7652 / How is original issue discount (OID) on corporate bonds treated if issued before July 2, 1982 and after May 27, 1969?

A prorated part of the original issue discount is included in income as interest each year, even though it is not actually received, unless the owner paid a premium (i.e., more than the stated redemption price) when the bond was purchased, or the obligation matured in one year or less. The amount is determined as follows:

By the original owner. The original issue discount is divided by the number of complete months plus any fractional part of a month (as explained below) from the date of original issue through the day before the stated maturity date. (This is called the “ratable monthly portion.”)¹ The ratable monthly portion is multiplied by the number of complete months plus any fractional part of a month the taxpayer held the bond during the year.²

By a subsequent owner. Like the original owner, a subsequent owner includes in income each year a “ratable monthly portion” of original issue discount multiplied by the number of months plus fractional parts of a month the subsequent owner held the bond. However, he or she may determine the ratable monthly portion in a different way if it results in a lower amount. Instead of dividing the original issue discount by the term of the bond, the subsequent owner may divide the amount by which the bond’s stated redemption price at maturity exceeds the bond’s cost to him or her by the number of complete months plus any fractional part of a month beginning on the day of purchase of the obligation and ending on the day before the stated maturity date of the obligation.³ An individual is not considered to have “purchased” the bond if the bond’s basis is determined, in whole or in part, by reference to the basis of the obligation in the hands of the person from whom it was acquired, or by reference to the estate tax valuation.⁴

Thus, if the amount paid by the subsequent owner is not more than the original issue price plus all amounts of original issue discount previously includable (whether or not included) in income by previous holders, his or her ratable monthly portion of the original issue discount is calculated like the original holder’s. However, if the subsequent owner paid more than the original issue price plus the amount of original issue discount includable in the income of any previous holder, he or she may reduce the original issue discount remaining by the excess amount before determining the monthly portion. This excess amount is called an “acquisition premium.” (In computing the amount of original issue discount includable by previous holders, one does not take into consideration any acquisition premium paid by previous holders or that a holder may, in fact, have purchased at a premium.)⁵

For either an original or subsequent holder, a complete or fractional month begins with the date of original issue and the corresponding day of each following calendar month (or the last day of a calendar month in which there is no corresponding day). If a holder sells the bond on any other day in the month, a part of the ratable monthly portion for that month is allocated between the seller and buyer based on the number of days in the month each held the bond. (Seller and buyer may allocate on the basis of a 30-day month.) The transferee is deemed to hold the obligations the entire day of acquisition, but not on the day of redemption.⁶

The original or any subsequent holder increases the holder’s basis by amounts of includable original issue discount actually included in income.⁷