Post-AJCA straddle rules.

The American Jobs Creation Act of 2004 (AJCA) changed the Sec. 1092 straddle rules, including (1) creating a new identified straddle regime, (2) repealing the so-called "stock exception" and (3) clarifying the consequences of physically settling a position that is part of a straddle.

Background

Sec. 1092 was enacted in 1981 to prevent taxpayers from sheltering income by entering into offsetting positions with little or no net economic benefits, disposing of one leg at a loss in the first year, using this loss to offset income from that year and postponing gain recognition on the offsetting position until a later year; for examples of such transactions, see Smith, 78 TC 350 (1982), and Rev. Rul. 77-185. Sec. 1092's key concept is the "straddle," which is defined in Sec. 1092(c) as offsetting positions in actively traded personal property. Positions are considered "offsetting" if holding one position substantially diminishes the risk of loss on another position held by the taxpayer.

Sec. 1092 and its regulations set forth special loss deferral and holding period rules for straddle positions. Under the general loss deferral rule of Sec. 1092(a)(1), taxpayers are required to match gains and losses realized on straddle positions by deferring the recognition of any losses realized on one leg of the straddle to the extent of any unrecognized gain in the offsetting leg at the end of the tax year. Temp. Regs. Sec. 1.1092(b)-2T's holding period rules generally operate to prevent taxpayers from aging the holding period of a position in actively traded personal property by entering into an offsetting position (i.e., by creating a straddle).

New Identified Straddle Regime

The mechanics of the loss deferral rule have created uncertainty and unintended consequences. As described above, loss is deferred to the extent of unrecognized gain in any offsetting position held at the end of the tax year. If a taxpayer holds one position that is larger than the other (an "unbalanced straddle"), a loss realized on disposition or termination of the smaller position would be deferred under the loss deferral rule to the extent of unrecognized gain in the entire offsetting position, even though the smaller position was not intended to reduce the entire position's risk.

Example 1: Taxpayer T holds 200 shares of X Co. stock. He subsequently acquires a put option on only 100 shares. This arguably subjects T to the straddle rules to the extent of his entire position in X, notwithstanding that only a portion of the position is hedged. T later disposes of 100 shares of X stock. Any loss realized on the put option is deferred to the extent of any unrecognized gain in the remaining 100 shares.

When the straddle rules were enacted over 20 years ago, Congress inserted two measures to address this issue. First, it constructed a very narrow identified straddle rule, which provided that if a taxpayer acquired offsetting positions on the same day, identified them as a straddle and disposed of them on the same day, neither position would be subject to the loss deferral rule. This rule obviously has provided only limited relief. Second, Congress directed Treasury to issue regulations addressing how the straddle rules should be applied to unbalanced straddles; see pre-AJCA Sec. 1092(c)(2)(B). Other than Letter Ruling 199925044, no regulations or other guidance addressing the treatment of unbalanced straddles has been issued.

AJCA Section 888(a) substantially revised the identified straddle rules and deleted the Sec. 1092(c)(2)(B) grant of regulatory authority. Pursuant to new Sec. 1092(a)(2), identified straddles are not subject to Sec. 1092(a) (1)'s general loss deferral rule. Rather, losses realized on a position of an identified straddle are capitalized into the basis of each identified offsetting position. According to Sec. 1092(a)(2)(B), an "identified straddle" for this purpose means any straddle clearly identified as an identified straddle before the close of the day on which the straddle is acquired (or such earlier date prescribed by regulations) and which is not part of a larger straddle.

Under Sec. 1092(a) (2) (B) (ii), regulations can limit the identified straddle regime to straddle positions that have a fair market value (FMV) greater than or equal to the taxpayer's adjusted basis in the position. Identification under new Sec. 1092(a) (2) is elective. This section, however, is now the exclusive identification regime. Accordingly, losses realized on positions not part of an identified straddle are subject to Sec. 1092(a) (1)'s general loss deferral rule.

