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option is treated as listed or unlisted; and c the nature of the propertyunderlying the option e.g., stock, stock indices, foreign currencies,bonds.For federal income tax purposes, optio

miums The two general rules reflect the substantially different bases onwhich such nonperiodic payments are calculated and amortized.

Swaps A nonperiodic payment that relates to a swap must generally be

recognized over the term of the swap contract by allocating the payment

in accordance with the forward rates (or, in the case of a commodity, theforward prices) of a series of cash-settled forward contracts that reflectthe specified index and the notional principal amount The forwardrates used to determine the amount of the payment will be respected bythe IRS if they are reasonable [Treas Reg §1.446-3(f)(2)(ii)] NPC deal-ers must use this allocation method [Treas Reg §1.446-3(f)(2)(iii)].25

Other swap participants may elect alternative methods

For example, in the case of a prepaid swap where an upfront ment is made, a swap participant other than a dealer can elect to use the

pay-“level payment method” for purposes of determining the timing ofincome and deductions The upfront payment may be amortized byassuming that the payment represents the present value of a series ofequal payments made throughout the term of the swap contract Thediscount rate used in this present value calculation must be the rate orrates used by the counterparties in determining the amount of the non-periodic payment If that rate is not readily ascertainable, the discountrate used must be a rate that is reasonable under the circumstances.Each equal payment is separated into a principal-recovery and a time-value component The principal-recovery components are treated asperiodic payments made on the payment dates specified in the swap con-tract.26 The time-value component is used only to compute the amorti-zation of the nonperiodic payment and is otherwise disregarded [Treas.Reg §1.446-3(f)(2)(iii)(A)]

A nonperiodic payment that is not made at the start of a swap tract may be amortized over the term of the swap by treating the con-tract as if it provided for (a) a single upfront payment equal to thepresent value of the nonperiodic payment, and (b) a loan between thecounterparties (The discount rate used to determine the deemedupfront payment and the time-value component of the deemed loan isthe rate used by the counterparties to determine the amount of the non-periodic payment.) The single upfront payment is then amortizedaccording to the level payment method described above The time-valuecomponent is added to the amortized amount of each deemed upfrontpayment, and the total is recognized as a periodic payment for theperiod [Treas Reg §1.446-3(f)(2)(iii)(B)].27

con-Caps and Floors The NPC Regulations provide a general rule for the

amortization of premiums paid for caps and floors Under this general

rule, a payment made to purchase or sell a cap or floor must be recognizedover the term of the agreement by allocating it in accordance with theprices of a series of cash-settled option contracts that reflect the specifiedindex and the notional principal amount Any reasonable option pricingformula used by the counterparties to determine the total amount paid forthe cap or floor will be respected [Treas Reg §1.446-3(f)(2)(iv)].28 Onlythat portion of the purchase price that is allocable to the option contract

or contracts that expire during a particular period is recognized for thatperiod Accordingly, straight-line or accelerated amortization of a cap pre-mium is generally not permitted [Treas Reg §1.446-3(f)(2)(iv)]

The general rule must be used by a counterparty that is a dealer inNPCs and enters into a cap or floor in its capacity as a dealer Taxpayersthat enter into cap or floor contracts primarily to reduce risk withrespect to specific debt instruments or groups of debt instruments theyhold or have issued can elect an alternative method

For caps and floors that hedge debt instruments, the NPC tions provide several alternative amortization methods that may be usedfor purposes of determining the timing of income and deductions [Treas.Reg §1.446-3(f)(2)(v)].29 Thus, a premium paid upfront for a cap or afloor may be amortized using the level payment method described above(i.e., by treating the payment as representing the present value of aseries of level payments to be made at the end of each of the periods towhich the cap/floor applies) [Treas Reg §§1.446-3(f)(2)(v)(A) and(f)(2)(iii)(A)] A nonperiodic payment on a cap or floor other than anupfront payment (e.g., where the cap or floor premium is paid in install-ments) may be amortized by treating the contract as if it provided for anupfront payment equal to the present value of the nonperiodic paymentand a loan between the counterparties As a result, a cap or floor pre-mium paid in level annual installments over the term of the contract istaken into account in accordance with the level payment method [Treas.Reg §1.446-3(f)(2)(v)(B)].30

