PLANNED GIVING GROUP
GREATER NEW YORK
PLANNED GIVING 007:
BONDS – JUST BONDS
NOVEMBER 12, 2003
PHILIP T. TEMPLE, ESQ. AND LISA NEWFIELD, ESQ.
MCCARTHY, FINGAR, DONOVAN,
DRAZEN & SMITH, L.L.P.
WHITE PLAINS, NEW YORK
A. Historically, debt instruments (bonds) regarded as conservative investment options with few tax issues.
B. No longer the case. With the proliferation of debt securities, many tax problems have arisen and the tax consequences will often dictate the treatment given to gifts of bonds to charity - - outright or to a split-interest arrangement.
C. Definition: Bonds are fixed obligations issued by a private company, a municipality or government agency or the Treasury to repay money loaned to them at a future time, generally providing periodic payments of interest - - usually fixed and paid semi-annually - - with exception such as U.S. Savings Bonds and Zero Coupon Bonds.
II. OVERVIEW OF BONDS – DEBT INSTRUMENTS.
A. FEDERAL AND MUNICIPAL DEBT INSTRUMENTS.
1. United States Treasuries – taxable obligations.
(a) Bills (T-bills) - short-term obligations payable in 3 months, 6 months or 1 year. Issued at discount, (i.e.) issued at a price below its face value, with difference between face value and the purchase price represented as interest.
(b) Notes – maturity of 2-10 years. Issued at par. 100% of face amount due at Maturity or close to par.
(c) Bonds – maturity of 10-30 years. Issued at par. 100% of face amount due at Maturity or close to par.
2. Federal Agencies. United States Government guarantees principal and interest paid on most of these. For those not guaranteed other form of financial backing is provided. Bear interest. Issued and redeemed at face value. Yields tend to be higher than United States Government Bonds. Federal Agencies also issue bills, notes and bonds.
3. State and Local Governments.
(a) Municipal Notes – maturity 1 month to 3 years. Generally 1 year maturity.
Two types of Municipal Notes:
(i) interest bearing: return the principal plus interest at maturity.
(ii) discounted notes: carry implicit interest payments because they are issued at less than par and are redeemed at face value.
(b) Municipal Bonds – return a stream of interest payments and the repayment of principal on maturity. Varying lengths of maturity from 3 months to 30 years.
B. INFLATION – INDEXED DEBT INSTRUMENTS.
Started January 15, 1997. Auctioned and issued on a quarterly basis. The auction process determines the interest rate. Interest rate remains constant through life of bond. However, the principal to which the interest is applied can change as the inflation rate fluctuates. Known as “Treasury Inflation Protected Securities” (“TIPS”). You will have a guarantee that your savings will not be eroded by inflation. Semiannual payment of interest.
C. CORPORATE DEBT INSTRUMENTS.
1. Bonds – secured by mortgage on corporate assets. Longer maturities (20 years or more). Sometimes convertible to corporation’s stock.
2. Debentures – backed by general credit of corporation. Maturity (10-20 years).
3. Notes – backed by general credit of corporation. Maturity 10 years or less from issue date.
4. Commercial Paper – unsecured short-term promissory note issued by large corporation to obtain short-term financing. Sells at discount off face value. Difference between purchase price and face value is interest.
D. CALL PROVISIONS AND PUT BONDS.
Debt instruments may be redeemable or “callable” at a fixed price before maturity at the option of the issuer. “Call” price is usually fixed above face amount that would be paid if the security were allowed to mature.
Issuers can issue Put Bonds – investors can “put” (sell back to issuer at par value) the bonds at a specified date before maturity. Usually will have lower rate of return because of the put protection given to investor.
III. TAX ISSUES ON PURCHASE.
A. TREATMENT OF ACCRUED INTEREST. When an investor buys a bond between interest dates, the amount paid for the bond may include the accrued interest (i.e. interest earned from the last interest payment until the date of purchase). When the buyer later receives the interest payment on the bond, only the amount in excess of the accrued interest purchased is taxable as income to the buyer.
B. AMORTIZATION OF BOND PREMIUM. The purchase of bonds at a premium in excess of face value gives rise to the need to amortize the premium (ex: when bonds are sold at premium – interest rates decrease prior to issue, but being issued at price above face value). After the initial issuance of a debt obligation, a bond premium can occur because of the bond’s relatively high interest rate or because of a general decline in interest rates.
1. Taxable Bonds. Investor has an option to:
(a) deduct the bond premium currently or
(b) elect to amortize the bond premium over the life of the bond. In this instance, the premium paid will be used to reduce the interest includible in income each year from the bond.
