Put and Qualified Covered Call Option on Same Equity Results in Straddle Treatment

In Rev. Rul. 2002-66, the Service held that if a grantor of a qualified covered call option (QC) holds a put option on the same underlying equity, the purchased put will cause the stock and the QC to be part of a larger straddle and ineligible for the Sec. 1092(c)(4) exception to straddle treatment for QCs. To be a QC, a covered call option cannot be a part of a larger straddle; see Sec. 1092(c)(4)(A)(ii).

The ruling outlined three fact patterns, in which the IRS assumed that (1) an inverse relationship exists between the value of the underlying equity and that of each option position; (2) because of the inverse relationships, each option position substantially diminishes the risk of holding the equity; (3) the acquisition of the put option substantially diminishes the risk of loss for the combined position, consisting of the equity and the QC on that equity; and (4) the call option is a QC under Sec. 1092(c)(4)(B).

Fact Patterns

In the first scenario, a company purchases 100 shares of a corporation's stock for $100 per share, writes a 12-month call option on 100 shares with a $110 strike price, and purchases a 12-month put option on 100 shares with a $100 strike price. The Service determined that all of the positions are part of a larger straddle. As a result, the covered call option would not qualify as a QC, so the straddle rules apply.

In the second scenario, a company purchases 100 shares of a corporation's stock on Sept. 3, 2002, for $102 per share. On Sept. 6, 2002, when the stock's fair market value (FMV) is $100, the company writes a 12-month call option for 100 shares with a $110 strike price, and purchases a 12-month put option on 100 shares with a $100 strike price. The Service determined that all of the positions are part of a larger straddle, beginning on Sept. 6, 2002. Thus, the covered call option would not qualify as a QC and the straddle rules would apply beginning on that date.

In the third scenario, a company purchases 100 shares of a corporation's stock on Oct. 1, 2002, for $102 per share. On Oct. 3, 2002, when the stock's FMV is $100, it writes a 12-month call option on the 100 shares with a $110 strike price. On Dec. 2, 2002, when the stock's FMV is still $100, the company purchases a 12-month put option on 100 shares with a $100 strike price. The IRS held that before Dec. 2, 2002, the combination of the QC and the underlying shares would not be part of a larger straddle. However, beginning on that date, all of the stock positions would be. As a result, the QC would no longer meet Sec. 1092(c)(4) requirements, resulting in application of the straddle rules.

Analysis

In all three scenarios, the IRS found that a purchased put substantially reduces the taxpayer's risk of a loss on the stock and any potential for enhancing his or her investment return through premiums. The put option protects against a decrease in the stock's value below the option's exercise price and, through the inverse relationship between the stock's and the option's values, reduces the effect of stock fluctuations. These factors “substantially diminish” the risk of holding the stock by itself, as well as that of combining the stock and the written call (although, admittedly, the purchased put does not reduce the risk on the written call).

According to the Service, when the stock's owner acquires the put, the premium received from the call option is offset by the amount paid for the put option, reducing any potential enhancement of investment return on the stock from receiving the call-option premium. As a result, the IRS concluded that it would be inappropriate to treat the covered call option as a QC, which would exclude it from the straddle rules.

Implications

The transactions described in Rev. Rul. 2002-66 resemble equity collar transactions. Many taxpayers have entered into cashless equity collar transactions in the past several years. Some wrote covered call options in the hopes of meeting the Sec. 1092(c)(4) straddle-rule exception. If the options were excluded from such rules, and if the taxpayer settled the call options in cash after the underlying equity appreciated significantly during the collar's term, current recognition of the payment would not be deferred under Sec. 1092(a). Because the Service concluded that a call option written in the context of the standard equity collar transaction is not a QC, it will regard the transaction as part of a larger straddle. Thus, any recognition of loss on a cash settlement for such option may be deferred under Sec. 1092(a).

From Marc D. Levy, Washington, DC