General Introduction: Tax Accounting

I don’t have a CPA so my qualifications in tax accounting are suspect.   Most of what I know about tax accounting I picked up in my free time in the office.

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Okay, okay, okay.  That’s not entirely true.  I have an undergraduate degree in accounting so it’s not like I’m completely toothless; but I’m still a lawyer that plays at accounting.  Truth be told though, I actually found tax accounting more satisfying than tax lawyering.  Tax law was always gray areas and “I don’t knows” where accounting always seemed like fun puzzles.

Now, this isn’t going to be a very orthodox way of approaching tax accounting.  If anything, all of my tax accounting posts will just be enough to get someone by.  I approach accounting with one main premise:  what is the most accurate way of conveying information to someone reviewing a financial statement.  More often than not this premise will lead you to the right answer (and should lead you to the right answer).  At the very least, it gives you a framework to ask why the actual answer is different than the one that the premise seems to suggest to you.  Ultimately, to get the correct answer you would have to consult the accountants, but it’s good to have the basic tools to have that discussion.

On to the very, very basics.  I’m pretty sure that many of you have heard of debits and credits.  If you haven’t heard of those concepts, you’ve probably heard of their synonyms:  left and right.    So, like port and starboard, accountants just gave new names for the terms left and right, yin and yang, Tom and Jerry.  At the end of the day, one of the most important rules of accountingness is to make sure that your debits and credits are in balance.  That is, every account that is a debit must also have an offset that is a credit.

The second basic layer of accountingly is that Assets = Liabilities + Equity.  This must also always be in a balance.

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Now, before trying to simplify this, I’m going to confuse you by layering the debits and credits into this equation.  As a general rule, debits increase Assets and decrease Liabilities and Equity.  On the flip side, credits generally decrease Assets and increase Liabilities and Equities.

These paragraphs are probably a meaningless jumble to you.  However, there is a handy-dandy tool that you can use to help you sort out these things.

basic chart

How?  What?  How?  Three excellent questions.   This chart layers the debits and credits on the left and right hand side of the fundamental accounting equation.  Here are a couple of things to remember about the chart:

  • Greens increase the part of the equation it lines up with; Reddish/Pinkish decreases it.
  • When doing an entry, the sum of the left side must be equal the sum of the right side.

Let’s take an example.  You borrow $100.  Easy enough, by borrowing $100 you now have $100 of cash.  Cash is an asset; therefore, you debit cash for 100.  Since you borrowed money, your liabilities went up and therefore, you credit liabilities for 100.  This is illustrated as follows:

basic chart2

You now have your first balance sheet!  Debits equal credits and Assets of 100 is equal to liabilities of 100.

Understanding the basic debit/credit stuff is fairly important to understanding more advanced tax accounting entries so I’ll stop here.  However, I have illustrated a few of the important accounts that are important in the tax world just so you can have a preview of where they fall in this debit/credit world and what we’ll be talking about in the future.

basic chart3

General Introduction: Economic Substance Doctrine

This post is another general introduction post that will serve as an anchor for future posts on economic substance.  It is not all that interesting by itself, but for those not familiar with the tax law’s economic substance doctrine, it can serve as a primer.

Analysis under the economic substance doctrine should generally precede analysis under substance over form doctrines such as tax ownership, step-transaction, debt versus equity, etc.  It’s somewhat axiomatic that substance over form analysis is not particularly relevant when the transaction had no substance in the first place.

In short, the economic substance doctrine requires that the transaction must not have been done solely for tax reasons; that there must be some other independent business purpose for the transaction.  In applying the economic substance doctrine, I generally walk through a three-part analysis (which is not all that original).

  1. Determine if the tax benefit obtained/sought is outside the scope of the doctrine.
  2. Define the scope of the transaction that you are testing.
  3. Apply the economic substance doctrine to the transaction as defined in the last step.
  1. Determine if the tax benefit obtained/sought is outside the scope of the doctrine.

There are obviously all sorts of tax benefits that were implemented by Congress to incentivize taxpayers to engage in certain activities.  To deny those tax benefits on economic substance grounds would clearly undermine the intent of Congress.

