I sent the article to David Nangle, a student of mine who has been interested and vocal on the importance of keeping track of basis given the taxpayer's propensity to prevaricate with impunity in the absence of a third party backstop. He has extensive experience with corporate information management and worked with a software platform that automatically sent trade information and pricing data (including basis and valuation information) to prime brokers and fund administrations for hedge funds including funds of funds. His response is that enforcement is not just difficult and painful, in fact it is impossible [edited & posted with his permission]:
"Whenever migrating existing a new fund onto our software, I always needed to know how they wanted their basis calculated similar to what the article discusses in #1. FIFO was among the most popular used by funds, yet not uniform. HIFO - highest in, first out - was equally widespread, and in the case of arbitrage funds (who do thousands of trades a day) they frequently used our 'Min Tax' option or another exotic and rarely used scheme. Obviously heavy trade volume in a particular security clouds the cost basis of your overall position, so it was essential to be able to track different trade tax lots to see which ones were closing off against each other and keep all the different parties involves on the same page. It would be a massive headache for a couple weeks if one institution's internal accounting of the fund's changing portfolio positions was off and we needed to figure out why, though generally speaking after a couple weeks these issues would fade.
Having seen firsthand the complex nature of this cost basis problem, I have absolutely no faith that regulators could ever successfully track the different tax lots of each trade and ensure that funds are doing it 'right'. There is just no way that the IRS will be able to track every funds' trade activity, along with pricing information, and conclude that particular funds are dodging tax liabilities. Its possible that they could find mistakes if they happened to know which fund or position to investigate, but this would be enormously difficult to look into without a tip that something is amiss in the first place.
The problem becomes much more complex when the overall structure of hedge funds, mutual funds and fund of funds is considered. When a fund uses a master feeder structure, or a 'block' fund, it buys a huge chunk of a particular security and then allocates the chunk of securities across multiple funds or investment pools. This clouds the reporting discussed in the article even more, because technically the brokerage houses are not using the individual fund account numbers to make the purchases, merely the 'block' account. The fund itself is allocating the shares to different strategies or sub accounts. Eventually, fund admins and brokerages learn the allocations after reconciliation, but that is not captured in the initial trade itself. Allocations can go to sub accounts that might have an existing position in that security, thus distorting the cost basis by either closing out or adding to the position, while other allocations are the first of that security's kind to be allocated to that sub account.
Therefore it is the fund's internal decision making which will ultimately be reporting this information anyway, and even if the IRS forces a brokerage unit to report on a client funds' trade activity the block account will shield the allocations until the fund has decided the best way to report out their sub portfolios' positions.I have to agree that the task sounds impossible. Yet overstating basis is a major problem for the IRS, one made even more challenging by last week's Home Concrete decision [pdf], which tightens the IRS' time to review and investigate even in egregious cases. Rock: hard place.