Big Concerns With Botched 1099-Bs and Discrepancies on Form 8949

As the leading CPA firm for preparing income tax returns for active online traders, we are spotting significant discrepancies between 2011 Form 1099-Bs provided by securities brokers – which include cost-basis information for the first time – and trade accounting software results. We have noticed scary differences on almost every file we have reviewed. It's hard to pin point the main area of concern — so far, our CPAs are reporting big differences all across the map and it varies greatly by broker, too.

We're putting tax filings on hold and filing extensions instead to have time to investigate these discrepancies. We expect brokers to issue wide-scale corrected 1099-Bs, and we wouldn't be surprised to see corrections later this year. Hopefully these problems will be resolved in time to file tax returns by the extended due dates (Oct. 15 for individuals and partnerships; Sept. 15 for S-Corps).

Ms. Karen Blumenthal, reporter for the Wall Street Journal, interviewed Robert Green and Darren Neuschwander in her March 10 column: “Dodging a 'Cost Basis' Crisis.” Here's an excerpt: “Try not to rush your return. Investors were supposed to receive the new 1099-Bs by Feb. 15, but a number of firms sought extensions of up to a month to get correct data out to investors. Corrected forms could still arrive in coming weeks. Robert Green, whose accounting firm Green & Co. represents active traders, says he has seen numerous errors and discrepancies between 1099-Bs and his clients' calculations and will be seeking extensions while the differences are sorted out.”

What's the problem?
As we reported previously in Cost-Basis Reporting on IRS Form 8949 Is a Nightmare, the new IRS Form 8949 replaces the Schedule D-1 attachment to Schedule D (Capital Gains and Losses). Taxpayers may no longer enter their securities trades onto Schedule D or D-1. In prior years, brokers just reported proceeds on stocks, so reconciling the total was not a big deal. An options trader had a higher amount since option proceeds were not reported on 1099-Bs.

Ms. Blumenthal points out in her article some valid reasons for discrepancies on Form 8949 such as a taxpayer choosing a different trade-accounting method vs. what his or her broker reported on 1099-B —FIFO vs. specific identification method or average cost basis, for example. But we are noticing much bigger problems than that, and many are not explainable. For example, many brokers botched wash sale reporting.

Wash sales are a big problem. One leading broker reported a $450,000 wash sale loss, but the trader couldn't have lost more than the $50,000, the total she had in her account during the year. The broker's wash sale program must be piling up wash sale loss deferrals without any adjustment or analysis of subsequent positions. Another top broker kept an old wash sale open from earlier in the year, even well after the client fully absorbed that wash sale loss deferral with subsequent capital gains on that same symbol. Another top broker told our software partner that they adjust wash sales to proceeds, when they should be adjusting wash sales to cost basis only. These wash sale errors are ridiculous and will likely result in tax notices.

1099-B reporting errors are wide-scale. Another top broker includes open short sales at year-end in 1099-B proceeds on stock. That was allowed in prior years, but not in 2011.

Brokers are choking on these new cost-basis reporting rules. We need more time to see more 1099-Bs and many brokers haven't even issued 1099-Bs yet. Many brokers requested a 30-day extension from the IRS so traders may not get their 1099-Bs until the end of March or even later. That's just the first 1099-B, too. Traders need time to isolate discrepancies with their own trade accounting and to investigate differences with brokers. You can image these brokers will be swamped with calls and emails, all during the March 15 (S-Corp) and April 15 (individual and partnership) tax deadlines. This is lunacy.

Reconciliations are much harder this year. In 2011, securities traders must reconcile their total and line-by-line trade accounting for securities trades to their 1099-B. The beefed-up and often botched Form 1099-Bs are making this very difficult for many traders. The IRS deputized traders as their accountants to find these expected discrepancies with brokers — choking on the application of these new rules in the first year — and the IRS forces taxpayers to explain all differences. With brokers making a huge mess of the new cost-basis rules, this is quite the task!

Will this undermine your faith in your trade-accounting software? Can you safely file a tax return with large unexplained discrepancies on Form 8949? Won't that significantly increase your chances of a tax exam, or lead to tax notices? What a nightmare.