Regula-Under the NPC Regulations, a taxpayer may also treat a cap and afloor that comprise a collar as a single NPC and may amortize the netnonperiodic payment to enter into the cap and floor over the term of thecollar, in accordance with the other methods that apply to caps andfloors Thus, in the case of a zero-cost collar, the premium paid wouldoffset the premium received, and there would be no net nonperiodicpayment to amortize [Treas Reg §1.446-3(f)(2)(v)(C)]

Termination Payments

The NPC Regulations provide specific rules for dealing with tion payments,” which are defined as payments made or received to

“termina-extinguish or assign all or a part of the remaining rights and obligations

of any party under an NPC A termination payment includes (a) a ment made between the original parties to the NPC (an “extinguish-ment”), (b) a payment made between one party to the contract and athird party (an “assignment”), and (c) any gain or loss realized on theexchange of one NPC for another [Treas Reg §1.446-3(h)(1)] Further,any economic benefit that is given to or received by a taxpayer in lieu of

pay-a terminpay-ation ppay-ayment is pay-also trepay-ated pay-as such pay-a ppay-ayment [Trepay-as Reg

§1.446-3(h)(4)(ii)]

A payment is not a termination payment if it is made or received by

a party in exchange for assigning all or a portion of one leg of an NPC

at a time when a substantially proportionate amount of the other legremains unperformed or unassigned Such a payment, depending on theeconomic substance of the transaction to each party, is either (a) anamount loaned or borrowed, or (b) a nonperiodic payment This char-acterization applies regardless of whether the original NPC is termi-nated as a result of the assignment [Treas Reg §1.446-3(h)(4)(i)].When one party assigns its remaining rights and obligations to athird party, the original nonassigning counterparty realizes a gain orloss provided the assignment results in a “deemed exchange” of con-tracts and a realization event under Code section 1001 [Treas Reg

§1.446-3(h)(1)] While the NPC Regulations do not themselves addresswhat may constitute a “deemed exchange” for this purpose, other Trea-sury regulations provide that a deemed exchange does not occur if (a)the party assigning its rights and obligations under the NPC and theparty to whom the rights and obligations are assigned are both dealers

in NPCs, and (b) the terms of the NPC permit the substitution [Treas.Reg §1.1001-4(a)]

Subject to certain limited exceptions (e.g., installment sales andstraddles), a counterparty must recognize a termination payment in theyear in which the contract is extinguished, assigned, or exchanged[Treas Reg §1.446-3(h)(2)] In addition, when the termination is recog-nized, the party making or receiving such payment also recognizes anyother payments that have been made or received pursuant to the NPC,but that have not been recognized (e.g., unamortized nonperiodic pay-ments) If only part of a counterparty’s rights and obligations is extin-guished or assigned, this rule applies only to a proportionate part of suchunrecognized payment

The assignee of a position in an NPC recognizes any terminationpayment made or received under the rules relating to nonperiodic pay-ments The termination payment must therefore be amortized over theremaining term of the NPC or, if the facts so require, taken into account

under the provisions relating to significant nonperiodic payments[Treas Reg §1.446-3(h)(3)].

Contingent Final Payments

The NPC Regulations reserve discussion on the taxation of contingentpayments made upon the maturity of NPCs (i.e., payments that are notfixed in amount at the inception of the NPC) It is not currently clearwhether such contingent final payments constitute nonperiodic pay-

Regardless of the classification of such payments, both cash-basis andaccrual method taxpayers generally have taken the position that a con-tingent final payment under an NPC is not taxable to the recipient untilthe taxable year in which the amount of such payment is paid or isdeterminable with reasonable accuracy, as the case may be.32

In 2001, the IRS announced that it is in the process of evaluatingfour alternative methods of taxing contingent payments under NPCsand invited comments from the public on the appropriate method forthe inclusion into income or deduction of contingent payments and thetreatment of such inclusions or deductions Each of these alternativesinvolves to some degree an attempt by the IRS to match the timing ofthe taxation of a contingent final payment to the recipient with thedeductibility of the payment by the counterparty.33

Character of Payments Made Under an NPC

The NPC Regulations do not specifically address whether paymentsmade pursuant to an NPC produce ordinary income and deductions orcapital gains and losses It is clear that NPC payments do not generally

