Futures and Commodities §1256 Trading
§1256 net loss carryback election
This page is under development 8,504 words
By “default,” traders are usually taxed under the often desirable yet sometimes undesirable §1256 M2M 60/40 capital gains method of accounting, just the same as most other taxpayers. With these §1256 trades 60% is treated as long-term capital gain or loss and 40% is treated as short-term capital gain or loss.
But taxpayer businesses that maintain a complete and separable set of accounting books and records which qualify under IRS Regs. §1.446-1(d)(1) and that otherwise qualify to file with Trader Status may optionally elect in advance(*1), by filing with the IRS, to use the “Mark-to-Market” (M2M) method of accounting, pursuant to IRC §475(f)(2), for the election year and all ensuing years, as described below. This accounting method treats what would normally be Schedule D “capital gains and losses” as Form 4797 “ordinary gains and losses.”
Note: this page discusses the IRC §475(f)(2) M2M election for Futures and Commodities traders. A discussion about the IRC §475(f)(1) M2M election for Securities traders is found here.
Form 1099-B reporting of Regulated Futures Contracts:
Many retail brokerage house are becoming more consistent at identifying §1256 transactions and reporting them on IRS Form 1099-B, Boxes 8 through 11 as Regulated Futures Contracts.
A trick that traders can use during the year to learn if a traded position is considered a security or if it is considered a regulated futures contract by the brokerage house is to look for the §31 transaction fee charge on sales confirmations. This is discussed below and on this Section 31 webpage and at cftc.gov.
Tax Treatment under section 1256 of the Tax Code, profit and loss on transactions in certain exchange-traded options are entitled to be taxed at a rate equal to 60% long-term and 40% short-term capital gain or loss, provided that the investor or trader involved and the strategy employed satisfy the criteria of the Tax Code.
Some positions that may be treated as Regulated Futures Contracts:
|options on BKX||options on BTK||options on DJX|
|options on EPX||options on HGX||options on MNX|
|options on MXEF||options on NDX||options on OEX|
|options on OSX||options on RTY||options on RUT|
|options on RVX||options on SLV||options on SOX|
|options on SPX||options on USO||options on UTY|
|options on UUP||options on VIX||options on VXX|
|options on XAU||options on XEO||options on XSP|
Also see: The Definitive Guide To 2015 ETF Taxation.
Also see: CBOE How are covered calls taxed?
Also see: ETF Options Vs. Index Options.
Also see: Good News For Index Investors
Much more detailed data are found on the old-school desktop webpage here: http://www.traderstatus.com/futures.htm
Regardless of the fact that most futures trading is exempt from detailed transaction reporting, traders must keep the detailed records in their files, just as any well-run business would maintain its records. If you are audited, these details will be used to substantiate the volume of your daily activity in support of claiming “trader status” on your tax return. Screen shots of your year-to-date transactions, saved and backed-up may be invaluable during an IRS examination. Also save your monthly statements and if available, your confirmations.
Beware of solicitations asking if you’re tired of the stock market – Leverage your dollars into millions in foreign currencies traded on the spot market and thousands of dollars daily with little risk. See: FOREX Scams and Commodities Fraud
General taxation of the E-mini
The E-mini is classified as an IRC §1256 contact and therefore the net capital gain or loss from your trading will be divided into 60% long-term and 40% short-term regardless of your actual holding period. Therefore, when you have a net gain from trading the E-mini, 60% of the net gain will be taxed at the more favorable long-term capital gain rates and only 40% at the short-term capital gain rates.
When trading the E-minis you do not account for the wash sale rule. The wash sale rule basically states that if you sell a security at a loss and buy replacement stock 30-days before or 30- days after the sale of the same security, you are denied a current tax deduction of that loss (the tax benefit of that loss is deferred). Since the IRS wants to tax all of your gains, this wash sale rule does not apply to gains but only applies to losses.
When trading the E-mini you may make an election annually to carryback a current year loss to three years prior to offset previously taxed gains from trading the E-mini or other §1256 items. By filing in this manner you may be able to receive a refund of the prior year taxes paid on the §1256 items. Any current year §1256 loss (in excess of up to $3,000 annual limit) that you do not carryback would be carried forward indefinitely until it is use up against future capital gains + $3,000 per year against other income.
Optionally a trader may make an IRC §475 election changing the net capital gain/loss to a net ordinary gain/loss. Ordinary losses are fully deductible against most all other types of income and can be carried back two years and/or forward twenty years. But ordinary gains are generally taxed at the highest applicable tax rates and you need to forgo the beneficial 60% / 40% rule mentioned above.
When trading the E-mini you generally do not need to provide the IRS a list of all the individual trades if the broker provides the net gain of loss to you in the §1256 section of IRS Form 1099-B. The net gain or loss from your trading is then reported on IRS Form 6781 without the corresponding detail.
General taxation of the SPX and SPY
SPX, DJX, NDX, and RUT options are Index Options. They are European Style options, which means, among other things, that their monthly “last trading day” is different than those of ETFs. Index options expire on the third Friday of the month, so their last trading day is the third Thursday of the month.
SPY, DIA, QQQ, and IWM are ETFs (Exchange Traded Funds) and are American Style options, and both the last trading day and the investor’s expiration day for these options are the same: the third Friday of the month just like options on individual stocks.
