Copyright (c) 1996 Tax Analysts

Tax Notes

OCTOBER 14, 1996

LENGTH: 18274 words

DEPARTMENT: Special Report (SPR)

CITE: 73 Tax Notes 203

HEADLINE: 73 Tax Notes 203 - TAXING THE INCOME FROM WRITING OPTIONS. (Section 1256 -- Futures Marked To Market) (96-27722 (18 pages))

AUTHOR: Johnson, Calvin H.

Tax Analysts

CODE: Section 1256 -- Futures Marked To Market

SUMMARY:

Calvin H. Johnson is the Andrews & Kurth Centennial Professor of Law at the University of Texas. This report was presented to the Tax Structure and Simplification Committee of the ABA Tax Section at its meeting on August 2, 1996, in Orlando, Florida, as a part of the committee's Financial Modernization Project.

Current law allows a taxpayer issuing an option on stock or other property the taxpayer holds to defer payment of tax on the option premium received until the option is exercised or lapses. Professor Johnson argues that the cash option premium should be taxed when received and that the deferral of tax is unjustified. The cash received is a realization event with respect to the underlying property, Johnson argues, and in a realization income tax, cash is a realized amount. Johnson would tax the cash as ordinary income because it is consumable yield and not capital that must be reinvested or preserved. For a bare option, however, when the issuer does not hold the underlying property, Johnson argues the cash receipt is a borrowing transaction and not the realization of built- in gain on any property.

Professor Johnson wishes to thank his colleagues, Joseph Dodge and Mark Gergen, and the participants in the August 2 panel, Brad Ferguson (moderator), and David Garlock and Clarissa Potter (commentators) for helpful comments. 'They set up a gauntlet,' he says, 'that both tested the thesis of this piece and helped improve our law. '

REFERENCES:

Subject Area:

Business Tax Issues

TEXT: 14 OCT 96

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Table of Contents

I. Facts and Current Law ................................... 204

A. Underlying Facts ..................................... 204

B. Current Tax Law ...................................... 204

II. Rethinking the Taxation of the Option

Premium ................................................. 205

A. The Problem of Deferral .............................. 205

B. Nonstarter Issues .................................... 207

III. Ordinary or Capital Gain Rate? .......................... 209

A. Expected Composite Rate .............................. 210

B. Fixed Systemwide Blended Rate ........................ 211

C. Determine Character Independently of

Outcome .............................................. 212

D. Shelterability by Capital Losses ..................... 213

IV. Recovery of Basis ....................................... 214

A. Expected Gain Model .................................. 214

B. Boot Model ........................................... 215

C. Naked Options ........................................ 217

D. Minimum Gain Rule for Unknown FMV .................... 218

Conclusion ...................................................... 220

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[1] Under current law, a taxpayer selling an option on property he or she holds is not taxed on the option premium received until the option is exercised or lapses. The rule deferring tax arises from a time when the time value of money in tax was not well appreciated. The tax deferral now needs to be ended. An option premium is nonrefundable cash that can be consumed, invested, or distributed by the issuer at its choice. In a realization income tax, cash received is realized. Deferral of the option premium misdescribes the issuer's economic position and undertaxes the option premium.

[2] This report argues that the premium from a 'covered option' is properly treated as ordinary income 'boot.' A 'covered option' is one in which the issuer holds the underlying property when the option is issued. The issuer should be taxed upon receipt of the option premium to the extent of the built-in gain on the underlying property. Basis in the underlying property would be recovered, but only after the built-in gain is taxed. 'Bare options,' however, where the issuer does not hold the underlying property, are not the recognition of built-in gain on any property. They are borrowing transactions in which the detriment of the cash the issuer receives is fully offset by the cash the taxpayer expects to pay out.

[3] This report first describes a hypothetical that is used with ordered changes in the facts throughout the report. It then describes current law. Part II argues that current law is too generous as to timing and then rejects various arguments for deferral. Part III discusses whether capital gain or ordinary income rates should apply and concludes that the option premium is ordinary income even when the underlying property is a capital asset. Part IV assumes that the issuer has not just gain but some basis in the underlying property and argues that the right rule is to tax built-in gain first, as in the boot rules for like-kind exchanges or reorganizations. The part concludes, however, that a bare option is just a borrowing transaction and not a realization of any gain. Part IV also discusses the cases in which the underlying property does not have a clearly ascertainable value, so that the built-in gain cannot be easily established. The conclusion summarizes the recommended rules.

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I. FACTS AND CURRENT LAW

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A. UNDERLYING FACTS

[4] Assume that taxpayer receives $100 for issuing an option that allows the holder to buy ABC stock at its current market price. TP owns stock of ABC Inc., now worth $126.04, which is a capital asset and portfolio stock in TP's hands. ABC stock has an ascertainable value because it is traded on an established market. TP sells D, an unrelated buyer, an option to buy ABC stock, exercisable at any time over the next two years, at a strike price equal to the current $126.04 value.

[5] ABC stock is risky. ABC holds promising technology that will make ABC stock climb in value in two years to $610.04 a share if the technology proves to be commercially feasible. There is only a 25 percent chance that ABC's technology will prove to be commercially feasible, however, and there is a 75 percent chance that the stock will be worthless. ABC Inc. will pay no dividends for the two-year term of the option. Assuming a 10 percent discount rate (so that amounts received in two years would be discounted to present value, by dividing by (1+10%)(squared)) and assuming that TP and the highest bidding buyers are risk-neutral, /1/ ABC stock is now worth $126.04, considering time value and risk:

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Table 1

ABC Inc. Stock Worth $ 126.04

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Expected

Outcome Chance Value

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High $ 610.04 25% $ 152.51

Low 0 75% 0

Sum: $ 152.51

Discounted: $ 126.04

Sum/(1+10%)(squared)

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[6] An option to buy ABC stock within two years for a strike price equal to the current $126 value is worth $100 at present. As a general rule, it is rational to exercise a fixed-strike-price option only at the last available moment because the delay in exercise delays the cost of coming up with the strike price by borrowing or by selling some other investment. /2/ ABC pays no dividends during the term and it is assumed that voting ABC stock is not important to D. Under the assumptions, the option is worth $100 when discounted for time value and chances of exercise:

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Table 2

Option Worth $ 100

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Expected

Outcome Chance Value

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Exercise $ 610.04126.04= 25% $ 121

$ 484

Lapse 0 75% 0

Sum: $ 121

Discounted: $ 100

Sum/(1+10%)(squared)

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The option at $100 is worth such a high percentage of the value of the underlying stock, at $126, because the underlying stock is unusually risky.

[7] It is assumed that where TP is a corporation, TP will pay a 35 percent tax rate on both ordinary income and capital gain. /3/ Where TP is an individual, TP will pay a 40 percent tax rate on ordinary income and a 28 percent tax rate on long-term capital gain. /4/

B. CURRENT TAX LAW

[8] Under current law, TP is not taxed on the receipt of the $100 until the option lapses or is exercised two years after receipt. /5/ The rationale is that TP cannot know upon receipt whether the $100 will be gain or recovery of basis and whether its character will be capital gain or ordinary income. /6/ An alternative rationale for deferral is that the $100 is said not to be earned when received. /7/

[9] If the option is exercised, the $100 option price is treated as part of the sale proceeds for the underlying property. ABC stock will be a long-term capital asset to TP by the time the option is exercised even if it was newly acquired when the option was issued. The $100 option premium will be included with the $126 strike price to calculate the amount realized and then the long-term capital gain or loss. /8/

[10] If the option lapses or TP sells the option or settles with D without exercising the option, the $100 will be a short-term capital gain upon lapse or settlement and not eligible for the 28 percent rate. /9/ Prior to 1976, the $100 option premium was ordinary income upon lapse of the option. The prior, ordinary-income rule remains the law if the underlying property is not stock, security, or a commodity. /10/

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II. RETHINKING THE TAXATION OF THE OPTION PREMIUM

A. THE PROBLEM OF DEFERRAL

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[11] Assume, first, that TP is a corporation, paying the 35 percent maximum corporate tax rate and that TP Inc. has a zero basis in ABC stock. The first assumption that the issuer is a corporation allows us to put off discussion of rate differentials /11/ and the zero basis assumption allows us to put off discussion of recovery of basis. /12/

[12] Under the assumption that TP is a corporation without basis in ABC stock, deferral of taxation of the option premium is not justified. Ordinarily, when a corporation has $100 cash realized, it must pay $35 immediately. The statutory tax rate of 35 percent is what Congress presumptively intended. The deferral of the tax for two years, however, means that the real burden drops below the statutory tax rate. At a discount rate of 6.5 percent, for instance, the $35 tax payable in two years has a present value of only $30.86. /13/ In real or present-value terms, the tax burden has dropped to slightly under 31 percent because of the deferral. Longer deferral, determined by the term set by the parties, will drop the real tax rate further.

[13] The value of deferral can also be measured in terms of its impact on the income earned subsequently from the investment of a $100 principal. Under a normal income tax, $100 of pretax money is reduced to $65 after tax immediately and the after-tax investment of the $65 generates taxable income that is itself subject to tax. A 35 percent tax on subsequent investment income will mean that the $65 investment grows to $73.72 after two years under the assumptions. /14/ With the deferral of tax on the option premium, however, the full pretax or 'soft-money' $100 can be invested and the investment of the soft money will yield $78.42 in two years, even after the deferred tax. /15/ The $78.42 end result is what might ordinarily be expected from a 1.6 percent tax on subsequent income, rather than a 35 percent tax on subsequent income. /16/ There seems to be no good policy reason why investments from normal sources should bear tax on their income at 35 percent, but investments from option premiums should bear tax on their income at the equivalent of 1.6 percent.

[14] For similar reasons there is no justification for taking the $100 option premium into income over the two-year term. /17/ Taking the $100 premium into income over two years would reduce the 35 percent statutory tax to the present value of only 32 percent, /18/ which is not as low as under a full two-year deferral, but is still unjustified. Taxing the $100 over two years would be like imposing a tax of 9.5 percent on investment income, under the logic just used, /19/ which is not as low as the 1.6 percent equivalent with the full two-year term, but is still unjustified. Bringing the $100 premium into income only over the next two years also misdescribes TP's situation: TP has $100 immediately, not $50 after a year and another $50 after two years. Neither a complete deferral nor two-year amortization is justified for a $100 that is immediate and investable capital.

[15] Concluding that the $100 cash received needs to be taxed is a modest conclusion, fully consistent with the deep norms of current law. Our income tax is in general a realization-income tax, meaning that economic gains are not taxed until the gains are severed from the underlying capital by the receipt of cash. /20/ A realization tax system, however, anticipates that cash is realization of prior gains that will lead to tax. Section 1031, for instance, enacted under the influence of Eisner v. Macomber, to exempt capital that remains in investment, /21/ taxes cash pulled out of investment. /22/ Section 453, giving deferral to buyer notes, still taxes cash payments received. /23/ A realization system has to tax the cash a taxpayer received, even though that represents just the realization of gain and not the economic accrual of new gain, because that is all that a realization system has left to tax.