NPCs that are properly identified as hedges under the Treasury tions concerning hedging transactions [Treas Reg §1.1221-2(a)(1)] andpayments with respect to NPCs held by dealers for purposes other thaninvestment would clearly produce ordinary income

regula-While there is no published authority directly on point, both odic payments and nonperiodic payments should result in ordinaryincome or loss, rather than capital gain or loss.35 This is because (a) acapital gain or loss results from the “sale or exchange” of a capitalasset, and (b) payments made pursuant to the terms of an NPC generally

peri-do not constitute a “sale or exchange.”36

Taxpayers have asserted that periodic payments could be treated ascapital gains or losses on the theory that each periodic payment consti-tutes either a partial termination of the NPC or a complete termination

of separate bifurcated NPCs However, the IRS rejected this assertion in

Technical Advice Memorandum 9730007 concerning periodic paymentsunder a commodity swap In concluding that the periodic paymentsconstituted ordinary income or expense, the IRS rejected the taxpayer’sarguments that a swap was economically identical to a series of cash-settled forward contracts and that the periodic payments were made orreceived to close each separate forward contract The IRS concludedthat, while an NPC is economically similar to a series of cash-settledforward contracts, it is a single indivisible financial instrument.

Significantly, this Technical Advice Memorandum did not discussthe tax characterization of nonperiodic payments However, the analysis

in this memorandum indicates that the IRS would also treat nonperiodicpayments, or any payments made pursuant to the terms of an NPC, asordinary income or loss When an NPC constitutes a capital asset to ataxpayer, Code section 1234A provides that a capital gain or loss resultsfrom the cancellation, lapse, expiration, “or other termination” of aright or obligation with respect to such asset.37 Accordingly, terminationpayments with respect to such an NPC should constitute capital gains orlosses to the recipient under this statutory provision

However, there is little guidance as to whether a particular paymentshould be treated as a cancellation, lapse, expiration, or other termina-tion of a right or obligation For example, should Code section 1234Aapply to a contingent payment made at the maturity of an NPC (e.g., apayment made at the end of an equity swap that reflects price movement

in the underlying equity over the term of the swap)? While the IRS tookthe position in Technical Advice Memorandum 9730007 that Code sec-tion 1234A does not apply to payments made pursuant to the terms of

an NPC, the terms of NPCs providing for contingent final payments arefactually distinguishable from the NPC analyzed in that TechnicalAdvice Memorandum, and many tax practitioners take the positionunder the current rules that Code 1234A provides capital gains treat-ment for contingent final payments

OPTIONS

The federal income tax treatment of option transactions is governed by

a number of statutory provisions (e.g., Code sections 1234, 1234A, and1256) and related pronouncements by the IRS As discussed more fullybelow, the tax rules applicable to a particular option transaction dependlargely on (a) whether the transaction is a capital transaction withrespect to each party or is entered into by option dealers in the course oftheir trade or business as market makers or specialists; (b) whether the

option is treated as listed or unlisted; and (c) the nature of the propertyunderlying the option (e.g., stock, stock indices, foreign currencies,bonds).

For federal income tax purposes, options are characterized as

“listed options” or “unlisted options” and as “equity options” or equity options.” A “listed option” is any option other than a warrant toacquire stock from the issuer that is traded on, or subject to the rules of,

“non-a “qu“non-alified bo“non-ard or exch“non-ange.” For this purpose, “non-a “qu“non-alified bo“non-ard orexchange” is defined as: (a) a national securities exchange registeredwith the Securities and Exchange Commission (SEC), (b) a domesticboard of trade that has been designated as a contract market by theCommodity Futures Trading Commission (CFTC), or (c) anotherexchange, board of trade, or market designated by the Treasury Depart-ment All other options (i.e., options traded over the counter) aretreated as “unlisted options” [Code secs 1256(g)(5) and (g)(7)]

An option is an “equity option” (whether or not listed) if it entitlesthe holder to buy or sell stocks, or if its value depends directly or indi-rectly on any stock, group of stocks or stock index, provided that (a) theCFTC has not designated a contract market for trading an option based

on the group of stocks, or stock index, and (b) the Treasury Departmenthas not determined that the requirements for CFTC designation havebeen met [Code sec 1256(g)(6)] Thus, any option on a single stock,such as an option on General Motors stock trading on the ChicagoBoard of Trade, is an equity option A cash-settled option based on anarrow group of stocks will probably be an equity option because it willlikely not meet the requirements for a designation of a contract market

by the CFTC.38

Any listed equity option that is purchased or granted by an “optionsdealer” in the normal course of its activity in dealing in options and alsolisted on the board or exchange on which the dealer is registered consti-tutes a “dealer equity option” [Code sec 1256(g)(4)] An “optionsdealer” is defined as any person registered with an appropriate nationalsecurities exchange as a market maker or specialist in listed options, orany person who performs similar functions, as determined by the IRSpursuant to Treasury regulations [Code sec 1256(g)(8)] An equityoption entered into by a dealer for investment purposes, however, doesnot constitute a dealer equity option [Code sec 1256(g)(3)]

