If Section 1092 does not apply when ESOs are one
of the offsetting positions:

If the straddle rule did not apply, then a $10,000

liquidated loss on the calls can be used immediately

as either an ordinary loss or a capital loss depending on

whether Section 1221 applied.

There is a good chance that it may be possible to claim

that the entire loss is ordinary income since it is part of

a "hedging transaction" under IRS Section 1221. But we

are not getting into that discussion now.

Tax treatment when the calls written or puts bought
have a profit:

Selling (writing) calls never creates a long term capital

gain regardless of the period held. The sale is considered

closed if the calls are bought back at a profit (or loss) or

if the calls are out of the money at expiration. The gain

is reportable as short term capital gain when closed.

If the sale of the calls were part of a "hedging transaction",

then IRS Section 1221 applies. The gain would then be

ordinary income and any losses would be ordinary losses.

If the written calls are in-the-money when they expire, the

listed call owner will exercise and the writer becomes

short stock. This is not considered a closing of the written

calls but a continuation of the written calls for tax purposes.

It is not a taxable event. The gain can be delayed

indefinitely as long as the seller of the calls (now short seller

of stock) wants to maintain a profitable short position.

If the call writer closes the short sale by buying stock back,

then there is a taxable event. It is either a gain or loss

depending on the price paid to cover and the price and terms

at which the call options were sold. It must be mentioned that

if the employee is an officer or director, he can only remain short

the stock to the extent that he is long the stock or long synthetic

stock (for example long in the money vested ESOs plus short a

put with the same exercise price as the ESOs). The officer or

director perhaps should avoid ever being short the stock by

buying the calls back shortly before they expire or selling his

puts when they become exercisable.


Buying Puts

If rather than selling calls to hedge, the risk reducing

grantee chooses to buy puts and finds the stock going

down substantially after the put purchase, he can sell

the puts and achieve a short term capital gain if

the puts are held less than a year or long term gain if

held over one year. If Section 1221 applies, the gains on

the puts would be ordinary income regardless of the

time held.

He can alternatively exercise the puts and substitute his long

puts for a short stock position. The exercise does not create

a taxable event. The gain becomes taxable when and if the

stock is purchased. This allows the delaying of a taxable

event on put and short sale profits indefinitely.


IRAs and the Straddle

Of course if the grantee wished to hedge his stock held

outside of his IRA by doing negative delta trades in his IRA

because he has liquid funds there, his gains will be tax

free or tax deferred.

How would the losses in an IRA be treated for tax purposes?

It depends if the straddle rule applied to the purchase of

puts to hedge inside of an IRA. My reading of the Section

1092 is that if there are offsetting positions even if one side

is in a IRA, that would create a straddle.

If it did apply, then the grantee could use the losses to raise

the costs basis of any stock positions if he designated the

offsetting positions as "identified straddles" under

Section 1092.



Conclusion:

There is some uncertainty as to how taxes will be assessed

against calls sold or puts bought to hedge ESOs because of the

possibility of there being an application of the straddle rule

Section 1092. I believe that Section 1092 will not apply.

But considering all possibilities, hedging ESOs is tax friendly.

Of course I can imagine a highly improbable event where the

tax treatment for hedging is not favorable.

For example: Assume that a grantee writes calls to buy

stock at 60 when he owns the same number of ESOs and

the stock quickly goes from 60 to 300. Then there comes

a ruling from the IRS saying that the Section 1221 does

not apply to offsetting positions where ESOs are one leg

and that there are mismatched tax treatments.

If the grantee had fully hedged his position and made no

delta adjustment as the stock rose, then he would have

a concern for this 1 chance in 100 situation.

But we never advise fully hedging the positions and adjust

deltas along the way if need be. If the ESO holder was

worried about such an event he could exercise gradually

some of his ESOs and defeat that highly improbable event.

So the 1 shot in 100 is not something to be concerned with

as a practical matter, in our view.

If the grantee/hedger was concerned about 1 in 100

chance events, he should make sure he is always

substantially delta long considering all of his positions.

If he is concerned about 1 in 100 chance events, he

certainly should be concerned about holding naked

options or naked ESOs, where the chance is perhaps

40 in 100 chance of the stock decreasing and making

the present at-the-money ESOs worthless at expiration.

Good Luck:

John Olagues