Form 1099-B and the New Adjusted Tax Basis and Sales Proceeds Reporting Rules for Brokers

Editor: Jon Almeras, J.D., LL.M.

Gains & Losses

On April 17, 2013, the IRS released final and temporary regulations (T.D. 9616) that provide guidance on the requirement of Sec. 6045 for brokers to report proceeds and adjusted tax basis for the sale or exchange of certain debt instruments, securities futures contracts, and options on Form 1099-B, Proceeds From Broker and Barter Exchange Transactions. Reporting under the regulations applies to certain debt instruments (described below) acquired on or after Jan. 1, 2014. The taxation of debt instruments is complex, but given the new reporting requirements, this is a good time to consider the topic. This item focuses on the general taxation of debt instruments and provides an overview of the new reporting requirements and the implications they raise.

General Tax Issues of Debt Instruments

Since the financial crisis of the late 2000s, transactions in debt instruments have increased in volume and complexity. From a tax accounting perspective, taxpayers and their advisers generally must consider two major categories of debt investments: (1) original issue and (2) secondary market purchases. Each category requires further examination of the facts and circumstances at the time of purchase, in addition to the terms of the instrument.

Original Issue Debt Instruments

An original issue debt instrument may be issued in one of three ways: below par with original issue discount (OID) (Secs. 1272 and 1273), at par without OID, or at a premium without OID. OID is the difference between the issue price of a bond and the amount payable to the holder when the debt instrument matures (known as the stated redemption price at maturity, or SRPM). SRPM is the sum of all payments under the debt instrument that are not qualified stated interest (QSI), i.e., interest that is unconditionally payable in cash or in property (other than debt instruments of the issuer) or that will be constructively received under Sec. 451, at least annually at a single fixed rate (Regs. Sec. 1.1273-1(c)).

If all stated interest is QSI, then the SRPM is simply the principal amount of the debt. All debt instruments that pay no interest before maturity are presumed to be issued with OID, e.g., zero-coupon bonds. In other words, OID is SRPM less issue price. If the debt instrument is issued with OID, taxpayers should include in their gross income the appropriate amount of accreted OID in “an amount equal to the sum of the daily portions of the original issue discount for each day during the taxable year on which such holder held such debt instrument” (Sec. 1272(a)(1)).

If an original issue debt instrument is issued at a premium, the holder may elect to amortize the premium under Regs. Sec. 1.171-1(a) on an effective-yield basis as an offset to interest income over the term of the debt. The amortizable premium is equal to the excess of (1) the holder’s basis in the debt instrument when purchased at original issue over (2) the SRPM. The election applies to all of the holder’s taxable premium debt instruments for the current and subsequent years, unless revoked with the IRS’s consent.

Upon disposition of an original issue debt instrument, the taxable gain or loss realized is generally the sale price of the debt instrument (or the redemption price if the bond is redeemed) minus the adjusted tax basis. If OID or premium amortization has been recognized currently, the adjusted basis of the debt instrument is increased or decreased, as appropriate, by the amortization.

Secondary Market Debt Purchases

Secondary market purchases generally have nine separate conditions. They may be either:

1. Issued at par and purchased at par, with no OID;
2. Issued at par, with no OID, and purchased with market discount;
3. Issued at par, with no OID, and purchased with bond premium;
4. Issued with OID and purchased with no bond premium or market discount;
5. Issued with OID and purchased with market discount;
6. Issued with OID and purchased with bond premium;
7. Issued at a premium, with no OID, and purchased at par;
8. Issued at a premium, with no OID, and purchased with market discount; or
9. Issued at a premium, with no OID, and purchased with bond premium.

Exhibit 1 illustrates the general rules for the amounts subject to OID, market discount, or market premium based on whether a debt instrument is an original issue or secondary purchase.

Tax Elections Relating to Debt Instruments Purchased on the Secondary Market

When debt instruments are purchased on the secondary market, certain elections may yield significant benefits for taxpayers, although the calculations that accompany those elections may be complex. Tax accounting for these elections may be further complicated when the instrument is “distressed,” has alternative prepayment terms, or has terms relating to contingent interest payments. A few common considerations for the various elections are described below.

