Rev. Rul. 78-182

Advice has been requested concerning the Federal income tax consequences to the holders and writers of "puts", "calls", and "straddles" purchased, sold or "closed out" in transactions on the Chicago Board Options Exchange, Incorporated (CBOE).

The purchaser of a "call" option pays a sum of money to the writer of said option for the right to purchase from the writer, at any time before a specified future date, a stated number of shares of stock at a specified price. The holder of the option is not obligated to purchase the stock that is the subject of the option. Thus, if the market value of such stock were to fall below the price specified in the option contract, the holder normally would not exercise the option and would allow it to lapse. On the other hand, if the market value of the underlying stock were to rise above the price specified in the option contract, the holder probably would exercise the option before it lapses.

The purchaser of a "put" option pays a sum of money to the writer of said option for the right to sell to the writer, at any time before a specified future date, a stated number of shares of stock at a specified price. As is the case with a call of option, the holder of a put is not obligated to exercise the option. Thus, if the market value of the stock that is the subject of the option were to rise above the price specified in the option contract, the holder of the put normally would not exercise the option and would allow it to lapse. On the other hand, if the market value of the underlying stock were to fall below the price specified in the option contract, the holder most likely would exercise the put before it lapses.

A straddle is a simultaneously written combination of a call and a put on the same number of shares of a security at the same price during the same period of time. The call and put components of a straddle are generally purchased by different holders. The holder of the call or put component of a straddle would normally exercise such option under the same circumstances as the holder would a call or a put that did not originate as part of a straddle. The CBOE is a national securities exchange that has established a national market in option contracts for the purchase and sale of puts, calls, and straddles. The Chicago Board Options Exchange Clearing Corporation (OCC) is a subsidiary of the CBOE and functions as a clearing house for all transactions on the CBOE.

Before formation of the CBOE, option contracts for the purchase and sale of stock could not be purchased through organized exchanges. The writer and holder of an option transacted over-the-counter are tied together in a direct contractual relationship where the writer is personally obligated to respond to the decision of a particular holder, and that holder may demand performance only from that particular writer.

By marketing through the CBOE, the writer of a put or call deals directly with the OCC. Thus, the writer is paid by the OCC for writing the option, and is obligated only to the OCC to perform in the event the option is exercised.

Through the medium of the CBOE, the OCC sells an option for each option it acquires. The purchaser of an option looks only to the OCC for performance in the event that the purchaser should elect to exercise the option. There is no direct contractual relationship between the writer and holder of an option. However, if a holder of an option were to obligate the OCC by exercising the option, then the OCC would cause a writer of an equivalent option to perform.

The CBOE has also established a procedure whereby the writer of an option may terminate the contract. The writer of an option accomplishes this by declaring a closing transaction, whereupon the OCC will purchase an equivalent option either from a new writer or from a holder wishing to terminate the contract. The OCC will pay to the writer or terminating holder of the equivalent option an amount representing the fair market value of such option at that time, and such amount will likewise be paid to the OCC by the closing writer. The closing writer will thereupon be released from the obligation under the option written.

The following rulings are based on the assumption that, with respect to the tax consequences to the holder, the securities that are the subject of the options are capital assets in the hands of the holder or would be if acquired by the holder, and with respect to the tax consequences to the writer, the option is not granted in the course of the writer's trade or business of granting options.

A. Holder of a call

1. Ruling: The cost of the call is a nondeductible capital expenditure.

Analysis: Rev. Rul. 58-234, 1958-1 C.B. 279, states, at page 283, that it is evidence from the nature and consequences of put and call option premiums and obligations, that there is no Federal income tax incident on account of either the receipt or the payment of such option premiums, that is, from the standpoint of either the optionor or the optionee, unless and until the options have been terminated, by failure to exercise, or otherwise, with resultant gain or loss.

2. Ruling: If the call is sold prior to exercise, any gain or loss recognized to the holder is capital gain or loss, and is short-term or long-term, depending upon the holding period of the call.

