Options

March 13, 2024

7584 / What is a "spread" transaction?

<div class="Section1">A “spread” is a position consisting of both long (purchased) and short (sold) options of the same type (i.e., put or call). The options may have different exercise prices and exercise dates. The basic purpose of the various types of spread transactions is to limit or define the risks of the options transaction. The “spread” is the actual dollar difference between the buy premium and the sell premium.<a href="#_ftn1" name="_ftnref1">1</a><div class="Section1"> <blockquote>Example: ILM corporation’s stock is trading at $91 in November, but Ms. Noel expects it to decline. She writes an ILM January 80 call and collects a premium of $1300 for it. Since she does not own ILM stock and does not wish to assume the risks of writing an uncovered call, Ms. Noel also buys an ILM January 90 call at a cost of $600. If the price of ILM drops to $79, Ms. Noel will have made a profit of $700 (the difference between the premium she paid and the premium she collected). If the price does not drop, she has limited her loss to $300 (the $1000 difference between the strike prices of the two options minus the $700 net premium).</blockquote> The three basic types of spreads are vertical (or price), horizontal (or time), and diagonal (combination of vertical and horizontal). Spreads are also (regardless of their type) referred to either as credit, debit, or even. In a debit spread, the costs of the long (purchased) position exceed the proceeds of the short (sold) position. In a credit spread, the proceeds of the short position exceed the cost of the long position. If the costs and proceeds are equal, the spread is even. Vertical Spreads. A vertical spread (also referred to as a price, money, or perpendicular spread) is the simultaneous purchase and sale of puts or calls with the same underlying security and expiration date, but with different strike prices. An investment in a vertical spread is based upon the expectation that the option purchased is undervalued relative to the option sold. Horizontal Spreads. A horizontal spread (also referred to as a time or calendar spread) is the simultaneous purchase and sale of puts or calls with the same underlying security and strike price, but with different expiration dates. Horizontal spreads are purchased in anticipation that over time the spread will widen. Diagonal Spreads. A diagonal spread is a combination of a vertical spread and a horizontal spread; thus, it is the simultaneous purchase and sale of puts and calls with the same underlying security but with different strike prices and expiration dates. Within each of the categories described above (vertical, horizontal, diagonal), a spread can also be characterized as a bull spread, bear spread, or butterfly spread. A bull spread is the combination of a long position at a lower strike price and a short position at a higher strike price. It is so named because it will generally be profitable if the underlying security goes up in value. In a bear spread the opposite is true: the strike price of the long position is higher than the strike price of the short position, and the investor will generally profit if the trading price of the underlying security goes down. A butterfly spread is a combination in which the investor holds three put or call positions in the same underlying security at three different strike prices. The expiration dates may be the same or the spread may be “diagonalized” by having different expiration dates. Butterfly spreads are so named because the respective “sizes” of the positions invoke the image of a butterfly. The Tax Court has described butterfly spreads as follows: “The highest and lowest strike positions are one-half the size of the middle position, and the middle position (the body) is long (or short) and the highest and lowest positions (the wings) are short (or long). The highest and lowest positions are equidistant from the middle position.”<a href="#_ftn2" name="_ftnref2">2</a> See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7585">7585</a> for an explanation of the tax treatment of spread transactions. </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   See Resser v. Comm., TC Memo 1991-423; Laureys v. Comm., 92 TC 101 (1989), acq. in part, nonacq. in part, 1990-1 CB 1, footnotes 5 and 11. <a href="#_ftnref2" name="_ftn2">2</a>.   See Laureys v. Comm., 92 TC 101 (1989), acq. in part, nonacq. in part, 1990-1 CB 1, footnotes 5 and 11. See also Andrea S. Kramer, Financial Products: Taxation, Regulation and Design (New York: John Wiley & Sons, Inc. 1991, Supp. 1993), § 5.4(c). </div></div>

March 13, 2024

7583 / How are nonequity options taxed?

