Discount from par value at the time a debt instrument is issued
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An original issue discount (OID) is a type of debt instrument. Often a bond, OID’s are sold at a lower value than face value when issued, hence the D in OID. On maturity, the face value is paid out to the investor. The difference received is a gain to the investor and is effectively the interest paid by the borrower or issuer.
While the bond owner receives no interest until maturity, thediscounted price of the bond is subject to income tax. This is due to the conceptual calculation of the price discount as, effectively, additional income to the bond owner. From the perspective of the IRS, the eventual payout is treated as income. Thus, the OID is effectively a zero-coupon bond treated with annual tax payments based on the expected future payouts.
As such, there are tax consequences when handling an original issue discount. These consequences are often seen as the biggest disadvantages of investing in OIDs. The portion of interest earned on maturity is effectively built into the bond’s price calculations.
In other words, the discount is amortized over the life of the bond. Investors are then required to declare this amortized value as taxable income, which results in annual tax due, even though the payment is not received until maturity.
IRC Section 6049 states that parties to an original issue discount transaction are required to calculate and report taxes for the bondholders. This means that brokers and other intermediaries are required to fill out form 1099-OID, subject to the value of the transaction surpassing a minimum threshold.
The legal structure of the original issue discount is designed to prevent manipulation of taxes and interest income. Since the income is amortized through the life of the bond, as opposed to calculated on maturity, purchasers of the OID are unable to defer income recognition.
Income Recognition Exemptions
The following debt instruments are exempt from the tax recognition rules outlined above. This list, however, is not exhaustive:
United States Savings Bonds
Short-term maturity debt instruments, with terms of less than or equal to one year
Furthermore, a “de minimis” rule applies when discounts are less than 25 basis points away from the stated redemption price, multiplied by the number of full years from the original issue to maturity date. In other words, if the de minimis rule is met, the bondholder can disregard OID tax recognition rules.
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