The rules have changed: Title IV, Section 403 of the Emergency Economic Stabilization Act of 2008* requires the reporting of adjusted cost basis information for covered securities to the Internal Revenue Service (IRS) and to taxpayers — and penalties can run up to $350,000.

    The initial effective date for cost basis reporting for most stocks applies to stock acquired on or after January 1, 2011; for mutual funds and dividend reinvestment plan stock (or similar arrangements) acquired on or after January 1, 2012; and for debt instruments, options, and other covered securities acquired on or after January 1, 2013. The provision is scored by the U.S. Treasury to raise $6.67 billion over a 10-year period, due to the systemic over-reporting of cost basis and thus under-reporting of actual tax liabilities.

    Although the initial effective date may seem distant, preparation to handle the technology, operational, tax, legal and business issues associated with compliance is likely to be very cumbersome for many firms, with brokers in particular needing to be acutely aware of the requirements. Besides these issues, failure to provide the IRS and taxpayers with correct cost basis reporting information could subject brokers to significant tax penalty risk. As a result, consultants at Celent strongly advise that brokerages aggressively seek a solution to be tested and live by the end of 2010 before trading begins in January 2011.

    Celent's call for urgency is based on a detailed survey of 175 responses conducted over the summer of 2009 with leaders in the financial services sector, including C-suite executives, VPs, directors, managers and line staff at broker-dealers, investment advisors, mutual funds, banks, asset managers/hedge funds and custodians. According to the survey, although the industry overall is aware of and concerned about the requirements of this law, it is quite weak in actual preparedness.

    So, what needs to be done? Active research and preparation is taking place, particularly at firms (such as broker-dealers and mutual fund companies) and business areas (such as tax and operations), and by people in the roles most affected by this law, with tax personnel the most acutely aware of the obligations and requirements to be placed on them.

    However, overall concern seems inappropriately low, given the scope of the new requirements and the needed implementations and modifications of technology systems and operations. While some are taking the necessary planning steps, others are planning to depend upon service providers for compliance, such as vendors and clearing firms. Still others have yet to allocate budgets and many do not have any implementation plans in place.

    Therefore, Celent believes that the industry has wholly underestimated the amount of time necessary to implement cost basis reporting solutions and that C-level executives must begin spurring staff to do more.

    This lack of urgency is likely due in part to complacency at firms and a history of successful ongoing relationships with trusted technology vendors and clearing firms who are promising delivery of a solution going forward. Moreover, while guidance on specific aspects of the law is expected shortly, firms must begin putting together a solution and not wait for the picture to be 100% clear before moving ahead.

    In conclusion, progress toward cost basis reporting compliance is not progressing as it should, given the timeline of the new law. More firms must move beyond research into actual planning and development, whether through internal resources or through partnerships with technology vendors and other key providers. The nature of the new law and the potential for penalties for noncompliance mean a lack of progress can lead to some undesirable outcomes.

    For instance, failure to provide the IRS and taxpayers with correct cost basis reporting information could subject brokers to significant tax penalty risk. The penalty for an error is essentially $100 per incorrect Form 1099 (a $50 penalty for providing the IRS an incorrect Form 1099 and another $50 penalty for providing the taxpayer with an incorrect Form 1099), subject to a current maximum on the broker for all failures during the calendar year of $350,000 ($250,000 on the returns provided to the IRS and $100,000 on the returns provided to taxpayers). In the case of an error that is due to intentional disregard, the aggregate penalty is the greater of $200 or 10% of the amount required to be reported correctly per return, without any maximum limitation.

    With the penalties for noncompliance as well as the important business considerations, C-level executives will be responsible for increasing the amount of attention and the all-important urgency factor to comply with the cost basis reporting law beginning in January 2011.

    For the full report, visit

    David Easthope is a senior analyst in Celent's securities and investments practice and is based in the firm's San Francisco office. He is a Chartered Financial Analyst (CFA) and member of the San Francisco Security Analysts Society. Mr. Easthope's expertise lies in securities trading and post-trade systems, including exchange platforms, electronic communication networks (ECNs), alternative trading systems (ATSs) and dark liquidity pools. He is also an expert in exchange and broker-dealer strategic initiatives, including the introduction of new multilateral trading facilities (MTFs), block and anonymous order types, algorithmic trading and IT procurement/partnerships

    * H.R. 1424, (the Act, Pub. L. No. 110-343), signed by President George W. Bush in October of 2008



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