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Stock Index Options - Determining When They Are Subject to the Mark-to-Market Rules
As previously discussed, an investor is generally taxed on investments in futures contracts, as well as exchange listed non-equity options and stock index options (and certain foreign currency contracts) under a special set of "mark-to-market" rules pursuant to Internal Revenue Code Section 1256, rather than under basic federal income tax principles that focus on the disposition or sale of investments as triggering "recognized" gain or loss. 

5/24/07

Under the Section 1256 mark-to-market rules, you generally treat contracts and options subject to the rules as sold at fair market value at the end of your tax year for purposes of computing taxable gains and losses.  For more general information, see GainsKeeper Blog entry dated 5/7/2007.

What Contracts Are Treated as Section 1256 Contracts Subject to These Rules?

The following types of contracts are Section 1256 contracts: 1) regulated futures contracts (futures contracts); 2) certain qualifying foreign currency contracts; 3) "nonequity options" (this definition is discussed in more detail below); 4) dealer equity options and 5) dealer securities futures contracts. 

For most individual investors, the two types of Section 1256 contracts that they are most likely to hold are futures contracts and nonequity options.  Some may also hold foreign currency contracts treated as Section 1256 contracts but the determination of which foreign currency contracts are Section 1256 contracts and which are not (particularly because of the requirement that such contracts must be traded in the interbank market) is beyond the scope of this discussion.

It is clear whether an investor holds a futures contract because all futures contracts are exchange traded and therefore should be readily identifiable as such.  However, there is a tricky and confusing aspect of the definition of a Section 1256 contract.  The determination of whether an option constitutes a "nonequity option" subject to the Section 1256 mark-to-market rules can be difficult.

As a threshold matter, only exchange listed options fall within the definition.  Thus, if an option is truly over-the-counter (rather than traded on an exchange), such option generally avoids the Section 1256 mark-to-market rules.

The dicey part is determining whether an option is a nonequity option.  The rule provides that any option other than an "equity option" is a nonequity option and then defines the term equity option.  An equity option is an option to buy or sell stock.  An equity option also includes an option on a group of stocks or a stock index, but only if "narrow-based," as determined under U.S. securities laws.  The definition of narrow-based has gotten smaller due to revisions in federal securities laws enacted in 2000.  An index is narrow-based if: 1) it contains nine or fewer stocks or securities; 2) no more than 30% of the group or indices value is attributable to a single stock or security; and 3) no more than 60% of the group or indices value is attributable to the five largest stocks or securities (by value).  Any index that does not qualify is narrow-based is considered broad-based.  Certain indices that may have been considered narrow-based under prior law may now be considered broad-based, changing the applicable tax treatment as described below.  Also, foreign equity index warrants are subject to the same rules and are generally treated as Section 1256 contracts.  How do you sort through all this?

First, determine if the option is listed on an exchange.  If not, then the option is not a Section 1256 contract subject to the mark-to-market rules.  Second, determine if the option relates to a single stock, a group of stocks or a stock index.  If the option relates to a single stock, it is not a Section 1256 contract.  If it relates to a group of stocks or a stock index, determine whether the group or index would qualify as narrow-based under applicable securities laws.  If so, the option is not a Section 1256 contract.  However, if the option relates to a broad-based index or group of stocks, or otherwise does not fit into the exceptions described, it would generally appear to qualify as a Section 1256 contract subject to the mark-to-market rules.

The IRS discusses the broad-based index requirement under "Cash-settled options" in its discussion of Section 1256 contracts in Chapter 4 of IRS Publication 550, "Investment Income and Expenses" (available from the IRS at www.irs.gov ) 

Options on ETFs and Stock Index Funds

"ETF" is an abbreviation for "exchange traded fund."  Exchange traded funds are new and a number of different kinds have emerged as this market has rapidly expanded.  Another new product is an "exchange traded note" (ETN) which is not discussed here. 

An exchange traded fund is an investment vehicle made up of a typically fixed portfolio of stocks (although some include bonds instead) that usually mirrors a particular stock index or tracks a specific sector of the stock market.  They have generally been fixed pools with little or no management activity.  There are several different brands of ETFs available in the market and they are popular investment vehicles.  Particular trade-marked brand of ETFs are "SPDRs," "iShares," and "QQQs."  An ETF is typically taxed as a mutual fund under tax rules for regulated investment companies and its shares are generally treated as stock for tax purposes.  However, some are taxed as grantor trusts or partnerships and their interests are not treated as stock and this difference could affect their tax treatment.

A stock index fund is an investment vehicle that holds a portfolio of stock that also matches a particular stock index.  However, the match may not be identical and the fund may somewhat or actively manage the portfolio.  As a result of portfolio management and management fees, the value of stock index fund shares will generally not quite track the related index, even though it may come close.  Similar tax treatment for stock index funds and their shares applies.

There are listed options available for certain index-linked ETFs.

There is no specific guidance regarding whether listed options on broad-based index-linked ETFs are treated as Section 1256 contracts.  On one hand, the option relates to the ETF share, which is typically treated as stock.  Thus, such an option would appear to fall within the definition of an equity option and would not be treated as a Section 1256 contract, thereby escaping the Section 1256 mark-to-market rules.  On the other hand, it is often said that the IRS challenges things that taxpayers do indirectly that they are not permitted to do directly.  So if the IRS were to consider such options as equivalent to listed options on broad-based stock indices, it is possible that the IRS could challenge such treatment and attempt to tax such options as Section 1256 contracts.  Whether the IRS would do so and whether it would be successful would appear unclear, at best. 

The Section 1256 rules were amended in 1984 in part to subject cash settled options to the mark-to-market rules and prevent taxpayers from treating certain commodity options as subject to the rules while treating others as not.

It should be noted that the IRS did issue Revenue Ruling 94-63 treating certain listed broad-based equity options as Section 1256 contracts.  The ruling also treated certain warrants based on a stock index as Section 1256 contracts because they "are economically, substantially identical in all material respects to options based on a stock index.." and therefore should be treated the same.  This was true even though the warrants were written by a corporation that was solely obligated to make cash payments on the warrants.  However, there could be several key reasons a tax advisor could consider important in determining why a warrant on a stock index is not the same as an option on an ETF or stock index fund.  Whether Revenue Ruling 94-63's treatment of such warrants provides any additional insight into how the IRS might view listed options on ETFs or other index funds—good or bad, is also unclear.

There is no specific guidance by the IRS on listed options on ETFs in its discussion of Section 1256 contracts in Chapter 4 of IRS Publication 550, referenced above.

Given the lack of guidance, what should an investor holding such options do?  A discussion with a tax advisor seem advisable.  A literal reading of the definition of equity options suggests that such options are not subject to Section 1256.  However, a tax advisor knows that it is critical to consider all the relevant facts and common tax law principles in determining the appropriate tax treatment and not to simply rely on a literal interpretation of the Code.  Thus, regardless of how a taxpayer decides to treat such options the proper answer might not be as clear as it first seems. 

As the great sage Obi-Wan Kenobi said in the 1977 film Star Wars IV: A New Hope: "Remember Luke, to use the force!"

Stevie

DISCLAIMER: The information and views set forth in GainsKeeper Tax Topics are general in nature and are not intended as legal, tax, or professional advice. Although based on the law and information available as of the date of publication, general assumptions have been made by GainsKeeper Tax Topics which may not take into account potentially important considerations to specific taxpayers. Therefore, the views and information presented by GainsKeeper Tax Topics may not be appropriate for you. Readers must also independently analyze and consider the consequences of subsequent developments and/or other events. Readers must always make their own determinations in light of their specific circumstances.