2016 Cost Basis Legislation and Tax Reporting Fixed Income

Advisor Toolkit Volume III

1

Table of Contents

Introduction and Overview of Regulations . . . . . . . . . . . . . . . . . . 2

More Complex Fixed Income: Cost Basis and Tax Reporting . . . . . . . . . . . . . . . . . . . . . . . 3

Amortization and Accretion Reporting Changes . . . . . . . . . . . . . . . . . . . . . . 7

2016 Tax Year 1099 Composite and Year-End Summary Changes . . . . . . . . . . . . . . 9

Transfer Reporting Delayed . . . . . . . . . . . . . . 15

Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

Appendix A: Reporting Rules for More Complex Fixed Income Securities . . . . . 18

Appendix B: Less Complex Fixed Income Amortization Defaults . . . . . . . . . . . . . . . . . . . 20

2

Introduction and Overview of Regulations

The Emergency Economic Stabilization Act of 2008 included new tax reporting requirements that dramatically changed the way advisors and their clients manage cost basis and realized gain/loss

reporting.

The goal of the Act is to ensure that investors accurately report investment gains/losses in their annual tax filings. To achieve this objective, custodians and brokers are required to report the cost basis of sold covered securities (including whether the gain or loss is short-term or long-term) to taxpayers and the IRS on Form 1099-B .

Cost basis reporting effective dates by security type

The final phase of the Emergency Economic Stabilization Act of 2008 took effect in January 2016 and impacts cost basis reporting changes for more complex fixed income instruments, generally categorized as debt without a fixed coupon or fixed maturity .

Cost basis legislation requires brokers/custodians to begin reporting cost basis information on more complex fixed income instruments for the 2016 tax year. Depending on the reporting preferences youve selected for your clients, they may see changes in cost basis, realized gain/loss, and unrealized gain/loss information on schwaballiance .com and reported on their monthly statement .

Weve created this Advisor Toolkit to help you understand the IRS direction on this final phase of the legislation. We also want you to know Schwabs plans for implementing these requirements and the upcoming changes that may affect your clients .

In addition, we will highlight changes to the 2016 IRS tax forms and enhancements made to the Year-End Summary report .

An important definition

Please note that the IRS uses the term debt instrument in place of fixed income securities or fixed income instruments in its publications online. When looking for fixed income information on the IRS website, use debt instrument as your search term . Schwab will continue to use fixed income securities or fixed income instruments, except when using debt instrument or both terms provides more clarity .

The IRS defines debt instrument as any instrument or contractual arrangement that constitutes indebtedness under the general principles of federal income tax law, including notes, bonds, debentures, or other evidence of indebtedness .

EquitiesMutual Funds,

ETFs, and Drips

Less Complex Fixed Income Instruments

and Options

More Complex Fixed Income Instruments

Acquired on or after

January 1, 2011 January 1, 2012 January 1, 2014 January 1, 2016

3

More Complex Fixed Income: Cost Basis and Tax Reporting

Properly accounting for the cost basis of a fi xed income security is considerably more complicated than for an equity security, ETF, or mutual fund . Cost basis can be affected by accruals of income as well as tax instructions the holder of the instrument makes . Many of the changes made by the IRS align broker reporting on Form 1099-B with taxpayer reporting requirements .

Cost Basis Reporting

The IRS cost basis reporting requirements apply to more complex fi xed income securities that were acquired on or after January 1, 2016. The following chart shows the more complex fi xed income securities generally categorized as debt without a fi xed coupon or fi xed maturity. It also shows fi xed income securities excluded from cost basis reporting.

