OID and Interest Shortfall on Contingent Payment Debt

[jk2]

I hope this is clear.  My client has a brokerage account with  LPL Financial and received a 1099 Consolidated statement.     The statement includes OID, and interest Shortfall on Contingent Payment Debt and the sale of the security.  

Facts:

The CPDI was sold in 2024.  The proceeds from the sale were $1,011,360 and cost basis $1,000,005 for an ordinary gain of $11,355.

Since 2017 the client has reported OID totaling $237,050 on this security.   This year, the OID is $36,069 for the security and the interest shortfall is $237,050.   

I am reporting as follows:

1.  The OID of $36,069 as interest income on Schedule B

2.  Ordinary income of $11,355 for the sale of the security 

3.  What do I do with the interest shortfall of $237,050?   I am getting a little lost in the instructions.   There was never a shortfall prior to this year on this security.   I am scared I am misinterpreting the instructions.   My understanding is I can offset it against the OID to create a loss...if that is the case, how do I provide info to the IRS to explain why I am taking the interest shortfall in one year?

4.   I have reported an interest shortfall on a different security (prior to selling it) as an offset against OID and the IRS sent a letter with a bill to the taxpayer stating additional taxes were due.   They completely disregarded the shortfall.   Should I have included additional detail with the return?   I did attach a copy of the 1099 with that return.   

If additional clarification is necessary, please let me know.   Constructive advice is appreciated.

[BobKamman]

I did a search for Tax Court opinions with "interest shortfall" and found the fascinating story, told by the inimitable Judge Holmes, of "Boris Putanec [who] entered into a complicated and carefully structured CARDS transaction that he hoped would bring to life more than $100 million in losses. We can't grant him his wish. The deal is the stuff of tax wizardry, while the Code treats us all as mere muggles."

https://www.ustaxcourt.gov/opinions/2016/TCMemo_2016-221.pdf 

There's no OID going on here, but what you have may be just another variation on an old tax shelter.  Whenever I see LPL I know it's through a financial adviser who can do almost anything with almost anyone.  (Check out the fines and penalties they have paid, on their Wikipedia page.) 

If this client walked into my office, I would be reminded of the lyrics written by a Nobel Price for Literature winner:  ""Something is happening here/ But you don't know what it is/ Do you, Mr. Jones?"

I would look for a reason that someone would be reporting all that OID for seven years, just to end up with a loss in 2024.  Were there losses that canceled out the interest income?  Was he banking the ordinary income, knowing that it would turn into a capital loss that he needed to offset a large capital gain down the road?  I would be concerned about playing the role of "useful idiot" by putting on a 1040 the results of a scheme engineered by someone else.  

[George4Tacks]

I would very carefully consider that the OID reported each year would be an addition to basis. My thought is that there was an expectation, based on the terms of the instrument. If a 1099-OID was issued each year, that would help to reinforce my consideration of a basis adjustment. 

I think even the reigning supreme source of tax how too agrees with me. https://ttlc.intuit.com/community/taxes/discussion/interest-shortfall-on-contingent-payment-debt/00/....

I would never bother attaching a 1099. IRS would already have it and they tend to never read any attachments, unless required.  Your #4 seems to say you did not properly explain what you did with proper documentation in the response to IRS letter. I am unclear how you determined a shortfall prior to sale. The explanation in the return would not have changed things. The explanation in response to the IRS billing should have worked if you were correct. Document what you do this year and confer with your sophisticated investor that your logic is correct. Have that documentation and agreement with client in hand for the IRS letter to come later. 

[BobKamman]

@George4Tacks Consider this scenario.  I have investment interest expense but can't deduct it, because I have no investment income.  So I go buy something with OID, that yes I have to report but no, it doesn't increase my tax because I have the offsetting deduction.  If I keep adding the OID to the basis of the security that "pays" it, does that get me anything that I don't get if I just carry over the unused interest expense?  Doesn't it depend on all the facts and circumstances?  And, of course, we know next to nothing of those here.  

[jk2]

Interesting, but not the case with this client.   They generally prefer simple.   I don't know how they were talked into this.

[jk2]

I contacted the current financial advisor (prior retired) and he flat admitted he did not understand the investment.   He contacted people higher up, and they told him client needs to speak to his CPA.

Sell, Sell, Sell....then pass the buck.

[Taxes-by-Rocky]

Assuming no ulterior motives by the issuer and the taxpayer, if you haven't, I would suggest reviewing IRS Publication 550 and the section "Discount on Debt Instruments."  

If you want more details on the investment, the following might help to put some of it in context (more from the issuer's perspective), not sure...  JOFP-21-02-Bauer-Bozkurt-Nicholas.pdf

[BobKamman]

There's a 50-page Tax Court opinion today (T.C. Memo. 2025-45, petitioners are Stevens) that mentions Bermuda options and Formosa bonds and 20% penalties for tax shelters with no economic substance.  And some of it involves artificial losses related to original issue discount.  I don't understand most of it, but it's an example of why I would stay away from any returns with seven-digit amounts related to OID.  

[Taxes-by-Rocky]

Bob, you definitely would not be a fan of the private credit market.  Where nothing is fixed or guaranteed, and many of the investors are tax-exempt.  Just saying.

[BobKamman]

@Taxes-by-Rocky  You're saying that private credit is traded publicly and is found in LPL accounts?  

[Taxes-by-Rocky]

Referring to the OID issue....