 Hello and welcome to this session in which we will discuss serious EE savings bond, which are type of original issue discount bond. Before we do so, we have to understand an IRS doctrine called the constructive receipt doctrine. What is the constructive receipt doctrine? Well, it's an IRS principle to determine when income should be taxed. So from the IRS perspective, when should they tax you? Well, here's what the IRS looks at. If they believe you have access to the money, if the money is credited to your account, if the money is available to you, then you did receive it. If you did receive it, you have access to it. If you have access to it, you should pay your taxes. So under this doctrine, doctrine in individual or business is considered to have received income even if they don't physically receive it. So let's assume the money was credited to your account. You did not receive it, but it's available to you. It is your money. Therefore, you need to pay taxes. So the purpose of this doctrine is to ensure that taxpayers cannot avoid paying taxes by deferring or delaying its receipt. Because one tax strategy is to delay paying taxes because of the time value of money. The more you can delay it, the better off you are. So if income is available to an individual or a business, they are considered to have constructively received it. And it must be reported as taxable income in the appropriate tax year regardless whether they actually did receive it or not. So for example, let's assume you received a check in the mail on December 31st. You did not pick it up until January 15th. You went on vacation. Well, guess what? You did receive it. You had access to it December 31st, but you just chose not to get it. Well, you have it. It's income to you for that year. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool that's going to help you with your CPA exam preparation, as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses, broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true, false questions, as well as exercises. Go ahead, start your free trial today. Now let's talk about original issue discount bond. Why is that important? Well, because what is a discount? A discount is the difference between the face value of a note, face value, and how much cash you received or how much cash you paid up front. So for example, lenders, what they do, they often offer loans with maturity payment, exceeding the original amount, resulting in this is what we call original issue discount. So if you're a lender, you go to borrow money from the bank, they would say, okay, I would like to borrow $100,000. They would say, yes, here's what we're going to do. You want to borrow $100,000, that's going to be the face value of the loan. We're going to issue a loan, okay, for $80,000. So right now we'll give you cash, we'll give you cash of $80,000, but you will pay us, you'll have to pay us back $100,000. So this is called a discount loan. It means you're getting $80,000 today, you'll pay them $100,000 later. Now, regardless of the taxpayer accounting method, original issue discount must be reported as it accrues, and interest earned is computed using the effective interest rate method. Now you may not pay this face value until three years later. Well, you'll get $80,000 now, you will pay it, or let's assume, let's assume the opposite. Let's assume you went to the bank and you deposited $80,000, and you're going to get $100,000 later, three years from now. Well, guess what? Your total return is $20,000. You're not going to get it until three years later. Regardless, each year, year one, year two, year three, what you have to do is you have income that you have to report. In total, you're going to get $20,000. Let's take a look at an example. Let's assume on January 1st, X1, John a taxpayer using cash basis lends $907,030 to a financial institution to a bank by purchasing a CD. The certificate is priced to yield 5% as the effective interest rate. Simply put, John's going to earn 5% every year for two years, 24 months. The interest is computed annually. No interest payments are made until maturity when John collects a million dollars. John walks into the bank today, lends the bank $907,030. Two years later, John can walk into the bank and get a million dollars, but that's again two years later. This deal yields to John. John will earn 5%. Here's what's going to happen. As of year one, John will do what? This money will grow at 1.05, which is the original amount plus 5%. If we take 907,030 times 5%, John earned the first year $45,351.50. This money was added to the original amount. This is what I did. By the end of the year, John will have $952,381. Now, this number is in the bank account of John, but John cannot take this money until the end of the year. Guess what? This $45,000 is taxable. This is a form of original issue discount. John gave 907,030, purchased a CD and will not get their return until two years later, but the IRS says, well, they credited the money to your account. You have to pay taxes. Well, I didn't get the money. Well, yeah, that's the deal. Now, this money will stay in the account for year two and will earn this money, will stay in the account and will earn another 5%. When they earn another 5%, which is the original amount plus 5%, John will withdraw a million dollars. So in year two, if we take 952,381.5 times 0.05, John earned in year two $47,620 rounding, or 619.50, 619.50. So this is how much John earned in year two. Well, this amount is taxable too. So notice, now in year two, which is good, John should have the ability to pay because John received their money. That's fine in year two, but in year one, John did not see this money, cannot touch it. They can, but they'll get a penalty if they do, but they're gonna have to pay taxes on it. So this is what we mean by the money is taxable as it accrues, regardless whether you are a cash basis or not. Now, good news for serious E and serious EE bonds, which are type of bonds. Well, serious E are gone, but we have to talk about them real quick. Serious E and serious EE are types of savings bond issued by the US Department of Treasury to help fund the government and allow individual to save money. So rather than giving your money to the bank, to the financial institution, you can buy those original issued discount bond from the government. Now bear in mind, serious E were issued from 1941 to 1980, and they have 30 year maturity. Those are gone because they're gone 30 years after 1980, they no longer exist. Serious EE on the other hand were introduced in 