Straddles And Other Transactions

<div class="Section1">Under the regulations, certain over-the-counter options may also qualify as qualified covered call options. A <em>qualifying over-the-counter option</em> is an equity option that is not traded on a national securities exchange registered with the SEC <em>and</em> is entered into with a person registered with the SEC as a broker-dealer or alternative trading system.<a href="#_ftn1" name="_ftnref1">¹</a> A qualifying over-the-counter option must meet the same requirements outlined in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7597">7597</a> for equity options with flexible terms.<a href="#_ftn2" name="_ftnref2">²</a><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. Treas. Reg. &sect; 1.1092(c)-3(a).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>. Treas. Reg. &sect; 1.1092(c)-3(b).<br /> <br /> </div></div><br />

<div class="Section1">A portion of any gain recognized upon disposition or other termination of a straddle that is part of a <em>conversion transaction</em> (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7615">7615</a>) may be treated as ordinary income. A straddle will be subject to these rules if substantially all of the taxpayer&rsquo;s expected return from the investment is attributable to the time value of the taxpayer&rsquo;s net investment in the transaction.<a href="#_ftn1" name="_ftnref1">¹</a> 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 class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC &sect; 1258(c).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> Assuming the straddle qualifies (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7614">7614</a>), the owner of a mixed straddle who has elected to have the IRC Section 1256 contract positions in the straddle excluded from the mark-to-market tax rules may also elect to have the tax straddle taxed as an &ldquo;identified straddle.&rdquo;<a href="#_ftn1" name="_ftnref1">¹</a> (Note that this election does <em>not</em> create what the regulations refer to as an &ldquo;IRC Section 1092(b)(2) identified mixed straddle.&rdquo; These are discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7608">7608</a>.)<br /> <br /> If this election is made, the straddle will not be subject to the loss deferral and wash sale rules discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7599">7599</a>.Instead, any loss with respect to a position in the straddle (including the IRC Section 1256 contract positions) will be treated as sustained no earlier than the day on which all positions making up the straddle are disposed of.<a href="#_ftn2" name="_ftnref2">²</a> The tax straddle short sale rules continue to apply. For details, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7599">7599</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7614">7614</a>. The application of the constructive sale rules of IRC Section 1259 to identified straddles is discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7614">7614</a>.<br /> <br /> An election to remove the IRC Section 1256 contracts from the mark-to-market tax rules is necessary in order for a mixed straddle to be taxed as an identified straddle because without this election the mixed straddle rules discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7607">7607</a> will control.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC &sect; 1092(a)(2)(B).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>. IRC &sect; 1092(a)(2)(A)(ii).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> <em>Equity options with flexible terms</em>. Unlike equity options with standardized terms, equity options with flexible terms can have strike prices at other than fixed intervals and can have expiration dates other than standardized expiration dates. Under the regulations, equity options with flexible terms may be qualified covered call options if they satisfy certain requirements. Specifically, an equity option with flexible terms is a qualified covered call option <em>only if</em> (1) the option meets the requirements of IRC Section 1092(c)(4)(B) (as outlined in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7596">7596</a>); (2) the only payments permitted with respect to the option are a single fixed premium paid no later than five business days after the day on which the option is granted, and a single fixed strike price stated as a dollar amount that is payable entirely at (or within five business days of) exercise; (3) an equity option with standardized terms is outstanding for the underlying equity; and (4) the underlying security is stock in a single corporation.<a href="#_ftn1" name="_ftnref1">¹</a> An equity option with standardized terms means an equity option that is traded on a national securities exchange (i.e., a listed option) and that is not an equity option with flexible terms.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> For purposes of applying the general rules, the benchmark for an equity option with flexible terms will be the same as the benchmark for an equity option with standardized terms on the same stock having the same applicable stock price.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. Treas. Reg. &sect; 1.1092(c)(c)(1).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>. Treas. Reg. &sect; 1.1092(c)-4(b).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>. See Treas. Reg. &sect; 1.1092(c)(c)(2).<br /> <br /> </div></div><br />

