Short sales against the box: an endangered income tax planning technique.

Short sales against the box have long been used by sophisticated investors to hedge security positions without negative income tax consequences. However, recent use of this hedging technique by members of the Lauder family, and the critical press reaction that followed, motivated the Treasury Department and the Clinton administration to request legislation that would eliminate the income tax benefits associated with short sales against the box. If this proposed legislation is enacted, the use of short sales against the box as an income tax planning technique would end. The mere existence of the proposal dictates caution in the meantime.

Overview of Short Sale Against the Box

A "short sale" involves the sale of stock that the seller does not own or control at the time of the sale. Thus, the stock sold short is borrowed stock. A "short sale against the box" occurs when a shareholder owns a particular stock and enters into a short sale with respect to borrowed shares of the same stock.

Example 1: S owns 10,000 shares of corporation XYZ stock that he purchased at $50 a share; they are currently worth $100 a share. Rather than selling the stock for cash and triggering $500,000 of capital gain, S deposits the XYZ stock with a broker. The broker then borrows another 10,000 shares of XYZ stock from a third party and sells the borrowed shares "short" on behalf of S. Because S already owns 10,000 shares of XYZ stock, any subsequent appreciation or depreciation in the XYZ stock will have no economic relevance to S, because he is both long and short 10,000 shares of XYZ stock at the same time (i.e., if the XYZ stock appreciates, S's gain on the shares of XYZ stock he owns will be offset by the loss on the XYZ stock that S sold short (and vice versa) ). When Swishes to close the short sale, he must deliver 10,000 shares of XYZ stock to the third party.

A short sale against the box enables an investor to eliminate the investment risk inherent in the shares of stock used in the transaction. In addition, the investor can use most of the short sale proceeds to reinvest in assets of his choosing. (However, there is also an interest cost attached to the borrowing.) As a result, under current tax law an investor can use a short sale against the box to effectively liquidate his position in appreciated stock without immediately recognizing the taxable gain inherent in such stock.

Income Tax Consequences Under Current Law

Under current tax law, a short sale against the box is not treated as a sale or exchange until the short sale is closed (Regs. Sec. 1.1233-1(a) (1); DuPont, 110 F2d 641 (3d Cir. 1940), cert. denied). Thus, no gain or loss on a short sale against the box is recognized until the short seller delivers stock to the lender to close the sale.

When the sale is closed, the short seller will recognize a gain to the extent the short sale price exceeds the seller's tax basis in the stock used to close the sale. If the short seller's tax basis exceeds the short sale proceeds, the seller will recognize a loss. Whether the gain or loss recognized from a short sale against the box is capital gain or loss depends on whether the property used to close the short sale is a capital asset in the hands of the short seller. Short sellers of stock who are not dealers in securities will recognize a capital gain or loss (Sec.1233(a); Regs. Sec.1.1233-l(a))

The period for which a short seller holds the property used to close the short sale generally determines whether the capital gain or loss recognized on a short sale against the box is long-term or short-term (Regs. Sec. 1.1233-l(a)(3)). Thus, an investor who sells 100 shares of XYZ stock short against the box and closes the sale at a gain by delivering 100 shares of XYZ stock he has held for more than one year generally will recognize a long-term capital gain.

Observation: To prevent taxpayers from converting short-term gains to longterm gains or long-term losses to short-term losses, and to prevent the creation of artificial losses, Sec. 1233(b) and (d) and Regs. Sec 1.1233-1 (c) contain special rules that apply whenever property "substantially identical" to the property sold short is held by the short seller on the date of the short sale or is acquired by the short seller after the short sale and on or before the date the short sale is closed. (A discussion of these special rules is beyond the scope of this item.)

As a result, under current tax law, an investor can use a short sale against the box to sell stock and defer recognition of any taxable gain inherent in that stock until the short sale is actually closed. When the short sale is actualIy closed, any gain recognized by the investor will be taxable as capital gain (assuming the investor is not a dealer in securities). If the short seller has held the stock used to close the short sale for more than one year (and he owns no other "substantially identical property"), the capital gain will be treated as long-term capital gain and taxed at no more than the current maximum rate of 28%.

Further, if an investor enters into a short sale against the box and dies: before the short sale is closed, any gain inherent in the stock used to close the short sale may be completely eliminated. For example, in Rev. Rul. 73-524, an individual sold 200 shares of stock short against the box. After the individual died, the individual's estate closed the short sale by delivering the individual's shares of stock to the broker. The Service concluded (1) that the short sale was not consummated until the estate delivered the individual's shares of stock to the broker, and (2) that, for purposes of determining gain or loss on the short sale, the basis of the stock used to close the short sale was the fair market value (FMV) of the stock on the date of the decedent's death (or alternate valuation date under Sec. 2032, if applicable). See also Letter Rulings 9436017 and 9319005 for the same conclusion.

In other words, the unrealized gain in the stock used to close the short sale is not treated as income in respect of a decedent under Sec. 691 and thus the basis of such stock included in the individual's gross estate is stepped up under Sec. 1014. As a result, if an investor sells appreciated stock short against the box and does not close the short sale before he dies, the investor's heirs can close the short sale and avoid paying any income tax on the unrealized appreciation in the stock used to close the short sale.

