Cost-Basis Reporting Is a Nightmare and FATCA Makes the IRS a FATCAT

By Robert A. Green, CPA

In an attempt to balance the budget and close the “tax gap,” Congress, the Obama administration and the IRS are on a mission to intimidate Americans into reporting ALL their income and accounting, including securities traders (with brand new tax form 8949 on cost-basis reporting), reporting or closing foreign accounts (FBAR), reporting or selling foreign assets (with brand new tax form 8938), and repatriating business operations, profits and cash back to spur jobs in America as a part of recent proposals by the President.

Before Congress and the President upset their political bases when they try to balance the budget by cutting entitlement or defense spending or passing new tax hikes, they want to close the tax gap (busting tax cheats), close special-interest tax loopholes, broaden the tax base and maybe lower tax rates, too (as suggested by the Bowles Simpson Deficit Commission).

The world is now the IRS's oyster, and by using new sophisticated technology and productivity – just like the rest of us – the IRS is on a mission to catch tax cheats and taxpayers who conveniently overlook income and asset reporting.

There are two new bombshells for our trader clients to deal with on their 2011 tax returns – the all new forms 8949 (Sales and Other Dispositions of Capital Assets) and 8938 (Statement of Foreign Financial Assets).

Securities traders will be shocked by the new tax-filing compliance headaches, red flags and problems caused by the IRS's new Cost-Basis Reporting rules, which are all a part of its new tax form 8949.

Futures traders can count their lucky stars — they are free from this mess. With mark-to-market (economic reporting) in Section 1256, futures traders receive a one-page Form 1099 with their realized and unrealized gains and losses for the year. Simply enter that one simple number for “aggregate profit and loss” to Form 6781 and you also benefit from lower tax rates with 60/40 tax treatment. It may not be as easy if you trade instruments like ETF options. Brokers may treat those as securities, but you will want to treat them as Section 1256 contracts instead per our content.

Active securities traders and their accountants face a nightmare in filling out Form 8949 and reconciling their own trade accounting records — like TradeLog — with beefed-up broker-provided Form 1099-Bs.

First, these 1099-Bs are coming very late this year, as brokerage firms are struggling with the new rules. We expect most brokers will revise their 1099-Bs several times. This makes it almost impossible to file a full tax return by the April 17 deadline. You should get a good handle on your securities trade accounting with TradeLog and send that information to your tax preparer as soon as possible. Plan to file an extension, and be sure it's valid by paying at least 90% of your tax liability by April 17 with the extension filing. Handle the difficult Form 8949 reconciliations and explanations required on your tax return after the extension and before the final due date of Oct. 15. Brokers may send revised 1099-Bs after April 15, too.

You can't enter information directly to Schedule D anymore, as you must use Form 8949 for all line-by-line reporting, received from the brokerage firm. This form has three types of situations (Parts A, B and C) for each short-term and long-term holding period (12 months) — six total different Form 8949s to deal with.

Part A — the good part — is used for cost basis that matches your 1099-B. As the instructions say “transactions reported on Form 1099-B with basis reported to the IRS.” For the 2011 tax return, this includes corporate stock purchased and sold in 2011.

These rules are being phased in, so many cost-basis items are not covered on 1099-Bs until 2012 and 2013. That's where column B is used, as the instructions say for “transactions reported on Form 1099-B but basis not reported to the IRS.” This could include stock purchased prior to 2011 and other non-covered securities in 2011 like options, mutual funds and bonds. Form 8949 instructions also state, “If there are wash sales for items, reported on Part I-A, then you enter that adjustment in column (g) and with W code in (b).”

Taxpayers often disagree with brokers on reporting wash sales, and this can be a challenge to report on Form 8949. Tax software often only allows wash sales reported in this new column if there is a taxable loss. That can be a problem when summary reporting refers to a separate TradeLog report showing a net gain. Expect wash sale adjustments in situations where one broker doesn't recognize a wash sale, which TradeLog may correctly recognize between a second brokerage account and an IRA.

Finally, Part C is for transactions where no Form 1099-B has been issued. This could be the case for a sale of personal assets or a home. We also may use this part for our transfers to Schedule C to allow home-office deductions.

Prior to this tax season, you could just leave the heavy lifting to TradeLog, and simply enter the 1099-B amount to Schedule D to satisfy the IRS. It's a whole different ball game this year — you must do the heavy lifting. TradeLog is working feverishly to issue an update that makes it easier for you, too. Good trade accounting software continues to be a must for active securities traders.

