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>.&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.1092(c)-3(a).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;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> (<em><em>see</em> </em> 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> <em><em>See</em> </em> 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>.&nbsp;&nbsp; IRC &sect;&nbsp;1258(c).<br /> <br /> </div></div><br />

<div class="Section1">Assuming the straddle qualifies (<em><em>see</em> </em> 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&nbsp;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>.)<div class="Section1"><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&nbsp;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, <em><em>see</em> </em> 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&nbsp;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&nbsp;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><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp; IRC &sect;&nbsp;1092(a)(2)(B).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp; IRC &sect;&nbsp;1092(a)(2)(A)(ii).<br /> <br /> </div></div><br />

<div class="Section1">If a transaction that would otherwise be a constructive sale is closed within certain time limits, it will be disregarded. The IRC states that constructive sales treatment will not apply to any transaction that would otherwise be treated as a constructive sale during the taxable year if:<br /> <blockquote>(1)   the transaction is closed before the end of the thirtieth day after the close of the taxable year (i.e., the “extended taxable year”);<br /> <br /> (2)   the taxpayer holds the appreciated financial position throughout the 60-day period beginning on the date the transaction is closed; <em>and</em><br /> <br /> (3)  at no time during the 60-day period is the taxpayer’s risk of loss with respect to the position reduced by reason of holding an option to sell, an obligation to sell, or a short sale, being the grantor of a call option, or certain other transactions diminishing the risk of loss.<a href="#_ftn1" name="_ftnref1">¹</a></blockquote><br /> A closed transaction that is, in essence, reestablished (or replaced with a substantially similar transaction) before the 60-day period described above elapses, then closed again<br /> within the extended taxable year, may also be disregarded. The Internal Revenue Code states that if:<br /> <blockquote>(a)   a transaction, which would otherwise be treated as a constructive sale of an appreciated financial position, is closed during the taxable year or during the 30 days thereafter (the extended taxable year), <em>and</em><br /> <br /> (b)  another substantially similar transaction is entered into during the 60-day period beginning on the date that the original transaction is closed, that (i) also would otherwise be treated as a constructive sale of the position, and (ii) is closed before the end of the extended taxable year in which the original transaction occurs, and the transaction meets requirements (2) and (3), above,</blockquote><br /> then the substantially similar transaction will be disregarded for purposes of determining whether the original transaction met requirement (3) above (relating to the reduction of the taxpayer’s risk of loss during the 60-day period following the closed transaction).<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC §§ 1259(c)(3), 246(c)(4).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.   IRC § 1259(c)(3)(B).<br /> <br /> </div>

<div class="Section1"><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&nbsp;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><div class="Section1"><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><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.1092(c)-2(c)(1).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.1092(c)-4(b).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp; See Treas. Reg. &sect;&nbsp;1.1092(c)-2(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 (<em><em>see</em> </em> 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>.&nbsp;&nbsp; IRC &sect;&nbsp;1092(b)(1); Temp. Treas. Reg. &sect;&nbsp;1.1092(b)-2T.<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></div><br /> <div class="Section1"><br /> <blockquote><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.</blockquote><br /> </div><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. § 1.1092-3T(b)(2).<br /> <br /> </div>

<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></div><br /> <div class="Section1"><br /> <blockquote><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).</blockquote><br /> </div><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. § 1.1092(b)-3T(b)(4).<br /> <br /> </div>

<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> <em><em>See</em> </em>Temporary Treasury Regulation Section 1.1092(b)-2T for the rules for determining the holding period with respect to such positions.</div><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. § 1.1092(b)-3T(b)(7).<br /> <br /> </div>

<div class="Section1">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.<div class="Section1"><br /> <br /> An &ldquo;applicable straddle&rdquo; means any straddle within the meaning of IRC Section&nbsp;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><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp; IRC &sect;&nbsp;1258(c).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp; IRC &sect;&nbsp;1258(d)(1).<br /> <br /> </div></div><br />