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Trading Stock Options Appendix

Income Tax Treatment Of  "Put" And "Call" Option Transactions

For non-legal explanation of trading stock options see headings 1-35 of Chapter 1 and 1-9 of Chapter 2 of this website (see index left).

Trading Stock Options Under the Internal Revenue Code of 1954

Revenue Ruling 58-234 and Other Rulings in Effect May 19, 1958

Prepared by Brach, Gosswein & Lane Certified Public Accountants

© 1958 Put & Call Brokers & Dealers Association, Inc.

Description of Transaction

I. PUTS

  1. As to the purchaser (optionee) of put

    1. Tax treatment of amount paid for put (premium) prior to its being exercised or its expiration

    2. Tax treatment of amount paid for put (premium) when put is not exercised but is held to expiration

    3. Tax treatment of amount paid for put (premium) when put is exercised

    4. Acquisition of a put as a short sale
Income Tax Treatment

In trading stock options, amount paid is to "be carried to a deferred account as a capital expenditure made in an in completed transaction entered into for profit."

Amount paid is capital loss for the year in which the put expired by limitation of time. If put has been held for not more than 6 months loss is short-term. If it has been held for more than 6 months loss is long-term. (Specific provision in Section 1234 I.R.C. 1954.) But if transaction falls within exception in (5) the amount paid is an addition to the cost of the related stock.

Upon exercise of put the purchaser (optionee) sells the property to which the put relates to the writer (optionor) for the option price. The amount paid for the put is a reduction of the proceeds of sale.

The acquisition of a put constitutes a short sale. If, at the time the short sale is made, taxpayer holds the related security which he has held for not more than 6 months, or, if while the short sale is open he acquires such security, the holding period of the security does not start until the date of the closing of the short sale. The exercise of the option, or the expiration thereof is considered as the closing of the short sale. (Sec. 1233(b) I.R.C. 1954) (This point is not covered in Revenue Ruling 58-234.) But see exception in (5) following.

Description of Transaction

I. PUTS (Continued)

  1. As to the purchaser (optionee) of put (continued)

    1. Exception if put is acquired on same date as related security is purchased

    2. Tax treatment if put is sold

  2. As to writer (issuer or optionor) of put

    1. Tax treatment of amount received for writing or issuing put (premium) prior to its being exercised or its expiration
Income Tax Treatment

In trading stock options, if put is acquired on the same day on which the security identified as intended to be used in exercising the put is acquired, and if the put, if exercised, is exercised through the sale of the property so identified, the acquisition of the put is not treated as a short sale. However, if the put is not exercised, the cost of the put must be added to the cost of the related stock (Section 1233(c) I.R.C. 1954). An informal and unpublished ruling holds that, if taxpayer sells the put instead of exercising it, the exception of Section 1233 (c) will not be applicable and the acquisition of the put will be considered a short sale.

Gain or loss on sale is capital gain or loss (except in the case of a dealer); long-term, if put has been held for more than 6 months, short-term, if held for not more than 6 months. (Section 1234 I.R.C. 1954.) If Section 1233(b) is applicable, by reason of long position in related security, gain on sale of put will be short-term, even though put has been held for more than 6 months if sale of put is considered "closing" of short sale. No opinion is expressed on this point for reason that law and regulations are not clear.

Amount received is to be carried in a deferred account. No tax consequences until put is exercised or expires.

Description of Transaction

I. PUTS (Continued)

B. As to writer (issuer or optionor) of put (continued)

  1. Tax treatment of amount received for writing or issuing put (premium) when put is not exercised but expires

  2. Tax treatment of amount received for writing or issuing put (premium) when put is exercised by purchaser thereof
  1. Holding period of security purchased by exercise of put by purchaser thereof

II. CALLS

A. As to purchaser (optionee) of call

  1. Tax treatment of amount paid for call (premium) prior to its being exercised or its expiration

  2. Tax treatment of amount paid for call (premium) when call is not exercised but is held to expiration
Income Tax Treatment

In trading stock options, amount received constitutes ordinary income for the year in which the failure of the holder to exercise the option becomes final. This is so, because, under Section 61,1.R.C. 1954, all income is ordinary income unless otherwise provided, and Section 1234, which deals with options to buy and sell, contains no reference to the gain from the failure to exercise an option.