2. Tax-exempt Bonds. No current deduction allowed for the premium paid on a tax-exempt bond.
3. In either event, the investor has to reduce the adjusted basis of the bond by the amortization for the year.
C. ORIGINAL ISSUE DISCOUNT (“OID”) – GOVERNMENT AND CORPORATE BONDS. Debt obligations sold at a price less than face amount because they bear no interest or bear interest at a rate lower than the current market rate.
1. The discount is additional taxable interest to the investor for the use of the money that was not paid for in the debt instrument.
2. OID rules do not apply to:
- short term obligations with a term of l year or less;
- tax exempt obligations (except for certain stripped tax exempts);
- U.S. savings bonds;
3. Different tax rules apply to treatment of OID depending on the date the bond was issued. The rules are complicated.
4. OID equals difference between purchase price and redemption price at maturity.
5. OID Related to Bonds Issued After 1984. The original holder must allocate to each day in any accrual period a ratable portion of the increase of the adjusted issue price of the bond during that accrual period in order to determine the daily portion of the instrument’s OID.
6. The adjusted basis of the bond is increased by the amount of OID included in gross income.
7. Subsequent purchaser may pay an acquisition premium for an original issue discount obligation. The premium occurs because the purchase price exceeds the issue price as adjusted upward to reflect the daily inclusion of the original issue discount in income.
8. A subsequent purchaser may acquire an original issue discount bond at a price that is less than the original issue amount and the accrued OID attributable for all periods prior to date of purchase, which would be subject to market discount rules (discussed below).
D. MARKET DISCOUNT.
1. After obligation issued, interest increases resulting in decline in value of instrument, i.e. market discount obligation. A market discount bond is a bond that is purchased at a discount from face value.
The market discount provisions do not apply to the following:
- short term obligations;
- tax exempt obligation acquired prior to 5/1/93;
- U.S. savings bonds;
- if discount is less than ¼% - deemed de minimis zero market discount.
2. Any gain on sale, exchange or gift of bond (issued after 7/10/84) is ordinary income to the extent that the gain does not exceed the market discount accrued on the bond to the date of sale. Any gain in excess of the accrued market discount receives capital gain treatment.
3. However, disposition of market discount bond by death does not result in realization or recognition of ordinary income. Ordinary income taint remains with bond received.
E. ACQUISITION DISCOUNT. Applies to original issue discount on short-term obligations (any debt instrument with a fixed maturity date not more than one year from the date of issue – exclusive of tax-exempt obligations). OID rules do not apply to short-term obligations. Acquisition discount equals excess of redemption price at maturity over taxpayer’s basis in instrument.
IV. TAX TREATMENT OF DIFFERENT TYPES OF BONDS.
A. TAX EXEMPT BONDS.
1. Generally interest on bonds issued by a state, U.S. territory, any political subdivision or D.C. (municipal bonds) is free from federal income tax if proceeds are used to finance activities paid for and conducted by the governmental unit.
2. Income generated by municipal bond may also be free from state income tax if buyer of bond resides in the state in which bond is issued and the state exempts its own issues.
3. Taxpayers who file federal income tax returns must report how much tax-exempt interest they have received or accrued during tax year.
4. Special rules exist for tax-free bonds with respect to acquisition discount, market discount, and original issue discount rules.
(a) Tax exempt bonds issued on or before 7/18/84 and purchased prior to 5/1/93 are not subject to the market discount rules under which the gain on sale or disposition of a market discount bond is considered ordinary income to the extent of the accrued market discount.
(b) Purchasers of tax exempt bonds after 5/1/93 which are bought at a discount must treat gain on the disposition as ordinary income, rather than capital gain, to the extent of accrued market discount.
(c) The original issue discount rules do not apply to tax-free bonds. On sale of tax exempt bond, gain attributable to original issue discount is deemed tax-free interest, while gain attributable to market discount is realized and recognized as capital gain.
B. U.S. GOVERNMENT AND AGENCY OBLIGATIONS:
1. Interest on obligations of the U.S. is not exempt from federal income tax.
2. Treasury notes and bonds and U.S. agency obligations with a maturity in excess of 1 year are subject to OID rules.
(a) For instruments issued after 12/31/54 and before 7/2/82, the OID is treated as interest that is taxable as ordinary income on the sale of the obligations.
(b) For instruments acquired after 7/2/82 for each day during the year that the investor holds the instrument, the OID accrues and is realized by the investor in an amount equal to the sum of the daily portions of the OID.
