2014 cost basis legislation and tax...

2014 Cost Basis Legislation and Tax ReportingFixed Income and Options

Advisor Toolkit

2

Table of Contents

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

2014 Cost Basis tax reporting requirements for fixed income securities . . . . . . . . . . . . . . . . . . 4

Where and how your clients will see changes to cost basis . . . . . . . . . . . . . . . . . . . . . . 8

Examples to help explain the changes to your clients . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

Sample communications . . . . . . . . . . . . . . . . . . 12

How clients will see the changes displayed on their statements and schwaballiance .com . . . . . . . . . . . . . . . . . . . . . . 15

Letter of Authorization (LOA) to Change Fixed Income Amortization & Accretion Settings form . . . . . . . . . . . . . . . . . 18

FAQs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

Options: what to expect in 2014 and 2016 . . . . . 22

1099 Forms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

3

Introduction

The most recent phase of cost basis legislation requires brokers/

custodians to begin reporting cost basis information on select

fixed income positions and options for the 2014 tax year. A

significant impact of the 2014 legislation will be on “covered”

fixed income holdings where the IRS has stipulated specific rules

for calculating the cost of the bond that in turn will affect the

basis for that holding . Depending on the reporting preferences

you’ve selected for your clients, they may see changes in cost

basis, realized gain/loss, and unrealized gain/loss information on

schwaballiance .com and reported on their monthly statement .

Your clients may begin to see changes in the unrealized gain/loss

values in August 2014—displayed online as they are made and in

August statements, which will be mailed and also available online

the first week of September. All changes to realized gain/loss

information are planned for November and will be retroactive to

January 2014 .

We’ve created this Advisor Toolkit to help you understand the

IRS direction on this next phase of the legislation, as well as

which securities the legislation covers . We also want you to know

Schwab’s plans for implementing these requirements and the

upcoming changes that may affect your clients . You may want to

explain to your clients which fixed income securities will be

covered at each reporting deadline and the changes to cost basis

calculations .

An Overview of IRS Regulations

The Emergency Economic Stabilization Act of 2008 included

new tax reporting requirements that dramatically change the way

advisors and their clients manage cost basis and realized gain/

loss reporting . The Act’s goal is to ensure that investors

accurately report investment gains/losses in their annual tax

filings. To achieve this objective, custodians and brokers are

required to report the cost basis of sold covered securities

(including whether the gain or loss is short-term or long-term) to

taxpayers and the IRS on Form 1099-B.

An important definition

Please note that the IRS uses the term “debt instrument”

in place of “fixed income securities” in its publications

online. When looking for information regarding fixed income

on the IRS website, use “debt instrument” as the search

term. Schwab will continue to use “fixed income

securities,” except when “debt instrument” or using both

terms provides more clarity .

The IRS defines “debt instrument” as any instrument or

contractual arrangement that constitutes indebtedness

under the general principles of federal income tax law,

including notes, bonds, debentures, or other evidence of

indebtedness .

4

2014 Cost Basis tax reporting requirements for fixed income securitiesProperly accounting for the cost basis of a fixed income security

is considerably more complicated than for an equity security,

ETF, or mutual fund . Cost basis can be affected by accruals of

income as well as tax instructions the holder of the instrument

makes. Many of the changes made by the IRS align broker

reporting on Form 1099-B with taxpayer reporting requirements .

Fixed income securities subject to January 1, 2014 cost basis reporting

Starting in 2014, the IRS cost basis reporting requirements will be

implemented for “less complex” fixed income securities acquired

on or after January 1, 2014. The less complex fixed income

securities in the accompanying chart generally have a single fixed

payment schedule for which a yield to maturity can be determined

under the general original issue discount (OID), the alternate

payment, and demand loan rules .

Fixed income securities subject to January 1, 2016, cost basis reporting

Another phase of the cost basis reporting requirements is

planned for January 1, 2016 . This phase will cover the

implementation of “more complex” fixed income securities. The

IRS has identified more complex fixed income securities as

having features that make calculating cost basis even more

complicated than it is for those classified as less complex.

Less Complex Fixed Income: Subject to 1/01/14 Reporting

More Complex Fixed Income: Subject to 1/01/16 Reporting

Fixed Income Excluded from Reporting

Taxable and non-taxable bonds that have a fixed rate, fixed maturity, and fixed payment schedule, even if they are callable by the issuer . These include:

• Treasury notes and bonds

• Fixed-rate corporate bonds

• Fixed-rate municipal bonds

The IRS will address fixed income securities that are more complex in terms of calculating adjusted cost basis in 2016. These include:

• Variable-rate bonds

• Stepped-rate bonds

• Convertible bonds

• Stripped bonds

• Certain tax-credit bonds

• Contingent-payment bonds

• Inflation-indexed fixed income securities

• Foreign-issued bonds or bonds that pay in foreign currency

• Payment-in-kind bonds

• Fixed income securities issued as part of an investment unit

• Fixed income securities for which terms are not reasonably available to brokers within 90 days of acquisition by client

• Fixed income securities evidenced by a physical certificate not held by a custodian or clearing agent (physical debt)

The IRS specifically excluded fixed income securities described in Section 1272(a)(6) of the IRS regulations from cost basis reporting requirements:

• Certain specific interests in or mortgages held by a Real Estate Mortgage Investment Conduit (REMIC)

• Certain other fixed income securities with payments subject to acceleration

• Pools of fixed income securities whose yield may be affected by prepayments

• Short-term fixed income securities (with a fixed maturity rate not more than one year from the date of issue) .

