De Minimis Rule (Bond Discount)

The de minimis rule, in the bond-discount sense, is a threshold below which the tax law disregards a discount on a debt instrument. IRC 1273(a)(3), under the heading "¼ of 1 percent de minimis rule," provides: "If the original issue discount determined under paragraph (1) is less than— (A) ¼ of 1 percent of the stated redemption price at maturity, multiplied by (B) the number of complete years to maturity, then the original issue discount shall be treated as zero." IRC 1278(a)(2)(C), under the heading "De minimis rule," provides the parallel for a bond bought below its redemption price after issue: "If the market discount is less than ¼ of 1 percent of the stated redemption price of the bond at maturity multiplied by the number of complete years to maturity (after the taxpayer acquired the bond), then the market discount shall be considered to be zero."

One formula, two statutes, one difference. For original issue discount the years are counted from the issue date; for market discount they are counted from the date the holder bought the bond. Because the two species of discount are taxed under separate sections, each carries its own copy of the threshold, and this page states the rule once; the original issue discount and market discount pages each refer back to it. Publication 550 states it in the OID setting: "You can treat the discount as zero if it is less than one-fourth of 1% (0.0025) of the stated redemption price at maturity multiplied by the number of full years from the date of original issue to maturity. This small discount is known as "de minimis" OID."

The phrase "de minimis" is Latin for something too small to matter, and the tax code uses it in many places that have nothing to do with bonds, including small employee fringe benefits and small loans between individuals. Those rules have their own thresholds and are covered elsewhere; the parenthetical in this page's title exists to keep them apart.

The regulation restates the OID threshold in decimals. Treasury Regulation 1.1273-1(d)(2) provides: "The de minimis amount is an amount equal to 0.0025 multiplied by the product of the stated redemption price at maturity and the number of complete years to maturity from the issue date." For a $1,000 bond that is $2.50 per complete year: $25 on a ten-year bond, $50 on a twenty-year bond, $75 on a thirty-year bond. The longer the bond, the larger the discount that can be ignored, because a small discount spread over many years is a smaller yield adjustment.

It is a cliff. Both statutes say the discount "shall be treated as zero" or "considered to be zero" only when it is "less than" the threshold. Nothing prorates. A ten-year $1,000 bond issued at $980 has $20 of OID, below the $25 line, so it has no OID at all. The same bond issued at $974 has $26 of OID, above the line, and every dollar of the $26 is OID that accrues into income each year, not just the $1 by which it crossed. The same is true on the market discount side: a discount one dollar over the threshold is market discount in full. A buyer comparing two prices a few dollars apart can be choosing between two entirely different tax characters.

What happens below the line, on each side. Regulation 1.1273-1(d)(1) provides that when OID is less than the de minimis amount, "the amount of OID is treated as zero, and all stated interest ... is treated as qualified stated interest," so the holder reports only the coupons. The discount does not vanish; it is simply recognized later and differently. Regulation 1.1273-1(d)(5) provides that a holder includes de minimis OID in income as principal payments are made, that any such amount "is treated as gain recognized on retirement of the debt instrument," and that gain attributable to de minimis OID on a sale or exchange "is capital gain if the debt instrument is a capital asset in the hands of the seller." Publication 550's example puts it in one parenthesis: for the $980 bond, "If you hold the bond at maturity, you will recognize $20 ($1,000 − $980) of capital gain." On the market discount side, a discount considered to be zero means there is no market discount bond, so the recharacterization in IRC 1276 never applies and the gain on disposition is capital gain in the ordinary way. In both cases the practical effect of falling below the line is that interest-like income is taxed as capital gain, at the capital gains rates and only when realized.

What happens above the line, on each side. Above the threshold, OID accrues into ordinary income each year under IRC 1272 whether or not any cash is paid, and the original issue discount page covers the constant-yield arithmetic. Market discount above the threshold is, by default, recharacterized as ordinary income when the bond is sold or repaid, up to the accrued amount, under IRC 1276, and the market discount page covers the accrual methods and the elections. The municipal bond page works through the threshold for a secondary-market purchase of a tax-exempt bond, where crossing the line turns part of an exempt bond's return into ordinary income.