<div class="Section1"><em>Short sale rules</em>. For purposes of determining whether a gain or loss on the disposition of a straddle position is long-term or short-term, two rules similar to the general short sale rules (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7525">7525</a>) apply. First, unless a position was held by the taxpayer for a period of time at least equal to the long-term capital gain holding period before a straddle including that position was established, the holding period of that position will be treated as beginning no earlier than the date on which the taxpayer no longer holds, directly or indirectly, an offsetting position with respect to that position. Second, the loss on the disposition of a straddle position (or positions) will, regardless of the holding period of such position, be treated as <em>long-term</em> capital loss <em>if</em> on the date such loss position was entered into the taxpayer held, directly or indirectly, one or more offsetting positions <em>and</em> all gain or loss on one or more positions in the straddle would have been treated as long-term capital gain or loss had such position(s) been disposed of on the day the loss position was entered into.<a href="#_ftn1" name="_ftnref1">¹</a><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC &sect; 1092(b)(1); Temp. Treas. Reg. &sect; 1.1092(b)T.<br /> <br /> </div></div><br />

<div class="Section1">If all positions of the mixed straddle are disposed of on the same day, gains and losses from the IRC Section 1256 contracts in the straddle are netted. Gains and losses from non-IRC Section 1256 contract positions are also netted. Net gain or loss from the IRC Section 1256 contracts is then offset against the net gain or loss from non-IRC Section 1256 positions. If total net gain or loss from the straddle is attributable to IRC Section 1256 positions, then the capital gain or loss will be treated as 60 percent long-term and 40 percent short-term. If the total net gain or loss from the straddle is attributable to non-IRC Section 1256 positions, then the gain or loss will be <em>short-term</em> capital gain or loss.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <p style="padding-left: 40px"><em>Example</em>. On March 1, Nathan enters into a non-IRC Section 1256 position and an offsetting IRC Section 1256 contract and makes a valid election to use the straddle-by-straddle identification rules. On March 10, Nathan disposes of the non-IRC Section 1256 position at a $600 loss and the IRC Section 1256 contract at an $800 gain. The total net gain of $200 on the straddle is attributable to the IRC Section 1256 position. Thus, 60 percent of the net gain ($120) will be long-term capital gain and 40 percent ($80) will be short-term capital gain.</p><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. Temp. Treas. Reg. &sect; 1.1092-3T(b)(2).<br /> <br /> </div></div><br />

<div class="Section1">If all of the IRC Section 1256 contract positions in the mixed straddle are disposed of (or deemed disposed of) on the same day, gains and losses realized on the IRC Section 1256 positions are netted. Also, realized <em>and unrealized</em> gains and losses with respect to non-IRC Section 1256 positions of the straddle are netted on that day. Net gain or loss realized from the IRC Section 1256 positions is then treated as <em>short-term</em> capital gain or loss to the extent of the net gain or loss on the non-IRC Section 1256 positions on the day. Net gain or loss with respect to the IRC Section 1256 positions that exceeds the net gain or loss on the non-IRC Section 1256 positions is treated as 60 percent long-term and 40 percent short-term.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <p style="padding-left: 40px"><em>Example</em>. On December 30, Joshua enters into an IRC Section 1256 contract and an offsetting non-IRC Section 1256 position and makes a valid election to use the straddle-by-straddle identification rules. On December 31, Joshua disposes of the IRC Section 1256 contract at a gain of $1,500. As of December 31, there is $1,000 of unrealized loss in the non-IRC Section 1256 position. Under these circumstances, $1,000 of the gain realized on the IRC Section 1256 contract is short-term capital gain (i.e., to the extent of the unrealized loss on the non-IRC Section 1256 position). The other $500 of gain from the straddle is treated as 60 percent long-term capital gain ($300) and 40 percent short-term capital gain ($200).</p><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. Temp. Treas. Reg. &sect; 1.1092(b)-3T(b)(4).<br /> <br /> </div></div><br />

