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Author: zman49 Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 11000  
Subject: Covered Calls and Taxes Date: 4/1/2000 4:39 PM
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Tax Implications of Covered Calls for Investors

In my wanderings through the web two things have become
clear to me.

(1)  There is no good source of information on the tax
    implications of certain option trading strategies, including
    selling covered calls.

(2)  Many people who sell covered calls do not understand
    the implications of their trading.

I hope to make a dent in this deficiency through this and,
possibly, future posts.  Other than believing I am somewhat
articulate, I have no qualifications for this task.  I am
not a tax professional.  I cannot guarantee my
interpretation of any fact will match that of the IRS or any
of its employees.

I will ask certain more qualified individuals to review this
article and comment upon it, although they are under no
obligation to do so.  Given the time of year I suspect they
are quite busy.  (Eventually I hope they will have the time
and inclination to supply more information on the tax
implications of options strategies, but I will not be
holding my breath.  Until the Treasury Department clarifies
some of the issues involved, it will be nearly impossible to
supply meaningful answers to certain questions.)

In this post I am only addressing "simple" covered calls
written against stock owned by an investor.  This
information does not apply to traders and dealers, to calls
covered by anything other than the underlying stock, or to
covered calls that are part of an option strategy that
includes other stock or option positions, such as a
strangle.

The following factors may impact the tax consequences of
selling covered calls:

(1)  Is the option substantial or not substantial?  To
   determine this you need to determine if selling the options
   "substantially reduces any risk of loss you may have from
   holding" the stock.  Covered calls are presumed to be
   substantial by the IRS, but you may determine that they are
   not in a particular case and present your argument to the
   IRS.

(2)  Was the option, at the time you sold it, deep-in-the-
   money, in-the-money, or out-of-the-money?  To determine this
   the IRS has very specific and detailed instructions in
   Publication 550.  In the 1999 edition they are located on
   page 54.  (Warning! If a stock price is falling, and you
   want to sell an out-of-the-money call, be sure you use a
   strike price is more than the previous closing price.  If a
   stock closed at 50, then opened the next day at 40, a call
   with a strike price of 45 would be considered in-the-money
   by the IRS.)

(3)  Is the covered call qualified or not qualified?  The
   call will be qualified if (a) there are more than 30 days
   until expiration at the time the call is sold and (b) the
   option is not deep-in-the-money, as defined in Publication
   550.

General rules applicable to all covered calls:

(1)  Selling a covered call does not create a taxable event,
   it creates a short position in your account. The taxable
   event occurs when the short position is closed.

(2)  If the call is exercised, increase the amount realized
   on the sale of the stock by the amount you received for the
   call.

(3)  If the call expires, report the amount you received for
   the call as a short-term capital gain as of the expiration
   date.

(4)  If you buy back the call, report the difference between
   the amount you paid and the amount you received for the call
   as a capital gain or loss.  If you made a profit, it will be
   a short-term capital gain.  If you had a loss, it will be a
   short-term capital loss unless there is an exception noted
   below.

 Rules applicable to specific covered calls:

(1)  If the option was not substantial you should (a) attach
   to your tax return an explanation of why the option was not
   substantial and (b) follow the general rules applicable to
   all covered calls.

(2)  If the option was substantial, out-of-the-money and
   qualified follow the general rules applicable to all covered
   calls unless the special year-end rule applies. This rule
   applies if (a) you closed one of the positions (sold the
   stock or bought back the options) in one tax year for a loss
   and (b) in less than 30 days closed the other position for a
   gain in the next tax year.  If this rule applies you must
   defer your loss until the year you recognized the profit.

(3)  If the option was substantial, in-the-money and
   qualified the holding period of the stock will be suspended
   for the amount of time the option position is open.
   Otherwise the tax implications are the same as for an out-of-
   the-money qualified covered call unless (a) you bought the
   option back for a loss and (b) you would have had a long-
   term capital gain or loss if you had sold the stock on the
   day you sold the option.  In this case, you would claim a
   long-term capital loss instead of a short-term capitol loss.

(4)  If the option was substantial and not qualified you
   will have created a "straddle" subject to specific rules and
   reporting requirements.  If the option was deep-in-the-money
   when sold and you had an unrecognized gain on the stock at
   the time of the sale, there is a chance you may have also
   created a "constructive sale" of the stock by selling the
   option.  From a tax viewpoint neither of these is likely to
   be beneficial to a taxpayer.  Aside from extra paperwork,
   the primary implication of a straddle is that any losses you
   recognize cannot be claimed as long as they are offset by
   unrecognized gains in other related positions. Another,
   sometimes more significant, implication of a straddle is
   that the holding period of the stock will be restarted when
   the straddle ends (unless you held the stock more than one
   year before you established the straddle).  The primary
   implication of a "constructive sale" is that you will be
   taxed as if you had sold and repurchased the stock at the
   time you sold the option.  Both straddles and constructive
   sales are discussed in some detail in IRS Publication 550.

