In Rev. Rul. 2002-66, 2002-42 IRB, the IRS held that, when a taxpayer enters into a collar transaction on an equity, all of the positions in the collar constitute a large straddle.  Previously there had been two private letter rulings that had taken inconsistent views on this issue.

Background

In a collar, the investor owns stock and buys a put and sells a call.  Typically, the strike price of the put is at or below the current price of the stock, and the strike price of the call is above the current price of the stock.  The put protects the investor from a decline in the price of the stock below the put’s strike price, but the investor forfeits any upside above the call’s strike price.  The investor has “collared” his economic interest in the stock to the interval between the strike prices of the options.  The investor also keeps the dividends, plus or minus the net proceeds or cost from entering into the collar.

In Ltr. Rul. 199925044, the IRS decided that, in a collar using over-the-counter options, the put and the stock constituted one straddle and the calls and the stock constituted a separate straddle.  TAM 200033044 dealt with a situation in which the taxpayer hedged a portfolio of stocks by purchasing puts and selling calls on S&P 500 stock index futures contracts.  In addition, the taxpayer also sold listed call options on some of the individual stocks in the portfolio.  While the Service found that a straddle did not exist under the facts it was presented with, they did state that, if the puts and calls had dealt with the same individual stock, then these calls would be part of a larger straddle.

Rev. Rul. 2002-66

Prior to the issuance of Rev. Rul. 2002-66, it was unclear whether entering into a collar constituted one or two straddles.  The issue is important because if there are two straddles then the straddle consisting of the stock and the call could be exempted from the application of the straddle rules if the call is a “qualified covered call”.  One of the requirements necessary for a call to be a qualified covered call is that it not be part of a larger straddle.  Now that Rev. Rul. 2002-66 has concluded that the stock, put and call are all one straddle, the call should not be treated as a qualified covered call.

Tax Planning Short-Circuited

The result of the Ruling is also to limit the tax planning potential for investors who enter into collars on less than their entire position on a stock.  Under the 1999 Ruling, it was possible to identify one lot of stock as constituting a straddle with respect to the put and another lot as constituting a straddle as to the call.  The call could have been a qualified covered call, and the stock and call would not constitute a straddle.  Thus, if the price of the stock rose, the loss on closing the call would have been deductible.  A portion of the stock could have been sold to fund the cost of closing the call, and the gain recognized on the sale of the stock would have been offset by the loss on the call.  Now that the qualified covered call exception is unavailable, the loss on the closing of the call will be deferred while the gain on the sale of the stock will be subject to tax.

Examples

Rev. Rul. 2002-66 describes three situations.

Situation 1.  On August 1, 2002, A buys 100 shares of X Corp stock for $100 per share, writes a 12-month call option on 100 shares of X stock with a strike price of $110, and buys a 12-month put option on 100 shares of X stock with a strike price of $100.  The following assumptions apply:

1. The call is a qualified covered call option under Section 1092(c)(4)(B).
    

2. When the call is written and the put is acquired, there is an inverse relationship  between the value of the stock and the value of each option, so that each option substantially reduces the risk of holding the stock.
    

3. Because of the magnitude of the inverse relationships, each option position substantially diminishes the risk arising from holding the equity.
    

4. The acquisition of the put substantially reduces the risk of loss from the combined stock and call.

Result: all of the positions in X stock are treated as part of a larger straddle, and none of the positions are excluded from straddle treatment.

Situation 2.  On September 3, 2002, B buys 100 shares of Y Corp stock for $102 per share.  On September 6, 2002, when the fair market value of Y stock is $100, B writes a 12-month call option for 100 shares of Y stock with a strike price of $110 and buys a 12-month put option on 100 shares of Y stock with a strike price of $100.  The assumptions are the same as in Situation 1.

Result.  All of the positions in Y stock are part of a larger straddle beginning on September 6, 2002.  Section 1092(c)(4) does not apply to any of the positions in Y stock beginning on that date.

Situation 3.  On October 1, 2002, C buys 100 shares of Z Corp stock for $102 per share.  On October 3, 2002, when the fair market value of Z stock is $100, C writes a 12-month call option on 100 shares of Z stock with a strike price of $110.  On December 2, 2002, when the fair market value of Z stock remains $100, C buys a 12-month put option on 100 shares of Z stock with a strike price of $100.  The assumptions are the same as in Situation 1.

Result.  Prior to December 2, 2002, the combination of the qualified covered call option and the underlying shares are not treated as a straddle for purposes of Section 1092 and 263(g).  However, beginning on December 2, 2002, all of the positions in Z stock are part of a larger straddle, and so Section 1092(c)(4) does not apply to any of the positions in Z stock beginning on that date.

This article and other articles herein are provided for information purposes only.  They are not intended to be an offer to engage in any securities transactions or to provide specific financial, legal or tax advice. Articles may have been rendered partly inaccurate by events that have occurred since publication.  Investors should consult their advisers before acting on any topics discussed herein. Options involve risk and are not suitable for all inveestors.  Before engaging in an options transaction, investors must review the booklet "Characteristics and Risks of Standardized Options".