Constructive sales treatment for appreciated financial positions.

Generally, a taxpayer does not recognize gain on a transaction until the transaction is closed. If a taxpayer owns a security (a long position), he is able to lock in the economic gain by "selling short against the box" (selling a borrowed security), or vice versa. Economically, the taxpayer is not affected by the valuation of the security; the values of his long and short positions move in exactly opposite directions.

Similar strategies have been executed with offsetting notional principal contracts, futures contracts, forward contracts and equity swaps on the same or similar securities. The IRS has repeatedly tried to tax the gain position, by treating it as a closed transaction when the risk of loss was eliminated. Regardless of the fact that the economic gain was already determined, the Service has lost its battles in the courts, and taxpayers were able to defer gain.

If a taxpayer died with these short-sale-against-the-box positions (i.e., the taxpayer owned securities that were the same as, or substantially identical to, the securities borrowed and sold short), the gain would escape taxation. Both the long position and the short position would be stepped up to fair market value (FMV) at death and the boxed gains would disappear.

These tax deferral schemes were virtually eliminated by the constructive sales provisions of the Taxpayer Relief Act of 1997. Currently, a constructive sale of an appreciated financial position will trigger gain as if such position were sold, assigned or otherwise terminated at its FMV as of the constructive sale date. The appreciated position would be treated as repurchased for its FMV on the constructive sale date.

The term "appreciated financial position" means any position for any stock, debt instrument or partnership interest if there would be gain were such position sold, assigned or otherwise terminated at its FMV. Exceptions are made for any position marked to market and also for any debt instrument, if three conditions are satisfied:

1. The debt unconditionally entitles the holder to receive a specified principal amount;

2. Interest payments are payable based on a fixed rate or, to the extent provided in regulations, on a variable rate; and

3. The debt is not convertible into stock of the issuer or any related person.

A taxpayer is treated as having made a constructive sale of an appreciated financial position if he (or a related person):

1. Enters into a short sale of the same or substantially identical property;

2. Enters into an offsetting notional principal contract with respect to the same or substantially identical property;

3. Enters into a futures or forward contract to deliver the same or substantially identical property;

4. Enters into a short sale, an offsetting notional principal contract or forward or futures contract and subsequently acquires a long position in the same property; or

5. To the extent prescribed in regulations, enters into other transactions with substantially the same effect as the above transactions.

For purposes of the constructive sale rules, any potential constructive sale transaction during the tax year will be disregarded if:

1. The transaction is closed before the end of the 30th day after the close of the tax year;

2. The taxpayer holds the appreciated financial position throughout the 60-day period beginning on the date the transaction is closed; and

3. At no time during the 60-day period is the taxpayer's risk of loss with respect to the position reduced.

If a taxpayer holds multiple positions in property, the determination of whether a specific transaction is a constructive sale and, if so, which appreciated financial position is considered sold, is made in the same manner as an actual sale. If a taxpayer does not specifically identify the positions in a transaction, FIFO will be used.

Currently, a "collar" is being used to avoid the constructive sale rules. In a collar, a taxpayer commits to options requiring him to sell a financial position at a higher fixed price (the call strike price) and permitting him to sell his position at a lower fixed price (the put strike price). For example, a shareholder may enter into a collar for a stock currently trading at $100 with a put strike price of $95 and a call strike price of $110. The effect of the transaction is that the seller has transferred the rights to all gain for the $110 call strike price and all loss below the $95 put strike price; the seller has retained all risk of loss and opportunity for gain in the price range between $95 and $110. A collar can be a single contract or a combination of puts and calls.

Wall Street usually uses 10% risk as a guideline to avoid the constructive sale rules. As long as both the upside and the downside potential are at least 10%, it presumes that the constructive sale rules will not be triggered. The 10% figure for risk came from an example describing a collar in the legislative history of the constructive sale rules. The legislative history did not indicate whether a 10% risk was acceptable or unacceptable. Until regulations are issued, caution should be exercised with these transactions. Congress anticipated that regulations, when issued, would provide specific standards for determining whether several common transactions will be treated as constructive sales.

Because the collar transaction is becoming common, there is one frequently overlooked problem. First, options expire. If the stock goes up in value, the put expires and there is a loss. There also may be money owed on the call, if the stock's FMV is more than the call strike price. Based on Sec. 1092 straddle rules, all or some of the losses incurred may not be used if there is unrealized gain. There also may be a need to give up part of the stock to make good on the call. Disposing of part of the stock means having to recognize gain. Taking the gain that may have to be recognized, the straddle rules and the unanswered questions in the constructive sale area into account can render using a collar much less effective.

A so-called "in-the-money" option (i.e., a put option in which the strike price is significantly above the current market price or a call option in which the strike price is significantly below the current market price) will most likely be treated the same as the underlying stock. If a stock transaction would have created a constructive sale, the in-the-money option will also create a constructive sale. For example, if a stock is trading at $10, an owner of a put option with a strike price of $12 will exercise the option and sell the stock for $12. Therefore, the stock that is owned would result in a constructive sale when the in-the-money put option is acquired.

Another strategy currently being used is the short sale of a similar security or a basket of securities that mimic the appreciated security owned. This appears to work; however, caution must be exercised so as not to violate the constructive sale rules. Currently, there are almost no guidelines in the area.

Even though Wall Street is constantly coming up with new products, any product that has been (or will be) developed that allows taxpayers to substantially reduce or eliminate their risk of loss (and opportunity for gain) will be taxed under the constructive sale rules.

These provisions are effective for constructive sales entered into after June 8,1997. A special rule is provided for transactions before this date that would otherwise have been constructive sales under these rules. The positions in such a transaction will not be taken into account in determining whether a constructive sale after June 8, 1997 has occurred, provided a taxpayer identified the offsetting positions of the earlier transactions before the close of the 30-day period beginning on the date of enactment (or a later date provided in regulations). The special rule will cease to apply on the date the taxpayer ceases to hold any of the offsetting positions so identified.

In the case of a decedent dying after June 8, 1997, if (1) a constructive sale of an appreciated financial position occurred before such date; (2) the transaction remains open (a) for not less than two years and (b) at some time during the three-year period ending on the decedent's death; and (3) the transaction was not closed in a taxable transaction within 30 days after the date of enactment, the appreciated financial position and the transaction resulting in the constructive sale will, if held at the time of the taxpayer's death, be treated as property constituting rights to receive income in respect of a decedent (IRD) under Sec. 691. However, when a constructive sale transaction subject to this rule is closed prior to death, gain that accrues after the transaction is closed will not be treated as IRD. The effect of these rules is generally to preserve the unrealized gain at the time of the constructive sale transaction and to tax a net amount equal to such gain to the taxpayer and his heirs or legatees under Sec. 691.

Hopefully, constructive sale regulations will be issued shortly and provide the guidance necessary to carry out the law and help effectively plan for clients.

FROM JEFFREY PALLEY, CPA, MST, ANCHIN, BLOCK AND ANCHIN LLP, NEW YORK, NY (NOT ASSOCIATED WITH KPMG LLP)