NON-EQUITY, INDEX OPTIONS SPX, DJX, NDX, RUT, VIX (CBOE) European Style Cash settlement Can exercise only on expiration day Can enter or exit from position at any time prior to expiration. Usually have wider bid-ask spread Last trading day – third Thursday of month (day before expiration day) Expiration day – third Friday of month Tax treatment – 60% long-term / 40% short-term
ETF OPTIONS SPY, DIA, QQQ, IWM (XXI) American Style Physically settled Can exercise any day Can enter or exit from position at any time prior to expiration. Usually have narrower bid-ask Last trading day – third Friday of month Expiration day – third Friday of month (same as last trading day) Also available are quarterlies and weeklies Tax treatment – 100% short term (when held less than one year)
1256 Mark-to-Market treatment vs. the §475 Mark-to-Market election Regulated futures (subject to mark-to-market treatment and traded on a qualified board or exchange), non-equity options and dealer equity options receive different treatment than NYSE/NASD stocks and CBOE/OCC options . These types of contracts are governed by IRC §1256 and are treated partly as a long-term gain or loss (60% of the gain or loss) and partly as a short-term gain or loss (40% of the gain or loss), regardless of the actual length of your holding period.
In addition to the above mentioned “mark-to-market treatment” which is mandatory for investors as well as traders – certain qualified traders may choose to separately make an optional, additional mark-to-market accounting election under IRC §475.
Normally the mandatory mark-to-market treatment results in your capital losses being deductible against capital gains and being then subject to a $3,000-per-year net capital loss limitation in any one year to be applied against ordinary income. There is also a limited carryback available of any losses in excess of the $3,000 limitation as computed under IRC §1256.
Whereas an advantage of the mark-to-market accounting election for commodity/futures traders is that they are no longer subject to the capital loss limitation in any one year. A qualified trader who makes the separately optional election generally would not be restricted from deducting any loss from trading IRC §1256 futures/commodities and would therefore be able to write off the entire loss against ordinary income and could also carry any excess remaining loss (NOL) back to prior years. Furthermore, although any gains would be changed from “capital” to “ordinary,” they would not be considered self-employment income and therefore would not be subject to self-employment tax.
The (potentially substantial) downside of making the relatively permanent §475 mark-to-market accounting election is that your gains will be taxed at the higher ordinary tax rates – rather than seeing 60% of the gains taxed at the preferable (lower) long-term capital gain rates nor being available for offset against capital loss carryforwards.
Tax Summary of the §475 election for Futures/Commodities/§1256Contracts:
forgo making the election and…
§1256 contracts have a nice long-term gain rate for 60% of gains if §475 M2M is not elected. 🙂
§1256 contracts are limited for deductibility of any trading losses if §475 M2M is not elected. 🙁
make the election and…
§1256 contracts have no long-term gain rate for 60% of gains if §475 M2M is elected. 🙁
§1256 contracts are not limited for deductibility of any trading losses if §475 M2M is elected. 🙂
Old Capital Loss Carryforwards may be trapped on Schedule D if §475 M2M is elected. 🙁
What qualifies for this treatment a/k/a §1256 contract treatment?
A commodity futures contract is a standardized, exchange-traded contract for the sale or purchase of a fixed amount of a commodity at a future date for a fixed price.
If the contract is a regulated futures contract, the rules described earlier under Section 1256 Contracts Marked To Market apply to it.
The termination or closing of a commodity futures contract generally results in capital gain or loss unless the contract is a hedging transaction or unless a separate IRC §1256 mark-to-market election has been made.
Securities Futures Contracts
A securities futures contract is a contract of sale for future delivery of a single security or of a narrow-based security index.
Under IRC §1234B and gain or loss from the contract generally will be treated in a manner similar to gain or loss from transactions in the underlying security. This means gain or loss from the sale, exchange, or termination of the contract will generally have the same character as gain or loss from transactions in the property to which the contract relates. For Investors any capital gain or loss on a sale, exchange, or termination of a contract to sell property will be considered short-term, regardless of how long you hold the contract. For Traders and for Investors these contracts are not §1256 contracts. For Dealers they will be treated as §1256 contracts. Rev. Proc. 2002-11 severely limits who may qualify as a dealer in securities futures contracts
. Section 1256 contract options. Gain or loss is recognized on the exercise of an option on a section 1256 contract. Section 1256 contracts are defined under Section 1256 Contracts Marked to Market
Section 1256 contracts and straddles. Use Form 6781 to report gains and losses from section 1256 contracts and straddles before entering these amounts on Schedule D. Include a copy of Form 6781 with your income tax return.
Section 1256 Contracts Marked to Market
If you hold a section 1256 contract at the end of the tax year, you generally must treat it as sold at its fair market value on the last business day of the tax year.
Section 1256 Contract
A section 1256 contract is any:
- Regulated futures contract,
- Foreign currency contract,
- Nonequity option, (see IRS Rev. Rul. 94-63)
- Dealer equity option, or
- Dealer securities futures contract.
Regulated futures contract. This is a contract that:
- Provides that amounts that must be deposited to, or can be withdrawn from, your margin account depend on daily market conditions (a system of marking to market), and
- Is traded on, or subject to the rules of, a qualified board of exchange. A qualified board of exchange is a domestic board of trade designated as a contract market by the Commodity Futures Trading Commission, any board of trade or exchange approved by the Secretary of the Treasury, or a national securities exchange registered with the Securities and Exchange Commission.
Foreign currency contract. This is a contract that:
- Requires delivery of a foreign currency that has positions traded through regulated futures contracts (or settlement of which depends on the value of that type of foreign currency),
- Is traded in the interbank market, and
- Is entered into at arm’s length at a price determined by reference to the price in the interbank market.
Bank forward contracts with maturity dates that are longer than the maturities ordinarily available for regulated futures contracts are considered to meet the definition of a foreign currency contract if the above three conditions are satisfied.
Special rules apply to certain foreign currency transactions. These transactions may result in ordinary gain or loss treatment. For details, see Internal Revenue Code section 988 and regulations sections 1.988-1(a)(7) and 1.988-3.
