What Is the Tax Treatment of a STRATS Trust?

A STRATS Trust is a financial product created by investment banks to repackage existing debt securities. These instruments, formally known as Structured Repackaged Asset-Backed Trust Securities, offer investors different risk, return, or maturity characteristics than the original underlying debt. A financial institution acquires a block of corporate bonds and places them into a newly formed trust, which then issues new securities, called certificates, to investors.

The value and payments of these certificates are derived from the performance of the underlying assets, allowing for customized features like a floating interest rate from a fixed-rate bond. For the investor, a certificate represents an ownership interest in the cash flows generated by the debt.

The Structure of a STRATS Trust

The creation of a STRATS Trust begins with securitization, where a financial institution, or sponsor, purchases a substantial amount of debt securities from a single corporate issuer. These securities are then transferred into a separate legal entity, the trust, which legally isolates the assets from the sponsor. The trust issues STRATS certificates, which represent the undivided beneficial interest in the assets it holds.

A trustee, typically a large bank, manages the trust in a passive capacity. The trustee’s primary roles are to hold the underlying collateral, administer the trust according to the governing documents, collect payments from the collateral, and distribute the cash flow to certificate holders.

The structure is composed of three distinct components. The first is the underlying collateral, which is most commonly a long-term, fixed-rate corporate bond from a well-known company. The second component is the trust entity itself, a passive vehicle established under a trust agreement. It holds the collateral and often enters into an interest rate swap agreement to convert fixed interest payments into floating-rate payments. The final component is the STRATS certificates purchased by investors, which represent a fractional ownership in the trust’s assets.

Tax Treatment of Income

The income an investor receives from a STRATS certificate is treated as interest income for tax purposes. This treatment often involves the concept of Original Issue Discount (OID). OID arises when a debt instrument is issued for a price that is less than its stated redemption price at maturity. The difference is the OID, which is considered a form of interest.

For tax purposes, OID accrues annually. Under Internal Revenue Code Section 1272, holders of debt instruments with OID must include a portion of the OID in their taxable income each year, even if they do not receive a corresponding cash payment. This means an investor can have taxable income from a STRATS certificate without receiving any cash. The amount of OID included in income is calculated using a constant-yield method.

To illustrate, imagine a certificate with a 10-year life is purchased at a discount. Each year, the investor must report a calculated amount of OID as interest income.

In addition to OID, STRATS certificates may also make regular cash payments to investors, referred to as stated interest. These payments, which are often determined by a floating rate formula, are also taxable as ordinary interest income in the year they are received. An investor’s total taxable interest income from the certificate in any given year is the sum of the stated interest received and the accrued OID for that year. This information is reported to the investor by the issuer or broker.

Tax Treatment of Disposition

When an investor sells, redeems, or otherwise disposes of a STRATS certificate, the transaction results in a taxable event. The capital gain or loss is found by subtracting the investor’s adjusted tax basis in the certificate from the sale proceeds. The adjusted basis starts with the original purchase price and is then increased by any OID that the investor has previously included in their taxable income. This adjustment for OID ensures that this portion of the return is not taxed again as a capital gain upon sale.

For example, if an investor bought a certificate for $950 and included $20 of OID in income, their adjusted basis would become $970. If they then sell the certificate for $990, their capital gain would be $20 ($990 – $970).

Another concept that can affect the tax outcome upon disposition is market discount. Market discount arises when an investor purchases a bond on the secondary market for a price that is less than its adjusted issue price. This discount is treated as ordinary income, not capital gain, when the bond is sold or redeemed. Under Internal Revenue Code Section 1276, the accrued market discount must be recognized as interest income at the time of disposition.

Conversely, an investor might purchase a certificate for more than its stated redemption price, creating an amortizable bond premium. An investor can elect to amortize this premium over the remaining life of the certificate. This annual amortization amount can be used to offset the stated interest income received from the certificate, thereby reducing the investor’s taxable income. If this election is made, the investor must also reduce their tax basis in the certificate by the amount of the amortized premium each year.

Reporting and Documentation

Proper tax reporting for a STRATS trust certificate relies on documentation provided by the brokerage firm or the trust’s paying agent. The primary document investors receive is Form 1099-OID, “Original Issue Discount.” This form reports the amount of OID that has accrued for the tax year, which must be included as interest income, and also reports any stated interest paid during the year.

When a STRATS certificate is sold, the transaction is reported on Form 1099-B, “Proceeds from Broker and Barter Exchange Transactions.” This form shows the gross proceeds from the sale. It is the investor’s responsibility to use this information along with their adjusted basis to calculate the resulting capital gain or loss, as the adjusted basis is not always reported on Form 1099-B.

Because the calculations for OID, market discount, and bond premium can be complex, brokerage firms provide supplemental tax information along with the standard IRS forms. This documentation often contains a detailed breakdown of accruals and adjustments specific to the investor’s holding period. Investors should review these additional statements to ensure they are accurately reporting income and adjusting their cost basis correctly.