Income Tax Consequences Under Proposed Legislation

To prevent taxpayers from eliminating the economic risk of loss and the opportunity for gain in appreciated property without recognizing taxable gain, and in order to more clearly reflect income from the sale of stock or other securities, President Clinton's proposed fiscal 1997 budget includes two revenue provisions addressing short sales against the box.

[] Substantially identical securities determined on average basis: Under this proposal, taxpayers generally would be required to determine their basis in substantially identical securities using the average cost method. Thus, for example, if a taxpayer holds 100 shares of stock in XYZ, 50 purchased for $25 and 50 purchased for $50, the taxpayer's average basis in each share of XYZ stock would be $37.50 [((50 X $25) + (50 X $50))/100]. Further, for purposes of determining whether gain or loss on the sale of securities is short-term or longterm, a taxpayer generally would be treated as selling or disposing of substantially identical securities on a FIFO basis.

This method of determining basis and holding period would apply to "securities" as defined under Sec. 475(c) (2) (other than subparagraph (F) thereof). Thus, the average cost method for determining basis would be required for the following securities:

[] Stock in a corporation. [] Partnership or beneficial ownership interests in a widely held or publicly traded partnership or trust. [] Notes, bonds, debentures or other evidence of indebtedness. [] Interest rate, currency or equity notional principal contracts. [] Certain derivative financial instruments, options, forward contracts and short positions.

If this proposal is enacted, taxpayers would no longer be able to identify particular borrowed securities as the ones delivered on a short sale. Consequently, this proposal would eliminate taxpayers' ability to avoid immediate recognition of gain through short sales against the box.

Example 2: Taxpayer Towns 100 shares of XYZ stock with an average cost basis of $37.50 and an FMV of $100. T instructs a broker to borrow 100 shares of XYZ stock and immediately sell the 100 shares Because T must determine the shares sold using the FIFO method, she would be treated as selling the 100 shares of XYZ stock she actually owns and not the 100 shares of borrowed XYZ stock. As a result, T would recognize $6,250 of gain on the sale [(100 X $100) - (100 x $37.50)]

The average basis provision would be effective 30 days after the date the proposal is enacted.

[] Recognition of gain on certain appreciated positions in personal property: This proposal would require a taxpayer to recognize gain (but not loss) on entering into a constructive sale of any appreciated position in stock, a debt instrument or a partnership interest. A taxpayer would be treated as making a constructive sale of an appreciated position when the taxpayer (or, in certain limited circumstances, a person related to the taxpayer) substantially eliminates risk of loss and opportunity for gain by entering into one or more positions with respect to the same or substantially identical property.

For example, a taxpayer who holds appreciated stock and enters into a short position (or an equity swap) with respect to that stock would immediately recognize any gain inherent in the stock. Similarly, a taxpayer who holds appreciated stock and grants a call option or purchases a put option on the stock would generally recognize gain on the stock if there is a "substantial certainty" that the option will be exercised. In addition, a taxpayer would recognize gain on an appreciated position in stock, debt or partnership interests if he enters into a transaction marketed or sold as substantially eliminating the risk of loss and opportunity for gain, regardless of whether the transaction involves the same or substantially identical property.

The proposal would not apply to any contract for the sale of any stock, debt instrument or partnership interest that is not a marketable security if the sale is reasonably expected to occur within one year of the date the contract is entered into. In addition, the proposal would not treat a transaction as a constructive sale if the taxpayer is required to mark-to-market the appreciated financial position under Sec. 475 (mark-to-market for securities dealers) or Sec. 1256 (mark-to-market for futures contracts, options and currency contracts).

A special rule would also apply for constructive sales entered into on or before the date the proposal is enacted by individuals dying after the date of enactment. If the constructive sale remains open on the day before the date of death and gain has not been recognized under this provision, the unrealized gain in the appreciated financial position would be treated as income in respect of a decedent under Sec. 691. As a result, the individual's basis in the appreciated financial position would not be stepped up to FMV under Sec. 1014. Consequently, taxpayers who entered into a short sale against the box after the effective date of this proposal, and before the date the proposal is actually enacted, would not be able to eliminate taxable gain by keeping the short sale open until death.

Under President Clinton's proposed fiscal 1997 budget, this proposal would be effective for constructive sales entered into after the date of enactment. In addition, the proposal would apply to constructive sales entered into after Jan. 12, 1996 and before the date of enactment, if the transaction resulting in the constructive sale remains open 30 days after the date of enactment. In such a case, the constructive sale would be deemed to occur on the date that is 30 days after the date of enactment.

However, on Mar. 29, 1996, Senate Finance Committee Chair William V. Roth, Jr. (R-Del.) and House Ways and Means Chair Bill Archer (R-Tex.) issued a statement saying the effective dates in President Clinton's proposed fiscal 1997 budget "will be no earlier than the date of appropriate congressional action." Thus, in the event Congress enacts this proposal, it appears its effective date will not be retroactive.

Although it is impossible to predict at this time whether either proposal will be enacted and, if enacted, in what form, the attention being focused on short sales against the box (and other similar hedging techniques) as an income tax deferral or avoidance device may eventually result in legislation eliminating the tax benefits currently associated with short sales against the box. Thus, the short sale against the box appears to be an endangered income tax planning technique that may soon be extinct.

FROM WILLIAM J. GOLDBERG, CPA/PFS, CFP, J.D., HOUSTON, TEX., AND MARK T. WATSON, CPA, MS, WASHINGTON, D.C.