Nonequity option. This is any listed option (defined later) that is not an equity option. Nonequity options include debt options, commodity futures options, currency options, and broad-based stock index options. A broad-based stock index is based upon the value of a group of diversified stocks or securities (such as the Standard and Poor’s 500 index). (see definition of narrow based stock index options below)
Warrants based on a stock index that are economically, substantially identical in all material respects to options based on a stock index are treated as options based on a stock index.
Cash-settled options. Cash-settled options based on a stock index and either traded on or subject to the rules of a qualified board of exchange are nonequity options if the Securities and Exchange Commission (SEC) determines that the stock index is broad based.
This rule does not apply to options established before the SEC determines that the stock index is broad based.
Listed option. This is any option that is traded on, or subject to the rules of, a qualified board or exchange (as discussed earlier under Regulated futures contract). A listed option, however, does not include an option that is a right to acquire stock from the issuer.
Dealer equity option. This is any listed option that, for an options dealer:
- Is an equity option,
- Is bought or granted by that dealer in the normal course of the dealer’s business activity of dealing in options, and
- Is listed on the qualified board of exchange where that dealer is registered.
An options dealer is any person registered with an appropriate national securities exchange as a market maker or specialist in listed options.
Equity option. This is any option:
- To buy or sell stock, or
- That is valued directly or indirectly by reference to any stock or narrow-based security index.
Equity options include options on a group of stocks only if the group is a narrow-based stock index.
Dealer securities futures contract. For any dealer in securities futures contracts or options on those contracts, this is a securities futures contract (or option on such a contract) that:
- Is entered into by the dealer (or, in the case of an option, is purchased or granted by the dealer) in the normal course of the dealer’s activity of dealing in this type of contract (or option), and
- Is traded on a qualified board or exchange (as defined under Regulated futures contract, earlier.)
A securities futures contract that is not a dealer securities futures contract is treated as described later under Securities Futures Contracts.
Marked to Market Rules
A section 1256 contract that you hold at the end of the tax year will generally be treated as sold at its fair market value on the last business day of the tax year, and you must recognize any gain or loss that results. That gain or loss is taken into account in figuring your gain or loss when you later dispose of the contract, as shown in the example under 60/40 rule, below.
Hedging exception. The marked to market rules do not apply to hedging transactions. See Hedging Transactions, later.
60/40 rule. Under the marked to market system, 60% of your capital gain or loss will be treated as a long-term capital gain or loss, and 40% will be treated as a short-term capital gain or loss. This is true regardless of how long you actually held the property.
Example. On June 23, 2001, you bought a regulated futures contract for $50,000. On December 31, 2001 (the last business day of your tax year), the fair market value of the contract was $57,000. You recognized a $7,000 gain on your 2001 tax return, treated as 60% long-term and 40% short-term capital gain.
On February 2, 2002, you sold the contract for $56,000. Because you recognized a $7,000 gain on your 2001 return, you recognize a $1,000 loss ($57,000 – $56,000) on your 2002 tax return, treated as 60% long-term and 40% short-term capital loss.
Limited partners or entrepreneurs. The 60/40 rule does not apply to dealer equity options or dealer securities futures contracts that result in capital gain or loss allocable to limited partners or limited entrepreneurs (defined later under Hedging Transactions). Instead, these gains or losses are treated as short term.
Terminations and transfers. The marked to market rules also apply if your obligation or rights under section 1256 contracts are terminated or transferred during the tax year. In this case, use the fair market value of each section 1256 contract at the time of termination or transfer to determine the gain or loss. Terminations or transfers may result from any offsetting, delivery, exercise, assignment, or lapse of your obligation or rights under section 1256 contracts.
Loss carryback election. An individual or partnership having a net section 1256 contracts loss (defined later) for 2002 can elect under §1212(c) to carry this loss back 3 years, instead of carrying it over to the next year. See How To Report, later, for information about reporting this election on your return.
The loss carried back to any year under this election cannot be more than the net section 1256 contracts gain in that year. In addition, the amount of loss carried back to an earlier tax year cannot increase or produce a net operating loss for that year.
The loss is carried to the earliest carryback year first, and any unabsorbed loss amount can then be carried to each of the next 2 tax years. In each carryback year, treat 60% of the carryback amount as a long-term capital loss and 40% as a short-term capital loss from section 1256 contracts.
If only a portion of the net section 1256 contracts loss is absorbed by carrying the loss back, the unabsorbed portion can be carried forward, under the capital loss carryover rules, to the year following the loss. (See Capital Losses under Reporting Capital Gains and Losses, later.) Figure your capital loss carryover as if, for the loss year, you had an additional short-term capital gain of 40% of the amount of net section 1256 contracts loss absorbed in the carryback years and an additional long-term capital gain of 60% of the absorbed loss. In the carryover year, treat any capital loss carryover from losses on section 1256 contracts as if it were a loss from section 1256 contracts for that year.
Net section 1256 contracts loss. This loss is the lesser of:
- The net capital loss for your tax year determined by taking into account only the gains and losses from section 1256 contracts, or
- The capital loss carryover to the next tax year determined without this election.
Net section 1256 contracts gain. This gain is the lesser of:
- The capital gain net income for the carryback year determined by taking into account only gains and losses from section 1256 contracts, or
- The capital gain net income for that year.
Figure your net section 1256 contracts gain for any carryback year without regard to the net section 1256 contracts loss for the loss year or any later tax year.
Traders in section 1256 contracts. Gain or loss from the trading of section 1256 contracts is capital gain or loss subject to the marked to market rules. However, this does not apply to contracts held for purposes of hedging property if any loss from the property would be an ordinary loss.
Treatment of underlying property. The determination of whether an individual’s gain or loss from any property is ordinary or capital gain or loss is made without regard to the fact that the individual is actively engaged in dealing in or trading section 1256 contracts related to that property.