Some of those tax benefits seem obvious, such as the low income housing tax credits, energy production credits, etc.  However, some benefits that are intended are the subject of continuing controversy, such as foreign tax credits.  Foreign tax credits generally exist to relieve US taxpayers from being taxed twice on foreign source income (once by a foreign country and then a second time by the US).  While that seems simple enough, there are several structured transactions where US taxpayers may have gone beyond the intent of the provision in an attempt to secure a benefit beyond relief from double taxation.  Therefore, merely because a benefit is intended by Congress, it does not necessarily qualify for a blanket exemption from the application of the economic substance doctrine simply because it meets the statutory requirements.  In those cases, courts will scrutinize a transaction to determine if the taxpayer secured a tax benefit beyond the intent of the provision.

In addition to being exempt because it is an intended benefit, certain provisions may also contain their own anti-abuse provisions that make the economic substance doctrine irrelevant.  In particular, they may have a tighter standard than the economic substance doctrine.  For example, IRC 269 applies to certain acquisitions where the “principal purpose” of the acquisition was evasion or avoidance of Federal income tax.  Because this requires only a “principal purpose” of tax evasion/avoidance as opposed to a sole purpose, you’d typically think the economic substance doctrine was irrelevant where 269 was applied.  However, due to the application of penalties under the new codified economic substance doctrine in IRC 7701(o), this may no longer be true.

  1. Define the scope of the transaction.

After determining that the tax benefit isn’t immune to the application of the economic substance doctrine, the next thing to do is define the scope of the transaction being analyzed.  This seems like it should be a fairly easy task but it really isn’t and there isn’t a lot of guidance on how to do it.

Here’s what the IRS had to say about the scope of the transaction Notice 2014–58 (“Additional Guidance Under the Codified Economic Substance Doctrine and Related Penalties”):

“transaction” generally includes all the factual elements relevant to the expected tax treatment of any investment, entity, plan, or arrangement; and any or all of the steps that are carried out as part of a plan. Facts and circumstances determine whether a plan’s steps are aggregated or disaggregated when defining a transaction.

Generally, when a plan that generated a tax benefit involves a series of interconnected steps with a common objective, the “transaction” includes all of the steps taken together – an aggregation approach. This means that every step in the series will be considered when analyzing whether the “transaction” as a whole lacks economic substance. However, when a series of steps includes a tax-motivated step that is not necessary to achieve a non-tax objective, an aggregation approach may not be appropriate. In that case, the “transaction” may include only the tax-motivated steps that are not necessary to accomplish the non-tax goals – a disaggregation approach.

This amounts to a lot of confusing babble where it seems that the IRS will apply economic substance to all of the aggregate steps in the transaction except in cases where they won’t.  It’s not entirely the wild wild west though, as the IRS does establish its own standard for disaggregating a step:  the transaction will generally be reviewed as a whole except that a tax-motivated step that is “not necessary” to achieve a non-tax objective.

This seems like a very tight standard since a “tax-motivated step” can be helpful for achieving an objective even if it falls short of being necessary.  Moreover, even if a tax-motivated step is not even helpful, it can be a fairly integrated (if not integral) part of the overall strategy.

Defining a transaction can be a crucial step in determining whether the transaction is considered tax-motivated or not.  For example, let’s take a simple transaction where a non-US taxpayer purchased a dividend paying US stock.  Upon realizing that the dividend would be subject to a US withholding tax rate of 30%, the non-US taxpayer decided to switch from a holding the US stock directly to a swap that references that same stock.  Assume also that we know that the only reason the non-US taxpayer switched was for tax reasons (i.e., if not for the tax advantage the taxpayer otherwise hates swaps).

If you define the transaction as the switch from stock-to-swap not inclusive of the original investment decision, then based on my assumption, this transaction is clearly solely tax motivated and would likely fail under the economic substance doctrine.  If you viewed the transaction as including the non-US taxpayer’s original decision to purchase the stock and the switch from stock-to-swap, then the transaction likely has economic substance since the non-US taxpayer’s original investment decision to buy the stock surely had non-tax motivation.

While it may seem tempting to say that, of course, the switch from stock-to-swap must be viewed in isolation, consider two taxpayers: one who entered into a swap in the first place (and therefore should clearly satisfy the economic substance doctrine in choosing swap over stock), and the other who switched from stock-to-swap only after realizing their error.  In my mind, it seems rather silly to claim that the first taxpayer should be treated differently from the second taxpayer.  Of course, maybe it’s justifiable under the general rule that smart taxpayers deserve better treatment that stupid ones, but arriving at that result under the auspices of economic substance doctrine seems weird.

