Wash Sale Computations May Vary from Broker to Broker

WALL STREET CONCEPTS

WSC BRIEFING Wash Sale Computations May Vary from Broker to Broker − The IRS has Strictly Interpreted its Look Back Rules Except in the Case of Looking Back to the ‘Same Lot’ − Pre-existing Inventory is Eligible to Function as Wash Sale Replacement Shares According to IRS Guidance

June 26, 2013

Wash Sale Computations May Vary from Broker to Broker Issue: Strict Interpretation vs. Inventory Reduction The Wash Sale regulations issued under Internal Revenue Code Section 1091 and the subsequent Revenue Ruling 1 guidance provided by the Internal Revenue Service have caused debate about the applicability of the rule in certain scenarios. As a result, different brokerage firms may treat the same trading fact pattern in different ways. This briefing discusses the differing views (strict interpretation vs. inventory reduction) on whether a wash sale exists when Replacement Shares are acquired earlier than the Original Shares, the disposal of which created the Disallowed Loss.

Summary •

Conflicting views on wash sales with regard to Replacement Shares.

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Therefore, brokerage firms may treat similar trades differently.

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Firms should consult their tax advisors on how best to handle these transactions as the popular view that pre-existing inventory should not function as replacement shares appears to be in direct conflict with IRS guidance.

Client Impact Transferring customers may take exception to practices that differ from their prior broker. Customer reliance on a broker’s approach may lead to IRS adjustment.

Background The Basis Reporting rules require brokers to report wash sales on identical securities (same CUSIP or other identifier) in the same account. This requires brokers to roll up a Disallowed Loss into Replacement Shares and tack on the Holding Period of the Original Shares.

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Revenue Rulings: Revenue Rulings include rulings to taxpayers, technical advice to district offices, studies undertaken by the IRS, court decisions, suggestions from practitioner groups, and so on. They are written determinations which address issues of substantive tax law within the Internal Revenue Code, related statutes, tax treaties and regulations. They are official interpretations of the law as applied to a specific set of facts and generally are binding on revenue agents and other IRS officials. Revenue Rulings are selected for publication in the Internal Revenue Bulletin because of their potential interest to the general public

SunGard | Wall Street Concepts | CONFIDENTIAL | June 26, 2013

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Wash Sale Computations May Vary from Broker to Broker

Historically, broker reporting of wash sales was an accommodation and not a legal requirement. As such, the reporting was often limited in the scope of securities covered and its accuracy was the subject of a disclaimer. Now that brokers are legally required to report wash sale information for covered securities, questions have arisen as to just what is “accurate” under Code Section 1091, and the regulations promulgated thereunder. Issues have arisen as to what actually constitutes a wash sale and what shares can be considered replacement shares. With many market participants believing there are no clear answers to these questions, brokers are faced with the difficult choice of interpreting IRS regulations in a manner that may favor the taxpayer over the IRS, or vice versa, while their legal reporting obligation is simply to apply the Wash Sale rule correctly.

Discussion Differences that can arise between brokers’ wash sale reporting are often a product of how a Basis Tracking System views Replacement Shares that were purchased prior to the date of sale of the shares they are replacing. The debate centers around whether the shares are to be considered part of pre-existing inventory, or a tax lot that was purchased to replace the Original Shares. There is general consensus that shares acquired after the acquisition date of those that were sold, whether before the sale or not, are subject to the Wash Sale rule. However, as a result of the use of specific identification, shares that were acquired within the Wash Sale window before the acquisition of those that were sold are the subject of differing viewpoints.

Inventory Reduction View In Revenue Ruling 56-602, the IRS held “that the deduction of a loss sustained on the sale of a portion of the shares of stock purchased in one lot by the taxpayer less than 30 days before the sale will not be disallowed by reason of the provisions of section 1091 of the Code merely because the taxpayer acquired in the original purchase more shares than he later sold.” This statement is cited by those promoting the inventory reduction view as establishing the concept that a reduction to inventory which was acquired concurrent with or earlier than the Original Shares should not create a wash sale. The reasoning is if the IRS takes the position reducing part of the same tax lot is a reduction in inventory, then shares that were held prior to those sold, are also a part of inventory and should not be considered Replacement Shares. To further bolster the view of inventory treatment, proponents point to the fact pattern of a taxpayer owning 2 lots of a security, one purchased earlier than the Wash Sale window and the other purchased within the window, and that the use of specific identification would negate the Wash Sale rule, provided the more recently acquired tax lot was the one identified as being sold. They do not believe the acquisition date of pre-existing inventory (before or within the window) should differentiate the tax treatment of transactions when the transactions arrive at the same outcome – a real reduction in taxpayer inventory.

