Author Topic: Peter's Tax Post  (Read 11393 times)

AmCap

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Peter's Tax Post
« on: March 08, 2013, 07:47:47 pm »
Peter wanted to know my thoughts on his tax post.  Of course well written but I have to quarrel with some things.  Generally not Peter's fault, but rather LC and Prosper's since it looks like they gave him incorrect information in several respects. 

Quote
1099-OID – Now, your 1099-OID should accurately reflect your total earnings. Service fees are now deducted from the amount of your 1099 as well.  Here is the exact formula for the number in box 1 of your 1099-OID as provided by Lending Club:

    1099 Interest = (regular interest + regular late fee – service fee) + (recovery interest + recovery late fee – recovery service fee)

I'm bewildered that LC told you that.  That is not OID plain and simple.  From the LC prospectus:

Quote
the Notes
...the Notes will have original issue discount, or OID, for U.S. federal income tax purposes because payments on the Notes are dependent on payments on the corresponding member loan. Further, a holder of a Note will be required to include the OID in income as ordinary interest income for U.S. federal income tax purposes as it accrues (which may be in advance of interest being paid on the Note),regardless of such holder’s regular method of accounting.

also...

Quote
  The amount of OID includible in a U.S. Holder’s income for a taxable year is the sum of the “daily portions” of OID with
respect to the Note for each day during the taxable year in which the holder held the Note. The daily portion of OID is determined by
allocating to each day of any accrual period within a taxable year a pro rata portion of an amount equal to the product of such Note’s
adjusted issue price at the beginning of the accrual period and its yield to maturity (properly adjusted for the length of the period). The
adjusted issue price of a Note at the beginning of any accrual period should be its issue price, increased by the aggregate amount of
OID previously accrued with respect to the Note, and decreased by any payments of principal and interest previously made on the
Note (net of the 1.00% service charge). A Note’s yield to maturity should be the discount rate that, when used to compute the present
value of all payments of principal and interest to be made on the Note (net of the 1.00% service charge) under the payment schedule
of the Note, produces an amount equal to the issue price of such note.

Cash payments of interest and principal (net of the 1.00% service charge) under the payment schedule on the Notes will not be
separately included in income, but rather will be treated first as payments of previously accrued but unpaid OID
and then as payments
of principal.

The quotes from the prospectus are accurate statements of law, and reflect that OID is an accrual-based form of taxation.  The cash payments you actually receive should not have any bearing on the amount of OID you include in a tax year.

Prosper's statement is similarly incorrect. 

Quote
We have modified our OID methodology to use actual interest received...

That statement is, in the tax world, nonsensical.    What the hell is Prosper's "OID methodology"?  The way OID is calculated is set out in the regulations accompanying Code Section 1272.  There is only one right way to calculate OID (one ring to rule them all...if you will).  As before, OID has nothing to do at all with the "actual interest received."  It is an accrual form of taxation, even if the taxpayer uses the cash method of accounting.
--

So why do we care.  Well, first, there's the issue of a material misrepresentation in the prospectus; you can't tell people your securities are taxed one way, and then take a position that is inconsistent with that. 

Second, calculating OID is important for a number of other issues that could pop up over the life of the bond.  If you buy a note at issuance, hold it to maturity, and it pays on time, every time, then no there really won't be much difference tax wise.  The difference will be between how LC calculates interest and how the Code and regulations tell you to calculate it, which for an individual note will be small.  But in aggregate, it adds up. 

Second, how OID is calculated directly affects the bond premium and sale/disposition rules.  Whether a note is issued with premium for tax purposes depends on LC's accurate calculation of the notes stated redemption price at maturity.  Further, if you sell a note, or it charges off, accurately calculating your gain or loss depends on accurate application of the OID rules because includible OID increases your basis in the note (I've discussed this issue at length in other posts).

--

Peter's discussion of how he's filing seems fine to me.  A few nits:

Quote
All charged off debts are reported on Schedule D as short term or long term losses.

