During 2006, Mr. H. sold securities for a total amount of over $14.8 million (as reported by his brokers to the Internal Revenue Service). On his 2006 tax return, however, Mr. H reported capital gains of only $2,291 and taxable income of $13,221. Dubious about the accuracy of Mr. H’s tax return, especially the small amount of capital gains reported and lacking any evidence as to Mr. H’s tax basis in the securities, IRS treated the entire $14.8 million as gain and assessed additional tax of about $5.2 million, together with understatement penalties of more than $1 million. Mr. H. challenged the assessment in the United States Tax Court but during discovery declined to respond to IRS’ requests for information to establish his tax basis in the securities. As a result, the Tax Court upheld the assessment. Mr. H. appealed to the federal Court of Appeals for the Eleventh Circuit, which affirmed the Tax Court’s decision, on May 2, 2014. Although this case involved special circumstances, notably Mr. H’s total lack of cooperation with IRS and a number of spurious claims made in his petition to the Tax Court and appeal, it stands as a vivid example of the potential cost of failing to keep track of tax basis.
In order to establish basis, investors should retain brokerage receipts from securities purchases. In particular, investors who participate in dividend reinvestment plans need to keep records of the amount of dividends reinvested and any costs incurred in reinvesting to establish basis in the shares purchased through the plan.
Note: With respect to most securities acquired on or after January 1, 2011 (2012 or 2013 for certain securities), the broker who handled the acquisition is required to keep track of owner’s tax basis and report the basis, as well as the sale proceeds, to IRS and to the seller on Form 1099-B. And, if the account is transferred to another broker the first broker is required to provide the basis information to the successor-broker. Also, some brokers may provide the seller (but not IRS) with basis information with regard to securities acquired before 2011. But regardless whether the broker provides basis information, the taxpayer is responsible for correctly reporting basis on the tax return for the year during which securities were sold.