Are capital gains taxes on an honor system?

January 26, 2000

Subject:  Reporting Capital Gains Tax - An Honor System?
From:  Joe Sebastian
Date:  Tue, 07 Dec 1999

Hi guys,

I have a question about capital gains tax on securities sales for which I have not been able to find a concrete answer anywhere.

I don't know much about taxes, tax law or IRS regulations and procedures. However, from the little I do know - and please correct me if I am misinterpreting the below described tax issues - it seems to me that in reporting capital gains or losses regarding securities, there is a lot of room for fraud. Let me try and explain what I mean.

If one works for an employer, his wages (W-2 form) are reported to the IRS by the person's employer. It is very straight forward. Even the unreported amount of tips (for certain professions) can be estimated by the IRS from an established table of averages.

When it comes to capital gains, however, the broker reports to the IRS only the proceeds from a person's securities sales (form 1099-B) without any information about the basis price and the consequent amount of capital gains or losses on those transactions. In other words, the IRS looking at the data officially reported to them by the broker has no idea or indication if that person had a capital gain or a capital loss. They only know that the person sold x-amount dollars worth of stocks and rely only on that person and that person alone to relate these figures to the basis prices, calculate and report on his return the amount of gain or loss.

It seems to me that the IRS has nothing to go by that would indicate any discrepancy between the amount of capital gains/losses reported by the individual on his tax return and the data reported to the IRS by the broker.

Unlike other professions, capital gains and losses in securities trading don't fit a law of averages or any probable outcome - one person who made 300 trades during a year can have a capital gain, while another person who also made 300 trades can have a capital loss, even though - and this is very important - the proceeds from the both individuals' stock sales are identical. Again, it is only up to the individual himself to put the proceeds into relation with the basis price and establish the amount of gain or loss.

If all of the above is true, consider a fraud hypothetically illustrated in the following example:

An individual made 500 trades one year (which nowadays is not as unusual as it used to be). After calculating the difference between the securities' purchase and sale prices (minus commissions) he arrives at a capital gain of "x." However, on his return he illegally enters a fictitious base for some of the trades and reports a total capital gain of only "y." The IRS, possessing only information about the proceeds from sales but not the basis price, has no way of knowing whether the amount of capital gains on the return is true or false. The only entities who know the true basis price for all those transactions are the trader and the broker. The only way the IRS can find out about the basis price is by auditing the individual. However, since there is - seemingly - neither an accounting discrepancy nor any return entry clashing with the broker-reported figure, the IRS has no apparent reason to audit (apart from unrelated issues). The only way for the IRS to have an indication of a possible discrepancy would be to compare the amount by which the individual's account grew during the given year with the capital gain he is reporting on his tax return. But since the broker does not officially report the individual's annual account appreciation , the IRS has nothing that would indicate anything unusual.

If the example is plausible, it seems to me that as far as reporting capital gains and losses in securities transactions, the IRS is relying on some sort of honor system. If every year individuals similar to the one from the above example shave off just a fraction of their capital gains on their tax returns, can you imagine the amount of revenue the IRS is losing?

I wish you could shed some light on these questions.

Thank you
Joe Sebastian

Answer

Date:  Dec 1999

Hello Joseph,

You wrote a very lengthy letter about this issue.

In a nutshell, there are many areas for which the tax system relies on the honesty of the taxpayer in reporting their information. There are penalties, in some cases (tax fraud) criminal penalties, for reporting false information.

For the most part, the system works surprisingly well. Although people make jokes about the tradition of cheating on your tax returns, most Americans are reasonably honest and afraid of being caught.

Good luck!
Mike Gray

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