<div class="Section1">If one or more non-IRC Section 1256 positions are held after all the IRC Section 1256 contract positions in the straddle have been disposed of, any gain or loss realized on those non-IRC Section 1256 positions will be <em>short-term</em> capital gain or loss to the extent that such gain or loss is attributable to the period when such positions were part of the straddle.<a href="#_ftn1" name="_ftnref1">¹</a> See Temporary Treasury Regulation Section 1.1092(b)T for the rules for determining the holding period with respect to such positions.<div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. Temp. Treas. Reg. &sect; 1.1092(b)-3T(b)(7).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> A &ldquo;conversion transaction&rdquo; is a transaction from which substantially all of the taxpayer&rsquo;s expected return is attributable to the time value of the taxpayer&rsquo;s net investment in the transaction, and that is (1) a transaction that encompasses an acquisition of any property and a substantially contemporaneous agreement to sell such property (or substantially identical property) at a price determined in accordance with the agreement; (2) an applicable straddle; (3) any transaction that is marketed or sold as producing capital gains from a transaction from which substantially all of the taxpayer&rsquo;s expected return is attributable to the time value of the net investment in the transaction; <em>or</em> (4) any transaction specified in future regulations.<a href="#_ftn1" name="_ftnref1">¹</a> In short, a conversion transaction is a financial arrangement that resembles a loan in an economic sense.<br /> <br /> An &ldquo;applicable straddle&rdquo; means any straddle within the meaning of IRC Section 1092(c), except that the term &ldquo;personal property&rdquo; includes stock.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> The income tax consequences of conversion transactions are explained in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7616">7616</a>.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC &sect; 1258(c).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>. IRC &sect; 1258(d)(1).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> <em>Flex options</em> are customized options that allow investors to customize key contract terms, including strike prices. The determination of the &ldquo;lowest qualified benchmark&rdquo; for standardized options is based upon the striking prices for standardized options, not for equity options with flexible terms (i.e., flex options).<a href="#_ftn1" name="_ftnref1">¹</a> Thus, certain taxpayers (primarily institutional and other large investors) can engage in transactions that would otherwise be unavailable to them, and other investors can continue to do business without regard to the existence of the institutional product.<br /> <br /> Currently, exchange rules provide for $2.50 benchmarks (i.e., strike prices at $2.50 intervals) for standardized options on stocks trading between $5 and $25, $5 benchmarks for options on stocks trading between $25 and $200 per share, and $10 benchmarks for options on stocks trading at more than $200. Apparently, if these benchmarks are modified by the exchanges or the exchanges otherwise change their practices, the IRS has broad authority to revise the foregoing rules.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> Regardless of the foregoing rules, a covered call option is <em>not</em> treated as qualified (and a tax straddle does exist) <em>if</em> the gain from the disposition of the underlying stock is includable in the investor&rsquo;s gross income for a tax year subsequent to the tax year in which either the call option was closed or the stock was disposed of at a loss <em>and</em> the stock or option was not held for 30 days or longer following the date the call was closed or the stock was disposed of. However, the rules discussed above, which require the tolling of the holding period of the underlying stock and which treat loss as long-term loss if there would have been long-term gain on a sale of the underlying stock, continue to apply.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> It is unclear whether a qualified covered call option can constitute a conversion transaction (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7615">7615</a>). If so, it may be subject to the additional rules set forth in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7616">7616</a>.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. See Treas. Reg. &sect; 1.1092(c)(b).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>. See IRC &sect; 1092(c)(4)(H); General Explanation &ndash; TRA &rsquo;84, p. 310.<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>. IRC &sect; 1092(c)(4)(E).<br /> <br /> </div></div><br />