Discussion:Constructive Sale of Stock - Covered Call Options

My question is: If you own an appreciated stock and write an "in-the-money" covered call option against it, have you constructively sold that stock?

Are there exceptions? Such as selling a Qualifed Covered Call as defined in Section 1092(c)(4)

If the taxpayers writes a "qualified covered call option" then the holding period of the underlying stock is suspended. Does that mean if they issue a "non-qualified" option, such as a deep-in-the money option, then the holding period is not suspended? That does not make sense.

Or maybe this Section is stating that while a "qualified" option would avoid the contructive sale rules it would still suspend your holding period. This would make sense. But I cannot find anything that first tells me that writing a covered call could trigger a constructive sale.

This would be extremely useful for all of those ISO clients who want to take the market risk out of the 12-month holding period requirement. Sounds too good to be true.

However, if I sell an out of the money call and purchase an out of the money put at the same time, I believe it is possible to argue that the risk of loss and opportunity for gain are both eliminated (costless collar). However, the SFC report talks about drafting a regulatory safe-harbor that would exclude certain costless collars from the application of the 1259 constructive sale rules if the difference in strike prices is minimal.

If writing an in-the-money or even a deep-in-the-money covered call against an appreciated stock position does not trigger a constructive sale or suspend the holding period, then this should be a viable strategy as part of exercising ISOs.

Try this..

Side note: I wonder if the brokerage firms will get this right when they have to start providing cost basis & holding period information next year. Can't imagine they will.

In fact that link includes no IRC cites. I can't find anything in the tax code that says the holding period is reset to zero. Section 1092 only deals with the deferral of losses as it applies to straddles. And this is not a loss deferral issue.

I don't believe that the above-statement is true.

All I can find in the code is Sec 1092(f) stating that the holding period is suspended when a taxpayer sells a QUALIFIED covered call option against their position.

Another cite that deals with holding periods being reduced is IRC §246(c)(4). However, IRC §246 is applicable to holding periods for purposes of deteriming the corporate dividend deduction or if a dividend qualifies for long-term capital gain tax rates.

IRC §1222(3) defines a long-term capital gain is from the sale or exchange of a capital asset held for more than 1 year. There is no reference to IRC §246 or IRC §1092.

I searched PLRs for anything including the words "covered call" & "holding period". All I come up with is issues relating to IRC §851 & IRC §246. I did get a TAM that references IRC §1092 (TAM 200033004), but this issue does not address my question. It is only dealing with straddles.

The Motley fools agree that the statement about the holding period discussed above is wrong, I think.

The option in this Rev Rul does not meet the constructive sale rules of Sec 1259 because the option does not meet the definiton of a forward contract as defined IRC Sec 1259(d)(1). (The option in the ruling had a variable delivery amount.) A call option also does not meet the definition of a forward contract because both sides are not bound to the transaction.

Let's take a big step back here. Are you honestly saying that you think that a sale of an option is never treated as a sale of the underlying? If that were the law, it wouldn't take much financial engineering to eliminate all income taxes, at least on financial transactions, and just a bit to get at a lot more. Just for example:

1. A tax-exempt entity, or a foreigner (with the benefit of an appropriate treaty if necessary), taxpayer with losses, securities dealer, etc., buys $1 million face amount of Treasury STRIPS maturing in 30 years and sells me, for very nearly the amount that it paid, an option to buy the STRIPS in 29 years and 364 days for 1 cent. I'm (virtually) certain to receive a net amount of $999,999.99 in 30 years, yet I pay no tax until then and get a capital gain at that time; the tax-exempt has a bunch of OID that it doesn't care about. Right?

2. A corporation identifies a business which is likely to produce big losses for the next 5 years, and then be worth about $1 billion. The corporation wants the benefit of the tax losses without real economic exposure to that business. So, it sets up a wholly-owned subsidiary which acquires the business, and then sells someone else, or the public at large, options to buy all of the subsidiary's stock in 5 years for an aggregate strike price of $100. The corporation has legal title to more than 80% by vote and by value of the subsidiary's stock, so it's allowed to file a consolidated return with the subsidiary. Right? (In both of these cases, the option is sold promptly after the underlying is acquired, so it won't be an "appreciated financial position" for sec. 1259's purposes, even if that applies to options.)

3. I set up a partnership with a tax-indifferent investor, owned 99% by it and 1% by me. I sign an employment contract to work for the partnership at minimum wage, and the partnership contracts out my services to my former employer at my former salary. The partnership terms provide for accumulation of all income for several years. I buy from my partner an option to buy it out for a nominal amount. Hence, I have shifted the tax on nearly 99% of my salary to the investor, though it knows it will never actually get its hands on any of that money. Right?

