Tax Treatment of Amortization on Market Discount Bonds

The purchase of equity and debt securities can play a significant role in a company’s overall investment strategy but may have tax implications that should be considered from a tax planning perspective. The purchase of market discount bonds, in particular, may have current and deferred tax implications related to the market discount amortization. Unless a taxpayer makes an election to recognize the accreted market discount in the current year’s taxable income, the current year portion of the accretion is deferred, lowering taxable income in the current year, and is only recognized as taxable income when the bond matures or is disposed of at a future date.

What are Market Discount Bonds?

According to the Internal Revenue Code (IRC)  I.R.C. § 1278 (a) (1) (A), the term “market discount bond” refers to any bond having a market discount with a few exceptions. The term does not apply to: 

• short term obligations, 
• United States savings bonds, or 
• installment obligations in which IRC section 453B applies. 

If a bond is purchased at a market rate (not an original issue) that is less than the issued par value or stated rate on the face of the bond, it is considered a bond issued at a discount or a “discount” bond. The purchaser will pay less than par value and the difference between the par value and the purchase price, the “market discount”, will accrete back to the stated par over the life of the bond.

How do Taxpayers Recognize Market Discounts?

During the life of a discount bond, taxpayers must first determine whether to include the accretion into taxable income each year or to defer the recognition of this income until the maturity date, call of the bond, or disposal. Under the deferral method (I.R.C § 1276), the gain or loss on interest income is recognized at bond maturity or disposition as an ordinary gain or loss to the extent of the accrued market discount. Any additional gain or loss beyond the accrued market discount is recognized as a capital gain or loss. Conversely, if a taxpayer chooses to recognize discount bond accretion on a yearly basis as opposed to the maturity or disposition date, they must make a tax election to include the market discount in current year income. 

How Can Taxpayers Elect to Include Market Accretion in Current Year Income?

I.R.C. § 1278 (b) (1) allows the taxpayer to elect to include current market discount bond income in current year income instead of deferring it to recognize at disposition. This election applies to all discount bonds acquired on or after the first day of the taxable year the election is made and all subsequent years thereafter unless the taxpayer receives consent from the IRS to revoke the election. The election results in the following:

• The current year portion of accretion is included in taxable income each year
• Current income is calculated by the ratable accrual method (default) or the constant year interest rate method (26 U.S. Code § 1276 (b) (2))
• The current market discount amount included in income increases the taxpayer’s basis in the discount bond

Why Does it Matter?

Electing to recognize market accretion on a yearly basis results in the recognition of interest income from all discount bonds sooner and in smaller amounts rather than a lump sum at maturity or disposition; however, taxable income is considered ordinary income regardless of when the interest income is recognized. Determining whether to make this election or not depends on the current and future tax environment and the tax benefits a taxpayer may receive. Generally, if a taxpayer’s future projected taxable income and/or future tax rates are expected to increase, it could be more beneficial to make the election to include the current year portion of accretion in taxable income each year rather than in a year they may be subject to higher taxes. 

The determination of whether to make the tax election must be considered from a tax planning strategy perspective. Several factors must be considered when making this decision including a taxpayer’s current and future levels of overall taxable income, enacted and future tax rates, and the total amount of discount bonds in a taxpayer’s portfolio.

How can Johnson Lambert Help?

At Johnson Lambert, our tax professionals are experts in tax compliance and beneficial tax planning strategies. The Johnson Lambert team can assist your organization in determining the best approach for recognition of market discounts and if a method change would be beneficial from a tax perspective.  Please contact our tax partners, Brandy Vannoy and Allan Autry, for further assistance.