1980 and are still being issued today. They follow the same concept. They earn a fixed rate of interest up to 30 years and can be redeemed after one year if you choose. Now, how does it work? Let's assume you want to, and this happens like, you know, your grandma, your grandpa, or your rich uncle or aunts, what they do on your birthday, they might buy you a bond. And today they pay for the bond like $500 or whatever amount they pay. And this bond will have a face value of $1,000, but that's you have to wait 18 years or something like that. So you'll get the bond today. It shows you have a bond for $1,000, but you have to wait 18 years to get the $1,000. They only paid $500. So every year, this bond will accrue interest until it reaches $1,000 after a year later. Now you can have any number, you can have $50,000 to $100,000, so on and so forth. Now, although these bond issued at discount, they do not follow the rules for the original issue discount. Remember, the original issue discount, like the John CD, John will have to pay interest every year. Here, income is usually postponed until the redemption or maturity. What does that mean? It means although you're earning interest every year on this bond, you're not receiving, you don't have to pay the taxes. And this aspect of US savings bond make them attractive as they offer income deferral benefit, not found in corporate bond or CDs like financial institution or banks. So this is why people will buy them. They would say, okay, I like to defer paying taxes. I'm earning the interest and I don't have to pay taxes until that bond mature. This is kind of a good news, bad news type of situation. Why? As we mentioned, the deferral feature, it's an advantageous. If the investors don't have enough money, they have insufficient fund to pay the taxes as the income accrues. So that's good. So as the income accrued, I don't have money to pay the taxes. That's good. So the the tax is being deferred. That's the good news. Now, at the same time, the federal may work against the investor. How? Here's what could happen, especially if the tax rate at the time of the redemption is higher when the income accrue, or if the bunch of the bond into one tax here moves the investor into a higher tax bracket. Let me explain this. So remember your rich aunt or uncle or your grandpa or your grandma gave you this bond, and they gave you the bond at 500,000. Let's make it 50,000. And after 18 years, you're going to get 100,000. Now your tax bracket between now and 18 years from now, because you're not making money, you're still young, maybe you are in the, I don't know, let's just make this up. 12% tax bracket. As interest is earned, you are in the 12% tax bracket. The government says you don't have to pay taxes now, you can pay the taxes later. They say, great, I'm deferring the taxes. But here's what's going to happen. Here comes your 18th year and you're making a lot of money, and now your tax bracket is 28%. So what happened is, now you have to pay 28% on these earnings, because while you defer them, you should pay them when the, your tax bracket is lower, or what could happen to this additional 50,000 of income from 50 to 50,000 kicked you in higher tax bracket, took you from 28% to 37%. I'm just making up those bracket. So this could be advantageous. So to avoid this possibility, here's what you can do. A cash taxpayer can choose to include the interest from these bonds and your annual income as they accrue. So what you will do, you would say, I am not going to wait until it matures to pay my taxes. I'm going to pay my taxes every year as they accrue. Two reasons. One is I pay a little bit of taxes every year. That's one. Two, my tax rate is lower now than later where I'm going to have to be making, I'm going to be making more money. I don't have to, but you should be making more money as you grow older. So this option is particularly useful for kids, for children. Why? Because most of their income is wiped out by their standard deduction. Also, remember, as you get older, you make more money. As you get, as you make more money, you are in a higher tax bracket. As you are in a higher tax bracket, you have to pay more taxes. So it's advantageous to do what? Don't wait, although they're giving you this option. But again, this is part of tax planning. As I mentioned, this is part of tax planning. Let's take a look at an example. John purchased $1,000 face value series EE savings bond for 500 on January 2 of the present year. By December 31, by the end of the year, the redemption value is $519.60. What can John do? John can say, you know what? I'm going to ignore this additional $19.60 or John say, I'm going to pay taxes on this. It's John's option. Well, if John defers this, it's part of the deferral strategy. What John's saying, maybe John don't have the money now. Don't want to pay taxes on this money. Or John says, maybe in the future, I have a lower tax bracket, I will wait until I cash it down the road. Or John could say, you know what? I'm going to pay it now. My tax rate is lower. And I have the money now, maybe down the road. I don't have the money. And my tax rate is higher. So when the bond is mature, John would receive a form 1099, telling them how much interest to include in their income. If John chose to report the income as it occurs, let's assume after when they get the 1099, they're going to say, you earned $500 in interest. And you have to pay the taxes. If John was paying the interest of that $500 over a period of the bond, they'll have to keep your record, say, no, I don't owe $500, I owe, I still have to pay taxes only on $20. Now, IRS rules for serious EE bonds. If the taxpayer choose to report the bond yearly, this election applies to all owned bonds and securities acquired afterwards. So if you choose to do that, you have to keep in mind, you have to pay the interest on all these investments, any investments you have that's similar to that. Okay. Changing the reporting method, then you have to talk to the IRS, just know the rules. What should you do now? Go to far hat lectures and look at additional resources, lectures, multiple choice through false additional notes. That's going to help you understand serious EE and serious EE savings bond. Really, it's serious EE savings bond. You have to understand how original issue discount work. And what's important in this original issue discount is the doctrine of constructive receipt. Good luck, guys. Study hard, stay safe, invest in yourself whether you are a CPA candidate, accounting students, or an enrolled agent.