3. Treasury notes and bonds and U.S. agency obligations with a maturity in excess of 1 year from the issue date are subject to the market discount rules. Any gain on the sale or disposition of such instrument issued after 7/18/84 constitutes ordinary income to the extent that it does not exceed the market discount accrued to the date of disposition.
4. U.S. Treasury Bills and short term U.S. agency obligations are subject to the acquisition discount rules.
(a) Taxpayers holding such short term instruments (including U.S. Treasury Bills) with a fixed maturity date of 1 year or less must account for the acquisition discount on an accrual method. Such daily ratable portion of the acquisition discount must be included in the investor’s income.
(b) Taxpayers not subject to above rules include the discount income on U.S. Treasury Bills and U.S. agency obligations in their income when instrument matures or is sold prior to maturity.
C. ZERO COUPON BONDS
1. Zero Coupon Bonds are debt securities that sell at substantial discount from face amount.
(a) No periodic interest payments.
(b) Principal amount or face value is paid at maturity.
(c) Includes U.S. Government, municipal and corporate obligations.
(d) During bond term, each year’s increase in redemption price is income.
Example: Jonathan buys a five year, 8% $15,000 zero coupon bond issued by XYZ Corporation on January 1, 2003. He will not receive any cash payments until December 31, 2007 when bond matures and corporation pays him $15,000.
(e) Zero Coupon Bonds issued by corporation or by U.S. Government or other municipality are subject to original discount provisions; market discount rules may also apply to a subsequent purchaser of bonds.
2. Original Issue Discount Provisions.
(a) Rules differ depending on issue date. The rules are complicated.
(b) Generally, part of the original issue discount must be reported as interest income each year the bond is held, whether or not the holder receives any payments from the bond issuer.
(c) An important exception to the OID rules are United States Savings Bonds.
(d) If bondholder is a subsequent purchaser or donee, important to ascertain how original holder treated OID so that determination as to how subsequent purchaser deals with OID can be made.
(e) The rules are complicated. Good accounting advice is an essential.
D. MORTGAGE BACKED SECURITIES:
1. Represents interests in a pool of mortgage loans, in most cases, on single family homes. Issued by U.S. government and private sector institutions. Mortgage backed securities issued by the U.S. government agencies are guaranteed by the U.S. government. Corporate assets of private institutions are used to back certificates issued by such organization.
2. Unlike conventional debt instruments, mortgage backed securities do not pay the principal at maturity. Principal payments, together with interest, are paid each month. They do not have fixed maturities.
3. Holder is deemed owner of undivided interest in income and principal.
4. Mortgage backed securities are subject to market discount rules. Any gain on sale or other disposition of security issued after 7/18/84 that is purchased at a discount constitutes ordinary income to the extent that it does not exceed the market discount accrued to date of disposition.
5. Original Issue Discount. In brief, the holder of a certificate on which there is original issue discount must generally include the OID in gross income as it accrues during each tax year in advance of the receipt of the cash that is attributable to such income.
1. Derivatives are financial products whose value is derived from performance of another financial product or benchmark, such as long-term interest rates, a commodity price index, market index, foreign currency rates, government or corporate debt, home mortgages or stocks.
2. Two varieties of derivatives:
(a) Options: Buyer has the right to buy or sell an asset at a present price over a specific period; and
(b) Forward-type contracts: Include forwards, futures and swaps, commit the buyer and seller to trade with given asset at set price on future date.
F. COUPON-STRIPPED BONDS:
1. Coupon-stripped bond is a bond that was originally issued with coupons, but from which the holder has detached the interest coupons and sold the coupons or the bond, or both separated.
(a) Coupon represents right to receive interest; and
(b) Bond represents right to receive principal.
2. Investor may purchase right to principal of a “stripped bond” at present value of bond at maturity. The value will be less than face amount of the bond. “Stripped bond” is bond issued at any time with interest coupons where a separation occurs between bond and coupon not yet payable prior to maturity.
(a) Investor may also purchase the right to interest represented by a “stripped coupon.”
(b) Any gain or loss on sale of entire interest treated as capital gain or loss (assuming no original issue or market discount).
(c) Seller of stripped bond or stripped coupon must allocate basis between part retained and part sold in accordance with their respective fair market values.
(d) Seller must also include in gross income amount of interest accrued on bond while held prior to disposition of bond or coupon. Adjusted basis of seller in the bond or coupons is increased by amount of accrued interest included in seller’s gross income.
3. Stripped Tax-Free Bonds (purchased after 10/22/86) generally do not have a call provision. Yield is locked in until the bond matures. In addition, some of the new stripped bonds are guaranteed by U.S. Treasury bonds.