For unbalanced straddles, the ability to identify which portion of a taxpayer's "larger" position is subject to the straddle rules should generally result in the quicker realization of losses than under prior law. As described above, losses realized on one leg of an identified straddle are capitalized into the basis of the offsetting leg, rather than suspended under the general loss deferral rule. Thus, a realized loss should be recognized when the position into which the loss is capitalized is disposed of, regardless of whether there is unrecognized gain in the "larger" position.

Example 2: Taxpayer T holds 100 shares of X Co. stock. Half of the shares (Block 1) were acquired for $50 a share; the other half (Block 2) were acquired for $60 per share. T subsequently acquires an at-the-money put option on 50 shares. Thus, T's position in X stock is only partially straddled by the put option.

Under prior law, T arguably would have been required to defer any loss realized on the put option to the extent of any unrecognized gain in his X stock position (both Blocks 1 and 2). Consequently, some or all of the loss could be deferred until all 100 shares were disposed of (assuming there was unrecognized gain in the shares). Under the new identified straddle regime, however, T may identify which X shares are straddled by the put option (e.g., Block 1 or 2, or a combination of each). To the extent T realizes a loss on the put option, it is capitalized into the basis of the X shares that T identified. If T then disposes of them, the loss will be immediately recognized through a decrease (increase) in the gain (loss) recognized on the stock sale, whether or not there is any unrecognized gain in the remaining shares held by T. Thus, it is not necessary for T to dispose of all 100 shares to recognize the loss realized on the put option.

The new identified straddle regime will not accelerate loss recognition, however, when the position offsetting the loss position does not have unrecognized gain. Under the new regime, losses are capitalized even if there is no unrecognized gain in the offsetting position, and recognized only when the position into which the loss is capitalized is disposed of. In contrast, under the general loss deferral rule, losses are deferred only to the extent of unrecognized gain in an offsetting position. Thus, when there is no unrecognized gain in an offsetting position, losses under the new regime will continue to be deferred, while, under Sec. 1092(a) (1)'s general loss deferral rule, they would be immediately recognized. Consequently, while the new identified straddle regime should generally be advantageous for taxpayers that hold unbalanced straddles, there may be cases in which taxpayers would be better off under Sec. 1092(a)(1)'s general loss deferral rule.

Repeal of the Stock Exception

Sec. 1092, as originally enacted, did not apply to straddles that included positions in stock. Over time, this "stock exception" was largely eliminated through amendments to Sec. 1092 (and its regulations) that applied the provision to all derivatives in actively traded stock and to actively traded stock offset by (1) an option or securities futures contract for such stock or (2) a position with respect to substantially similar or related property (other than stock).

Prior to the AJCA, the straddle rules covered the majority of straddles consisting of positions in actively traded stock. The one major exception was a short-against-the-box transaction, in which a taxpayer sells short stock that it also owns. These transactions were specifically carved out of the straddle rules and were governed by Sec. 1233.

In light of the limited circumstances in which the stock exception applied, Congress elected to repeal the exception. Under current Sec. 1092(d)(3), as amended by AJCA Section 888(c), stock is treated as personal property subject to the straddle rules if it is of a type that is actively traded and at least one of the positions offsetting the stock is a position with respect to such stock or substantially similar or related property. Additionally, as under prior law, stock in a corporation formed or availed of to take positions in personal property that offset positions taken by any shareholder is also personal property for straddle-rule purposes.

As a result of repealing the stock exception, short-against-the-box transactions are now generally subject to Sec. 1092, rather than Sec. 1233. Thus, Sec. 1233 has become largely superfluous. In the case of short sales of stock not subject to the straddle rules, however, Sec. 1233 arguably still retains a place in the Code. For example, it treats a long put option as a short sale for purposes of applying the Sec. 1233(b) holding period rules (similar to the straddle holding period rules).Thus, if stock and a put option are not subject to the straddle rules because, for example, the put option is so far "out of the money" that it does not substantially diminish the taxpayer's risk of loss on the stock, the Sec. 1233(b) holding period rules should continue to apply to the stock and the put option, rather than the Sec. 1092 straddle rules. Sec. 1233 also applies to short sales of nonactively traded stock and other personal property.

