Series 7: Taxes and Tax Shelters (Taxation of Equity Options)

A customer buys 100 shares of ABC stock for $12,500. Over the next 2 years, the customer sells ABC Call contracts for an aggregate premium of $1,500. The call contracts expired unexercised. After expiration, the customer's cost basis in the ABC shares is:

$12,500 The expiration of the call contracts results in a short term capital gain to the writer of $1,500, taxable in the year of expiration. The cost basis of the stock position is unaffected at $12,500 per share. Notice that this tax treatment is the one that is most beneficial to the IRS; and worst for the investor. The call premium is taxed as a short term capital gain at expiration; it cannot be used to reduce the cost basis of the long stock position, which has the same effect as increasing the potential capital gain on the stock.

A customer sells short 100 shares of ABC stock at $63 per share. The stock falls to $47, at which point the customer writes 1 ABC Sept 45 Put at $2. The stock falls to $36 and the put is exercised. The customer's gain per share is:

$20 The customer sold the stock short at $63 per share (sale proceeds). Later, the customer sold a Sept 45 Put @ $2 on this stock. If the short put is exercised, the customer is obligated to buy the stock at $45 per share. Since the customer received $2 in premiums when the put was sold, the net cost to the customer is $43 per share for the stock (this is the cost basis in the stock for tax purposes). The stock that has been purchased is delivered to cover the short sale, closing the transaction. The customer's gain is: $63 sale proceeds - $43 cost basis = 20 point gain.

A customer sells short 100 shares of ABC stock at $50 per share. The stock falls to $40, at which point the customer writes 1 ABC Sept 40 Put at $4. The stock falls to $30 and the put is exercised. The customer's cost basis upon exercise of the put is:

$36 The customer sold the stock short at $50 per share (sale proceeds). Later, the customer sold a Sept 40 Put @ $4 on this stock. If the short put is exercised, the customer is obligated to buy the stock at $40 per share. Since the customer received $4 in premiums when the put was sold, the net cost to the customer is $36 per share for the stock (this is the cost basis in the stock for tax purposes). The stock that has been purchased is delivered to cover the short sale, closing the transaction. The customer's gain is: $50 sale proceeds - $36 cost basis = 14 point gain.

A customer buys 1 ABC Jan 55 Put @ $9 when the market price of ABC is $50. The put is exercised when the market price is $40. For tax purposes, the sale proceeds are:

$4,600 When a put is exercised, a holder is selling the stock at the strike price. The premium paid for the put reduces the sale proceeds. The stock is being sold at $55, but since $9 was paid in premiums, the net sale proceeds are $46 per share or $4,600 for the contract. Note that this is the same as the breakeven point.

A customer sells 1 ABC Oct 50 Call @ $3 and the contract is exercised. What are the sale proceeds for tax purposes?

$53 When a call contract is exercised, the writer is selling the stock. The sale proceeds are equal to all monies received for the stock - $50 per share strike price plus $3 per share received in premiums equals a $53 per share sale proceeds. Notice that this is the same as the breakeven.

A customer buys 100 shares of XYZ stock at $51 and buys 1 XYZ Jan 50 Put @ $4 on the same day. The put expires and the stock is sold in the market for $59. For tax purposes, what is the cost basis of the stock?

$55 When a put is purchased on a stock on the same day that the stock is bought, the put is said to be "married" to the stock position. The only reason the option was purchased was to protect the customer against loss if the market for the stock fell. It was not purchased to speculate in the market. The IRS treats a "married" put as part of the cost basis of the stock. Notice that, therefore, the put premium cannot be deducted as a capital loss if the put expires worthless; instead, it has increased the stock's cost basis and will reduce any potential capital gain, when, and if, the stock is sold. As one would expect, this is the tax treatment that is most beneficial to the IRS and least beneficial to the investor. The cost of the stock is $51 + $4 premium = $55 per share. When the stock is sold at $59, the customer reports a 4 point capital gain.

A customer sells short 100 shares of ABC stock at $74 per share. The stock falls to $66, at which point the customer writes 1 ABC Sept 65 Put at $3. The stock falls to $58 and the put is exercised. The customer's cost basis upon exercise of the put is:

$62 The customer sold the stock short at $74 per share (sale proceeds). Later, the customer sold a Sept 65 Put @ $3 on this stock. If the short put is exercised, the customer is obligated to buy the stock at $65 per share. Since the customer received $3 in premiums when the put was sold, the net cost to the customer is $62 per share for the stock (this is the cost basis in the stock for tax purposes). The stock that has been purchased is delivered to cover the short sale, closing the transaction. The customer's gain is: $74 sale proceeds - $62 cost basis = 12 point gain.

In January, a customer buys 100 shares of ABC stock at $50. Eleven months later in December, the stock is trading at $60. The customer buys 1 ABC Feb 60 Put @ $3. In February, the stock is trading at $51 and the customer exercises the put. The tax consequence is:

$700 short term capital gain If a customer buys stock and does not buy a put on the same day, then the put is not married to the stock. The worry of the IRS is that the customer might attempt to buy a put on stock that has appreciated in value to lock in a gain while the holding period is short-term, and then simply wait until the holding period is long term to sell the stock (either in the market or by exercising the put and be taxed at the lower 15% rate) without having been at risk. So if the put is purchased when the stock is held short-term, the IRS wipes out the holding period and it does not start counting again until the put expires (and it starts from day 1 at this point). In this example, the customer bought the stock at $50 and11 months later when the stock is at $60, bought a 60 Put. This wipes out the stock's holding period. When the stock is sold via the exercise of the put, the stock is sold for $60 Strike - $3 Premium = $57 Sale Proceeds. The customer's Cost Basis is $50, so the customer has a $700 gain, and it is short term because the customer has no holding period!