How To Report
If you disposed of regulated futures or foreign currency contracts in 2003 (or had unrealized profit or loss on these contracts that were open at the end of 2002 or 2003), you should receive Form 1099-B, or an equivalent statement, from your broker.
Form 6781. Use Part I of Form 6781, Gains and Losses From Section 1256 Contracts and Straddles, to report your gains and losses from all section 1256 contracts that are open at the end of the year or that were closed out during the year. This includes the amount shown in box 9 of Form 1099-B. Then enter the net amount of these gains and losses on Schedule D (Form 1040). Include a copy of Form 6781 with your income tax return. Note: If optional §475 mark-to-market was elected, then use Form 4797 rather than Schedule D.
If the Form 1099-B you receive includes a straddle or hedging transaction, defined later, it may be necessary to show certain adjustments on Form 6781. Follow the Form 6781 instructions for completing Part I.
Loss carryback election. To carry back your loss under the election procedures described earlier, file Form 1040X or Form 1045, Application for Tentative Refund, for the year to which you are carrying the loss with an amended Form 6781 attached. Follow the instructions for completing Form 6781 for the loss year to make this election.
On the amended Forms 6781 for the years to which the loss is carried back, report the carryback on line 1 of that year’s amended Form 6781. Enter “Net section 1256 contracts loss carried back from” and the tax year in column (a), and enter the amount of the loss carried back in column (b).
The marked to market rules, described earlier, do not apply to hedging transactions. A transaction is a hedging transaction if both of the following conditions are met.
- You entered into the transaction in the normal course of your trade or business primarily to manage the risk of:
- Price changes or currency fluctuations on ordinary property you hold (or will hold), or
- Interest rate or price changes, or currency fluctuations, on your current or future borrowings or ordinary obligations.
- You clearly identified the transaction as being a hedging transaction before the close of the day on which you entered into it.
This hedging transaction exception does not apply to transactions entered into by or for any syndicate. A syndicate is a partnership, S corporation, or other entity (other than a regular corporation) that allocates more than 35% of its losses to limited partners or limited entrepreneurs. A limited entrepreneur is a person who has an interest in an enterprise (but not as a limited partner) and who does not actively participate in its management. However, an interest is not considered held by a limited partner or entrepreneur if the interest holder actively participates (or did so for at least 5 full years) in the management of the entity, or is the spouse, child (including a legally adopted child), grandchild, or parent of an individual who actively participates in the management of the entity.
Hedging loss limit. If you are a limited partner or entrepreneur in a syndicate, the amount of a hedging loss you can claim is limited. A hedging loss is the amount by which the allowable deductions in a tax year that resulted from a hedging transaction (determined without regard to the limit) are more than the income received or accrued during the tax year from this transaction.
Any hedging loss that is allocated to you for the tax year is limited to your taxable income for that year from the trade or business in which the hedging transaction occurred. Ignore any hedging transaction items in determining this taxable income. If you have a hedging loss that is disallowed because of this limit, you can carry it over to the next tax year as a deduction resulting from a hedging transaction.
If the hedging transaction relates to property other than stock or securities, the limit on hedging losses applies if the limited partner or entrepreneur is an individual.
The limit on hedging losses does not apply to any hedging loss to the extent that it is more than all your unrecognized gains from hedging transactions at the end of the tax year that are from the trade or business in which the hedging transaction occurred. The term unrecognized gain has the same meaning as defined under Straddles, later.
Sale of property used in a hedge. Once you identify personal property as being part of a hedging transaction, you must treat gain from its sale or exchange as ordinary income, not capital gain.
Gains and losses derived in the ordinary course of a commodity or option dealer’s trading in section 1256 contracts and property related to these contracts are included in net earnings from self-employment. In addition, the rules relating to contributions to self-employment retirement plans apply.
Final Rule: Exemption of Transactions in Certain Options and Futures on Security Indexes from Section 31 of the Exchange Act – re: the trick on how to potentially identify §1256 transactions: The semi-annual adjusted Section 31 fees no longer apply to sales of options on securities indexes (other than narrow-based security indexes). Therefore, if your sales proceeds are being reduced by the fee rates listed on this web page, the trade is not a Sec 1256 transaction.
List of narrow-based and broad based Exchange-Traded Index Options
COMMODITY FUTURES TRADING COMMISSION SECURITIES AND EXCHANGE COMMISSION Release No. 34-49469 Joint Order Excluding Indexes Comprised of Certain Index Options from the Definition of Narrow-Based Security Index pursuant to Section 1a(25)(B)(vi) of the Commodity Exchange Act and Section 3(a)(55)(C)(vi) of the Securities Exchange Act of 1934
AGENCIES: Commodity Futures Trading Commission and Securities and Exchange Commission.
ACTION: Joint Order.
SUMMARY: The Commodity Futures Trading Commission (“CFTC”) and the Securities and Exchange Commission (“SEC”) (collectively, “Commissions”) by joint order under the Commodity Exchange Act (“CEA”) and the Securities Exchange Act of 1934 (“Exchange Act”) are excluding certain security indexes from the definition of “narrow-based security index.” Specifically, the Commissions are excluding from the definition of the term “narrow-based security index” certain indexes comprised of series of options on broad-based security indexes.
EFFECTIVE DATE: March 25, 2004.
FOR FURTHER INFORMATION CONTACT:
CFTC: Thomas Leahy, Assistant Branch Chief, Market and Product Review Section, Division of Market Oversight, Commodity Futures Trading Commission, 1155 21st Street NW, Washington, DC 20581. Telephone 202/418-5278.