5

What Schwab is doing when—and why

Here’s when you’ll see changes:

August 2014 System changes that may affect unrealized gain/loss values on Schwab Advisor Center, schwaballiance.com, monthly statements with cost basis information included, and advisor cost basis data files

November 2014 System changes that may affect fixed income positions that were sold from January 1, 2014, up to the time we make changes in August 2014. These changes may result in changes to clients’ realized gain/loss values and will be visible on Schwab Advisor Center, schwaballiance.com, and advisor cost basis data files

Q1 2015 New IRS Form 1099-B and changes to the 2014 advisor 1099 tax file download

Schwab is making adjustments to its amortization settings

Amortization/accretion affects the calculation of whether a bond

purchased at a premium or a discount has a gain or loss at

disposition . Schwab is required to make changes to these settings

in our cost basis system to conform to the new IRS reporting rules

on certain bond types in taxable accounts .

We plan to implement the following changes to our system

settings in August 2014 retroactive to January 1, 2014 . Following

is a summary of changes Schwab will make:

• Enable amortization/accretion for all taxable accounts .

• Calculate market discount using the straight line accounting

method (this is parallel to the IRS default for taxpayers).

• Exclude market discount in current income and adjust and

report cost basis at disposition . Until now, we assumed clients

included market discount in current income provided that the

amortization/accretion system settings were enabled .

• Use other methods to calculate the amortization/accretion

amount depending upon whether a bond is an original issue

discount or was purchased at a premium or market discount,

and if there is a call or put feature aligning with taxpayer

requirements (see table at right) . Note that the method for

taxable bonds purchased at a premium with a call feature will

be operational in November and should impact few clients .

Amortization changes

Following is a summary of the “enabled” versus “not enabled”

amortization scenarios for taxable and non-taxable accounts .

Account Type Change Effect

Taxable Account With Amortization Enabled

Amortization settings changed to the new required broker IRS defaults—potential impact to adjusted cost

Taxable Account With Amortization Not Enabled

Amortization enabled with new required broker IRS default settings—adjusted cost value provided and cost basis calculated using adjusted cost

Non-Taxable Account With Amortization Enabled

Amortization settings changed to the new required broker IRS defaults—potential impact to adjusted cost

Non-Taxable Account With Amortization Not Enabled

No change—Schwab is not required to enable amortization settings for these accounts

6

How the new amortization settings may impact you and your clients

Previous Schwab Settings NEW 2014 Schwab Settings

BondsA/A Rule Type

Yield Method*

Apply de Minimus Rule?

A/A Rule Type

Yield Method

Apply de Minimus Rule?

Original Issue Discount– No Call or Put Feature

Constant Yield

Yield to Maturity

Yes Constant Yield

Yield to Maturity

Yes

Market Discount Constant Yield

Yield to Maturity

Yes Straight Line

N/A Yes

OID–Call Feature Constant Yield

Yield to Maturity

Yes Constant Yield

Yield to Worst (Lowest Yield)

Yes

OID–Put Feature Constant Yield

Yield to Maturity

Yes Constant Yield

Yield to Best (Highest Yield)

Yes

OID with Acquisition Premium

Constant Yield

Yield to Maturity

Yes Constant Yield

Original Yield to Maturity, then apply acquisition premium

Yes

Bond Premium– No Call or Put Feature

Constant Yield

Yield to Maturity

No Constant Yield

Yield to Maturity No

Bond Premium– Call Feature

Constant Yield

Yield to Maturity

No Constant Yield

Yield to Best (Highest Yield) Taxable Bonds Yield to Worst (Lowest Yield) Tax-Exempt Bonds

No

Bond Premium– Put Feature

Constant Yield

Yield to Maturity

No Constant Yield

Yield to Best (Highest Yield)

No

• For clients with amortization/accretion enabled on their

accounts—both taxable and non-taxable—Schwab will

calculate cost basis, bond premium, and market discount using

different methods (refer to the table below) . This may result in

a different adjusted cost basis.

• For clients with amortization/accretion not enabled on their

taxable accounts, Schwab will begin calculating adjusted cost

basis, including market discount and bond premiums, using

these same methods .

These changes will be reflected on both Schwab Advisor Center

and schwaballiance .com and in the unrealized cost basis data

files we currently make available via Schwab Data Delivery on

Schwab Advisor Center. These files will begin to include adjusted

cost values for all fixed income positions for which amortization/

accretion has been recently enabled . Previously enabled

accounts’ adjusted basis will be based on the new broker

guidelines . Since the setting changes are retroactive to January

1, 2014, there will be adjustments to realized/gain loss values

that will be reflected in the files in November 2014.

Note: In the past, advisors could choose whether or not to adjust

cost basis for amortization/accretion .

What happens when amortization is enabled

Schwab uses the constant yield methodology. The adjusted

cost basis (price) on a specific date is determined by the

yield to maturity (call) when the security was acquired and

the remaining cash flows until maturity (or call) date.

Schwab adjusts on a daily basis—generally, the price at any

point in time (for example, the date of the client’s

statement) is adjusted so the yield calculated from the

remaining cash flows is the same as the original yield to

maturity calculated at the time of purchase .

Yield method changes

Following is a summary of amortization methods that will be

modified for taxable/non-taxable accounts with amortization

currently enabled .

* Previously this was "Constant Yield to Maturity" unless it was a pre-refunded bond. Then Schwab calculated to the first call date.

7

Schwab Advisor Center screen shots

Advisors will see two values on schwabadvisorcenter .com:

original cost basis and adjusted cost basis. On the Unrealized

Gain/Loss tab of the Cost Basis screen, the position-level cost

value will display adjusted cost. The Cost Basis Details screen

will display the original cost basis as well as the adjusted cost

basis .

Schwab Data Files

Advisors will also see changes to values included in their

cost basis unrealized gain/loss data files. If amortization/

accretion was just enabled on the position, the data will

include the adjusted cost. If amortization/accretion was

previously enabled, the adjusted cost value may have

changed with the implementation of the new required

amortization/accretion settings .

Beginning in August 2014, the Cost Basis value will reflect the adjusted Cost Basis based on new IRS default amortization/accretion methods, and will be displayed on the Unrealized Gain/Loss screen .

You can view the Original Cost Per Share, Original Cost Basis, and additional Adjusted Cost Details on the Lot Detail screen .