GreenTraderTax has always recommended Section 475 MTM for securities business traders so they could be exempt from wash sales – which represent many of these difficult adjustments to be reported. Some traders have always incorrectly assumed that with Section 475 MTM, they could use summary reporting on Form 4797, stating “details available on request.” They are very wrong — Form 4797 requires line-by-line reporting too.

Plus, leading tax publisher RIA and PPC recommend that Section 475 MTM traders report total proceeds on Form 8949, and then back it out with an adjustment in Part C. While Section 475 MTM traders may be free from the mess of reconciliations on Form 8949, they still should fill out the form to avoid trouble. Its likely IRS computers will work in overdrive to match every individual's Form 1099-B with their individual tax return and a Form 8949. We expect a huge increase in computer tax notices and headache and cost for taxpayers to deal with those notices. Get it right the first time to avoid getting a tax notice.

For more information and examples of dealing with Form 8949, watch our Webinar recording from Feb. 2, 2012.

After facing this nightmare once for tax year 2011, you will want to form an entity for your trading business in 2012 to skip these tax problems and unlock plenty of other tax savings. Entities currently aren't required to file a form 8949; hopefully that continues to be the case for 2012 and subsequent tax years. Like with an individual Schedule C, the IRS turns up the heat on individual taxpayers, thinking they are less sophisticated and more prone to errors, whether inadvertent or purposeful.

Our important transfer strategy for sole proprietor business traders of moving some Schedule D trading gains to Schedule C to unlock home-office deductions and 100% Section 179 depreciation is even more of a red flag in 2011. It must be in that dreaded “Other” column on Form 8949. That's okay, since we explained this transfer in our footnotes in the past anyway — but this year the IRS computers may choke on that more and send a tax notice.

This is not a problem with an entity return. The IRS is also beefing up audits of Schedule Cs and asked many traders to document and justify their trading expenses, too. The IRS audits entities much less. Our entity formation service is excellent and the price is right, so check with us soon.

In the past, we suggested entities for business traders only, since the AGI-deductions (retirement plan and health-insurance premiums) are beneficial with trader tax status. This year, investors may want to consider an entity as well, just to avoid the dreaded Form 8949 accounting and reconciliation mess that individuals face.

Over the past decade, it's become increasingly easy for traders and investors to tap into foreign markets including emerging markets, tax havens and offshore funds. Plus, Americans move around the world for business or personal opportunities and they wind up with foreign accounts and transactions. Plenty of non-resident aliens marry Americans, or move to America becoming greencard holders and U.S. residents, too. Now, the IRS considers this all their business, too!

The Foreign Account Taxpayer Compliance Act (FATCA) is not just about tax reporting by Americans. It's also to pressure foreign banks into divulging their American client information so the IRS can bust both the taxpayer and these foreign banks. Congress has gone on a similar extra-territorial path with Dodd-Frank and new CFTC restrictions for retail American forex trading accounts. The EU is reciprocating and also complaining about FATCA; perhaps a new Congress in 2013 will backtrack, or even this Congress in 2012. Stay tuned.

Oddly, another way to avoid Form 8949 headaches is to use a foreign broker, as they are not subject to these new complex cost-basis reporting rules for U.S. brokers only. But, then you trade in one set of tax compliance headaches for another, the foreign reporting ones which can be more onerous.

We wrote several blogs last year about Report of Foreign Bank and Financial Accounts (FBAR) on Form TD F 90-22.1. We also wrote about the IRS OVDI and OVDP programs, which the IRS recently reopened again (see details below). I blogged about Gov. Romney's tax return — almost half of his 500+ tax forms had to do with foreign reporting. It must have cost him a fortune in tax preparation fees.

Another blogger did a nice job on this topic — see his blog here . He covers Form 8938 in full.

The IRS recently reopened an offshore voluntary disclosure program (OVDP) to allow taxpayers with offshore financial accounts (including brokerage accounts, mutual funds, pension plans and life insurance) or assets to comply with their U.S. federal income tax obligations and foreign account reporting requirements. Because the FATCA will force foreign banks to divulge information regarding their U.S. clients, U.S. taxpayers have a strong incentive to enter the OVDP rather than risk detection by the IRS. Once the IRS has begun an audit of a taxpayer, the taxpayer is no longer eligible to participate in the OVDP.

The new OVDP will be open for an indefinite period, but the IRS could choose to end it at any time.

The new program has no deadline to apply. However, the IRS emphasized that the terms of the new program could change in the future. The IRS stated that, for example, at any time the penalties under the program could be increased.

If you are going to be snagged with Form 8949 adjustments, and or reporting of foreign tax matters, make sure to get a handle on your tax preparation plan sooner rather than later. Don't spring this on your tax preparer at the last minute and it's a huge mistake to hide anything foreign.