First, taxpayers may elect to amortize market premium (the excess of purchase price over adjusted issue price) over the remaining life of the instrument. Similar to the election for an original issue debt instrument, this may reduce not only the current taxable income but also the debt instrument’s adjusted tax basis. Therefore, on disposition or redemption of the instrument, a larger capital gain or reduced capital loss may be recognized.

When a debt instrument is purchased with market discount (i.e., the purchase price is below the SRPM), the tax rules do not require a current accrual (in contrast to OID). Rather, the default rule is to recognize the accrued portion of market discount in income as ordinary income when there is a principal payment, sale, or redemption that results in a taxable gain to the holder. Practitioners think of this as a “reclass” between capital gain and ordinary income upon disposition. If the debt instrument is sold at a loss, there is no reclass between market discount and capital loss.

A taxpayer may elect to include the market discount accruals on a current basis rather than waiting for a taxable disposition. Such an election applies to all debt instruments held by the taxpayer (Sec. 1278(b)). Note that many mutual funds make this election so that the financial statement and taxable income are more closely aligned (and required distributions are increased); by contrast, many private investment funds do not elect current accrual, as their investors may be more tax-sensitive.

Whether a taxpayer decides to accrue market discount currently or reclassify gain to ordinary income upon a taxable event, the taxpayer may elect to use either the ratable method or the current-yield-to-maturity method. Unlike the current-accrual election discussed in the preceding paragraph, the election of the ratable or current-yield-to-maturity method for calculating market discount can be made on an instrument-by-instrument basis (Sec. 1276(b)). Under the ratable method, the amount of accrued market discount is equal to the product of the total market discount and the ratio of days held to the total days between the acquisition and disposition date to the maturity date. The formula is:

Ratable inclusion = [Market discount × Number of days held] ÷ Number of days from acquisition to maturity

The ratable method may be most beneficial if the holder is not certain when a principal payment will be made or if the taxpayer is holding an instrument that has only one principal payment. In practice, most taxpayers use the ratable method because it conforms to the financial accounting method of accrual or is relatively easy to calculate. The adjusted tax basis of the debt instrument is increased by the amount of market discount recognized each tax period.

Under the current-yield-to-maturity method, the holder relies on OID principles to compute the accrued market discount, substituting “adjusted basis” for “adjusted issue price” and the holder’s yield to maturity for the original yield on the debt. Electing the current-yield-to-maturity method may be more advantageous to holders who plan to hold the instrument for a relatively short time, as a smaller amount of ordinary income is generated and a larger capital gain could be recognized upon a taxable disposition. Note that many taxpayers do not use the current-yield-to-maturity method because either they are unaware of the potential benefits or the current-yield-to-maturity method calculations are more complicated than those for the ratable method due to the need to calculate the yield to maturity for each debt instrument.

See Exhibit 2 for a graph comparing the general results with respect to timing and the amount of market discount.

In Exhibit 2, the graph illustrates that, if the taxpayer disposes of the debt instrument before year 8, the current-yield-to-maturity method would result in a smaller market discount accrual; therefore, the taxpayer will have a larger long-term capital gain, as compared with the ratable method. As noted earlier, the ratable versus the current-yield-to-maturity method election is made on an instrument-by-instrument basis; if the taxpayer has not elected to include market discount in income currently, the method election represents one of the few tax planning opportunities that may be implemented with hindsight. The taxpayer can decide which method to use when there is a taxable event.

The Final Debt Instrument Reporting Rules

The final regulations will phase in over several years. Basis reporting begins with debt instruments acquired on or after Jan. 1, 2014, that have “less complex” features, such as a single fixed payment schedule, for which a yield and maturity can be determined, an alternate payment schedule for which a yield and maturity can be determined, and a demand loan for which a yield can be determined (see Regs. Secs. 1.1272-1(b)–(d) for determination factors).

