By Carol G. Warley, CPA, JD, Kenneth M. Horwitz, CPA, JD, Christina A. Mondrik, CPA, JD, William Stromsem, CPA, JD, and Thomas Ochsenschlager, CPA, JD
Preparers and their clients with taxable bond portfolios need to be aware of potential problems with the new IRS rules for reporting taxable bond premium amortization so they can promptly initiate necessary communications with brokers. The new rules are included in the instructions for the 2014 Form 1099-INT (http://www.irs.gov/pub/irs-pdf/i1099int.pdf) and the temporary regulations 1.6049-9T (http://www.irs.gov/irb/2013-20_IRB/ar07.html).
In the past, few taxpayers elected to amortize taxable bond premiums under IRC Section 171 because the information for making the election was not readily available. New rules generally require brokers to report taxable bond interest and the basis on “covered” taxable bonds (generally certain bonds that were acquired after 2013 and that are covered by the broker basis reporting rules as described in Reg. Section 1.6045-1(a)(15)(i)) assuming that taxpayers elected to amortize taxable bond premiums even though the election likely was not made. While this election is generally advantageous to taxpayers, the election must apply to all taxable bonds held by the taxpayer. This can cause problems if the taxpayer’s portfolio also includes “non-covered” taxable bonds (generally certain bonds acquired before 2014 that are not covered by the broker basis reporting rules as described in Reg. Section 1.6045-1(a)(15)(i)). For non-covered taxable bonds, the temporary regulations do not require the broker to assume taxable bond premiums are being amortized, and thus the broker will report interest income without amortization. This inconsistent 1099 treatment between covered and non-covered taxable bonds can cause several problems, including a possible invalid election and mismatching of both interest income and basis reported on tax returns versus that reported on Forms 1099.
If the taxpayer only has covered taxable bonds - The brokerage firm will report interest income either net of amortization or with both gross interest and the amortization amount. The broker will also reduce the investor’s basis by the amortization amount. The taxpayer should attach a statement to his or her income tax return to make the election to amortize taxable bond premiums. Absent this affirmative election, an IRS representative has indicated that the current unofficial position of the IRS is that simply reporting interest net of amortization is sufficient to elect amortization. Taxpayers and their preparers likely will not want to rely on an unofficial position, so care must be taken in reporting interest income. If the election is made, it is only revocable with IRS approval, and it applies to all taxable bonds currently held and subsequently acquired. The election will automatically apply to taxable bonds that were not previously amortized. The broker should, but may not, track the unamortized premium in the basis of these partially unamortized taxable bonds, so the taxpayer may wish to do so.
If the taxpayer has both covered and non-covered taxable bonds - The taxpayer must choose between two approaches, neither of which is simple. The taxpayer can choose either to not amortize premiums on all taxable bonds or to calculate amortization on the non-covered taxable bonds and report all taxable bonds with amortization of taxable bond premiums. The taxpayer should weigh the relative costs and benefits of each approach. In making this choice, if the taxpayer must determine the amount of amortization, this will require information from the broker, a potentially difficult process that requires the brokers’ cooperation. For non-covered taxable bonds, the Form 1099 will likely not report amortization, and for covered taxable bonds, the broker might provide interest net of amortization. Even if amortization is provided, it likely will be a single figure for all taxable bonds and not be detailed for each bond held. The basis of taxable bonds will also have to be calculated for non-covered taxable bonds.
Choice to not amortize any taxable bond premiums - The taxpayer does not get to offset interest income with the amortization of taxable bond premiums, and the tax benefit will be deferred until the bond is disposed of in a capital transaction, with a higher basis that will not have been reduced for amortization. This will result in the recognition of a capital loss rather than a reduction to interest income (likely a permanent difference in the tax benefit related to the taxable bond premium).
Electing not to amortize bond premiums on covered taxable bonds can cause issues with basis reporting. If the taxpayer notified the broker before Dec. 31, 2014 that taxable bond interest was not going to be amortized, the broker should be reporting both covered and non-covered taxable bonds consistently and will not reduce basis for amortization. However, few taxpayers were aware that notification was required. Thus, the broker likely will not reverse the covered taxable bond basis reduction and interest income reduction for 2014, requiring the taxpayer to not offset interest income and to track the basis until the bond is disposed. This will be necessary in order to avoid both a reduction of interest income currently and a capital loss on disposition. For future years, the taxpayer can notify the broker by Dec. 31 that premiums are not being amortized. This should avoid additional basis calculation issues. If this is done, the taxpayer will only have to keep track of the erroneous basis adjustment for 2014.
For covered taxable bonds, the broker may report Form 1099 interest net of amortization or the gross amount with the amortization amount. If the broker provides the net amount, the taxpayer will have to determine the interest income without amortization. Hopefully, the broker will provide the information from its records. However, if the broker does not issue a corrected Form 1099 (and the broker likely will take the position that the taxpayer should have given notice by Dec. 31 as required in Reg 1.6045-1)(n)(5)(ii)(B)), an IRS computer may generate a matching notice because the Form 1099 shows interest income net of amortization and the tax return shows interest without amortization. The unofficial IRS position is that this should not be a problem because not amortizing will result in higher interest income on the tax return that is easily explained. The taxpayer should consider attaching an explanatory statement to the tax return.
Choice to calculate amortization on “non-covered” taxable bonds - While this will reduce interest income, the taxpayer will have to obtain information from the broker and likely incur additional costs to calculate the amortization. This may also result in a computer-generated matching notice, but this time, the interest income on the tax return will be less than reported on the Form 1099. Again, a statement with the return may help resolve the issue. The taxpayer must maintain records for basis adjustments because the brokerage firm is not required to adjust basis for amortization for “non-covered” taxable bonds. In order to avoid the issues associated with holding both “covered” and “non-covered” taxable bonds, the taxpayer might consider selling his or her non-covered taxable bonds and buying new taxable bonds (i.e., covered taxable bonds), thus enabling the taxpayer to make the election to amortize premiums on all taxable bonds on his or her 2015 tax return. Otherwise, this result will be achieved over time as non-covered taxable bonds mature or are sold. Of course, there may be adverse economic consequences of disposing of taxable bonds purchased before 2014 that must be considered.
Bond discounts - Note that Form 1099 reporting rules do not require amortization of taxable market bond discounts. This is favorable to the taxpayer who might otherwise have to pay tax on the additional interest income without having received cash.
TSCPA’s Federal Tax Policy Committee discussed these issues with an IRS representative and will submit a comments letter to the IRS and the Department of Treasury.