More Complex Fixed Income Securities

Subject to January 1, 2016 Cost Basis Reporting

Fixed Income Securities

Excluded from Cost Basis Reporting

Variable-rate bonds (VRDI) Infl ation-indexed fi xed income securities (TIPS) Stripped bonds (principal only) Stripped bonds (interest only) Convertible bonds Stepped rate bonds Contingent payment bonds (CPDI) Foreign-denominated debt (fi xed rate) Payment-in-kind bonds (PIK) Certain tax credit bonds Fixed income securities issued as part of an investment unit Capital appreciation bonds (CAB)

The IRS has specifi cally excluded the following fi xed income securities described in Section 1272(a)(6):

- Certain specifi c interests in or mortgages held by a real estate mortgage investment conduit (REMIC)

- Certain other fi xed income securities with payments subject to acceleration

- Pools of fi xed income securities whose yield may be affected by prepayments

Short-term fi xed income securities (with a maturity not more than one year from the date of issue)

Fixed income securities for which terms are not reasonably available within 90 days of acquisition

Fixed income securities evidenced by a physical certifi cate not held by a custodian

Its important to assess how this phase of the cost basis legislation will affect your fi rm and clients. While this phase is considered more complex, less than 3% of the debt holdings at Schwab meet the defi nition of more complex fi xed income. We recommend that you review your portfolio to determine which of your clients hold more complex fi xed instruments and direct your related communications only to them .

Your clients started seeing changes in unrealized gain/loss values in December 2016displayed online as they were made and

on December statements . All changes to realized gain/loss and unrealized positions are retroactive to January 1, 2016 . More

complex fi xed income instruments purchased prior to January 1, 2016, will not be adjusted due to varied reporting methods

available prior to the creation of the cost basis legislation .

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Tax Reporting

The IRS treats income for most complex fixed income security types as non-qualified stated interest (NQSI), which is reported on the 1099-OID. Qualified stated interest is reported on the 1099-INT. NQSI is generally the excess of a fixed income securitys stated redemption price at maturity over its issue price . Original issue discount (OID) is a type of NQSI, but NQSI does not necessarily mean the security was issued at a discount, especially when reporting complex debt . The constant yield method is used to calculate the amount of NQSI reportable for any given year for most complex fixed income security types. The IRS has modified the calculation for certain security types, including contingent debt, variable debt, inflation-indexed debt, and stripped bonds, due to their variable nature. Specific rules regarding NQSI calculations for these securities can be found in Appendix A: Reporting Rules for More Complex Fixed Income Securities .

In addition to the IRS rules governing calculation of OID income, de minimis rules also apply . The rule says that if OID is less than the de minimis amount then all stated interest is treated as qualified stated interest and the discount is considered to be zero .

Defining original issue discount

OID is the excess of a fixed income securitys stated redemption price at maturity over its issue price. Inflation-indexed fixed income securities, zero-coupon bonds, and debt instruments that pay no interest until maturity are examples of OID instruments .

De Minimis Amount

= 0 .25% XStated

Redemption Price

X# of Complete Years from Issue Date to

Maturity Date

To calculate the de minimis amount on debt with installment obligations, the same formula is used but instead of using complete years uses the weighted average maturity .

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Debt Instrument Amortization/Accretion Income Reported On Principal Reported On

Inflation-indexed fixed income securitiesTreasury Inflation Protected Security (TIPS) only

Can adjust every accrual period based on fluctuations in the index

Form 1099-INT and Form 1099-OID for increases in the inflation index

Form 1099-INT and the Negative Original Issue Discount section of the Year-End Summary for decreases in the inflation index

Dispositions are reported on Form 1099-B . Increases in principal for the tax year are reported as NQSI income on Form 1099-OID . Decreases in principal will be reported in the Negative Original Issue Discount section of the Year-End Summary .

Stripped bonds principal only

No market discount or premium

1099-OID 1099-B

Stripped bonds interest only

No market discount or premium

1099-INT Not reportable . Each payment is considered a new issue and therefore a short-term instrument .

Contingent payment bonds (CPDI)

The yield to calculate OID accretion is based on a projected income schedule provided by the issuer .

1099-OID Form 1099-B

Variable-rate bonds For every accrual period, the yield will adjust based on the new coupon rate .