V. SALE, EXCHANGE AND RETIREMENT OF BONDS.
A. CONVERSION of corporate debt instruments into common stock:
1. if investors choose to exercise conversion privilege, no taxable gain or loss realized or recognized on conversion: basis in stock is equal to cost of bond; holding period is equal to date bond purchased.
2. if additional cash paid in conversion: basis in stock is equal to cash paid; holding period is equal to date cash paid.
B. SALE OF DEBT INSTRUMENTS.
1. Bond is long term capital asset in hands of an investor who sells; capital gain or loss results on sale, exchange or redemption.
2. Bonds held as inventory: if, however, bonds are held “primarily for sale in ordinary course of business” (holder is dealer) ordinary income or loss will generally result.
3. Treatment of premium amortization: differs depending on whether bond is taxable or tax exempt.
(a) Taxable Bonds.
(i) If investor chose to amortize bond premium, adjusted basis of bond is reduced and he has received a corresponding deduction as gross income; then on sale, unamortized premium is included in adjusted basis.
(ii) Rules are complicated. Treatment depends on when bonds were issued or when acquired. Keep in mind: amortizing the premium results in lesser interest income reported but larger capital gain or loss.
(iii) Generally premium is reported ratably over the life of the bond.
(b) Tax Exempt Bonds.
(i) Investor’s Amortized Premium. No corresponding deduction in computing income.
(ii) Example: Lisa is a calendar year cash method investor and she purchased a $10,000 face amount tax-exempt bond on July 1, 1998 for $12,000. The maturity date is June 30, 2008. On December 31, 2001, she sells the bond for $8,500. The period from the date of purchase to the date of maturity is 120 months. The $2,000 premium must be amortized over 120 months at the rate of $16.67 a month. She held the bond for 42 months before selling it. She must reduce her adjusted basis by $700.14 (42 x $16.67) or to $11,299.86 ($12,000 minus $700.14). Her capital loss on the sale of the bond equals $2,799.86 ($11,299.86 - $8,500) not $3,500 ($12,000 - $8,500).
4. Treatment of Taxable Short Term Bonds (including short term commercial paper): Generally, amount received will be either ordinary income or short term capital gain or a combination thereof. Again, the rules are complicated.
5. Sale or Exchange of Long Term Corporate and Taxable Government Bonds:
(a) Treatment depends upon when bonds issued and whether there was intention to call prior to maturity.
(b) Generally, original issue discount was included in gross income each year bonds held - either ratably or by constant interest rate method. Amount of original issue discount includable in income increases adjusted basis - thereby decreasing capital gain or increasing amount of loss.
(c) Then, any amount realized will be treated as capital gain.
(d) Also take market discount rules into account. To repeat, the rules – particularly, the interaction of the original issue discount and market discount rules - are complicated.
VI. TAX ISSUES ON GIFTS TO CHARITIES.
A. VALUATION. Value of a listed bond is the mean of the highest and lowest selling prices quoted for the bond on the day of the gift.
1. If the high and low selling prices for the day are not available, but closing prices are available, then the value is the means between the closing price on the day of the gift and the closing price on the preceding trading date.
2. If there were no sales on the preceding date, but there were sales within a reasonable period before the gift, fair market value is determined by taking the weighted average of the quoted closing prices for day of gift and nearest date before the date of gift.
3. If there were no sales on date of gift, but there were sales within a reasonable period before and after the day of the gift, an inverse weighted average of selling prices on the nearest dates before the gift and after the gift are used.
B. INCOME TAX CHARITABLE DEDUCTION RULES.
1. Gifts of appreciated property are valued at the fair market value on date of gift, but fair market value may be reduced for purposes of the income tax charitable deduction depending on these separate distinct elements:
(a) The income tax treatment that would have been given the gain from the property if it had been sold rather than donated (ordinary income vs. capital gain);
(b) The charity’s tax status (public charity vs. private foundation);
2. As previously discussed in the outline, bond owners may recognize and realize ordinary income upon the sale or other disposition of a bond.
3. Ordinary income property is property that if the donor had sold at its fair market value on the date of contribution, would have produced a gain other than a long-term capital gain. The gain is taxable at ordinary income rates rather than at capital gain rates.
4. The amount allowed as a charitable contribution deduction for a gift of ordinary income property is the fair market value of the property on the date of contribution reduced by 100% of the ordinary income that would have been realized had the donor sold the property.
C. ORIGINAL ISSUE DISCOUNT BONDS.
1. Original buyers – OID is usually taxed currently as interest or can be taxed as ordinary income at time of the bond’s sale.
2. Subsequent buyers of OID bonds for more then the stated redemption price at maturity – OID rules do not apply and donor had capital gain loss on sale or redemption.