[16] A realization income tax, combined with a step up in basis at death, /24/ is quite plausibly the worst tax: it is inefficient because it induces taxpayers to avoid realization until death can wipe all gain accounts. It is unfair because it wastes so much revenue giving advantage to existing capital, while denying advantage to new capital, where an incentive might do some good. A move away from a realization system either toward an accrued-income tax, taxing gains without realization, or toward consumption tax would improve the system by equalizing effective tax rates among industries and taxpayers. Moves toward imputing taxable interest on investments /25/ or taxing increases in value of property that is not sold /26/ are to be applauded as improving both equity and efficiency. But taxing cash from an option premium is a modest proposal, which requires no modification of the norm, most conservatively interpreted, that gains must be realized to be taxed. Cash is a quite sufficient realization event.

[17] The case that established deferral, Virginia Iron Coal & Coke Co., /27/ is wrongly decided and needs to be overruled under current law. The case arose at a time in which the time value of money was underappreciated in taxation. /28/ The judges seem to be thinking that deferral is a free choice without any adverse consequences that they may use at will to solve problems of determining character or gain. For TP, a corporation with zero basis in ABC stock, none of the reasons for deferral exist and the deferral is not cost-free. Deferral of tax is an advantage where no justification for advantage has been shown. The tax law governing taxation of option premiums is presumably trying to describe TP's economic situation and not to lend some subsidy. In construing or constructing taxable income, administration, court, and Congress should presume that a rule that supports a broad and unavoidable tax is better than a rule that leads to a narrower tax base and avoidable tax. Taxation of undertaxed items can even reduce the deadweight loss from the tax system. /29/ For any chosen level of government, moreover, widening the tax base allows the tax rates to drop and reduces the avoidable damage from the collection of revenue. /30/

[18] The proper taxation of option premiums is also important as a building block or foundation for the taxation of other financial instruments. Financial instruments are often best analyzed, as consisting of an interest or rental return, at a risk-free rate, plus an option. /31/ As long as the option is undertaxed, it is difficult to tax properly those instruments that are equivalent to an option or have an option embedded in them. /32/

[19] Consequent basis adjustments. Immediate taxation of the $100 option premium when received entails that the $100 not be taxed again. If the option is exercised, option premium needs to be excluded from the amount realized by sale, whereas current law includes the option premium in amount realized on exercise. Lapse of the option would be a nontaxable event for TP, the issuer, whereas current law taxes the premium upon lapse of the option. Once taxed on the $100, TP could establish basis of $100 by investing the option premium in some other property, but no basis adjustments would be appropriate for that other property whether the option is exercised or lapses.

B. NONSTARTER ISSUES

[20] There are a number of arguments for deferral that do not withstand serious scrutiny.

1. Earned.

[21] TP's $100 option premium will be TP's to keep, whether or not the option is exercised, so that there are no contingencies under which the $100 needs to be refunded to D. Still it is sometimes said that TP's $100 is deferred because it is not yet 'earned.' /33/

[22] CRITIQUE. Since there are no refund contingencies with respect to the $100 premium, it is difficult to see the sense in which the $100 is said not to be 'earned.' /34/ The $100 is vested and nonforfeitable. Under general standards, in any event, lack of 'earning' is not appropriately a reason for deferral. The income tax is a comprehensive tax that taxes accessions to wealth, whether or not they are 'earned.' /35/ The $100 is a fully consumable or investable amount for TP when received.

2. Consideration in return.

[23] By issuing an option that D is willing to pay $100 for, TP has undertaken an obligation to give up ABC stock should it prove to be in D's interest to exercise the option. Just as D has purchased something -- the option-- worth $100, so TP has given up something -- an interest in the ABC stock -- that is worth $100. TP's remaining interest in ABC stock goes down in value by $100 from $126.04 to $26.04 by reason of its being made subject to the option:

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Table 3

Stock Remainder Declines to $ 26.04

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Expected

Outcome Chance Value

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Exercise $ 126.04 25% $ 31.51

Lapse 0 75% 0

Sum: $ 31.51

Discounted: $ 26.04

Sum/(1+10%)(squared)

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[24] The reduction in the value of TP's interest in ABC stock by the amount of the option premium is a general phenomenon. The issuer's interest in the underlying will always go down in value by the same option premium ($100 here) that the holder is willing to pay for the option. The total value of ABC stock does not increase when the option is issued; TP and D just share the total value. The equality of the option premium and drop in TP's remaining interest will always be true whenever TP and D are risk-neutral and assess the risks in the same way.

[25] CRITIQUE. The interest that TP gave up in consideration for the $100 received cannot imply that TP is immune from tax on the $100. Under the starting assumption, TP has a zero basis in ABC stock. A transfer of an interest in zero basis property can never be used as a ground for not taxing the cash received in return, or no cash would ever be taxed in an arm's length commercial sale. A taxpayer who sells zero basis property for $100 has given up property worth $100: the cash and the consideration will have equal value because of the arm's length bargain. Still, the seller is taxed on the $100 realized gain. Similarly, if value given served to exempt cash received, no cash rent could ever be taxed, because the value of use of the property would offset the cash received. No cash compensation would ever be taxed because the value of the services would offset the cash compensation. So similarly, an obligation to deliver zero basis property cannot be used to offset the taxability of the $100 premium received. Using future delivery of zero basis property to offset taxability is not just a timing error, but something more fundamental: zero basis items given in exchange for cash do not prevent taxation of the cash.

3. Deferred expense on the other side.

[26] The holder, D, on the other side of the transaction, has a capital investment of $100. D's cost is an investment with significant future value, which has not expired. For the expenditure, D gets $100 basis and not a $100 deduction. To prevent double taxation of both D and TP, it is argued, TP should defer tax on the $100 as long as D must capitalize it. /36/

[27] CRITIQUE. D's capitalization carries no implication that TP's income should be deferred. If D had purchased stock worth $100 from TP, then TP would have $100 realized and D would have a $100 basis. There can be no theorem that a recipient may exclude amounts received if the payer has to capitalize them, or that the payer may expense investments if the recipient pays tax on them. If there were such a theorem, Treasury would then receive no net tax from any investments or capitalized expenditure arising between equal tax-rate investor and provider. The tax collected on one side of the transaction would always be offset by tax refunded on the other side. Realized amounts are taxed in a realization-based income tax, even when the amounts are capital expenditures on the other side. The reason is the fundamental one that Treasury should be taxing investment under the norms of an income tax.

4. $100 loan?

[28] The holder, D, has made a $100 investment in the option, but, under current law, D is not taxed on the return from that investment, unless and until D sells ABC stock. Professors Shuldiner and Schenk have argued that current law undertaxes D. Net-present- value discounting implies that D could have made a 10 percent return on another investment and will pay a price for the option so as to make a 10 percent return on the option premium. The bet on ABC stock, in the core hypo, is worth $121 at the end of two years (as the weighted average of the possible outcomes), which implies that D achieved the expected discount rate. To remedy the undertaxation of D, it is argued, the $100 option payment should be considered a loan. D would then have imputed income under the original issue discount provisions, and TP would have a tax deduction for the imputed interest. TP's imputed-interest deduction would offset taxable income that TP achieves from the investment of the $100 while the option is open and would shift the tax incidence over to D. /37/

[29] CRITIQUE. D, indeed, is relatively undertaxed on his side of the transaction. An investment of $100 in a taxable bond would have generated $10 of interest a year at the 10 percent assumed rate. D has made a rational choice, building in a 10 percent discount rate, by paying $100 for the option. All investments can reasonably be analyzed as consisting of a risk-free interest rate, plus or minus a bet. But the argument for taxing D does not depend upon whether D's $100 investment is a loan investment or an equity investment, and the investment is better understood as equity. Even if D might have interest imputed, moreover, that should not imply that TP should be undertaxed.

[30] D has made an equity investment and not a debt investment. TP issuer gets to keep the $100 (less whatever tax) and consume it immediately. If TP invests the $100 for a year, TP can consume $110 (less tax). If TP had merely borrowed the $100 from D, and made just the going $10, then TP would have nothing left at year end after repaying creditor D. In the core hypo, TP has sold to D a slice of ABC stock and may keep the $100 or $110. D now 'owns' the value of ABC stock that is in excess of the strike price (if ABC becomes worth more than the strike price). That is a sale of equity.

[31] Suppose that TP had sold D some interest in fee in some other stock for $100. We would capitalize D's cost. We would also tax TP on the $100 if that were over TP's basis. But we would not impute interest payments from TP to D, infinitely, so long as D owns the stock in fee and we would not save TP from tax on both the $100 and subsequent interest for the infinite period of time of the fee. The sale of the option is no different, just because its term is limited.

[32] In the option, D has purchased appreciation with his $100 investment in the ABC option. TP has kept the interim dividends on ABC stock, if any, and must pay tax on them as they are paid. TP has disposed of the appreciation in ABC stock in excess of the strike price and ought to realize gain from that sale. D has an equity investment seeking appreciation. We might someday reasonably tax D on unrealized appreciation or at least impute interest at a riskless rate and wait for the rest to see how the bet comes out, but we do not now do that under the historical cost convention underlying current law.

5. Interest charge instead?

[33] Tax law sometimes allows taxpayers to defer paying taxes, but then charges interest, at a risk-free interest rate, on the delayed taxes. /38/ The function of the interest charge is to compensate the government for forbearing from collecting tax at the earlier date. The interest charge also offsets the taxpayer's economic benefit from delaying payment of tax. TP, for instance, could be treated as if TP owed $35 tax to the government as soon as the $100 option premium was paid, but the government would then loan TP the $35 for two years, charging interest, at risk-free rates, for the delay in collecting the $35.

[34] CRITIQUE. The $100 cash option premium is liquid and there are no special considerations for why tax might not be paid from out of the cash. Deferral plus an interest charge is not an appropriate remedy when TP has no liquidity problems that make immediate payment of tax especially difficult. The purpose of the interest charge for deferral is to take away the economic benefit of deferral. If the charge succeeds in taking away the taxpayer's benefit, why bother granting both the advantage of deferral and the offsetting interest to neutralize the advantage? An interest rate that leaves the taxpayer with some economic benefit even after paying interest is not justified by any special considerations as to the option. A risk-free interest rate does not leave the government whole because the government undertakes some credit risk that it may not be able to collect the $35 plus interest from TP. Interest adds complexity. If the function of interest is to relate the $35 back to the time the $100 option premium is received, it is far simpler just to collect the $35 tax out of the $100 upon receipt.

6. Refreshing net operating losses.

[35] It is sometimes said that the $100 option premium needs to be deferred on the ground that TP may be trying to refresh expiring net operating losses ('NOLs') by achieving $100 income. /39/ A taxpayer might, for instance, take elective income into account early so that the income would be sheltered by expiring net operating losses, whereas if the income were taken into account 'on time' the income would be taxed.

