TAM 201214021 appears to reconsider an issue addressed in CCA 201104031, issued about a year earlier. Both involved versions of a combination of a type of forward contract with the settling of the contract by physical delivery of borrowed shares—that is, a short sale. Both conclude that the value of the forward at the time of delivery of the borrowed shares should be the amount of gain recognized by the forward seller. The TAM is better reasoned than the CCA, but still just announces a conclusion without any on point authority.
The CCA’s facts were like the simplified Example 1, below. The CCA is discussed in Cummings, “Variable Prepaid Forward or Short Against the Box or Both?” 38 DTR J-1 (2/25/2011).
Example 1: In year one, the taxpayer (the variable prepaid forward contract seller) received $100 from the bank (the forward buyer) in exchange for a contract to deliver securities in year three (the settlement date for the forward contract). The taxpayer owned such securities at the time of contracting. In year three, as part of the settlement of the forward contract, the taxpayer received another $20 from the bank with respect to the contract, the taxpayer held similar securities worth $50 with a basis of $40, the taxpayer borrowed similar securities, and the taxpayer delivered the borrowed securities to the bank in settlement of the forward contract.
The taxpayer claimed (1) the prepaid forward was not taxable in year one generally because it was an open transaction, and was not taxable under section 1259 because it was “variable” and not for a fixed amount of securities (IRS agreed with both points); (2) the prepaid forward remained open in year three because the taxpayer still could not compute its gain or loss because it settled the forward with a short sale against the box that was a second open transaction, which, however, was partly taxable under section 1259 in the amount of the gain the taxpayer recognized in year three under the special rule of section 1259, $10 (difference between value of securities held in the box and their basis); and (3) when the taxpayer later pays $30 to buy securities to close out the short sale in year five (assume), it would report an additional gain of $40 in year five ($70 remaining amount realized less $30 basis = $40 gain in year five, plus $10 gain reported in year one = $50 total gain).
The CCA concluded that the short sale did not keep the original forward contract open, so the taxpayer should report as income in the year of settlement of the forward by physical delivery of the stock the entire difference between the price received by the taxpayer for the forward contract and the value of the delivered (borrowed) shares.
The TAM involves slightly more complicated, but basically similar, facts. It also concludes that the taxpayer’s put (in this case) should be closed out when the borrowed shares are delivered by the taxpayer, with gain being equal to the difference between the put price received initially by the taxpayer and the value of the (borrowed) shares delivered by the taxpayer to the party that paid for the put.
The key to the CCA’s reasoning is that options have to be taxed when they are closed, and they are closed when the property purchaser under the option (here, a put) gets the property. That is a reasonable legal analysis by the IRS, so far as it goes. But, the IRS went further to conclude that the gain that the taxpayer had to recognize on the settlement of the option was the value of the transferred property, subtracted from the option price.
For the latter point, the CCA really has poor citation. It basically reasons that is the only possible way to determine the economic benefit to the taxpayer, despite the fact that economic benefit may be eroded later when the taxpayer has to pay a higher price to settle the stock borrowing transaction.
Conclusion. The IRS is not likely to back down on this position, now that it has refashioned its reasoning in the CCA. However, taxpayers in this situation do have reasonable arguments that gain has not been “clearly recognized” upon the settlement of the put.