Per Code Section 166, non business bad debts are treated as short term capital losses, regardless of how long you've held the debt instrument.  See generally, http://www.fool.com/school/taxes/2000/taxes000107.htm for why that matters.  If you have net short-term capital loss, you can deduct against ordinary income up to $3k per year.

Note that the mandatory short-term rule only applies to losses, not to gains.  If you buy a note, hold it for a year, and sell for a gain over your adjusted basis, you get long-term capital gain (yippee!).

--

My final thoughts.  LC and Prosper's structure is innovative, and the tax rules don't spell out everything perfectly.  (Well, ok the rules spell out some things as clear as day and they just get it wrong). At the very least, they have an obligation to conform their reporting with their prospectus, which generally sets out the tax treatment of the notes correctly.  My creeping suspicion is that a very good tax lawyer did their prospectus tax discussion, but less sophisticated parties are in charge of LC's tax reporting.  Hence the disconnect.  Not an excuse, but maybe a reason...

I see no reason why, to the investor, the tax reporting here should be any more difficult than if you had a Scottrade account or something.  We may have a need for some innovation in this area.

If you made it all the way to the end, please reward yourself with a [large] glass of wine.  If you have any questions please feel free to ask.  If you actually enjoyed reading this, maybe no more wine for tonight... :)

AmCap

Randawl

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Re: Peter's Tax Post
« Reply #1 on: March 08, 2013, 09:00:24 pm »
Love the discussion, thank you for posting this.

*goes and gets more wine anyway*

Peter

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Re: Peter's Tax Post
« Reply #2 on: March 08, 2013, 09:55:29 pm »
Thanks AmCap, I appreciate your detailed thoughts. Well I am bewildered. I spent a great deal of time confirming with LC and Prosper that I had it correct. But it is clear there is a disconnect. For one, Prosper and Lending Club offer identical investments (from a tax perspective) so you would think that their tax treatment would be identical. Seeing that it is not has always raised a bit of a red flag for me.

What I wish they would do is both hire a tax lawyer, preferably the same one, and get this right once and for all. How hard can it be?

Now, back to my wine...
Publisher of the Lend Academy blog

See my returns here: http://www.lendacademy.com/returns

writing2reality

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Re: Peter's Tax Post
« Reply #3 on: March 08, 2013, 10:01:54 pm »
*burp*

Nice work AmCap, thank you for your analysis.

And I agree with Peter... They are big enough, especially now, that there is no excuse for them not to have taken the appropriate steps in hiring a tax lawyer.
WriteYourOwnReality Blog: http://www.writeyourownreality.com

brycemason

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Re: Peter's Tax Post
« Reply #4 on: March 09, 2013, 01:11:55 am »
AmCap, what an informative and thorough post! Well done!

Wine time.

jpildis

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Re: Peter's Tax Post
« Reply #5 on: March 09, 2013, 10:10:45 am »
As much as I would like to use Section 166 to turn my long term defaults into short-term losses, the statute clearly states that this rule does not apply to securities as defined by 165(g)(2)(C):

For purposes of this subsection, the term “security” means—
(A) a share of stock in a corporation;
(B) a right to subscribe for, or to receive, a share of stock in a corporation; or
(C) a bond, debenture, note, or certificate, or other evidence of indebtedness, issued by a corporation or by a government or political subdivision thereof, with interest coupons or in registered form.

Based on this, I think it's clear LC & Prosper notes are securities.

AmCap

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Re: Peter's Tax Post
« Reply #6 on: March 09, 2013, 11:26:13 am »
As much as I would like to use Section 166 to turn my long term defaults into short-term losses, the statute clearly states that this rule does not apply to securities as defined by 165(g)(2)(C):

For purposes of this subsection, the term “security” means—
(A) a share of stock in a corporation;
(B) a right to subscribe for, or to receive, a share of stock in a corporation; or
(C) a bond, debenture, note, or certificate, or other evidence of indebtedness, issued by a corporation or by a government or political subdivision thereof, with interest coupons or in registered form.

Based on this, I think it's clear LC & Prosper notes are securities.

