When a taxpayer holds multiple lots and/or shares of the same securities with different costs basis and/or holding periods, the default method of determining which securities are sold first is the first-in, first-out (FIFO method). Taxpayers are allowed to elect out of the FIFO method and direct their broker to specifically identify the lots and/or shares they would like to sell or use the last-in, first-out (LIFO method). Taxpayers who own multiple lots of the same securities may want to sell securities that they have not held for more than one year first, while keeping older lots that have been held for more than one year or are close to being held for more than one year, in order to possibly benefit from the 15% tax bracket. Alternatively, they may want to choose to sell the lots and/or shares that have the highest tax basis.
In a recent case (Kenan Turan, Petitioner v. Commissioner of Internal Revenue, Respondent (T.C. Memo.2017-141)), the Tax Court found that the taxpayer did not direct their broker in identifying the shares in which they intended to sell. When electing to use an alternative method, the taxpayer bears the burden of proof when they elect to use one of the alternative methods, i.e. the LIFO method or the specific lot identification.
The taxpayer was not able to furnish documentation to the Tax Court to corroborate his claim that he directed the broker to use LIFO instead of FIFO. In the taxpayer statements to the Tax Court, he stated that he attempted to inform the broker by communicating through the broker’s client portal and phoning the broker of his intention.
The Tax Court found he lacked credibility due to the broker not having records of being contacted by the taxpayer. On the taxpayer’s 2013 tax return, he omitted reporting the capital gains reported to him from the broker’s 1099-B, due to the broker not reporting the correct basis of the securities sold.
The Tax Court found the taxpayer under-reported his income tax liability by $45,454 and assessed an accuracy penalty of $9,091. The penalty was assessed on the basis that the taxpayer substantially understated his tax liability and did not act with reasonable cause and in good faith.
Specific identification as compared to FIFO can prove tax advantageous in numerous situations as allowing taxpayers the flexibility to essentially control the amount of gain or loss realized on the sale of securities. The Tax Court case, however, underscores the importance of maintaining proper corroborating documentation in terms of informing the broker to use specific identification as compared to FIFO.
Christopher Williams is a partner with Kram, McCarthy, Ayers & Frost with over 10 years of experience in public accounting, specializing in financial services. His clients include high net worth individuals, investment companies, hedge funds, private equity funds, general partnerships, and management companies. He can be reached at 410-643-4477 or firstname.lastname@example.org.