That said, the definition of the transaction can be the one place where the economic substance doctrine can be clawed or de-clawed in ways that seem almost arbitrary.

  1. Analyze the transaction using the subjective and/or objective test:

Once the transaction has been defined, now it’s time to apply the core of the economic substance doctrine.  Under common law, the economic substance doctrine had a subjective and an objective component whose theoretical (if not practical) application varied from jurisdiction to jurisdiction.

The subjective component of the doctrine is the mens rea part of the test.  That is, it depended on the intent of the person engaging in the transaction.  Was the person engaging in the transaction solely for tax purposes?  Because the test is “subjective”, it depended only on the state of the mind of the person engaged in the transaction.

The objective component of the transaction requires that the transaction change the taxpayer’s economic position in a meaningful away (apart from Federal income tax effects).  For this test, the taxpayer’s state of mind is irrelevant; it requires that some real observable change in the taxpayer’s economic position take place.

As mentioned above, the above two tests were not applied consistently across all jurisdictions.  Some of the ways they have been applied include:

  • Subjective test applied only with facts and circumstances (I view this as applying the objective test to determine the credibility of the taxpayer’s subjective state of mind).
  • Taxpayer must satisfy both the subjective and objective test.
  • Taxpayer must satisfy the subjective or the objective test.

Because of the confusion and the disparate treatment of the various jurisdictions (and a lust for vengeance), Congress codified the economic substance doctrine in March 2010 in IRC 7701, requiring that the taxpayer pass both the subjective and the objective test.  In addition to requiring both the subjective and the objective test to be satisfied, Congress also provided that if the potential for pre-tax profit is used to satisfy the subjective/objective test, the reasonably expected pre-tax profit from the transaction is substantial in relation to the present value of the expected net tax benefits.

Lastly, Congress also instituted a penalty for when a transaction failed due to the application of the economic substance doctrine:  40% if not disclosed and 20% if disclosed.

These new twists added by Congress clean up some of the ambiguity that existed under case law (e.g., subjective and/or objective tests) but add some new ones to the mix (what is “substantial”?).

Selling a Cooperative Apartment: Hey My Basis Just Went Up

I own a coop and am in the process of selling it.  Since I bought it quite a while ago, I expect to pay some taxes on it, so I’ve been doing some research in an area of tax law I’m not very familiar with.

One surprising thing I learned is this from Treas. Reg. Sec. 1.216-1:

(c) Disallowance of deduction for certain payments to the corporation. For taxable years beginning after December 31, 1986, no deduction shall be allowed to a stockholder during any taxable year for any amount paid or accrued to a cooperative housing corporation…which is allocable to amounts that are paid or incurred at any time by the cooperative housing corporation and which is chargeable to the corporation’s capital account. Examples of expenditures chargeable to the corporation’s capital account include….the payment of the principal of the corporation’s building mortgage. The adjusted basis of the stockholder’s stock in such corporation shall be increased by the amount of such disallowance. 

You see, when you sell an cooperative unit, you are really selling shares in the building.  So you have to calculate your basis in the shares.  If i’m reading this correctly, I get to add any principal that my coop has paid on its mortgage for the period I was a resident.  In effect, part of your maintenance costs for living in a coop go to interest deduction and real estate taxes, which are currently deductible.  However, another portion also goes to principal payments on the coop’s mortgage and other capital improvements.  These costs aren’t currently deductible but they do appear to go into your basis.

I feel stupid for not knowing this (assuming I’m reading this right).

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But it’s a pretty neat thing for reducing my tax liability for the upcoming sale.  Now, someone tell me how to get information relating to these payments!!!  I guess I better call the management company.

Case Study: Tax Ownership and Stock Held in Prime Brokerage Accounts

In my last post on tax ownership, I discussed AM 2010-005 and basket options and left you with a cliffhanger…

ive been expecting you

In the memorandum, it appears that the IRS analogizes the arrangement between the taxpayer and the bank to stock held in a prime brokerage account.  While there are some differences, the analogy does appear appropriate in some respects:  (1) the taxpayer (at least per the IRS’ argument) has full control over the stock in an account, (2) the bank provides financing to the taxpayer for a financing charge, (3) the bank appears to have the ability to re-hypothecate stock in the account, and (4) the taxpayer appears to substantively have full opportunity for gain and risk of loss.  While there are some notable differences, these are some of the things you’d see in a margin account.  Of course, the IRS uses this analogy to bring home the point that, just like a customer who owns stock in a margin account, the customer must be considered the owner of the underlying reference.  Here, we examine whether that’s true.