Eh I went back and forth on mentioning 165 but decided against it for a few reasons and in the sake of simplicity. 

First, 165 only applies to securities that are in registered form.  Virtually all publicly traded debt instruments are in registered form, but I really don't know enough about LC to say that for certain.  Very few debt instruments are issued with physical interest coupons, and LC notes certainly aren't. 

Second, the language of the prospectus, which indicates that the holder can take a deduction only when the debt becomes "wholly worthless" is typical of describing Section 166 deductions, and I've generally found the language of the prospectus to be correct.
 
Finally, do you care?  Your deduction will be capital whether its deducted under 165 or 166.  We just don't like the $3,000 cap against ordinary income (wages, OID, etc).  But 165 doesn't get you out of that.  We also don't like the fact that we pay tax on accrued but unpaid OID at ordinary income rates (assuming you're rich lol), but are capped on the deduction on losses because the OID is wrapped into the basis of the note.  The prospectus doesn't swing at that pitch, only saying that the issue isn't free from doubt, but I think the law is clearer than that.

Look at the end of the day is anybody gonna get audited over all this? I'd think almost certainly not.  Maybe if you have an account in the millions and are doing something that fragrantly isn't permitted.  But, as I said before, to the extent possible, I think LC and Prosper have a responsibility to get it right...especially when investors are not getting tax benefits to which they are entitled (e.g., LC's failure to include accrued OID in the tax basis of notes).  I think it's becoming clear that they are not quite at the mark yet.


PennySaved

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Re: Peter's Tax Post
« Reply #7 on: March 09, 2013, 12:49:48 pm »
I understand from AmCap his discussions of OID, what it is supposed to be and what LC says it is from their prospectus.  But for my charged-off  LC loans, the Interest OID reported for these loans was actual interest received and did not include any accrued interest during the time that payments were missed by the borrower before the loan was charged.  While this may be incorrect reporting of interest by LC, it sure makes it easier for reporting the charge-offs on my taxes.  I don’t have to do any calculations per charged-off note to adjust the basis of the notes as was explained in another posting (was maybe by AmCap, not sure).  That threw me off and had me scrutinizing every charge off carefully to figure out the actual interest received versus the interest OID reported by LC, on both the original and revised OID forms issued.  Basically, LC did not include accrued interest and I then figured out that they had deducted the service fee from the interest before reporting it as OID.  Maybe this is why LC is reporting OID this way- to save us a lot of work on calculating the amount of charge-offs to deduct for taxes.  Maybe technically they should not be doing this, but I, for now, am glad they are. Now that I understand all this, hopefully next tax year will go a little smoother. 

Perhaps what they should be doing is correctly reporting OID with accrued interest, then for charge-off loans issuing lenders a report with each charge-off adjusted by accrued interest (this would be a bear for us to figure out for every charged off note) so we have a accurate listing of the losses to report on Schedule  D.  We would be allowed to deduct this accrued interest because it had been included it as taxable interest OID, maybe in the same tax year or the prior tax year. Anyway, as time goes on perhaps the tax reporting will become simpler and more understandable.  And big thanks to Peter, for taking the effort to explain the tax forms for both Prosper and LC.

rawraw

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Re: Peter's Tax Post
« Reply #8 on: March 09, 2013, 12:50:21 pm »
I'm starting an AmCap fan club.

AmCap

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Re: Peter's Tax Post
« Reply #9 on: March 09, 2013, 01:22:29 pm »
I understand from AmCap his discussions of OID, what it is supposed to be and what LC says it is from their prospectus.  But for my charged-off  LC loans, the Interest OID reported for these loans was actual interest received and did not include any accrued interest during the time that payments were missed by the borrower before the loan was charged.  While this may be incorrect reporting of interest by LC, it sure makes it easier for reporting the charge-offs on my taxes.  I don’t have to do any calculations per charged-off note to adjust the basis of the notes as was explained in another posting (was maybe by AmCap, not sure).  That threw me off and had me scrutinizing every charge off carefully to figure out the actual interest received versus the interest OID reported by LC, on both the original and revised OID forms issued.  Basically, LC did not include accrued interest and I then figured out that they had deducted the service fee from the interest before reporting it as OID.  Maybe this is why LC is reporting OID this way- to save us a lot of work on calculating the amount of charge-offs to deduct for taxes.  Maybe technically they should not be doing this, but I, for now, am glad they are. Now that I understand all this, hopefully next tax year will go a little smoother. 