A subsequent buyer of a de minimis OID bond is in the market discount regime. Regulation 1.1273-1(d)(5)(iii) provides that a later holder who buys such a bond at a premium does not include the de minimis OID in income, and that otherwise "a subsequent holder includes any discount in income under the market discount rules (sections 1276 through 1278) rather than under the rules of this paragraph (d)(5)." Publication 550 says the same: "If you buy a debt instrument with de minimis OID at a discount, the discount is reported under the market discount rules." So a bond can be issued with a discount too small to count, then fall in price and hand its second owner a discount that does count, measured from that owner's own purchase date.

Installment obligations use a different year count. Where principal is paid in more than one installment, Regulation 1.1273-1(d)(3) replaces the complete years to maturity with the instrument's weighted average maturity, and for a self-amortizing obligation, one that provides for equal payments of principal and interest, allows 0.00167 to be substituted for 0.0025. Publication 550 notes the modification and points to the regulation.

The MSRB's vocabulary is the OID version. The MSRB's glossary defines a de minimis discount as "The amount of discount, sometimes referred to as the "cut-off price," at which, for federal income tax purposes, interest on an original issue discount bond is not required to be included as income in advance of receipt," and lists "cut-off price" as a synonym. That entry describes the 1273 rule for bonds issued at a discount. A buyer of a municipal bond in the secondary market, a common situation in which a retail investor meets the term, needs the 1278 rule for market discount instead. The two share a formula, so the arithmetic comes out the same, but the year count runs from a different date and the consequence of crossing the line is different: yearly accrual on the OID side, ordinary income at sale on the market discount side. Reading one while meaning the other is the standing trap in this corner of bond taxation, and it is the reason this rule has a page of its own.

Take the bond's stated redemption price at maturity, multiply by 0.0025, and multiply again by the number of complete years to maturity, counted from the issue date for a bond bought at issue and from the purchase date for a bond bought later. Compare the actual discount with that figure. If the discount is smaller, it is treated as zero and the eventual gain is capital gain. If it is equal or larger, the entire discount is OID or market discount and is taxed under those rules.

A hypothetical example, using the figures in Publication 550. A taxable corporate bond has a stated redemption price at maturity of $1,000 and 10 complete years to maturity from its issue date. The de minimis amount is 0.0025 × $1,000 × 10 = $25.

Issued at $980. The OID is $1,000 − $980 = $20. That is less than $25, so the OID is treated as zero. The holder reports only the bond's coupons each year, and, in Publication 550's words, "If you hold the bond at maturity, you will recognize $20 ($1,000 − $980) of capital gain."

Issued at $950. The OID is $50. That exceeds $25, so, again quoting Publication 550, "you must include the OID in income as it accrues over the term of the bond." All $50 accrues as ordinary interest income over the ten years, on a constant-yield schedule, with no cash from the bond to pay the tax.

Issued at $974. The OID is $26, one dollar over the line, and the result is the same as at $950: the full $26 is OID and accrues into income. Nothing about the rule softens the crossing.

The same bond, bought later. Suppose the $980 bond, with its de minimis OID ignored, is sold three years after issue to a second buyer for $960 when it has 7 complete years left. The second buyer's threshold is 0.0025 × $1,000 × 7 = $17.50, counted from the purchase date, and the discount is $1,000 − $960 = $40. That exceeds $17.50, so the second buyer holds a market discount bond and, by default, will recognize up to $40 of ordinary income when the bond is sold or repaid, as the market discount page explains. The first buyer's de minimis result does not carry over; each holder measures from their own purchase.

Pros

• Keeps trivial discounts, such as a Treasury auction price a few cents below par, out of the yearly OID accrual, which Publication 550 notes expressly for Treasury notes and bonds.
• Converts a small discount into capital gain recognized at maturity or sale, taxed at capital gains rates and only when realized.
• The formula is simple enough to check by hand from three numbers: the redemption price, the years remaining and the price paid.
• The threshold scales with maturity, so a long bond bought a little below par is more likely to fall inside it.

Cons

• It is a cliff: a discount one dollar over the line is taxed in full as interest, so two nearly identical purchase prices can produce two different tax characters.
• The year count runs from a different date for OID and for market discount, and the MSRB's "de minimis discount" entry describes only the OID version, so the wrong rule is easy to apply.
• For a bond with few years left the threshold is small, so almost any secondary-market discount on a short bond is market discount in full.
• A discount that was de minimis to the original buyer can become full market discount to the next buyer, measured from that buyer's own purchase.
• Installment obligations use a weighted average maturity and a different coefficient, so the simple formula does not apply to every instrument.