Analysis: Section 1234(a)(1) of the Internal Revenue Code of 1954 provides that gain or loss attributable to the sale or exchange of, or loss attributable to failure to exercise, an option to buy or sell property shall be considered gain or loss from the sale or exchange of property that has the same character as the property to which the option relates has, or would have, in the hands of the taxpayer. Thus, if the stock to which the option relates would be a capital asset in the hands of the option holder, capital gain or loss results from the sale of a call prior to its exercise. Under section 1222, such capital gain or loss would be long-term or short-term depending on how long the taxpayer held the call prior to its sale.

3. Ruling: If the call is allowed to expire without exercise, the expiration is treated as a sale or exchange of the call on the expiration date. The resultant loss is a capital loss, and is short-term or long-term, depending on the holding period of the call.

Analysis: Section 1234(a)(2) of the Code provides that if a loss is attributable to the failure to exercise an option, the option shall be deemed to have been sold or exchanged on the day it expired. Thus, under the rules of sections 1234(a)(1) and 1222, the loss will be treated as long-term or short-term capital loss depending on the holding period of the call.

4. Ruling: If the call is exercised, its cost is added to the basis of the stock purchased.

Analysis: Rev. Rul. 58-234 states, at page 286, that when an option to buy property (a call) is exercised, the option cost (premium) should be included by the optionee, with the option price thereupon paid or accrued, in determining the (total) cost basis of the property that the optionee purchased pursuant thereto, for subsequent gain or loss purposes.

B. Writer of a call

1. Ruling: The premium received for writing the call is not included in income at the time of receipt, but is carried in a deferred account until (1) the writer's obligation expires through the passage of time, (2) the writer sells the underlying stock pursuant to the exercise of a call, or (3) the writer engages in a closing transaction.

Analysis: Rev. Rul. 58-234 states, at page 283, that there is no Federal income tax incident on account of either the receipt or the payment of such option premium, that is, from the standpoint of either the optionor or the optionee, unless and until the options have been terminated, by failure to exercise, or otherwise, with resultant gain or loss.

2. Ruling: If the writer's obligation expires through the passage of time, the premium is short-term capital gain to the writer upon such expiration.

Analysis: Effective for options written after September 1, 1976, section 1234(b)(1) of the Code provides that any gain to the grantor of an option arising from the failure of the holder to exercise it shall be treated as gain from the sale or exchange of a capital asset held not more than 6 months (9 months if the option expires in a taxable year beginning in 1977; 1 year if the option expires in a taxable year beginning on or after December 31, 1977).

3. Ruling: If the writer sells the underlying stock pursuant to exercise of a call, the premium received by the writer increases the amount realized upon the sale of such stock in determining gain or loss. Such gain or loss is short-term or long-term depending upon the holding period of the stock.

Analysis: Rev. Rul. 58-234 provides, at page 285, that when a call option is exercised, the amount (premium) received by the writer (issuer or optionor) for granting it is includible by the writer, with the option price, which the writer received for the securities involved upon its exercise, in the total amount realized for the securities that the writer sold pursuant thereto for the purpose of determining gain or loss on their sale. Because the stock is a capital asset in the hands of the taxpayer, the capital gain or loss resulting from the sale is short-term or long-term depending on how long the taxpayer held the stock prior to the sale under section 1222 of the Code.

4. Ruling: Section 1233(b) of the Code does not apply when a call is written, but only when stock is sold short or a put is purchased. Consequently, if a call is written at a time when the underlying stock (or a call thereon) has been held by the taxpayer for 6 months or less (9 months or less in a taxable year beginning in 1977, 1 year or less for taxable years beginning after December 31, 1977), or if the underlying stock (or a call thereon) is acquired after a call is written and before exercise or expiration of the call so written, the writing of the call does not affect the holding period of the underlying stock (or of the call thereon).

