The Section 1288(b) Election for Short-Term Obligations

The U.S. tax code has specific rules for financial instruments that mature in one year or less, known as short-term obligations. The income from the discount on these instruments has a default tax treatment that allows for deferring income recognition. However, taxpayers can elect an alternative method that changes when the income is reported for tax purposes.

Defining Short-Term Obligations and Acquisition Discount

A short-term obligation is a debt instrument, such as a bond, note, or certificate, with a fixed maturity date of one year or less from its issue date. This category includes U.S. Treasury Bills (T-bills), commercial paper issued by corporations, and banker’s acceptances. These instruments are purchased for less than their face value and do not make periodic interest payments.

The difference between the purchase price and the maturity value is known as the acquisition discount. It is calculated as the excess of the stated redemption price at maturity over the taxpayer’s basis in the obligation, which is the purchase price. For instance, if an investor purchases a T-bill for $9,800 that will be redeemed for its $10,000 face value at maturity, the acquisition discount is $200. This concept is distinct from Original Issue Discount (OID), as tax rules for these instruments focus on the acquisition discount.

Default Tax Treatment for Short-Term Obligations

Under the default tax rules, the acquisition discount on a short-term obligation is not taxed as it accrues over the holding period. Instead, the income is deferred until the year the obligation is sold, exchanged, or redeemed at maturity. The character of this income is ordinary, not a capital gain, up to the amount of the calculated acquisition discount.

This treatment allows for a delay in tax liability. Continuing the previous example, the $200 of acquisition discount on the T-bill would be reported as ordinary income in the tax year the T-bill matures. It would not be included in the investor’s income in the year the T-bill was purchased if that was a different tax year.

Electing Current Income Inclusion

As an alternative to deferring income, tax law permits an election to include the acquisition discount in gross income on a current basis. When this choice is made, the discount is accrued ratably, meaning the total discount is spread evenly over the number of days from the acquisition date to the maturity date.

Making this election requires a corresponding adjustment to the investor’s tax basis in the obligation. The basis is increased by the amount of the discount that is included in income each year. This upward adjustment ensures that the income is not taxed a second time when the obligation is sold or redeemed and reduces the amount of gain recognized upon disposition.

This current-inclusion method is the mandatory reporting method for certain entities, such as those using an accrual method of accounting, banks, dealers in securities, and regulated investment companies. The election is therefore primarily a choice available to individual investors who use the cash basis method of accounting.

How to Make the Election

An investor makes the election for current income inclusion by reporting the accrued acquisition discount as interest income on their timely-filed federal income tax return. The election becomes effective for the tax year in which it is first made. No separate form or statement is required, as the act of reporting the income serves as the formal declaration.

Once made, the election applies to all short-term obligations acquired by the taxpayer during the year of the election and in all future taxable years. It is not an obligation-by-obligation choice but a comprehensive change in the taxpayer’s method of accounting for these instruments.

An election to currently include acquisition discount in income cannot be revoked without first obtaining formal consent from the Internal Revenue Service (IRS). The process of securing such consent is granted only in specific circumstances, making the initial choice a lasting one for tax reporting purposes.