Original Issue Discount

Original issue discount refers to the discount from par value at the time a debt instrument is issued.

What is an Original Issue Discount?

An original issue discount (OID) is a debt instrument (DI), usually a bond, which is sold at a value much lower than the face value when it is initially issued. These bonds, however, will still mature at the face value benefiting the investors with the gain. The difference between the issue price and the face value represents the interest paid by the bond issuer.

The discounted price of the bond is subjected to income tax, even though the bond owner doesn’t actually receive any of the interest until the bond matures.  This is because the price discount is, in effect, additional interest income to the owner. The United States Internal Revenue Service views this cash flow stream as, in essence, a zero coupon bond upon which tax payments are due yearly based on “phantom income” imputed from the difference between the original investment and “guaranteed” eventual payout.

The tax consequences are the major drawback of OIDs. Although during the life of the bond, the investor does not receive interest payments, or receives very low payments, the portion of interest returned at maturity, along with principal, is amortized over the life of the bond. This means that the investors must report the amortized amount each year on their taxes and pay any income tax due on the amortized interest, despite the fact that they won’t receive it for years.

Reporting

Section 6049 of the Internal Revenue Code requires brokers and other middlemen to calculate and report original issue discount for bond owners. This reporting is required on Form 1099-OID if the total for the calendar year is $10 or more.

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 the I.R.C. §§ 1272 does not apply to a holder who purchases the debt instrument at a premium, or whose basis in the debt instrument is determined by reference to its basis in the hands of a person who purchased at premium (I.R.C. § 1272(c)(1)).

Exemptions

Certain debt instruments are exempt from the rules requiring recognition of income, including:

  • Original issue discount municipal bonds (the exemption does not cover “stripped” tax-exempt obligations);
  • U.S. savings bonds;
  • Debt instruments with maturities of one year or less; and
  • Debt issued by an individual before March 2, 1984, or loans of less than $10,000 between individuals who are not in the business of lending money.

In addition, “de minimis” rules apply (meaning you can disregard the original issue discount rules) if the discount is less than a quarter of 1% of the stated redemption price multiplied by the number of full years from the date of original issue to maturity.