One caveat before I start this:  I’m not a master of how brokerage accounts work, but I have a working knowledge (and the ability to google things).  

Stock held in cash accounts.  Before we slide into a discussion of margin accounts, however, we should make a brief stop in cash accounts.  This is probably the type of account that most people are quite familiar with.

Unconfusingly enough, it’s simply an account where you buy stock for cash.  From a tax ownership perspective, the important thing to remember about this account is that the broker typically cannot borrow shares in this account and cannot otherwise rehypothecate those shares.  In this, the broker is acting as a custodian.

Because the broker does not have the power to dispose of the shares (and the beneficial owner of the account does), I think it’s fairly easy to declare the beneficial owner the tax owner of the shares.  Therefore, the beneficial owner is not deemed to sell the shares by holding them in this account and when dividends are paid, the beneficial owner of the account would receive a “real” dividend and not a substitute dividend.  Easy.

Stock held in margin accounts.  While it’s possible to have securities purchased for cash in a margin account, for purposes of this discussion we’ll assume that stock held in a margin account was bought on margin; that is, it was purchased, in part, with a loan from the broker.

Unlike stock held in a cash account, stock held in a margin account can typically be rehypothecated by the broker.  Here are links to two margin account applications I could find online:  Margin Account Application 1 and Margin Account Application 2.   They both have provisions that deal with rehypothecation.  For example, one of the agreements provides, in part, as follows:

Note that property in a margin account may be pledged or repledged, hypothecated (loaned) or rehypothecated, either separately or in common with any other property, for as much as your obligation to us or more, without our having to retain a like amount of similar property in our control for delivery.

Generally, pledgees of stock can only dispose of collateral in the event of default.  However, the right to rehypothecation is generally the right of a prime broker to re-use client assets for its own purposes.   When assets are rehypothecated, title to those assets transfers to the prime broker and the prime broker’s only obligation is to return ‘equivalent assets’. If the prime broker becomes insolvent in the meantime, the customer will likely become a mere unsecured creditor of the broker.

A broker who is given a right of re-hypothecation can exercise this right and dispose of the stock, typically by means of sale, repo, or loan to another third party.  While there are certain legal limitations on the ability of the broker to rehypothecate stock in margin accounts, this regulatory landscape is too vast to describe here (and I’m not the one to do it)..

But what does all of the above mean for tax ownership?  Well, to the extent that the broker actually rehypothecates a security, it’s pretty much a done deal.  The prime brokerage customer could not possibly be considered the owner of the stock.  The arrangement now looks almost exactly like a stock loan arrangement whereby the stock lender loaned shares to the borrower who used the shares to close out an unrelated short sale.  Like the stock lender, a prime brokerage customer in such case should generally not be considered the owner of shares that have been rehypothecated.

But the more interesting case arises when shares have been purchased on margin but haven’t been rehypothecated.  Is the prime brokerage customer the owner of those shares?  This can be important because brokers may themselves borrow shares from other parties over dividend dates to place in a margin customer’s account.  This presumably allows the customer to receive a “real” dividend and not a substitute dividend.  This may be important for tax sensitive margin loan account holders who want to obtain the preferential tax rate that applies to so-called “qualifying dividend income”.  This lower rate only applies to dividends paid on shares actually held, not to “in lieu of” dividend payments  Therefore, it’s important that the prime brokerage customer (and not the broker) be treated as the owner of the shares for tax purposes.

However, there is a slight problem here.  For shares purchased on margin, the broker has the right to dispose of the shares, even if the shares are just sitting there.  It’s simply a right that the broker hasn’t exercised.  This strikes me as problematic from a theoretical perspective because I believe the power to dispose is the relevant inquiry for tax ownership.  In my mind, an actual disposition simply proves that the right to dispose existed; that is, it removes any doubt that the right existed in the first place.  It’s evidence of, but not a requisite for, transfer of ownership.  Think of it this way, if you give someone your car and tell them they can do whatever they want with it, do you still own the car even if they leave it on the curb overnight?  Or, using my “go to” analogy, if you lend someone $1,000, and they keep the money you loaned on their nightstand for a week, are those specific dollar bills still yours?   Is the broker having the right to dispose of the shares and simply not exercising it different from these examples?

