Showing posts with label financial-disposition-meaning. Show all posts
Showing posts with label financial-disposition-meaning. Show all posts

Disposition and Taxes- Introduction

Disposition and Taxes


Introduction

The tax consequences arising out of option transactions are extremely complex. Options, like stocks, are classified as capital assets, and the disposition of such assets is a taxable event. As with stocks, how long the position has been held determines whether the gain or loss is classified as short- or long-term. Furthermore, how the gain or loss is treated also depends on whether the option contract has been terminated through trade, expiration, or exercise and assignment. Because of this sensitivity to how an option contract is terminated, the first part of this chapter describes all three terminating actions and the corresponding times by which they must be initiated and accomplished. These are especially important in nip-and-tuck situations where the exercise price of an option is very close to the market price as the expiration day approaches.

Trading

Until June 23, 1997, trading in all equity options, including LEAPS, stopped at 4:10 PM.* Today, however, in order to minimize disruptions in the options market as a result of news announcements and earnings reports made after the regular markets close at 4:00 PM, trading in equity options now ceases at 4:02 PM. Customers are typically required by brokerage firms to submit requests for option trades by 3:55 PM at the latest because of the time needed for them to process the trade. This entails looking up trading symbols, verifying account numbers, and filling out trading slips and submitting them to trading desks, which must in turn transmit the orders to the trading floor of the appropriate stock exchange in time for verification and confirmation. 

Requests for option trades submitted by customers between 3:55 PM and the 4:02 PM absolute cutoff time are often accepted and submitted in hopes of beating the deadline, but the customer assumes all risk in such instances. These times apply to expiration Friday* as well. Although there are no exceptions to the 4:02 PM trading cutoff on expiration Friday, the CBOE now extends this closing time on the final trading day of each quarter to accommodate the particularly large number of transactions submitted by institutional and mutual fund managers on those days. For future reference, note that trading in broad-based and international indexes stops at 4:15 PM.

Exercise

Option exercise ordinarily begins with the option holder notifying his or her brokerage firm that exercise is to take place.** Through a sequence of steps, notification in turn is given to the appropriate clearinghouse member of the Options Clearing Corporation, the relevant options exchange, and, ultimately, the Options Clearing Corporation itself. Predictably, there are different cutoff times at different points in this chain and they vary from brokerage firm to brokerage firm. At the various option exchanges, the cutoff time for notification is typically 4:30 PM on all days except expiration Friday, when it is 5:30 PM. The 5:30 PM deadline has been known to be extended up to half an hour by options exchanges on the rare occasion when there is a backlog of exercise orders awaiting execution because of jammed communication lines or networking glitches. 

In any event, the Options Clearing Corporation must receive its notification by 8:00 PM (7:00 PM in Chicago, where the OCC is located) on all days, including expiration Friday. To meet all deadlines and allow enough time for confirmation, brokerage firms typically require customers to submit exercise requests by 4:00 PM on regular days and by 4:30 PM or soon thereafter on expiration Friday. Brokerage firms will rarely, if ever, take on the risk of attempting to submit exercise notices after the cutoff time imposed by clearinghouse members or options exchanges. Although options do not formally expire until noon the next day, Saturday morning is used for reconciliation between open and closed orders and the selection of which option writers get assigned.

Assignment

The assignment of options for which notification has been received in a timely fashion by the Options Clearing Corporation is performed by noon on Saturday. After that time, option rights become absolutely extinguished. However, option writers who did not close their positions will not find out whether the options were exercised against them until some time on the following Monday, when they are notified by their brokerage firms. Surprises do happen in this regard. Holders of slightly in-the-money options frequently elect not to exercise their rights to buy or sell the underlying equity, and holders of at-the-money or slightly out-of-the-money options will sometimes exercise their options during the last trading day because they do not know where the final closing price will be relative to the strike price. 

Holders of at-the-money or slightly out-of-the money options have been known to exercise their options simply because they want to put stock to, or call away stock from, the other fellow. Another surprise that often happens in the final days or hours of trading is that an option writer will instruct his or her broker to buy back the option and close the position only to receive a notice of assignment a business day or so later. If the exercise preceded closing, the option writer is a candidate for assignment notwithstanding the fact that the writer did not receive notification until after the closing transaction took place. The real surprise to option writers that occurs from time to time is that options are exercised against them that are significantly out of the money. 

This typically happens as a result of major news (bad or good) announced immediately after regular trading hours on expiration Friday. Suppose you are the writer of a put on XYZ Corporation with strike price $40. You have been monitoring the price of the underlying stock all day long on expiration Friday and are happy to see it close at 4:00 PM at $40 5/8. Two minutes later, you see the last trades for $40 puts on XYZ close out at 1/16. Great, you figure, the premium you collected all those months ago was pure profit, and you can go home and relax for the weekend. At 4:20 PM, however, XYZ Corporation issues an earnings warning, or announces that it has lost its largest client, or issues a press release stating that its latest wonder drug seems to have harmed more people than it helped. 

