Capital Gains Tax Gap:

Requiring Brokers to Report Securities Cost Basis Would Improve Compliance if Related Challenges Are Addressed

GAO-06-603: Published: Jun 13, 2006. Publicly Released: Jun 13, 2006.

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For tax year 2001, the Internal Revenue Service (IRS) estimated a tax gap of at least $11 billion from individual taxpayers misreporting income from capital assets (generally those owned for investment or personal purposes). IRS did not estimate the portion of this gap from securities (e.g., stocks, bonds, and mutual fund capital gains distributions). GAO was asked for information on (1) the extent and types of noncompliance for individual taxpayers that misreport securities capital gains, (2) actions IRS takes to reduce the securities tax gap, and (3) options with the potential to improve taxpayer voluntary compliance and IRS's ability to address noncompliant taxpayers. For estimates of noncompliance, GAO analyzed a probability sample of examination cases for tax year 2001 from the most recent IRS study of individual tax compliance.

GAO estimates that 38 percent of individual taxpayers with securities transactions misreported their capital gains or losses in tax year 2001. A greater estimated percentage of taxpayers misreported gains or losses from securities sales (36 percent) than capital gain distributions from mutual funds (13 percent). This may be because taxpayers must determine the taxable portion of securities sales' income whereas they need only add up their capital gain distributions. Among individual taxpayers who misreported securities sales, roughly two-thirds underreported and roughly one-third overreported. Furthermore, about half of these taxpayers who misreported failed to accurately report the securities' cost, or basis, sometimes because they did not know the basis or failed to adjust the basis appropriately. IRS attempts to reduce the securities' tax gap through enforcement and taxpayer service programs, but challenges limit their impact. Through enforcement programs, IRS contacts taxpayers who may have misreported capital gains or losses and seeks to secure the correct tax amount. IRS also offers services to help taxpayers comply with capital gains tax obligations, such as guidance on how to determine securities' gains and losses. Challenges that limit these programs' impact include the lack of information on basis, which IRS needs to verify most gains and losses, and uncertainty as to whether taxpayers use or understand the guidance. Expanding the information brokers report on securities sales to include adjusted cost basis has the potential to improve taxpayers' compliance and help IRS find noncompliant taxpayers. IRS research shows that taxpayers report their income much more accurately when it is reported to them and IRS. Basis reporting also would reduce taxpayers' burden. For IRS, basis reporting would provide information to verify securities gains or losses and to better target enforcement resources on noncompliant taxpayers. However, basis reporting would raise challenges that would need to be addressed. For instance, brokers would incur costs and burdens--even as taxpayers' costs and burdens decrease somewhat--and many issues would arise about how to calculate adjusted basis, which securities would be covered, and how information would be transferred among brokers. However, industry representatives said that many brokers already provide some basis information to many of their clients and some use an existing system to track and transfer basis and other information about securities. Many of the challenges to implementing basis reporting also could be mitigated. For example, many of the challenges could be addressed by only requiring adjusted basis reporting for future purchases, and by developing consistent rules to be used by all brokers. To the extent that actions to mitigate the challenges to basis reporting delay its implementation or limit coverage to only certain types of securities, the resulting improvements to taxpayers' voluntary reporting compliance would be somewhat constrained.

Status Legend:

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  • Review Pending-GAO has not yet assessed implementation status.
  • Open-Actions to satisfy the intent of the recommendation have not been taken or are being planned, or actions that partially satisfy the intent of the recommendation have been taken.
  • Closed-implemented-Actions that satisfy the intent of the recommendation have been taken.
  • Closed-not implemented-While the intent of the recommendation has not been satisfied, time or circumstances have rendered the recommendation invalid.
    • Review Pending
    • Open
    • Closed - implemented
    • Closed - not implemented

    Matters for Congressional Consideration

    Matter: Congress may wish to direct IRS to work with brokers and related parties to develop rules that seek to mitigate some of the challenges associated with requiring basis reporting.

    Status: Closed - Implemented

    Comments: Congress included a provision requiring brokers to report basis information to IRS and taxpayers in the Emergency Economic Stabilization Act of 2008 (Pub. L. No. 110-343). IRS developed proposed regulations and received comments from brokers in preparing the regulations.

    Matter: Either in connection with requiring basis reporting or separately, Congress may wish to require brokers to report to taxpayers and IRS whether the securities sold were short-term or long-term holdings.

    Status: Closed - Implemented

    Comments: Congress included a provision requiring brokers to report basis information to IRS and taxpayers in the Emergency Economic Stabilization Act of 2008 (Pub. L. No. 110-343). The law also requires brokers to report whether a gain or loss from the sale of a security is short-term or long-term. These provisions take effect on January 1, 2011, and are expected to raise $6.7 billion in revenue through 2018, according to the Joint Committee on Taxation.

    Matter: In order to reduce the capital gains tax gap for securities, Congress may wish to consider requiring brokers to report to both taxpayers and IRS the adjusted basis of securities that taxpayers sell and ensuring that IRS has sufficient regulatory authority to implement the requirement.

    Status: Closed - Implemented

    Comments: Congress included a provision requiring brokers to report basis information to IRS and taxpayers in the Emergency Economic Stabilization Act of 2008 (Pub. L. No. 110-343). The provision generally takes effect on January 1, 2011, and is expected to raise $6.7 billion in revenue through 2018, according to the Joint Committee on Taxation.

    Recommendations for Executive Action

    Recommendation: To assist taxpayers in accurately reporting their capital gains and losses from securities, in the instructions to Schedule D the Commissioner of Internal Revenue should clarify the appropriate use of capital losses to offset capital gains or other income.

    Agency Affected: Department of the Treasury: Internal Revenue Service

    Status: Closed - Implemented

    Comments: IRS's instructions to Schedule D of the individual tax return for 2007 contain a new section that clarifies the appropriate use of capital losses to offset capital gains or other income.

    Recommendation: To assist taxpayers in accurately reporting their capital gains and losses from securities, in the instructions to Schedule D the Commissioner of Internal Revenue should provide guidance on resources available to taxpayers to determine their basis.

    Agency Affected: Department of the Treasury: Internal Revenue Service

    Status: Closed - Implemented

    Comments: IRS's instructions to Schedule D of the individual tax return for 2007 contain a new section explaining that IRS partners with companies that offer accounting software that can help taxpayers track their adjusted basis in securities, and directs taxpayers to IRS's web site for more information.

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