[36] CRITIQUE. Elective income needs to be taxed in a realization income tax. Income not taxed upon realization will often never be taxed, especially given the section 1014 step up in basis at death. Trying to prevent extension of the NOLs would just reduce tax on normal sources of income on the ground that the income is elective. In a realization income tax system, elective timing of income is quite common. Taxpayers with appreciated property, for instance, can always sell property to use up expiring losses. Deferral of income is also fairly easy, but a taxpayer with expiring NOLs can just stop deferring income. By sale or ending deferral, taxpayers would have cash that would create deductions or depreciation to be used after the statutory expiration of the NOL. Thus if extension of expiring net operating losses, in this way, were a social problem, Treasury would not have a very good chance of containing it by ignoring elective income.

[37] Fortunately, refreshing NOLs is not a material tax policy problem. Extending use of net operating losses beyond 15 years is not a very important issue, either in value or as a matter of policy. Net operating losses under current law may be carried forward to be used against taxable income for 15 years after the dollar was lost. /40/ At corporate tax rates of 35 percent and a 6.5 percent discount rate, any tax losses that have survived to the end of the 15-year period have a time value of less than 13 cents per dollar that had to be lost to generate the NOL. /41/ The low level of economic benefit from NOLs at the end of the 15 years does not leave very much room for abuse.

[38] The period for carryovers has been extended from time to time /42/ and there is no special reason why 15 years is an inevitable cut-off. Treasury might extend the time for using net operating losses without significant fear of abuse. Net operating losses used 20 years after the dollar was spent, for instance, would be worth only 10 cents per dollar lost to get them. /43/ There is indeed a school of thought that says that NOLs should generate tax refunds much earlier, even if the taxpayer has no income to use them against, so that the tax savings on the losses would be worth 35 cents per dollar lost. /44/ Tax planning to extend net operating losses may be a self-help remedy, but it achieves a goal -- extension of the carryforward -- that is not a serious social problem.

[39] Finally there is no special merit to the assumption that taxation of the $100 option premium, when received, is 'premature' or that deferral until lapse or exercise is waiting until the income is 'on time.' The $100 is consumable, investable money that is taxable under any norm of the income tax. If Treasury were to grant easy deferral of income on the grounds that an immediate tax on real income might refresh net operating losses, it will be shooting itself in the foot.

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III. ORDINARY OR CAPITAL GAIN RATE?

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[40] One of the rationales given for deferral is that it is impossible to determine when the $100 is received whether the tax rate applied should be an advantageous capital gain rate or an ordinary income rate. /45/ For corporations, the issue does not now matter, since they pay the same 35 percent tax whether the income is long-term capital gain or not. Corporations, accordingly, should not get deferral under this rationale. For an individual TP, however, the 28 percent long-term capital gain tax rate will apply to the $100 if the option is exercised and the 40 percent assumed ordinary rate or short-term capital gain rate will apply if the option lapses. Until it is known for sure whether the option is exercised, it is argued, it cannot be known for sure which rate, 40 or 28 percent, is appropriate.

[41] Imposition of tax at zero rate on the receipt of the $100 option premium is not a reasonable settlement of ambiguities as to whether the rate of tax should be at 40 or 28 percent. TP should be taxed immediately notwithstanding that lapse or exercise two years would affect character.

[42] With considerable complexity, one can preserve current law character of lapse or exercise, even with immediate tax. It is generally possible, for example, to compute an expected rate, blending the capital 28 percent tax rate and the 40 percent ordinary rate according to a weighted average reflecting how likely the parties thought it was to have lapse or exercise. A simpler rule with considerable theoretical appeal, however, is to review current law and in so doing to make the $100 ordinary income when received, without regard to expectations of lapse or exercise, even when ABC stock is a capital asset.

A. EXPECTED COMPOSITE RATE

[43] For any given option on a capital asset, there is an 'expected tax rate' between 28 and 40 percent that reflects the percentage likelihood that the 28 or 40 percent rate will be applied. The expected tax rate depends on the likelihood of exercise option. The expected tax rate on the ABC option, for instance, is 37 percent: Under the given facts, the ABC option had only a 25 percent chance of being exercised, meaning that there was only a 25 percent chance of the $100 being considered long-term capital gain. In 75 percent of the cases, the option was expected to lapse and give a 40 percent tax rate character to the $100. The expected rate of 37 percent is 25 percent of the way down from 40 percent (and 75 percent of the way up from 28 percent) to reflect the likelihood of lapse (and exercise).

[44] In general, TP faces an expected tax rate, looking at the likelihood of exercise, as follows:

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(1) Expected tax rate = e%* cg + (1-e%) * t

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where e% is the expected percentage of cases in which the option will be exercised, cg is the tax rate on capital gain, and t is the tax rate on ordinary income. /46/ Under equation (1), the expected tax rate on the ABC option is 25%*28% + 75%*40% or 37%.

1. Expected tax rate revealed.

[45] The likelihood of exercise (e%) to be used in equation (1), expected tax rate, can be computed from a known option price, strike price and fair market value for ABC stock. Even if the parties do not understand or do not want to reveal a likelihood of exercise, e%, still the terms of the transaction will reveal a unique value for e% that is built into the bargain the parties have set.

[46] An option is more valuable to D, the holder, than a forward contract, which binds D to buy and TP to sell. The extra value comes from two elements:

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(a) TIME VALUE. D need not pay the strike price ('Sk') until the

end of the term.

(b) LOSS PROTECTION OR PUT VALUE. D will avoid losing the strike

price by not exercising in those cases when the stock value is

not above the strike price at the end of the term.

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[47] It follows that the value D will be willing to pay to TP immediately for the option is

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(2) OP = FMV Sk/(1+i)(to the nth power)

+ (1-e%)*[Sk/(1+i)(to the nth power)]

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where OP represents the option premium (and value of the option), FMV represents the fair market value of ABC stock when the option terms are set, e% represents the likelihood that the option will be exercised, i represents the discount rate generally available to D and TP, /47/ and n represents the term of the option. Equation (1), in English, says the value of an option is equal to the fair market value of the underlying property less the discounted value of the strike price D must pay to get the property plus the 'put value,' that is, the value that arises because D will not lose the strike price in those cases in which it is not rational to exercise the option.

[48] Equation (2) has an alternative presentation, derived from looking at TP on the other side of the bargain. TP will sell his stock only when the value TP receives in return is equal to its value:

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(3) FMV = OP + e% * Sk/(1+i)(to the nth power)

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[49] In English, equation (3) says that TP must receive consideration, combining the option price plus a strike price (discounted by time and expected likelihood of occurring) that is at least equal to the current value of the stock TP is selling. Equation (3) is also just an alternative expression of equation (2) because it can be derived from Equation (2). /48/

[50] The expected likelihood of exercise of the option (e%) built into the bargain between D and TP can be derived from either the holder-side equation (2) or the issuer-side equation (3) /49/:

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(4) e% = (FMV-OP) / [Sk/(1+i)(to the nth power)]

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Equation (4) says that the likelihood of exercise is equal to the difference between the current value and option premium divided by discounted value of the strike price. For the givens of the ABC stock, the values for equation (4) are ($126100) / (126/1.21) = 26/104 = 25%, which is indeed the given likelihood that the option on ABC stock would be exercised. In turn, plugging back the 25 percent as e% in the equation (1) for expected tax rate gives the 37 percent expected tax rate.

[51] There are some counterintuitive aspects to equation (4) in that the larger option premiums yield an expected tax rate closer to ordinary rates and the smaller option premiums yield an expected tax rate closer to capital gains rates. For any given relationship between strike price and fair market value (e.g., strike price = current value), the larger option premiums are associated with the lower exercise likelihoods, e%. This relationship follows from the fact that higher option premiums (OP) are associated with more volatile stock. The smaller option premiums are thus associated with higher e% and hence with an expected rate shaded more toward capital gain.

[52] Equation (4) still has some unknowns and estimates, even once OP, Sk, n, and FMV are known. Equation (4) assumes that there are no dividends on ABC stock for the term of the option or that if there are, the expected dividends can be stated as an annual interest rate that reduces the discount rate. Still, equation (4) provides a workable estimate of the likelihood of exercise, built into the terms the parties bargained for, and a workable estimate of expected value.

2. Outcome or variance.

[53] The expected tax rate, while a good estimate, does not need to be the final word. For example, if the option is exercised, the appropriate tax rate, judged from the outcome, is 28 percent, not the expected rate of 37 percent. Determining the rate by the exercise outcome entails that TP should be refunded the difference or 11 percent, plus interest. Conversely if the option lapses, TP paid only 37 percent tax, whereas judged by the outcome, the option should have borne 40 percent ordinary tax. Judged by outcomes, TP should bear another 3 percent tax, plus interest. The 37 percent tax is fine as a standard to apply to the $100 option premium initially, but if outcome counts in principle, variances between standard and outcome should yield more tax or a refund once outcome is known. Since the $100 was money in hand when the option was written, moreover, variances determined upon outcome should bear interest for or against TP to relate them back to the time of the receipt.

[54] It can be argued, on the other hand, that outcomes do not matter enough to undertake the complexity of variances and interest charges. It can be argued next that outcomes should not really matter at all - - the $100 is ordinary when received-- and there is an intermediate position that outcomes matter enough to set expected rates, but not enough to justify accounting for variances. If the expected rate accurately reflects the expectations of the parties, revealed by their bargain, it is arguable that the law can forgo the complexity of taxing or refunding variances plus interest. Tax would then be set according to expectations rather than outcomes. Some taxpayers would pay too much tax and some too little, measured by outcomes, but no taxpayer would know of the error when allocating capital to invest, so no taxpayer could assume over-or undertaxation when deciding whether to go into the transaction. Tax would not distort pretax decisions. Where the expected tax rate turns out to be too high, taxpayers could also be said to have waived objection because they knew when they entered the transaction that the variances from the expected tax rate would not be taken into account.

[55] It seems inappropriate, however, to undertake the effort of variances and interest-rate adjustments just because the tax rates change after issuance. Even if the character of an option premium were to be derived from lapse or exercise, two years hence, still the year of receipt should determine the final tax rate.

B. FIXED SYSTEMWIDE BLENDED RATE

[56] There is not a single blended rate that works reasonably well for all options. Some options are not very likely to be exercised (hence should have a blended rate shaved toward 40 percent) and some options are not very likely to be exercised. A good census of options under current law would not be terribly illuminating. Options are relatively attractive ways to extract cash from property, under current law's deferral of tax, especially for the options most likely to lapse. The status quo thus does not provide a very accurate measure of nontax values or a very attractive norm. If rates applied to all option premiums upon receipt are going to fixed nationwide for all options, then variances and interest on the variances seem compelled, so that the nationwide rate can be reconciled to real outcomes once the outcome is known.

[57] POLITICAL RATE? There is a political compromise, embedded in section 1256, that would lead to a blended tax rate of 32.8 percent here. Section 1256 taxes unrealized increases in the market value of certain traded or dealer options and future contracts. As a political quid pro quo, section 1256 imposes a blended tax on the unrealized gains, composed by making 40 percent of the market gain ordinary income and 60 percent capital gains. Under the assumed rates here, the 40-60 percent compromise would yield a blended tax rate of 40%*40% + 60%*28% or 32.8 percent.