Adjusted Cost Basis

Original Cost Basis details

Adjusted Cost Basis details

8

Where and how your clients will see changes to cost basis

Depending on the cost basis reporting preferences you have

chosen for your client accounts, clients may see changes on

schwaballiance .com and/or their monthly statements beginning

with August statements. Please contact Client Reporting to

identify your chosen preferences, or click on the Subscription/

Status link on the Cost Basis tab in Schwab Advisor Center to

view the reporting preferences for accounts linked to your master

accounts .

Bond premium

Clients who previously did not have the bond amortization

preference enabled will see changes to their cost basis as we

enable bond amortization for all taxable accounts .

Clients will now see two values on schwaballiance .com: original

cost basis and adjusted cost basis. The position-level cost value

will display adjusted cost. The Lot Details window will contain

both . See Example A.

Since some yield methods used in the cost basis calculation have

changed, clients who had previously enabled the amortization/

accretion settings may still see a change in their adjusted cost

basis depending on the type of bond . See Example B.

Any basis change calculations will also be reflected on monthly

client statements that report unrealized gains/losses .

Market discount

Clients who have purchased bonds at a discount will see a

change in the cost basis value of their unrealized gains/losses

because cost basis is no longer adjusted daily for market

discount accruals. It will now be adjusted at disposition. In

addition, clients’ realized cost basis value may differ if they sell

their bonds prior to maturity due to a change in the rule type

from constant to straight line yield for the market discount

calculation . See Example C.

Clients will see two values on schwaballiance .com: original cost

basis and adjusted cost basis. The position-level cost value will

display adjusted cost. The Lot Details window will contain both.

Any basis change calculations will also be reflected on monthly

client statements that report unrealized gains/losses .

9

Examples to help explain the changes to your clients

Example A: Taxable bond purchased with bond premium

On April 1, 2014, you purchased $10,000 original face value (par of 100) of a 10% annual coupon-rate corporate bond issued on

4/01/05, with maturity on 4/01/15, at a price of $105 . Cost basis displays as:

Purchase 4/01/14

Before Change in Tax Reporting After Change in Tax Reporting

No Amortization Constant Yield to Maturity Amortization

Cost Basis $10,500 ($10,000 x $105/100) $10,500 ($10,000 x $105/100)

On October 1, 2014 (midway between purchase and maturity), the unrealized gain/loss displays cost basis as:

Unrealized Gain/Loss 10/01/14



Cost Basis $10,500 $10,252.98 (Adjusted)

On April 1, 2015, at maturity, the realized gain/loss displays the following:

Maturity 4/01/15



Proceeds $10,000 $10,000

Cost Basis $10,500 $10,000 (Adjusted)

Realized Gain (or Loss) ($500) $0

Proceeds $10,000 $10,000

Cost Basis $10,000 (Adjusted) $10,000 (Adjusted)

Realized Gain (or Loss) $0 $0

10

Example B: Taxable bond with call feature purchased at premium

On April 1, 2014, you purchased $10,000 original face value at a price of $105 of a 10% annual coupon-rate corporate bond issued on

4/01/05, with a call date of 12/01/14, at a call price of $102, and maturity on 4/01/15 . Cost basis displays as follows:

Purchase 4/01/14


Constant Yield Using Yield to MaturityConstant Yield Using Yield to Best (Call, Put, or Maturity)

Cost Basis $10,500 ($10,000 x $105/100) $10,500 ($10,000 x $105/100)

On October 1, 2014 (midway between purchase and maturity), the unrealized gain/loss displays cost basis as:

Unrealized Gain (or Loss) 10/01/14



Cost Basis $10,252.98 (Adjusted) $10,274.11 (Adjusted)

On April 1, 2015, at maturity, the realized gain (or loss) displays the following:

Maturity 4/01/15



Proceeds $10,000 $10,000

Cost Basis $10,000 (Adjusted) $10,000 (Adjusted)

Realized Gain (or Loss) $0 $0

Note: Yield-to-best functionality will not be available until later in 2014 .

11

Example C: Taxable bond purchased at market discount

On April 1, 2014, you purchased $10,000 original face value (par value 100) of a 10% annual coupon-rate corporate bond issued on

4/01/05, with maturity on 4/01/15, at a price of $50 . Cost basis displays as:

Purchase 4/01/14


Constant Yield Accretion, Adjusted DailyStraight Line Accretion, Adjusted at Disposition (Sale or Maturity)

Cost Basis $5,000 ($10,000 x $50/100) $5,000 ($10,000 x $50/100)

On April 2, 2014 (one day after purchase), the unrealized gain/loss displays cost basis as:

Unrealized Gain (or Loss) 4/02/14



Cost Basis $5,008.50 (Adjusted) $5,000

If on October 1, 2014, you sell the bond, the realized gain (or loss) displays cost basis as:

Realized Gain (or Loss) 10/01/14



Cost Basis $7,000 (Adjusted) $5,000

Market Discount $0 $2,500

However, if you hold the bond to maturity, on April 1, 2015, the realized gain/loss displays the following:

Maturity 4/01/15



Proceeds $10,000 $10,000

Cost Basis $10,000 (Adjusted) $5,000

Market Discount $0 $5,000

Realized Gain/Loss $0 $0

12

Sample communications

Let your clients know in advance about the new fixed income reporting requirements

You may wish to adapt these sample communications as either

letters or emails to your clients . If you have enabled cost basis

reporting preferences for their accounts, your clients may see

changes on schwaballiance .com and/or on their monthly

statements beginning with their August 2014 statements .

Please note that these sample communications are relevant only

if cost basis is displayed on schwaballiance .com or your clients’

statements. For confirmation of your current reporting

preferences, view your settings under the Cost Basis tab on

schwabadvisorcenter .com . Go to the Subscription/Status link for

the applicable master account to view schwaballiance .com and

statement settings. You may also contact Client Reporting at

1-877-762-6446 or ascostbasis@schwab .com to obtain this

information .