The new yield will be used to calculate the premium, discount, or OID income .

Any amortization or accretion within a specific period will require the adjustment of the amortized income to match the actual income .

Form 1099-OID Form 1099-B

Stepped-rate bonds Market discount and premium bonds are treated like any other fixed-rate bonds.

The difference between the original rate and subsequent, increased rates is treated as NQSI income and reported on Form 1099-OID . All income will be reported on Form 1099-OID .

Form 1099-B

The table below provides information for each type of fixed income security covered by the regulations.

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Capital appreciation bonds (CABs)

Yield is calculated based on a zero-coupon and fixed-coupon period .

No income reporting on municipal OID . OID and NQSI on tax-exempt issues are reported in the supplemental section .

Form 1099-B

Convertible bonds Market discount and OID bonds are treated like any other fixed-rate bonds. The IRS requires brokers to assume 100% of a premium is due to the convertibility option, which is not permitted to be amortized .

Form 1099-OID Form 1099-B

Foreign-denominated debt

For fixed-rate, fixed-maturity (FR/FM) bonds, the amortization is calculated based on foreign currency and converted to USD for reporting purposes . Complex bonds are not covered, because the issuers do not provide U .S . tax opinions on the treatment .

Form 1099-INT only for FR/FM

Form 1099-B regular gain/loss, market discount, and foreign currency FR/FM

Tax credit bonds Follows general rules for fixed-rate bonds.

Form 1099-INT Form 1099-B for disposition

Payment-in-kind (PIK) bonds

N/A; PIK payments received in lieu of cash are treated as 100% OID .

Form 1099-OID

Interest payment may include additional face value and/or actual income .

PIK payments increase the principal, and the additional face value is payable at maturity .

Fixed income issued as part of an investment unit covered under widely held fixed investment trust (WHFIT) reporting rules

N/A Form 1099-INT Form 1099-B

Fixed income instruments excluded from the cost basis reporting requirements described in the regulation:

Mortgage-backed securities Short-term fixed income securities (with a maturity not more than one year from the date of issue)

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Amortization and Accretion Reporting Changes

Amortization/accretion affects the calculation of whether a bond purchased at a premium or a discount has a gain or loss at disposition . Schwab is required to make changes to these settings in our cost basis system to conform to the new IRS reporting rules on certain bond types in taxable accounts .

Schwab implemented changes to the amortization rules in our cost basis engine in December 2016 . Previously, Schwab was making bond premium adjustments daily . Going forward, amortization adjustments will be applied to premium bonds on interest payment dates . These changes will be visible on Schwab Advisor Center, schwaballiance .com, monthly statements with cost basis information included, and advisor cost basis data files. There will be no changes to market discount or acquisition premium.

In addition, amortization settings for more complex fixed income securities were enabled to comply with the IRS cost basis reporting requirements. Some cost basis for more complex fixed income positions purchased before January 1, 2016, will continue to reflect original cost basis and N/A for adjusted cost basis .

The table below shows when required changes will occur in Schwabs systems .

Reporting changes timeline

December 2016 January 2017 Q1 2017

System changes that may affect unrealized gain/loss or realized gain/loss values on Schwab Advisor Center, schwaballiance .com, monthly statements with cost basis information included, and advisor cost basis data files

System changes that may affect the unrealized gain/loss or realized gain/loss values for complex fixed income positions purchased in 2016 and after . These changes may result in changes to clients cost basis values and will be visible on Schwab Advisor Center, schwaballiance .com, monthly statements with cost basis information included, and advisor cost basis data files

New IRS Form 1099-B and changes to the 2016 advisor 1099 tax file download

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Letter of Authorization (LOA) to Change Fixed Income Amortization & Accretion Settings Form

The IRS-designated defaults may not coincide with what your clients have used for tax filing purposes in the past. But the IRS will allow taxpayers to instruct their brokers to use settings for taxable bonds that differ from the defaults . They can choose to:

Disable bond premium amortization

Accrue market discount using straight-line

Include market discount in current income

If your client is considering changes to the default settings, instructions must be submitted in writing to Schwab by December 31 of that tax year . They will be retroactive to January 1 of that tax year . We will process all forms received by December 31 in time for 1099 reporting for that tax year .