[58] The section 1256 political compromise is not a very attractive model. Two years deferral drops the effective tax rate from 40 percent to roughly 35.6 percent /50/ and there is no pressing need to reduce the real tax burden on option premiums below the current levels. Taxing unrealized appreciation might be reasonable theory but it was an unprecedented departure from a long history of requiring realization in 1981 when section 1256 was enacted. /51/ By contrast, option premiums are realized receipts in cash, with no contingencies allowing refund. Deferral is not sound theory. There should be no political compromises needed to tax nonrefundable cash.

C. DETERMINE CHARACTER INDEPENDENTLY OF OUTCOME

[59] Considerable simplification is also possible just by setting the final character of the option premium at its receipt and without regard to subsequent lapse or exercise of the option. If the character is set by the legal theory with finality when the option premium is received, no variances or interest would ever be needed.

[60] The rule deferring option premiums until exercise or lapse set the character of the option premium arose at time in which an option was considered by the case law to be mere 'potential income,' /52/ or an 'open transaction' /53/ and not income or complete transaction by itself. An option, however, is better viewed now as a taxable event apart from the sale and not just as a partial step within a potential sale. /54/

[61] Looking at the option premium by its own character apart from its relationship to sale of stock yields a conclusion that the $100 is appropriately ordinary income:

1. No sale or exchange.

[62] The option premium is not necessarily part of a sale or exchange of the underlying property because the issuer will retain the option premium whether the sale or exchange of the property occurs. The sale or exchange is not a but-for cause of the premium.

[63] The value that the option has for the holder, moreover, can be attributed to the 'nonexercise' or 'put value,' that is, the value from the fact that the exercise price is not committed to the stock and will not be lost if the stock declines. /55/ Viewing the option value in that way means that the option premium is attributable, not to sale or exchange, but to its absence.

[64] Even when the underlying property is a capital asset, accordingly, the option premium does not arise from the sale or exchange of the underlying asset. Without a sale or exchange, gain cannot be capital. /56/

2. Carve-out.

[65] Under current tax law, secondly, sale of a 'carve out' interest is ordinary income because the seller has retained the 'capital' by retaining a reversionary right in the underlying property. Rent received for a building or land, for instance, including the crop received for use of farm land under a crop-sharing agreement, is ordinary income to the landlord, not qualifying as capital gain, because of the fact that the landlord retains the underlying capital. /57/ In return for rent, the landlord has sold an interest, a chronological interest, in the underlying property, but the chronological interest sold is sale of a 'carve-out' and not the sale of the capital. A sale of a carve-out is neither capital gain nor the occasion for recovery of the landlord's basis.

[66] An option premium is the proceeds from the sale of carve- out interest, like renting, because TP achieves the income without disposing of the underlying capital, ABC stock. The issuance of an option leaves TP with his capital still intact. TP keeps the dividends from the ABC stock, if there are dividends, and the votes from ABC stock, if votes matter. The option is not a fee interest or fractional interest in the whole of ABC stock because D's interest will expire (or ripen) in two years. The option given by the issuer TP is not a capital asset because it is a carve-out, that is, because TP has retained TP's capital intact in the underlying property. /58

3. Consumable yield not carrying reinvestment responsibility.

[67] The core rationale for the preferential taxation of capital gain is that the gains are expected to be reinvested rather than consumed. At common law under feudal systems, capital gain belonged to corpus. Corpus had to be reinvested for the benefit of remainder and could not be consumed by the income beneficiary. /59/ The preferential rate for capital gain arises as a compromise with arguments that investment and changes in the subject of the investment should not be taxed at all. /60/

[68] Option premiums do not qualify as capital gain, under this standard, because investors do not ordinarily assume the premiums will or need to be reinvested. According to surveys, individual investors usually issue covered options to achieve a consumable dividend-like yield from the option premiums. The premiums are sought and used for consumption. Option premiums are not treated as 'capital' that needs to be preserved or capital that needs to be reinvested. /61/ Option premiums are not capital within the ordinary meaning of 'capital.'

D. SHELTERABILITY BY CAPITAL LOSSES

[69] Taxing option premium as ordinary income or at a blended or expected tax rate will affect not only the rate of tax applied to the $100 but also whether the $100 can be sheltered by TP's capital losses. There is no reason, it is concluded here, to allow the $100 option premium to be sheltered by capital losses.

1. Current law.

[70] Prior to 1976, lapse or exercise of an option determined not just the tax rate to be applied, but also whether the option could be sheltered by capital losses. If the underlying property was a capital asset, exercise of the option would be capital gain, but lapse would be ordinary income. /62/ Capital gain can be offset by capital losses in full, /63/ but ordinary income can be offset by capital losses only to the extent of a relatively small 'dribble out' rule. /64/ In 1976 Congress provided that gain on lapse of an option on stock, securities, or commodities would be short-term capital gain, taxable at ordinary tax rates, but also shelterable by capital losses. /65/ If the option is not on stock, securities, or commodities, however, the prior case law governs and the $100 premium on lapse is nonshelterable ordinary income.

[71] Treating premiums on stock and commodity option as shelterable income if the option lapsed came in 1976 as a pro- taxpayer part of package instigated to cut down on abuses. Treasury was concerned about ordinary losses from option trading that converted ordinary income into capital gain. To achieve its goals, it was willing to accede to a tax relief of 'hardship' under which an option issuer who had both ordinary income from issuing options and capital losses would not be able to use the capital losses against the option premium income. /66/

2. Proper scope of section 1211.

[72] There does not seem to be anything special about options that make the rationale for section 1211 limitations less forceful for options and there does not seem to be any pressing reason to preserve the special shelterability of option premiums. The function of the section 1211 limitations on deduction of capital losses is to prevent a taxpayer from taking advantage of risk and the ability to elect realization. A taxpayer, for instance, might go into a portfolio of risky stocks each of which will double or nothing by year end. As a whole the portfolio would retain or increase its value, but individual stocks within the portfolio would double or disappear. The taxpayer would, however, show the tax system only part of the portfolio: The taxpayer would realize all losses by sale or worthlessness and hold all gains indefinitely or unto death. If the losses were deductible in full against salary and other normal sources of income, the taxpayer could always display no net income, even if the portfolio was appreciating as a whole and the taxpayer's standard of living was high from the high, but fully sheltered, income. Section 1211 remedies the abuse potential by restricting capital losses. The taxpayer is presumed to have expected capital gains from the risk fluctuations, whenever there are capital losses, and the tax recognition of the losses is deferred to be matched against capital gains when the taxpayer confesses the gains. /67 Amounts shelterable by capital loss, under the policy of the section 1211 limitations, are those gains that are the outcome of a risk or fluctuation.

[73] Option premiums are not returns from the positive outcome of fluctuation or risk because the taxpayer keeps the premium whether or not the stock or commodity increases in value. They are more like dividends or rents or other income from capital received without regard to the outcome of a risk. As such they should not be shelterable under the more general rationale of the capital loss limitations.

[74] The 'hardship' result cited in 1976 in making option premiums on stock, securities, and commodities was just a routine result of section 1211, limiting the use of capital losses to capital gains. The ad hoc nature of the solution is shown, for instance, by the fact that although the $100 is characterized as 'gain' on lapse of the option, there is no sale of anything that would make the lapse a gain rather than just income. A lapse is not a sale, so it should not be a gain under section 1211. The ad hoc nature is also shown by the asymmetry of the 1976 solution: The 1976 act did not make the $100 short-term capital gain if the option is exercised and the underlying property is long-term gain. It is not, accordingly, necessary to preserve shelterability in moving to an expected tax rate or ordinary income system for taxing capital gain.

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IV. RECOVERY OF BASIS

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[75] A final rationale given for deferring tax for two years is that it is impossible to determine when the option is issued whether the $100 is a recovery of basis or gain. Under current law if the option is exercised, the option premium is part of the amount realized, and amount realized in a complete disposition of property is taxable gain only after basis has been subtracted. /68/ If the option lapses, however, no basis recovery is allowed. /69/

[76] For zero basis, deferral would not be needed to see if there was an event upon which basis is allowed, since there was no basis to recover in any event. If, however, TP has some basis in the underlying property, some decision must be made as to what portion of the $100 option represents gain and what part recovery of basis. This section presents two models, an expected gain model and a boot model, and concludes that the boot model, taxing built-in gain to the extent thereof, better describes the issuer.

A. EXPECTED GAIN MODEL

[77] By the same logic used to compute an expected tax rate that depended upon the likelihood of exercise (e%), (Equation 1), one can compute an 'expected gain model' that blends the tax consequences of lapse and exercise as established by current law. The model would use an exercise likelihood (e%) built into the negotiated terms of the option.

[78] Upon exercise in e% of the cases, the gain under current law is strike price (Sk) plus option premium (OP) less adjusted basis (B). Upon lapse in (1-e%) of the cases, the option premium (OP) is taxed in full. The expected gain, combining the two, would be

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(5.1) Expected gain = e% * [(OP+Sk) - B] + (1-e%) * [OP]

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[79] The strike price will not be received immediately at the time the option is issued. If we are going to tax gain immediately, we should be discounting the strike price (Sk) not only to account for the percentage likelihood of Sk being received, but also for time value. The discounted value of the strike price is Sk/(1+i)(to the nth power) and substituting Sk/(1+i)(to the nth power) for Sk in equation (5.1) yields

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(5.2) Expected gain = e% * [(OP+Sk/(1+i)(to the nth power) - B] +

(1-e%) * [OP]

which is equivalent /70/ to

(5) Expected gain = OP + e% * [Sk/(1+i)(to the nth power) - B]

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Equation (5) says that the option premium will be taxed in every event and, if the option is exercised, there will also be gain equal to the discounted strike price less basis.

[80] Under a realization based income tax, OP would also be another limit on the amount taxed when the option premium is received. The discounted strike price has e% likelihood of being received, but it is not yet received. Thus, under a realization tax, the maximum expected and realized amount is the amount received:

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(5A) Maximum expected gain = OP

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[81] CRITIQUE. Even subject to the limits of equation (5A), the expected gain model of equation (5) creates taxable gain when TP has no economic gain and hence, unnecessarily overtaxes TP. Assume, first, for instance, that TP buys ABC stock for $126.04 and then promptly issues an option to D to buy ABC for the same $126.04 strike price, receiving the $100 option premium. Under the expected gain model (equation 5), TP would have expected gain of

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(5B) Equation gain = $ 100 + 25% * [126.04/(1+10%)(squared) - $ 126.04]

= $ 94.53

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It is difficult to see how TP has gain of $94.53 or any gain by buying ABC stock for $126.04 and promptly issuing D a $100 option. When TP wrote the option in exchange for the $100, the value of TP's remaining interest in ABC stock goes down by $100 and TP has a residual interest in ABC stock that is worth only $26.04. /71/ In the transaction as a whole, TP starts with $126.04 cash and ends with a $100 cash option premium and a residual interest in ABC stock worth $26.04. If TP had had zero basis in the ABC stock, the $100 would properly be gain because it was an amount realized. When TP has a full $126.04 basis, the $100 amount realized should be considered to be just a recovery of TP's $126.04 investment. TP would then adjust his basis in ABC stock downward by $100 to $26.04, which accurately describes TP's remaining economic investment.