While Schwab will be communicating to your clients via an

insert included with their August statements, you may want

to prepare them in advance with your own communications .

To help you begin, we’ve provided these sample

communications you can use or modify .

13

Letter or email #1 For clients with amortization/accretion settings that are currently enabled

Re: 2014 IRS Rule Changes to Fixed Income Securities Purchased at a Premium or Discount

We’re writing to let you know that new IRS legislation requires that brokers and custodians (like Schwab) begin

reporting cost basis information on select fixed income positions for the 2014 tax year.

Beginning in August 2014, Schwab will make changes to the amortization settings in its cost basis system to

conform to the new IRS reporting rules. The changes will be implemented over a several-week period in August

and will be retroactive to January 1, 2014 .

Below is a summary of the changes Schwab will implement for taxable and non-taxable* accounts beginning in

August 2014:

• The methods used to calculate amortization and accretion will be updated depending on whether a bond is

purchased at a premium, original issue discount, or market discount, and/or if there is a call or put feature .

• Market discount on a bond purchased on the secondary market will be calculated using the straight line

accounting method (this is parallel to the IRS default for taxpayers).

• The amount of the market discount will not be incorporated into current income or adjusted cost basis until

the position has been sold, has matured, or has been called . Prior to this change, Schwab assumed that you

included market discount in your current income and adjusted cost basis daily.

These changes will affect all open bond holdings in your accounts . As a result, you may see changes to the cost

basis information reported online and on your monthly statements beginning with your August statement,

which will be mailed and available online the first week of September. It’s important to note that the changes

don’t affect bonds that were purchased and sold prior to the beginning of this year . In addition, bonds that

closed in 2014 up to the August implementation date will be updated this fall .

If you have any questions or would like to schedule time to discuss the changes, please don’t hesitate to call to

set up a time to talk .

Sincerely,

[Advisor Name]

*For all accounts (taxable and non-taxable) that currently have amortization enabled, Schwab will amortize positions using the new methods.

Independent investment advisors are not owned by, affiliated with, or supervised by Schwab.

14

Letter or email #2 For clients with amortization/accretion settings NOT currently enabled

Re: 2014 IRS Rule Changes to Fixed Income Securities Purchased at a Premium or Discount

We’re writing to let you know that new IRS legislation requires that brokers and custodians (like Schwab) begin

reporting cost basis information on select fixed income positions for the 2014 tax year.

Beginning in August 2014, Schwab will make changes to the amortization settings in its cost basis system to

conform to the new IRS reporting rules. The changes will be implemented over a two-week period in August

and will be retroactive to January 1, 2014 .

Below is a summary of the changes Schwab will implement for taxable accounts beginning in August 2014:

• Enable amortization settings .

• The methods used to calculate amortization and accretion will be based on whether a bond is purchased at

a premium, original issue discount, or market discount, and/or if there is a call or put feature .

• Market discount on a bond purchased on the secondary market will be calculated using the straight line

accounting method (this is parallel to the IRS default for taxpayers).

• The amount of the market discount will not be incorporated in current income or adjusted cost basis until the

position has been sold, has matured, or has been called . Prior to this change, Schwab assumed that you

included market discount in your current income and adjusted cost basis daily.

These changes are effective January 1, 2014, and will affect all open bond holdings in your accounts . As a result,

you may see changes to the cost basis information reported online and on your monthly statements beginning

with your August statement, which will be mailed and available online the first week of September. It’s important

to note that the changes don’t affect bonds that were purchased and sold prior to the beginning of this year . In

addition, bonds that closed in 2014 before the August implementation date will be updated this fall .

If you have any questions or would like to schedule time to discuss the changes, please don’t hesitate to call to

set up a time to talk .

Sincerely,

[Advisor Name]


15

How clients will see the changes displayed on their statements and schwaballiance .com Your clients will see changes in their August 2014 statements if the cost basis display is enabled for their statements:

Note: If you haven’t subscribed your client accounts to cost basis display on their Statements, there won’t be a change in their experience after August 2014 . We’ll continue to suppress cost basis information for these clients .

Reflects the Adjusted Cost Basis per new IRS default

16

If you have enrolled your client accounts to view cost basis value online, the new adjusted Cost Basis value reflecting the new IRS default amortization/accretion methods will display in the “Unrealized Gain/Loss” and “Lot Details” screens.

Clients who use schwaballiance .com and have accounts enabled to view cost basis data will see these changes:

Adjusted Cost Basis

Adjusted Cost Basis

Adjusted Cost/Share

17

To view the original lot details including original Cost per Share and Cost Basis, your clients can launch the “Original Lot Details” screen via the “View Original Lots” link on the top right of the “Lot Details” screen.

Original Cost Basis Original Cost/Share

Note: If you haven’t enrolled your client accounts to view cost basis information online via schwaballiance .com, there won’t be a change to their online experience after August 2014. We’ll continue to suppress cost basis information including the “Unrealized Gain/Loss” screen on schwaballiance .com for these clients .

18

Letter of Authorization (LOA) to Change Fixed Income Amortization & Accretion Settings form

Client instructions

The new IRS-designated defaults may not coincide with what your

clients have used for tax filing purposes in the past. But the IRS

will allow taxpayers to instruct their brokers to use settings for

taxable bonds that differ from the defaults . They can choose to:

• Accrue market discount using constant yield .

• Include market discount in current income .

• Disable bond premium amortization .

• Treat all interest as OID .

Please note: Schwab is able to support all the instructions above

for the 2014 tax year except the instruction to “Treat all interest

as OID.” We’ll provide an update about this instruction in 2015.

If your client is considering changes to their default settings,

instructions for the 2014 tax year must be submitted in writing to

Schwab by December 31, 2014, and will be retroactive to January

1, 2014 . Schwab will ensure that all forms received by December

31 will be processed in time for 1099 reporting for that tax year .