A nonequity option is any listed option that does not qualify as anequity option [Code Sec 1256(g)(3)] Thus, listed options on commodi-ties and foreign currencies and options on futures contracts are noneq-uity options Any option traded on a national securities exchange (orother market designated by the Treasury Department) whose value isdetermined directly or indirectly by reference to a group of stocks or a

stock index is also a nonequity option if (a) the CFTC has designated amarket for a contract based on the group of stocks or stock index, or (b)the Treasury Department has determined that the option otherwise meetsthe legal requirements for such a designation [Code sec 1256(g)(6)(B)].The IRS has ruled that options based on a stock index that aretraded on (or subject to the rules of) a qualified board of exchange meetthe requirements for contract designation and are nonequity options if(a) the options provide for cash settlement, and (b) the SEC has deter-mined that the underlying stock index is a “broad-based” index War-rants based on a stock index that are substantively identical in allmaterial economic respects to options based on a stock index are treated

as nonequity options [Revenue Ruling 94-63, 1994-2 C.B 188].

Listed nonequity options and dealer equity options qualify as tion 1256 contracts” and are subject to the special taxation rules pro-

options held by nondealers (e.g., traders or investors) are generally ject to the tax rules provided in Code section 1234.40

sub-The following discussion assumes that Code section 1234 applies tothe transaction and that the property underlying the option is a capitalasset in the hands of the holder It thus applies to put and call options(whether listed or unlisted) on individual stocks, since they constituteequity options [Code sec 1256(b)] that are capital assets in the hands of

an investor [Code sec 1234(a) and Treas Reg §1.234-1(a)] The tion of listed nonequity options and dealer equity options is discussed inthe section entitled “Section 1256 Contracts.”

taxa-Tax Treatment for Option Holders

The premium paid by a holder to purchase an option and any relatedtransactional costs (e.g., fees or commissions paid) represent the costs ofthe option and constitute nondeductible capital expenditures that are

added to the holder’s basis in the option [Revenue Ruling 78-182,

1978-1 C.B 265 and Revenue Ruling 58-234, 1978-1958-1978-1 C.B 279] These costs

are taken into account upon a subsequent sale, exchange, lapse, or othertermination of the option

Depending on the holder’s other investments, the purchase of a putmay trigger any of several provisions that can affect the holding period

or tax treatment of the put and the other investments For example, tain combinations of options and offsetting positions that have theeffect of reducing the holder’s risk of loss and opportunity for gain cantrigger the constructive sale rules under Code section 1259 (discussedabove in the section entitled “Short Sales”) In addition, because thepurchase of a put is treated in the same manner as a short sale [Code

cer-sec 1233(b)], the purchase may result in the creation of a tax dle,” which, as discussed below, can have adverse consequences for thetax treatment of the stock underlying the put option.41 Purchase of anoption can also trigger the “wash sales” rules if it occurs within the 30-day period surrounding the sale of “substantially identical” securities[Code section 1091(a)].42

“strad-Upon the sale, exchange, or other disposition of an option, theoption holder will recognize a gain or loss equal to the differencebetween the premium paid in the opening transaction and the net pro-ceeds received upon such disposition, after adjustment for commissionsand other expenses of sale The character of this gain or loss is deter-mined by the character of the underlying property [Code sec 1234(a)and Treas Reg §1.1234-1(a)] Capital gain or loss will result if theunderlying property is a capital asset in the hands of the holder Theinvestor’s holding period in the option on the date of its disposition willdetermine whether this capital gain or loss is long term or short term

[Treas Reg §1.1234-1(a) and Revenue Ruling 78-182, supra].

If the option holder allows the option to expire or lapse cised, the option is deemed to be sold or exchanged on the date of expi-ration or lapse [Code sec 1234(a)(2) and Treas Reg §1.1234-1(b)].The holder can then deduct its tax basis in the option (i.e., the premiumand any transaction costs paid to acquire the option) as a capital loss.The holder’s period in the option will determine whether this capital

unexer-loss is long term or short term [Revenue Ruling 78-182, supra].

