Broker Basis Reporting of Debt Instruments and Options: Actions Holders or Issuers Must (or May Want to) Take

Editor: Frank J. O’Connell Jr., CPA, Esq.

Procedure & Administration

On April 18, 2013, Treasury and the IRS issued final regulations relating to basis reporting by brokers for transactions involving debt instruments and options (T.D. 9616). Buried in these regulations are optional or necessary actions to be taken in certain circumstances by holders of debt instruments, issuers of debt instruments subsequently registered with the SEC, and securities issuers that undertake organizational actions affecting the basis of specified securities. This item addresses these provisions.

Background

The final regulations reflect changes in the law made by the Energy Improvement and Extension Act of 2008, P.L. 110-343, which mandated that brokers that are required to file gross proceeds information returns under Sec. 6045 (Form 1099-B, Proceeds From Broker and Barter Exchange Transactions) for the sale of covered securities must include the customers’ adjusted basis in the sold securities and classify any gain or loss as long term or short term. On Nov. 25, 2011, proposed regulations were published (REG-102988-11) relating to information reporting for debt instruments and options that affected brokers, transferors, and issuers of these securities.

An effective date of Jan. 1, 2013, was proposed; however, Treasury and the IRS received many requests for a delay. In response to those requests, the IRS issued Notice 2012-34 to delay the effective date of basis reporting for debt instruments and options to no earlier than Jan. 1, 2014. Effective dates in the final regulations vary, but generally, reporting for less complex debt instruments and options takes effect for instruments acquired on or after Jan. 1, 2014, with reporting for more complex securities beginning Jan. 1, 2016.

Taxpayer Elections for Bond Premium and Discount Affecting Basis Reporting

Multiple elections are available to holders of debt instruments regarding the computation and/or recognition of original issue discount (OID), acquisition premium, and secondary market discount and premium, all of which affect the holder’s basis in the security. The IRS wanted to minimize the need for reconciliation between information reported by a broker to a customer and the IRS and the amounts reported on a customer’s tax return, while at the same time balancing taxpayer flexibility and consistency of practice among brokers. Therefore, the final regulations require brokers to report information using default assumptions provided in the relevant statutes and regulations. However, Regs. Sec. 1.6045-1(n)(4) designates five elections brokers must address in computing and reporting basis (and allows only these five elections to be taken into account):

1. The election under Sec. 1278(b) to include market discount in income currently as it accrues;
2. The election under Sec. 1276(b)(2) to compute the accrual of market discount using a constant-yield method;
3. The election under Regs. Sec. 1.1272-3 to treat all interest on a taxable debt instrument (adjusted for any acquisition premium or premium) as OID;
4. The election under Regs. Sec. 1.988-2(b)(2)(iii)(B) to translate interest income and expense at the spot rate on the last day of the interest accrual period with respect to a covered debt instrument denominated in a currency other than the U.S. dollar; and
5. The election under Sec. 171 and Regs. Sec. 1.171-4 to amortize bond premium on a taxable debt instrument.

Under Regs. Sec. 1.6045-1(n)(5), the broker must assume that the first four elections above have not been made, unless the customer notifies the broker in writing to the contrary. Conversely, the broker must assume that the fifth election, to amortize bond premium, has been made, unless it receives written notification to the contrary. Regarding bond premium amortization, a customer must notify the broker in writing by the end of the calendar year for which the customer does not want to amortize bond premium, or by the end of the relevant calendar year for which the customer subsequently changes course and does want bond premium amortization taken into account.

For elections 1–4 above, a customer must notify the broker in writing of the election by the end of the calendar year in which the subject debt instrument is acquired in, or transferred into, an account with the broker or, if later, by the end of the calendar year for which the election is effective. If the customer has revoked or will revoke elections 1, 3, 4, or 5, notice is required to the broker by the end of the calendar year for which revocation is effective. Since revocation of these elections is allowed only with the IRS’s consent (and revocation of election 2 is not allowed at all), advance planning may be required. Written electronic notification is acceptable. Debt instrument holders must be aware of these new rules so they give timely notification to brokers.

