How Are Structured Notes Taxed on Gains and Income?

Structured notes are debt securities from financial institutions that offer returns linked to an underlying asset, like a stock index or commodity. They provide customized risk-return profiles, such as offering full principal repayment at maturity while capping the potential upside.

While structured notes offer unique opportunities, their tax treatment is complex. This complexity arises because the payments are not fixed, which requires a specialized approach to classifying the investment and recognizing income for tax purposes.

The Core Tax Framework for Structured Notes

The tax treatment for most structured notes is governed by a specific set of U.S. Treasury regulations known as the contingent payment debt instrument (CPDI) rules. A security falls under this framework because its payments are contingent on the future value of an asset. This uncertainty means they cannot be taxed like a traditional bond, necessitating a different approach to calculate and report income.

The CPDI framework is based on the “comparable yield.” This is an estimated interest rate the issuer would have to pay on a traditional, fixed-rate debt security that is otherwise similar in terms of credit quality and maturity. The issuer determines this rate when the structured note is issued and it serves as the foundation for subsequent tax calculations.

Based on this comparable yield, the issuer then creates a “projected payment schedule.” This schedule maps out all the expected payments an investor would receive over the note’s term, assuming the investment performs according to the comparable yield. This schedule is hypothetical and is created solely for tax calculation purposes.

The combination of the comparable yield and projected payment schedule is known as the “noncontingent bond method.” Under Internal Revenue Service (IRS) regulations, investors must treat the structured note as if it were this hypothetical bond. This requires you to accrue interest income based on the comparable yield, regardless of the actual cash received.

Taxation During the Holding Period

During the time an investor owns a structured note, the primary tax consequence stems from Original Issue Discount (OID). Based on the comparable yield, the investor must accrue OID income each year. This accrued amount is treated as ordinary interest income for tax purposes and must be reported on the investor’s annual tax return.

This tax treatment can result in “phantom income,” as investors are taxed on the OID amount each year even if they do not receive any corresponding cash payments. This occurs because tax rules require income to be recognized as it accrues based on the projected payment schedule, not when it is actually paid out. This can lead to a tax liability in years where the investment generates no cash flow.

For instance, imagine an investor purchases a five-year, $10,000 structured note linked to a stock index. If the issuer determines the comparable yield is 5%, the investor would be required to report approximately $500 in OID income in the first year. This amount would be taxable as ordinary income, even if the note makes no cash payments until maturity. If the note also pays a separate, fixed coupon, that payment is treated as a return of capital that reduces the investor’s basis.

The annual accrual of OID has a direct impact on the investor’s adjusted basis in the note. Each year, the amount of OID income reported increases the basis. This adjustment is important because it prevents the same income from being taxed again when the note is ultimately sold or matures.

Taxation at Sale, Redemption, or Maturity

The tax treatment at a note’s sale, redemption, or maturity involves calculating the final gain or loss by comparing the final proceeds with the investor’s adjusted basis. Any gain on a structured note governed by CPDI rules is treated as ordinary interest income. This means the gain is taxed at the investor’s standard marginal income tax rate, which is often higher than the preferential rates for long-term capital gains from stocks.

The tax treatment of a loss is more nuanced. If the final proceeds are less than the adjusted basis, the resulting loss is treated as an ordinary loss, but only up to the amount of OID income previously included by the investor. An ordinary loss can be used to offset other ordinary income. Any loss that exceeds the total previously reported OID is characterized as a capital loss, which is subject to deduction limitations.

For example, consider an investor who bought a note for $10,000 and reported a total of $2,000 in OID income over its life, resulting in an adjusted basis of $12,000. If the note matures and pays out $13,000, the $1,000 gain is taxed as ordinary interest income. Conversely, if the note pays out only $9,000, the investor has a $3,000 loss. The first $2,000 of that loss is an ordinary loss, and the remaining $1,000 is a capital loss.

Tax Reporting for Structured Notes

The information needed to report the tax consequences of a structured note is provided by the brokerage firm on specific IRS forms. Investors do not need to calculate the complex accruals themselves, but they do need to know where to find the figures on their annual tax statements and how to report them correctly.

For the annual income accrued during the holding period, investors will receive Form 1099-OID, “Original Issue Discount.” The amount of OID that must be reported as ordinary interest income for the year is shown in Box 1 or Box 8 of this form. This is the “phantom income” that is taxable even if no cash was received.

When the structured note is sold, called, or matures, the transaction details are reported on Form 1099-B, “Proceeds from Broker and Barter Exchange Transactions.” This form will show the gross proceeds from the disposition in Box 1d. The cost basis of the note will be reported in Box 1e. It is important for investors to verify that the basis reported by the broker has been correctly adjusted for all the OID income previously reported.

The adjusted basis on Form 1099-B should reflect the original purchase price plus the cumulative OID. Investors should use the information from these forms to report the transaction on Form 8949 and Schedule D of their tax return, ensuring the proper characterization of gains and losses.