II. OPTIONS IN GENERAL
For federal income tax purposes, an option contract is defined as an agreement giving the holder the right, but not the obligation, to buy or sell a specified item, at any time until a future date (American) or at a fixed future date (European). There are two basic types of options, namely put options and call options. A put option permits the holder of the option to deliver property to the writer of the option at an agreed price (known as the strike price). A call option permits the holder to purchase property from the writer at the strike price. Options may be cash-settled so that rather than delivering property upon exercise of the option, a cash payment is made equal to the different market value of that item at the time the option is to be exercised. IN exchange for granting the option, the writer receives a premium that is generally paid at the time the option is entered into.
Options can either be listed on an exchange or purchased over-the-counter. The option holder or options purchaser can generally lose no more than the premium paid for the option and has unlimited gain potential. The option writer or option seller is obligated to perform if the holder exercises the option. The writer’s gain is generally limited to the amount of premium received, and the writer has unlimited potential for losses.
Section 1234 of the Internal Revenue Code sets forth the basic income and loss characterization rules governing options. For purchasers of options, gains or loss attributable to the sale or exchange, or loss attributable to the failure to exercise an option is characterized as gain or loss from property that has the same character as the property to which the options relates. In addressing the tax treatment of index options, there are three general characteristics that will determine how an option will be taxed. Timing determines when gain or loss will be recognized, while character determines whether gain or loss is ordinary or capital. This distinction is especially important for individuals because long-term capital gain income is taxed at a lower rate than ordinary income. Also, capital losses can only offset capital gain income (except for a small amount of permissible cross-character offset), thus limiting the use of such losses. Finally, source determines whether gain or loss will be taxable in the United States at source.
A. General Tax Treatment of writer
Premiums received by an option writer are not included in income at the time of receipt; rather they are carried forward in a deferred account until:
- the writer’s obligation expires through the passage of time;
- the writer sells the underlying stock or pays cash pursuant to the exercise of the options; or
- the writer engages in a closing transaction
A closing transaction is defined as “any termination of the taxpayer’s obligation under an option in property other than through the exercise or lapse of the option”. Upon exercise, the writer recognized gain or loss equal to the difference between (1) the writer’s basis in the optioned property and (2) the sum of the option strike price plus the option premium. Gain or loss to the writer from the sale of an option is the difference between the premium and any amount paid to the party assuming the writer’s obligation under the option. Gain to the writer on termination of an option is equal to the difference between the premium and any amount paid for the termination. The writer’s gain from the lapse of an option is equal to the amount of the premium.
Gain or loss that is recognized from an equity option for taxpayers that are dealers in neither the underlying equity nor the equity options will generally be capital gain or loss. If the writer’s obligation expires through the passage of time, the premium will constitute short-term capital gain to the writer upon such expiration. If the writer sells the underlying stock pursuant to the exercise of a call option, the premium received by the writer increases the amount realized upon the sale of such stock in determining gain or loss. If the writer purchases the underlying stock pursuant to the exercise of the put option, the premium decreases the writer’s basis in such stock. If the writer of a call or put option enter into a closing transaction by payment of an amount equivalent to the value of the call or put at the time of such payment, the difference between the amount so paid and the premium received is short-term capital gain or loss.