Temporary Regulations Related to Reporting of Bond Premium and Acquisition Premium

Under the current information reporting rules, interest income is reported to recipients without adjustment for bond premium or acquisition premium. The regulations discussed above prompted the IRS to conform the rules for reporting of interest income associated with a bond acquired at a premium with the rules regarding basis reporting for these same debt instruments. Newly issued temporary regulations under Sec. 6049 require brokers to report any amortized bond premium or acquisition premium for a covered debt instrument.

Under Temp. Regs. Sec. 1.6049-9T(b), unless the broker has been notified that the customer does not want to amortize bond premium, the broker must report the amount of any amortizable bond premium allocable to a stated interest payment made to the customer during the calendar year. The broker may choose to report a gross amount for both stated interest and amortizable bond premium, or may report a net amount of stated interest that reflects the offset of the stated interest by the amount of amortizable bond premium allocable to the payment. This requirement also applies to bond premium that must be amortized on a tax-exempt obligation.

Under Temp. Regs. Sec. 1.6049-9T(c), a broker must report the amount of any acquisition premium that reduces the amount of OID includible in income by the customer during the calendar year, using the constant-yield method, if notified in writing that a customer has made the constant-yield election. Again, the broker may report a gross amount for both OID and acquisition premium or report a net amount of OID that reflects the offset of the OID includible in income by the customer for the calendar year by the amount of acquisition premium allocable to the OID. This paragraph does not apply to tax-exempt obligations.

Form 8281: Issuers of Registered Debt Instruments

An issuer of a publicly offered debt instrument issued with OID must file a Form 8281, Information Return for Publicly Offered Original Issue Discount Instruments, within 30 days after the issue date of the debt instrument. To be publicly offered, a debt instrument generally must have been registered with the SEC as of the instrument’s issue date. This requirement facilitates the IRS’s publication of OID information in Publication 1212, Guide to Original Issue Discount (OID) Instruments. However, in many circumstances a debt instrument issued in a private placement is registered with the SEC after the issue date and, therefore, no Form 8281 reporting was required, and the relevant OID information would not appear in Publication 1212. Regs. Sec. 1.1275-3(c)(4) has been added to require filing Form 8281 for a debt instrument that is part of an issue offering that is registered with the SEC after the issue date. This form must be filed within 30 days of the registration of a privately placed debt instrument that is part of an offering registered with the SEC on or after Jan. 1, 2014.

Issuer Reporting Under Sec. 6045B

Sec. 6045B requires issuers of specified securities that undertake organizational actions affecting the basis of these securities to report information to both the IRS and to securities holders on Form 8937, Report of Organizational Actions Affecting Basis of Securities. A specified security is defined in Sec. 6045(g)(3)(B) as stock in a corporation; any note, bond, debenture, or other evidence of indebtedness; any commodity, or contract or derivative with respect to such commodity (as Treasury determines appropriate); and any other financial instrument (as Treasury determines appropriate). Regs. Sec. 1.6045-1(a)(14)(ii) clarifies that a regular interest in a real estate mortgage investment conduit (REMIC) is not a specified security and, therefore, is not subject to reporting requirements.

An issuer may meet its reporting requirement by posting a completed and signed Form 8937 in a readily accessible format in an area of its primary public website dedicated to this purpose and kept accessible to the public on this website or the primary website of any successor organization for 10 years. The preamble to the final regulations confirms that, to maintain consistency, a whole replica of Form 8937 must be provided on the website; however, to address concerns regarding potential identity theft of the certifying company official’s signature, Regs. Sec. 1.6045B-1(a)(3) allows an issuer to publicly post a Form 8937 with an electronic signature as an alternative to a written signature.

Scrutiny Needed for Compliance

The final regulations include much more than what is discussed above, including implementing reporting requirements for a transfer of a debt instrument or an option to another broker and numerous clarifying rules regarding basis reporting for options. However, as brokers themselves will be going over these regulations with fine-toothed combs to create their compliance processes, this item highlights the actions that could or must be taken by others—the holders or issuers of debt instruments, and securities issuers required to report certain organizational actions to their securities holders.

EditorNotes

Frank J. O’Connell Jr. is a partner with Crowe Horwath LLP in Oak Brook, Ill.

For additional information about these items, contact Mr. O’Connell at 630-574-1619 or frank.oconnell@crowehorwath.com.

Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.