• The Letter of Authorization (LOA) to Change Fixed Income

Amortization & Accretion Settings form must be signed and

completed by the account holder for each affected account .

Advisors cannot execute the LOA on their client’s behalf .

• Some instructions are not revocable and others require IRS

commissioner approval for revocation .

• Your clients are also responsible for filing the appropriate

instructions with the IRS on their tax returns.

• To obtain the Letter of Authorization (LOA) to Change Fixed

Income Amortization & Accretion Settings form, contact the

Client Reporting Services Team at 1-877-762-6446.

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©2014 Charles Schwab & Co., Inc. All rights reserved. Member SIPC. CS21493-03 (0614-3922) APP80646W-00 (06/14)

www.schwab.com 1-800-435-4000 (inside the U.S.)

+1-317-596-4501 (outside the U.S.) 1-888-686-6916 (multilingual services)

Clients of independent investment advisors, contact your advisor directly

or Schwab Alliance at 1-800-515-2157.

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*APP80646W-00=01*

Letter of Authorization (LOA) to Change Fixed Income Amortization & Accretion Settings Use this form to make changes to the IRS broker defaults for fixed income amortization and accretion settings that are currently applied to your Charles Schwab account.

Complete, sign, and return this form to:

Charles Schwab & Co., Inc. 2423 E. Lincoln Drive, Phoenix, AZ 85016

You may also fax this completed form to 1-866-713-8388.

1. Current Schwab Account Amortization and Accretion Settings as Required by the IRS Broker Defaults• Bond premium will be amortized for any taxable bonds in your account.

• Market discount will be calculated using the straight-line method.

• Market discount will be included on the 1099-B when the security is sold or matures.

2. Changes to IRS Broker Defaults for Fixed Income AmortizationpLEASE NOTE THAT SuBMITTING AN INSTRuCTION ON THIS FORM TO CHARLES SCHWAB DOES NOT SATISFY THE IRS REQuIREMENTS FOR MAKING ELECTIONS ON YOuR TAX RETuRN. IT IS YOuR RESpONSIBILITY TO FILE THE AppROpRIATE ELECTION WITH THE IRS. SOME ELECTIONS ARE NOT REVOCABLE AND OTHERS REQuIRE IRS COMMISSIONER AppROVAL FOR REVOCATION. WE STRONGLY RECOMMEND THAT YOu CONSuLT WITH A TAX ADVISOR BEFORE SuBMITTING THIS FORM.

Your instructions must be received by December 31 of the current tax year to be applied for that same tax year. Changes for forms received after December 31 will be applied to the following tax year.

Review your options below and check the boxes for the broker defaults that you would like to change. This change will be applied to all taxable fixed income positions in the account unless otherwise stipulated. Instructions must be given for each individual account.

Account Number Turn Off Taxable Bond Premium Amortization1

Market Discount—Use Constant Yield2

Include Market Discount in Current Income3

1 The bond premium will not be amortized for any taxable bonds in your account now or in the future. Individual positions may not be selected.2 The market discount will be calculated using constant yield. Applies to all taxable bonds unless individual positions are specified for as long as you hold the bond.

3 Charles Schwab will include the market discount on your 1099-INT and 1099-OID annually. Applies to all taxable bonds in your account for as long as you hold the bond. Individual positions may not be selected.

3. Special InstructionsPlease use this area to specify additional accounts or to specify the CUSIPs for individual bonds for the Market Discount—Use Constant Yield instruction. Alternatively, you may attach a separate sheet.

The Letter of Authorization (LOA) to Change Fixed Income Amortization & Accretion Settings form will be available September 1, 2014 .

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FAQs

Why is Schwab making adjustments to cost basis and reporting

calculations this year?

The IRS has issued guidelines for brokers and custodians for the

next set of securities they are required to include in their tax

reporting . For tax year 2014, brokers and custodians are required

to report cost basis on select fixed income securities and options.

The guidelines require Schwab to begin amortizing/accreting

bonds purchased at a premium/discount and adjust the cost and

basis accordingly . While Schwab is not required to make changes

that affect gain/loss calculations on options contracts, there are

tax withholding and reporting requirements on options that we

will be making as a result of this phase of the legislation .

What securities and positions will be considered covered and

reported to the IRS?

This year, the IRS requires custodians and brokers to report cost

basis on select fixed income positions and options purchased on

or after January 1, 2014. With respect to fixed income holdings,

the legislation is in effect only for what the IRS is categorizing as

“less complex” bonds. These are bonds that generally have fixed

rates and fixed terms, including Treasury notes and bonds,

fixed-rate corporate bonds, and municipal bonds. In 2016, cost

basis on bonds considered “more complex” is expected to

become reportable to the IRS. Examples of more complex bonds

include variable-rate bonds, convertible bonds, contingent

payment bonds, or other bonds that make it difficult for brokers

to calculate a yield . The full list of bonds that will be reportable in

this initial phase is available on page 4 of the Advisor Toolkit .

What changes will Schwab be making to cost basis reporting on

fixed income holdings?

Schwab is required to comply with IRS guidelines for fixed

income cost basis accounting . The guidelines require the

following changes:

• Amortizing/accreting covered bonds

• Updating the amortization yield method (these differ based on

bond feature; refer to the appropriate section of the Advisor

Toolkit for details)

• Updating the market discount to accrue at disposition

• Updating the market discount accrual method to straight line

To ensure consistent accounting for all fixed income holdings, the

three amortization/accretion setting changes listed at left will be

applied to all bond positions with these settings enabled,

including both covered and uncovered positions in taxable and

non-taxable accounts .

NOTE: For the 2014 tax year, Schwab will only be reporting to the

IRS adjusted cost basis on covered securities (less complex bonds

and options) purchased and sold on or after January 1, 2014 .

Which of my clients will be affected?