SEC: Elizabeth K. King, Associate Director, at 202/942-0140, or Theodore R. Lazo, Senior Special Counsel, at 202/942-0745, Division of Market Regulation, Securities and Exchange Commission, 450 Fifth Street, NW, Washington, DC 20549-1001.
SUPPLEMENTARY INFORMATION: I. BACKGROUND Futures contracts on single securities and on narrow-based security indexes (collectively, “security futures”) are jointly regulated by the CFTC and the SEC.1 To distinguish between security futures on narrow-based security indexes, which are jointly regulated by the Commissions, and futures contracts on broad-based security indexes, which are under the exclusive jurisdiction of the CFTC, the CEA and the Exchange Act each includes an objective definition of the term “narrow-based security index.” A futures contract on an index that meets the definition of a narrow-based security index is a security future. A futures contract on an index that does not meet the definition of a narrow-based security index is a futures contract on a broad-based security index.2
Section 1a(25) of the CEA3 and Section 3(a)(55)(B) of the Exchange Act4 provide that an index is a “narrow-based security index” if, among other things, it meets one of the following four criteria:
(i) the index has nine or fewer component securities;
(ii) any component security of the index comprises more than 30 percent of the index’s weighting;
(iii) the five highest weighted component securities of the index in the aggregate comprise more than 60 percent of the index’s weighting; or
(iv) the lowest weighted component securities comprising, in the aggregate, 25 percent of the index’s weighting have an aggregate dollar value of average daily trading volume of less than $50,000,000 (or in the case of an index with 15 or more component securities, $30,000,000), except that if there are two or more securities with equal weighting that could be included in the calculation of the lowest weighted component securities comprising, in the aggregate, 25 percent of the index’s weighting, such securities shall be ranked from lowest to highest dollar value of average daily trading volume and shall be included in the calculation based on their ranking starting with the lowest ranked security.
The first three criteria evaluate the composition and weighting of the securities in the index. The fourth criterion evaluates the liquidity of an index’s component securities.
Section 1a(25)(B)(vi) of the CEA and Section 3(a)(55)(C)(vi) of the Exchange Act provide that, notwithstanding the initial criteria, an index is not a narrow-based security index if a contract of sale for future delivery on the index is traded on or subject to the rules of a board of trade and meets such requirements as are jointly established by rule, regulation, or order by the Commissions. Pursuant to that authority, the Commissions may jointly exclude an index from the definition of the term narrow-based security index.5
In September 2003, CBOE Futures Exchange, LLC (“CFE”), a designated contract market approved by the CFTC, announced plans to trade futures contracts on certain “volatility indexes” created by the Chicago Board Options Exchange, Inc. (“CBOE”).6 Each of these volatility indexes is designed to measure the variability of daily returns on a security index (“Underlying Broad-Based Security Index”), as reflected in the prices of options on the Underlying Broad-Based Security Index. Accordingly, the component securities of a volatility index are put and call options on a security index.7 In light of CFE’s announcement, the Commissions have considered whether volatility indexes are narrow-based security indexes.
The statutory definition of the term narrow-based security index is designed to distinguish among indexes comprised of individual stocks. As a result, certain aspects of that definition are designed to take into account the trading patterns of individual stocks rather than those of other types of exchange-traded securities, such as options. However, the Commissions believe that the definition is not limited to indexes on individual stocks. In fact, Section 1a(25)(B)(vi) of the CEA and Section 3(a)(55)(C)(vi) of the Exchange Act give the Commissions joint authority to make determinations with respect to security indexes that do not meet the specific statutory criteria without regard to the types of securities that comprise the index.
Subject to the conditions set forth below, the Commissions believe that it is appropriate to exclude certain indexes comprised of options on broad-based security indexes from the definition of the term narrow-based security index. An index must satisfy all of the following conditions to qualify for the exclusion.
The first condition limits the exclusion to indexes that measure changes in the level of an Underlying Broad-Based Security Index over a period of time using the standard deviation or variance of price changes in options on the Underlying Broad-Based Security Index. The Commissions believe this condition is necessary to limit the exclusion to indexes calculated using one of two commonly recognized statistical measurements that show the degree to which an individual value tends to vary from an average value. The second, third, and fourth conditions provide that the exclusion applies to indexes that qualify as broad-based security indexes under the statutory criteria that evaluate the composition and weighting of the securities comprising an index. The fifth condition provides that the exclusion applies only if the Underlying Broad-Based Security Index qualifies as a broad-based security index under the statutory criterion that evaluates the liquidity of the securities comprising an index. The Commissions believe at this time that this condition is appropriate so that any such Underlying Broad-Based Security Index, including those that are not narrow-based under any of the exclusions to the definition under Sections 1(a)(25)(B) of the CEA and 3(a)(55)(C) of the Exchange Act, meets the statutory liquidity criterion. The sixth condition provides that the exclusion applies if the options comprising the index are listed and traded on a national securities exchange. Given the novelty of volatility indexes, the Commissions believe at this time that it is appropriate to limit the component securities to those index options that are listed for trading on a national securities exchange where the Commissions know pricing information is current, accurate and publicly available. Finally, the seventh condition provides that the exclusion applies only if the options comprising the index have an aggregate average daily trading volume of 10,000 contracts. The Commissions believe that this condition limits the exclusion to indexes for which there is a liquid market on a national securities exchange for the options on the Underlying Broad-Based Security Index, which contributes to the Commissions’ view that futures on such indexes should not be readily susceptible to manipulation.
The Commissions believe that indexes satisfying these conditions are appropriately classified as broad based because they measure the magnitude of changes in the level of an underlying index that is a broad-based security index. In addition, the Commissions believe that futures contracts on indexes that satisfy the conditions of this exclusion should not be readily susceptible to manipulation because of the composition, weighting, and liquidity of the securities in the Underlying Broad-Based Security Index and the liquidity that the options comprising the index must have to qualify for the exclusion. Specifically, these factors should substantially reduce the ability to manipulate the price of a future on an index satisfying the conditions of the exclusion using the options comprising the index or the securities comprising the Underlying Broad-Based Security Index.
