The general principle is that a taxpayer does not realize taxable income upon the receipt of an option premium. If the option expires unexercised, the premium income, less fees, and commissions become income to the grantor on the date of expiration and are included in income in the year of the expiration. The amount of income realized by the option grantor upon the exercise of an option includes the amount of the premium less commissions and fees. These amounts are added to the amount paid for the underlying stocks, and the taxpayer will have a gain if the strike price plus premium is greater than its basis in the stock sold, or a loss if the strike price plus premium is. The treatment of option purchasers mirrors that of option grantors. The mere payment of a premium plus commissions and fees for an option does not trigger any tax consequences. If the option expires unexercised, the taxpayer is treated as if it disposed of the option on the expiration date. Purchasers will therefore have a loss for the amount of the option premium, plus commissions and fees in the year the option expired. In the option is exercised, no gain or loss is recognized, but the premium plus commissions and fees are included in the basis of the stock acquired.
Cash Settlement Options
While the exercise of physically-settled equity options has no immediate tax consequence, the exercise of a cash-settled option is traded as the sale or exchange of the option. Therefore, the taxpayer will have taxable gain or loss upon such exercise. The exception to these general rules are numerous, and include the following:
Options that Are Part of a Tax Straddle
The U.S tax law provides for special treatment of “offsetting positions in personal property”. Most particularly, for tax purposes, a taxpayer will not be able to deduct currently a loss sustained in a transaction on one of the positions in a straddle to the extent of unrealized gains in any other offsetting positions; it must capitalize all expenses associated with carrying positions that are part of a straddle, and its holding period on any position that is part of a straddle does not begin to run until the position ceases to be part of the straddle.
For these purposes, a taxpayer will be considered to hold “offsetting positions with respect to personal property” if holding one of the positions substantially diminishes the taxpayer’s risk of loss from holding any other position. “Personal property” is any property of kin that is actively traded. Stock is not included in the definition of personal property unless: (1) the stock is stock in a corporation formed or availed of to take positions in property which offset the taxpayer’s other positions; or (2) the straddle consists of stock and an option with respect to that stock or substantially identical stock; or (3) The straddle consists of stock and an option with respect to that stock or substantially identical stocks; or (4) The straddle consists of stock and a position with respect to “substantially similar or related property other than stock” The definition of “substantially similar or related property” is contained in regulations issued in1995. There regulations provide that, in general, the property is substantially similar or related to stock when: (1) the fair market values of the stock and the property primarily reflects the performance of (a) A single firm or enterprise; (b) The same industry; or (c) The same economic factors; and Change in the fair market value of the stock are reasonably expected to approximate, directly or inversely, changes in the fair market value of the property or a fraction/multiple thereof.
There regulations provide special rules to determine whether a position reflecting the value of a portfolio of stocks (e.g., an option on the S&P 500) is “substantially similar or related” to the particular stocks that make up a taxpayer’s portfolio.
The straddle rule do not apply to certain straddles consisting of qualified covered call options and the optioned stock. A qualified covered call option is an option granted by the taxpayer to purchase stock held by the taxpayer if the option is traded on a national securities exchange; the option is granted more than 30 days before the day on which the option; the option is not granted by an options dealer in connection with its dealer activity, and gain or loss with respect to the options is not ordinary income or loss.
Options that are also “S1256 Contracts“
Stock options may not be subject to the general rules if the options are “S1256 contracts”. Section 1256 contracts must be marked-to-market a year-end or when the taxpayer’s rights are terminated or transferred during the year by offsetting, by taking or making a delivery, by exercise or by being exercised, by assignment or by being assigned, by lapse, or otherwise. Options on individual stocks, even if listed on a U.S exchange, are not required to be marked to market, because S1256 defines quite narrowly the kinds of equity options that come within its ambit, namely: (1) “Dealer equity options,” i.e., an equity option granted or purchased by an options dealer in the course of the dealer’s activity as a market maker or specialist in listed options; and (2) “Nonequity options, i.e., in this context, a stock index option listed on a U.s exchange.”
Dealers or Traders in Securities
Taxpayers which are considered “dealers in securities” are subject to mark-to-market treatment on their securities portfolio. A “dealer” for these purposes is a taxpayer who regularly purchases securities from or sells securities to customers in the ordinary course of a trade or business, or regularly offers to enter into, assumer, offset, assign, or otherwise terminate positions in securities with customers in the ordinary course of a trade or business. Security included stock, evidence of indebtedness, swap, or other derivatives instruments on stock or debt. An equity option could be part of a dealer’s portfolio, and unless the option is held by the taxpayer as an investment, or is a hedge of a security held for investment, the taxpayer treats the option as if it sold for its fair market value on the last business day of the taxable year, and take the resulting gain or loss into account in the year.
Under the Taxpayer Relief Act of 1997, a trader in securities is also entitled to elect mark-to-market treatment on its trading portfolio. A trader is somewhat circularly defined as “a person who is engaged in a trade or business as a trader in securities.” A trader who elects mark-to-market treatment may avoid marking security to market if the trader establishes to the satisfaction of the Secretary of the Treasury that security has no connection to the activities of the taxpayer as a trader, and specific same-day identification are compiled with.