The term non-covered security refers to a legal definition of securities, the details of which may not necessarily be disclosed to the Internal Revenue Service (IRS). The competent authority that makes such designations for tax reporting purposes in the U.S. is the Securities and Exchange Commission (SEC).
The designation entails that when a security is small and of limited scope, then there is no compulsion to the brokerage firm to report its cost basis to the IRS. The adjusted cost basis of such securities only needs to be reported by the brokerage firms to the taxpayer or assessee.
The term non-covered security refers to a legal definition of securities, the details of which may not necessarily be disclosed to the (Internal Revenue Service) IRS.
Cost basis means that the original cost of any asset must be revised annually, according to depreciation in the case of fixed assets, and must be increased in the case of capital expenditure, market value appreciation, etc.
Legislation passed in 2008 means that the adjusted cost basis of any security purchased during or after the 2011 tax year must be reported to the IRS.
What Is Covered Security?
According to the SEC, a covered security is one that is considered large enough in scope for it to be reported to the IRS. It means that the brokerage firm is legally mandated to disclose and report the cost bases and any sale information regarding that security to the IRS.
The firm is also responsible for sending information regarding transactions in covered securities to a new brokerage firm, should the taxpayer transfer their account to a different brokerage firm.
What is Cost Basis?
In 2008, the U.S. Congress passed legislation under which brokers are required to use the adjusted cost rather than the purchase price of securities for tax reporting purposes.
It means that the original cost of any asset must be revised annually. It must be reduced according to depreciation in the case of fixed assets and must be increased in the case of capital expenditure, market value appreciation, etc. It is done in order to calculate the capital gains income under the gross income of the taxpayer.
The capital gains may be taxable even if they haven’t been realized yet, since authorities may need it to determine the tax rate applicable to the taxpayer.
The legislation came into effect starting the assessment year 2011. It means that the adjusted cost basis of any security purchased during or after the 2011 tax year must be reported to the Internal Revenue Service.
Examples of covered securities include the following, all of which must have been acquired on or after January 1, 2011:
1. Any share capital (in a corporation): Purchased on or after January 1, 2011
2. Any mutual funds, and stocks or American Depository Receipts that are acquired through a dividend reinvestment plan: Purchased on or after January 1, 2012
3. Any derivatives, options, and less complex bonds: Purchased on or after January 1, 2014
4. Any derivatives, options, and more complex bonds: Purchased on or after 1st January 2016
Any investments purchased before the aforementioned effective dates are classified as non-covered securities as per U.S. laws. It means that the adjusted cost basis of these assets may not be reported to the IRS.
However, it is only in cases where the capital gains are not realized. It means that in cases where a sale of the aforementioned securities is made, the amount realized would be considered as a capital gain, which would then be taxable according to the appropriate capital gains tax rate applicable to the taxpayer. The amount may be the redemption value of the gross proceeds from the sale.
Moreover, any securities acquired through corporate action, i.e., a decision made by a company’s board, are considered to be non-secured. For example, a stock split or a stock dividend may usually result in additional shares of value for the investor. If the value was generated via non-covered shares, they are not taxable.
For example, consider than an investor purchase 200 shares of Company X in 2009. In 2011, the company went for a split share issue and followed a one for one system. It means that the investor got 200 additional shares of Company X in 2011. Even though they are acquired after the cut-off date, i.e., January 1, 2011, they would be considered non-secured.