File an extension
It's such a big problem that our CPA firm Green NFH, LLC decided to put our clients with these unresolved problems on extension by the due date of April 15. We want our clients to formally request corrections from their securities brokers, with our help of course. We want brokers to explain discrepancies, and to correct them when required by the IRS. All tax information documents like 1099-s or W-2s can be corrected and resent to the IRS and the taxpayer. So far, brokers are refusing to correct their 1099-Bs for many of these errors and that further concerns us. We want more time for the IRS, media and customers to pressure brokers into fixing their mess. There's never a rush to file a full tax return by April 15. For decades, many of our clients have filed extensions, as it takes more time to file trader tax returns in the best way possible. In this case, the “early bird will get audited,” so filing later is wiser.

File a valid extension by April 15 using trade accounting software like TradeLog. You automatically then have six months longer to file your full tax return by Oct. 15. That should give you and your broker sufficient time to work through Form 8949 discrepancies and hopefully arrange for corrected 1099-Bs.

A valid extension requires payment of 90 percent of tax liability by April 15. Use “good faith” to calculate or estimate your trading gains and losses and other taxable income. When you file your full tax return by the extended due date and your payment is over 10% of your tax liability, you trigger late-filing penalties (4.5% per month) and late-payment penalties (0.5% per month), plus interest expense. Not filing can trigger penalties of 100% of the balance due. If your tax extension is deemed invalid because you owe over 10 percent of your liability, try to argue that you used “good faith” and seek abatement of penalties from the IRS. It's best to use TradeLog and prepare correct extensions with the payment of 90 percent of your estimated tax liability by April 15.

Don't forget new Section 475 MTM elections are due by April 15, too. Making a Section 475 MTM election could be tricky based on using unreliable tax information. It can affect your decision to file or skip the Section 475 MTM election. Generally, we recommend Section 475 MTM on securities only, providing the business trader doesn't have capital loss carryovers. Traders need capital gains to use up capital loss carryovers, not Section 475 MTM ordinary income. On the other hand, wash sales from 2011 can be converted into Section 475 MTM ordinary losses in 2012 with a MTM election. See our year-end tax planning content and consult a trader tax expert about this election. It's beyond the scope of this blog article.

Section 475 MTM exempts traders from Form 8949 and wash sales, too. GreenTraderTax has recommended Section 475 MTM for securities business traders since Congress opened this door in 1997. It's our claim to fame. All these years, it exempted business traders from wash sale rules – which have always been a pain to understand and apply – and that onerous capital loss limitation of $3,000 against ordinary income. Now, Section 475 MTM also exempts business traders from Form 8949, as Section 475 is reported on Form 4797 Part II ordinary gain or loss.

Entities are exempt from Form 8949, too. Another way to avoid the Form 8949 nightmare is by trading in an entity, with or without trader tax status. The IRS does not currently require entities to use Form 8949. Pass-through entities do receive 1099-Bs, but entities may still report line-by-line securities trades on Schedule D and Schedule D-1 attachments. Entities are very tax beneficial to business traders, unlocking opportunities for retirement plan and health insurance premium AGI deductions. Consider a trading entity soon this year.

Congress and the IRS botched this cost-basis rule
This is a classic case of government trying to fix things, but making them worse, at least in the short run. Congress wanted to “close the tax gap” and the IRS claimed that too many securities traders were making errors on cost-basis reporting and underpaying their capital gains taxes. So, Congress and the IRS enacted the cost-basis reporting rules in 2008, allowing brokers to begin a three-year phase-in. Most would think that was plenty of time, but apparently it was not. Plus, the rules seem to be poorly designed. Even after full phase-in, many instruments are still not “covered” on 1099-Bs, and trade accounting will continue to have large discrepancies with 1099-Bs. Hopefully they can be easily explained in 2013.

Should the IRS hold tax notices or even retract Form 8949? Why didn't the IRS hold off on Form 8949 until 2013, after the cost-basis reporting rules fully phase in? Why ask taxpayers to reconcile a much bigger difference in 2011 than will be required in 2013? Isn't it unfair and outrageous if the IRS sends tens of thousands of tax notices from Form 8949 discrepancies? Imagine having to endure a protracted IRS exam with the agent tracing every single confirmation and more. I hope the taxpayer advocate gets involved here and this fiasco is put on hold.

Further help may be on the way
The AICPA recognized this wide-scale problem with IRS cost-basis reporting rules and it recently formed a new task force to tackle the problem. Kudos to my partner Darren Neuschwander, CPA: The AICPA invited him to join this task force, and they have their first meeting very soon. Mr. Neuschwander was also on the AICPA committee for dealing with the IRS on its cost-basis reporting rules. By Robert A. Green, CPA and founder of Green & Company Inc. (GreenTraderTax.com and GreenTraderFunds.com)