IT IS ORDERED, pursuant to Section 1a(25)(B)(vi) of the CEA and Section 3(a)(55)(C)(vi) of the Exchange Act, that an index is not a narrow-based security index, and is therefore a broad-based security index, if:
(1) The index measures the magnitude of changes in the level of an Underlying Broad-Based Security Index that is not a narrow-based security index as that term is defined in Section 1(a)(25) of the CEA and Section 3(a)(55) of the Exchange Act over a defined period of time, which magnitude is calculated using the prices of options on the Underlying Broad-Based Security Index and represents (a) an annualized standard deviation of percent changes in the level of the Underlying Broad-Based Security Index; (b) an annualized variance of percent changes in the level of the Underlying Broad-Based Security Index; or (c) on a non-annualized basis either the standard deviation or the variance of percent changes in the level of the Underlying Broad-Based Security Index;
(2) The index has more than nine component securities, all of which are options on the Underlying Broad-Based Security Index;
(3) No component security of the index comprises more than 30% of the index’s weighting;
(4) The five highest weighted component securities of the index in the aggregate do not comprise more than 60% of the index’s weighting;
(5) The average daily trading volume of the lowest weighted component securities in the Underlying Broad-Based Security Index upon which the index is calculated (those comprising, in the aggregate, 25% of the Underlying Broad-Based Security Index’s weighting) has a dollar value of more than $50,000,000 (or $30,000,000 in the case of a Underlying Broad-Based Security Index with 15 or more component securities), except if there are two or more securities with equal weighting that could be included in the calculation of the lowest weighted component securities comprising, in the aggregate, 25% of the Underlying Broad-Based Security Index’s weighting, such securities shall be ranked from lowest to highest dollar value of average daily trading volume and shall be included in the calculation based on their ranking starting with the lowest ranked security;
(6) Options on the Underlying Broad-Based Security Index are listed and traded on a national securities exchange registered under Section 6(a) of the Exchange Act; and
(7) The aggregate average daily trading volume in options on the Underlying Broad-Based Security Index is at least 10,000 contracts calculated as of the preceding 6 full calendar months.
By the Commodity Futures Trading Commission.
Jean Webb Secretary
March 25, 2004
By the Securities and Exchange Commission.
Margaret H. McFarland Deputy Secretary
March 25, 2004
1 See Section 1a(31) of the CEA and Section 3(a)(55)(A) of the Exchange Act, 7 U.S.C. 1a(31) and 15 U.S.C. 78c(a)(55)(A).
2 See 17 CFR 41.1(c).
3 7 U.S.C. 1a(25).
4 15 U.S.C. 78c(a)(55)(B).
5 See, e.g., Joint Order Excluding from the Definition of Narrow-Based Security Index those Security Indexes that Qualified for the Exclusion from that Definition under Section 1a(25)(B)(v) of the Commodity Exchange Act and Section 3(a)(55)(C)(v) of the Securities Exchange Act of 1934 (May 31, 2002), 67 FR 38941 (June 6, 2002).
6 See CBOE News Release, “CBOE Announces Launch of Futures on VIX: First Tradable Volatility Product Will be Offered on New CBOE Futures Exchange” (September 5, 2003). The news release is available at www.cboe.com.
7 CBOE has published a White Paper describing the calculation and methodology of its volatility indexes, which is available at www.cboe.com/micro/vix/vixwhite.pdf.
drsynthetic: I have an IRS letter that talks about those types of trades, I asked for it last tax season. drsynthetic: here is the IRS excerpt -There is a quirk in the tax law in regard to exchange-traded options of index stocks (for example QQQ, SPX, XOI, etc.). These are a type of nonequity option. Nonequity options are all options that are not directly or indirectly related to a specific equity (stock). The IRS has issued a ruling that QQQs are a type of nonequity option. Most if not all publicly traded index options are nonequity options and are subject to the provisions of Internal Revenue Code Section 1256. Nonequity options are usually reported on Form 6781, unless they are used as a hedge. A hedge would be buying, for example, the QQQ, and then selling call options against them. WolfK: After much back and forth, the IRS told me that it comes down to whether the issuer of the option considers it an equity option. I asked the AMEX about their options and never got an answer. You know anyone to call over there?
The Mixed Straddle Election
Any straddle made up of non-§1256 contracts and at least one §1256 contract is a “mixed straddle.” 241 Such a straddle can have a number of tax consequences:
- As indicated in the discussion of the mark to market rule, where at year end the §1256 position is marked to market for a gain, this gain must be recognized without taking into account any unrecognized losses from any offsetting non- §1256 contract positions. Conversely, where the marking to market of the §1256 contract results in a loss, it will be disallowed under the §1092 loss deferral rule if there is any unrecognized gain with respect to offsetting non-§1256 positions.
- Without regulations that require a different result, the mixed straddle can convert short-term gain to 60/40 gain.
/Footnote/ 241 Technically, a “mixed straddle” does not come into being until its positions have been identified. §1256(d)(4). For ease of reference, however, the term is used in this discussion as defined above. Where the §1256(d)(4) meaning is intended, this will be termed a “§1256(d) mixed straddle.”
