Context and Basic Rules
The holder of a debt instrument that is issued with original issue discount (OID) must include part of the OID in gross income in each taxable year that the debt instrument is held, even though the OID is not paid until maturity (I.R.C. § 1272). The current inclusion applies regardless of the method of accounting used by the holder of the debt instrument. The current inclusion rule does not, however, apply to “any tax-exempt obligation” (I.R.C. § 1272(a)(2)(A)), which makes sense, because OID is treated as interest and, with respect to a tax-exempt obligation, should be excludable from gross income.
The policy of OID is to prevent taxpayers from trying to convert ordinary income (interest income) into capital gains (appreciation), and also to prevent taxpayers from deferring recognition of interest. The current inclusion under I.R.C. § 1272 does not apply to a holder who purchases the debt instrument (DI) at a premium or whose basis in the DI is determined by reference to its basis in the hands of a person who purchased at premium (I.R.C. § 1272(c)(1)).
The OID rules under I.R.C. §§ 1272 and 163(e) (deduction of interest with respect to OID) essentially place both taxpayers (the issuer and the buyer) on the accrual method of accounting. You are required to account for interest as it is earned based on passage of time and effective yield to maturity.
See “Discount and Premium Bonds: Dealing with the Tax Issues” and “Taxation of Municipal Bonds Flash Cards” for additional discussion.
OID = Stated redemption price at maturity (SRPM) – Issue Price (§ 1273(a))
SRPM, as defined in I.R.C. § 1273(a)(2) means the amount fixed by the last modification of the purchase agreement and includes interest and other amounts payable at that time (other than any interest based on a fixed rate, and payable unconditionally at fixed periodic intervals of 1 year or less during the entire term of the debt instrument). (The regulations more clearly define SRPM as the sum of all payments provided by the debt instrument other than qualified stated interest payments.)
Issue Price (I.R.C. §§ 1273(b) and 1274) = (1) If DI has Adequate Stated Interest (ASI), IP = Stated Principal Amount (SPA) (2) If DI does not have ASI, Issue Price = Imputed Principal Amount (IPA)
ASI (I.R.C. § 1274(c)(2)) = Yes, if the SPA of the DI (the face amount) <= IPA
IPA (I.R.C. § 1274(b)) = Sum of the PVs of all payments due on the DI (the AFR is used to compute the PV, and compounding is done semi-annually).
OID is treated as zero if the excess is less than 1/4 of one percent of the stated redemption price at maturity, multiplied by the number of complete years to maturity (§ 1273(a)(3)). But note that I.R.C. § 1288 states that OID for a tax-exempt obligation is calculated without taking into account the de minimis OID rule of I.R.C. § 1273(a). Therefore, de minimis OID does not exist for tax-exempt bonds.
Discussion of OID Rules
Rules of thumb: (1) If the bond bears interest at least at the applicable federal rate (AFR), there is adequate stated interest (ASI) and therefore no OID; and (2) If the Issue Price = SRPM, there is no OID.
The definition of IP depends on whether the DI was issued for money or property, and whether the debt instrument is publicly traded. “Property” includes services and the right to use property, but does not include money. (Note that stock and securities are “property” and therefore cannot be “cash” – as suggested by I.R.C. 1273(b)(3)(B) references to stock and securities.)
- IP of publicly offered DI issued for money = initial offering price to public at which substantial amount of DI is sold.
- IP of not publicly offered DI issued for money = price paid by the first buyer of instrument.
- IP of publicly offered DI issued for property = FMV of the property.
- IP of not publicly offered DI issued for non-publicly offered property = look at ASI.
Note the following special rules to distinguish between I.R.C. §§ 1273 and 1274 application:
- Special I.R.C. § 1274 definition of “Issue Price” does not apply if none of the payments due on DI are due more than 6 months after the date of the sale or exchange of the debt instrument.
- I.R.C. § 1274 does not apply to publicly offered debt instruments.