[82] When TP's basis is lower than the fair market value of ABC stock, but not zero, the gain is realized in full or part by receipt of the $100, but equation (5) (expected value) overstates the gain. Equation (5) creates more gain than TP would have if TP sold ABC stock in full at arm's length at the same time.

[83] The surplus gain in equation (5) can be attributed to failure to allow use of recovery of basis for the lapse leg of the expected outcome. Under equation (3) fair market value of ABC stock equals the option premium plus the expected and discounted value of the strike price:

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(3) FMV = OP + e% * [Sk/(1+i)(to the nth power)]

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If TP sold ABC stock immediately for its fair market value, TP would have gain equal to FMV minus his basis. Using equation (3) as FMV, the taxable gain would be equal to

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(6) FMV Gain = (OP + e% * [Sk/(1+i)(to the nth power)]) B

which compares to equation (5), the 'expected gain':

(5) Expected gain = OP + e% * [Sk/(1+i)(to the nth power) - B]

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The difference between equation (6) (gain from fair market value sale) and equation (5) ('expected gain') is use of B or Basis. In FMV gain (equation 6), TP's basis of B is always subtracted. In expected gain (equation 5), B is subtracted only in the e% of the cases when the option is exercised.

[84] When the fair market value of ABC stock is known, it is difficult to see why TP should have a greater gain from an option premium than TP would have from sale of the entire ABC stock. The value that TP could pull out of ABC stock, by arm's length negotiations, could not exceed fair market value because that is the most that D or any other buyer would be willing to pay. Thus the expected gain model should recede, when value is known, to a model that will tax TP on no more than the amount that could be realized by a full sale. The boot model, explained next, does this.

B. BOOT MODEL

1. Boot described.

[85] The model that best describes TP, within the confines of a realization-based income tax, is what is called the 'boot model' here. Under the boot model, cash is taxable first to the extent of the TP's economic gain on the ABC stock. The cash is a (tax-exempt) recovery of TP's capital only after all of TP's gain in ABC stock has been taxed. Alternatively stated, TP's gain is the lesser of the $100 cash received or the gain built into the ABC stock immediately before TP issued the option. /72/

[86] If TP, for instance, had a $60 basis in the ABC stock (worth $126.04), then TP would have $66.04 built-in gain. The taxpayer will recognize gain to the extent of the built-in gain (here $66.04) and the remainder of the $100 amount realized ($33.94) will be a tax-free recovery of basis. The tax-free recovery of basis reduces TP's basis from $60 down to $26.04, /73/ that is, the value of TP's interest in ABC stock after having written the option.

[87] The function of the basis account, under the general norms of an income tax, is to describe TP's investment. In an income tax, investments are capital expenditures that create basis, rather than deductions, when they are made. Under an income tax, investments are made with posttax hard money -- i.e., basis. Investments are also continued with hard money or basis so long as they retain their real investment value.

[88] The boot rules prevent a taxpayer from recovering basis, by an exclusion or deduction against the $100 cash received, when the taxpayer has not lost the basis or investment. The grant of an option is not a loss of TP's entire investment in ABC stock. TP's interest in ABC Inc. was worth $26.04 after the grant of the option. Recovery of basis to exclude cash received from tax is functionally the same as a deduction of the basis from unrelated cash. Neither exclusion nor deduction should be allowed for the $26.04 of TP's basis in ABC that has not been lost.

[89] The boot rules were first adopted in 1923, /74/ to deal with cash received in corporate reorganizations and like kind exchanges, to prevent 'profit' from qualifying as recovery of basis. The Revenue Act of 1921 had provided that if cash was received in a reorganization or like-kind exchange, basis would be recovered in full before any boot was taxed. /75/ The 1921 rule was criticized as allowing stock investors to realize their profit without paying any tax. /76/ Allowing recovery of basis so as to drop TP's remaining basis below the $26.04 continuing investment would mischaracterize profit as if it were loss of investment.

[90] TP basis in ABC stock should not be driven down by the tax accounting to below the real investment value of TP's interest in ABC stock after writing the option. The ability to make or continue an investment with untaxed or deductible 'soft money' is an extraordinary privilege within an income tax, tantamount to an exclusion from tax for the subsequent income from the property. The value of property is the same for high- and low-bracket bidders, moreover, only if the basis of the investment they are bidding for is kept equal to the fair market value of the investment. /77/ There is, accordingly, a prime directive under an income tax: the accounting should yield an adjusted basis for property that describes the taxpayer's income-generating investment. Accounting systems that better make adjusted basis describe value are better than systems that move adjusted basis farther away from investment value.

[91] The boot rule, taxing gain first, describes the interest that TP has sold. TP has sold a top slice in ABC stock, meaning the sale is a sale of unrealized appreciation first: By the option, TP has sold to D all of the value of ABC stock in excess of the strike price. D will exercise the option if ABC turns out to have value greater than the strike price and take it away from TP. Provided the strike price is greater than TP's basis, however, the value of the ABC stock, over strike price, is all unrealized appreciation.

[92] Consistently TP has kept a bottom slice of ABC stock. Under the option, TP will retained the ABC stock if its value proves to be less than the strike price, because D will not rationally exercise. TP basis resides entirely in the value of the interest that TP has retained. TP's capital remains preserved in the underlying stock. /78/

[93] The boot rule would not create taxable income in excess of TP built-in gain. If TP had a basis in ABC stock equal to or greater than the fair market value of the stock, then the $126.04, the fair market value of ABC stock, the full $100 would be tax-free recovery of capital, reducing basis by $100. Writing an option, however, would not be the occasion for recognition of loss under a boot model even if TP has a basis higher than current value. /79/ The taxpayer's loss resides in the stock and will be recognized when the ABC stock is sold.

[94] TP's taxable gain from issuing an option would also not exceed the $100 cash received, under the boot model, even if built-in gain were greater than $100. If TP had $10 basis in ABC stock and hence $116.04 unrealized appreciation or built-in gain, for instance, then the TP would $100 taxable gain but would not be taxed upon receipt of the option premium on the last $16.04 of built in gain. That result follows within the confines of a realization tax system, under which economic gain is not taxed until realized. A mark-to- market system would tax TP on gain to lift basis to $126.04, without regard to cash received. The scope of mark-to-market rules is growing within our overall tax system, and is probably inevitably to solve problems of equity and efficiency that a realization system can not solve. This proposal is not intended to interfere or delegitimate a move to mark to market, but only to work with the truth that even under the premises of a realization system, the $100 cash is an amount realized. The boot model falls entirely within an overall realization, rather than mark-to market, tax system. The realization rule, however, does not seem implicated, beyond making $100 the upper limit of the taxable amount. Since $100 was realized here when the option was issued, the realization rule is not a constraint for any of the possible outcomes that might be imposed on the premium up to a tax on $100.

2. Collateral basis issues under the boot rule.

[95] Under a boot rule, TP basis in the underlying ABC stock would go down to the extent that the $100 was considered to be tax- exempt recovery of capital. The $100 cash would have its own basis, because the cash drew basis from the underlying property or was taxed itself, and TP could establish $100 basis by buying property with the cash. There would be no basis adjustments to either the ABC stock or the property purchased with the boot premium whether the option lapsed or was exercised. The strike price (and not the option premium) would be the only amount realized on exercise.

3. Related problems.

[96] The boot rule, taxing gain first, also seems to yield some reasonable corollaries for related problems: The rule seems to say that better accounting would treat the option price as gain to the extent of the highest gain on any ABC stock that TP holds. The rule would, however, not create gain if the taxpayer holds no ABC stock.

a. Unidentified stock.

[97] If TP holds more shares of ABC stock than TP writes an option for, there is a problem of identifying which gain TP has realized under the boot rules. When TP sells a covered option on ABC stock, there is no reason to identify which shares that TP will sell if there is an exercise: Stock is fungible for nontax reasons, so it makes no difference except for which tax shares are delivered two years in the future should D exercise. If ABC shares in a large portfolio were purchased at different times, however, the basis of different shares would be different. Which basis to use will determine what gain would be taxed under a gain-first boot rule.

[98] Under general law, a taxpayer holding a portfolio of identical shares can minimize the gain on sale of a share if the taxpayer adequately identifies the shares sold. The taxpayer must identify to his broker the specific shares to be sold, or if the taxpayer holds the shares, must deliver the specific shares to be sold. /80/ Under optimal tax planning, the taxpayer would identify the specific shares with the highest basis as the shares sold. Treasury has proposed rules requiring average cost. Specific shares of ABC stock would never be identified, but instead total cost would be spread across all shares of ABC stock held by the taxpayer at sale. /81/

[99] The rationale underlying the boot rule suggests that the $100 option premium should be gain to the extent of the highest gain on any specific shares TP holds. There is a prime directive under which basis should describe the value of the taxpayer's investment. Allocating the option premium to the shares with the most gain would minimize unrealized appreciation and bring the aggregate basis as close as possible to the fair market value of the taxpayer's real investment. In an appreciating market, a FIFO convention might be an acceptable approximation, as long as the difference between FIFO and the rule minimizing unrealized appreciation is not material.

b. Aggregation of portfolio.

[100] An alternative is to treat TP's entire portfolio of ABC stock as a single investment with a single amount of gain, even when the option covers only some of the shares. A rule that taxed gain, share by share, would occasionally result in aggregate basis for an entire portfolio at the end of the transaction that is greater than fair market value of the portfolio. Assume that TP, for instance, holds 10 shares of ABC, 5 bought at $240 and 5 bought at $20 for a total cost of $1,300 and that the shares are now worth $126.04 each so that the portfolio is worth $1,260.40. TP sells an option on five shares for $500 and all of the $500 is gain under a boot rule that taxed the gain because there are five shares in the portfolio with at least $500 gain built in. On the five shares identified by the rule as the gain shares, the rule would bring basis closer to value for those shares. The rule would tax TP on gain on five shares, however, even though there is a loss in the whole portfolio. A rule that looked to the portfolio as a whole and identified $40 of the $500 as recovery of basis would, however, better describe TP's investment in the portfolio as a whole. Looking to the aggregate basis of the portfolio would help the taxpayer when there is loss built into the entire portfolio.

[101] Usually, however, an aggregate perspective would tax more of unrealized gain than a perspective limiting gain to the number of shares subject to the option. Under an aggregate approach a $100 option premium with respect to an option on one share could cause realization of gain on many shares of ABC stock. On this issue, it seems wisest to limit the gain to gain on the number of shares subject to the option.

[102] If TP sells a number of options, then it seems feasible to tax gain on share after share of ABC stock, until TP's entire gain has been taxed. If basis for shares is uneven, the last options sold would have more basis recovery than earlier ones.

C. NAKED OPTIONS

1. Loan only.

[103] If TP owns no ABC stock, it is difficult to see in what sense TP has realized $100 gain on ABC stock. When TP has some low- basis ABC stock, the option premium realizes the gain and the boot rule for identifying the gain brings TP's basis closer to a description of TP's residual investment in ABC. If TP has no gain to be realized and no residual investment, however, the reasons for the boot rule do not exist.

