms:  the first is the business logic required to support FIFO and Specific ID. Legacy systems that were only designed to support average cost will be very difficult to modify in such a way to efficiently support other LRMs. In most cases, the results will be systems which require substantial manual (e.g. expensive) support. The other issue, which is often over-looked, but can be very difficult to resolve and will actually change the nature of the relationship between firms and shareholders, is addressing the requirement that shareholders be allowed to select the LRM of their choice. Satisfying this requirement means opening a communications channel with the shareholders. If this is executed poorly, the result is a confusing and unsatisfying experience for clients and a costly exercise for firms.

Another consideration for introducing a cost basis solution well before 2012 is that clients will begin receiving adjusted cost basis data from their brokerages in 2011. This means customers will receive tax reporting assistance, in the form of adjusted cost, from their brokerage, but not their fund company. At a minimum, this will lead to client confusion and a spike in help desk traffic; but in some cases, it also could result in dissatisfaction leading to a shift in assets. Those companies that introduce cost basis systems next year will not only  get ahead of the legislation, they will be perceived as innovators within the industry and potentially be rewarded with in-flows from firms that are slow to respond.

The bottom line is that investors have always struggled with tax reporting. Mandatory reporting or not, providing adjusted cost basis to shareholders improves the overall investment experience and increases customer loyalty.

One leading investment management firm that has already moved to tackle the cost basis challenge is Vanguard, which recently selected Scivantage Maxit to track cost basis for its client base.  By addressing the basis reporting challenge now Vanguard once again has distinguished itself as an innovator among peers.

Changing Regulatory Landscape: Requirements Every Financial Institution Must Address to Comply With Mandatory Reporting Rules

Live Webinar Event: Wednesday, Nov. 19 @ 4:00 PM EST

In just a short time, brokerage firms and mutual fund companies will be required to track and report adjusted cost basis to both their clients and the IRS. Doing so will require major system upgrades to support corporate action adjustments, wash sale treatment, and proper lot relief methodologies. Failure to properly address even a single component of cost basis will result in significant penalties and disgruntled clients. 

Scivantage, a leader in providing automated, adjusted cost basis solutions to the financial services community, will host an in-depth discussion on the new legislation and provide insight into how the latest technology innovations can help ensure your firm is ready to comply.

Register today for this free, live webinar to take a closer look at how Scivantage’s Maxit solution can help reduce operational costs, deliver a substantial competitive advantage and ensure compliance in a rapidly changing regulatory environment.

Key topics covered during this webinar will include:

To pre-register for this event, click here.

All this industry talk about cost basis and Basis Reporting legislation, and it takes a market correction (or maybe worse) to emphasize perhaps the most important reason for financial firms to provide cost basis: tax management. Or, for those who break out in hives at the mere mention of “tax”, think of it as an opportunity to increase after-tax performance.Investors who have real-time access to their adjusted cost basis have numerous ways to manage their taxes. “Tax loss harvesting” is probably the best know tactic. Tax loss harvesting is simply selling losing lots to realize those losses, reduce capital gains liabilities and effectively increase after-tax performance. But this is hardly the only opportunity afforded to those who know the cost basis of their holdings. They can also take advantage of the lower long-term capital gains tax rate, defer payments on gains and avoid wash sales. Too complicated for the average investor? Techniques best reserved for tax professionals? The answer is no on both counts. All it requires is access to a real-time, adjusted cost basis solution and the appropriate tax management tools (both pieces are provided in Scivantage Maxit).

What does all of this have to do with the recent market woes? Here are two examples of how real-time cost basis can lead to improved after-tax performance:

• 1) Let’s say an investor bought 500 shares of Citigroup (C) last spring when it was trading at $50. By December Citi had sunk below $30. If the investor were already considering exiting the position, doing so before the last trading day in December, rather than after the first trading day in January, would have been beneficial. The investor could have realized the $10,000 loss (approximating the fill price and commissions) which could be used to offset 2007 gains, potentially leading to $3,500 in tax savings (assumes 35% tax bracket). Waiting until January to sell postpones the savings for a full year, giving the IRS, and not the investor, the investment power of the $3,500.
• 2) Another investor bought Home Depot (HD) at $41 in late January 2007. That tax lot will be going long-term shortly. If the investor were planning to sell the position, with the stock now trading closer to $26, they should do it before the one year anniversary of the original purchase. Why? Because as a short-term loss it can be used to offset short-term gains, which would be taxed as high as 35%. If the position is held for more than 365 days and then sold, the loss would offset long-term gains, which are only taxed at 15%. Let’s say the loss were $15,000. The difference in after-tax impact between selling the security short- and long-term could be as high as $3,000! (the difference between 15% and 35% applied to $15,000).

Bear, bull or sideways market - the benefits of proper tax management can be gained in any market.  Providing tools to help investors and advisors manage the tax implications of their portfolio(s) can help improve performance regardless of market conditions.

Only the geekiest of financial service professionals noticed the recent IRS revenue ruling, 2008-5, on wash sales. But those who did see the note (and bothered to read it) the significance is noteworthy on many levels. As the IRS seems to pride itself on vague wording in wash sales rulings (”substantially identical” anyone?) the clarity of this ruling signals just how serious the IRS is about this issue. It also confirms that trading into a wash sale in an IRA account can be one of the costliest mistakes an investor can make.

Here’s why:

Normally a wash sale occurs by selling a security for a loss in a taxable account and then repurchasing the same security within 30 days, before or after the sale, in the same account (to keep this relatively simple, we’ll forget about “substantially identical” for now). A wash sale can also occur by having the same combination of transactions across multiple taxable accounts with the same tax payer ID (couples filing jointly, take notice). Under these circumstances wash sales are to be avoided because it means losses are deferred, along with the tax benefits of those losses. However, when the investor eventually sells the repurchased lot(s) the losses will be recovered.

If, on the other hand, an investor trades into a wash sale in their IRA the losses are lost forever. How significant would that be? Very. Let’s say an investor in the 35% tax bracket sells a security in their taxable account for a $20,000 loss and then purchases the same security in their IRA within 30 days. They’ve just lost that $20,000 loss for ever. That’s $7,000 in tax dollars!