<div class="Section1">Nonequity options are taxed under the mark-to-market rules that apply to regulated futures contracts and other IRC Section 1256 contracts (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7592">7592</a>).<div class="Section1"> Like any other position taxed under the “mark to market” requirements, a nonequity option is excluded from the definition of an appreciated financial position under IRC Section 1259(b)(2)(B) (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7617">7617</a>). However, it appears that, depending on the taxpayer’s other holdings, the acquisition of a nonequity option could be construed as a constructive sale of a position that is substantially identical to the nonequity option or the property underlying it.<a href="#_ftn1" name="_ftnref1">1</a> Future regulations may clarify this and other issues with respect to the application of IRC Section 1259 to options transactions. For the tax treatment of a nonequity option that is part of a tax straddle, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7593">7593</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7614">7614</a>. For the tax treatment of a nonequity option that is considered part of a conversion transaction, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7615">7615</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7616">7616</a>. </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC § 1259(c)(1)(E). </div></div>

March 13, 2024

7585 / How are spread transactions taxed?

<div class="Section1">Generally, spread transactions are subject to the tax straddle rules to the extent that the positions in the spread are offsetting (see below). Consequently, certain spreads will apparently be subject to the constructive sale treatment of IRC Section 1259 (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7617">7617</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7621">7621</a>).<a href="#_ftn1" name="_ftnref1">1</a><div class="Section1"> Generally, positions are offsetting if the taxpayer substantially reduces the risk of holding one position with respect to personal property while at the same time holding another position with respect to personal property, whether or not it is of the same type.<a href="#_ftn2" name="_ftnref2">2</a> See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7593">7593</a> for an explanation of the IRC definition of “offsetting” and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7599">7599</a> for an explanation of the treatment of tax straddles. The Tax Court has taken the position that spread transactions are not “similar arrangements” within the meaning of IRC Section 465(b)(4), and that losses on stock option spreads are thus not limited by the “at risk” rules.<a href="#_ftn3" name="_ftnref3">3</a> However, the IRS, issuing a very limited partial acquiescence to the Tax Court’s Laureys decision, noted its nonacquiescence as to whether offsetting positions in stock options are subject to the limitations of IRC Section 465(b)(4). See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8004">8004</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8005">8005</a> for an explanation of the “at risk” rules. To the extent that one position of a spread is offset by only a portion of the other position, only those portions of the spread that offset one another will be treated as offsetting (and subject to the tax straddle rules) unless the position is part of a larger tax straddle.<a href="#_ftn4" name="_ftnref4">4</a> Apparently, any options positions that are not offset by other positions will be taxed under the general rules governing equity options (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7560">7560</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7581">7581</a>). Positions consisting entirely of options that are IRC Section 1256 contracts (i.e., dealer equity options and nonequity options) are exempt from the tax straddle rules and, instead, taxed under the mark-to-market rules in IRC Section 1256. Such positions will not constitute an “appreciated financial position” (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7617">7617</a>), but may constitute a constructive sale of another position (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7618">7618</a>). See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7592">7592</a> for an explanation of IRC Section 1256 treatment. Spreads consisting of at least one, but not all, IRC Section 1256 contracts are subject to the rules for “mixed straddles.” For an explanation, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7605">7605</a>. Aside from the special rules for IRC Section 1256 contracts (see above), it is clear that certain combinations of options (to be specified in future regulations) or options held contemporaneously with offsetting positions that have the effect of reducing both the taxpayer’s risk of loss and opportunity for gain, will trigger constructive sales treatment under IRC Section 1259, unless certain exceptions apply (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7617">7617</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7621">7621</a>).<a href="#_ftn5" name="_ftnref5">5</a> A spread transaction that is a straddle under IRC Section 1092(c) may also constitute a conversion transaction. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7615">7615</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7616">7616</a> for the definition and tax treatment of conversion transactions. </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC § 1259(c)(1)(E); Conference Committee Report for TRA ’97. <a href="#_ftnref2" name="_ftn2">2</a>.   IRC § 1092(c). <a href="#_ftnref3" name="_ftn3">3</a>.   See Resser v. Comm., TC Memo 1991-423; Laureys v. Comm., 92 TC 101 (1989), acq. in part, nonacq. in part, 1990-1 CB 1, footnotes 5 and 11. <a href="#_ftnref4" name="_ftn4">4</a>.   IRC § 1092(c)(2)(B). <a href="#_ftnref5" name="_ftn5">5</a>.   IRC § 1259(c)(1)(E). </div></div>

March 13, 2024

7580 / How is the writer of a listed call or listed put taxed if he terminates his obligation by making a closing purchase in the market?

