Equity Derivative Strategies Equity Derivative Strategies Joanne M. Hill Vice President, Equity Derivatives Goldman, Sachs & Company Understanding the tax implications of equity derivatives and the application of these instruments for taxable U.S. clients is a challenge worth meeting. Equity derivatives can playauseful role in implementingtax-efficient strategies that maximize after-tax returns. The key is to understand the costs, benefits, and rules for applying each instrument or strategy and then to select the best instrument to accomplish the investor's objectives and minimize the taxes. istorically, u.s. trust departments thatmanaged Capital Gains. For individuals, sales of securi­ H money for taxable investors were restricted in ties generally result in a long-term capital gain or loss their use of derivative securities. Because of such if the securities are owned more than 12 months. A obstacles (some of which are a matter of education holding period of 12 months or less results in a short­ more than anything else), derivatives are not the first term capital gain or loss. For individuals, net long­ tool that comes to mind for managing taxable invest­ term capital gains are taxed up to a federal rate of 20 ments, even though they offer advantages for many percent whereas net short-term capital gains (and clients. Derivatives are often perceived as complex in ordinary income) are generally taxed at the top mar­ themselves; the roles derivatives can play when taxes ginal tax rate of 39.6 percent. are involved add yet another layer of complexity. Equity derivatives, independent of any tax motiva­ Dividend Received Exclusion. us. corpora­ tion, are used for reducing the risk of holding equities tions that hold equity in other u.s. corporations may or as efficient substitutesfor equities. In bothcontexts, exclude 70 percent of dividend income from their derivatives have natural applications in tax-related income tax. One requirement is that the position be strategies. This presentationdiscusses the general tax held"at risk" for 46 days. The impactof this dividend issues facing corporate money managers or high-net­ exclusion is that corporations generally have an worth individuals with respect to equity derivatives, incentive to convert as much income into qualified explains how to use derivatives to maximize after-tax dividends as possible. In this regard, common and portfolio returns, discusses specific tax-efficient preferred stock are preferable to fixed-income secu­ derivative strategies, and provides a case studyhigh­ rities. lighting tax loss harvesting.' General Tax Issues Straddles. The first question to answer when discussing the tax status of a derivative transaction Before a discussion of applications of derivatives for is whether it constitutes a straddle. If a security or a enhancing after-tax returns and risk management, a derivative substantially diminishes the risk of loss of review of the general U.S.tax issues that affect the use another security, this set of securities is considered a of equity derivatives will be helpful. The most com­ straddle position. Straddles include hedging a mon issues are how to distinguishbetweenlong-term stock and short-term capital gains and the dividend with a swap, a long put, or a short "nonqualified" received exclusion. More-complex issues involve call (qualified versus nonqualified calls are defined straddles,stock optiontransactions, qualifiedcovered in the section "Qualified Covered Calls"). Selling calls, Section 1256contracts, and the wash-sale rule. stock index futures or stock index call options or buyingindex putsagainst a portfolio thatholds more 1I would like to acknowledge the contributions of Michael Dweck, than 70 percent of the market capitalization of the Carmen Greco, Maria Tsu, and Mark A. Zurack in conducting the index constitutes a straddlebecause it basically takes research and compiling the insights for this presentation. an indexlike portfolio and hedges it. ©Association for Investment Management and Research 69 Investment Counseling for Private Clients Straddle situations affect taxable investors in traded. Second, they must have more than 30 days to several ways. First, the investor's holding period is expiration. Third, the strike price must be not less either suspended or terminated, which is not neces­ than the first available strike price below the closing sarily abadthingifthe investor alreadyhaslong-term stock price. For example, if the stock closes at $52, an capital gains. Second, and most troublesome, is the option with a strike price of $50 is the first call one inability to deduct losses to the extent that the inves­ could sell for it to be considered qualified. tor has an unrecognized gain. Also, financing charges Qualified covered calls can be used to extend the for straddle positions are not deductible. Instead, for holdingperiod,and theyare probablythe mostwidely the investor in a straddle situation, the charges are usedinstrumentfor deferringgains. Selling a qualified capitalized into the