Other Rules

(1)  If a "related party" has a long or short position in
   the same stock, or an option on the same stock, you may have
   to make some adjustments to your return to reflect that
   ownership.

(2)  Wash sale rules apply to options as well as stock if
   two positions are "substantially identical."

Unresolved Issues

(1)  The Congress anticipated that future Treasury
   regulations would clarify when selling a covered call option
   constitutes a constructive sale.  It is clear that a
   constructive sale was intended if the call option is
   sufficiently in the money to eliminate substantially all of
   the risk of loss and opportunity for income and gain.  If
   there is a substantial risk of loss, or a substantial
   opportunity for gain, a constructive sale was not intended.
   Until Treasury regulations are issued no one can tell you
   where to draw the line.  Similarly, there are no definitive
   guidelines to determine when an option position is
   "substantially identical" to another position and can invoke
   the wash sale rule.

(2)  Section 1092 of Title 26, the statute on straddles,
   indicates "If 1 or more positions offset only a portion of 1
   or more other positions, the Secretary shall by regulation
   prescribe the method for determining the portion of such
   other positions which shall be taken into account for
   purposes of this section."  To the best of my knowledge
   these regulations have never been issued.  Consequently, if
   you owned 1,000 shares of a stock (purchased at different
   times and prices) and sold five calls expiring in 25 days,
   the implications are not defined.  Would the straddle
   consist of 1,000 shares of stock and five call options, or
   500 shares and five call options?  If only 500 shares were
   included, which 500 shares would it be?

(3)  IRS regulations assumed strike prices would be set at
   regular intervals for listed options.  Due to splits,
   mergers, and FLEX options it is possible that there may be
   nonstandard strike prices for a particular stock.  When
   determining the "lowest qualified benchmark" (LQB) to
   determine it an in-the-money call is qualified, it is not
   totally clear if you have to consider these nonstandard
   strike prices.  Until there is some clarification from the
   IRS the regulations, as written, imply they should be
   included.  As a result, if you sell two options with
   identical strike prices on two stocks with identical price
   quotes, one may be qualified and the other not qualified.

Observations

(1)  I have several times heard people say they were told
   premiums you received from covered calls were not taxable
   until the underlying stock was sold. I don't care whether
   you heard it from your broker, your father, your minister,
   your CPA or your cocker spaniel, IT IS NOT TRUE.

(2)  I have heard a number of people recommend always
   selling covered calls for the next month immediately after
   expiration of calls sold for the current month.  Since there
   are frequently less than 30 days between the third Fridays
   of two consecutive months, this strategy will generate
   straddles.  If you plan to hold the stock for over a year to
   achieve long-term capital gains status, such sales will
   defeat your plan.

References

http://www.cboe.com/resources/tax.htm

http://ftp.fedworld.gov/pub/irs-pdf/p550.pdf

Determining if an option is deep-in-the-money, in-the-money,
or out-of-the-money by my interpretation of IRS regulations.

(1)  Find the closing price of the stock the last day it
   traded and the opening price of the stock the day you wrote
   the option.

(2)  Determine the applicable stock price by comparing 110%
   of the closing price to the opening price.  If the opening
   price is greater use it as the applicable stock price,
   otherwise use the closing price.

(3)  If the strike price is greater than or equal to the
   applicable stock price it is considered out-of-the-money.

(4)  If the strike price is not out-of-the-money you need to
   determine the lowest qualified benchmark (LQB) for the
   stock.

   (a)  If the applicable stock price is $25 or less, the LQB
      will never be less than 85% of the applicable stock price.
   (b)  If the applicable stock price is $150 or less, the LQB
      will never be less than $10 below the applicable stock
      price.
   (c)  Unless restricted as noted above the LQB is
      (i)  the highest available strike price less than the
           applicable stock price, or
      (ii) the second highest available strike price less than the
           applicable stock price if the strike price is more than $50
           and the option has a term of more than 90 days.

(5)  If the strike price is less than the LQB the option is
   considered deep-in-the-money.  If the strike price is equal
   to the LQB or between the LQB and the applicable stock price
   it is considered in-the-money but not deep-in-the-money.
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