Determination of AFR: Is set by IRS pursuant to Rev. Proc. DI term is < 3 years, use short-term AFR. DI term is > 3 years and < 9 years, use mid-term AFR. Otherwise, use long-term AFR. Debt Instrument (I.R.C. § 1275(a)(1)) = Bond, debenture, note or certificate or other evidence of indebtedness.
Effect on Issuer = Issuer may deduct the same amount under I.R.C. § 163(e).
Effect on Purchaser = Purchaser is required to include part of the OID in gross income currently.
Amount to be included = Sum of “daily portions” of OID for each day during the taxable year during which the holder held the debt instrument. Daily Portion = Allocate to each day that day’s ratable portion of the increase.
Increase for any accrual period = (Adj. IP at beginning * Yield to Maturity) – Sum(Amts payable as interest on the DI during the accrual period).
Early redemption by the Issuer = Issuer has COD, which is ordinary income.
If DI is a municipal bond (I.R.C. § 1288):
- Do get basis adjustment, even though interest is not taxable.
- Can still take loss.
- Market Discount rules apply (and O.I. will be taxable at disposition!).
- Acquisition Premium (irrelevant for federal tax purposes, but still reduce basis)
OID need not be included in gross income for the following:
- Tax-exempt obligations
- U.S. Savings bonds
- Short-term obligations
- Certain other DIs
I.R.C. § 1271(a): Amounts received by the holder on retirement of a debt instrument shall be considered as amounts received in exchange thereof.
Once an OID bond, always an OID bond. In all subsequent transactions involving the bond, you look at the original OID inclusion schedule.
Assume S sells property (FMV of $100K and A/B of $20K) to B. B gives S a promissory note where B will pay $150K to S in 5 years, with no interest. S reports no income until the fifth year, when B pays the $150K, and then reports $130K as capital gain ($150K A/R – $20K A/B). AFR is 8.447%. May S report $130K as capital gain, and thereby convert interest income (that would otherwise apply) into capital gain?
- SRPM = $150K
- IPA = $100K (PV of $150K payment to be made in 5 years using the AFR of 8.447%)
- ASI = No, because the stated principal amount of $150K is not less than the IPA.
At maturity: You have picked up all OID, and upon maturity and the deemed S/E treatment, your basis is equal to the A/R.
Thus, because there is not ASI, use IPA for Issue Price. OID is therefore $50K (difference between SRPM – IP).
S is therefore deemed to have received $50K of interest income (not capital appreciation) over the five years. S therefore only has capital gain of the difference between her “Gain” from the S/E ($130K) and the portion constituting interest ($50K). That capital gain is $80K, not $130K that S had hoped for.
Assume same facts but assume B’s note provides B will pay $30K in five equal installments, with the first payment due one year after closing. The effect of this is that it changes the total amount imputedly paid. By paying down principal earlier, B will be paying less interest.
- IPA = Sum of PVs of each payment using the AFR of 8.447%. Thus, IPA here turns out to be $119,789 (simply b/c paid down earlier).
- OID = $150,000 – 119,789 = $30,211
$30,211 would be considered ordinary income (because it is OID which is interest) and the remaining $119,789 would be capital gain.
Seller S sells property to B for $100K cash plus a buyer’s note of $100K, payable over 10 years at $10,000 principal per year. The APR is 10%. Under the note, however, B will pay 5% interest. This is a below market loan, so we already know this is an OID candidate.
- IPA = the PV of the ten payments is $79,570. So, no adequate stated interest. Thus, use IPA as Issue Price.
- OID = $100,000 – 79,570 = $20,430.
Assume the same facts, but B’s note provided for interest of 10%. Would there be OID? No. The AFR is also 10% and the sum of PV of the payments to be made under the note would be $100,000. There is adequate stated interest because the stated principal of $100K is less than or equal to the IPA.
What if the interest rate were 12% and the AFR is 10%? No OID. The sum of the PV of the payments to be made would be $108,746. There is adequate stated interest because the stated principal amount of $100K is less than or equal to the IPA which is $108,749.