Clients should complete the Letter of Authorization (LOA) to Change Fixed Income Amortization & Accretion Settings form, shown below, to submit their instructions .

The Letter of Authorization (LOA) to Change Fixed Income Amortization & Accretion Settings form must be completed and signed by the account holder for each affected account . Advisors cannot execute an LOA on their clients behalf .

Some instructions are not revocable, and others require IRS commissioner approval for revocation .

Your clients are responsible for filing the appropriate instructions with the IRS on their tax returns .

To obtain a Letter of Authorization (LOA) to Change Fixed Income Amortization & Accretion Settings form for their use, contact the Client Reporting Services Team at 1-877-762-6446 .

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2016 Tax Year 1099 Composite and Year-End Summary ChangesThe new reporting rules for more complex fixed income securitiesspecified in the Emergency Economic Stabilization Act of 2008 and now released by the IRShave impacted the 1099 Composite for 2016 . Schwab has also made enhancements to the Year-End Summary section .

Changes to Form 1099-B

Box 1g changed to report wash sale loss disallowed

Box 1f changed to report accrued market discount

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Box 2, added as an ordinary income indicator. In the event Box 2 is checked, the security is a Contingent Payment Debt Instrument subject to the noncontingent bond method. When checked, an adjustment may be required. A new Worksheet for Contingent Payment Debt Instrument Adjustment on IRS Form 8949 should be used to fi gure the adjustment to enter in column (g).

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Changes to Form 1099-INT

Box 12, Bond Premium on Treasury Obligations, added to report bond premium for these securities. Includes both open and closed covered U.S. Treasury obligation holdings for the current tax year.

Only the amount of amortized U.S. Treasury obligation bond premium allocated to the stated interest payment made during the calendar year will be reported. Any excess premium is carried forward to the following tax year.

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Changes to Form 1099-OID

Box 10, Bond Premium, added to report bond premium that exceeds the OID amount for all covered bonds with the exception of convertible bonds. If the bond premium is less than the OID amount, nothing is reported in Box 10.

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Changes to the Year-End Summary Section

Bond premium reported on U.S. Treasury obligations (from Form 1099-INT) added to the Detail Information of Interest Income section.

The sale of stock for bankrupt companies will now be provided in the Realized Gain or (Loss) section. This transaction is not reported on the 1099-B.

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The state of the municipal securities reported in the Amortization and Accretion for Fixed Income section has been added.

The amount of dividends paid on the short sale of securities has been added to a new section.

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Transfer Reporting Delayed

Cost basis reporting on security transfers of more complex fixed income positions and options issued as part of a fixed income instrument purchased in 2016 will be required one year later than the date for purchases . The IRS has delayed requirements for reporting cost basis on transfers for an additional year . This will allow brokers the necessary time to change their transfer reporting systems. Any covered, complex fixed income security transferred during this time may be treated as uncovered.

1099 Reporting Transfer Statements

More complex fixed income January 1, 2016 January 1, 2017

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Glossary

171 Election A taxpayer (bondholder/client) election under Internal Revenue Code Section 171 to amortize bond premium on a taxable fixed income security .

Accretion The process of adjusting the purchase price of a bond upward to par . The difference between the price of a bond bought below par and its par value is called the discount . When an investor buys a security in the secondary market at a discount (if the security was issued below or near 100), the purchase price is adjusted upward to 100 over the remaining life of the security until it reaches par on the maturity date .

Acquisition Premium The excess of a fixed income securitys adjusted cost basis immediately after purchase, including purchase at original issue, over the fixed income securitys adjusted issue price at that time .