When the option holder exercises a call option, the basis of thestock acquired is equal to the sum of the exercise price and the holder’s

tax basis in the option [Revenue Ruling 78-182, supra] The holding

period in the acquired stock begins on the day after exercise of the

option [Revenue Ruling 88-31, 1988-1 C.B 302 and Revenue Ruling

70-598, 1970-2 C.B 168] When the holder exercises a put option, theoption’s tax basis is deducted from the amount received from the optionwriter in determining the holder’s gain or loss from the transaction.Assuming the property sold pursuant to the exercise of the put is a capi-tal asset to the holder, the holder will recognize a capital gain or loss onthe sale The holding period in the property will determine whether thiscapital gain or loss is long term or short term

Option Writers

The option writer does not recognize any income upon receipt of a mium for writing an option, regardless of whether the option is listed or

pre-unlisted [Revenue Ruling 78-182, supra] or whether the premium is paid

at once or over a period of time [Koch v Commissioner, 67 T.C 71

(1976) acq., 1980-2 C.B.1] Instead, the option writer carries the

pre-mium in a deferred account until the option is exercised, sold, or lapses,

or until the writer’s obligations under the option are terminated in a

clos-ing transaction [Revenue Rulclos-ing 78-182, supra] Any commissions or fees

paid by the option writer in connection with writing the option are

deducted from the premium received [Revenue Ruling 58-234, supra].

An option writer who does not grant options in the ordinary course

of a trade or business recognizes a short-term capital gain when theoption lapses or expires without being exercised by the holder [Codesec 1234(b)(1)] The amount of the gain equals the net premiumreceived by the option writer in the opening transaction

When a listed or unlisted call option is exercised by the holder andthe option writer is required to sell the underlying stock, the net pre-mium received for writing the option is added to the amount realized onthe sale of the stock Any resulting gain or loss is treated as a long-term

or short-term capital gain or loss depending on the option writer’s ing period in the property, regardless of the time the call option wasoutstanding

hold-When the writer of a put option purchases stock pursuant to theholder’s exercise of the option, the net premium received for writing the

option decreases the writer’s tax basis in the purchased stock [Revenue Ruling 78-182, supra] Further, the holding period for the purchased

stock begins on the date after the purchase and not on the date the put

was written [Revenue Ruling 78-182, supra].

The writer of a listed or unlisted option that repurchases the optionfrom the holder will recognize a short-term capital gain or loss to theextent of the difference between the premium paid to repurchase theoption and the premium originally received [Code sec 1234(b)(1)]

Securities Futures Contracts

A “securities futures contract” (SFC) is a contract for future delivery of

a single security or a “narrow-based security index,” including anyrelated interest [Code sec 1234B(c) and Section 3(a)(55)(A) of the Secu-rities Exchange Act of 1934] The following summarizes the principalfederal tax consequences of the purchase and sale of SFCs by taxpayersother than “dealers” in SFCs.43

The timing of the recognition of gains and losses on SFCs is ally similar to that for single stock equity options under Code section

gener-1234 Merely entering into an SFC does not usually trigger a taxableevent Rather, a gain or loss will be recognized upon the sale, exchange,

or termination of the SFC The general rule governing the character ofany gain or loss is also comparable to that governing single stock

options Subject to certain specified exceptions, the gain or loss istreated as having the same character as the property to which the SFCrelates [Code sec 1234B(a)(1)] Accordingly, the gain or loss recognized

by a market neutral trader or investor would be treated as a capital gain

or loss However, ordinary income or loss results from the sale,exchange, or termination of SFCs that constitute inventory or “hedgingtransactions,” or from a contract that would otherwise give rise to ordi-nary income [Code sec 1234B(a)(2)]

A taxpayer that has entered into an SFC to buy a security closes outits position in the contract in one of three ways: (a) offsetting its posi-tion through entering into an identical SFC to sell the security; (b) set-tling the SFC in cash on the contract maturity date; or (c) taking delivery

of the underlying security The taxpayer in (a) or (b) will recognize acapital gain or loss, which will be long term or short term in natureaccording to the taxpayer’s holding period in the SFC A taxpayer thatcloses an SFC by taking delivery of the underlying security (situation (c)above) is treated as purchasing the security for the price specified in theSFC In this event, the taxpayer’s holding period in the stock is deemed

to include the taxpayer’s holding period in the SFC [H.R Conf Rep.No.106-1033 (Community Renewal Tax Relief Act of 2000)]

