Tax Consequences Associated With Option Strategies- Part II

Posted by Investment Management Group on Oct 9, 2011 11:43:02 AM

In our last post, we examined the basics of the straddle rules, including the definition of a straddle and loss deferral rules associated with a straddle. In this post, we will look at an important exception to the straddle rules.

Qualified Covered Call Exception

With respect to covered calls (i.e. a written call option on a long stock),when these rules were enacted, Congress concluded that if the option is granted with an exercise price not substantially less than the price of the stock at the time the option is granted, the potential for abuse is negligible. Thus, in the case where the two "legs" of a straddle consist of long stock and a "qualified" covered call (“QCC”) as the offsetting position, the deferral rules of IRC section 1092(a) discussed in the previous post do not apply, and the long stock/written call position is not considered a straddle. For a call option to be "qualified," it must meet five conditions.

  1. the option must be granted (written) more than 30 days prior to its expiration date
  2. it may not be granted (written) by an options dealer in the course of business of dealing in options
  3. gain or loss from such option must not be ordinary income or loss to the grantor
  4. the option must be traded on an SEC regulated exchange, and
  5. it must not be "deep-in-the-money"

The first four conditions are relatively self-explanatory, however, the "deep-in-the-money" test needs further clarification. A deep-in-the-money option is an option having a strike price lower than the "lowest qualified benchmark," a term generally meaning the highest available strike price which is less than the "applicable stock price." The "applicable stock price" is either the closing price of such stock on the most recent day on which such stock was traded before the date on which the option was written or, the opening price of such stock on the day on which the option was written, but only if such price is greater than 110% of the closing price of the most recent day in which the stock was traded. The tax rules in this area are somewhat complex. In general, for stock whose "applicable price" is:

  • Less than $25, the option cannot be more than $2.50 in the money or it is considered deep in the money
  • Greater than $25 but less than $200, the option cannot be more than $5 in the money or it is considered deep in the money, and
  • $200 or more, the option cannot be more than $10 in the money or it is considered deep in the money

The above is based upon generally available option strike prices. There are several exceptions to the rules described above for determining whether a call option is in the money. They are as follows:

  • If at the time the call option is written, it has 90 days or more until expiration and its strike price is greater than $50, then the lowest qualified benchmark is considered to be the second highest available strike price. This means for a stock with an applicable price less than $200, the call option cannot be more than $10 in the money and for a stock with an applicable price that is $200 or more, the call option cannot be more than $20 in the money, or it is considered deep in the money.
  • If the applicable stock price is $25 or less and the lowest qualified benchmark would be less than 85% of the applicable stock price, then the lowest qualified benchmark is adjusted to equal 85% of the applicable stock price. For example, if a stock is trading for $10, then any option written with a strike price under $7.50 would be considered deep in the money. This special rule modifies this determination so that any option written with a strike price under $8.50 is considered to be deep in the money.
  • If the applicable stock price is $150 or less and the lowest qualified benchmark would be less than the applicable stock price minus $10, then the lowest qualified benchmark is adjusted to equal the applicable stock price minus $10. For example, if a stock is trading at $100 per share but for whatever reason the highest available strike price is $85, then the lowest qualified benchmark is deemed to be $90, rendering the $85 call option to be a non-qualified option.

For options with terms greater than one year, in order to determine the applicable stock price, the price of the stock needs to be adjusted by a "time factor" provided in tables found in the tax regulations, for the purposes of the deep-in-the-money test.

There is another statutory exception to the straddle rules that says: a substantially out-of-the money option to sell does not diminish the taxpayer's risk of loss on its stock “unless the option is held as part of a strategy to substantially offset changes in the fair market value of the stock.” The tax regulations do not indicate what such a strategy might be. We have heard this interpreted to apply only to substantially out of the money put options. However, the regulations do not define when a put option is "substantially" out of the money.

Our next post will discuss the “holding period” consequences associated with covered call writing and in particular, the effect on the character of the realized gain or loss on the sale of the underlying stock and the available tax favored treatment of the dividends on that stock.

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