IRS Regs Neutralize
J. Boczar and Robert Gordon
Originally published in Trust and Investments, American
Bankers Association: Washington, D.C., September/October 2001.
Investors subject to straddle
rules stand to lose if proposed regulations are enacted.
Note: This is
the second of two articles assessing the relative merits of stock
concentration risk management techniques that are implemented
through financial derivatives, including options, swaps and
Moves for Concentrated Stock Positions” in the July/August issue
of Trust and Investments focused on investors
who are not subject to the “straddle rules” because their
stock was acquired before 1984.
This article focuses on investors who are subject to
the straddle rules, having acquired stock after 1983.
the current state of the tax law, in most instances a collar will
prove to be the superior hedging strategy.
Specifically, the “income-producing collar” (one that
generates a net credit to the investor) has emerged as the
superior strategy because its economics and cash flows somewhat
resemble a synthetic short sale, yet it can be structured in a
manner that should not violate the constructive sale rules.
collar strategy can be implemented through various financial
derivatives (options, swaps and forwards). The challenge for the wealth manager is to implement the
collar strategy by using the derivative “tool” that minimizes
the after-tax cost to each particular investor.
The Straddle Rules
Revenue Code Section 1092 addresses “straddles”.
If stock was acquired after 1983, the straddle rules apply.
A straddle exists when holding one position substantially
reduces the risk of holding another.
Because a collar substantially reduces the risk of owning
the underlying stock, the stock and collar together should in most
instances be treated as a straddle for federal tax purposes.
can encounter two negative ramifications from the stock and collar
being deemed a straddle. First,
any loss realized from closing one leg of a straddle must be
deferred to the extent that there is any unrealized gain on the
open leg. Thus, as a
collar expires, is terminated, or is rolled forward, any losses
must be deferred. Gains are currently taxed.
interest expense incurred to “carry a straddle” must be
capitalized (as opposed to being currently deductible).
There has been (and continues to be) spirited debate about
the methodology to be applied in determining the amount, if any,
of the interest expense that must be capitalized under Code
The objective for the investor
who owns stock that was acquired after 1983 is to mitigate the
negative impact of the straddle rules as much as possible.
of the Single-Contract Collar.
Investors can address the first problem of getting
"whipsawed" using an over-the-counter (OTC) derivative
contract that encompasses both the put and the call. For example,
suppose that XYZ is selling at $100 per share. The investor
constructs a three-year zero-cost collar on the stock (with either
listed or OTC options), buying puts struck at $90 for $14, and
selling calls struck at $160 for $14. If the collar expires with
the stock price between $90 and $160, the investor faces a tax of
$5.47 (39.1% of $14 short-term capital gain) on each expired call.
However, the investor cannot currently deduct the
"wasted" $14 cost of the puts (deferred long-term
capital loss). The investor created economic protection and some
potential for profit, but the after-tax cost is more than $5 per
share (with no actual profits realized).
that instead of buying separate puts and calls, the investor
hedges XYZ by employing a one-contract collar. With this approach,
the investor could create the same economic structure -
effectively buying puts at $90 and selling calls at $160. But when
a zero-cost collar is documented using a single contract, the
price of the collar for tax purposes should be zero even if the
straddle rules apply. Thus, if the collar expires with the stock
price anywhere between $90 and $160, the expiration should not
create any taxable income or loss. The investor has created the
same level of economic protection and potential for profit without
incurring any additional tax burden.
it is not currently possible to implement a single-contract collar
with listed options because the documentation that is currently
used by the options exchanges treats the put and call as separate
contracts. Some practitioners are encouraging the exchanges to
develop this type of collar. It is possible, however, to implement
a single-contract collar with OTC options.
respect to a swap with an embedded collar or a variable forward,
the amount received for the embedded call and the amount paid for
the embedded put will also net against each other.
equity swap with an embedded collar is tax-disadvantaged because
any payments received by the investor up-front or during its term
will be taxed currently as ordinary income, whereas a
single-contract options-based collar or a variable forward would
allow such a payment to be part of an open transaction with the
matter where the stock price is on the expiration date, OTC
options documented as a single contract and variable forwards
should receive essentially the same tax treatment when settling
the collar. Listed options are tax-disadvantaged because of the
current inability to net the option premiums.