Rev. Rul. 82-150 involved taxpayer A getting an option to buy a newly-formed foreign holding company, FX, at a strike price of 30% of its current value. The statutory attribution for options didn't help because A didn't (in form) own outright any shares. Nevertheless, the Service held that A is treated as having purchased the stock, and therefore the company was an FPHC: "It has long been a principle of federal tax law that the substance of a transaction and not its form will determine the federal income tax consequences of the transaction. Commissioner v. Court Holding Company, 324 U.S. 331, 89 L. Ed. 981, 65 S. Ct. 707, 1945 C.B. 58 (1945), 1945 C.B. 58; Rev. Rul. 61-18, 1961-1 C.B. 5, 6-7. In form, A acquired an option to purchase for 30,000x dollars an asset worth 100,000x dollars. Stock, which represents the ownership or equity of a corporation, is a risk investment and to purchase stock means to assume the risks of an investor in equity. See John Kelley Co. v. Commissioner, 326 U.S. 521, 530, 90 L. Ed. 278, 66 S. Ct. 299, 1946-1 C.B. 191 (1946), 1946-1 C.B. 190, 195; Zilkha and Sons, Inc. v. Commissioner, 52 T.C. 607, 613 (1969), acq., 1970-1 C.B. xvi. By obtaining the right to purchase for 30,000x dollars stock worth 100,000x dollars, A has assumed the risks of an investor in equity. In substance, 100 percent of the funds used to capitalize FX and, hence, 100 percent of the funds at risk have been or will be furnished by A. Depending upon the success or failure of FX, it is A's investment, not that of B, that will appreciate or depreciate. A has assumed the benefits and burdens of the ownership of FX stock and, therefore, the sale of FX stock to A has been completed. See Tennessee Natural Gas Lines, Inc. and Subsidiary v. Commissioner, 71 T.C. 74, 83 (1978), acq., 1979-2 C.B. 2."

Rev. Rul. 85-87 involved a taxpayer trying to dodge the wash sale rule by selling in-the-money puts rather than buying back the stock or calls on it; the ruling doesn't give numbers, but says: "When the put was sold by A, the market price of the stock was substantially less than the exercise price of the put. In light of the spread at the time the put was sold between the value of the underlying stock and the exercise price of the put, the term of the put, the premium paid, the historic volatility in the value of the stock, and other objective factors, there was, at that time, no substantial likelihood that the put would not be exercised." (Under sec. 1091(a), buying ANY call creates a wash sale, but there's no corresponding rule for puts.) The entirety of the analysis of the issue is: "The substance, rather than the form, of a transaction in which a taxpayer is involved governs the tax consequences of the transaction. In the instant case, at the time the put was sold there was no substantial likelihood that the put would not be exercised. Thus, for purposes of section 1091 (a), the put sold by A is in substance a contract to acquire stock."

Finally, the Progressive case dealt with a real company, with real lawyers arguing its case. Part of the holding (not relevant to this point) was about the holding period for DRD purposes with a protective put. The other part was about ownership, for dividends received deduction purposes, in the call-sale scenario: Progressive had a regular "dividend capture" trading strategy, in which it would buy stock shortly before an ex-dividend date, and (incompletely) hedge its economic exposure by selling in-the-money calls. The IRS had disallowed the DRD. The district court gave Progressive summary judgment and the government appealed. The 6th Circuit reversed and remanded "for a determination of whether the call options sold by Progressive were so deep-in-the-money as to be the equivalents of the contractual obligations to sell mentioned in section 246(c)(3)." The government had cited Rev. Rul. 80-238, which held that in-the-money calls can be treated that way.

Good enough?

However, the Committee Reports do suggest that the IRS had some more homework to do on this issue::

H Rept No. 105-148 (PL 105-34) p. 442 . Congress anticipates that IRS will use its authority to issue regs to treat as constructive sales other financial transactions that, like those specified in the constructive sale rules, have the effect of eliminating substantially all of the taxpayer's risk of loss and opportunity for income or gain with respect to the appreciated financial position. Because this standard requires reduction of both risk of loss and opportunity for gain, Congress intends that transactions that reduce only risk of loss or only opportunity for gain will not be covered. Thus, for example, Congress does not intend that a taxpayer who holds an appreciated financial position in stock will be treated as having made a constructive sale when the taxpayer enters into a put option with an exercise price equal to the current market price (an “at the money” option). Because that type of option reduces only the taxpayer's risk of loss, and not its opportunity for gain, the test may not be met.

S Rept No. 105-33 (PL 105-34) p. 126 . For purposes of the constructive sale rules, Congress does not intend that risk of loss and opportunity for gain be considered separately. Thus, if a transaction has the effect of eliminating a portion of the taxpayer's risk of loss and a portion of the taxpayer's opportunity for gain with respect to an appreciated financial position which, taken together, are substantially all of the taxpayer's risk of loss and opportunity for gain, Congress intends that IRS regs will treat this transaction as a constructive sale of the position.