Covered Security: What it Means, Tax Handling

What Is a Covered Security?

Covered securities are those that are subject to federally imposed exemptions from state restrictions and regulations. Most stocks traded in the U.S. are covered securities.

Understanding Covered Securities

Covered securities were developed to standardize security regulations and filings across the U.S., rather than making individual companies register, file and comply with regulations state-by-state. Compliance costs vary widely by state. According to the Securities and Exchange Commission (SEC), they run as low as a $100 fee and 0.1% of the value of the securities sold in Texas, to a simple $1,000 fee for those offered in Florida.

The 1996 National Securities Market Improvement Act superseded state regulations and stipulates what constitutes a covered security, also known as a "federal covered security." The law applies to securities listed on public exchanges such as the New York Stock Exchange and the Nasdaq National Market, or any national exchange with similar listing standards. Stocks traded on particular tiers of the Pacific Exchange, the Philadelphia Stock Exchange, and the Chicago Board Options Exchange are classified as covered securities, as are options listed on the International Securities Exchange.

Covered securities also include those issued by an investment company that is registered or has filed a registration statement under the Investment Company Act of 1940. The designation of covered securities extends to the sale of those securities to qualified purchasers as defined by the SEC.

By type of security, the definition includes stock in a corporation, including American depositary receipts (ADR), acquired on or after Jan. 1, 2011, or either type of security acquired through a dividend reinvestment plan (DRIP) on or after Jan. 1, 2012. It includes two classes of bonds, derivatives, and options: less-complex varieties purchased on or after Jan. 1, 2014, and complex types purchased on or after Jan. 1, 2016.

Tax Treatment of Covered Securities

Brokers must disclose to the Internal Revenue Service the adjusted cost basis of covered securities when they are sold. This must be reported on Form 1099-B. Taxpayers who sell covered securities must also report the transactions with their tax filings. If covered securities and non-covered securities are within the same investment account, they will be treated separately for tax purposes.

Other criteria come into play. Company stocks acquired starting in 2011, as well as shares of stock in dividend reinvestment plans and mutual-fund shares purchased in 2012 and afterward, are designated as covered securities. This means that many bonds, notes, commodities, and options bought from 2013 onward are also classified as covered securities. Securities purchased prior to these dates are non-covered securities whose adjusted cost basis is not reported when they are sold.