Rev. Rul. 78-181

The Internal Revenue Service has reconsidered the conclusion reached in Rev. Rul. 70-205, 1970-1 C.B. 174, concerning the treatment of the amount paid to repurchase a 30-day call option prior to the expiration of its exercise period.

In Rev. Rul. 70-205, the taxpayer purchased 1,000 shares of stock for $67,000 and simultaneously sold a 30-day call option on those shares for $10,000. Prior to the expiration of the 30-day option period, the taxpayer, who is neither a stockbroker nor a dealer in securities, repurchased the call option for $16,000 and simultaneously sold the 1,000 shares of stock for $74,000. The purchases and sales were transacted through the taxpayer's stockbroker. Rev. Rul. 70-205 holds that the amount paid by the taxpayer to repurchase the call option in excess of the selling price received for the call option is a capital expenditure that is an additional cost of the underlying stock to be taken into account in determining gain or loss on the sale of such stock.

Rev. Rul. 58-234, 1958-1 C.B. 279, provides that, if a put or call option is exercised, the premium (consideration paid for the option) is allocated as an adjustment to the price or cost of the underlying stock that is the subject of the option, so that capital gain may result. When, however, a put or call expires without having been exercised, the premium received by the issuer or the writer is ordinary income. Thus, Rev. Rul. 58-234 recognizes that income from the sale of a capital asset is different from income realized by the writer of an option contract that expires without being exercised.

Rev. Rul. 63-183, 1963-2 C.B. 285, states that when an optionee permits a put or call to expire without being exercised, the premium the writer received is not associated with, and has no relevance in, fixing the amount of gain from the disposition of any particular stock or securities.

In the instant case, the taxpayer's repurchase of the call is analogous to the lapse of the option, since, in both instances, the transaction causes termination of the taxpayer's obligation. Therefore, the purchase and sale of the underlying stock are considered separate taxable events, unrelated to and unaffected by the writing and repurchase of the option by the taxpayer.

Section 1221 of the Internal Revenue Code of 1954 provides that the term "capital asset" means all property held by the taxpayer unless specifically excluded therein. Section 1222 provides that capital gain or loss is derived from the sale or exchange of a capital asset.

Section 63 of the Code, as amended by the Tax Reduction and Simplification Act of 1977, provides that, in the case of an individual, the term "taxable income" means adjusted gross income reduced by the sum of the excess itemized deductions, and the deductions for personal exemptions provided by section 151 and increased (in the case of an individual for whom an unused zero bracket amount computation is provided by section 63(e)) by the unused zero bracket amount (if any).

Under section 62 of the Code, adjusted gross income is determined by subtracting from gross income certain enumerated deductions, one of which, under section 62(4), is losses from the sale or exchange of property.

Section 165(a) of the Code generally allows a deduction for any loss sustained during the taxable year and not compensated for by insurance or otherwise. Section 165(c) provides, in part, that the deduction for losses of individuals is limited to losses incurred in a trade or business and losses incurred in any transaction entered into for profit, though not connected with a trade or business.

In Commissioner v. Ferrer, 304 F.2d 125 (2d Cir. 1962), the court analyzed prior opinions that held contract rights to be capital assets, and determined that those opinions had the common characteristic of finding that the taxpayer had an estate, an encumbrance, or an option to acquire an interest in property that would have been a capital asset in the hands of the taxpayer. In like manner, the determination of whether the repurchaser of a call realizes capital gain or loss or ordinary gain or loss must rest on an analysis of what rights were created by the writer when the call was created.

The writer of an option has created no rights in the writer, but only an obligation to perform in the event the holder exercises the option. Therefore, the option writer does not have a capital asset. Similarly, as to the option writer, the option does not represent property within the meaning of section 62(4) of the Code.

Accordingly, the taxpayer has incurred an ordinary loss of $6,000 ($16,000 cost of the repurchase over $10,000 realized on the sale) from the repurchase of the option contract. Since it has been determined that the repurchase of the option did not result in a sale or exchange of property, the loss, although authorized by section 165(a) of the Code, is not deductible in computing adjusted gross income pursuant to section 62(4). The loss is deductible to the extent provided by section 165(a) but only if the taxpayer elects to itemize deductions pursuant to section 63. Furthermore, the taxpayer realizes a short-term capital gain of $7,000 ($74,000 - $67,000) to be recognized from the sale of the $1,000 shares of stock. The loss incurred from the repurchase of the option contract will not be considered, in any manner, in determining the amount of gain realized from the disposition of the stock, regardless of the fact that the repurchase of the option and the sale of the stock occurred simultaneously.

Because of the amendment to section 1234 by the Tax Reform Act of 1976, applicable to transactions involving options granted after September 1, 1976, the principles in this ruling will apply only to the repurchase of calls originally written before September 2, 1976. Also, pursuant to the authority granted by section 7805(b) of the Code, these principles will not be applied adversely to any taxpayer who, prior to May 15, 1978, repurchased a call originally written before September 2, 1976, and to whom Rev. Rul. 70-205 would have applied. However, if such a taxpayer treats the amount by which the repurchase price of a call exceeds the selling price as a capital expenditure that is an additional cost of the underlying stock, the taxpayer should not also claim a loss on the repurchase of the call.

Section 1234(b)(1) of the Code, which applies to options granted after September 1, 1976, provides that in the case of the grantor of an option, gain or loss from any closing transaction with respect to, and gain on the lapse of, an option in property shall be treated as a gain or loss from the sale or exchange of a capital asset held not more than 6 months (9 months in a taxable year beginning on or after January 1, 1977; 12 months in a taxable year beginning on or after January 1, 1978). Section 1234(b)(2)(A) defines "closing transaction" as any termination of the taxpayer's obligation under any option in property other than through the exercise or lapse of the option.

Under section 1234(b)(1) of the Code, as amended, therefore, the $6,000 loss on the option closing transaction would be treated as a short-term capital loss, which would have to be netted against the taxpayer's other capital gains or losses. Thus, if the transactions described above were the taxpayer's only capital transactions for the year, the $6,000 short-term capital loss would be subtracted from the $7,000 short-term capital gain from the sale of the stock, leaving a net short-term capital gain of $1,000.

See Rev. Rul. 78-182, page 265, which holds that the writer of an option who closes out the obligation through the medium of the Chicago Board Options Exchange, Inc., realizes short-term capital gain or loss measured by the difference between the amount received for writing the option and the amount paid by the writer to terminate the obligation under the option.

Rev. Rul. 70-205 is revoked.