Basis reporting for debt instruments and options is phased-in

In final regulations implementing the basis reporting requirements under Sec. 6045(g) that apply to debt instruments and options, the IRS, in response to comments about the complexity of complying with these rules, is implementing the reporting requirements for debt instruments and transfer reporting in phases, to give brokers ample time to develop and implement reporting systems (T.D. 9616). T.D 9616 finalizes proposed regulations (REG-102988-11) released in November 2011. The final regulations are effective April 18.

Sec. 6045(g) requires securities brokers and other affected persons to report to the IRS and customers (on Form 1099-B, Proceeds From Broker and Barter Exchange Transactions) the adjusted basis of covered securities sold and whether any gain or loss upon their sale is long- or short-term. It requires securities brokers to begin providing this information for corporate stock purchased in 2011 and later years, or beginning in 2012 for stock for which an average-basis method is permissible under Sec. 1012.

Reporting on all other specified securities, including debt instruments and options, was to begin with securities acquired or granted after Dec. 31, 2012, but that date was delayed, so that reporting is not required except for debt instruments and options acquired on or after Jan. 1, 2014 (Notice 2012-34). The final regulations delay this date even further for certain debt instruments and options.

Debt instruments

The IRS received many comments suggesting a narrower number of debt instrument and options be subject to reporting, such as limiting basis reporting to a debt instrument that has a fixed yield and fixed maturity date, but the IRS noted that Sec. 6045(g) by its terms covers a broad range of instruments. But phasing in basis reporting depending on the complexity of a debt instrument was another option it did adopt. So, for debt instruments with less complex features, the regulations retain the Jan. 1, 2014, effective date. These include

1. Debt instruments that provide for a single fixed payment schedule for which a yield and maturity can be determined for the instrument under Regs. Sec. 1.1272-1(b),
2. Debt instruments that provide for alternate payment schedules for which a yield and maturity can be determined for the instrument under Regs. Sec. 1.1272-1(c) (such as a debt instrument with an embedded put or call option), and
3. A demand loan for which a yield can be determined under Regs. Sec. 1.1272-1(d).

The IRS did not agree to the request to delay reporting on instruments with embedded put or call options because too many securities would fall under that category.

Basis reporting applies to debt instruments acquired on or after Jan. 1, 2016, if they are (1) a debt instrument that provides for more than one rate of stated interest (such as a debt instrument with stepped interest rates), (2) a convertible debt instrument, (3) a stripped bond or coupon, (4) a debt instrument that requires payment of either interest or principal in a non-U.S. dollar currency, (5) certain tax credit bonds, (6) a debt instrument that provides for a payment-in kind feature, (7) a debt instrument issued by a non-U.S. issuer, (8) a debt instrument whose terms are not reasonably available to the broker within 90 days of the date the customer acquired the debt instrument, (9) a debt instrument issued as part of an investment unit, and (10) a debt instrument evidenced by a physical certificate unless the certificate is held (directly or through a nominee, agent, or subsidiary) by a securities depository or by a clearing organization. Non-fixed yield and maturity date instruments that will not be subject to reporting unless they are issued after Jan. 1, 2016, include contingent payment debt instruments, variable-rate debt instruments, and inflation-indexed debt instruments.

The final regulations retain the exemption from reporting in the proposed rules for debt instruments with principal subject to acceleration and add an exemption for short-term debt instruments (debt instruments with a fixed maturity date not more than one year from the date of issue). It rejected a suggestion that debt instruments that were are longer than one year, but have less than a year left until they mature when they are transferred should also be exempt from reporting.

Another provision in the regulations concerns the consistency of reporting between different brokers when some permit their customers to make certain basis elections and others may not. Because this inconsistency could create problems when instruments are transferred between brokers, the final rules adopt default assumptions, but require brokers to offer certain elections to customers.

Under these rules, if a customer provides written notification, a broker must take into account the following elections for basis reporting purposes: the election to accrue market discount using a constant yield; the election to include market discount in income currently; the election to treat all interest as original issue discount; and the spot rate election for interest accruals for a covered debt instrument denominated in a currency other than the U.S. dollar.

In addition, to improve consistency between income reporting and basis reporting for debt instruments, T.D. 9616 contains new temporary regulations requiring, under Sec. 6049, brokers to report interest (original issue discount) income to reflect amounts of amortized bond premium or acquisition premium for a covered debt instrument.

Options

The reporting requirements apply to the following options granted or acquired after Jan. 1, 2014: an option on one or more specified securities, including an option on an index substantially all the components of which are specified securities; an option on financial attributes of specified securities, such as interest rates or dividend yields; and a warrant or a stock right on a specified security. The scope provisions in the final regulations are generally the same as the scope provisions in the proposed regulations, except that the final regulations explicitly exclude a compensatory option. The final regulations also apply to any over-the-counter option on a specified security.

The regulations apply different reporting rules to Sec. 1256 options and non-Sec. 1256 options. For a nonequity option described in Sec. 1256(b)(1)(C) on one or more specified securities, brokers must use the Regs. Sec. 1.6045-1(c)(5) reporting rules that apply to a regulated futures contract. For an option on one or more specified securities that is not described in Sec. 1256(b)(1)(C), a broker will report gross proceeds and basis using the rules in the final regulations for a non-Sec. 1256 option.

For a cash settled non-Sec. 1256 option, the regulations required a broker to adjust gross proceeds related to an option transaction by increasing gross proceeds by the amount of any payments received for issuing the option and decreasing gross proceeds by the amount of any payments made on the option. These rules for a cash settled option are based on the idea that costs related to the acquisition of a position affect basis, while the costs related to the sale or closeout of a position affect gross proceeds.

In a change from the proposed regulations, the final regulations do not permit brokers to adjust basis to account for the exercise of a compensatory option that is granted or acquired on or after Jan. 1, 2014. The IRS says this approach will eliminate confusion and uncertainty for an employee who has exercised a compensatory option.

—Sally P. Schreiber (sschreiber@aicpa.org) is a JofA senior editor.