CBOE Risk Management Conference

What Everyone Needs to Know About Listed Options Taxation

William Paul, Covington & Burling LLP

March 5, 2013

Taxation of One-Sided Equity Options Positions

Long call Gain/loss on closing transaction is capital gain/loss

Same for loss on expry

Long-term capital gain/loss if hold > 1 year

If exercise, premium added to cost basis of stock

Long put Same for gain/loss on closing transaction or expry

If exercise, put premium reduces proceeds from sale of stock

Wash Sale Rules apply Rolls OK

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Taxation of One-Sided Equity Options Positions

Short call Gain/loss on closing transactions is capital gain/loss

Same for gain on expry

Always short-term capital gain/loss

If assigned, call premium added to proceeds from sale of stock

Short put Same for gain/loss on closing transaction or expry

If assigned, premium reduces cost basis of the stock

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Taxation of One-Sided Equity Options Positions

Exercise and Assignment

If exercise call or assigned on short put, holding period in stock does not include the period the option was open

If assigned on short call or exercise put, the premium adjusts gain/loss on the stock and the gain/loss will be long-term if stock held >1 year.

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Section 1256 Contracts

Listed options on broad-based indexes, large basket of stocks, and non-equity underliers Gain/loss is 60% long-term capital gain, 40% short-term

capital gain/loss regardless of holding period Open positions are marked to market at end of year

Options on ETFs are generally not § 1256 contracts For options market-makers, listed equity options are

also § 1256 contracts Does not apply to OTC options

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Two-Sided Positions

The “tax straddle” rules offsetting positions options and stock options and other options

Loss deferral rule Impact on holding period for long-term gain and

dividends Capitalization of carrying charges Qualified Covered Call exception

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What’s New for 2013?

Higher tax rates!

End of Bush tax cuts for upper-income taxpayers

New 3.8% Medicare tax on net investment income

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What’s New for 2013?

2012 Rate 2013 Rate

Long-term Capital Gain 15% 23.8%

Short-term Capital Gain 35% 43.4%

60/40 Gains 23% 31.64%

Interest 35% 43.4%

Dividends 15% 23.8%/43.4%

Maximum Combined Tax Rates for Upper-Income Taxpayers: Regular Income Tax Plus 3.8% Tax on Net Investment Income

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Chairman Camp’s “Discussion Draft” Proposals

Tax reform for financial products

All derivatives, including listed options:

marked to market at year-end

ordinary income and ordinary loss

60/40 repealed

Stock that is part of two-sided position with a derivative

treated like a derivative

mark-to-market

ordinary income/loss

Appreciated stock treated as sold if buy put or write call

No Qualified Covered Call exception

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Example 1

Alice has held 1,000 shares of AT&T stock for 30 years. Her basis is $5 a share and AT&T is currently trading for $35 a share. In a time of market turmoil like the recent financial crisis, Alice is concerned that the stock may decline significantly. She does not want to sell the stock because she likes getting the dividend. So she buys a put with a strike price of $25 a share.

• Current law: Alice has no gain or loss from buying the put. • Draft proposal: Alice is treated as selling her AT&T stock for $35 a

share, with a resulting taxable gain of $20,000. Alice will need to come up with the cash to pay the tax.

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Example 2 Fred buys 100 shares of Intel stock for $20 a share. After holding the Intel stock for 3 months and at a time when Intel is trading at $25, Fred writes a 60-day, $30 call for $2 to generate some additional income. Assume that the option expires worthless after 60 days and that Intel is trading for $26 when the option expires.

• Current law: Fred has no gain or loss when he writes the covered call. He has a $200

short-term capital gain when the call expires. Fred’s holding period in the stock continues to accrue while the written call is outstanding.

• Draft proposal: Fred is treated as selling his Intel stock for $25 a share when he writes the call and he recognizes $500 of short-term capital gain at that time. When the option expires, Fred recognizes $200 of ordinary income on the option and $100 of ordinary income on the stock (because the stock appreciated from $25 to $26 while the option was outstanding). Fred is treated as having a basis of $26 a share in the Intel stock for purposes of computing subsequent gain or loss and has a 3-month holding period in the stock. (His holding period is suspended during the 60-day period in which the written call was outstanding.)

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