Which of the following can affect the holding period of a stock held short term?

Buy a put The best answer is B. If a customer buys stock and does not buy a put on the same day, then the put is not married to the stock. The worry of the IRS is that the customer might attempt to buy a put on stock that has appreciated in value to lock in a gain while the holding period is short-term, and then simply wait until the holding period is long term to sell the stock (either in the market or by exercising the put and be taxed at the lower 15% rate) without having been at risk. So if the put is purchased when the stock is held short-term, the IRS wipes out the holding period and it does not start counting again until the put expires (and it starts from day 1 at this point). Note that if the put is married to the stock on the same day, the stock's holding period counts normally; and if the stock was already held long term when the put was purchased, then the investor was not trying to stretch a short term capital gain to a long term capital gain without being at risk, and the holding period counts normally.

When a stock and a put option on that stock are purchased on the same day, which of the following statements are TRUE? I The put option is said to be "married" to the stock II The put option is said to be "covered" by the stock III The premium paid for the put option is treated as part of the cost basis of the stock IV The premium paid for the put option is treated independently of the stock position

I and III When a put is purchased on a stock on the same day that the stock is bought, the put is said to be "married" to the stock position. The only reason the option was purchased was to protect the customer against loss if the market for the stock fell. It was not purchased to speculate in the market. The IRS treats a "married" put as part of the cost basis of the stock. Notice that, therefore, the put premium cannot be deducted as a capital loss if the put expires worthless; instead, it has increased the stock's cost basis and will reduce any potential capital gain, when, and if, the stock is sold. As one would expect, this is the tax treatment that is most beneficial to the IRS and least beneficial to the investor.

A customer buys 100 shares of a stock and sells a call against the stock position. If the call contract expires unexercised, which of the following statements are TRUE regarding the tax consequence of the stock and option positions for the customer? I The expired call results in a short term capital gain to the customer II The expired call results in no gain or loss until the stock position is sold III The cost basis of the stock decreases by the amount of the call premium received IV The cost basis of the stock is unaffected by the call premium received

I and IV The expiration of the call contracts results in a short term capital gain for the customer, taxable in that year. The cost basis of the stock position remains unaffected. There is no "linkage" between the two positions for tax purposes. Notice that this tax treatment is the one that is most beneficial to the IRS; and worst for the investor. The call premium is taxed as a short term capital gain at expiration; it cannot be used to reduce the cost basis of the long stock position. This has the same effect as increasing the potential capital gain on the stock.

A customer buys 2 ABC Jul 45 Calls @ $5. The customer lets the contracts expire when the market price is $40. Which statement is TRUE?

The customer has a capital loss of $1,000 If the holder of an option contract allows the option to expire, he or she has a capital loss equal to the premium paid as of the expiration date. Since there are 2 contracts, the customer has lost the $500 premium paid x 2 = $1,000 capital loss.

A customer has written 1 ABC Jan 50 Put @ $3. The contract is exercised. The tax consequence to the writer is a:

cost basis of $4,700 If the writer of a put is exercised, he must buy the stock at the strike price. The premium received is a reduction of the cost of buying the stock. The writer of the put must buy 100 shares at $50 ($5,000), but he or she received $300 in premiums for writing the contract, so the adjusted cost basis is $4,700 for 100 shares.

Gain or loss on all of the following options positions will be short term EXCEPT for those realized from:

long equity LEAP options Since regular stock options have a maximum life of 8 months, all gains and losses are short term. Regarding equity LEAPs, these are Long Term Equity AnticiPation options with lives of 28 months. Thus, a purchaser who buys a LEAP when it first starts trading, must have held the contract for over 1 year when it expires - thus, the holder has a long term capital loss. The writer (seller) of a LEAP that expires will always have a short term capital gain at expiration, or of the contract is traded, because the IRS views the writer as a "short seller" who never had a holding period in the position.

A customer sells 1 ABC Jan 50 Call @ $4 when the market price of ABC is $51. The stock then moves to $58 and the customer is exercised. The tax consequence upon exercise is a:

sale proceeds of $5,400 If a writer of a call is exercised, he or she is selling the stock. The customer's sale proceeds is the sale price of the stock ($50) plus the premium received ($4) = $54. Notice that this is the same as the breakeven. No taxable event occurs until the stock is bought.

A customer is short 1 ABC Jan 90 Put @ $5. The put is exercised when the market price of ABC is $80. The cost basis of the shares is:

strike price minus premium If a short put is exercised, the writer is required to buy the stock at the strike price ($90). Since $5 per share was received in premiums, the writer's cost of the stock is $85 per share for tax purposes. Note that this is the same as the breakeven on the position, which is the strike price minus the premium.

A customer is long 1 ABC Jan 90 Call @ $5. The call is exercised when the market price of ABC is $100. The cost basis of the shares is:

strike price plus premium If a long call is exercised, the holder is buying the stock at the strike price ($90). Since $5 per share was paid in premiums, the holder's cost basis is $95 per share for tax purposes. Note that this is the same as the breakeven on the position, which is the strike price plus the premium.