A taxpayer holding a mixed straddle has $100 of unrelated short-term capital gain. He closes out the non-§1256 straddle position242 for a loss of $100. This loss offsets the unrelated gain. The §1256 position is closed out for a gain of $100, subject to 60/40 treatment. While the straddle positions offset each other, the taxpayer winds up with the unrelated short-term gain converted to 60/40 gain. If, on the other hand, the §1256 position is the loss position, the result is the opposite. Assume again that there is $100 of unrelated gain. If the gain is long-term, disposition of both sides of the straddle ($100 of short-term gain from the non §1256 position; $60 of long-term loss and $40 of short- term loss from the §1256 position) will leave the taxpayer with $60 of short-term gain and $40 of long- term gain. Thus, $60 of the long-term gain has been converted to short-term gain. As explained below, regulations issued to implement the modified short sale rules effectively prevent any tax benefit from a mixed straddle by requiring characterization of any loss attributable to the non- §1256 position as 60/40 loss. There is no provision changing the disadvantageous result, however, where the loss position is the §1256 position. This one-way anti-conversion rule is sometimes called the “killer” rule.
/Footnote/ 242 In the discussion below, “§1256 position” and “non-§1256 position” dispense with the word “contract” after “§1256.”
The adverse tax consequences outlined above can be avoided, however, by making a mixed straddle election243.
/Footnote/ 243 The killer rule can also be avoided by making the elections provided by Regs. §1.1092(b)-3T and 1.1092(b)-4T, explained below.
Where the taxpayer identifies all the positions of such a straddle before the close of the day (or such earlier time as provided by regulations) on which the first §1256 contract included in the straddle is acquired, the taxpayer may elect to have the mark to market and 60/40 rules not apply to all §1256 contracts in the straddle244. The mixed straddle election applies on a straddle-by-straddle basis.
/Footnote/ 244 §1256(d). This election is sometimes referred to as the “§1256(d) election.” It is irrevocable unless the IRS consents. Technically, a “mixed straddle” arises only where identification and election have occurred, but the term is used here (and in the §1092(b) regulations) to mean any straddle qualifying for such election regardless of whether it has been so identified.
No action need be taken to identify non-§1256 contract positions before the first §1256 contract position of the straddle is acquired. Thus, an options dealer may have a stock position acquired at an earlier date included in the mixed straddle election. To include the previously acquired stock in the election, the taxpayer must identify both the stock and the option position as being the positions of the mixed straddle before the end of the day on which he acquired the option.
A mixed straddle may also be identified as an “identified straddle245.” In this case, not only do the mark to market and 60/40 rules not apply to any of the §1256 contracts in the straddle, but the loss deferral rules do not apply to any positions in the straddle or to any other positions held by the taxpayer by reason of their being offsetting to positions that are part of the identified straddle.
/Footnote/ 245 §1092(a)(2).
Many taxpayers would be presented with a difficult choice in choosing whether to make the §1256(d) election, thus forfeiting any advantage from 60/40 treatment of gains from §1256 contracts, or not to make the election, risking the adverse tax consequences outlined above. As discussed below, however, the §1092(b)(2) regulations offer an alternative to the §1256(d) election that substantially preserves the advantage of 60/40 treatment of any net gain from a mixed straddle.
The §1092(b) Regulations Introduction As part of the loss deferral rules for straddles246, Congress directed the IRS to prescribe “such regulations with respect to gain or loss on positions which are part of a straddle” as are appropriate to carry out the purposes of §1092. Congress provided that “to the extent consistent with such purposes” the regulations were to include rules applying wash sale principles247 and certain portions of the short sale rules248 discussed above249. /Footnote/ 246 §1092. /Footnote/ 247 §1091(a) and §1091(b). /Footnote/ 248 §1233(b) and §1233(d). /Footnote/ 249 §1092(b)(1). In enacting 1984 amendments to the loss deferral rules, Congress understood that the straddle rules, including the regulatory extension of wash and short sale principles to straddle transactions (as revised to include stock options), would create difficulties for traders who regularly enter into mixed straddles. This was especially so for options dealers who typically grant, buy and sell dealer equity options (§1256 contracts) while holding non-§1256 contract long or short positions in the underlying stock. To deal with this problem, Congress specified that the §1092(b) regulations were to provide “elective provisions in lieu of §1233(d) principles,” namely, provisions permitting the taxpayer to offset gains and losses from positions that are part of a mixed straddle under rules requiring either straddle-by-straddle identification or the creation of mixed straddle accounts250. /Footnote/ 250 §1092(b)(2). The (temporary) regulations issued under these directives fall into three parts. (1) The first part251 coordinates the wash sale rules with the loss deferral rules and governs the extent to which a loss sustained from the disposition of a straddle position must be deferred. (2) The second part252 contains rules based on principles similar to those underlying the short sale rules relating to the treatment of holding periods and the characterization of losses sustained with respect to straddle positions. /Footnote/ 251 Temp. Regs. §1.1092(b)-1T. /Footnote/ 252 Temp. Regs. §1.1092(b)-2T. Note: Parts (1) and (2) parts are referred to as the “§1092(b)(1) regulations.” (3) The third part provides rules carrying out the directive of §1092(b)(2) to provide elective alternatives to the Regs. §1.1092(b)(1) provisions applying §1233(d) principles. These regulations are called the “§1092(b)(2) regulations.”
60/40 Treatment of Futures, Options under Assault Source: Daily News; White Plains Publication date: 2003-05-20 WASHINGTON (HedgeWorld.com) – The U.S. Senate’s vote for the Jobs and Growth Tax Relief Reconciliation Act of 2003 came with a last- minute kicker – a manager’s amendment containing various revenue enhancers including the abolition of the current 60/40 tax treatment for gains and losses on futures and options transactions.
The Futures Industry Association, Washington, opposes any such change. Its president, John M. Damgard, said Tuesday that he is very curious about the origins of the idea. “Somebody in the bowels of the treasury has a drawer full of what they call revenue enhancers’ – what we call tax increases – and this one comes out of the drawer regularly,” he said. Furthermore, the “scoring” (i.e. the calculation of the amount of revenue the amendment would raise) is suspect. “Funny arithmetic sometimes is necessary to make things work,” he said.
