Final regs address basis and character reporting rules for securities acquired after 2010–Part II Preamble to TD 9504, 10/12/2010 ; Reg. § 1.408-7 , Reg. § 1.1012-1 , Reg. § 1.6039-2 , Reg. § 1.6042-4 , Reg. § 1.6044-5 , Reg. § 1.6045-1 , Reg. § 1.6045-2 , Reg. § 1.6045-3 , Reg. § 1.6045-4 , Reg. § 1.6045-5 , Reg. § 1.6045A-1 , Reg. § 1.6045B-1 , Reg. § 1.6049-6 , Reg. § 31.6051-4 , Reg. § 301.6721-1 , Reg. § 301.6722-1 IRS has issued final regs explaining the complex basis and character reporting requirements for most stock acquired after 2010, for shares in a regulated investment company (RIC, i.e., a mutual fund) or stock acquired in connection with a dividend reinvestment plan (DRP) after 2011, and other specified securities acquired after 2012. This article, covering the abolition of the double category method for determining RIC shares' basis, DRPs, and reporting of sales by S corporations, is the second installment of a multi-part article on these complex new final regs. For Part I, covering the statutory background, broker returns, share identification and determining basis that has to be reported, see ¶ 2 . Double-Category Method for Determining Basis of RIC Shares Abolished Under pre-existing regs, where a taxpayer can adequately identify which shares of stock, or which bonds, are transferred, the basis used is the basis of that stock or those bonds. If the shares sold can't be adequately identified, a first-in, first-out (FIFO) rule applies. However, a taxpayer who sells RIC shares held by a custodian or agent may elect to determine the basis of the shares sold by determining the average basis of the shares on either a “single-category method” or a “double-category method.” Generally, the single-category method groups in one category all shares regardless of holding period; the double-category method divides all shares by their holding period. The basis is then averaged over all the shares in their respective category. A shareholder who doesn't elect either of the above methods uses the normal FIFO method for determining which shares were sold. The final regs retain the general rule for determining basis for shares sold ( Reg. § 1.1012-1(c)(1) , retain the election for holders of RIC shares to elect to use the average basis method, and extend the average basis method to shares of stock acquired after Dec. 31, 2010, in connection with a DRP. ( Reg. § 1.1012-1(e)(1)(i) ) However, the final regs eliminate the double-category method previously available for RIC stock and provide that the taxpayer may use the average basis method (i.e., the “single category method”) for RIC stock (or shares of stock acquired after Dec. 31, 2010, in connection with a DRP). Basis is computed by averaging the basis of all identical stock in an account regardless of holding period. ( Reg. § 1.1012(-1e)(1) , Reg. § 1.1012(-1e)(7) ) Under a transition rule, a taxpayer using the double-category method for stock he acquired before Apr. 1, 2011, and that he sells, exchanges, or otherwise disposes of on or after that date, must calculate the average basis of this stock by averaging together all identical shares of stock in the account on April 1, 2011, regardless of holding period. ( Reg. § 1.1012-1(e)(7)(iii) ) Ordering rules specify that the holding period of stock to which the average basis method applies is determined on a FIFO basis. Thus, the first shares sold or transferred are those with a holding period of more than 1 year (long-term shares) to the extent that the account contains long-term shares. If the number of shares sold or transferred exceeds the number of long-term shares in the account, the excess shares sold or transferred are treated as shares with a holding period of 1 year or less (short-term shares). ( Reg. § 1.1012-1(e)(7)(ii) ) Illustration 1: If a taxpayer sells 50 shares from an account containing 100 long-term shares and 100 short-term shares, the shares sold or transferred are all long-term shares. If, however, the account contains 40 long-term shares and 100 short-term shares, the taxpayer has sold 40 long-term shares and 10 short-term shares. ( Reg. § 1.1012-1(e)(7)(ii) ) RIA illustration 2: Dan buys shares of LCO mutual fund on the following dates and at the following