ABUSE OF STRUCTURED FINANCIAL PRODUCTS- Misusing Basket Options to Avoid Taxes and Leverage Limits MAJORITY AND MINORITY STAFF REPORT

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managed account which, in the case of high volume trading, can be substantial. In addition, the
option seller can protect against any financial loss by hedging the option through the managed
account and using the profits from the transactions in that account to cover any gains owed to the
option buyer.
Potential Tax, Leverage, and Transparency Abuses. Basket options are vulnerable to
the same tax, leverage, and transparency abuses identified above for derivatives generally. Of
particular concern in the Subcommittee’s investigation is abuse of basket options to avoid tax.
Option buyers have used the basket option structure to characterize short-term trading profits
from the daily trading activity in the managed account as long-term capital gains for tax
purposes. Option buyers have claimed that those profits were entitled to long-term capital gains
treatment, because the option itself was held open for more than one year and thereby lowered
the tax rate an investor had to pay on the gains paid out upon the exercise of the option. Option
buyers have also claimed that they were not required to recognize any taxable gain from
dividends paid on securities in the managed account until the option is exercised, despite the fact
that the option buyer was credited with the gains from those dividends prior to any exercise of
the option. In addition to those tax abuses, basket options can be used to circumvent the leverage
limits in Regulation T and the reporting requirements in Schedule 13 D, as indicated earlier.
B. Overview of Tax Principles
To understand the tax issues raised by basket options, it is useful to review key tax
principles involving the taxation of capital gains and stock dividends; an existing tax code
section, Section 1260, that sought to stop the use of abusive derivatives, including options; and
the judicial doctrine warning taxpayers against elevating form over substance to avoid taxation.
Also relevant is a 2010 IRS advisory memorandum determining that basket option arrangements
did not entitle the option holders to treat their short-term trading profits as long-term capital
gains.
(1) Short and Long-Term Capital Gains Tax Treatment
Because basket options involve the trading of securities, one key tax issue involves the
taxation of capital gains, and whether those gains should be taxed at the short or long-term
rate. A related issue is when the gains are realized.
The profit realized from the sale of a capital asset is known as a capital gain. 47 Capital
assets include stocks, options, bonds, precious metals, and real property held for investment. 48
When such an asset is sold, the difference between the amount paid for the asset and the amount
for which it is sold is a capital gain. 49 When an asset is owned by a taxpayer for one year or
less and sold, the gain is considered a “short-term” capital gain, and when the asset is held for
more than a year at the time of sale, the gain is classified as a “long-term” capital gain. 50
47 2/27/2014 “Topic 409-Capital Gains and Losses,” prepared by IRS, http://www.irs.gov/taxtopics/tc409.html.
48 Id.
49 Id.
50 Id.