There is one other aspect of this arrangement I’d like to consider though.  The prime brokerage customer does retain the ability to “de-margin” and, in doing so, restrict the ability of the broker to rehypothecate the shares.  Basically, the customer turns the margin shares into cash shares.  Now, the question before us is whether the power of the customer to “re-possess” is enough for the customer to claim actual ownership over shares that the broker has the power to dispose of.  I tend to think not.

The problem with this customer’s “power” is that it has the feel of a condition subsequent and not a condition precedent.  Recall in my discussion about conditions as it relates to options, where there is a condition precedent to the power to dispose, it is natural to conclude that the person whose power is subject the condition is not the owner because they can’t exercise that power until the condition has been satisfied.  A condition subsequent turns off a power that one possesses.  In this case, the broker’s power to dispose is in the “on” position and the customer can flip it to the off position.

In a way, the exercise of the customer’s power here (from the customer’s perspective) seems like it’s subject to a similar condition that would apply to the purchase of a house.  The purchaser of a house can’t get the house until the settlement/closing date (ie., the date they actually pay the cash), and the customer cannot take away the broker’s power until they pay cash for the shares.  Some might argue that the customer is exercising power over the shares when they sell stock A and buy stock B.  However, it’s easy enough to counter that they simply terminated stock loan on A and entered into new stock loan on B.

Given the above, I think there are some very problematic theoretical issues in treating customers as owners of stock in margin accounts.  Does this mean everyone who holds stock on margin is at real risk that they will not earn a “real” dividend?

Probably not I’d be surprised if the IRS actually pursued this angle.  I’d guess they would take the opposite view.

While you may not take a lot of comfort in my guesses, there is some comfort one could take from Treas. Reg. Sec. 1.6045-2 which sets forth rules as to how broker’s may allocate “in lieu of” dividend payments to the specific owners known to have had their shares loaned out based on the broker’s records.  These rules are written in such a way that they apply to allocations of shares actually transferred by the broker.  In other words, Treasury did not require “in lieu of” dividend payments to be associated with shares that were held in margin accounts but had not yet been rehypothecated.

Therefore, there’s probably very little to worry about from a practical perspective.

Circling back to AM 2010-005.

Well, what does this mean for AM 2010-005 and the IRS claim the hedge fund was really the owner of the shares?  Does the taxpayer have an opening because the Bank in AM 2010-005 had the power to re-hypothecate?

Actually, no.  It really doesn’t mean a heck of a lot.  The taxpayer would still not be a in a good position.  Whether the taxpayer is viewed as buying and selling shares or terminating and opening stock loans, the tax result will be similar in that the taxpayer will not be able to get long-term gain.  So yeah, I tricked you into thinking there was a cliffhanger.  How does that feel?

charlie chaplin


Current Events: New Proposed Regs. under 707: Partnership Allocations and Disguised Payments for Services

Treasury issued new proposed regulations that list factors for determining whether a partnership has made a disguised payment for services to a partner.

An issue that has existed in the hedge fund space for quite some time is whether interests allocated to general partners or management companies would be treated as allocations of partnership income or would be treated as service payments; the ultimate issue being the character of the income received by these “partners”.

It seems that the regulations adopt all of the factors addressed by the legislative history and adopt an additional factor not discussed in the legislative history.  Specifically, the new factor is present if “…the arrangement provides for different allocations or distributions with respect to different services received, where the services are provided either by a single person or by persons that are related under sections 707(b) or 267(b), and the terms of the differing allocations or distributions are subject to levels of entrepreneurial risk that vary significantly.”

The proposed regulations provide an example where the general partner is subject to a clawback on its interest but the management company is not.  As a result of this factor, the management company is more likely to be treated as having received a disguised payment for services.

Case Study: Tax Ownership and “Basket Options” – AM 2010-005

In this post, I’ll be taking a closer look at Office of Chief Counsel IRS Memorandum AM 2010-005See also, CCA 200941015(which outlines some precedent the IRS was relying on).

This memorandum contains the IRS analysis of the so-called “basket options” that eventually lead to the Senate Permanent Subcommittee of Investigations Report and Notices 2005-47 and Notices 2005-48.