Amortization The process of adjusting the purchase price of a bond downward to par . The difference between the price of a bond bought above par and its par value is called the premium . When an investor buys a security in the secondary market at a premium (if the security was issued above or near 100), the purchase price is adjusted downward to 100 over the remaining life of the security until it reaches par on the maturity date .

Bond Call Feature Allows the issuer the right to redeem the bond, under specific conditions, prior to its maturity date .

Bond Premium Amount by which your cost basis in the bond right after you buy it is more than the total of all amounts payable on the bond after you get it (other than payments of qualified stated interest).

Bond Put Feature Allows the holder to force the issuer to repurchase the security at specified dates before maturity.

Constant Yield A method of amortizing bond premium . The constant yield amount is calculated by multiplying the adjusted cost basis by the yield at issuance and then subtracting the non-qualified stated interest.

Debt Instrument or Fixed Income Security The IRS defines debt instruments (aka fixed income securities) as any instrument or contractual arrangement that constitutes indebtedness under the general principles of federal income tax law, including notes, bonds, debentures, or other evidence of indebtedness .

De Minimis Under federal tax laws and regulations, for the discount rules to apply to a security, the discount must be at least 0 .25% of the stated redemption price for the bond at maturity, multiplied by the number of full years from the date of original issue for OID and purchase for market discount to maturity . Otherwise, the discount is considered to be zero .

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Fixed Income Security or Debt Instrument The IRS defines debt instruments (aka fixed income securities) as any instrument or contractual arrangement that constitutes indebtedness under the general principles of federal income tax law, including notes, bonds, debentures, or other evidence of indebtedness .

Market Discount The stated redemption price of a bond at maturity minus your cost basis in the bond immediately after you acquire it . Market discount arises when the value of a debt obligation decreases after its issue date .

Original Issue Discount (OID) The amount by which the stated redemption price at maturity of a fixed income security is more than its issue price .

Qualified Stated Interest In general, qualified stated interest is stated interest that is unconditionally payable in cash or property (other than fixed income securities of the issuer) at least annually over the term of the fixed income security at a single fixed rate (i.e., bond coupon payments).

Straight-Line Amortization A simple amortization method that spreads out the cost of an asset equally over its lifetime .

Widely Held Fixed Investment Trust (WHFIT) A fixed investment trust held by a third party or parties.

Yield to BestYield to Highest The yield that would be realized on a callable bond if it were redeemed on the date that would result in the highest yield .

Yield to Maturity The average annual return on a bond, assuming the bond is held to maturity and all interest payments are reinvested at the same rate . The yield includes an adjustment for any premium or discount from face value .

Yield to WorstYield to Lowest The yield that would be realized on a callable bond if it were redeemed on the date that would result in the lowest yield to the holder .

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Appendix A: Reporting Rules for More Complex Fixed Income Securities

Debt Instrument Reporting Requirements

Inflation-indexed fixed income securities Principal is adjusted up or down based on the Consumer Price Index (CPI) .

Income is also adjusted up or down based on the CPI .

Increases or decreases in principal are treated as NQSI income for each tax year .

Schwab will adjust the reporting requirements based on the purchase price .

Variable-rate bonds For every accrual period, the market discount rate will adjust based on the new coupon rate .

Each time the coupon rate is adjusted, the yield to maturity will be recalculated using the new rate. The new rate will reflect the amount of premium, discount, and OID income .

Any amortization or accretion within a specific period will require the adjustment of the amortized income to match the actual income .

Stepped-rate bonds Once the yield to maturity is calculated, market discount, OID, and premium bonds are treated like any other fixed-rate bonds.

Capital appreciation bonds (CAB) All NQSI must be reported .

Income reporting for municipal NQSI/OID is not anticipated to be required until 2017 or later .

Schwab will still adjust the cost basis for NQSI .