<div class="Section1">Any gain or loss realized by the writer of a listed option in a closing purchase (i.e., the “purchase” in the market of an option identical to the one written) is short-term capital gain or loss.<a href="#_ftn1" name="_ftnref1">1</a> The amount of such gain or loss will be the difference between the premium paid by the writer in the closing purchase and the premium previously received in the original sale of the option.<a href="#_ftn2" name="_ftnref2">2</a> See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="702">702</a> for the treatment of capital gains and losses.<div class="Section1"> Certain combinations of options, or options held contemporaneously with offsetting positions that have the effect of reducing both the taxpayer’s risk of loss and opportunity for gain, may trigger constructive sales treatment under IRC Section 1259. The operation of these rules is explained at Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7617">7617</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7621">7621</a>, and the effect of closing out or reopening certain transactions that are subject to constructive sale treatment is explained at Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7618">7618</a>. The contemporaneous holding of a call option and granting of a put option with respect to an equity interest in a pass-through entity may constitute a “constructive ownership transaction” under IRC Section 1260. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7622">7622</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7623">7623</a>. It is unclear whether the writer of a call will be deemed to have entered into a contract to sell the underlying property within the meaning of IRC Section 1258(c)(2). For more on conversion transactions, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7615">7615</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7616">7616</a>. </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC § 1234(b); Rev. Rul. 78-182, 1978-1 CB 265. <a href="#_ftnref2" name="_ftn2">2</a>.   Rev. Rul. 78-182, 1978-1 CB 265. </div></div>

March 13, 2024

7576 / If a put or call expires without exercise, how is the writer taxed?

<div class="Section1">When a put or call (whether listed or unlisted) expires without exercise (i.e., lapses), the premium that has been carried by the writer in a deferred account since the option was sold (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7574">7574</a>) is recognized as short-term capital gain and included in the writer’s gross income for the tax year in which the option expired.<a href="#_ftn1" name="_ftnref1">1</a> See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="702">702</a> for the treatment of capital gains and losses.<div class="Section1"> Under regulations expected to be issued in the future, if the underlying property on which the option is written becomes worthless, the taxpayer will recognize gain or loss in the same manner as if the contract were closed when the property became substantially worthless.<a href="#_ftn2" name="_ftnref2">2</a> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC § 1234(b)(1); Rev. Rul. 78-182, 1978-1 CB 265. <a href="#_ftnref2" name="_ftn2">2</a>.   IRC § 1233(h)(1). </div></div>

March 13, 2024

7578 / How is the writer of a put taxed when the option is exercised by the owner?

<div class="Section1">The writer of a put (listed or unlisted) realizes no taxable gain or loss on the purchase of the underlying stock pursuant to exercise of the put. However, for purposes of determining the writer's gain or loss on a subsequent sale of the underlying stock, the writer's tax basis in that stock is reduced by the amount of the option "premium" received in the original sale of the put. Furthermore, the holding period of the underlying stock begins on the date of its purchase, not on the date the put was written.<a href="#_ftn1" name="_ftnref1">1</a></div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. Rev. Rul. 78-182, 1978-1 CB 265. </div>

March 13, 2024

7582 / What is a "nonequity" option?