Some of the relevant facts of the memorandum are as follows:

  1. The taxpayer was a hedge fund (“HF”) which had general partner (“GP”) that also managed other related funds.
  2. HF entered into a contract (“Basket Contract”) with Foreign Bank (“FB”) which was nominally structured as a call option on a basket of securities (“Reference Basket”) held in a specified prime brokerage account administered by FB.
  3. The value of the securities in the Reference Basket was $10x (which was the strike price of the “option”) when the parties entered into the Basket Contract, and the Reference Basket was funded with $1x in “premium” paid by HF and $9x paid by FB.
  4. While FB put up $9x of funding, FB had protection from losses to the extent the Basket Contract exceeded HF’s $1x.premium
    1. The Basket Contract contained a “Knock-Out” provision that automatically terminated the contract at any time that Basket Losses reached 10% (i.e., whenever the losses exceeded the $1x of HF’s investment).
    2. FB also had the right to require HF to enter into risk reducing trades even before losses in the Reference Basket reached the 10% barrier.
  5. HF and FB entered into an Investment Management Agreement related to the Basket Contract which provided that GP managed the securities in the Reference Basket, subject to certain guidelines. The memorandum doesn’t go into these guidelines but I imagine that they are restrictions that dealt with FB’s regulatory requirements.
  6. GP would generally issue instructions to the FB which executed all of the trading instructions, though it was not contractually obligated to do so. GP also had power to make corporate action decisions over the securities, addressing tender offers, mergers, and other decisions that offer a choice of consideration of cash or shares.
  7. Nothing contractually prohibited FB from commingling, lending or otherwise using the securities in the Reference Basket without notice to HF.

Based on the facts above, the economics of the Basket Contract were such that the taxpayer, HF, effectively had full economic exposure to the Reference Basket.  One potential risk of loss to FB was that Basket Contract would have losses that blew past the Knock-Out and FB would end up covering that loss.  But this seemed very unlikely given the parameters of the contract.

The first part of the IRS analysis concluded that the Basket Contract was not an option, arguing that the terms of the Basket Contract precluded lapse and that the Basket Contract did not relate to any specific property.  A different way of saying this is that the option holder didn’t really have any choice.  I mean, it’s not called an “option” for nothing, right?

The only provision that seemed to act like an option was the “knock-out” provision, but this seemed to act more like a condition subsequent than a condition precedent.  That is, it terminated the duties of the parties to the contract rather than initiated them.  Therefore, it’s hard to find the sorts of condition precedents you’d expect to see which would normally preclude the option holder from being treated as the owner of the property.

Next, the IRS addressed the ownership issue more directly.  Here, the IRS indicated that a factor-test should be implied but then they went on to discuss the IRS went to a factor test but limited their discussion to three factors:

  1. HF had full opportunity for gain.
  2. HF had full risk of loss.
  3. HF, through GP, had complete dominion and control over the Reference Basket.

This is the kind of a joke, right?  They basically suggest that they are going to use the factor test and the first two factors seem almost entirely pointless.  In a “plain vanilla” stock loan, I had concluded that the stock lender, who has full opportunity for gain and risk of loss related to the reference is generally not the owner of the stock loaned and presume that the IRS would agree with me (again, the generic case).   But they came up with a different answer here.  Therefore, the issue would seem to almost entirely turn on the resolution in point 3.

Of course, it’s arguable I’m seeing it this way because, based on everything I’ve said in previous posts, I obviously think that this is the right, if not only, factor to focus on. In any event, giving an agent of the taxpayer (i.e., GP) complete control over the Reference Basket is ultimately the problematic point. The IRS does point out that FB did not have the contractual obligation to execute the GP trades but it did, in fact, execute all such trades, and, therefore, it does appear that the taxpayer had control over disposition of the securities.

Notwithstanding this, there is an opening for the taxpayer here at least theoretically if not practically.  The IRS does concede that the FB has some control over the Reference Basket as they could lend or re-hypothecate securities in the account without HF’s knowledge or consent.  Here, the IRS rightly analogized this to the customary powers that a broker would have over assets under custodial arrangement with prime brokerage customers.

Of course, the IRS asserts this as a way of drilling home that HF is the owner of the Reference Basket because everyone knows that the prime brokerage customer who buys stock on margin loan is the owner of the stock in that account.  Right?…

…this is a cliffhanger.

Case Study:  Tax Ownership and Options


I discussed tax ownership in the context of stock loan in my previous post.  There I concluded that in a “plain vanilla” stock loan the stock lender would not be treated as the owner of the stock that was loaned, even though the lender held something pretty close to the economic equivalent of owning the stock outright and even though the lender may be entitled to physical delivery of shares of the stock at the conclusion of the contract.