[104] Writing an option without owning the underlying property - - a naked option -- is a different transaction from writing an option on gain property TP holds. When TP owns the underlying property, D's $100 is a payment for a 'top-slice' interest in property -- appreciation over the strike price -- and TP realized gain or recovery of basis on sale of that top slice. In a naked option, however, TP will satisfy the option only by paying cash in two years should it be rational for D to exercise the option. Under the given facts there was a 25 percent chance that ABC stock would be worth $610.04 in two years (and a 75 percent chance that it will be worth nothing), and TP has a delivery burden has an expected value of 25%*610.04 or $121 in two years. Thus TP undertook an obligation that had an expected value of $121 in two years.

[105] A naked option is in pattern a borrowing transaction to TP. TP has received $100, but has undertaken an obligation that has an expected value of $121 in two years. The $121 is just the $100 borrowed plus 10 percent, the given interest rate, compounded for two years. The borrowing transaction is embedded within a bet. D has bet that ABC's invention will prove commercially feasible and TP is betting that it will not. But risky investments are analyzed as a combination of a certain time-value of money interest rate, plus or minus the outcome of a bet. /82/

[106] Borrowing money is not ordinarily taxable because the borrower may have cash, but has no gain. When a bank or other creditor lends money, it will ordinarily insist upon an obligation to repay plus interest that has a discounted present value equal to the cash loan proceeds. The debtor has $100 cash in hand, but also an offsetting obligation to repay the $100 plus interest that leaves the debtors with no expected net present value improvement. /83/ For a two-year loan with 10 percent interest, TP will get $100 and must repay $100*(1+10%) /2/ or $121 in two years. TP is in a similar case when selling a naked option to D. TP has $100 in hand plus an obligation with an expected value of $121 in two years.

[107] The sale of a naked option may prove to give TP a gain. If the option is not exercised -- in 75 percent of the cases -- TP will pocket the $100 and have survived the 25 percent chance of having to pay $610 to buy a share of ABC to cover TP's option obligation. D may have overestimated the chances of success, or TP may have inside information, or D or TP may be very unlucky/ lucky on the whole. Still, TP's gain due to luck or information would be plus or minus from an expected value of $100 for TP's obligation under the naked option. By contrast when TP holds the ABC stock with at least $100 gain built into it, then TP has the gain even assuming the option proved to be worth just its expected value.

[108] It is, accordingly, proposed that TP's sale of a naked option, collecting $100 from D when TP does not own the underlying TP stock would not be a taxable event. If the option lapses, however, TP would then have the $100 free of the obligation to repay it and needs to be taxed on the $100 at that time.

[109] If TP starts with a naked option and then buys some ABC stock for under $100, then TP has satisfied his obligations that made the option premium tax-free and freed some of the $100 option premium for use as disposable income. The $100 option premium, less the cost of the ABC stock to TP, should then be treated as ordinary income at the purchase of the stock.

[110] Tax exemption for issuing a naked option combined with a boot rule for gain on ABC stock TP holds means that there is a different rule for taxing the cash receipt depending upon how it is considered that TP will settle the issuer-side obligation. If TP is to settle in cash, the $100 is tax-exempt when received. If TP is to settle with ABC stock held now, the $100 is realization of gain to the extent of gain. The boot rule and prime directive justify the result. The option premium needs to be realized gain to bring basis to be an accurate description of TP's investment. When TP holds ABC stock as an investment the ending basis for stock should be $26.04, which will sometimes require taxation of gain. When TP holds no stock, there is no gain to tax and no investment to describe.

2. Off-balance sheet portfolio.

[111] Tax exemption for writing a naked option combined with a boot rule for writing a covered option also means that taxation of the $100 depends upon what ABC stock TP holds. TP will need to report TP's holdings of ABC stock when the premium is received or at least such part of the holdings that would justify $100 gain.

[112] The boot rule also needs to look to holdings of ABC stock by affiliate corporations, household family members and nominees who can distribute or contribute ABC stock to TP tax-free. Otherwise TP could hold low-basis, high-gain ABC stock in storage off the record and get the beneficial naked option rule, even while economically owning the high-gain ABC stock. The section 318 constructive ownership rules are one possible model for aggregating taxpayers. The underlying rationale to set the scope of the constructive ownership rules is to identify related parties who can give appreciated property to the TP to satisfy the option, without tax on the appreciation, provided it makes some economic sense for the nominal holder of the ABC stock to make the tax-free transfer to TP.

[113] A constructive ownership rule might have to be reinforced with a hindsight ownership rule. A brother-in-law or accountant, for instance, is not part of the constructive ownership group of section 318 and yet we may be able to see in hindsight that the appreciated stock was de facto held for TP, off TP's balance sheet. The brother- in-law's low basis stock would not be part of TP's portfolio unless the stock ended up as a gift to TP to satisfy the option and then the gain would be related back to the year the premium was received. Under a gain-first model, however, there does not seem to be any reason to count ABC stock that TP has an option to buy, unless the option is so far in the money that it is the TP who holds the appreciated property already.

3. Settlement of a covered option in cash.

[114] A covered option can be settled by TP by paying cash to D. If ABC stock has the high outcome, $610, then TP can ordinarily satisfy the option either by giving ABC stock for $126 or by paying over the $484 bargain in cash. Does that make every covered option enough like a naked option to justify deferral?

[115] The possibility of satisfying a covered option in cash does not justify deferral of tax on the $100 TP receives, or justify shifting the tax burden on the income from the $100 away from TP. When TP received the $100 there were hundreds of possible expenses that TP might make within the next two years. None of the possible future expenditures justify not taxing TP. If they did, no TP would pay tax, because all TPs have potential future expenses. As long as TP should bear tax on the interim income from the $100, moreover, taking account of any expenses when they occur in the future will have the same terminal-value or economic impact as allowing only a discounted value earlier. /84/ We thus can wait to account for a settlement in cash, until the cash occurs.

D. MINIMUM GAIN RULE FOR UNKNOWN FMV

[116] A boot rule, taxing gain first, is possible only because the built-in gain can be identified by subtracting basis from an ascertainable fair market value. ABC stock, it was assumed, was traded on an established market so that the investment value of ABC stock could be easily ascertained. Assume now, however, that the underlying property is AB acres, that is, real property not listed on a well-established market and not resembling property so listed.

[117] Every option has a known strike price and option price, but a unique fair market value of the underlying property cannot be deduced from option price and strike price alone. As explained in Equation (3), the FMV of the underlying property will be equal to the option premium plus the strike price, discounted for time and expectancy of exercise:

________________________________________________________________________________

(3) FMV = OP + e% * Sk/(1+i)(to the nth power)

________________________________________________________________________________

Equation (3), however, does not reveal very much about FMV assumed in the bargaining, even though OP and Sk are known, because e% can range from likelihood of almost zero to almost inevitability (i.e., probability of 1). We can conclude from equation that the fair market value of the underlying property is greater than the $100 option premium (OP) even with a very small e% value. We can also conclude that the fair market value is less than the sum of the option price plus discounted strike price ($204.17 here), even when e% approaches inevitable. In common cases, however, the range allowed by equation (3) is large enough to make it indeterminate whether all TP's basis should be recovered under a boot rule or none of it.

[118] Without a fair market value figure, the built-in gain, taxed first under the boot model, cannot be known. TP will have a motive to understate fair market value to understate gain and so to allow more of the $100 option premium to be considered recovery of capital, and D on the other side of the transaction has no motive to contradict TP.

1. Estimated value.

[119] It is possible to administer a tax system on the basis of approximations of fair market value. Tax law commonly imposes rules that depend upon fair market value of property in absence of actual sales or reliable public market quotes. /85/ Fair market value is determined according to a counterfactual or hypothetical situation: What would a willing buyer pay to a willing seller, neither being under compulsion to buy or sell? /86/ Sometimes there are sales on comparable properties that provide real guidance and real constraints on the value asserted for ABC land, and sometimes there are reliable future cash flow estimates that provide a reliable intrinsic value. But sometimes 'ascertaining fair market value' is a bit like the old market-polling joke that ends, 'But if you had a sister, how much Federman's Mustard would she be willing to buy?' The great value of a realization tax, refusing to tax gain until there is a market transaction setting a real selling price, is that it does not depend upon appraisals and counterfactual sales.

2. Minimum gain model.

[120] Within a realization system that eschews appraisals, it should nonetheless be possible to tax at least the minimum amount of gain that TP might have under the option. If TP is going to have $100 gain if the option lapses, for instance, and $60 gain if the option is exercised, then at least $60 of the cash received will be gain in any event. /87/ There is no need to defer tax to wait and see how the option comes out to justify tax on at least $60 of the $100 realized cash. A realization rule may limit the taxable gain to $100, but no more.

[121] A minimum gain rule would tax the lower of the option price or the gain on sale. The strike price is part of the gain on sale, but it is not received until the exercise date, so that it needs to be discounted, if tax is to occur at the time the option is issued. Formally,

________________________________________________________________________________

(7) Minimum gain is the lesser of

(7A) Op

or

(7B) [Op + Sk/(1+i)(to the nth power)] - B

________________________________________________________________________________

The minimum gain rule, expressed in (7), is equivalent to a rule that basis is allocated first to the future exercise event, so that basis could be recovered against the option premium, only to the extent that TP's basis is greater than the discounted strike price. If basis is lower than the discounted strike price, all of the option premium is taxable. Whenever Sk/(1+i)(to the nth power) > B, that is, discounted value of strike price is greater than basis, therefore, the entire option premium (OP) is taxed. Although (7B) is larger than (7A) in that case, (7A) or OP is the lesser amount. This is consistent with the realization rule saying tax no more than the $100 received.

[122] Whenever Sk/(1+i)(to the nth power) < B, then expression (7B) is smaller than OP. Therefore OP + [SK/(1+i)(to the nth power) - B] will be less than OP. The minimum gain rule means, in sum, that TP would have some basis to recover against the option premium only if the basis is greater than the discounted strike price. TP's basis would be allocated first to the future benefits of the discounted strike price.

[123] The minimum gain rule is also consistent with the idea that by writing the option for $100, TP has sold a top slice of ABC property and kept his investment in the bottom slice or exercise price. If ABC property turns out to have value greater than the strike price, D will take the top away for his $100, leaving TP with only the strike price. On the other side, TP has kept the bottom slice of ABC property: if the ABC does not prove to be worth the strike price, then the property is TP's by reason of the lapse of the option. Basis resides in the bottom slice to be used, first, in the future against the exercise price. TP has kept basis to the extent consistent with the exercise price by keeping the residual interest in the property subject to the option. The top slice sold is first built-in gain, realized by the sale.

[124] The minimum gain rule is also consistent with the common law rule that under a realization-based tax, basis resides in the remainder and not in the earlier chronological interests. /88/ The rule that no basis can be allocated to earlier income (rents and interests) sometimes leads to the result that the basis of the remainder interest often is higher than the value of that interest; to which the courts respond that taxpayer can realize the loss by disposing of the remainder.