The consensus among analysts is that XYZ will open three or more points down when trading commences Monday morning. For the next hour, holders of the $40 put option who stuck around after trading stopped are submitting exercise notices to their brokers. On Monday morning, XYZ opens at $36 a share, and numerous put writers of the $40 strike option who did not close out their positions on Friday wake up to find they are the owners of a $36 stock that has just cost them $40 plus commission. In situations like this, only a certain fraction of the out-of-the-money options will have been exercised because many of the option holders will have considered their option worthless and gone home for the weekend by 4:00 PM. 

Suppose the open interest in the $40 put options totaled 1,000 contracts, of which 200 were exercised at the last minute. Who gets assigned and who does not is determined by a two-step procedure. First, the Options Clearing Corporation allocates the 200 assignments among the various brokerage firms in proportion to the open interest each firm represents. That is, if clients of the ABC Securities Corporation had written 120 of the 1,000 open put options, then 20 percent of 120, or 24 assignments (120 × 200 ÷ 1,000) would be allocated to ABC. Then that firm will select 24 option contracts at random from among the 120 open interest put writers and notify them accordingly. It is thus luck of the draw that determines who gets stuck and who does not in such situations.

To avoid such situations, it is therefore recommended that investors make arrangements with their brokers to close out all option contracts that might have any possibility of taking the option writer by surprise owing to bad news announced after trading ends on expiration Friday. If you had pocketed $1,000 in premiums many months before (and earned interest on that amount since then), buying back the option for 1/8 ($12.50) is a relatively small price to pay, and doing this will permit you to leave for the weekend on expiration Friday with complete peace of mind. As stated before, for active participants many brokers will forgo the usual commission on such deals and charge a nominal amount under the circumstances.

Trading Halts

A frequently asked question on the CBOE bulletin board is exactly what happens to option writers and option holders when trading in the underlying equity is halted. In general, halting the trading in the underlying equity automatically halts the trading of associated options. This restriction applies strictly to trading, so under ordinary situations (i.e., order imbalance, news pending, etc.), option holders are still able to exercise their option rights. Much more tricky is what happens on those occasional instances when the OCC suspends option exercise as well. 

This situation is particularly worrisome near expiration Friday. As stated in Characteristics and Risks of Standard Options, the "OCC or an options market may restrict the exercise of an option while trading in an option has been halted, and the restriction may remain in effect until shortly before expiration." So relax—this means that the OCC must lift the exercise restrictions in sufficient time for option holders to exercise their options before such rights are permanently extinguished.

Recent History of Tax Treatment of Capital Assets

The tax treatment of capital gains and options has undergone several shifts and reversals over the past few years. For a long time prior to 1997, gains and losses on capital assets were classified as being either short- or long-term depending on whether the underlying assets had been held for less than or longer than 12 months.

The Taxpayers Relief Act of 1997

The Taxpayers Relief Act of 1997 introduced substantial changes in the ways in which gains and losses on capital assets were recognized, treated, and taxed. Gains and losses, previously classified as short-term or long-term, were now classified as being short-term, midterm, or long-term. As before, assets held for under 12 months were classified as short-term; assets held between 12 and 18 months were midterm, and assets held for 18 months and longer were long-term.

Short-term assets were taxed at ordinary income rates, which for individuals could be as high as 39.6 percent. Midterm assets were taxed at the flat rate of 28 percent, and long-term assets were taxed at the flat rate of 20 percent. A flat rate of 10 percent was also applicable to individuals in a 15 percent tax bracket. These rates applied to both the regular and alternative minimum taxes as well. The tax rate on long-term gains on collectibles remained at 28 percent, and the long-term rate on real estate investments was 25 percent.

The IRS Restructuring and Reform Act of 1998

The IRS Restructuring and Reform Act of 1998 eliminated the midterm holding period (and its 28 percent tax rate) and reverted once again to the short- and long-term capital gains classification. Under the IRS Restructuring and Reform Act, a capital gain from the sale of property held more than one year is eligible for the same 10-, 20-, and 25- percent capital gains rates as was provided under the 1997 Act.

