Short sales against the box: an endangered income tax planning technique.

• Author: Goldberg, William J.

Short sales against the box have long been used by sophisticated investors to hedge security positions without negative income tax consequences. However, recent use of this hedging technique by members of the Lauder family, and the critical press reaction that followed, motivated the Treasury Department and the Clinton administration to request legislation that would eliminate the income tax benefits associated with short sales against the box. If this proposed legislation is enacted, the use of short sales against the box as an income tax planning technique would end. The mere existence of the proposal dictates caution in the meantime.

Overview of Short Sale Against the Box

A "short sale" involves the sale of stock that the seller does not own or control at the time of the sale. Thus, the stock sold short is borrowed stock. A "short sale against the box" occurs when a shareholder owns a particular stock and enters into a short sale with respect to borrowed shares of the same stock.

Example 1: S owns 10,000 shares of corporation XYZ stock that he purchased at $50 a share; they are currently worth $100 a share. Rather than selling the stock for cash and triggering $500,000 of capital gain, S deposits the XYZ stock with a broker. The broker then borrows another 10,000 shares of XYZ stock from a third party and sells the borrowed shares "short" on behalf of S. Because S already owns 10,000 shares of XYZ stock, any subsequent appreciation or depreciation in the XYZ stock will have no economic relevance to S, because he is both long and short 10,000 shares of XYZ stock at the same time (i.e., if the XYZ stock appreciates, S's gain on the shares of XYZ stock he owns will be offset by the loss on the XYZ stock that S sold short (and vice versa) ). When Swishes to close the short sale, he must deliver 10,000 shares of XYZ stock to the third party.

A short sale against the box enables an investor to eliminate the investment risk inherent in the shares of stock used in the transaction. In addition, the investor can use most of the short sale proceeds to reinvest in assets of his choosing. (However, there is also an interest cost attached to the borrowing.) As a result, under current tax law an investor can use a short sale against the box to effectively liquidate his position in appreciated stock without immediately recognizing the taxable gain inherent in such stock.

Income Tax Consequences Under Current Law

Under current tax law, a short sale against the box is not treated as a sale or exchange until the short sale is closed (Regs. Sec. 1.1233-1(a) (1); DuPont, 110 F2d 641 (3d Cir. 1940), cert. denied). Thus, no gain or loss on a short sale against the box is recognized until the short seller delivers stock to the lender to close the sale.

When the sale is...