In Defense of Share Identification
By Kaye A. Thomas
Current as of January 3, 2015
Both Republicans and Democrats have proposed doing away with share identification. Here’s why this would be a tax policy blunder.
A sensible rule that’s important to millions of investors is under attack, and we seem to be its only defenders. Without articulating a valid reason for doing so, both President Obama and Dave Camp, the Republican Chair of the House Ways and Means Committee have proposed to repeal share identification, the rule that permits investors to choose which shares they’re selling when disposing of part of their holdings. They would replace it with a rule that is far more complicated and produces arbitrary, inaccurate results. Most importantly, the change would interfere with neutrality of investment choice, making it disadvantageous for someone holding shares of a particular stock to add to those holdings.
Investors often hold more than one lot of shares of a particular stock, bought at different times and prices. The tax consequences of selling part of those holdings depend on which shares are sold, as some will produce more gain or loss than others and some may be short-term while others are long-term. For nearly as long as we’ve had an income tax, investors have been permitted to choose which shares they’re selling, through a process called identification (or sometimes, redundantly, specific identification or adequate identification).
- See our page explaining how to identify shares
What’s the problem?
Apart from their tax characteristics, shares of a single class of stock are economically identical. An investor who identifies shares for sale does not alter the economics of the transaction, and presumably obtains a tax advantage from the procedure, which would otherwise be pointless. To some observers, it seems inappropriate to offer a tax advantage for doing something that has no economic substance.
Yet the tax law offers literally hundreds of similar provisions. Generally they’re known as tax elections, though some of them, such as Roth conversions, don’t go by this name. Taxpayers can choose whether to treat a limited liability company as a partnership or a corporation, and then choose between C corporation and S corporation. Investors have numerous elections at their disposal affecting such items as investment interest expense and the income produced by certain bonds. Share identification is simply one of the many tax elections permitted under the law — and it serves an important purpose.
Those who would repeal identification appear to believe that the rule confers an improper advantage. In reality, the rule merely preserves neutrality. In other words, it protects investors from experiencing and improper disadvantage when adding to their holdings of a particular stock, rather than investing in a different stock they don’t already own.
Consider an investor who owns 100 shares bought at $10 and is considering whether to buy another 100 when the stock is trading at $20, or perhaps instead buy $2,000 worth of some other stock. If this investor chooses the other stock, she’ll be able to sell that stock later while retaining the older shares. Identification offers the same choice if she adds to her existing holdings.
What if identification is repealed? The two choices are no longer neutral. If the investor buys more of the same stock, she can’t sell those shares later without selling the older shares. She might lose money on the new purchase, but still be required to report a gain for tax purposes when she backs out of it. The potential for this kind of unfair result would complicate the buying decision. Investment choices would have to take into account the inferior tax consequences when adding to an existing holding.
Our article in the Winter 2014 issue of the Journal of Taxation of Investments (subscription required) makes this argument in much greater detail. We’ve also sent correspondence to the heads of congressional tax committees on this issue. We believe the proposal to do away with identification is completely wrongheaded, creating enormous problems without serving any useful purpose. We think this issue is important, and it’s distressing that it has received so little attention from tax policy experts, the securities industry, and others with a stake in preventing a grievous policy blunder.