total cost: Jan. 8, 2012, 25 shares, $200; Feb. 8, 2012, 24 shares, $200; Mar. 8, 2012, 20 shares, $200. At Dan's direction, 40 shares from the account are sold on Jan. 15, 2013, for $10 per share or a total of $400. Dan uses the average basis method for LCO shares. The average basis for the shares sold on Jan. 15, 2013, is $8.70 ($600 total cost of shares × the total number of shares of 69). The shares sold are the shares first acquired. Thus, Dan realizes $32.50 (($10 − $8.70) × 25) long-term capital gain for the 25 shares acquired on Jan. 8, 2012, and $19.50 (($10 − $8.70) × 15) short-term capital gain for 15 of the shares acquired on Feb. 8, 2012. A taxpayer elects to use the average basis method by notifying the custodian or agent in writing by any reasonable means, including writing by any electronic format. The taxpayer may make the average basis method election at any time, effective for sales or other dispositions of stock occurring after the taxpayer notifies the custodian or agent. The taxpayer makes the election separately for each account holding stock for which the average basis method is allowed. ( Reg. § 1.1012-1(e)(9)(i) ) Generally, a taxpayer may revoke an average basis method election by the earlier of one year after he makes the election or the date of the first sale or other disposition of that stock following the election. A revocation applies to all stock the taxpayer holds in an account that is identical to the shares of stock for which the taxpayer revokes the election. After revocation, the taxpayer's basis in the shares of stock to which the revocation applies is the basis before averaging. ( Reg. § 1.1012-1(e)(9)(iii) ) Dividend Reinvestment Plans (DRPs) A DRP is defined to include a written arrangement, plan, or program administered by an issuer or non-issuer of stock. A plan is a DRP if the plan documents require that at least 10% of any dividend paid be reinvested in identical stock. If this 10% requirement is met, a plan may reinvest different percentages of dividends in different stocks. Additionally, stock may be held in a DRP even if no dividends have ever been declared or paid or the issuer has ceased paying dividends. ( Reg. § 1.1012-1(e)(6)(i) ) Stock acquired in connection with a DRP. Stock is treated as acquired in connection with a DRP if the stock is acquired under the DRP or the dividends paid are subject to the DRP. Stock acquired in connection with a DRP includes: the initial purchase of stock in the DRP; subsequent transfers of identical stock into the DRP; additional periodic purchases of identical stock through the DRP; and identical stock acquired through reinvestment of dividends paid under the DRP. ( Reg. § 1.1012-1(e)(6)(ii) ) If a taxpayer withdraws stock from a DRP or the plan administrator terminates the DRP, shares of identical stock acquired after the withdrawal or termination are not treated as acquired in connection with a DRP. After the withdrawal or termination, the taxpayer may no longer use the average basis method for the stock, but the basis of each share of stock immediately after the change would be the same as the basis immediately before the change. ( Reg. § 1.1012-1(e)(6)(iv) ) Reporting of Sales by S Corporations Under current rules, a broker doesn't have to report sales of securities by corporations. A broker may treat a customer as a corporation if the broker has actual knowledge that the customer is a corporation, if the customer files a Form W-9, “Request for Taxpayer Identification Number and Certification,” exemption certificate claiming an exemption as a corporation, or, absent knowledge to the contrary, if the name of the customer contains an unambiguous expression of corporate status such as “Corporation” or “Incorporated” (the so-called “eyeball test”). To comply with the Code Sec. 6045(g)(4) requirement that brokers report sales by customers that are S corporations of covered securities acquired on or after Jan. 1, 2012, S corporations are excluded under the regs from the list of exempt Form 1099-B recipients, but only for sales of covered securities acquired by an S corporation on or after Jan. 1, 2012. ( Reg. § 1.6045-1(c)(3)(i)(B)(1) ) The regs also curtail the ability of brokers to rely