3. Comparison to realization of fair market value.

[125] The minimum gain rule would sometimes overtax TP compared with a boot or mark-to-market rule. Assume again, for instance, TP writes an option with an exercise price of $126.04, receiving a $100 option premium. Assume TP has $100 basis in ABC acres, just below the $104 present value of the strike price. The minimum gain rule would tax TP on the full $100 option premium because the basis is below the discounted value of the strike price. When the fair market value of ABC acres is uncloaked as equal to $126.04, we can see that TP had gain of only $26.04 built into AB acres and the rest of the $100, or $73.96, should have been recovery of capital. With no information about value, however, there is no way of computing whether exercise is inevitable or unthinkable and TP would be taxed on the minimum gain, the lesser of which is the full $100 option premium.

[126] More generally, a minimum gain rule would overtax TP relative to a boot rule whenever basis is greater than the strike price, discounted by time and likelihood of exercise: e% * Sk/(1+i)(to the nth power). A mark-to-market or boot rule would tax TP on

________________________________________________________________________________

(6) Gain = OP + e% * [Sk/(1+i)(to the nth power)] - B

The minimum gain rule would tax

(7B) Op + Sk/(1+i)(to the nth power) - B

________________________________________________________________________________

whenever B is greater than Sk/(1+i)(to the nth power). Whenever B is greater than Sk/(1+i)(to the nth power) then (7B) yields something less than OP, but since e% is never 1 or greater, (7B) must then be a higher taxable amount than (6). When B is less than Sk/(1+i)(to the nth power) then (7) would yield tax of just OP, whereas (6) would yield less than OP. Only when B drops down to e% *Sk/(1+i)(to the nth power) does (6) yield just OP. When B is less than something less than e% *Sk/(1+i)(to the nth power) a boot rule would just tax OP, the same as the minimum gain rule.

[127] It would be possible to correct these overtax cases and bring them into line with a boot rule, if e%, likelihood of exercise, were known, but in absence of any information, e% might well approach 100 percent. If e% reached 100 percent, then (7B) would be perfectly consistent with a boot rule.

[128] TP's interest in the underlying ABC property will have a built- in loss, whenever the gain taxed under the minimum gain rule is greater than the boot rule. TP can reduce adjusted basis to real investment value by self-help by selling the ABC property, subject to the option. A realization tax system commonly leaves it up to the taxpayer to prove declines in value by the self-help of engaging in a bona fide sale. Decline in the value of property is invisible for tax purposes under a realization system, until the property is sold at a loss. Requiring a real sale avoids appraisals and rests the loss on real arm's length sale prices rather than on self-serving statements about what those sales might bring.

[129] Plausibly, moreover, default rules should be stricter than rules depending upon fair market value, just so that taxpayers will undertake the actions -- sale -- that will solve the fair market value problem, or at least come up with plausible assessments of value to avoid the harsher default rule. That does not make the overtaxation of TP correct, viewed omnisciently with knowledge of fair market value or exercise likelihood, but in absence of omniscience, the overtax seems inevitable.

________________________________________________________________________________

CONCLUSION

________________________________________________________________________________

[130] The following rules are recommended:

A. BASIS RECOVERY.

1. FMV Known: Boot rule.

[131] When the fair market value of the underlying property is known, the option premium should be taxed as ordinary income to the extent of gain on the underlying property at the time the option premium is received. The option premium would be recovery of the taxpayer's basis in the underlying property only after all of the built-in gain is first taxed. If TP holds a portfolio, the option premium would be attributed to gain on the property that has the largest built-in gain that TP owns, actually or constructively.

2. Naked options.

[132] If TP holds none of the underlying property, the option premium should be treated as borrowed proceeds and not taxed.

3. Unknown FMV: Minimum gain.

[133] If the gain cannot be readily ascertained from market quotes, the option premium would be a recovery of basis only to the extent that the basis exceeds the discounted present value of the strike price.

B. CHARACTER: ALL ORDINARY.

[134] The option premium should be ordinary gain, not from the sale or exchange of any asset, even when the underlying property is a capital asset, because the issuer has retained capital in the underlying property because no 'sale or exchange' is necessary to the premium, and because investors routinely consume the option premium currently. An 'expected-tax-rate rule' would preserve current law expectations and blend capital and ordinary rates according to expectations as determined from the terms of the option, but the status quo is not attractive enough to justify the complexity.

________________________________________________________________________________

FOOTNOTES

________________________________________________________________________________

/1/ The assumption of risk neutrality is often unrealistic for individuals. Individuals have a steep diminishing marginal utility for money so that they cannot take bets with zero expected outcomes. An individual who was offered a double or nothing bet for his or her nest egg at even odds, for instance, would have to say no. Losing the nest egg would endanger subsistence or at least cut into muscle and bone. Winning would not double happiness, but just add fat. For bets that TP can hedge with offsetting bets or for small bets that do not endanger standard of living, however, assuming risk neutrality is not materially inaccurate.

/2/ See, e.g., John C. Coxe & Mark Rubenstein, Option Markets 141 (1985) (An option 'should never be exercised prior to the expiration date' [within their quite reasonable set of assumptions]).

/3/ Section 11 (35 percent rate for corporations with taxable income in excess of $10,000,000). Section 1(h) (28 percent ceiling on capital gain tax) does not apply to corporations.

/4/ Section 1(a)-(d), (h).

/5/ Bruce Kayle, 'Realization Without Taxation? The Not-So Clear Reflection of Income From an Option to Acquire Property,' 48 Tax L. Rev. 233 (1993), is an excellent recent review of the law.

/6/ Virginia Iron Coal & Coke Co., 37 B.T.A. 195, 198 (1938), aff'd 99 F.2d 919, 921 (4th Cir. 1938), cert. denied 307 U.S. 630 (1939); Rev. Rul. 78-182, 1978-1 C.B. 265, 267 (ruling B1) modifying Rev. Rul. 58-234, 1958-1 C.B. 279, 283. Before Rev. Rul. 58-234 conceded the issue, the IRS had previously ruled that the $100 was ordinary income immediately, O.D. 1028, 5 C.B. 83 (1921); I.T. 3681, 1944 C.B. 64 (both revoked).

/7/ Kitchen v. Commissioner, 353 F.2d 13, 15 (4th Cir. 1965); Rev. Rul. 58-234, 1958-1 C.B. 279, 283.

/8/ Rev. Rul. 78-182, 1978-1 C.B. 265, 267 (ruling B3).

/9/ Section 1234(b); Rev. Rul. 78-182, 1978-1 C.B. 265, 267 (ruling B2). If TP is dealer, issuing options in the ordinary course of TP's trade or business, the sale or settlement of the position produces ordinary gain. Section 234(b)(3). Section 1234(b), turning the gain from lapse of nondealer options on securities and commodities into short-term capital gain, was added in 1976 to lift the capital loss limitations for taxpayers with substantial capital losses. Staff of the Joint Committee on Taxation General Explanation of the Tax Reform Act of 1976, 675, 1976-3 C.B. 687.

/10/ Reg. section 1234-1(b) (1979). Ordinary income was also the pre-1976 rule for lapse of options on stock, securities, or commodities. Rev. Rul. 58-234, 1958-1 C.B. 279, 284.

/11/ See heading III. infra.

/12/ See heading IV. infra.

/13/ 35/(1.065)(squared) = 30.86.

/14/ $100 less $35 or $65 of taxable income can ordinarily be invested. The $65 will grow at a 6.5 percent annual rate (i.e., 10 percent less 35 percent annual tax). At the end of two years the investment is worth $65 * (1+6.5%)(squared) = $73.72.

The general 'income' formula for the terminal result of an investment of $1 under an income tax is:

$1 * (1t) * [1+i * (1t)]n

where t is the tax rate, i is the pretax interest or return rate and n is the number years of growth to the end of the investment. The formula says that income tax is imposed on a $1 income earned, so that the amount invested is only $1 * (1t) or $65 in the example. The bracketed portion represents the formula for growth of compound interest at rate i * (1t). The investment will grow at rate i * (1t) or 6.5 percent in the example, because interest is subject to tax as earned.

/15/ $100 * (1+6.5%)(squared) = 113.42, less $35 tax at the end of two years, yields $78.42.

/16/ The $78.42 is the amount that would normally be expected from a 1.6 percent tax on subsequent investment income because $65 * [1+10% * (1te)](squared) = $78.42, where te = 1.6 percent. The symbol te stands for equivalent tax on subsequent investment income. The formula is just the income tax formula explained in supra note 14, with an initial t equal to 35 percent and the t on the subsequent income being the te or 1.6 percent.

The drop in te, equivalent tax on subsequent investment income, is slightly less valuable than the more familiar 'Cary Brown thesis,' that soft money investing is equivalent to exemption from tax for the subsequent income, because the model assumes that reinvested income is subject to tax before it becomes an investment. For option premiums, tax is deferred only on the original principal and not the subsequent reinvested income. The measurement will climb above 1.6 percent as deferral goes on, because more of the investment consists of such reinvested taxed income. If taxes at issue on the option are higher than 35 percent, te will drop below 1.6 percent; te is inversely related to the rate of tax at issue on the option premium, but the relationship is inelastic (less than one to one), nonlinear, and complicated.

/17/ Cf. Notice 89-21, 1989-1 C.B. 651 (amortizing premium received for issuing a 'swap' over the term of the swap).

/18/ (35/2)* [(1/(1.065) + 1/(1.065)(squared)] = $31.85.

/19/ The terminal value of the investment under two-year amortization of the $100 premium into income would be ($100)*(1+6.5%)(squared) [$17.50 * (1+6.5%)] $17.50 = $77.285. That $77.285 terminal value is like a tax of 9.5% on interim investment income because $100 * (135%) * [1+10% * (1te)](squared) = $77.285, where te (equivalent tax) = 9.5%.

/20/ See Eisner v. Macomber, 252 U.S. 189 (1920) (holding that stock dividend was not income, taxable under the authority of the 16th Amendment to the Constitution, because it did not represent a severance from capital).

/21/ Marjorie Kornhauser, 'Section 1031: We Don't Need Another Hero,' 60 S. Calif. L. Rev. 397 (1987).

/22/ Section 1031(b).

/23/ Section 453(c) (taxing payments received on the notes).

/24/ Section 1014.

/25/ See, e.g., section 1272.

/26/ See, e.g., section 475.

/27/ 37 B.T.A. 195, 198 (1938), aff'd 99 F.2d 919, 921 (4th Cir. 1938), cert. denied 307 U.S. 630 (1939).

/28/ See, e.g., Henry Simons, Personal Income Tax 168-69 (1938) (arguing that no serious inequities arise in postponing tax so long as the code taxes gain ultimately).

/29/ Countervailing taxes (e.g., loophole closing) will reduce deadweight loss. See, e.g., Robin Broadway & David Wildasin, 'The Measurement of Deadweight Loss of Taxation' in Public Sector Economics 387, 392 (2d ed. 1984).

/30/ See, e.g., Joseph Stiglitz, Economics of the Public Sector 376 (1986) (magnitude of deadweight loss increases with the square of the increase in tax rate).