Perhaps what they should be doing is correctly reporting OID with accrued interest, then for charge-off loans issuing lenders a report with each charge-off adjusted by accrued interest (this would be a bear for us to figure out for every charged off note) so we have a accurate listing of the losses to report on Schedule  D.  We would be allowed to deduct this accrued interest because it had been included it as taxable interest OID, maybe in the same tax year or the prior tax year. Anyway, as time goes on perhaps the tax reporting will become simpler and more understandable.  And big thanks to Peter, for taking the effort to explain the tax forms for both Prosper and LC.

Interesting.  If you are right, then LC's reporting is investor-friendly, but not in compliance w/ law.  That's actually a little scary to me actually; if you have a large portfolio then do you get in trouble b/c the Service says that you are improperly characterizing capital losses as ordinary to absorb your other (high) ordinary income?  Maybe one could come up w/ a scheme to buy distressed notes, capture the interest while it accrues, and then deduct it against other ordinary income.  I can see potential abuse there... 

There's no authority that allows you to "reverse" accrued but unpaid interest - that would work as a deduction of ordinary income essentially.  I agree that's probably what the law *should* be, but that isn't what the law *is*.  Your suggestion sounds pretty much right - OID should accrue until it is clear the debt is worthless (i.e. at charge off) and be included in your basis in the note.  Then when it's charged off, the 1099-B would catch it and report a sale/exchange for $0.

It's a bear yes, but I think that's for the issuer to sort out, not the investor.  They are the ones in the best position to report accurately.

Rawraw, you are free to go right ahead, provided it comes with a page in wikipedia noting that I am the first tax person in the history of governmental exaction to have a fan club!

PennySaved

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Re: Peter's Tax Post
« Reply #10 on: March 09, 2013, 01:32:15 pm »
Count me as a member of the AmCap fan club.  I have learned so much from his posts. 

Also more thanks to Peter for finding out that the late fees are now included on 1099-OID.  I had gotten these off my monthly statements for previous tax years and reported them as misc. income.  Now I don’t have to bother with that. I can now forget about  the extra $0.20 I was reporting as misc income for 2012 because it should already be included on the 1099-OID.  I know these amounts are insignificant but I want to understand what the heck I am doing on my tax forms and why.  If my LC investments increase in the future, these types of problems and mistakes will cost me more.

I was thinking that now that I have Peter’s post, I am finally ready to finish my taxes, but wait!  I just forgot about a problem I saw with my 1099-B from Lending Club.  They had contradictory reporting of my recoveries as short-term and long-term on the same 1099-B form.  I sent them the following email on 2/23/12 to tax@lendingclub.com    This is the email address given on the bottom of the form to report any problems or questions.  I have not heard anything back (sigh).

Email to Lending Club: This attached Form 1099-B is reporting my recoveries on charged off loans.  It list two short term loan recoveries which total $0.91 and four long term loan recoveries which total $0.99 if you total them by how each note is listed as short- term or long- term in Box 1c of Form 1099-B . However, the form1099-B reports short term subtotals as $1.12 and long term subtotals as $0.78, which conflicts with how the loans are classified in Box 1c.  The grand total is the same, $1.90.  I need to know the correct amounts because I have to report short term recovery amounts on a different part of the tax form 8949 from the long term recovery amounts.    Please advise.   

I went ahead and filled out two Form 8949s for the short and long term recoveries (as basis not reported to IRS) based on the characterization reported in box 1c, not based on the description of the subtotals.  I nearly forgot about this problem.  I guess I could try and call Lending Club on Monday.  I really want to get this tax stuff over with.  Anyone else have this same 1099-B problem?