Clients holding less complex bonds in both taxable and non-

taxable accounts may be affected . Clients who have amortization/

accretion currently enabled on their accounts may see a change

in cost basis for their less complex bonds . For clients who do not

currently have amortization/accretion enabled, there will be

adjustments to their cost basis in their taxable accounts (the new

settings will only be enabled for taxable accounts) . Your clients’

level of awareness of these changes will depend on the reporting

preferences you have chosen for their accounts . If you have

enabled your clients to view gain/loss information on

schwaballiance .com and/or on their monthly statements, your

clients may see the adjusted cost basis values.

Will you adjust the cost basis on both open and closed

positions?

We will enable the new settings per the guidelines above on

affected bonds in August 2014 . Later this year, we will

retroactively adjust the settings on bonds that were closed after

January 1, 2014, and through the August implementation . We will

provide additional information on the changes that will affect

closed positions later this year .

What will be reported and where?

All realized gains/losses for bonds and options in taxable

accounts will be included on your clients’ 2014 Form 1099-B, but

only the cost basis for those covered bonds and options

purchased and sold on or after January 1, 2014, will be reported

to the IRS.

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Do I and/or my clients need to take any action to ensure that

the required changes are implemented?

No . Neither advisors nor their clients need to do anything to

ensure that the proper changes are made . Schwab will be

implementing changes and updates to its cost basis systems to

ensure adherence to the new guidelines issued by the IRS.

Will my clients see the adjusted cost basis of fixed income

positions for amortization/accretion?

Depending on the settings you have chosen, your clients may

see the adjusted cost basis on statements and/or

schwaballiance .com . You may view your settings in the Cost

Basis tab on schwabadvisorcenter .com or call Schwab for this

information . Click on the Subscription/Status link for the

applicable master account to view these settings, or call Client

Reporting Services at 1-877-762-6446.

What information will Schwab report to the IRS on covered

bonds and options for 2014?

Schwab will report adjusted cost basis and total market discount

at disposition (sale or maturity) on IRS Form 1099-B. Schwab will

also report bond premium on an annual basis to the IRS on Form

1099-INT and acquisition premium on Form 1099-OID .

From what date will Schwab adjust my clients’ cost basis?

Once adjusted cost is implemented on your clients’ accounts,

Schwab will “catch up” calculations on all applicable positions

from the acquisition of the position to the current day .

Will Schwab provide both original and adjusted cost basis

figures to me?

Advisors will see both original and adjusted cost on

schwabadvisorcenter.com and in cost basis data files. If you have

selected to include cost basis on your clients’ statements, the

electronic copies of these statements that you have access to

through schwabadvisorcenter.com will also reflect the changed

values .

Will Schwab provide me with my clients’ market discount and

bond premium on an annual basis?

Yes, this information on less complex fixed income holdings will

appear in the amortization section of the 1099 Composite and

Year-End Summary .

What if a client reports their bonds differently on their income

tax return than the IRS-prescribed defaults?

The IRS will allow taxpayers to instruct Schwab to use settings

for taxable bonds that differ from the defaults . To do so, clients

must sign and complete the Letter of Authorization (LOA) to

Change Fixed Income Amortization & Accretion Settings form .

For the different settings to be in effect, the form must be

submitted prior to the end of this year. The IRS has approved

these instructions:

• Accrue market discount using constant yield .

• Include market discount in current income .

• Disable bond premium amortization .*

• Treat all interest as OID .

Please note: Schwab is able to support all the instructions above

for the 2014 tax year except the instruction to “treat all interest

as OID.” We will provide an update regarding support for this

instruction in 2015 .

What if a client doesn’t accrue their market discount using the

straight line method? Are you able to calculate it using the

constant yield method?

Yes, but to do so, your client must complete and return the Letter

of Authorization (LOA) to Change Fixed Income Amortization &

Accretion Settings form and instruct Schwab to make the change .

What if a client holds all their bonds until maturity? Does it

matter whether you accrue the discount using the straight line

or constant yield method?

No, if a bond is held until maturity, the result will be the same

regardless of whether we calculate straight line or constant yield .

Generally, if a bond is sold prior to maturity, the straight line

method may accrue the discount at a faster rate than constant

yield .

* Schwab will stop amortizing and adjusting cost basis for bond premium for taxable bonds only. We are still required to accrete for market discount and original issue discount for both taxable and non-taxable bonds.

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What if a client includes their market discount and pays tax on

it in their income tax return every year? Are you able to change

their account settings to include market discount in income

currently?

Yes, but to do so your client must complete and return the Letter

of Authorization (LOA) to Change Fixed Income Amortization &

Accretion Settings form . This gives us the authority to update the

setting on their account to include their market discount in their

annual 1099-INT or 1099-OID reporting. We will also adjust their

cost basis daily when they select current inclusion .

What if a client doesn’t want you to calculate their market

discount at all? Will you disable market discount reporting?

No, if a bond is covered under the cost basis reporting rules, we

are required by the IRS to report market discount when a bond is

sold or matures .

Are you able to stop amortizing bond premium on my clients’

accounts?

Yes, but only for taxable bonds . We are required to make the

adjustments and report the premium for non-taxable bonds in

alignment with the taxpayer requirements .

How can I obtain the Letter of Authorization (LOA) to Change

Fixed Income Amortization & Accretion Settings form?

You can obtain the form by contacting the Advisor Services Client

Reporting Services Team at 1-877-762-6446.

When will the Letter of Authorization (LOA) to Change Fixed

Income Amortization & Accretion Settings form be available?

The Letter of Authorization (LOA) to Change Fixed Income

Amortization & Accretion Settings form will be available on

September 1, 2014 .

Can I sign and submit the Letter of Authorization (LOA) to

Change Fixed Income Amortization & Accretion Settings form

on behalf of my client?

No, the IRS requires that the account holder execute the form.

Why are you making these changes now rather than in January

2014, when the changes became effective?

The IRS released the final cost basis regulations in April 2013.

The guidelines provided require Schwab to upgrade its cost basis

systems . To ensure proper 2013 tax reporting, we needed to wait

until tax year 2013 ended before making the required changes .

