Guest Contributor: Stevie Conlon, Senior Director & Tax Counsel, Wolters Kluwer Financial Services, with special thanks to support from Tax & Regulatory Specialists Anna Vayser and John Kareken.
Final regulations issued in April 2013 (T.D. 9616) provide rules for reporting of basis on debt instruments and for adjustments to basis by brokers for OID (original issue discount), bond premium, market discount, and acquisition premium. The IRS has not released some final and draft Forms 1099-B, INT or OID that reflect the 2013 final regulations discussed below. This will strain brokers and tax reporting managers and systems, as more changes could be forthcoming (note that an updated Form 1099-B reflecting cost basis reporting for debt has not yet been released). Accompanying temporary regulations would further increase the complexity of Form 1099-INT and 1099-OID reporting for debt instruments acquired on or after January 1, 2014. Brokers must make sure they can correctly calculate and report amounts newly required under the temporary regulations on the forms by their deadline as well as quickly address any other changes in recently updated Forms 1099-INT and 1099-OID (as well as any additional future form updates).
Changes to Form 1099-OID
The Form 1099-OID for the 2014 tax year (that will generally be filed and delivered to taxpayers in early 2015) contains brand-new boxes for market discount currently included in taxable income and acquisition premium adjustments to reported OID. The newly finalized instructions dated January 3, 2014 state that for reporting of both qualified stated interest (formerly just referred to as interest in the draft instructions) and OID on a taxable obligation, the payor may report both qualified stated interest (QSI) and OID on Form 1099-OID. On the Form 1099-OID, the qualified stated interest is reported in Box 2 and the OID in Box 1 or Box 8 (OID on U.S. Treasury obligations). Qualified stated interest on Treasury Inflation-Indexed Securities (TIPS) may be reported on Form 1099-INT (in Box 3) rather than on the 1099-OID. A separate Form 1099-OID is filed for each obligation, but if the taxpayer has more than one certificate (presumably “certificate” refers to a separate debt instrument), you can file a single Form 1099-OID only if: (1) they are the same issue, (2) held the same amount of time during the calendar year, (3) acquired at the same time, (4) acquired for the same price, and (5) all debt elections (or lack of elections) are the same for all certificates.
The instructions refer the payor to Publication 1212, Guide to Original Issue Discount (OID) Instruments for information on certain instruments with OID. A significant challenge for brokers calculating cost basis relating to debt instruments beginning for calendar year 2014 is that OID information for many debt instruments is not published in Pub. 1212 (such as OID for tax-exempt bonds, government securities, etc.). Brokers will need to look elsewhere to find this information.
As noted, acquisition premium is reported in Box 6 of the 1099-OID. Under Treas. Reg. 1.6045-1(n)(7)(ii), debt instruments acquired at a premium require the broker to decrease basis in the debt instrument by the amount of acquisition premium that reduces OID otherwise includible in income for the year under either a straight line accrual or, if elected by the taxpayer, a constant accrual basis. According to the instructions, for covered securities, the broker may (a) report the net amount of OID (the reduced amount after offset by the premium) and not report any premium in Box 6, or (b) report the gross OID amount and then also report the acquisition premium in Box 6. For noncovered securities, only the gross OID amount is required.
New boxes for market discount and acquisition premium on Form 1099-OID provide new and more detailed information that will benefit the taxpayer in tax preparation, but which will create substantial new reporting burdens for brokers. For covered debt instruments, market discount of $10 or more is reported in Box 5 if the bondholder has made the election to accrue market discount currently (previously such market discount is reported on Form 1099-MISC). Under the cost basis reporting regulations, market discount is one of the elections required to be taken into account by brokers. This elections applies to all debt instruments acquired by the taxpayer during the taxable year in which the election is made, and thereafter until revoked. In the absence of notification, the broker must assume that the taxpayer has not made the election.
