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Tax planning with complex securities transactions.

Currently, there may be many taxpayers with large, potentially unusable capital loss carryforwards, or with expiring capital loss carryforwards. An opportunity exists for these taxpayers to employ an investment strategy that generates capital gain income at an annual rate approximating the Treasury rate. This strategy, which economically equates to a lending, is called a "forward conversion." A forward conversion is a combination of stock and options that economically equates to a bond. In this transaction, a taxpayer's capital loss carryforwards can be used against the capital gain income generated by this trade (as opposed to a loan, in which the interest income generated may not be offset with capital losses). Thus, the taxpayer can effectively receive a Treasury rate of interest, tax free. See the example on page 244.

There are a number of factors that could change the economics of the transaction illustrated in the example.

* If the stock pays a dividend within the option period, that will count towards the overall yield on the forward conversion. This reduces the amount of capital gain generated by the transaction. For example, if ABC stock paid a dividend of $200 on Oct. 20, 1993, the option pricing would be such that T's $1,200 gain would be comprised of $1,000 of capital gain from the delivery of the ABC stock against one of the options and $200 of dividend income. For a taxpayer attempting to maximize the use of his capital losses, dividend paying stock is less beneficial. * If the price of the ABC stock moves substantially before Oct. 22, 1993 and one of the options is exercised early (probably the calls, since the taxpayer controls the timing of the puts' exercise), the economics become more favorable to T. if the stock increases substantially and the call is exercised on July 22, 1993, T will receive $50,000 for his ABC stock in three months and not six, thus doubling his annual yield to approximately 10%. In addition, T retains his 10 puts, which he can hold or sell for a nominal amount, thus slightly improving the yield on the transaction.

The forward conversion strategy can also be employed with commodities. If a taxpayer purchases gold on Apr. 22, 1993 and also sells short a six-month gold futures contract, he has in effect entered into a forward conversion. The pricing should give the taxpayer a six-month Treasury rate of return in the form of capital gain when the gold is delivered against the futures contract in October 1993. It should be noted that if taxpayers use this strategy and attempt to enhance their yield through the use of leverage or by varying the timing of the recognition events over year-ends, the straddle rules of Sec. 1092, the capitalization rules of Sec. 263 and the mark-to-market rules of Sec. 1256, among others, will limit the additional benefits the taxpayer is attempting to obtain.

In conclusion, there are many securities transactions, with varying degrees of risk, which taxpayers can use to enhance their yield on investments or cash. However, there must be a substantial economic motive for entering into the transactions, or the IRS will clearly challenge them. In the instant example, the tax benefit is limited to the current interest rate (assuming no early exercise). As current interest rates are very low, this strategy requires a substantial amount of capital to achieve significant benefits. However, if interest rates rise in the future under the Clinton administration, or if taxpayers are sitting with cash invested in Treasuries or other liquid or semi-liquid investments, the forward conversion may be an excellent strategy to enhance the taxpayer's overall yield. Before entering into such transactions, taxpayers should review the economics of the Particular forward conversion they are considering, as there are other economic factors that may influence the initial pricing of the options.
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Author:Tingus, Nicole
Publication:The Tax Adviser
Date:Apr 1, 1993
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