<div class="Section1">For federal income tax purposes, a nonequity option is any option traded on a national securities exchange or commodity futures exchange (or other exchange, board of trade, or market designated by Treasury) that is not an “equity” option.<a href="#_ftn1" name="_ftnref1">1</a> Thus, options on regulated futures contracts are nonequity options. In addition, the term “nonequity option” includes any option traded on a national securities exchange (or other market designated by Treasury) whose value is determined directly or indirectly by reference to broad-based groups of stocks and broad-based stock indexes.<a href="#_ftn2" name="_ftnref2">2</a> See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7560">7560</a> for the definition of “broad-based security index.”<div class="Section1"> The IRS has ruled that options to buy or sell stock that are based on a stock index and that are traded on (or subject to the rules of) a qualified board or exchange meet the requirements for contract market designation and are nonequity options if (a) the options provide for cash settlement, and (b) the SEC has determined that the stock index is a “broad-based” index. These options are considered “IRC Section 1256 contracts” (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7592">7592</a>). Furthermore, warrants that are based on a stock index and that are economically, substantively identical in all material respects to options based on a stock index are treated as options based on a stock index.<a href="#_ftn3" name="_ftnref3">3</a> As one of several types of “IRC Section 1256 contracts,” a nonequity option is taxed under the “mark to market” requirements (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7592">7592</a>). Such a position is excluded from the definition of an appreciated financial position under IRC Section 1259(b)(2)(B) (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7617">7617</a>). However, depending on the taxpayer’s other holdings, it appears that a constructive sale could result from the acquisition of a nonequity option (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7617">7617</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7621">7621</a>).<a href="#_ftn4" name="_ftnref4">4</a> For an explanation of the application of the conversion transaction rules to transactions involving the contemporaneous acquisition of a put option and the underlying (or substantially identical) stock, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7616">7616</a>. </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC §§ 1256(g)(3), 1256(g)(7). <a href="#_ftnref2" name="_ftn2">2</a>.   H.R. Conf. Rep. No. 106-1033 (CRTRA 2000); IRC § 1256(g)(6). <a href="#_ftnref3" name="_ftn3">3</a>.   Rev. Rul. 94-63, 1994-2 CB 188. <a href="#_ftnref4" name="_ftn4">4</a>.   IRC § 1259(c)(1)(E). </div></div>

March 13, 2024

7575 / Are the commissions a writer of a put or call pays in connection with the sale of that option tax deductible?

<div class="Section1">No. Commissions paid by a writer to sell a put or call (whether listed or unlisted) merely reduce the total "option premium" received in consideration for the obligations under the option.<a href="#_ftn1" name="_ftnref1">1</a></div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. Rev. Rul. 58-234, 1958-1 CB 279; Rev. Rul. 68-151, 1968-1 CB 363. </div>

March 13, 2024

7579 / How is the writer of an unlisted put or unlisted call taxed if the writer repurchases the option from the holder?

<div class="Section1">If the writer of an unlisted option repurchases the option from its holder, he or she will realize short-term capital gain or loss to the extent of the difference between the premium paid to repurchase the option and the premium originally received by the writer.<a href="#_ftn1" name="_ftnref1">1</a> See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="702">702</a> for the treatment of capital gains and losses.<div class="Section1"> Certain combinations of options, or options held contemporaneously with offsetting positions that have the effect of reducing both the taxpayer’s risk of loss and his or her opportunity for gain, may trigger constructive sales treatment under IRC Section 1259. The operation of these rules is explained at Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7617">7617</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7621">7621</a>, and the effect of closing out or reopening certain transactions that are subject to constructive sale treatment is explained at Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7618">7618</a>. The contemporaneous holding of a call option and granting of a put option with respect to an equity interest in a pass-through entity may constitute a “constructive ownership transaction” under IRC Section 1260 (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7622">7622</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7623">7623</a>). </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC § 1234(b); Rev. Rul. 78-181, 1978-1 CB 261. </div></div>

March 13, 2024

7577 / How is the writer of a call taxed when the option is exercised by the owner?

<div class="Section1">When a listed or unlisted call is exercised and the writer thereof is called on to sell the underlying stock, the writer adds the amount of the option “premium” received for writing the call to the total strike price to determine the total amount realized on the sale. Then, to the extent that the total amount realized exceeds the writer’s tax basis in the stock sold, he or she realizes a capital gain; if the writer’s tax basis exceeds the total amount realized, he or she has a capital loss. (See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="702">702</a> for the treatment of capital gains and losses.) The nature of such gain or loss generally depends on the holding period of the stock sold (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="699">699</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="702">702</a>), regardless of the time the “call” was outstanding.<a href="#_ftn1" name="_ftnref1">1</a><div class="Section1"> If an investor writes a call option as part of an overall tax straddle, the tax straddle rules may result in deferring recognition of a loss realized on the exercise of the call option and, in addition, may have unfavorable effects on the characterization of gains and losses realized on positions making up the straddle. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7593">7593</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7614">7614</a> for details. It is unclear whether the writer of a call will be deemed to have entered into a contract to sell the underlying property, within the meaning of IRC Section 1258(c)(2). For more on conversion transactions, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7615">7615</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7616">7616</a>. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7594">7594</a> for an explanation of the rules governing covered call options. </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   Rev. Rul. 78-182, 1978-1 CB 265. </div></div>