Municipal CABs will follow the same reporting requirements as stepped-rate bonds .

Convertible bonds Reporting requirements for market discount and OID bonds remain the same as for fixed-rate bonds.

For premium bonds, no amortization is required to be reported . The assumption is that 100% of the premium is attributable to the conversion feature .

Stripped bonds Interest-only stripped bonds are not reportable . Each payment is considered a new security .

Principal-only stripped bonds are reported as OID income . The issue price is equal to the purchase price . There is no market discount or bond premium .

Contingent payment bonds The yield to calculate OID accretion is based on a projected income schedule provided by the issuer .

All income is considered OID .

Any payments above or below the projected income schedule will result in an adjustment to the OID income .

Any purchase outside of the adjusted issue price at the time of purchase will result in an adjustment to the OID income over the remaining life of the bond .

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Foreign-denominated debt These instruments generally do not provide a U .S . tax opinion .

If the required data and tax opinion are not readily available within 90 days, the IRS provides a safe harbor to make these securities uncovered .

For fixed-rate, fixed-maturity bonds, the amortization is calculated based on foreign currency and converted to U .S . dollars for reporting purposes .

Tax credit bonds There are no reporting requirements for broker-dealers .

Claiming the tax credit is the responsibility of the taxpayer .

These bonds follow general amortization and accretion rules .

Payment-in-kind bonds (PIK) The interest payment may include additional face value and/or actual income .

Additional face value is considered a PIK payment .

PIK payments increase the principal, and the additional face value is payable at maturity .

PIK payments are recognized as OID income over the life of the bond .

Schwab will adjust cost basis to reflect the additional face value over the remaining life of the bond .

Fixed income issued as part of an investment unit

Most unit investment trusts (UITs) are considered Regulated Investment Companies (RICs) or covered under the WHFIT reporting rules .

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Appendix B: Less Complex Fixed Income Amortization Defaults

Bonds Amortization Method Yield Apply De Minimis Rule

Original Issue Discount No Call or Put Feature

Constant Yield Yield to Maturity Yes

Market Discount Constant Yield Yield to Maturity Yes

OID Call Feature Constant Yield Yield to Worst (Lowest Yield) Yes

OID Put Feature Constant Yield Yield to Best (Highest Yield) Yes

OID With Acquisition Premium

Constant Yield Original Yield to Maturity, Then Apply Acquisition Premium

Yes

Bond PremiumNo Call or Put Feature

Constant Yield Yield to Maturity No

Bond PremiumCall Feature Constant Yield Yield to Best (Highest Yield)Taxable Bonds

Yield to Worst (Lowest Yield)Tax-Exempt Bonds

No

Bond PremiumPut Feature Constant Yield Yield to Best (Highest Yield) No

Options carry a high level of risk and are not suitable for all investors. Specific requirements must be met to trade options through Schwab. Please read the options disclosure document Characteristics and Risks of Standardized Options.

Futures trading carries a high level of risk and is not suitable for all investors. Specific requirements must be met to trade futures. Please read Risk Disclosure Statement for Futures and Options before considering any futures transaction.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors.

For general informational purposes only. Meant for an institutional audience.

Schwab Advisor Services serves independent investor advisors and includes the custody, trading, and support services of Charles Schwab & Co., Inc. (Schwab).

Independent investment advisors are not owned by, affiliated with, or supervised by Schwab.

This general information is not intended to be a substitute for specific individualized tax, legal, or investment planning advice and is not intended to be construed as tax advice.

This information cannot be used for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Where specific advice is necessary or appropriate, Schwab recommends consulting with a qualified tax advisor, CPA, financial planner, or investment manager.

2017 Charles Schwab & Co., Inc. All rights reserved. Member SIPC.

JUT (0117-TC5Z) MKT95651-00 (01/17)

00189888

Questions?

The Client Reporting Services Team is available at 1-877-762-6446 to answer any additional questions you may have .