Final regs. on covered call rules.

On Jan. 25, 2000, the IRS published Regs. Sec. 1.1092(c)-1 on the application of the rules governing qualified covered calls (QCCs).

In general, under Sec. 1092(a)(1), a taxpayer with "offsetting positions" in "personal property" (i.e., a straddle) is precluded from recognizing, within a tax year, any loss realized on one "leg" of a transaction, unless that loss exceeds the unrecognized gain in the opposing position in the same tax year. Any loss unrecognized under this provision is carried to subsequent tax years and may be recognized to the extent of income from the offsetting position. These straddle rules are designed to prevent taxpayers from deferring income to a later year, while enjoying currently deductible losses.

A share of stock is not treated as "personal property" for purposes of these rules, unless a taxpayer owns the stock and "an option with respect to such stock or substantially identical stock or securities" (S. Rep. No. 97144, 97th Cong., 1st Sess. (1981), 19812 CB 412, 470). For example, a taxpayer may own stock in two companies, because their share prices tend to move inversely according to normal fluctuations in the economy. This portfolio diversification, alone, would not result in straddle treatment under Sec. 1092. However, a straddle would exist if the taxpayer owned one of the companies and also held an option on that company's stock that substantially diminished the taxpayer's risk of loss on that stock; see Sec. 1092(c)(2)(A).

In general, therefore, a taxpayer who owns stock in a company, and also holds an option that substantially diminishes his risk of loss on that stock, is subject to the straddle rules. However, in some circumstances, owning stock and related options is a non-tax-motivated investment strategy. In recognition of this, an exception was included for QCCs. Under Sec. 1092(c)(4), writing a QCC option and owning the optioned stock is not treated as a straddle.

Congress believed that, in certain limited circumstances, a taxpayer who grants a call option does not substantially reduce his risk of loss on the optioned stock. A mechanical (rather than a subjective test) was established to determine whether this exception would apply. A QCC is an option granted by a taxpayer that gives the 'option holder the right to buy stock the taxpayer owns when the option is granted or acquires in connection with the option grant. In addition, the following requirements must also be met:

1. The option must be traded on a national securities exchange registered with the SEC;

2. The option's term must exceed 30 days;

3. The taxpayer must not be an options dealer granting the option in connection with his activity of dealing in options;

4. Gain or loss on the option may not be ordinary income or loss; and

5. The option must not be "deep in the money."

A call option is "in the money" if the exercise (strike) price is below the market price for the stock when the option is granted. For example, if the owner of stock trading at $100 per share writes a call (i.e., sells) that allows the call buyer to buy the company's stock in three months for $95 a share, the option would be "m the money" when written. "Moneyness" of an option (whether the option is in, at or out of the money) is an objective fact; whether an option is "deep" in the money is, like beauty, sometimes in the eye of the beholder. In the option market, owners of a company's stock trading at more than $100 recently wrote call options on that stock at $75 and even lower. It would be hard to argue that a 25% or more discount from the current market value was not deep in the money.

According to the IRS, a call option is deep in the money if the strike price falls below the "lowest qualified benchmark." This is usually the highest strike price available on the options market that is less than the current price of the underlying stock; see Sec. 1092(c)(4)(C) and (D). Based on the Service's definition, if stock closed at 104 3/4 and call options were traded with strike prices at 105, 100, 95, 90, 85, down to below 50, a call at 100 would not have been deep in the money, while one at 95 would have been. (A call option at 105 would have been "out of the money" and, if all of the other factors were present, a QCC.)

At the time the QCC rules were written, listed options were available only at standardized maturity dates and strike price intervals (generally, intervals of $5). This fixed interval system was a basic assumption of the legislative approach and the basis for the definition of a deep-in-the-money option. Financial markets tend to be among the least static segments of the economy, and it was not long before these assumptions were obsolete. Some option exchanges began trading put and call equity options with flexible terms (strike price, expiration date and exercise style (e.g., American, European, etc.)). In many cases, the option strike price could be denominated in the smallest interval available on the option exchanges (e.g., 1/8, point or 12 1/2 cents). Thus, the existence of these "flexible-term equity options" could cause almost all below-market calls to be deep in the money. If a flexible-term equity option were available at 104 5/8 (1/5 below market), the call referred to at 100 would be deemed to be deep in the money--at least according to the straddle rules.

Proposed regulations under Sec. 1092, published in 1998, precluded equity options with flexible terms from affecting the "lowest qualified benchmark" for other options, Regs. Sec. 1.1092(c)-I established this rule substantially as proposed, with the additional clarification that a strike price for a flexible-term option need not actually be traded for it to be ignored for these purposes A price for such an option must simply be "available." Presumably, this will prevent the Service from obtaining a quote on a flexible-term option from a trader, assert that it did establish a benchmark price because it was not being currently traded, and thereby put a taxpayer back in the straddle again.

FROM David A. DIMUZIO, J.D., LL.M., GRAND RAPIDS, MI