cost basis of the long position. covered call against a stock results in a capital gain or Finally, corporations lose the 70percent deductionon loss to the call writer, allows the holding period to all qualified dividends for stocks that are part of continue if the call is out of the money, and suspends straddle positions. Only in a few circumstances the holding period if the call is in the money. In the would a company want to do something that would example of selling the call withthe $50strike price, the constitute a straddle; corporations should generally holding period is suspended. Finally, covered calls avoid straddles. also allow for the dividend received exclusion. Stock Option Transactions. The premium re­ Section 1256 Contracts. These contracts in­ ceived or paid for stock option transactions is consid­ clude U.S. exchange-traded stock index futures, ered a capital item. When a physically settled stock broad-based index options, and options on index option is exercised or unassigned, the cost basis or futures, which are all accorded the same tax status as sale price can be adjusted by the premium received commodity futures. Examples of Section 1256 con­ or paid. Stock options, with the exception of listed tracts are S&P 500 Index futures and options, CME index options, are generally not marked to market at (Chicago Mercantile Exchange)-Nikkei futures con­ year end for tax purposes. The tax treatment of stock tracts, and SIMEX-Nikkei futures contracts. The options depends on the time to expiration, the type good news is that no matter how long an investor of option, and how it is exercised or assigned. holds these derivatives, any gain or loss on Section Short-dated options. Profits on short-dated 1256 contracts is treated at 60 percent long term and options are generally considered short-term capital 40 percent short term. Section 1256contracts provide gains, but losses may be considered long term if the investors the ability to sell short and obtain partial option is part of a straddle position. long-termcapitalgains tax treatmentand to make the Long-dated options. For buyers of long-dated holding period irrelevant for long-term and short­ options, the tax treatment depends on the holding period. For example, if an investor buys a LEAP termcapital gains tax treatment. The bad news is that (Long-term Equity AnticiPation security-that is, an these derivatives are marked to market every year; option that has 18 months, two years, three years, or therefore, a tax event occurs every year if these posi­ more to expiration) and holds it to term, the gain on tions remain open at year-end. In addition, investors that option will qualify as a long-term gain. are unable to qualify for 100percentlong-termcapital Call exercise/assignment. The cost basis or the gains tax treatment. sale price (i.e., the strike price) is increased by the GTC index options are not considered Section amount of premium paid or received. For example, 1256 contracts and are treated the same as single­ ifan investoris shorta call and sells the stock through stock options for tax purposes. Therefore, if struc­ the exercise of the call, the premiumis reflected in the tured with a term greater than a year and held for a selling price of the stock. year or more, gains on a long GTC option can be Put exercise/assignment. Similarly, the cost treated as long term. Also, taxes are payable follow­ basis or sale price of stockis decreased by the amount ing the year the option is sold rather than marked to of the premium paid or received from a put. market annually as with 1256 contracts. Cash settlement. Forcash-settled options, such as indexoptions andsomeGTC options thatare never Wash-Sale Rule. Call options cannotbe used to assigned or exercised, the premium paid or received avoid IRS Section 1091, the wash-sale rule, which does not become part of the cost basis. Options that prevents taxpayers from selling securities at a loss are never assigned are treated like a physicallysettled and reacquiring "substantially identical" securities option that is closed out prior to expiration. within a 30-day period before or after the loss sale. However, although an investor cannot sell a stock Qualified Covered Calls. Covered call options and replace it with a call option, the investor can sell must meet several criteria to be considered qualified a stock and replace it with a short put under certain covered calls. First, they mustbe listed and exchange restrictions. 70 ©Association for Investment Management and Research Equity Derivative Strategies A short put represents the right to sell a stock at the investorcanmaximizethe long-termcapitalgains a fixed price to the writer. If I sell a put, somebody component of total return. In addition, the LEAP, like has the right to sell the stock to me at a fixed price. stock, allows the portfolio to be hedged with index The put arrangementis good news if I have a position futures or options without creating a straddle posi­ with a loss in it and I want to harvest it in order to tion.