SunGard | Wall Street Concepts | CONFIDENTIAL | June 26, 2013

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Wash Sale Computations May Vary from Broker to Broker

Strict Interpretation While the inventory approach seems logical, it is not in agreement with the strict interpretation of Revenue Rulings 56-602 and 71-316. Immediately after RR 56-602 carves out the exception for shares of the same tax lot, it states “However, the deduction will be disallowed if the taxpayer, in another transaction occurring within the period beginning 30 days before the date of the sale and ending 30 days after such date, has acquired … additional substantially identical stock or securities.” By noting that the transaction for Replacement Shares can occur within 30 days before the sale, this would seem to include inventory purchased anytime within the 30 day window, including before the purchase of shares that were sold. However, the use of the word ‘additional’ may have added to taxpayer uncertainty in that if shares were already owned then they cannot be ‘additional’ acquired shares. However, RR 71-316, in its findings that a sale of stock purchased on margin is still a sale and subject to the Wash Sale rule, confirms that shares purchased prior to those sold will be considered part of a wash sale and not exempted as inventory. The example used in that ruling is as follows: “On July 1, 1970, a taxpayer purchased 100 shares of M company stock for cash. On July 15, 1970, the taxpayer purchased 100 shares of M company stock on margin. On July 29, 1970, he sold the 100 shares of M company stock purchased on margin at a loss. Section 1091 of the Code precludes the taxpayer from deducting the loss since he acquired substantially identical stock within a period beginning 30 days before the date of the sale resulting in a loss.” This example clearly indicates that even using specific identification to select a tax lot will not avoid the Wash Sale rule. Some commentators dismiss this example, citing that the ruling’s focus was on margin securities and the example was not meant for any other purpose, or was just an incorrect application of the rule.

Interpretations in Practice In the table below, 3 similar scenarios are illustrated. In each case, the investor has an inventory of 500 shares on 4/15/12 and sells 100 shares at a loss. In one case the loss is disallowed, while in the other two the loss is permitted, but for different reasons. Scenario 1 Transactions

Result

Comment

3/1/12

Scenario 2

Scenario 3

Buy 400

3/27/12 Buy 400

4/15/12 Buy 100

4/15/12 Buy 100

4/25/12 Sell 100

4/25/12 Sell 100

4/25/12 Sell 100

The lot acquired on 4/15 is sold at a loss. The loss may be recognized.

The lot acquired on 4/15 is sold at a loss. The loss is disallowed.

A portion of the lot acquired on 4/15 is sold at a loss. The loss may be recognized.

The 3/1/12 acquisition is outside the wash sale window.

The 3/27/12 acquisition is within the wash sale window

The partial sale of the lot acquired on 4/15/12 is considered an inventory reduction.

SunGard | Wall Street Concepts | CONFIDENTIAL | June 26, 2013

4/15/12 Buy 500

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Wash Sale Computations May Vary from Broker to Broker

Congressional Intent The consideration of both views is further complicated by some references in RR56-602 to congressional intent. Specifically, the IRS cited congress’s consistent use of words such as "new acquisition," "repurchasing" and "buying back" shares of stock found in the congressional record. They noted that these terms indicated an “intent to prevent taxpayers taking losses for tax purposes while giving up a security position for only a few days or not at all”, not an intent to “disallow a loss sustained in a bona fide sale of securities made to reduce the taxpayer's holdings.”

Conclusion Despite the backdrop of congressional intent, the IRS has indicated that its understanding of the Wash Sale rule does not include the inventory approach beyond shares acquired in the same tax lot. Thus, while the inventory view may be a popularly supported position, it appears to be outside of the actual guidance the IRS has twice offered in revenue rulings. When considering the proper approach for handling such transactions in a Basis Tracking System, a firm should consult its tax advisors as to the latest guidance in this area and how best to apply it to wash sales.

References and Citations •

Sec. 1091: Loss from wash sales of stock or securities

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26 CFR 1.1091-1: Loss from wash sales of stock or securities

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RR 56-602

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RR 71-316

SunGard | Wall Street Concepts | CONFIDENTIAL | June 26, 2013

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SunGard | Wall Street Concepts | CONFIDENTIAL | January 31, 2013

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