3. Subsequent buyers of OID bonds for more than the original issue price plus OID accumulated on it until the purchase (acquisition premium) – the OID reportable is reduced by the amount of acquisition premium.
Note: 1099 – OID will not reflect the acquisition premium paid.
D. MARKET DISCOUNT BONDS: These rules do not apply to:
• short term obligations;
• U.S. savings bonds; or
• tax exemptions
In general, unless the bondholder elects to report currently in each year’s income the year’s share of accrued market discount (that is, the year’s portion of market discount as spread over the period between his bond acquisition and its maturity), the following rules govern:
(a) Any gain on a disposition of a bond issued after July 18, 1984, which was acquired at a market discount is taxed as ordinary income to the extent of the part of accrued market discount that is allocable to the period he held the bond. And, in case of a disposition other than a sale or exchange (for example: a gift), the holder will be treated as realizing income in an amount equal to the fair market value of the bond on the disposition, with the result that the holder will recognize this accrued market discount at that time (unless the particular type of disposition will be excepted by regulations).
(b) If, (a) the year’s interest expense incurred to buy or carry market discount bonds that are required after July 18, 1984, is greater than (b) the interest income from them plus OID reportable as to them for the year, then either the difference between these two amounts, or the amount of market discount allocated to the year from the bonds, whichever is smaller, cannot be currently deducted. The disallowed deduction is postponed until the bond is disposed of. And if the bond’s disposition is a non-recognition transaction, then the deduction can be taken at that time only to the extent of gain recognized at disposition. Further, in the case of a bond that was issued before July 19, 1984, any gain on the bond’s disposition will be treated as ordinary interest income, to the extent of the amount of the disallowed deduction that can be taken in the year of disposition.
E. SPLIT-INTEREST GIFTS. To differentiate between amount of income “to be paid to beneficiary and value for purposes of calculating charitable contribution deduction.”
(a) For purposes of computing annuity payment or annuity trust payment, include accrued interest.
(b) However, in calculating charitable deduction, ignore accrued interest because that is ordinary income element without any cost basis. Therefore, no charitable deduction.
VII. U.S. SAVINGS BONDS.
A. TAXATION OF U.S. SAVINGS BONDS.
1. Interest always free of state and local income tax. Interest accumulated free of federal income tax unless holder of bonds elects to report interest annually as it accrues.
2. However, when bonds are cashed in, reissued to another person or redeemed on maturity, then built up interest taxable.
3. Rollover to HH bonds; defers reporting of accumulated interest.
4. Problem with matured bonds - no longer accrue interest.
B. LIFETIME GIFTS.
1. Treasury Regulations restrict lifetime transfers except to family members and “personal estate trusts” such as revocable living trusts.
2. So, to make charitable gift, individual must cash in bond, give cash and claim a charitable contribution deduction of said interest income.
(a) Many bond owners claim standard deduction and, therefore, get no tax benefit from a charitable deduction.
(b) If, however, bond owner has significant other income, could be a wash.
Example: Individual cashes in $50,000 B bonds generating $25,000 of interest income. She has $25,000 of other income. She gives the $50,000 of the redemption proceeds to charity and can deduct up to 50% of her adjusted gross income. She deducts $25,000 (one-half of $50,000) thereby offsetting the $25,000 of interest income. Her tax status is the same - - she has $25,000 of income.
3. If gift is for charitable gift annuity, charitable deductions is only for value of charitable gift portion. Therefore, difficult to completely avoid income tax. But, reducing payment can leverage charitable deduction to offset more of the interest income. Increase in income also helps to mitigate tax on the interest income.
C. U.S. SAVINGS BONDS ARE INCOME IN RESPECT OF A DECEDENT (IRD) ASSET.
1. Unlike capital gain asset, IRD assets get no step-up basis at death.
2. IRD income includable in gross estate and in estate’s (or beneficiary’s) income. Person who inherits IRD assets have to report IRD income.
3. Law allows income tax deduction (not subject to 2% floor on miscellaneous itemized deductions) for amount of estate tax paid attributable to the IRD.
4. Since charities are tax exempt, a bequest of IRD asset to charity will generate both an estate tax charitable deduction and the IRD would not be taxed to the charity.
5. If testamentary CRT established and funded with bonds, income tax on IRD is avoided but charitable deduction is for calculated value of remainder interest.
6. IRS has ruled that income tax deduction for estate tax attributable to IRD asset not allowed to beneficiaries but only to CRT.
If you think you may require the assistance of Lisa Newfield in any matter, email (email@example.com) or phone her (914-385-1032) with any question you may have.