The IRS only requires brokers to make changes on less complex

bonds purchased after January 1, 2014, in taxable accounts.

Why did Schwab decide to apply the changes to the bonds my

clients purchased prior to 2014 and also apply these changes to

amortized bond positions in non-taxable accounts?

We made this decision because we believe that it will result in a

simpler and easier message to communicate to your clients, and

that it will deliver a more consistent experience to your clients .

How will my clients find out about these changes? Is Schwab

communicating information to them directly?

You should inform your clients about these changes . We’ve

provided resources within the Advisor Toolkit to help advisors

communicate this information directly to their clients . Schwab

will communicate the changes to clients who access cost basis

through schwaballiance .com in the Unrealized Gain/Loss tab . In

addition, all clients with cost basis on their statements will

receive an insert in their August 2014 statements, which will be

mailed early in September .

Whom should I and/or my clients call with questions?

Advisors should contact the Advisor Services Client Reporting

Services Team at 1-877-762-6446 . If your clients want to speak

to someone at Schwab, direct them to Schwab Alliance at

1-800-515-2157 .

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Options: What to expect in 2014 and 2016

The IRS regulations also change reporting cost basis on options

on stocks, indices, single stock futures, stock rights, and

warrants. Although these instruments are not currently subject to

gross proceeds or cost basis broker reporting on Form 1099-B,

brokers will now be required to do so if they are acquired on or

after January 1, 2014 .

If option contracts are exercised or assigned, brokers are

required to adjust the cost basis or proceeds of the underlying

positions. Schwab has been reporting the adjusted cost basis on

option exercises and assignments since 2011 .

Wash Sales

Schwab will continue to perform wash sale adjustments on

options with the same CUSIP that have disallowed losses .

Cost Basis reporting

There are several adjustments that brokers will not be permitted

to make when reporting the adjusted cost basis of stock rights,

options, and warrants:

• Schwab will not take into account the impact of option

purchases or sales in determining disallowed losses on sales

of the underlying securities . You should explain to clients that

this treatment differs from taxpayer requirements .

• Brokers may not apply straddle rules on options in reporting

adjusted cost basis to the IRS.

Options Subject to 1/1/14 Reporting Options Subject to 1/1/16 Reporting Options Excluded From Reporting

• Options on a single security

• Options on more than one specified security, including an index in which the components are considered covered securities

• Options on financial attributes of specified securities, such as interest rates or dividend yields

• Warrants or stock rights

• Investment units in which options, stock rights, or warrants are issued together with a fixed income security

• Incentive stock options

• Foreign currency options

• Commodity options

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Reporting change for employee stock option exercise

Brokers will no longer be able to report the income component of stock acquired through the exercise of incentive stock options

granted after January 1, 2014 .

Example: The client is granted an employer’s Non-Qualified Stock Option (NQSO) to purchase 100 shares of stock at $10 a share

(total cost $1,000) .

Current Reporting Reporting for grants after 1/01/14

The company’s stock price is at $15 a share when exercised (total value $1,500) . The client has $500 of ordinary income at the time of exercise reported on W-2 .

The company’s stock price is at $15 a share when exercised (total value $1,500) . The client has $500 of ordinary income at the time of exercise reported on W-2 .

If the client sells the shares at the time of exercise, Schwab reports $1,500 sales proceeds and $1,500 – commission cost . There will be a small loss on the transaction .

Proceeds = $1,500

Cost = $1,500 – commission

RGL = $0.00 or loss

If the client sells the shares at the time of exercise, Schwab reports $1,500 sales proceeds and $1,000 – cost minus commission . There will be a large gain on the transaction .

Proceeds = $1,500

Cost = $1,000 – commission

RGL = $500 or gain

The client will now be responsible for adding the $500 of income reported on the W-2 as a basis adjustment on Form 8949.

24

Broad-based index options

Broad-Based Index Options (Section 1256 Contracts)

Non-equity options that are marked to market under Section 1256—i .e ., listed options for non-equity securities and broad-based

stock indexes—will be reported under the rules for regulated futures contracts .

Example: Activity

• On March 5, 2014, buy broad-based index options contract for $3 .

• On December 31, 2014, options contract is worth $7 .

2014 1099-B Reporting

Box 9

Profit (or loss) realized on closed contracts 2014

$0

Box 10

Unrealized profit (or loss): open contracts—December 31, 2013

$0

Box 11

Unrealized profit (or loss) on open contracts held in your account on December 31, 2014

$4 Fair Market Value (FMV) ($7 less premium paid of $3)

Box 12

Aggregate profit (or loss) on contracts

$4

• On June 30, 2015, sell for $9 .

2015 1099-B Reporting

Box 9

Profit (or loss) realized on closed contracts 2015

$6 (proceeds of $9 less premium paid of $3)

Box 10

Unrealized profit (or loss): open contracts— December 31, 2014

$4

Box 11

Unrealized profit (or loss) on open contracts held in your account on December 31, 2015

$0

Box 12

Aggregate profit (or loss) on contracts

$2 ($6 + $0 - $4)

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A reminder about backup withholding changes

Schwab is required to withhold the federal backup withholding

rate, currently 28%, from the proceeds of their options contract,

right, and warrant sales, in addition to all other reportable gross

proceeds transactions. If a client lives in a state subject to state

backup withholding on gross proceeds, the current state rate will

also apply .

Schwab modified its existing process to collect federal backup

withholding taxes on all gross proceeds transactions at the time

of trade . State backup withholding will continue to be applied the

day after the trade date .

Explain to clients that if their accounts are subject to backup

withholding on gross proceeds, it is because:

• They received “B” Notices from the IRS due to missing or

incorrect name/taxpayer ID number combinations .

• They have not submitted a W-9 form .

• Their W-8 certification has lapsed.

Transfer reporting delayed one yearCost basis reporting on security transfers of covered fixed income and options will be required one year later than the date for purchases.

