Tax Consequences Associated With Option Strategies- Part III
Posted by Investment Management Group on Oct 11, 2011 11:50:43 AM
As we continue to explore the tax consequences associated with covered call writing, we turn to certain collateral issues related to the straddle rules. Namely, the effect on the “holding period” of the underlying stock for tax periods and its effects on the character of the gain or loss on the sale of that stock and the ability to qualify dividend income on that stock for certain tax favored treatment.
QDI, DRD, and Holding Periods
Most of us know that when a stock is sold, if it has been held for one year or more, the resulting gain or loss is considered to be long-term capital gain or loss. Long term capital gains are subject to a tax favored 15% tax rate. Sales of stock held for less than one year yield short-term capital gains and losses. Short term capital gains are taxable as “ordinary income”, potentially at the taxpayer’s highest marginal rates (up to 39.6%). As a consequence, investors typically prefer all of their capital gains to be long term and their capital losses to be short term. Covered call writing can affect the underlying stock’s “holding period” – i.e. the period of time it is considered to have been held by the taxpayer for purposes of determining if the resulting gain or loss is long-term or short-term. Holding long stock subject to a written call option can potentially result in either a suspension of the stock’s holding period or in some cases, a complete elimination of the stock’s holding period.
Furthermore, as mentioned above, dividend income from stocks can, in certain cases, qualify for favored tax treatment. For example, when a corporation receives dividend income from another corporation, to the extent that dividend income qualifies for the DRD, a certain percentage of it (typically 70%) can be excluded from taxation. For individual taxpayers, to the extent that their dividend income qualifies as QDI, it is subject to a maximum tax favored rate of 15%. Accordingly, it is beneficial to the holder of a long stock position to have the dividends paid on such stock qualify for these tax favored provisions. Writing covered calls against long stock however, can interfere with a taxpayer’s eligibility for these dividend oriented tax benefits. This interference operates by reference to the underlying stock’s holding period. Basically, in order to qualify a dividend for DRD, the holding period rules require the stock to be held for more than 45 days during the 91-day period beginning on the date that is 45 days before the date on which such stock goes ex-dividend. The QDI rules by analogy require the same - but by substituting 60 days for the 45 days and 121 days for 91 days.
The rules for determining holding period suspension for purposes of determining long-term v.s. short term capital gain or loss are found in the straddle regulations under IRC section 1092. The rules for suspending holding periods for purposes of qualifying dividends for the DRD (and by analogy qualifying dividend income as QDI for individuals) are found in the regulations under IRC section 246. These two sets of tax rules are very similar.
Under IRC section 246 and the regulations thereunder, the holding period for determining DRD eligibility is suspended where the taxpayer has "diminished his risk of loss by holding one or more other positions with respect to substantially similar or related property.” Note, that the definition of diminished risk of loss for this purpose is the same definition used in the tax rules for determining if a straddle exists (see previous post). Hence the rules for determining whether a straddle exists and the rules for suspending holding period for DRD and QDI purposes are tied into one another.
The following summarizes the tax rules for suspending holding periods for purposes of determining the character of gain or loss upon the disposition of stock or options. We also included the related dividend suspension rules in this analysis. Here is how the holding period suspension / elimination rules operate. There are three levels of suspension / elimination of holding period:
- For a stock that is subject to any straddle under IRC section 1092 (including a deep in the money covered call), for purposes of determining the character of gain or loss, the holding period is eliminated. The holding period restarts when the stock is no longer subject to the straddle or is not covered by a QCC described in item #2 below. Dividends are generally not qualified for DRD or QDI during this time period, but may be if the stock was held for the requisite period (45 out of 91 days or 60 days out of 121 days as described above) prior to the QCC being written because the holding period is only suspended, not eliminated for purposes of dividend qualification.
- For a stock that is subject to a QCC that is in the money (but not deep-in-the-money), the holding period is suspended for the period during which the stock is covered for purposes of determining the character of gain or loss. Dividends are generally not qualified for DRD or QDI, but may be if the stock was held for the requisite period prior to the QCC being written.
- For a stock that is subject to a QCC that is out-of-the-money, the holding period is not suspended or eliminated. Gain or loss character upon sale of the stock is determined by reference to the stock's original holding period unadjusted for any suspension or elimination. Dividends are qualified for DRD and QDI assuming the holding period requirements discussed above are met.
For a stock which is subject to point 1 or 2 above and which consistently is being covered, the realized gain or loss upon disposition will most likely be short-term. However, if a stock has already been held for a long-term holding period and is being covered by an "in-the-money" call, and such call is subsequently closed at a loss, such loss is treated as long-term. Further, there is a special rule that may still result in loss deferral even if the written call option is a QCC. That is, if either leg of the covered position (stock or call option) is closed at a loss in one tax year and the other leg is closed at a gain in the following tax year but within 30 days of the date the realized loss was incurred, then the loss incurred in the first year is deferred into the following tax year. This effectively treats the QCC arrangement as a straddle, but only for loss deferral purposes and not for holding period suspension purposes.
This post examined important holding period related tax consequences resulting from covered call writing strategies. In our next and final post in this series, we will present examples that illustrate the principles presented in items 1 through 3 above.