Update: Under the American Jobs Creation Act of 2004, writing in-the-money calls suspends the holding period required to capture dividends or the DRD.  See Tougher Rules For Hedging Dividends.

On April 26, 2002, the Treasury issued final regulations regarding qualified covered calls, or “QCCs”. In general, these regulations restrict the ability of listed options and FLEX options to achieve qualified covered call status.  However, they allow over-the-counter options to constitute QCCs under certain circumstances.

A covered call involves the sale of a call on a stock the investor owns; the stock holding “covers” the call sale. Often a stock holding and a sale of a call on the same stock will stop the stock’s holding period or create a straddle and thereby produce negative tax consequences under various sections of the Internal Revenue Code (including 246, 852, 857, 901, 1092 and 1259). However, if a call is a qualified covered call, then these negative consequences may be avoided.

The new regulations generally make it more difficult for listed options to achieve QCC status. They prohibit QCC treatment for any call with a maturity of greater than 33 months. In addition, they often require higher strike prices for calls to qualify.

Before these regulations, the minimum strike price required for QCC status was usually one strike below the stock’s previous day’s closing price. In addition, the strike price had to be at least 85% of the closing price.  For example, if ABC stock closed at $20.00, an ABC FLEX call with a strike of $17.00 or more would have qualified. Under the regulations, the minimum strike price is either 85% of the stock’s close or the lowest qualified standard strike price available for calls on that stock — whichever gives less protection. So if ABC had closed at $20.00 and standard ABC calls are only available with strike prices of $15.00 and $20.00, then only the call with the $20.00 strike would qualify.

The regulations also impose additional strike price rules on calls with terms over twelve months. They maintain the old rule requiring a minimum strike price relative to the stock’s close, but they also mandate that before applying this rule, the investor must first increase the stock’s closing price by a non-compounded two percent per quarter. So if a stock closed at $40.00 and a call had a twenty-five month term, the investor would first multiply $40.00 by 1.16, reaching a product of $46.40. With this “applicable stock price”, the minimum strike price required for the call would be $45.00 (rather than $40.00, the pre-regulations minimum strike).

The new regulations limit the ability of FLEX options to achieve QCC status.  Prior to the regulations, it appeared that these options met the requirements for QCC status, and the new regulations do confirm that FLEX options can achieve this status. However, they require not only that listed standard options on the underlying stock be outstanding but also that the FLEX have a single fixed premium with a single fixed strike price which must be at least as high as that required for a standard option.

The regulations may allow over-the-counter options to be treated as QCCs if they meet the same requirements as FLEX options. Prior to these regulations, OTC options could never constitute QCCs.  Unfortunately, the regulations limit OTCs’ eligibility to situations where listed calls would also be available.

The regulations’ overall effect is to limit investors’ choices. They prohibit QCC status for options extending beyond 33 months, and for options with terms over one year, they raise the minimum strike prices necessary to qualify. They allow OTC options to be treated as QCCs but require terms no different than those available through flex options.

The regulations apply to options entered into on or after July 29, 2002.

This article and other articles 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 investors.  Before engaging in an options transaction, investors must review the booklet "Characteristics and Risks of Standardized Options".