Analysis - Deductibility of Interest Expense
addition to hedging, most investors with appreciated stock wish to
generate liquidity in order to reinvest and diversify their
investments. Often investors choose to monetize, or borrow
against, their appreciated stock. Borrowing creates interest
expense. If the borrowing cost occurs in conjunction with a
straddle, there is the possibility that the interest expense might
need to be capitalized.
January 17, 2001, the Internal Revenue Service proposed
regulations making clear that if shares that are hedged by a
collar are pledged as collateral for a borrowing, the interest
must be capitalized.1 However, the regulations do give
an investor the right to specify which shares form a straddle and
which are being leveraged. A careful identification of collateral
will preclude the IRS from allocating (and therefore capitalizing)
any of the borrowed proceeds against the shares that have been
of this "specific identification" rule, if an investor
has liquid securities (other than the collared shares) to post as
collateral, it is still possible to deduct some or all of the
interest expense. For example, suppose an investor with $100 of
XYZ wants to hedge the stock with either an options-based collar
or a variable forward that is not prepaid2 and
then monetize the maximum amount possible under the margin rules
(Regulation T) in order to diversify. The investor could borrow
$50 against the hedged XYZ position. Assuming that the investor
diversifies into publicly traded securities, the investor then
could finance the purchase of $100 of reinvestment securities
through an additional $50 margin loan against the reinvestment
portfolio. Under the regulations, the interest expense incurred by
borrowing against the hedged XYZ position must be capitalized,
while the interest expense incurred by borrowing against the
reinvestment portfolio would be deductible.
the facts slightly, suppose an investor with $200 of XYZ wants to
hedge $100 of XYZ with either an options-based collar or a swap
with an embedded collar and then monetize $100 in order to
diversify. The investor could borrow $50 against the unhedged
XYZ position. Assuming that the investor diversifies into publicly
traded securities, the investor could then finance the purchase of
$100 of reinvestment securities through an additional $50 margin
loan against the reinvestment portfolio.
the regulations, currently both the interest expense incurred by
borrowing against the unhedged XYZ position and the interest
expense incurred by borrowing against the reinvestment portfolio
would be deductible because there was no borrowing against the
under the regulations investors can readily monetize both
options-based collars and swaps with embedded collars through
margin loans and in most instances still achieve a current
deduction for some or all of the interest expense incurred with
respect to the monetization. In certain instances, however, it
might be necessary to use a prepaid variable forward to achieve
the monetization level that is desired because of margin rule
(Regulation T) limitations.
example, assume that an investor with $100 of XYZ wants to hedge
the stock with a collar and then monetize the maximum amount
possible in order to diversify into a portfolio of investments
that are not publicly traded (e.g., alternative
investments, such as hedge funds, private equity, and venture
an investor hedges the XYZ with either an options-based collar or
a variable forward that is not prepaid combined with a margin
loan, a maximum of $50 could be borrowed against the hedged XYZ
under Reg. T. It will not be possible to borrow against the
reinvestment portfolio in this instance because it consists of
investments that cannot be given collateral value by a brokerage
firm because they are not publicly traded securities. In this
instance only $50 could be monetized, and under the proposed
regulations all of the interest expense would need to be
capitalized because the borrowing was incurred against a collared
the investor instead used a prepaid variable forward, the
investor most likely would be able to monetize between 80% and 90%
of the value of the position because the Reg. T limitations do not
apply to prepaid variable forwards. Although the nature of a
prepaid variable forward effectively defers and converts interest
expense into a deferred capital loss, in this instance there is no
tax disadvantage because if margin loans were used to monetize the
position, the interest expense would have to be capitalized
because the borrowing is against the collared stock.
under the proposed regulations have the right to specify the
collateral pledged to secure margin indebtedness. If the interest
expense is incurred by borrowing against securities that are
unhedged, the investor currently can deduct such expense;
otherwise, it must be capitalized.
the monetization structure that should deliver optimal after-tax
results should be either an option-based collar or variable
forward that is not prepaid combined with a margin loan. A prepaid
variable forward is tax-disadvantaged because its structure
ensures that all net borrowing costs are deferred and capitalized.
Tool For Post-1983 Stock
Under The Regulations
that the proposed regulations (with respect to straddles rules and
the capitalization of interest) become effective, it appears that in
most instances a single-contract collar combined with a margin
loan should deliver the minimum after-tax cost.