If that’s the case, we should be able to handle options in really short order then.  If stock lenders are not considered owners of the stock, then call option holders (or put option grantors) on stock should a fortiori not be treated as the owner of stock.  And, as a general matter this is true because (1) like stock loan, the option holder likely does not have control over the disposition of any identifiable property, and (2) the option is subject to significant condition precedents that a stock loan isn’t typically subject to.

Option holder cannot restrict the use of any specifically identifiable property

First, because an option generally does not give the call option holder (or put option grantor) the power to control/prevent the disposition of any identifiable property, it is unlikely that the call option holder (or put option grantor) should be viewed as the owner of the property.  This is similar to the stock loan example where the stock lender does not expect the return of the exact shares loaned cannot prevent the borrower from disposing of any particular shares.  They just expect the return of shares that are similar/Identical to the shares loaned at the end of the contract but retain no control for the duration of the contract. Consequently, if you have an option on a few IBM shares, you wouldn’t normally expected to be treated as the tax owner of any particular IBM shares even if there existed no condition precedents to your acquisition.  Why?  The person on the other side of the option retains full control over disposition of those shares (assuming your counterparty even has the shares) and there is no reason to think that the counterparty’s control over disposition of the shares is illusory.  (See, Rev. Rul. 80-238, 1980-2 C.B. 96, 1980-36 I.R.B. 10).

Some authors refer to this as funginess (fungibility? fungibility-ness? fungineity?).  Because the subject of the contract is fungible, there is no specific thing that you require to be delivered to you at the conclusion of the contract; the option holder would only require a “like” thing and can’t prevent the counterparty from disposing of any particular property.  Therefore, until you gain actual possession, you can’t claim any specific thing as your own.  Recall the analogy to a money loan—where you loan somebody money, there are no specific dollar bills that you can claim as your own and you can’t prevent the borrower from disposing of any dollars in their possession.

As a previous comment has pointed out, however, the ability to specifically identify the property is not the dispositive issue.  It merely supports the notion that the option holder doesn’t really have control over the disposition of any particular thing the option issuer may have in its possession from time-to-time.

Ultimately, this fits into the notion that control over property is really the core issue in the ownership analysis. The fact that the property is not “identifiable” makes it easy to believe that control didn’t really exist.

Condition precedent and condition subsequent.   

In addition to funginess (which may or may not be present), options have a significant condition precedents that make tax ownership less likely than stock loan.  First, the option may not be exercisable for some time.  Second, at the time the option is exercisable, the holder of the option may not choose to exercise it.  Third, even If the holder chooses to exercise the option, the call option holder (or put option grantee) must actually have the wherewithal to pay the strike price.  There may be more things than that, but that’s what I could come up with off the top of my head.

In any event, each of the foregoing act to preclude the ability of the option holder from enjoying possession of, and having the ability to control disposition of, the subject property.

But what do I mean by a condition precedent?  For those who went to law school, this is Contract 101 stuff.  For those who go on the internet, this is Wikipedia stuff.

In contract law, a condition precedent is an event which must occur before the performance of the contract becomes due.  This should be contrasted with a condition subsequent.  A condition subsequent is an event which terminates the duty of a party to perform.   It’s often difficult to distinguish a condition precedent from a condition subsequent in a real setting since the difference between them is pretty close to negligible.  If it makes it easier, you can think of the conditions of a contract as operating an on/off light switch.  When you enter into a contract, the performance of the duties of the contract is set to “off”.  The occurrence of a condition precedent switches the light on and the party whose performance was subject to the condition must now perform.  Once the light is on, the occurrence of a condition subsequent switches the light off and the party who was performing may stop performing.

Therefore, when I indicated that an option is subject to significant condition precedents, the party that owns the subject property is under no duty to perform (ie., deliver the property) until those condition precedents have flipped the light on.   Given significant condition precedents, it is difficult to see how the call option holder (or put option grantor) could be viewed as the owner of the subject property.   This is essentially the decision in the Supreme Court case Lucas v. Comm’r, 281 US 11 (1930).  The Court in Lucas was attempting to decide whether a sale of timber lands occurred in 1916 or 1917.  In that case, the seller had given the buyer a 10-day option to purchase the lands and the buyer was solvent and able to make the purchase.  Moreover, on December 30, 1916, the buyer notified the seller that it would exercise the option and was prepared to close once all the papers were prepared.   However, this would not occur until the transaction was closed in 1917 and consequently, “…unconditional liability of vendee for the purchase was not created in [1916].”    In other words, the contract remained subject to significant precedents and therefore ownership could not transfer until 1917.

