Guest Contributor: George Michaels, G2 FinTech
With tax season right around the corner, we wanted to shed some light on the historical creation of straddles and why they are important to a tax-aware portfolio strategy.
A straddle is a set of investment transactions that simultaneously take two offsetting positions on the same underlying security; one of the two positions holds long risk and the other holds short. Historically used to avoid paying taxes, a “tax straddle” uses these two positions to construct a tax shelter in which a taxpayer artificially creates taxable losses in order to offset pre-existing gains from unrelated transactions. Through repeated use of this strategy, gains can be indefinitely postponed from one year to the next.
Surprisingly, this practice was legal until 1981 when the IRS closed the straddles tax haven and started requiring firms to calculate gains on straddles transactions, whether they were intentional or not.
Straddles History 101
To understand how a tax straddle might affect capital gains calculations, let’s first look more closely at the historic case that closed the straddles tax haven.
The most well-known case of straddles abuse is the now infamous “Silver Butterfly Case.” The case was based on the actions of two investors, who, in 1973 executed 84 long futures transactions and 84 short futures transactions on silver. By the end of the calendar year, they had both significant unrealized losses and gains on the individual positions with a net profit of close to zero. The IRS decided to audit the firm and subsequently disallowed the losses.
In 1977, the IRS published a ruling (77-185) to support its decision, but unfortunately, there was no support in the tax code for it so the issue went to Washington for resolution.
When the case was brought to Congress, it sparked an epic battle between Dan Rostenkowski (Democratic Representative from Illinois) and Patrick Moynihan (Democratic Senator from New York) where Moynihan and others fought to close this loophole. In the end, Moynihan won and Congress added Section 1092 to the tax code via Title V of the Economic Recovery Tax Act of 1981 (ERTA).
Ultimately, Section 1092 of the tax code disallowed losses on the retired leg(s) of a straddle to the extent of the unrealized gain on the non-retired leg(s) at the end of the tax year.
Why the Silver Butterfly is Important
Today, there are two classes of straddles: basic and identified. These two categories differ in terms of how transactions become classified as straddles.
For firms to be able to run an accurate and truly comprehensive tax analysis process in order to submit accurate K1s to the IRS, they need to be able to correctly identify straddles, wash sales, constructive sales, Section 988 income bifurcation and qualified dividends. On top of this, firms also need to understand the interweaving of these taxable events, how they affect each other and, ultimately, how they impact a firm’s capital gains and losses.
The Silver Butterfly Case was the first step to shut down the use of straddles as a tax haven. Subsequently, the creation and implementation of Section 1092 is essential to smoothly transitioning a firm’s investment book to their tax book. Accurate straddles calculations are essential to producing accurate reports for the IRS and investors. They must be considered in a tax conscious portfolio and if firms understand when their investment positions result in unwanted taxable gains, they can adjust the unintended straddle before it has a negative tax implication for the firm and the investor.