Analysis: Section 1233(b), relating to gains and losses from short sales, applies only where substantially identical property is sold short, or where a put is acquired giving the owner the right to sell substantially identical property. It does not apply where, instead of selling short or purchasing a put, the taxpayer writes a call.

5. Ruling: If the writer of a call enters into a closing transaction by payment of an amount equivalent to the value of the call at the time of such payment, the difference between the amount so paid and the premium received is short-term capital gain or loss.

Analysis: Effective for options written after September 1, 1976, section 1234(b)(1) of the Code provides that in the case of the grantor of an option, gain or loss from any closing transaction shall be treated as a gain or loss from the sale or exchange of a capital asset held not more than 6 months (9 months if the closing transaction occurs in a taxable year beginning in 1977; 1 year if the closing transaction occurs in a taxable year beginning after December 31, 1977). Section 1234(b)(2)(A) defines "closing transaction" as any termination of the taxpayer's obligation under any option in property other than through the exercise or lapse of the option.

C. Holder of a put

1. Ruling: The cost of a put is a nondeductible capital expenditure.

Analysis: Rev. Rul. 71-521, 1971-2 C.B. 313, holds that the purchase of a put is a transaction entered into without respect to any particular acquisition of shares of the stock named, for which reason the cost of a put upon its acquisition should not be entered as a part of the purchase price of any particular block of stock, but should be carried in a deferred account as a capital expenditure made in an incompleted transaction entered into for profit.

2. Ruling: If the put is sold prior to exercise, any gain or loss recognized to the holder is a capital gain or loss, and is short-term or long-term, depending on the holding period of the put.

Analysis: Section 1234(a)(1) of the Code provides that gain or loss attributable to the sale or exchange of, or loss attributable to failure to exercise, an option to buy or sell property shall be considered gain or loss from the sale or exchange of property that has the same character as the property to which the option relates has, or would have, in the hands of the taxpayer. Thus, if the stock to which the option relates would be a capital asset in the hands of the option holder, capital gain or loss results from the sale of a put prior to its exercise. Under section 1222, such capital gain or loss would be long-term or short-term depending upon how long the taxpayer held the put prior to its sale.

3. Ruling: If the put is allowed to expire without exercise, the expiration is treated as a sale or exchange of the put on the expiration date. The resultant loss is a capital loss and is short-term or long-term, depending on the holding period of the put.

Analysis: Section 1234(a)(2) of the Code provides that if a loss is attributable to the failure to exercise an option, the option shall be deemed to have been sold or exchanged on the day it expired. Thus, under the rules of sections 1234(a)(1) and 1222, the loss will be treated as short-term or long-term capital loss, depending on the holding period of the put.

4. Ruling: If the put is exercised, its cost reduces the amount realized upon the sale of the underlying stock in determining gain or loss. Such gain or loss is capital gain or loss and is short-term or long-term, depending on the holding period of the stock involved.

Analysis: Rev. Rul. 71-521 holds that if the taxpayer exercises the put, thereby causing the sale of stock involved in the put, the cost of the put is offset against the price received for the stock in order to compute the amount realized by the taxpayer for purposes of determining gain or loss on the sale of the stock. Because the stock is a capital asset in the hands of the taxpayer, the capital gain or loss resulting from the sale of the stock is short-term or long-term, depending on how long the taxpayer held the stock prior to the sale, under section 1222 of the Code.

5. Ruling: For purposes of section 1233(b) of the Code, the acquisition of a put is a short sale and the exercise, sale or expiration of the put is a closing of the short sale. If the put is acquired at a time when the underlying stock has been held by the taxpayer for 6 months or less (9 months or less if the put is acquired in a taxable year beginning in 1977; 1 year or less if the put is acquired in a taxable year beginning after December 31, 1977), or if shares of the underlying stock are acquired after acquisition of the put and before its exercise, sale or expiration, any gain on exercise, sale or expiration of the put is short-term capital gain, and the holding period of the underlying stock begins to run on the earliest of (1) the date such stock is disposed of, (2) the date the put is exercised, (3) the date the put is sold, or (4) the date the put expires.