This decision shouldn’t be unfamiliar to anyone that has entered into a contract to purchase a house which, until closing, remains subject to significant condition precedents.  It would be a rare thing indeed if the purchaser thought that they were the owner of the house prior to the satisfaction of those conditions and tried to sleep in the seller’s bed.

200 (4)

This conclusion should also not be unfamiliar to anyone who has taken out a nonrecourse loan to buy something.  A nonrecourse loan is essentially a loan where the lender takes a security interest in some specific property and on default, does not have recourse to any assets other than the specific property.  A nonrecourse is essentially identical to the lender granting a put option to the borrower because if the value of the property fell below the value of the amount owed by the borrower, the borrower would simply walk away and give/put the property to the lender.  Since the lender’s right to acquire the subject property remains subject to significant condition precedents (e.g., default/exercise of the put), the lender would not be considered the owner of the property. for tax purposes, which is what most “normals” would expect.

Therefore, due to the significant condition precedents contained in options, it is unlikely that actual ownership of the subject property will change hands until the condition precedents have been removed.  See, Rev. Rul. 71-265 1971-1 C.B. 223 (option to purchase exercisable only after death of the optionor).

The option references specific property and the absence of condition precedents?

It naturally follows from the above that if all condition precedents are removed and the option references specific property, then ownership likely does transfer.

Recall that in the introduction, I identified 3 significant condition precedents that are inherent in options (again, there are probably more but I’m trying to think through this fast):

  1. the option may not be exercisable for some time.
  2. at the time the option is exercisable, the holder of the option may not choose to exercise it.
  3. even If the holder chooses to exercise the option, the call option holder (or put option grantee) must actually have the wherewithal to pay the strike price.

Were these conditions present in Rev. Rul. 82-150, 1982-2 C.B. 110, 1982-33 I.R.B.   which held that the holder of the option was actually the holder of the underlying the stock?   In the ruling, B, a nonresident alien in a foreign country set up foreign corporation FX with 100,000x dollars, receiving all of the stock of FX.  A, a US citizen, paid 70,000x to B for an option to purchase all of FX stock, exercisable at A’s discretion at any time, at a price of 30,000x dollars.  Obviously, A acquired a very deep-in-the-money option since the value of the company was 100,000x dollars and the option strike price was 30,000x dollars.

Now, let’s compare it to some of the significant condition precedents that I identified.  First, the option is exercisable at any time—so out goes (1).  Second, the holder must choose to exercise it.  Well, I guess the holder has the “choice” to exercise it, but in this case, the choice is illusory.  Unless A is the stupidest person on the planet, they will exercise the option since they will be getting 100,000x dollars of value for a payment of 30,000x dollars.  We’ll skip (3) for now since I don’t have the facts to establish A’s ability to actually pay the 30,000x strike price but I have to imagine that wasn’t going to be a problem.   Lastly, the property referenced here is not exactly fungible property—that is, it is very specific property and B can’t substitute it with something else that is like the shares of FX Corporation.  Therefore, B likely has very little ability to actually control disposition of the property.  Therefore, it appears that the IRS came to the right conclusion here.

Finally, you also need to take some care in identifying whether the condition is actually a condition precedent or a condition subsequent.  If the “condition” is actually a condition subsequent, you can be assured that the transfer will likely have transferred.  For example, in Rev. Rul. 75-563 1975-2 C.B. 199, the taxpayer entered into an “irrevocable written option” for the purchase of certain real property which gave the taxpayer the right to (1) immediate possession of the property, (2) unrestricted use of the property, and (3) acquisition of title to the entire tract of land upon payment of 400x dollars.   If the taxpayer elected to continue the “option”, the taxpayer was required to pay 40x dollars on January 2, 1973, and each succeeding January 2 until 1982.  The IRS, unsurprisingly, held that ownership transferred.  Here, the option was more in the nature of a condition subsequent such that the contract had been executed but the exercise of the option turns off the contract.

To sum up, because ownership relates to control over disposition, where the derivative contract relates to something fungible, there is no specific property that the option holder (or stock lender) expects to be returned to them; therefore, they don’t control disposition over any specific thing.  Second, where there are significant condition precedents to obtaining property, the condition precedents keep one from exercising control.