Upon exercise of put, the writer (optionor) buys the security at the option price. The amount received for writing the option (premium) constitutes an offset against the amount paid in determining the net cost basis of the security purchased.

Holding period of the security purchased starts the date the put is exercised, and not the date the put was issued.

Amount paid is to "be carried to a deferred account as a capital expenditure made in an incompleted transaction entered into for profit."

Amount paid is capital loss for the year in which the call expired by limitation of time. If call has been held for not more than 6 months, loss is short-term. If it has been held for more than 6 months, loss is long-term (specific provision in Section 1234 I.R.C. 1954).

Description of Transaction

II. CALLS (Continued)

A. As to purchaser (optional) of call (continued)

  1. Tax treatment of amount paid for call (premium) when call is exercised
  1. Holding period of security acquired through exercise of call
  1. Acquisition of call as short sale

  2. Call as substantially identical property

  3. Tax treatment if call is sold

B. As to writer (issuer or optionor) of call

  1. Treatment of amount received for writing or issuing call (premium) prior to its being exercised or its expiration
Income Tax Treatment

In trading stock options, amount paid is an addition to the cost of the stock purchased on the exercise of the call.

Holding period of the security purchased starts on the date the call is exercised and not the date the call was acquired.

The acquisition of a call (unlike the acquisition of a put) does not constitute a short sale. Section 1233(b) does not relate to calls.

The call and the related security are not substantially identical properties. Hence, gain on sale of call held for more than 6 months is long-term gain, even though a short sale of the related security was made during period call was held. (Letter ruling dated February 27, 1957, published in Tax Services)

Gain or loss on sale is capital gain or loss (except in the case of a dealer); long-term if call has been held for more than 6 months, short-term if held for not more than 6 months. Short sale of related security does not kill holding period (see [5] above). (Section 1234, I.R.C. 1954)

Amount received is to be carried in a deferred account. No tax consequences until call is exercised or expires.

Description of Transaction

II. CALLS (Continued)

B. As to writer (issuer or optionor) of call (continued)

  1. Tax treatment of amount received for writing or issuing call (premium) when call is not exercised but expires

  2. Tax treatment of amount received for writing or issuing call (premium) when call is exercised
Income Tax Treatment

In trading stock options, amount received constitutes ordinary income for the year in which the failure of the holder to exercise the option becomes final. This is so, because, under Section 61,1.R.C. 1954 all income is ordinary income unless otherwise provided and Section 1234, which deals with options to buy and sell, contains no reference to the gain from the failure to exercise an option.

Upon exercise of call, the writer (optionor) sells the security at the option price. The amount received for writing the option (premium) is added to the amount received as the option price, in arriving at the gain or loss on the sale of the security. (IT 3835 C.B. 1947-1, p. 53)

Description of Transaction

III. GENERAL PROVISIONS

Adjustments for cash dividends, stock rights, stock dividends and stock splits

Income Tax Treatment

In trading stock options, under common trade practice, the purchaser (optionee) of a call who exercises it is entitled to receive from the writer (optionor) an amount equal to all cash dividends, regular or extra, plus the market value of all rights accrued on the security involved (determined on the basis of the first sale of rights on the day the stock sells ex-rights). To reflect this right, the option price is reduced by such amount and the purchaser (optionee) pays the writer (optionor) the adjusted option price. A similar adjustment of the option price is made in the case of a put. In that case, the price which the writer (optionor) pays the purchaser (optionee) is reduced by the amount of such cash dividends and the value of such rights. The number of shares to which the option relates is increased to reflect the additional shares which would be received during the life of the option on the shares originally covered by the option by reason of stock dividends or stock splits and the option price per share is correspondingly reduced, the total option price remaining unchanged. The cash adjustment for cash dividends and rights is not ordinary income but is a reduction of the option price, whether the option price is adjusted or the cash adjustment is made separately. (Revenue Ruling 58-234) (see also IT 4007, C.B. 1950-1, p. 11 and Revenue Rulings 56-153 and 56-211).


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