solely on the name of the customer (the “eyeball test”) to determine whether the customer is a corporation exempt from reporting, but only for sales of covered securities acquired on or after Jan. 1, 2012. However, the final regs retain a limited eyeball test for insurance companies and foreign corporations, because insurance companies and foreign corporations are ineligible to be S corporations. ( Reg. § 1.6045-1(c)(3)(i)(C)(2) , Preamble to TD 9504, 10/12/2010 ) Effective date. The regs on broker basis reporting basis and whether any gain or loss on a sale is long-term or short-term under Code Sec. 6045(g) apply to: (1) any share of stock other than RIC stock or DRP stock acquired on or after Jan. 1, 2011; and (2) any share of RIC stock or DRP stock acquired on or after Jan. 1, 2012. Regs on the timing for reporting short sales of securities under Code Sec. 6045 apply to short sales opened on or after Jan. 1, 2011. The regs regarding the determination of basis under Code Sec. 1012 generally apply for tax years beginning after Oct. 18, 2010, but the rules in Reg. § 1.1012-1(e)(1)(i) (election to use average basis method) in part, apply to stock acquired on or after Jan. 1, 2011, the rules in Reg. § 1.1012-1(e)(2) (determination of basis method) apply to stock acquired on or after Jan. 1, 2012, the rules in Reg. § 1.1012-1(e)(7)(iii) (transition rules for certain RIC stock) apply for stock acquired before, and sold, exchanged, or disposed of on or after Apr. 1, 2011, and portions of the rules in Reg. § 1.1012-1(e)(7)(i) (computation of average basis), Reg. § 1.1012-1(e)(9) (time for making average basis election), and Reg. § 1.1012-1(e)(10) (application of average basis method account by account), apply to sales, exchanges, or other dispositions of stock on or after Jan. 1, 2012. Regs regarding transfer statement reporting under Code Sec. 6045A apply to: (1) transfers of on-RIC stock on or after Jan. 1, 2011; and (2) transfers of RIC stock on or after Jan. 1, 2012. Regs on issuer reporting under Code Sec. 6045B apply to: (1) organizational actions affecting basis of stock in an entity organized as, or treated for federal tax purposes as, a corporation (foreign or domestic) other than RIC stock on or after Jan. 1, 2011; and (2) organizational actions affecting basis of RIC stock on or after Jan. 1, 2012. EXP ¶10,124.7701 Basis of securities sold, disposed of, or exchanged starting Jan. 1, 2011—account-by-account basis. In the case of the sale, exchange, or other disposition of a “specified security” on or after the “applicable date” (see below under Specified security and applicable date defined and ¶60,451.00029 ), the conventions prescribed by regulations under Code Sec. 1012 (see ¶10,124.77 , ¶10,124.7801 , and ¶10,124.79 ) will be applied on an account-by-account basis. Code Sec. 1012(c)(1) as amended by Sec. 403(b)(3)DivB, PL 110-343, 10/3/2008 . Thus, the conventions prescribed by regs under Code Sec. 1012 for determining adjusted basis (the first-in, first-out (FIFO) (see ¶10,124.77 ), specific-identification (see ¶10,124.79 ), and average-cost conventions (see ¶10,124.7801 )) will apply on an account-by-account basis. Under this rule, for example, if a customer holds shares of the same specified security in accounts with different brokers, each broker makes its adjusted basis determinations by reference only to the shares held in the account with that broker, and only shares in the account from which the sale is made can be identified as the shares sold. Joint Comm Staff, Tech Expln of H.R. 7060, “The Renewable Energy and Job Creation Tax Act of 2008”—(i.e. A Predecessor Bill to H.R. 1424) (JCX-75-08), 9/25/2008, p. 135, see ¶60,451.00029 . For brokers' information reporting requirements for customers' basis in securities transactions, see ¶60,451.00029 . Separate-account treatment of stock for which average-basis method is allowed. Except as provided in the election below, any stock for which an average-basis method is permissible under Code Sec. 1012 (see ¶10,124.7801 ) which is acquired before Jan. 1, 2012, will be treated as a separate account from any stock acquired on or after Jan. 1, 2012. Code Sec. 1012(c)(2)(A) as amended by Sec. 403(b)(3)DivB, PL 110-343, 