Coping with cost basis: A framework for the managed solutions industry

In the managed accounts industry, investment managers often track gains and losses for client accounts. However, they are not required to report this information to the Internal Revenue Service, and typically do not share it with the client. Historically, issuers of 1099s, including broker-dealers, have reported only the gross proceeds from the sale of securities.

Under the impending cost basis reporting law, a provision of the Emergency Economic Stabilization Act of 2008, broker-dealers and custodians will be obligated to report the cost basis for all covered securities and to indicate if they were short- or long-term gains or losses.

Consequently, managed account sponsors must have the necessary technology in place to do native tax lot accounting in their custodial systems. And custodians as well as broker-dealers have invested untold sums upgrading their accounting and portfolio systems to comply with the imminent regulation.

Among the changes on the horizon, sponsors will now need to close open tax lots as trades are booked. But while the brunt of responsibility falls on brokers and custodians to comply with the new law, operational interaction between managed account sponsors and investment managers may also be affected by the requirement to maintain cost basis information for client accounts.

A unique selling proposition for managed accounts is the ability for the investor to control his investment's tax liability. For example, when he opens a managed account, the client is not exposed to potential unearned capital gains as would be the case with a mutual fund investment. Also, because it is a separately managed account, the investor owns all the securities and can raise gains and losses at any time to minimize tax impact for the year, a process called tax harvesting.

For example, if in the course of the year, the trading trend is positive and the manager realizes $20,000 in gains, the advisor will look for an equal amount of unrealized losses and may direct the manager to raise losses in the account to offset the anticipated gains. This kind of control has material impact.

In addition to tax harvesting, there are many situations where the client may direct a manager, as part of maintaining the account, to do something specific regarding the securities in the account, such as raise cash for a distribution from the account or terminate management of the account with partial or full liquidation of its holdings. In all cases, the portfolio manager picks the positions to sell.

Agreement between sponsor and manager on how tax lots are closed is necessary so that client-specific instructions from the sponsor to the manager that involve the sale of securities are handled as expected. The types of instructions that involve securities where cost basis information may be required include:

New account opening (when the account is funded with securities)
Distribution of cash (when securities must be sold to raise cash)
Distribution of securities
Tax harvesting
Termination (when a partial liquidation of account holdings is requested)

Cost basis and tax lot information will be stored on the custodian platform, but the new law does not require the manager to store this information on its portfolio management system. In fact, so-called “un-shadowed” SMA managers do not maintain records of client holdings at all.
But for the majority of managers who use shadow holdings information to make investment decisions, it will be necessary to agree with sponsors on how tax lot information is communicated, and how lots are closed when trades are booked.

We recommend the implementation of a four-level scheme under which managers and sponsors can agree on the sharing of tax lot information. The four levels represent progressively tighter integration between the sponsor’s custodial systems (which must be in compliance with the new law) and the managers’ accounting and portfolio management systems (which need not be compliant).

Level 1 – The manager doesn’t receive any cost basis information from the sponsor. When sending trades, the manager communicates at position level only, and doesn’t include lot composition. When the manager does trade, the sponsor closes the trade lot based on a standing policy relative to the client’s account. This approach is less work for the IM, but it is possible that certain instructions (particularly tax harvesting) will not be implemented the way the advisor expected.
Level 2 – The sponsor provides the manager with cost basis and tax lot information. The advisor can now instruct the manager which specific lots to sell or deliver when submitting client requests.
Level 3 – The sponsor provides the manager with cost basis and lot information, and sponsor and manager agree upon a “selling rule” for the client account (e.g. FIFO, LIFO, greatest gain, greatest loss). This approach provides further direction to the investment manager, and increases the probability that the lots closed by the manager will be booked as expected by the sponsor.
Level 4 – Unlike Levels 1-3, Level 4 is a two-way share of information. The sponsor provides the manager with cost basis and tax lot information. The manager, when sending trade details to the sponsor, communicates which lots are to be closed.

This approach allows the manager to consider the tax impact of a particular trade when managing the client’s assets, since the manager now can ensure the sponsor will record the completed trade by closing the expected tax lots. The ability for a manager to communicate tax lot information to the sponsor is therefore required for “tax aware” or “tax optimized” management, where the ability to take advantage of lower tax rates for long-term capital gains is desirable.

As an example of the difference between Levels 1, 2, 3, and 4, we’ll consider the case of an advisor who requests a manager to harvest $20,000 in losses from a client’s account.

Level 1: Because the manager may not have complete cost basis information for the account, the manager may not show $20,000 in unrealized losses, requiring additional communication with the advisor before the instructions can be fulfilled. Even if the advisor specifies to the manager the lots to be sold, there is no guarantee that the sponsor will close those lots after receiving trade details from the manager.
Level 2: Because the manager has reconciled tax lots with the sponsor, the advisor can be confident that the manager will be able to raise the requested losses. However, it is possible that the lots closed on the sponsor’s books will vary from those intended by the investment manager, realizing a loss greater or lesser than that which was expected by the advisor.
Level 3: The manager relies on the “selling rule” to close lots. This should allow the manager to execute the advisor’s instructions, and have the resulting trades faithfully replicated when being booked by the sponsor. However, the manager’s ability to tax-optimize the trades may be limited by the need to adhere to the selling rule.
Level 4: The manager interprets the advisor’s request in the context of its tax optimization policy. The lots closed by the manager are specifically communicated to the sponsor, avoiding any potential for variation when booked to the client account.

The above levels equally apply to other types of client instructions that require the investment manager to close tax lots, such as requests for cash distributions. In those cases, advisors may also specify securities to be sold to fulfill client requests, including lot-level details.

While we believe managers and sponsors will need to explicitly agree on the policy under which they share cost basis information on managed accounts, we don’t think a “one size fits all” approach is practical. The levels proposed above allow firms to tailor their procedures to the investment products they service, and the portfolio management and accounting capabilities they possess.

When it comes to sponsor and manager communications, client-specific instructions are commonly communicated in an unstructured way, often by fax or email. However, these methods may not be suitable for Levels 2, 3 and 4. The potential for error in communicating fully-qualified lot information by fax or email is great, even if a unique identifier for each tax lot is used.

Instead, we believe compliance with the new cost basis regulations will provide further justification for firms to adopt industry communications standards for account origination and maintenance requests; the standards currently support lot-level information for securities data.

Control of tax consequences is the most tangible benefit of separately managed account products, as opposed to unitized managed investments such as mutual funds and ETFs. Client expectations in this regard will continue to be high.

And while supporting the new cost basis regulations will likely require significant effort among sponsors and managers, defining levels for sharing lot information among participants will help to ease the transition. Continued adoption of message standards for communication of client requests will ensure instructions are faithfully executed, and ultimately improve the quality of service provided to the client.