Adjusted tax basis reporting will be required for “more complex” debt instruments without a fixed yield and a fixed maturity date that are acquired on or after Jan. 1, 2016. Complex debt instruments include debt instruments that provide for more than one rate of stated interest (such as those with stepped interest rates); convertible debt instruments; stripped bonds or coupons; debt instruments that require payment of either interest or principal in a non-U.S.-dollar currency; certain tax credit bonds; debt instruments that provide for a payment-in-kind feature; debt instruments issued by a non-U.S. issuer; debt instruments for which the terms of the instrument are not reasonably available to the broker within 90 days of the date of acquisition by the customer; debt instruments that are issued as part of an investment unit; debt instruments evidenced by a physical certificate, unless the certificate is held (whether directly or indirectly through a nominee, agent, or subsidiary) by a securities depository or by a clearing organization described in Regs. Sec. 1.1471-1(b)(18); contingent payment debt instruments; variable-rate debt instruments; and inflation-indexed debt instruments.

Generally, short-term debt instruments—those with a fixed maturity date not more than one year from the date of issue—are not subject to the adjusted tax basis reporting requirements.

Default Elections

Brokers are required to report information using default assumptions provided in relevant statutes and regulations with respect to computing OID, market discount, bond premium, and acquisition premium; however, brokers are also required to accommodate taxpayers that choose to depart from the default elections. The regulations require brokers to allow taxpayers to make and revoke five specific elections that may have an impact on the cost basis of certain debt instruments. Taxpayers may direct their brokers in writing to apply the following elections:

1. Currently include in income accrued market discount;
2. Accrue market discount using the constant-yield method;
3. Treat all interest on a taxable debt instrument as OID; or
4. Translate interest income and expense at the spot rate on debt denominated in a foreign currency.

If a taxpayer makes a proper notification of one of these elections, the broker must apply it when computing cost basis. Further, if properly notified of a subsequent revocation, a broker must compute cost basis considering such a revocation.

These final regulations make an exception to the general rule requiring brokers to use the default elections provided in the statute and regulations in the case of bond premium. Sec. 171 generally requires taxpayers to affirmatively elect to amortize bond premium on taxable bonds, which then offsets interest income on the bond. The final regulations require brokers to assume that customers have made the election to amortize bond premium when reporting basis, unless the customer has notified the broker otherwise. If the broker does not receive notification from a taxpayer, the broker is to assume that the customer has elected to amortize bond premium and none of the other elections have been made, if applicable.

The regulations state that the taxpayer may notify the broker of the election electronically, and an election can be made by the end of any calendar year in which it is to be effective or for which a change is requested.

Conventions

Many brokers do not use the same conventions for debt instrument computations. They may use 30 days or the actual days per month, 360 or 365 days per year, or other periods for interest computations; they also may use different accretion assumptions, different accrual periods, and different rounding conventions, among other variations. Indeed, nothing in the final regulations prevents this variability:

These final regulations do not prescribe a particular day count convention brokers must use for basis reporting. Instead, these final regulations provide that a broker may use any reasonable day count convention. The terms of a debt instrument, however, generally include the day count convention that the issuer will use to compute interest payments. [Preamble to T.D. 9616, Summary of Contents, B.2.]

In addition, the final regulations do not prescribe a particular rounding convention.

Conclusion

Many taxpayers do not adequately consider the various elections available to them when holding and disposing of debt instruments. Proper planning based on examining available elections may result in greater tax efficiency. In particular, electing to use the current-yield-to-maturity method may generate more long-term capital gain while reducing ordinary income.

Once the new cost basis and proceeds reporting rules become effective, taxpayers will be required to reconcile any differences between the proceeds and adjusted basis reported on Forms 1099-B and those reported on the tax return using Form 8949, Sales and Other Dispositions of Capital Assets. This reconciliation will likely be very complex, given the various elections that can be made and the different conventions that can be used.

EditorNotes

Jon Almeras is a tax manager with Deloitte Tax LLP in Washington, D.C.

For additional information about these items, contact Mr. Almeras at 202-758-1437 or jalmeras@deloitte.com.

Unless otherwise noted, contributors are members of or associated with Deloitte Tax LLP.