If you’ve ever wondered about the intricacies of covered and non-covered securities, this article is here to demystify the concept. Non-covered securities, as designated by the SEC, have limited reporting requirements, leaving you with the responsibility of reporting their cost basis to the IRS. In contrast, covered securities are subject to more comprehensive reporting by brokers and are classified based on specific criteria. Let’s delve into the world of covered and non-covered securities, unraveling their definitions and implications for your investments.
What is a non-covered security?
A non-covered security is an SEC designation under which the cost basis of securities that are small and of limited scope may not be reported to the IRS. The adjusted cost basis of non-covered securities is only reported to the taxpayer, and not the IRS.
What is a covered security?
In 2008, Congress passed legislation that required brokers to report the adjusted cost basis for securities and mutual funds to both the investors and the Internal Revenue Service (IRS), effective tax year 2011. Since 2011, the cost basis of certain securities has been reported through Form 1099-B, which indicates whether the capital loss or gain from the sale of the security is short or long term. Any transaction that occurs on or after this effective year is a covered security and is reported on Form 1099-B.
Definition of a covered security
A covered security is defined as:
- Any stock in a corporation, including American Depositary Receipts (ADRs), acquired on or after Jan. 1, 2011.
- Mutual funds acquired on or after January 1, 2012.
- Stocks or ADRs acquired through a dividend reinvestment plan (DRIP) on or after Jan. 1, 2012.
- Less complex bonds, derivatives, and options purchased on or after Jan. 1, 2014.
- More complex bonds, derivatives, and options purchased on or after Jan. 1, 2016.
Understanding non-covered security
Non-covered securities refer to any investments purchased before the effective dates listed above. The detailed cost basis following the sale of a non-covered security is not required to be reported to the IRS by a broker. However, the gross proceeds or redemption value from a sale may still be reported to the IRS. While a broker will still report the cost basis to the investor or taxpayer, it is up to the investor to report this information to the IRS through Schedule D on Form 1040 for shares sold, whether covered or non-covered. Even if the taxpayer does not receive a cost basis report, they must still report their adjusted cost basis to the IRS.
The IRS considers securities to be non-covered if they are acquired through a corporate action and if their cost basis is derived from other non-covered securities. Corporate actions, such as stock splits, stock dividends, and redemptions, usually result in additional shares for the investor. The additional shares will be classified as non-covered if they were received through non-covered shares. For example, an individual who bought 100 shares in a company in 2010 that split three-for-one in 2013 will receive an additional 200 shares. Even though the 200 shares were acquired after 2011, they are considered non-covered because they were split from shares acquired before 2011.
A dividend reinvestment plan (DRIP) allows an investor to reinvest their dividends for additional shares in the same company. An investment security that was purchased in 2011 but transferred in the same year to a DRIP that uses the average cost method of calculating the cost basis for an asset is a non-covered security. But if the transfer occurred after 2011, it will remain a covered security.
Investment sales and Form 8949
Investment sales are divided into covered and non-covered securities using Form 8949. Transactions on non-covered securities not reported on Form 1099-B are reported on Form 8949, where Code C is used for short-term holdings, and Code F for long-term holdings.
Here is a list of the benefits and drawbacks to consider.
- Clarity for Investors: Understanding the difference between covered and non-covered securities provides investors with clarity regarding their tax reporting obligations.
- Tax Efficiency: Knowing which category a security falls into can help investors make more tax-efficient investment decisions, potentially reducing their tax liability.
- Flexibility: Investors can plan their investment strategies more effectively, taking into account the tax implications of covered and non-covered securities.
- Cost Savings: Properly categorizing securities can lead to cost savings by reducing tax preparation fees and minimizing tax liabilities.
- Tax Planning: Investors can engage in tax planning to optimize their investment outcomes by strategically managing covered and non-covered securities.
- Complexity: The rules governing covered and non-covered securities can be complex and may require a thorough understanding of IRS regulations.
- Tracking: Investors must keep accurate records of their securities and transactions to correctly identify covered and non-covered securities.
- Potential Penalties: Failing to report covered and non-covered securities accurately can result in penalties or legal issues with the IRS.
- Changing Rules: IRS regulations can evolve, and investors need to stay informed about any changes that may affect their securities’ classification.
- Professional Advice: To navigate the complexities and ensure compliance, investors may need to seek professional tax or financial advice, incurring additional costs.
Frequently asked questions
What is the significance of the SEC designation for covered and non-covered securities?
The SEC designation determines the level of reporting required for the cost basis of securities. Covered securities have more comprehensive reporting, including reporting to both investors and the IRS, while non-covered securities have limited reporting, with the onus on taxpayers to report their cost basis.
How do I report the cost basis of non-covered securities to the IRS?
For non-covered securities, the broker will report the cost basis to the investor, but it’s the responsibility of the investor to report this information to the IRS through Schedule D on Form 1040 when they sell shares, regardless of whether they received a cost basis report.
Can non-covered securities become covered securities?
Non-covered securities can become covered if certain conditions are met. For example, if you transfer a non-covered security to a dividend reinvestment plan (DRIP) after a specific effective date, it may transition into a covered security. The specific rules and effective dates vary, so it’s essential to understand the IRS guidelines.
Are there any exceptions to the effective dates for covered securities?
Yes, there are exceptions. In some cases, securities acquired before the specified effective dates may still be considered covered securities. For example, securities inherited from a decedent and certain types of employee stock options may be treated as covered securities even if they were acquired earlier. It’s advisable to consult the IRS guidelines or a tax professional for specific exceptions.
Can a security change its classification from covered to non-covered or vice versa?
Yes, securities can change their classification under certain circumstances. For instance, a non-covered security may become a covered security if it’s transferred to a dividend reinvestment plan (DRIP) after a particular effective date. Conversely, a covered security can become non-covered if its cost basis is derived from non-covered securities in a corporate action like a stock split. Understanding these transitions is essential for accurate tax reporting.
How do I determine the cost basis of non-covered securities?
For non-covered securities, you can typically find the cost basis information on your brokerage statements. Brokers are still required to report the cost basis to investors, even if they don’t report it to the IRS. It’s essential to maintain accurate records of non-covered securities to ensure correct tax reporting. If you have questions about the cost basis of a specific non-covered security, consult your broker or financial advisor.
- Covered securities require more comprehensive reporting to both investors and the IRS, while non-covered securities have limited reporting, with the onus on taxpayers to report their cost basis.
- Non-covered securities typically include investments purchased before specific effective dates, and the IRS may not receive detailed cost basis reports from brokers.
- Corporate actions like stock splits can create non-covered securities if the additional shares are derived from non-covered shares.
- A transfer of a non-covered security to a dividend reinvestment plan (DRIP) may change its status to covered, depending on the effective date of the transfer.
View article sources
- 26 CFR § 1.6045A-1 – Statements of information required – Legal Information Institute
- 2023 Instructions for Form 1099-B – Internal Revenue Service
- Mastering Financial Planning – SuperMoney
- 26 CFR § 1.6045-1 – Returns of information of brokers – Legal Information Institute