10/3/2008 . Thus, unless the election below applies, any stock for which an average-basis method is permissible under Code Sec. 1012 (see ¶10,124.7801 ) which is acquired before Jan. 1, 2012 will be treated as a separate account from any of that stock acquired on or after that date. Joint Comm Staff, Tech Expln of H.R. 7060, “The Renewable Energy and Job Creation Tax Act of 2008”—(i.e. A Predecessor Bill to H.R. 1424) (JCX-75-08), 9/25/2008, p. 135, see ¶60,451.00029 . Consequently, if adjusted basis is being determined using an average-basis method, average basis will be computed without regard to any stock acquired before Jan. 1, 2012. Thus, the adjusted basis of any security other than stock for which an average-basis method is permissible under Code Sec. 1012 (i.e., regulated investment company (RIC) shares) will be determined under the first-in, first-out (FIFO) method (see ¶10,124.77 ) unless the customer notifies the broker by making an adequate identification (under the rules of Code Sec. 1012 for specific identification, see ¶10,124.79 ) of the stock sold or transferred. Joint Comm Staff, Tech Expln of H.R. 7060, “The Renewable Energy and Job Creation Tax Act of 2008”—(i.e. A Predecessor Bill to H.R. 1424) (JCX-75-08), 9/25/2008, p. 135, see ¶60,451.00029 . The adjusted basis of stock for which an average-basis method is permissible under Code Sec. 1012 (see ¶10,124.7801 ) is determined in accordance with the broker's default method under Code Sec. 1012 (i.e., the FIFO (see ¶10,124.77 ), average-cost (see ¶10,124.7801 ), or specific-identification method (see ¶10,124.79 )) unless the customer notifies the broker that the customer elects another permitted method. This notification is made separately for each account in which stock for which the average-cost method is permissible is held and, once made, applies to all stock held in that account. As a result of this rule, a broker's basis computation method used for stock held in one account with that broker can differ from the basis computation method used for stock held in another account with that broker. Joint Comm Staff, Tech Expln of H.R. 7060, “The Renewable Energy and Job Creation Tax Act of 2008”—(i.e. A Predecessor Bill to H.R. 1424) (JCX-75-08), 9/25/2008, p. 135, see ¶60,451.00029 . OBSERVATION: Thus, the basis of mutual fund stock acquired before Jan. 1, 2012 can be reported using any acceptable method (i.e., FIFO, specific identification, average cost). The basis of mutual fund stock acquired after Dec. 31, 2011 will be reported using the broker's default method for computing basis, unless the customer notifies the broker that the customer has elected another acceptable method. If a fund subject to the above rule elects to have Code Sec. 1012(c)(2)(B) apply with respect to one or more of its stockholders: (1) Code Sec. 1012(c)(2)(A) (discussed above) (treating any stock in a fund acquired before Jan. 1, 2012 as a separate account) won't apply to any stock in a fund held by the stockholders, and ( Code Sec. 1012(c)(2)(B)(i) as amended by Sec. 403(b)(3)DivB, PL 110-343, 10/3/2008 ) (2) all stock in the fund held by the stockholders will be treated as covered securities described in Code Sec. 6045(g)(3) (see ¶60,451.00029 ) without regard to the date the stock was acquired. Code Sec. 1012(c)(2)(B)(ii) as amended by Sec. 403(b)(3)DivB, PL 110-343, 10/3/2008 . Thus, a RIC will be able to elect (at the time and in the form and manner prescribed by IRS), on a stockholder-by-stockholder basis, to treat as covered securities (defined in ¶60,451.00029 ) all stock in the company held by the stockholder without regard to when the stock was acquired. When this election applies, the average basis of a customer's RIC stock will be determined by taking into account shares of stock acquired before, on, and after Jan. 1, 2012. Joint Comm Staff, Tech Expln of H.R. 7060, “The Renewable Energy and Job Creation Tax Act of 2008”—(i.e. A Predecessor Bill to H.R. 1424) (JCX-75-08), 9/25/2008, p. 135, see ¶60,451.00029 . Rules similar to those in the election above will apply to a broker holding stock in a fund as a nominee. Code Sec. 1012(c)(2)(B) as amended by Sec. 403(b)(3)DivB, PL 110-343, 10/3/2008 . Thus, a similar election