The general rules governing the timing, character, and holdingperiod for SFCs to purchase securities also apply to SFCs to sell securi-ties (a “short SFC”) Thus capital gain or loss will result on closing ashort SFC relating to a security that is a capital asset to the taxpayer.The capital gain or loss is considered to be short term when the tax-payer purchases the underlying security on the open market within oneyear prior to the delivery date A short SFC is generally treated as equiv-alent to a short sale of the underlying security; thus capital gain or lossfrom the sale or exchange of a short SFC is generally treated as shortterm, except to the extent provided by the tax rules applicable to “strad-dles” or under applicable Treasury regulations [Code sec 1234B(b)]

A short SFC also constitutes a “futures or forward” contract withinthe meaning of the constructive sale rules contained in Code section

1259 Accordingly, subject to the short-term hedging exception tained in Code section 1259(c)(3), a constructive sale will occur when ataxpayer enters into a short SFC and holds or acquires securities “sub-stantially identical” to the securities underlying the SFC

con-Holding an SFC and selling short the securities underlying the SFCwill result in the application of the special holding period rules relating

to short sales [Code sec 1233(e)(2)(D)] Similarly, when a taxpayerenters into a short SFC while holding “substantially identical” securi-ties, Code sections 1233(b) and (d) may apply to characterize certaincapital gains and losses as short term

SECTION 1256 CONTRACTS

Code section 1256 was enacted in 1981 as part of Congress’s attempts

to restrict abusive straddle transactions As discussed below, this tory provision conforms the taxation of “Section 1256 contracts” to themark-to-market daily cash settlement used for futures contracts ondomestic exchanges

statu-A “Section 1256 contract” is statutorily defined to include (a) lated futures contracts, (b) foreign currency contracts, (c) nonequityoptions, (d) dealer equity options, and (e) any SFC entered into by adealer [Code sec 1256(b)] Nonequity options and dealer equityoptions have been defined in the previous section relating to options

regu-A “regulated futures contract” (RFC) is a contract traded “on orsubject to”44 the rules of a qualified board of exchange (as defined ear-lier in the section on options), with respect to which the amount of pay-ments made and received depends on a system of marking to market thevalue of the contract at the close of each trading day [Code sec.1256(g)(1)] Because all domestic futures contracts are traded on adomestic board of trade designated as a contract market by the CFTCand employing a mark-to-market system, all domestic futures contractsqualify as RFCs The Treasury Department has determined that the fol-lowing foreign futures exchanges constitute a qualified board orexchange for purposes of Code section 1256: the International Futures

Exchange (Bermuda) Ltd [Revenue Ruling 85-72, 1985-1 C.B 286]; the Mercantile Division of the Montreal Exchange [Revenue Ruling 86-

7, 1986-1 C.B 295]; and the Singapore International MonetaryExchange Limited (provided its futures contracts are assumed by theChicago Mercantile Exchange under the Mutual Offset System created

between the two exchanges) [Revenue Ruling 87-43, 1987-1 C.B 252].

For purposes of Code section 1256, a foreign currency contract is acontract that (a) requires delivery of, or is settled with respect to, thevalue of a foreign currency in which positions are also traded throughRFCs (e.g., the Canadian dollar, British pound, Japanese yen); (b) istraded in the interbank market;45 and (c) is entered into at arm’s length

at a price determined by reference to the price in the interbank market[Code sec 1256(g)(2)(A)].46 The Treasury Department has the statutoryauthority to prescribe regulations necessary or appropriate to carryingout the purposes of the definition of a foreign currency contract and toexclude any contract or type of contract from Code section 1256 if it isinconsistent with such purposes [Code sec 1256(g)(2)(B)]

Under Code section 1256, each Section 1256 contract that a taxpayerholds at the end of the year is treated as if it were sold for its fair marketvalue on the last business day of the year and any resulting gain or loss

is taken into account for that year [Code sec 1256(a)(1)].47 If the tion 1256 contract is a capital asset of the taxpayer, 60% of the gain orloss resulting from the deemed year-end sale is treated as a long-termcapital gain or loss and 40% is treated as a short-term capital gain orloss, regardless of the actual time the taxpayer has held the Section 1256contract [Code sec 1256(a)(1)] When a Section 1256 contract that hasbeen marked to market is subsequently disposed of, the taxpayer adjustsany resulting gain or loss to reflect marked-to-market gains or lossespreviously recognized [Code sec 1256(a)(2)] If the Section 1256 con-tract is an ordinary asset of the taxpayer, the mark-to-market rule stillapplies, but any gain or loss is recognized as ordinary income or loss[Code secs 1256(a)(3) and (f)(2)]