Analysis: Section 1233(b) of the Code provides that the acquisition of a put is a short sale and the exercise or failure to exercise such option shall be considered as a closing of such short sale. Section 1233(b) also provides that if the put is acquired at a time when the underlying stock has been held by the taxpayer for 6 months or less (9 months or less if the put is acquired in a taxable year beginning in 1977; 1 year or less if the put is acquired in a taxable year beginning after December 31, 1977), or if the underlying stock is acquired after acquisition of the put and before the taxpayer exercises, or fails to exercise the put, any gain on such closing is short-term capital gain, and the holding period of the related stock begins to run on the date (1) the taxpayer disposes of such stock, (2) the taxpayer exercises the put, or (3) the taxpayer "fails to exercise" the put, whichever date occurs first. For purposes of section 1233(b), the failure to exercise a put includes the lapse of the put or the sale of the put.

6. Ruling: If a put and the stock identified to be used in its exercise are acquired on the same day, the acquisition of the put is not a short sale for purposes of section 1233(b) of the Code. If the put is exercised and if the identified stock is delivered pursuant to the exercise, the premium paid for the put reduces the amount realized on the sale. If the put is not exercised, the premium paid for the put is added to the basis of the identified stock.

Analysis: Section 1233(c) of the Code provides that if a put and the stock identified to be used in its exercise are acquired on the same day, section 1233(b) does not apply and the acquisition of the put is not a short sale. Under Rev. Rul. 71-521, if the put is exercised and if the identified stock is delivered, the premium paid reduces the amount realized on the sale of the stock. If the put is not exercised, the premium paid is added to the basis of the identified stock.

D. Writer of a put

1. Ruling: The premium received for writing the put is not included in income at the time of receipt, but is carried in a deferred account until the writer's obligation expires through the passage of time, until the writer purchases the underlying stock pursuant to the exercise of a put, or until the writer engages in a closing transaction.

Analysis: Rev. Rul. 58-234 states, at page 283, that there is no Federal income tax incident on account of either the receipt or the payment of such option premium, that is, from the standpoint of either the optionor or the optionee, unless and until the options have been terminated, by failure to exercise, or otherwise, with resultant gain or loss.

2. Ruling: If the writer's obligation expires through the passage of time, the premium is short-term capital gain to the writer upon such expiration.

Analysis: Effective for options written after September 1, 1976, section 1234(b)(1) of the Code provides that any gain to the grantor of an option arising from the failure of the holder to exercise it shall be treated as gain from the sale or exchange of a capital asset held not more than 6 months (9 months if the option expires in a taxable year beginning in 1977; 1 year if the option expires in a taxable year beginning after December 31, 1977).

3. Ruling: If the writer purchases the underlying stock pursuant to the exercise of a put, the premium received decreases the writer's basis in such stock. The holding period of the underlying stock begins on the date of its purchase, rather than on the date the put was written.

Analysis: Rev. Rul. 58-234 states, at page 285, that if a writer purchases stock by reason of the exercise of a put, the premium received reduces the cost of the stock so purchased. The period of time during which the writer of a put option was obligated under the option may not be added to the period of ownership of the stock in determining the holding period of the stock acquired pursuant to the holder's exercise of the put.

4. Ruling: Section 1233(b) of the Code does not apply when a put is written, but only when stock is sold short or a put is purchased.

Analysis: Section 1233(b) applies only when substantially identical property is sold short, or when a put is acquired giving the owner the right to sell substantially identical property. It does not apply when instead of selling short or purchasing a put, the taxpayer writes a put.

5. Ruling: If the writer of a put enters into a closing transaction by payment of an amount equivalent to the value of the put at the time of such payment, the difference between the amount so paid and the premium received is short-term capital gain or loss.