What Lies Ahead

The tax acts of 1997 and 1998 specify that starting in the year 2001, the capital gains tax rates of 20 percent and 10 percent for assets held for five years or more are to be 18 percent and 8 percent, respectively. The 18 percent rate (but not the 8 percent rate), however, is restricted to assets acquired on or after January 1, 2001. Individuals in a 15 percent tax bracket are to have their long-term capital gains taxed at just 8 percent starting in 2001, even on assets acquired before then. Because LEAPS typically have life spans of at most 30 months (although they can by regulation be issued for up to 39 months), the special five-year tax rates of 18 percent and 8 percent are of little relevance to option contracts.

Table  Effective Tax Rates on Capital Gains under the Tax Acts of 1997 and 1998


As you can see, the tax on $1,000 of capital gains can range from a maximum of $396 down to as little as $80, depending on the holding period and tax bracket involved.

Tax Implications for Option Holders

For call and put buyers who sell their options, the gain or loss is the difference between the net sales price (sales price less commission) and the adjusted cost basis (purchase price plus commission). The gain or loss will be classified as short- or long-term, depending on whether the position was held for less than or equal to 12 months or longer than 12 months. By extension, the capital loss for call and put buyers whose options expire worthless is the adjusted cost basis, and the loss is classified as being short- or long-term based on the period between acquisition and expiration.

For call buyers who exercise their options, the adjusted cost basis of acquiring the stock (strike price plus commission) is increased by the adjusted cost basis of the call. Whether the gain or loss on ultimate sale of the stock is short- or long-term will depend on the subsequent holding period of the stock alone, without regard to how long the call was held. For put buyers who exercise their options, the net sales proceeds are reduced by the adjusted cost basis of the put. Whether the gain or loss upon delivery is classified as short- or long-term depends solely on how long the stock alone was held, without regard to how long the put was held.

As an example, suppose you purchase a LEAP put for $10 a share plus a $30 commission to protect your position on XYZ, a $50 stock that you've owned for six months:

Cost Basis                                                                                                                        $1,000
Plus: Commission                                                                                                                  30
Adjusted Cost Basis                                                                                                       $1,030

Fifteen months later you sell the LEAP put on XYZ for $2 a share less a $25 commission:

Sales Proceeds                                                                                                                 $ 200
Less: Commission                                                                                                                 25
Net Sales Proceeds                                                                                                           $ 175

The capital gain and corresponding tax for this transaction are therefore:

Adjusted Cost Basis                                                                                                      $1,030
Less: Net Sales Proceeds                                                                                                    175
Long-Term Capital Loss                                                                                                 $ 855
Income Tax @ 20%                                                                                                             171-

The dash indicates a credit that can offset the taxpayer's other tax liability.

Tax Implications for Option Writers

For call and put writers, premiums received are not treated as immediate income. How and when option writers pay taxes on such premiums depend on the disposition of the option involved. For call and put writers who close out their positions by buying back the options involved, the gain or loss is the difference between the adjusted closeout cost (closeout cost plus commission) and the net premium (premium less commission) originally received. In general, the resultant capital gain or loss is treated as a short-term gain or loss, irrespective of the period involved.* By extension, if the option expires without exercise, the net premium (premium less commission) is treated as a short-term capital gain, irrespective of the period involved.

As an example, suppose you write a LEAP put on XYZ for $10 a share less a $30 commission:

Premium Generated                                                                                                            $1,000
Less: Commission                                                                                                                        30
Net Premium                                                                                                                           $ 970

Fifteen months later, you buy back that LEAP put for $2 a share plus a $25 commission:

Closeout Cost                                                                                                                          $ 200
Plus: Commission                                                                                                                        25
Adjusted Closeout Cost                                                                                                         $ 225

The short-term capital gain and maximum corresponding tax for this transaction are therefore:

Net Premium                                                                               $970.00
Less: Adjusted Closeout                                                               225.00
Cost                                                                 
Short-Term Capital Gain                                                           $745.00
Income Tax @ 39.6%                                                                    295.02 (maximum)

Notice that the gain is treated as short-term, irrespective of the holding period.

For call writers whose options were exercised against them, the adjusted sales price (strike price plus commission) of the delivered stock is increased by the net premium (premium less commission) originally received. Whether the gain or loss upon delivery of the stock is classified as short- or long-term depends on two things: how long the stock was held, and whether the call at the time it was written was out of the money, in but near the money, or deep out of the money. 

In general, writing out-of-the-money calls or calls on stock already qualifying for long-term treatment has no effect on the holding period. On the other hand, writing in-but-near-the-money calls on stock held less than 12 months can suspend the prior holding period of the stock, while writing deep-out-of-the-money calls on stock held less than 12 months can eliminate the prior holding period of the stock altogether. Whether a call is classified as in but near the money or deep out of the money depends not only on the relative strike and stock prices involved, but also on the remaining time to expiration. 