Sec-Under a special statutory rule, any gain or loss derived from thetrading of Section 1256 contracts is treated as a capital gain or loss,provided the taxpayer does not hold the Section 1256 contract for thepurpose of hedging property that would produce an ordinary loss if dis-posed of by the taxpayer [Code secs 1256(f)(3)(A) and (B)] Whether ataxpayer is actively engaged in dealing in or trading Section 1256 con-tracts is not taken into account for purposes of determining whethergain or loss realized is a capital gain or loss or ordinary income or loss[Code sec 1256(f)(3)(C)]

In general, noncorporate taxpayers are not entitled to carry back netcapital losses to offset capital gains derived in earlier taxable years,although they are permitted to carry these losses forward indefinitely [Codesec 1212(b)] Under a special rule, however, noncorporate taxpayers canelect to carry back any net capital losses from Section 1256 contracts toeach of the three taxable years preceding the year in which the net capitalloss was realized [Code sec 1212(c)(1)(A)] To the extent allowed, thecarry back is treated as 60% long-term capital loss and 40% short-termcapital loss [Code sec 1212(c)(1)(B)] The carried-back loss is permitted tooffset only net capital gains that the taxpayer derived from Section 1256contracts in the earlier taxable years and may not increase or produce a netoperating loss [Code sec 1212(c)(3)] Under this special rule, any carried-back capital loss that is not fully utilized during the three-year carry-backperiod is carried forward to future taxable years under the general capitalloss carry-forward rules [Code sec 1212(c)(6)].48

The mark-to-market and 60/40 rules that apply to Section 1256 tracts held at the end of a taxable year also apply when the taxpayer’s

con-rights and obligations under a Section 1256 contract are terminated ortransferred by offsetting, by taking or making delivery, by exercise or beingexercised, by assignment or being assigned, or by lapse or otherwise [Codesec 1256(c)(1)] If such a termination or transfer occurs, the Section 1256contract is treated as if it were sold for its fair market value and the gain orloss is taken into account by the taxpayer in the year of termination [Codesec 1256(c)(3)].49 The wash sale rules that generally apply to losses fromthe sale of stocks or securities do not apply to any loss arising from a Sec-tion 1256 contract [Code sec 1256(f)].

STRADDLE RULES FOR STOCK

This section discusses the general applicability of the special tax rules

on “straddles” to market neutral investment strategies involving equityinvestments As indicated below, the application of the straddle ruleswhere stock is involved is complex and, because of ambiguous statutorylanguage, somewhat confusing

This discussion assumes that a market neutral investor does notenter into any hedging transactions with respect to one or more of thestocks that it owns (e.g., the investor does not purchase put or calloptions or acquire other positions on the particular stocks that it owns).However, as discussed below, the straddle rules may apply when a mar-ket neutral investor acquires an option on an index that substantiallyoverlaps with the stocks in its portfolio

A “straddle” is defined for federal income tax purposes as ting positions with respect to personal property” [Code sec 1092(c)(1)].Subject to certain special rules applicable to stock (which are discussedbelow), “personal property” generally means “any personal property of

“offset-a type which is “offset-actively tr“offset-aded” (here“offset-after ““offset-actively tr“offset-aded property”)[Code sec 1092(d)(1)] For purposes of the straddle rules, activelytraded property includes any personal property for which there is an

“established financial market” [Treas Reg §§1.1092(d)-1(a) and

futures, forward contract, or option) in personal property [Code sec.1092(d)(2)]