Analysis: Effective for options written after September 1, 1976, section 1234(b)(1) of the Code provides that in the case of the grantor of an option, gain or loss from any closing transaction shall be treated as a gain or loss from the sale or exchange of a capital asset held not more than 6 months (9 months if the closing transaction occurs in a taxable year beginning in 1977; 1 year if the closing transaction occurs in a taxable year beginning after December 31, 1977). Section 1234(b)(2)(A) defines "closing transaction" as any termination of the taxpayer's obligation under any option in property other than through the exercise or lapse of the option.

E. Writer of a straddle

1. Ruling: If the writer of a CBOE straddle sells the put and call components for separate, identifiable premiums, such writer must utilize the separate premiums received for the put and the call in determining the respective gains or losses for each, and may not utilize the allocation provisions of Rev. Proc. 65-29, 1965-2 C.B. 1023. However, where the writer of a CBOE straddle sells the put and call components for a single premium so that the amount attributable to the put and call components can not be determined, the writer must either allocate the premium between the component options according to the relative market value of each component option or utilize the allocation provisions of Rev. Proc. 65-29.

Analysis: Rev. Proc. 65-29 provides, in part, that a taxpayer may allocate 55 percent of the premium received with respect to straddle contracts involving corporate stock to the call option and 45 percent of the premium to the put option. As an alternative, the writer may allocate the premium on the basis of the relative market values of such component options at the time of their issuance. That portion of the premium allocated to the exercised call must be added to the amount realized on the sale of the stock by the taxpayer. That portion of the premium allocated to the exercised put decreases the writer's basis in the stock purchased pursuant to the put. That portion of the premium allocated to the lapsed put or call must be reported by the taxpayer as a short-term capital gain pursuant to section 1234(b)(1) of the Code. However, a writer of a straddle should not allocate the premium received for granting the straddle when the writer sells the component options for separate, identifiable amounts.

Rev. Rul. 65-31, 1965-1 C.B. 365, held that the writer of a straddle has ordinary income in the amount of the premium allocable to either the lapsed call or put, or both options of the straddle. Due to subsequent amendment of section 1234 of the Code by the Tax Reform Act of 1976, that holding no longer applies. The other holdings of Rev. Rul. 65-31, that it is necessary to allocate the premium received for writing the straddle to the put option and the call option, the manner in which the allocation is to be made, and the treatment if both options are exercised or if neither option is exercised, are restated in this Revenue Ruling. Accordingly, Rev. Rul. 65-31 is obsolete.

2. Ruling: Gain or loss from any closing transaction with respect to, and gain on the lapse of, an option written as part of a CBOE straddle is a short-term capital gain or loss, regardless of whether the writer's obligation pursuant to the other option comprising the straddle is terminated by reason of the passage of time, by exercise, or by cancellation in a closing transaction.

Analysis: Effective for options written after September 1, 1976, section 1234(b)(1) of the Code provides that in the case of the grantor of an option, gain or loss from any closing transaction with respect to, and any gain on the lapse of, an option in property shall be treated as gain or loss from the sale or exchange of a capital asset held not more than 6 months (9 months for a taxable year beginning in 1977; 1 year for taxable years beginning after December 31, 1977).

See Rev. Rul. 78-181, page 261, in which a taxpayer purchased 1,000 shares of stock and simultaneously sold a 30-day call on those shares. Prior to the expiration of the 30-day option period, the taxpayer repurchased the call and simultaneously sold the 1,000 shares of stock. The revenue ruling holds that the gain or loss on the repurchase of the option is determined separately from the gain or loss on the repurchase of the option is measured by the difference between the amount received by the taxpayer for writing the option and the amount paid by the taxpayer to terminate the option. The simultaneous sale of the underlying stock gives rise to capital gain or loss, which is unaffected by the amounts received or paid by the taxpayer with respect to the option contract.

In accordance with the discussion in Ruling E-1, Rev. Rul. 65-31 is declared obsolete.