There is no simple formula for all of this, and readers should consult the appropriate tables published by the Internal Revenue Service to determine whether a specific in-the-money call written on stock already owned qualifies for mere suspension versus elimination of the prior holding period. Covered call writers can elect to use stock they already own or stock they immediately purchase in the open market to deliver, so to that extent they can influence or control the holding period and cost basis of the delivered stock. Such complexities are another reason why I prefer not to utilize covered call writing as part of my investment program.

For put writers whose options were exercised against them, the adjusted purchase price (strike price plus commission) of the acquired stock is decreased by the net premium (premium less commission) originally received. Whether the gain or loss on delivery of the stock is short- or long-term will depend on the subsequent holding period of the stock alone, without regard to when the option was written. As an example, suppose you write a LEAP put with strike price $50 on XYZ for $10 a share less a $30 commission:

Premium Generated                                                                                                        $1,000
Less: Commission                                                                                                                    30
Net Premium                                                                                                                       $ 970

Fifteen months later the option is exercised against you (because the stock fell to $40) and you purchase the delivered stock for $50 a share plus a $75 commission:

Strike Price of Stock                                                                                                        $5,000
Plus: Commission                                                                                                                     75
Adjusted Purchase Price                                                                                                 $5,075
Less: Net Premium                                                                                                                970
Adjusted Cost Basis                                                                                                         $4,105

Six months later, you sell your XYZ shares for $48 a share less a $75 commission:

Sales Proceeds                                                                                                                  $4,800
Less: Commission                                                                                                                     75
Net Sales Proceeds                                                                                                           $4,725

The capital gain and maximum corresponding tax for this transaction are therefore:

Net Sales Proceeds                                                             $4,725.00
Less: Adjusted Cost Basis                                                   4,105.00
Short-Term Capital Gain                                                   $ 620.00
Income Tax @ 39.6%                                                             245.52 (maximum)

Notice that the gain is treated as short-term because the holding period is that of the stock, without regard to the length of time the option position was held. Further note that there was a capital gain on ultimate disposition even though you sold the stock at a price ($48) lower than what you paid for it ($50), a consequence of the premium received 21 months before.

Other Tax Implications

The tax consequences in the case of spreads, strangles, straddles, and other combinations are much more complicated and are beyond the scope of this book. Indeed, I think an entire book could be written about the tax implications of puts and calls. There are many traps that await the unwary in the options arena. As a simple instance, suppose you purchased a put to protect a stock in your portfolio that was acquired less than one year before that. What is not so apparent is that the holding period of the stock being protected is completely eliminated in that instance and will not begin again until the put is disposed of.

As an example, let's go back to our very first example where you purchased a LEAP put on XYZ to protect your position on this $50 stock that you had purchased for $45 plus a $75 commission and had owned for six months. Fifteen months later, you sold 'the LEAP put for a loss of $855 and tax credit of $171. Suppose you then sold the XYZ stock itself ten months after that for $80 a share less an $85 commission.

Sales Proceeds                                                                                                               $8,000
Less: Commission                                                                                                                  85
Net Sales Proceeds                                                                                                         $7,915
Cost Basis                                                                                                                        $4,500
Plus: Commission                                                                                                                  75
Adjusted Cost Basis                                                                                                       $4,575

The capital gain and maximum corresponding tax for this transaction after you held this stock for 31 months are therefore:

Net Sales Proceeds                                                                       $7,915.00
Less: Adjusted Cost Basis                                                             4,575.00
Short-Term Capital Gain                                                           $3,340.00
Income Tax @ 39.6%                                                                     1,322.64 (maximum)

This is considerably more than the 20 percent long-term capital gains tax of $668 you were expecting to pay because as far as tax law is concerned, you had only held the stock for 10 months. There are ways to avoid this, such as by waiting the requisite 12 months before buying the protective put or by ''marrying'' the put and the stock; that is, by buying both the stock and the put at the same time with the announced intention of selling the stock by exercising the put. In any case, none of this should scare you away from the use of protective puts as part of your overall asset management program. Rather, it is just to show you that tax law is complex, that as it is applied to options it is even more complex, and that a tax adviser should be consulted before embarking on any extensive options program.

By the way, it is possible to use some of these quirks in the tax law to your advantage in certain situations. For example, suppose you own a stock for close to one year that has tanked badly, but which for one reason or another you do not wish to dispose of immediately. If you do delay the sale, the short-term capital loss will become a long-term loss (and therefore no longer available to offset short-term gains). On the other hand, if you purchase a put or a deep-in-the-money call on that stock, the holding period on the stock is immediately set back to zero, preserving its short-term status. This is true whether you hold the option one minute or one year. In case you skimmed over it the first time, let me repeat: a tax adviser should be consulted before embarking on any extensive options program.

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