Listed options are clearly disadvantaged because of the
inability to net the option premiums, which can easily be
accomplished with OTC derivatives.
variable forwards are clearly tax disadvantaged because of their
structure, which gives an investor no choice but to defer and
capitalize the net cost of carry. However, prepaid variable
forwards do have several nontax advantages. First, the cost of the
borrow is fixed throughout its term, in contrast to a floating
rate borrow typical of a margin loan. Second, because Reg. T is
not applicable, a margin call would not be possible in the future
(a margin call is possible only if margin loans are used). Third,
because Reg. T is not applicable, the investor is not limited to
borrowing a maximum of 50% of the value of the hedged position if
the purpose of such borrowing is to reinvest in other securities,
as it would be if a margin loan were used. Fourth, because there
are no "moving parts" (that is, no interest payments
because the interest has been prepaid, no interest rate resets
because it is fixed rate debt, no mark to markets, etc.) until the
expiration date, there are no monthly statements and other
periodic communications from the brokerage firm (as there are with
options and swaps) to confuse and frustrate a private client.
it should be noted that recently released Field Service
Advisory 200111011 casts new doubts on the variable forward
structure because a taxpayer was deemed to have sold his shares by
executing a particular type of prepaid variable forward. Although
in the end this advisory may have minor importance, investors
should be aware of its existence.
Recent Developments -
May 9, 2001, Rep. Richard E. Neal, D-Mass., introduced a bill
that, if enacted in its current form, would eliminate the use of
exchange funds as they are currently structured as a viable
strategy to diversify highly appreciated securities. Until the
Neal bill becomes law, exchange funds can prove useful in two
a derivative-based solution is not available due to the
a particular stock3 (e.g., the stock is difficult to
borrow or is subject to liquidity constraints) an exchange fund
might be thought of as the diversification tool of last resort.
Also, if an investor's objective is to diversify out of all or a
portion of a highly appreciated stock position and into a
passively managed portfolio that tracks a certain index (e.g., the
Standard and Poor's 500) certain exchange funds should prove
particularly useful. Certain exchange funds have historically
exhibited a very high degree of correlation with the index they
were designed to track and their "all in" cost compares
favorably to what it would otherwise cost to monetize through a
derivative-based solution and re-deploy the proceeds into an index
of the constructive sale rules, derivative-based solutions
generally have a maximum length of five years at which time they
must be rolled over in order to maintain the benefit of the tax
deferral. Exchange funds are often structured with an unlimited
that exchange funds have once again come under attack, this time
via the Neal proposal, investors considering an investment in an
exchange fund might wish to act sooner rather than later to take
advantage of the current opportunities.
regulations recently proposed by the IRS are mostly negative with
respect to investors interested in hedging and monetizing
appreciated securities. The regulations have to some degree
"leveled the playing field" because of the various
derivative tools that are available to hedge and monetize stock
acquired after 1983. Listed options no longer enjoy the huge
potential advantage they once did, and the fact that interest
expense incurred by a borrowing that is collateralized by a hedged
stock position must be capitalized has narrowed the possible
advantage that a single-contract collar combined with a margin
loan has over a prepaid variable forward. In addition, the Neal
proposal, if enacted in its current form, would eliminate exchange
funds as they are currently structured as a viable strategy to
diversify highly appreciated securities.
Proposed Regulation Section 1.263(g)-3(c)(2).
A variable forward can be either prepaid or not. If it is prepaid,
the investor has economically collared the position and receives
an up-front payment from the dealer that is not currently taxed.
If it is not prepaid, the investor has economically collared the
position but does not receive an up-front payment from
dealer. In the latter situation, the investor could effectively
monetize the stock hedged through the variable forward through
If an investor hedges a long stock position through a collar, the
dealer will be synthetically long in the underling stock. To hedge
this exposure, the dealer will typically establish a short
position in that stock. In order to establish a short position,
the dealer must be able to borrow shares from someone who
currently owns them in order to be able to deliver shares to the
buyer on settlement date of the short sale. Also, the stock must
be sufficiently liquid to enable the dealer to increase or
decrease its short position without significantly impacting the
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other articles herein
information purposes only. They are not intended to be
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provide specific financial, legal or tax advice. Articles may
have been rendered partly inaccurate by events that have
occurred since publication. Investors should consult
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Options involve risk
and are not suitable for all
investors. Before engaging in an
options transaction, investors must review the booklet "Characteristics
and Risks of Standardized Options".