Twenty-First Securities Corporation
Originally published in Derivatives Report, copyright 2002,
RIA, 395 Hudson Street, New York, New York. 1-800-431-9025.
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
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.
2002-66 describes three situations.
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
The call is a qualified covered call option under
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.
Because of the magnitude of the inverse
relationships, each option position substantially diminishes the
risk arising from holding the equity.
The acquisition of the put substantially reduces
the risk of loss from the combined stock and call.
all of the positions in X stock are treated as part of a larger
straddle, and none of the positions are excluded from straddle
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.
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.
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.
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.
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Options involve risk
and are not suitable for all
inveestors. Before engaging in an
options transaction, investors must review the booklet
and Risks of Standardized Options".