OID Coupon vs OID bond on a US Strip Treasury

How is a US Strip Treasury OID taxed for Coupon and Bond portions.

I am looking at a Schwab statement that has as description “US Treasury Strip O%26” and in box 8 of the 1099 INT is $3,037. So the idea is that some bright financier has purchase the whole bond and strip it into 2 components. The annual interest portion or the “Coupon” bond and then a second part the “Principal” bond.

For example: Bond pays 2.5% interest for 10 years before being split.

Principal Bond portion of Strip 80,000 (2016 FMV) —– 100,000 (2026 payout)                     OID is 20,000.

Coupon portion 20,000 (2016 FMV) —– 25,000 (2026 payout)            OID is 5,000.
Keep in mind  with the Coupon portion you dont actually get 2,500 in cash each year, rather you get 25,000 in cash 10 years from now.

So the Schwab statement says the OID is $3,037 but I have no idea if the client owns the coupon bond portion of the Strip or the principal bond portion of the Strip. And I have concluded it does not matter.

If you look at IRS publication 1212 you get the following info:

“If you strip one or more coupons from a bond and then sell or otherwise dispose of the bond or the stripped coupons, they are treated as separate debt instruments issued with OID. The holder of a stripped bond has the right to receive the principal (redemption price) payment. The holder of a stripped coupon has the right to receive an interest payment on the bond. The rule requiring the holder of a debt instrument issued with OID to include the OID in gross income as it accrues applies to stripped bonds and coupons acquired after July 1, 1982.  So the OID rule applies to both stripped bond portion and stripped coupon portion of the bond.”
The IRS goes on in Pub 1212,
“The amount shown in box 8 of the Form 1099-OID you receive for a stripped bond or coupon may not be the proper amount to include in income.”   The IRS is confusing in its instructions.  You can have US stripped bonds,  state and city stripped bonds, and private stripped bonds. If you include in Box 8 then this is for state and city OID.  In other words box 8 is  for state and city bonds with OID that  are tax exempt at the federal level but taxable at the state level if the bond is not a bond from your state ( an out of state bond).  However interest on a federal obligation like a US Treasury Bill or Note or US Strip Treasuryies are  taxable at the Federal level, but not at the state level.  So the US OID has to be entered in Box 3.
I am going to pick up the OID as taxable federal and not taxable state. The question comes to mind why not just buy a treasury bond? Why would I want to recognize interest income and have no cash to show for it?

The other thought is that this US Strip Treasury bond is in a child’s name and with the time I spend figuring out the Kiddie tax form on 2 children’s 1040s and my cost and time does it really do the family any benefit investing in these US Strip Treasury obligations.  The Kiddie tax on the 1st $1,050 of income is $0, so the savings in not including the US Strip Treasury interest is the parents rate at 25% or $262.50.  The child’s rate is used on the interest income from $1,050 to $2,100 so that rate is 10% vs the parent rate leaves a savings of $157.50.  On any income earned on the instrument from $2,100 to $3,037 is tax at the parents rate and so no benefit.  So the total benefit is $420 and I charged $400 to do the child’s return.

Now IRS form 8814 allows the parent to elect to report the children’s interest and dividends on their tax return and thus avoid having to prepare a separate return and related cost for the child’s tax return preparation.   The problem here is that once there is a stock or bond sale of one of the child’s investment a schedule D is required and then the parent cannot elect to use the 8814 form reporting of income and the child has to have a separate tax return prepared on their behalf.

 

Here is an example from Wikepedia:

 

Example Original Issue Discount

Bond Issuance Price	$7,462
Bond Redemption Price	$10,000
Original Issue Discount	$2,538

Most loans require interest payments. Loans that require inadequate or no interest payments bear original issue discount. Whether interest is adequate is determined with reference to the applicable federal rate (AFR). Under the Internal Revenue Code, original issue discounts on debt instruments are taxed each year, even though the debt may not be repaid until a later date. The tax system will impute an interest rate on the loan. The rules for calculating the original issue discount utilize a compounding interest formula, with the principal recalculated every six months. Section 1272(a) of the tax code requires that the Original Issue Discount is includible in the lender’s taxable income at the end of each tax year, or part of the tax year if the loan was not owned for the full year.

The daily portion of the discount uses a compounded interest formula with the principal recalculated every six months. The following table illustrates how to calculate the original issue discount for a $7,462 bond with a $10,000 repayment and a three-year maturity date:

Period	Adjusted Issue Price	Yield	Original Issue Discount
1	$7,462	.05	$373
2	$7,835	.05	$392
3	$8,227	.05	$411
4	$8,638	.05	$432
5	$9,070	.05	$454
6	$9,524	.05	$476
Redemption	$10,000

This is a general tax discussion.  You need to consult your own tax preparer before taking any action on this discussion above.  I hope this has been helpful on OID Coupon vs OID bond on a US Strip Treasury treatment.