Changes to Form 1099-INT
There are also important changes to note on the 2014 Form 1099-INT. Under the finalized instructions dated January 3, 2014 for this form and the 1099-OID), you must report the amount of bond premium amortization for the tax year for a covered security acquired with bond premium. However, in the case of a taxable bond, if you have been notified by the taxpayer that the taxpayer does not elect to amortize bond premium, you must not report any amount of bond premium amortization. If you are required to report the amount of bond premium amortization for the tax year, you may report either (a) a net amount of interest that reflects the offset of interest by the amount of bond premium amortization for the year or (b) a gross amount for both the interest and the bond premium amortization for the year. The instructions give an example: If a taxpayer receives $20 of taxable interest from a corporate bond and the amount of bond premium amortization for the year is $2, you may report $18 of interest income in box 1 and $0 in box 11, or you may report $20 of interest income in box 1 and $2 in box 11. For a noncovered security acquired with bond premium, you are only required to report the gross amount of interest.
It is also important to note that the draft 2014 1099-INT instructions had directed brokers to include in box 1 any accrued interest on bonds sold between interest dates, while the final instructions clarify that box 1 should include accrued qualified stated interest on bonds sold between interest dates. QSI is defined under Treasury Regulation 1.1273-1(c) and this definition completely or partially excludes stated interest paid on debt instruments under certain circumstances, such as payment intervals in excess of one year or stepped interest rates. Some brokers’ Form 1099-INT reporting of interest may not capture the nuanced distinction between “interest” and QSI.
Complex New Tax Reporting Challenges for Brokers
The short amount of time left before the reporting requirements become mandatory is clearly the greatest challenge brokers face in getting ready to comply with the new Forms 1099-OID and 1099-INT reporting requirements. Even if all issues are settled as to the reporting of OID, the fact remains that development is still an extremely lengthy process for a complex process such as OID reporting and coding for the new boxes for discount and premium.
A noteworthy aspect of the new reporting rules is that they require unique computations for every tax lot (i.e., every purchase of debt on different dates and at different prices) relating to bond premium, accrued market discount and acquisition premium. That is a massive change. Right now, brokers can complete Forms 1099-INT and 1099-OID based primarily on generic information relating to all debt instruments comprising a debt issue for tax purposes. Bond premium, market discount and acquisition premium calculations, on the other hand, are all based on the specific purchase prices and dates of individual tax lots rather than using generic information applicable to an entire debt issue.
Brokers have several additional concerns. First, Form 1099-OID does not currently allow OID reporting for tax-exempt bonds. However, it essentially doesn’t matter because brokers must make the calculations anyway in order to correctly calculate and report adjusted cost basis on Form 1099-B. There are also concerns about the proper reporting of OID on stripped bonds (where the purchase price equals issue price under Internal Revenue Code Sec. 1286).
Supporting Required Calculations Affected by Individual Customer Elections
Another major headache is the development of systems and ongoing support to track customer elections. Brokers will be required to monitor the customer’s written notices of several different special computations and reporting elections in order to correctly compute bond premium amortization, market discount or acquisition premium. Such notices may not come until the end of the calendar year. Likewise, written notices of revocation of an election or that the taxpayer will revoke an election may come up to the end of the calendar year. This flexibility for the customer translates to great burdens of recordkeeping for the broker, who is required to calculate the market discount daily, track and apply the stated taxpayer preference, and deal with notices that are either mistakenly provided and then countered by notices of revocation, or notices sent by the taxpayer with the intent to file an election with the IRS that is never filed, or any other combination of sending or not sending notices, filing or not filing the associated elections, and sending or not sending notices of revocation, all due to mistakes, changed minds, or ignorance of the law or procedures.
Brokers and their tax reporting teams will be forced to scramble to address these new Form 1099-OID and Form 1099-INT reporting requirements (as well as not yet released changes to Form 1099-B). It will be a significant burden and challenge for them because of the paradigm shift from calculations based on debt issue generic information to unique tax lot calculations for bond premium, market discount and acquisition premium that will be subject to reporting beginning in the first quarter of 2015. Investors will benefit because brokers will essentially be performing the complex calculations required of taxpayers, thereby making tax reporting easier for customers. Unfortunately, brokers will bear the cost of this new regulatory tax reporting burden. And brokers that fail to comply or calculate these soon-to-be required amounts incorrectly could be subject to substantial tax penalties amounting to hundreds of thousands of dollars or more.
More tax related issues will be discussed at FTF’s FATCA Breakfast on March 6, 2014. Firms in the U.S. and abroad need to optimize their operational infrastructures, workflows for KYC, governance and reporting, and documentation to stay ahead of the FATCA overhaul.