The IRS has delayed requirements for reporting cost basis on transfers for an additional year. This will allow brokers the necessary time to

change their transfer reporting systems. Any fixed income or options transferred during this time will be treated as uncovered.

1099 Reporting Transfer Statements

Less complex fixed income January 1, 2014 January 1, 2015

Options January 1, 2014 January 1, 2015

More complex fixed income January 1, 2016 January 1, 2017

Options issued as part of a fixed income instrument January 1, 2016 January 1, 2017

26

1099 Forms

The IRS released the final cost basis regulations that will result in

new reporting requirements for fixed income and options that will

impact the 2014 1099 Composite, Year-End Summary, and

Transfers reports mailed in Q1 of next year . Later in 2014,

Schwab will provide advisors with educational tools that describe

the changes to the 1099 Composite and other reporting

platforms, and share our plans for communicating these changes

to your clients . Here is a summary of the changes that will be

made to existing tax reports .

Form 1099-B

• Report adjusted cost basis, disallowed loss, holding period,

and acquisition date for “less complex” fixed income, options,

stock rights, and stock warrants acquired on or after 1/1/14 .

• Remove sales reporting for short-term debt issued after

1/1/14 .

• Report all principal payments (cost basis reporting is not

required) .

• Add a box to report market discount at disposition for covered

bonds .

• Add four boxes for regulated futures reporting for section 1256

contracts .

Forms 1099-INT/1099-OID

• Add a box for Bond Premium/Acquisition Premium .

• Add a box for Market Discount (used only if your client currently

instructs us to include market discount in their income) .

Schwab is making system changes in August 2014 and

November 2014 to prepare clients’ accounts for tax

reporting that reflects required IRS changes—making tax

preparation easier for you and your clients .

27

Glossary

171 Election A taxpayer (a bondholder or client) instruction under Internal Revenue Code Section 171 to amortize bond premium on a taxable fixed income security.

Accretion The process of adjusting the purchase price of a bond upward to par. The difference between the price of a bond bought below par and its par value is called the “discount.” When an investor buys a security in the secondary market at a discount (if the security was purchased below par of 100), the purchase price is adjusted upward to 100 over the remaining life of the security until it reaches par on the maturity date .

Acquisition Premium The excess of a fixed income security’s adjusted cost basis immediately after purchase, including purchase at original issue, over the fixed income security’s adjusted issue price at that time.

Amortization The process of adjusting the purchase price of a bond downward to par. The difference between the price of a bond bought above par and its par value is called the “premium.” When an investor buys a security in the secondary market at a premium (if the security was purchased above par of 100), the purchase price is adjusted downward to 100 over the remaining life of the security until it reaches par on the maturity date .

Bond Call Feature Allows the issuer the right to redeem the bond, under specific conditions, prior to its maturity date.

Bond Premium Amount by which your cost basis in the bond right after you buy it is more than the total of all amounts payable on the bond after you get it (excluding payments of qualified stated interest).

Bond Put Feature Allows the holder to force the issuer to repurchase the security at specified dates before maturity.

Constant Yield A method of amortizing bond premium . The constant yield amount is calculated by multiplying the adjusted cost basis by the yield to maturity at issuance and then subtracting the non-qualified stated interest .

Debt Instrument or Fixed Income Security

The IRS defines “debt instruments” (also referred to by Schwab as fixed income securities) as any instrument or contractual arrangement that constitutes indebtedness under the general principles of federal income tax law, including notes, bonds, debentures, or other evidence of indebtedness .

De Minimus Under federal tax laws and regulations, for the discount rules to apply to a security, the discount must be at least 0 .25% of the stated redemption price for the bond at maturity, multiplied by the number of full years from the date of original issue for OID securities or purchase date for market discount to maturity . Otherwise, the discount is considered to be zero .

Fixed Income Security or Debt Instrument

The IRS defines “debt instruments” (also referred to by Schwab as fixed income securities) as any instrument or contractual arrangement that constitutes indebtedness under the general principles of federal income tax law, including notes, bonds, debentures, or other evidence of indebtedness .

Market Discount The stated redemption price of a bond at maturity minus your cost basis in the bond immediately after you acquire it . Market discount arises when the value of a debt obligation decreases after its issue date .

Original Issue Discount (OID) The amount by which the stated redemption price at maturity of a fixed income security is more than its issue price .

Qualified Stated Interest In general, qualified stated interest is stated interest that is unconditionally payable in cash or property (other than fixed income securities of the issuer) at least annually over the term of the fixed income security at a single fixed rate (e.g., bond coupon payments).

Straight Line Amortization A simple amortization method that spreads out the cost of an asset equally over its lifetime .

Yield to Best— Yield to Highest

The yield that would be realized on a callable bond if it were redeemed on the date that would result in the highest yield .

Yield to Maturity The average annual return on a bond, assuming the bond is held to maturity and all interest payments are reinvested at the same rate. The yield includes an adjustment for any premium or discount from the face value .

Yield to Worst— Yield to Lowest

The yield that would be realized on a callable bond if it were redeemed on the date that would result in the lowest known yield to the holder .

For general informational purposes only. This information is not intended to be a substitute for specific individualized tax, legal, or

investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax

advisor, CPA, financial planner, or investment manager.

For general informational purposes only. Meant for an institutional audience.

Schwab Advisor Services serves independent investor advisors and includes the custody, trading, and support services of Charles Schwab & Co., Inc. (“Schwab”).


This general information is not intended to be a substitute for specific individualized tax, legal, or investment planning advice and is not intended to be construed as tax advice.

This information cannot be used for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Where specific advice is necessary or appropriate, Schwab recommends consulting with a qualified tax advisor, CPA, financial planner, or investment manager.

©2014 Charles Schwab & Co., Inc. All rights reserved. Member SIPC. CS21701-02 (0614-4301) MKT81234-00 (08/14) 000000000

Questions?

The Client Reporting Services Team is available at 1-877-762-6446 to answer any additional questions you may have .

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