Tax planning strategies with equity derivatives.

• Author: Rubinger, Jeffrey L.

A derivative is a financial instrument, the value of which is determined by reference to the value of another asset (i.e., the underlying asset). While many tax practitioners may believe that derivatives have little, if any, relevance in their practice, these same tax practitioners may be surprised to learn that derivatives could be used in everyday tax planning. This article will illustrate some of the potential uses. (1)

Basic Types of Equity Derivatives

* Options

There are four basic types of equity derivatives: options, collars, forwards, and equity swaps. (2) An option is a contingent contract to buy or sell an equity during a specified time period for a specified price. When entering into an option contract, the purchaser will pay to the seller or writer of the option an option premium. In return for this option premium, the purchaser is granted the right, but not the obligation, to purchase (in the case of a "call" option) or to sell (in the case of a "put" option) the underlying stock at a fixed exercise or "strike" price.

Generally, an option will only be exercised if it is "in the money." Specifically, the holder of a call option typically will only exercise the option if the fair market value of the underlying equity exceeds the option's exercise price, whereas the holder of a put option generally will only exercise the option if the fair market value of the underlying equity is less than the option's exercise price.

* Collars

A collar is a combination of a put option and a call option on the underlying shares of stock. Investors typically will enter into collars (as opposed to simply buying a put or a call option) in order to minimize or eliminate option premium costs. With a "zero cost collar," the respective exercise prices of the options are set so as to eliminate any upfront premium payment by the investor.

Collars can be used to either gain exposure to a particular equity without actually purchasing the underlying equity (i.e., purchase of call and sale of put), or divest oneself of economic exposure to a particular equity without actually selling the underlying equity (i.e., sale of call and purchase of put).

Example: A owns 100 shares of Yahoo stock with a cost basis of $5 a share. Yahoo is currently trading at $30 a share (down from a high of $90 a share). A wants to protect against a further decline but does not want to pay a premium to acquire put options. Thus, A sells three-month call options on Yahoo to B and purchases three-month put options on Yahoo from B. The premiums offset each other. The exercise price of the call options is $40 a share and the exercise price of the put options is $20 a share. By entering into the collar, A has eliminated the risk of any decline below $20 a share but has given away any upside above $40 a share.

* Forwards

A forward contract is a contract where one of the parties agrees to purchase (i.e., the "long" party), and the other party agrees to sell (i.e, the "short" party), the underlying equity at a price (i.e., the delivery price) and date set forth in the contract. With the exception of prepaid forward contracts, where the delivery price is paid upfront, neither party generally makes any payments until the maturity of the contract.

* Equity Swaps

An equity swap is a cash-settled bilateral contract, in which each party agrees to make certain payments to the other depending on the price and dividend performance of the underlying equity. Similar to collars, taxpayers usually enter into equity swaps to either simulate an investment in an underlying equity interest without making an actual investment in the underlying equity, or to divest oneself of economic exposure with respect to the underlying equity without actually selling the underlying equity. Unlike collars, however, the payments made pursuant to an equity swap are required to be made, whereas with collars the options may never be exercised.

Example: Taxpayer A wants to invest in a hedge fund, but because of certain legal restrictions, it is prevented from owning a direct interest. Therefore, A enters into a five-year equity swap with an investment bank whereby: 1) A receives from the bank quarterly payments representing distributions ("quarterly distribution payment") made by the hedge fund, and a payment at maturity equal to the net appreciation ("appreciation payment") in the value of an interest in the fund from inception to maturity, and 2) A pays to the bank quarterly payments equal to an interest rate multiplied by the value of an interest in the fund at the fund's inception, and a payment at maturity equal to the net depreciation ("depreciation payment") in the value of an interest in the fund from inception to maturity. The bank would hedge its position by purchasing the underlying shares. (3)

In the example, A has an interest in the equity swap that is analogous to a leveraged purchase of an interest in the underlying hedge fund. The bank, on the other hand, has an interest in the equity swap that is analogous to a leveraged sale of an interest in the hedge fund.

Tax Treatment

* Options--Purchaser's Tax Treatment

The premium paid by a purchaser of an option is a nondeductible capital expense. (4) If a purchaser allows an option to lapse, the lapse will be treated as a sale or exchange of the option, and will give rise to a loss equal to the taxpayer's basis in the option (i.e., the premium...