M E M O R A N D U M

June 28, 2011


TO: Distribution

FROM: Burt, Staples & Maner, LLP

RE: Average Basis Creates "Revocation" and "Change" Issues

The IRS is considering a change to the cost basis regulations that may require brokers to alter the way they handle customer requests to stop calculating basis by averaging. The average basis rules do not go into effect until next year, but brokers should consider what impact this change will have on their existing and planned systems and procedures.

Last week the IRS released Notice 2011-56, which states that the IRS is considering several changes to the final regulations. The possible average basis change concerns the effect of the broker’s “default” method. Every broker can choose whether regulated investment company (“RIC”) and dividend reinvestment plan (“DRP”) stock should be accounted for on an average basis or separate basis by default. The customer has the right to countermand the broker’s default method.

Under the final regulations, if the broker’s default method is average basis, a taxpayer who tacitly accepts that method is not considered to have made an “election” to use that method, and therefore cannot “revoke” that election, but can “change” to the separate basis method. The consequences of a “revocation” and a “change” are different: a valid revocation retroactively restores the separate cost of the shares, while a “change” is prospective only, and the basis of the shares going forward is the basis of those shares immediately before the change (i.e., as averaged). Thus, taxpayers who default into the average basis method and do not immediately notify their brokers that they wish to change to the separate basis method would have no way under the final regulations to restore the separate cost of any shares purchased through or transferred into their accounts. Taxpayers who affirmatively elect average basis, on the other hand, would be able to retroactively restore separate basis by timely revoking their elections.

Notice 2011-56 states that the IRS expects to allow taxpayers who default into average basis to have the same ability to restore separate basis, provided they inform the broker within one year (or longer, if the broker permits) of receiving notice of the broker’s default method and before the first sale, transfer or other disposition of the shares subject to the average basis method.

The IRS states that the broker’s notice “must identify the securities subject to the broker’s default average basis method.” The IRS has informally said its intention is that – unless a customer instructs a broker to opt an account out of average basis in its entirety – every time the customer makes an initial purchase of a specific RIC or DRP security, the customer would receive a notice explaining how to revert back to separate cost for that issue. Brokers possibly could provide the notice on the purchase confirmation or in an e-mail. This would seem to create a new requirement to keep track of the first purchase of specific RIC and DRP shares in a particular account, as well as the date of the relevant broker’s notice and whether there have been any sales, transfers or other dispositions of the shares of that issue. Otherwise, should a customer request a change in basis calculation method, the broker would not be able to determine whether to restore the separate basis of the shares. In addition, by putting the choice of basis calculation method in front of the customer more frequently, this new requirement may result in more customers opting out of the broker’s default method.

Notice 2011-56 proposes two additional technical changes. First, the final regulations mandate that a DRP require shareholders to reinvest at least 10% of dividends in identical stock. The IRS expects to clarify that a DRP does not fail this test if it pays cash when the amount of the dividend is too small to buy a full share. Second, the final regulations do not specify whether first-in, first-out or other lot selection methods that may be chosen by the customer apply on an account-by-account basis or to the customer’s holdings with the broker as a whole. The IRS expects to clarify that lot selection is an account-by-account determination.

Of the proposed changes, the most challenging for brokers is likely to be the “revocation” of the broker’s default method. Brokers should consider submitting comments to the IRS regarding the mechanics and system requirements relating to average basis elections, revocations and changes so the IRS can take those considerations into account in drafting the regulations.

 

 

   
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