7627 / Is an investor who holds a short-term taxable corporate obligation required to include discount in income prior to sale or maturity? Is an investor required to include interest as it accrues?

The taxpayer making the election must include as income an amount equal to the sum of the daily portions of original issue discount (in the case of T-bills, daily portions of acquisition discount) for each day that the taxpayer held the obligation in the tax year.

An irrevocable election may be made, on an obligation-by-obligation basis, to determine the amount of original issue discount by using daily compounding at a constant interest rate.⁴

Rather than electing to include original issue discount as it accrues, a taxpayer may elect to include “acquisition discount” (the difference between the stated redemption price at maturity and the basis in the obligation) as it accrues.⁵ The manner in which acquisition discount accrues is discussed in Q 7625.The election to accrue acquisition discount applies to all such obligations (and Treasury bills) acquired by the taxpayer on or after the first day of the first taxable year to which the election applies and thereafter until the Service consents to a revocation.

Certain investors must include original issue discount (or, by election, acquisition discount) in income prior to sale or other disposition of corporate short-term taxable obligations. They must also include interest payable on the obligation as it accrues.⁶ The mandatory inclusion rules apply to obligations if they are: (1) held by accrual basis taxpayers; (2) held by a bank; (3) held by a regulated investment company (RIC) or common trust fund; (4) held as inventory; (5) identified as part of a hedging transaction;⁷ or (6) held by a pass-through entity (e.g., a trust, partnership or S corporation) formed or availed of to avoid the mandatory inclusion rule, or a pass-through entity in any year in which taxpayers who would be subject to the rule held 20 percent or more of the value of the interests in the entity for 90 days or more.⁸ Discount must also be included in income as it accrues on a stripped bond or stripped coupon held by the person who stripped the bond or coupon or by a person whose basis is determined by reference to the basis in the hands of the person who stripped the bond or coupon (e.g., a person who receives it as a gift) (see   Q 7674).⁹

The basis of a short-term taxable corporate obligation is increased by amounts of accrued discount included in income prior to disposition or redemption.¹⁰ As to how gain or loss is treated upon disposition of corporate short-term taxable obligations with original issue discount when the taxpayer has not made an election to include discount as it accrues, see Q 7628.