will be allowed for any broker holding stock in a RIC as a nominee of the beneficial owner of the stock. Joint Comm Staff, Tech Expln of H.R. 7060, “The Renewable Energy and Job Creation Tax Act of 2008”—(i.e. A Predecessor Bill to H.R. 1424) (JCX-75-08), 9/25/2008, p. 135, see ¶60,451.00029 . “Specified security” and “applicable date” defined. For tax years beginning after Dec. 31, 2010 ( Sec. 403(e)(1)DivB, PL 110-343, 10/3/2008 ), the terms “specified security” and “applicable date” have the meaning given those terms in Code Sec. 6045(g) (see ¶60,451.00029 ). Code Sec. 1012(c)(3) as amended by Sec. 403(b)(3)DivB, PL 110-343, 10/3/2008 . Special rules for dividend reinvestment plans. For stock acquired after Dec. 31, 2010, in connection with a dividend reinvestment plan (defined below), the basis of the stock while held as part of the plan will be determined using one of the methods which can be used for determining the basis of stock in an open-end fund. Code Sec. 1012(d)(1) as amended by Sec. 403(b)(3)DivB, PL 110-343, 10/3/2008 . OBSERVATION: The language above provides, “using one of the methods which can be used for determining the basis of stock in an open-end fund,” but Code Sec. 1012(c)(2)(B) only provides methods for a “fund” (see above under Separate-account treatment of stock for which average-basis method is allowed ). Presumably, Congress meant to say, “using one of the methods which can be used for determining the basis of stock in a fund,” and will correct the language in Code Sec. 1012(d)(1) in a technical or clerical correction in future legislation. If stock held in a dividend reinvestment plan is transferred to another account also held in a dividend reinvestment plan, the transferred stock will have a cost basis in the other account equal to its basis in the dividend reinvestment plan immediately before the transfer (properly adjusted for any fees or other charges taken into account in connection with the transfer). Code Sec. 1012(d)(2) as amended by Sec. 403(b)(3)DivB, PL 110-343, 10/3/2008 . Rules similar to the rules of Code Sec. 1012(c)(2) (see above under Separate-account treatment of stock for which average-basis method is allowed) will apply to dividend reinvestment plans. Code Sec. 1012(d)(3) as amended by Sec. 403(b)(3)DivB, PL 110-343, 10/3/2008 . OBSERVATION: Presumably, therefore, any stock in a dividend reinvestment plan acquired before Jan. 1, 2012, will be treated as a separate account from any stock acquired on or after Jan. 1, 2012. But, if a dividend reinvestment plan elects to have Code Sec. 1012(c)(2)(B) (see above under Separate-account treatment of stock for which average-basis method is allowed) apply with respect to one or more of its stockholders: (1) Code Sec. 1012(c)(2)(A) (see above under Separate-account treatment of stock for which average-basis method is allowed) (treating any stock in a dividend reinvestment plan acquired before Jan. 1, 2012 as a separate account) won't apply to any stock in a dividend reinvestment plan held by the stockholders, and (2) all stock in the plan held by the stockholders will be treated as covered securities described in Code Sec. 6045(g)(3) (see ¶60,451.00029 ) without regard to the date the stock was acquired. Rules similar to those in (1) and (2) above will also apply to a broker holding stock in a dividend reinvestment plan as a nominee. Code Sec. 1012(d)(3) as amended by Sec. 403(b)(3)DivB, PL 110-343, 10/3/2008 ; Code Sec. 1012(c)(2) as amended by Sec. 403(b)(3)DivB, PL 110-343, 10/3/2008 . OBSERVATION: Thus, a dividend reinvestment plan will be able to make the election not only for its stockholders, but also for a broker holding stock in the plan as a nominee. The term “dividend reinvestment plan” means any arrangement under which dividends on any stock are reinvested in stock identical to the stock with respect to which the dividends were paid. Code Sec. 1012(d)(4)(A) as amended by Sec. 403(b)(3)DivB, PL 110-343, 10/3/2008 . Stock will be treated as acquired in connection with a dividend reinvestment plan if the stock is acquired under the plan or if the dividends paid on the stock are subject to the plan. Code Sec. 1012(d)(4)(B) as amended by Sec. 403(b)(3)DivB, PL 110-343, 10/3/2008 .