For purposes of the straddle rules, a taxpayer holds offsetting tions with respect to actively traded property if there is a “substantial dim-inution of the taxpayer’s risk of loss” from holding any position becausethe taxpayer holds one or more other positions [Code sec 1092(c)(2)(A)].Risk reduction resulting merely from diversification is usually not consid-ered to substantially diminish risk for purposes of the straddle rules as

posi-long as the positions are not balanced posi-long and short Therefore, a payer holding several types of securities, but not holding any short posi-tions, would generally not be considered to be holding offsetting positions[“1981 Bluebook” at 288] The Code gives six rebuttable presumptionsunder which positions in personal property are presumed to be offsetting[Code secs 1092(c)(2)(B) and (c)(3)] Four presumptions apply to posi-tions whose values ordinarily vary inversely with one another (i.e., thevalue of one position decreases while the other increases).51

tax-When a position offsets only a portion of another position inactively traded property, the two positions should be treated as offset-ting only to the extent of the portion that overlaps The TreasuryDepartment has the authority to issue regulations prescribing themethod for determining the portion of a position that is to be treated as

an offsetting position in these circumstances To date, no such Treasuryregulations have been issued.52

Special Rules for Stock

For purposes of the straddle rules, personal property does not generallyinclude stock, although it may include an “interest” in stock, includingactively traded contracts or options to buy or sell stock [Code sec.1092(d)(3)(A)] However, four statutory exceptions apply to stock andexchange-traded options acquired on or after January 1, 1984 Under

the first three exceptions, stock is personal property when it is part of a

straddle that includes (a) an option on the stock or on “substantiallyidentical” securities; (b) a position in “substantially similar or relatedproperty (other than stock)”; or (c) an SFC to sell “substantially identi-cal” stock [Code secs 1092(d)(3)(B)(i)(I) and (III)] Under the fourthexception, stock is personal property if it is the stock of a corporationformed or used to take positions in actively traded property that offsetpositions taken by any shareholder [Code sec 1092(d)(3)(B)(ii)] Forpurposes of these exceptions, stock is initially treated as personal prop-erty (i.e., one position of a straddle) in order to determine whether asecond offsetting position is present [Code sec 1092(d)(3)(C)(i)].Under the first exception, a straddle exists if a taxpayer ownsactively traded stock and a put option on that stock.53 The straddle rulesalso apply when a taxpayer writes a call option on actively traded stockthat it owns (i.e., a covered call option), unless the option constitutes a

excep-tion, the straddle rules apply to SFCs in the same manner that theyapply to equity options, except the QCCO exception is inapplicable.The second exception to the exclusion of stock as personal property

is the exception most likely to apply to market neutral investment

strat-egies The legislative history to the Code suggests that a straddle sisting of stock and “substantially similar or related property”(hereafter “substantially similar property”) includes (a) offsetting posi-tions consisting of stock and a convertible debenture of the same corpo-ration where the price movements of the two positions are related, and(b) a short position in a stock index RFC (or, alternatively, an option onsuch an RFC or an option on the stock index) and stock in an invest-ment company whose principal holdings mimic the performance of thestocks included in the stock index (or, alternatively, a portfolio of stockswhose performance mimics the performance of the stocks included in

futures or options entered into to hedge general market risks associatedwith a diversified stock portfolio are not “substantially similar prop-erty” of the type that would subject the stock to the straddle rules [H.R

Trea-sury Department, however, takes the position that only direct interests

in stock and short sales of stocks are excluded from the straddle rules[Prop Treas Reg §1.1092(d)-2(c)]

The Treasury Department has issued regulations defining tially similar property” for purposes of the straddle rules [Treas Reg

“substan-§1.1092-2(a)] Under these regulations, the first step is to determine ifthe index underlying the option or futures position reflects the value of

20 or more stocks of unrelated corporations If so, the position is

“sub-stantially similar” to the stocks held by the taxpayer only to the extent

the position and the taxpayer’s stockholdings “substantially overlap” as

of the most recent testing date [Treas Reg §1.246-5(c)(1)(ii)].56 A tion may be “substantially similar” to a taxpayer’s entire stockholdings

posi-or to only a pposi-ortion of those holdings [Treas Reg §1.246-5(c)(1)(ii)].Treasury regulations provide the following three-step procedure todetermine whether a taxpayer’s position and stock portfolio “substan-tially overlap” [Treas Reg §1.246-5(c)(1)(iii)]

Step One: Construct a subportfolio that consists of stock in an amount

equal to the lesser of the fair market value of each stock represented inthe position and the fair market value of the stock in the taxpayer’sportfolio

Step Two: If the fair market value of the subportfolio is equal to or

greater than 70% of the fair market value of the stocks represented inthe position, the position and the subportfolio “substantially overlap.”

Step Three: If the position does not “substantially overlap” with the

subportfolio, repeat Steps One and Two, reducing the size of the tion The largest percentage of the position that results in a “substan-