PennySaved

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Re: Peter's Tax Post
« Reply #11 on: March 09, 2013, 02:04:58 pm »
Regarding LC mistakes on my 1099-B as reported in my above post, I was thinking it did not make a difference on my overall taxes how I reported the totals for this year, plus it seemed obvious that the characterizations of the recoveries as reported in box 1c were correct given length of time between the Date of Acquisition reported in Box 1b and Date of Sale or Exchange reported in Box 1a.  Based on those dates I can clearly see which notes were charged off within a year or not. 

But NO.  After checking my spreadsheet of detailed info I had previously put together on my charged off loans,  the Dates of Sale or Exchange reported for my six note recoveries does not match what is reported as charge off date  in collection log for each of the six notes.  Sigh.  The charge off dates are all earlier than the reported Date of Sale or Exchange on 1099-B.  So does this mean the reported Dates of Sale on Form 1099-B are the dates then notes were sold to collection agencies?  And is this the date I should be reporting on column C of Form 8949 for date sold or disposed?  I had used the charge off date for these loans on Form 8949.   

This also brings up the issue of how can I be declaring these charge-offs as bad debt in the same tax year as I have recoveries for the same notes.  I did not see anything in the IRS regs against doing this, but I can't keep tabs forever on charged off notes to see if and when recoveries might occur.

PennySaved

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Re: Peter's Tax Post
« Reply #12 on: March 09, 2013, 02:52:33 pm »
Interesting, at the bottom of the LC 1099-B, it says if you have any questions regarding 1099 statement to send email to tax@lendingclub.com or call 888-596-3159. 

On the LC website, it give a different email address.
   What if I have questions?
If you have questions about what data is being reported on the year-end statement or IRS 1099 forms, please email investing@lendingcl ub.com or call (888) 596-3159. Tax questions should be directed to your financial or tax advisor.  Lending Club does not provide tax advice and...


So maybe I need to send my email to the investing@... address.  I wanted to do email because I could then attach the 1099-B.

By the way, I opened a Roth IRA LC account in January (separate for LC account that I am dealing with taxes on).  I emailed the application to the investing@lendingclub.com as instructed and waited.  Never heard anything.  Then I had to call them and and resend the email to a specific name.  They also went back to find my original email and said it was there, must have been "overlooked".  So I am going to resend the email regarding my 1099-B to the "investing@...and also call them. 

My charge-off dates are not matching the 1099-B sale dates on my six note recoveries except in one case.  The other five sale dates are all the same date, 10/16/12 and don't seem to match up to anything in the collection logs.  Three notes have $0.02 recovery reported on 1099-B but the the reported recovery shown for the note(s) on the LC website is reported as Zero.  Other notes have recovery values on 1099-B lower than the recovery amt reported on the website, but I understand that recovery late and service fees have probably been subtracted from the amount recovered, because these fees are supposedly included on 1099-OID, according to Peter.

alchemista

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Re: Peter's Tax Post
« Reply #13 on: March 17, 2013, 05:26:32 pm »
Thanks for the discussion posts.  When I view the IRS instructions (http://www.irs.gov/taxtopics/tc453.html), it says that nonbusiness bad debts require a separate bad debt statement to be attached, with extra information on what you tried to do to collect, etc.  Is this really required for LC's charged-off loans?  Is that what everyone is doing?

H&R Block says that you cannot efile either if you have nonbusiness bad debts - likely because of the bad debt statement requirement.

I realized I never wrote-off the charged-off loans from last year, but it was only $100ish so it's not worth doing an amendment.  I may just skip it this year as well for $90ish of charge-offs.

The tax issues with these small loans is ridiculous - think I'm just going to withdraw from LC - I'm only making about 5-6% there anyway.

AmCap

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Re: Peter's Tax Post
« Reply #14 on: March 17, 2013, 05:34:53 pm »
Alchemista...that makes me sad to hear that tax would cause you to withdraw.  Hopefully we can work to make the tax side no more difficult than if you owned a mutual fund.  Stick with us!