In this case, it “worked” in the sense of securing passage but just barely. Despite the revenue-enhancing amendments, proposed by Sen. Chuck Grassley (R-Iowa) in order to firm up the commitment of wavering senators worried about ballooning the deficit, the bill carried only 51 to 50, with the tie-breaking vote of Vice President Dick Cheney.
Mr. Grassley, chair of the Senate Finance Committee and floor manager for the bill, proposed the amendments as part of a package that included a two-year phase-in of an exemption of dividend income from the federal income tax. The proposed dividend tax relief, long a priority of the Bush administration, comes with a sunset provision for 2007.
The resulting bill, passed by the Senate May 15, is in many ways quite different from the version passed by the House of Representatives on May 9. The House bill reduces but does not eliminate tax rates on dividends and capital gains, and its reduction (to 15%) does not expire until 2013. The House bill also contains no change in the 60/40 rule. The conference committee will have to hash all this out.
The 60/40 tax rule dates to 1981, when it was part of a compromise to a dispute over whether taxpayers should be required to mark their “butterfly straddles” to market value. Internal Revenue Code 1256 was created to require taxpayers to characterize the gains or losses on futures contracts as 60% long-term and 40% short-term capital gains or losses, regardless of how long the contracts had been held.
Since 1981, according to Garry L. Moody, national director of Deloitte & Touche LLP’s investment management services group, hedge funds that trade in options have been able to account for their short-term gains as offsets to expenses, while the 60% accounted as long-term gain gets favorable tax treatment. “Taking this away would have a favorable impact on the budget,” Mr. Moody acknowledged, but “I’m sure there’s going to be a lot of discussion before this is enacted.”
Chicago Exchanges Both Opposed
On Monday, the leadership of the Chicago Mercantile Exchange and the Chicago Board of Trade sent a joint letter for the conferees, warning that abrogation of the 60/40 rule will “impair liquidity in U.S. futures markets and thereby increase the cost of government debt by reducing the ability of bidders in treasury market auctions to hedge their exposures in fixed-income and interest rate futures markets.”
Separately, Charles P. Carey, chairman of the board of the CBOT, and Bernard W. Dan, its chief executive, sent a letter to their membership describing the Senate’s action as a “grave danger” to the industry. The letter added that both men (and CME Chairman Terry Duffy) would be traveling to Washington this week as the House/ Senate conference looms.
“Our D.C. office is fully engaged and coordinating with a coalition of markets and market users to ensure that this proposed legislation does not become law,” members were assured.
Publication date: 2003-05-20
- Senate Repeals 60/40 Tax Treatment, Then Reverses Decision After weeks of negotiations on a broad package of tax reductions and economic stimulus measures, the Senate on May 15 narrowly approved the Jobs and Growth Tax Relief Reconciliation Act of 2003. During the voting process, the Senate agreed to a manager’s amendment containing a number of revenue enhancements designed to limit the overall cost of the legislation. One of these measures repealed section 1256(a)(3) of the Internal Revenue Code and thereby eliminated the current 60/40 tax treatment applied to gains and losses on futures and options transactions.Responding to an intensive 3-day lobbying campaign from the futures and options industry, the Senate on May 20 approved a “technical corrections” bill that among other things removed the 60/40 repeal from the tax bill. Republican leaders are now negotiating ways to combine the House and Senate versions of the tax bill. The 60/40 repeal is not contained in the House version, and now that it has been struck from the Senate bill, the current tax regime for futures and options is no longer a part of the current tax discussions.The FIA, together with leading U.S. futures exchanges, played an important role in persuading key members of Congress to reject the hastily approved repeal of 60/40. In letters and conversations with lawmakers, the FIA stressed the damaging repercussions of such a change on the markets and their participants, including investors in commodity pools and hedge funds. In addition, the FIA pointed out that the provision would have eliminated the 60/40 treatment, but leave untouched other sections of the tax code that require the assessment of taxes on unrealized gains and losses at year-end. In effect, the Senate bill would have made it impossible for market participants to record any long-term gains or losses on futures and options transactions.
Optional §1256 contracts net loss carryback election:
Using IRS Form 6781 a taxpayer may elect to carry back three years an amount of capital losses in excess of $3,000 from §1256 contracts. The carried back losses may generate a tax refund by being offset against §1256 contract gains in that 3rd year, with any remaining net loss coming forward year-by-year.
(*1) Generally, individuals elect to use the mark-to-market method of accounting by filing the election statement no later than April 15th for the year of the election (i.e. after the beginning and before April 16th of the year for which M2M takes effect). For most partnerships, LLCs and corporations that means no later than March 15th (or April 15th as the case may be) for the year of the election. For new taxpayers, for example those who have not previously filed an income tax return (such as a newly formed multi-member LLC), then that means #1 preparing the actual election statement no later than 2 months and 15 days after the entity’s formation and #2 to notify the IRS that the election was timely made, the new taxpayer must attach a copy of the statement to its original federal income tax return for the election year (which is filed after the end of the first year).
The §475(f) election may be revoked by filing a request to change the method of accounting no later than April 15th for the year of the revocation (or other date similar as described above) – or in lieu of revocation the owners may simply stop using the entity, liquidate it or dissolve it.
In addition, generally, IRS form 3115 must be timely filed one year after the request to change is filed: either the request to change to M2M or a request to revoke a prior M2M election.
Late M2M elections are generally not allowed:
Pursuant to Reg. §301.9100-2(b) This paragraph (b) does not apply to regulatory or statutory elections that must be made by the due date of the return excluding extensions.