Understanding Non-Covered Securities: Definition & SEC Role

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)Securities and Exchange Commission (SEC)The US Securities and Exchange Commission, or SEC, is an independent agency of the US federal government that is responsible for implementing federal securities laws and proposing securities rules. It is also in charge of maintaining the securities industry and stock and options exchanges.

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.

Summary

• 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 firmBrokerageA brokerage provides intermediary services in various areas, e.g., investing, obtaining a loan, or purchasing real estate. A broker is an intermediary who 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 assetsFixed AssetsFixed assets refer to long-term tangible assets that are used in the operations of a business. They provide long-term financial benefits 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 Regulations

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 splitStock SplitPublicly-traded companies all have a given number of outstanding shares or shares of stock in their company that have been purchased by and issued to investors. A stock split is a decision by the company to increase the number of outstanding shares by a specificied multiple. 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.

Additional Resources

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In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:

• Capital Gains TaxCapital Gains TaxCapital gains tax is a tax imposed on capital gains or the profits that an individual makes from selling assets. The tax is only imposed once the asset has been converted into cash, and not when it’s still in the hands of an investor.
• Depreciation MethodsDepreciation MethodsThe most common types of depreciation methods include straight-line, double declining balance, units of production, and sum of years digits.
• Dividend Reinvestment Plan (DRIP)Dividend Reinvestment Plan (DRIP)A dividend reinvestment plan (DRIP or DRP) is a plan offered by a company to shareholders that it allows them to automatically reinvest their
• Public SecuritiesPublic SecuritiesPublic securities, or marketable securities, are investments that are openly or easily traded in a market. The securities are either equity or debt-based.