Tracy Byrnes
If you trade OTC options or LEAPS, listen up. Uncle Sam has spoken.
, or long-term options that have more than one year before expiration. Opposition to this part of the regulations is expected, said Robert Willens, tax strategies guru and managing director of Lehman Brothers. The crux of the proposed regulations surround the villainous qualified covered call rules, which, in simplest terms, allow you to keep your holding period -- the amount of time you've held the stock -- when you write an option against your long stock positions. Why do you care about this? Because, as with all things taxwise, the goal is hold a position for more than 12 months to qualify for the 20% long-term capital-gains rate. So you need your holding period clock to keep ticking. But in many instances, writing a call on your existing shares could terminate your holding period, ruining any hope for long-term capital gain treatment. Understanding these rules could save you from forking over too much money to Uncle Sam. As with all tax issues surrounding options, this stuff ranks right up there on the difficulty-meter with molecular biology, so hold on for a wild ride. What's a Qualified Covered Call?
A call option is the right, but not the obligation, to buy a specific amount of a given stock at a specified price by a certain date. One option contract typically represents 100 shares of stock and it expires on the third Friday of each month. A call is "covered" when you own the underlying stock. So if you wrote (i.e. sold) a call option on your Microsoft (MSFT Quote - Cramer on MSFT - Stock Picks) shares, you now have a covered call, according to the tax rules. There are ways that calls (and puts) can be used to significantly reduce the risk of a stock holding, says Jim Bittman, a senior instructor at the Chicago Board Options Exchange. And that's a good thing -- for investment purposes. But remember, the IRS never will let you have your cake and eat it, too. So if your risk is reduced too much by the use of options, the IRS will step in and take away any beneficial tax treatment. In this case, the holding period on your long position will be terminated. Once the call is closed, the holding period on your long shares then will start over. Suppose you have a big capital gain in stock held for 10 months that's trading around $74, and you write a "deep in the money" call on that position (meaning the strike price of the call option is much less than the share price of the underlying stock). Let's assume you write the call at $60. That means if your stock tanks to $55, the option expires worthless and you keep the money you were paid for it. You also get to keep your stock. In this instance, you've reduced your risk, because even if your stock tanks, you have generated some gains, through the money you received from the option, to offset that loss. So your holding period now becomes zero, according to the IRS. When the call is closed two months later, you do not qualify for long-term capital gain treatment. But that covered call becomes "qualified" when you write (sell) a call that is up to one or two strikes in the money, depending on the length of time to maturity, stock price and strike price of the option, says Richard Shapiro, an Ernst & Young securities tax partner and author of CBOE's Taxes & Investing booklet. In our example, you would write the option at, say, $70. Then the risk of your investment is not substantially reduced, so your holding period only is suspended. You still can qualify for the long-term capital gain rates if you hold the stock naked for two more months after you unwind the option. Big note: The rules surrounding qualified covered calls are convoluted. Check out the tax section of the CBOE's Web site for more details.The Good News and the Bad News
Up until now, only listed options could be eligible for the qualified covered call rules, says Shapiro. But the proposed rules expand the scope of these rules to include over-the-counter options as well as options with flexible terms. "That's a material change to how the option world works," Shapiro said. And since the market for OTC options is exploding these days, many folks could benefit, taxwise, from these regulations. "The goal is to put OTC options on level playing with listed options," according to Shapiro. On the flip side, the proposed regulations narrow the definition of qualified covered calls to exclude LEAPS, says Willens. LEAPS -- or Long-term Equity Anticipation Securities -- are options with expiration cycles as long as two years. Unlike traditional options that expire within months, LEAPS are set to expire in January of each of the next two calendar years. Why eliminate LEAPS? It comes down to intent. The IRS believes that if you're writing covered LEAPS, you clearly are in the market to diminish your risk of loss, Willens says. So you should not qualify for beneficial tax treatment, to boot. Again, there's a big market in long-term options, so it's no surprise that people would be upset, Shapiro said.It's Just a Proposal
Fortunately, these disgruntled traders have the, uh, option to speak their mind. A public hearing is scheduled for May 9 and the IRS should anticipate some lobbying, says Willens. These proposed regulations do not go into effect for 90 days after they are finalized. And we are now at the mercy of President George W. Bush and his team to accept or reject these proposed regulations. So nothing is in stone. Nevertheless, it's big news in the options world and traders should stay tuned.Send your questions and comments to investorforum@thestreet.com, and please include your first and last names. Investor Forum appears Tuesdays, Thursdays and Saturdays.
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