Two-Step Physical Settlement

Physical settlement of a derivative financial instrument has historically been taxed as an acquisition or disposition of the underlying physical position. For example, if a taxpayer physically settled a forward contract on stock by delivering stock to the counterparty in exchange for the forward contract price, the taxpayer was treated as simply selling the stock for the forward price without realizing gain or loss on the forward contract itself, notwithstanding that the contract was a separate property right that may have had built-in economic gain or loss. In contrast, if the taxpayer instead sold the stock into the market and used the sale proceeds to settle the forward contract, the taxpayer would realize gain or loss on both the stock (equal to the difference between the taxpayer's basis therein and the amount realized on the sale) and the forward contract (equal to the amount of cash delivered to the forward contract counterparty). The net gain or loss the taxpayer realized was the same whether the contract was physically settled or cash-settled. The tax consequences to the taxpayer could, however, differ significantly if the contract being settled was part of an unbalanced straddle. In that case, the taxpayer could often avoid the Sec. 1092 loss deferral rule by electing physical settlement, rather than cash settlement.

Example 3: Taxpayer T owns 200 shares of X Co. stock, with a basis of $100 per share. When the stock has a value of $103, he enters into a forward contract to sell 100 shares for $105 per share in one year. T may physically or cash-settle the contract. On the settlement date, X stock is worth $110 per share. Thus, the forward contract has a $500 built-in loss ($5 difference between the contract price and the FMV per share X 100 shares).

If T physically settles the contract by delivering 100 shares of X stock to the counterparty for $10,500, he realizes a $500 gain under the one-step approach ($10,500 realized--$10,000 basis). If instead T sold 100 shares to a third party and used $500 of the proceeds to cash-settle the forward contract, he would realize a $500 loss on the contract settlement and a $1,000 gain on the stock sale ($11,000 realized--$10,000 basis in 100 shares).

When offset with the loss realized on cash-settling the forward contract, T's net gain from the transaction would be $500. Thus, the net gain realized would be the same whether the contract was physically settled or cash-settled. If the forward contract and the stock were a straddle, however, any loss realized on cash-settling the forward contract would be deferred to the extent of unrecognized gain in the offsetting stock position. Because T held 200 shares of X, the loss realized on the forward contract, which was for only 100 shares, would be deferred to the extent of the built-in gain in the retained X stock position (absent identification under Sec. 1092(a)(2)). In contrast, if the forward contract was physically settled, no loss would be realized (only a net gain on delivery of the stock) and the straddle rules would not apply.

AJCA Section 888(b) eliminated this disparity in treatment and requires taxpayers to treat the physical settlement of a derivative that is part of a straddle as a two-step transaction if cash-settling the derivative would result in a loss. Under the two-step approach, the taxpayer is treated as (1) terminating the derivative for its FMV and (2) selling the property delivered to settle the derivative for its FMV (rather than the contract price). Thus, taxpayers may no longer avoid realizing losses on their straddle positions simply by choosing between cash or physical settlement.

It may be possible, however, for taxpayers that hold unbalanced straddles to avoid any adverse consequences associated with the creation of a loss under the two-step approach, by making an identified straddle election under the new identified straddle regime described above. In that case, the loss deemed to result from cash-settling the terminated position is added to the basis of the identified straddle position. If the identified position is used to settle the contract, the benefit of the loss should be realized as an adjustment to the taxpayer's realized gain or loss on the deemed disposition of the identified position for its FMV. Accordingly, the significance of the two-step approach may be diminished as a result of the new identified straddle regime.

Effective Date

The AJCA's amendments to the straddle rules apply to positions established after Oct. 21, 2004.

FROM ELIZABETH R. DYOR, J.D., LL.M., CPA, WASHINGTON, DC