Final regs. on covered call rules.

• Author: Dimuzio, David A.
• Position: IRS regulations

On Jan. 25, 2000, the IRS published Regs. Sec. 1.1092(c)-1 on the application of the rules governing qualified covered calls (QCCs).

In general, under Sec. 1092(a)(1), a taxpayer with "offsetting positions" in "personal property" (i.e., a straddle) is precluded from recognizing, within a tax year, any loss realized on one "leg" of a transaction, unless that loss exceeds the unrecognized gain in the opposing position in the same tax year. Any loss unrecognized under this provision is carried to subsequent tax years and may be recognized to the extent of income from the offsetting position. These straddle rules are designed to prevent taxpayers from deferring income to a later year, while enjoying currently deductible losses.

A share of stock is not treated as "personal property" for purposes of these rules, unless a taxpayer owns the stock and "an option with respect to such stock or substantially identical stock or securities" (S. Rep. No. 97144, 97th Cong., 1st Sess. (1981), 19812 CB 412, 470). For example, a taxpayer may own stock in two companies, because their share prices tend to move inversely according to normal fluctuations in the economy. This portfolio diversification, alone, would not result in straddle treatment under Sec. 1092. However, a straddle would exist if the taxpayer owned one of the companies and also held an option on that company's stock that substantially diminished the taxpayer's risk of loss on that stock; see Sec. 1092(c)(2)(A).

In general, therefore, a taxpayer who owns stock in a company, and also holds an option that substantially diminishes his risk of loss on that stock, is subject to the straddle rules. However, in some circumstances, owning stock and related options is a non-tax-motivated investment strategy. In recognition of this, an exception was included for QCCs. Under Sec. 1092(c)(4), writing a QCC option and owning the optioned stock is not treated as a straddle.

Congress believed that, in certain limited circumstances, a taxpayer who grants a call option does not substantially reduce his risk of loss on the optioned stock. A mechanical (rather than a subjective test) was established to determine whether this exception would apply. A QCC is an option granted by a taxpayer that gives the 'option holder the right to buy stock the taxpayer owns when the option is granted or acquires in connection with the option grant. In addition, the following requirements must also be met:

1. The option must be...