/31/ See, e.g., Reed Shuldiner, 'A General Approach to the Taxation of Financial Instruments,' 71 Tex L. Rev. 243, 323, 327 (1992) (analyzing caps and hybrid debt into fixed interest plus (or minus) an option).

/32/ Edward Kleinbard, 'Beyond Good and Evil Debt (And Debt Hedges): A Cost of Capital Allowance System,' 67 Taxes 943, 951 (1989) (Without fixing deferral of options, policymakers face a Hobson's choice of extending bad rule or inconsistent treatment of economically identical instruments); Larry Lokken, 'New Rules Bifurcating Contingent Debt -- A Good Start,' Tax Notes, Apr. 29, 1991, pp. 495, 502 (accord): Alvin Warren, 'Financial Contract Innovation and Income Tax Policy,' 107 Harv. L. Rev. 460, 486 (1993) (arguing that we cannot tax embedded options equitably until we tax the naked option right). But see David Hariton, 'New Rules Bifurcating Contingent Debt -- A Mistake?' 43 Tax L. Rev. 731, 785 (1988) and as principal draftsman of 'Report and Recommendation for the Treatment of Contingent Debt Instruments Under Proposed Regulations Section 1.1275-4,' Tax Notes, Dec. 6, 1993, p. 1241, obviating the need to identify an option embedded in a financial instrument by identifying earned interest, at a risk-free rate, instead.

/33/ Kitchen v. Commissioner, 353 F.2d 13, 15 (4th Cir. 1965); Rev. Rul. 58-234, 1958-1 C.B. 29, 283.

/34/ See, e.g., Signal Banking Corp. v. Commissioner, 106 T.C. No. 5 (1996) (nonrefundable credit card fees must be taken into income immediately when received; refundable fees are different).

/35/ See, e.g., Commissioner v. Glenshaw Glass Co., 348 U.S. 428, 429, 431 (1995) (language of Eisner v. Macomber that income must be derived from labor or capital was not intended to provide a touchstone for tax: Congress intended to exert full measure of taxing power and all accessions to wealth may be taxed). Unearned windfalls are subject to tax. Cesarini v. United States, 428 F.2d 812 (6th Cir. 1970); Treas. reg. section 1.61-14(a) (1958). See generally, Calvin Johnson, 'The Illegitimate 'Earned' Requirement in Tax and Nontax Accounting,' 50 Tax L. Rev. 373, (1995).

/36/ Reed Shuldiner, supra note 31, 71 Tex. L. Rev. 243, 296 (1992), argues, by analogy, that D and TP should be considered as one party so that capitalization (and imputed interest) for D implies exclusion for TP.

/37/ Deborah Schenk, 'Taxation Without Realization: A 'Revolutionary' Approach to Ownership,' 47 Tax L. Rev. 725, 775-786 (1992); Reed Shuldiner, supra note 31, 71 Tex. L.Rev. 243 (1992).

/38/ See, e.g., section 453A (interest charged if large installment sales are outstanding). See Christopher Hanna, 'The Virtual Reality of Eliminating Tax Deferral,' 12 American J. of Tax Policy 449, 481 (1995).

/39/ Lee Sheppard, 'Weird Scenes in the Gold Mine: Accounting for Notional Principal Contracts,' Tax Notes, July 22, 1991, p. 384 (premium received by issuer for interest rate swap should not be taxed when received because it would be used to refresh expiring net operating losses).

/40/ Section 172(b)(A)(ii).

/41/ ($* 35%)/(1+6.5%)(to the 15th power) = 13.6 cents.

/42/ See, e.g., Department of the Treasury, 'Business Loss Offsets,' Press Service No. S-505 (October 1947) (giving history of carryforwards up to 1947, which had never been more than two years up to that time).

/43/ ($1 * 35%)/(1+6.5%)(to the 20th power) = 9.93 cents.

/44/ Mark Campisano & Roberta Romano, 'Recouping Losses: The Case for Full Loss Offset,' 76 NW U.L. Rev. 709 (1981).

/45/ Virginia Iron Coal & Coke Co., 37 B.T.A. 195, 198 (1938), aff'd 99 F.2d 919, 921 (4th Cir. 1938), cert. denied 307 U.S. 630 (1939); Rev. Rul. 78-182, 1978-1 C.B. 265, 267 (ruling B1).

/46/ Expected value calculations make a simplifying assumption of risk neutrality, such that a 10 percent change of making $100 worth exactly $10. Given the diminishing marginal utility of money, the assumption is often unrealistic and needs to be corrected when it is feasible to do so.

/47/ Under the assumption that ABC will pay no dividends, i is the generally available return or interest rate, but if ABC stock paid dividends at rate d per year, then i used in discounting would be reduced by d. To work within the model, dividends must be expressible as a constant annual return rate.

/48/ From equation (2):

________________________________________________________________________________

(2) OP=FMVSk/(1+i)(to the nth power) + (1-e)* [Sk/(1+i)(to the

nth power)] [equation (2)]

(2.1) OP=FMVSk/(1+i)(to the nth power) + Sk/(1+i)(to the nth

power) - e%*Sk(1+i)(to the nth power) [multiply out 1-e%]

(2.2) OP=FMV -e%*Sk/(1+i)(to the nth power) [cancel + and -

Sk/(1+i)(to the nth power)

(3) FMV=OP+e% * Sk/(1+n)(to the nth power) (add e%Sk/(1+i)(to the

nth power) on both sides and switch left and right [Equation

3]

________________________________________________________________________________

/49/ Starting from equation (3):

________________________________________________________________________________

(3) FMV=OP+e% * Sk/(1+i)(to the nth power) [Equation 3]

(3.1) FMV-OP=e% * Sk/(1+i)(to the nth power) [subtract OP from both

sides]

(3.2) (FMV-OP)*(1+i)(to the nth power)=e% * Sk (multiply (1+i)(to the

nth power) both sides)

(4) e%=[(FMV-OP)/SK(1+i)(to the nth power)] (divide both sides by

SK/(1+i)(to the nth power)]

________________________________________________________________________________

/50/ $40/[1+10%(1-40%)](squared) = $35.60.

/51/ The 1981 legislation was, however, adopted from the nontax daily mark-to-market accounting required the United States commodities futures exchanges. Joint Committee on Taxation, General Explanation of the Economic Recovery Tax Act of 1981, at 295 (Comm. Print 1982).

/52/ Palmer v. Commissioner, 302 U.S. 63, 71 (1937) (option distributed to shareholders was not dividend 'even though the rights have a market or exchange value' because 'no distribution of corporate assets or diminution of the net worth of the corporation results in any practical sense.'); Helvering v. Bartlett, 71 F.2d 598, 600 (4th Cir. 1934) (accord, stock rights do not constitute dividend to shareholder).

/53/ Virginia Iron Coal & Coke Co., 37 B.T.A. 195, 198 (1938) aff'd 99 F.2d 919, 921 (4th Cir. 1938) cert. denied 307 U.S. 630 (1939).

/54/ See, e.g., Redding v. Commissioner, 630 F.2d 1169, 1181- 1184 (7th Cir. 1980) cert. denied 450 U.S. 913 (1981) (option is property, taxable as dividend to shareholders when distributed). Cf. Baumer v. United States, 580 F.2d 863, 878 (5th Cir. 1978) (option was property taxable as dividend to shareholder, although for administrative ease it was taxed when option was exercised when value was more readily ascertainable).

/55/ Equation (1) and accompanying explanation.

/56/ Section 1222(1) & (3). Commissioner v. P.G. Lake, 356 U.S. 260 (1958) (capital gain not available for carved out oil payment interest); Hort v. Commissioner, 313 U.S. 28 (1941) (capital gain not available for landlord's receipt for freeing tenant from lease).

/57/ Commissioner v. Gillette Motor Transportation Inc., 364 U.S. 130, 134 (1960) (government's taking of use of property by eminent domain did not yield capital gain).

/58/ Hort v. Commissioner, 313 U.S. 28 (1941); Commissioner v. Gillette Motor Transportation Inc., 364 U.S. 130, 134 (1960).

/59/ Lawrence Seltzer, The Nature and Tax Treatment of Capital Gains and Losses 26-29 (1951); See, e.g., cases collected Annotation, 'Rights of Life Tenant and Remainderman Inter Se Respecting Increase, Gains and Enhanced Value of the Estate,' 76 ALR 2d 162, 187 (1961) (capital gains belong to corpus or remainderman rather than to life tenant or income beneficiary).

/60/ Marjorie Kornhauser, 'The Origins of Capital Gains Taxation: What's Law Got To Do With It?' 39 S.W.L.J. 869, 891 (1985) (argument for preferential rate for capital gain presumes that gain would and should be reinvested); see also Seltzer, supra note 59, at 29 (noting argument that ordinary changes in investments should not be taxed); Comment, 30 Yale L.J. 396, 399 (1921) (arguing that tax on capital would reduce money 'held for investment, that is, capital.')

/61/ Hersh Shefrin and Meir Statman, 'Behavior Aspects of the Design and Marketing of Financial Capital, 22 Financial Management 123, 12124, 131 (1993) (individuals issue covered options to achieve consumable income 'without dipping into capital' and to get steady stream of low income in lieu of high-risk returns).

/62/ See, e.g., Rev. Rul. 58-234, 1958-1 C.B. 279.

/63/ Section 1222(5), (7).

/64/ Section 1211 (Individuals, but not corporations, may deduct up to $3,000 of capital losses per year).

/65/ Section 1234(b) enacted by Tax Reform Act of 1976, Pub. L. 94-455, section 2136.

/66/ Staff of the Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1976, 675, 1976-3 C.B. 687.

/67/ See, e.g., Alvin Warren, 'The Deductibility by Individuals of Capital Losses Under the Federal Income Tax,' 40 U. Chi.L.Rev. 291 (1973).

/68/ Section 1001.

/69/ Virginia Iron Coal & Coke Co., 37 B.T.A. at 198 (Murdock, J.) (no need to allow basis if option lapses).

/70/ Multiply out the e% and 1-e% term of equation (5.2) and rearranging the terms yields (5.3) expected gain = e% * OP - e% * OP + OP + e%*[Sk/(1+i)(to the nth power) - B], which in turn becomes equation (5) in text when + and -e% * OP cancel out.

/71/ See Table (3) supra.

/72/ See sections 351(b), 356, 1031(b) for statutory embodiments of boot.

/73/ Sections 358, 1031(d) describe the taxpayer's basis as original basis ($60 here) less cash (boot) and plus gain recognized. The rationale is best explained by reordering the terms as cumulative basis ($60+new gain) less that part of the basis ($100) allocated to cash taken away from the stock. The text reaches a result that must also be the same as a matter of mathematics: Original basis less that part of the $100 option premium that does not represent gain ([$60- (100-$66.04)] = $26.04 must equal original basis less option premium plus gain ($60-$100+$66.04 = $26.04).

/74/ Act of March 4, 1923, ch. 294, 42 Stat. 1560, amending Revenue Act of 1921, section 202(e).

/75/ Revenue Act of 1921, ch. 136, section 202(e), 42 Stat. 227.

/76/ 64 Cong. Rec. 2855-2856 (1923) (Rep. Tom Green of Iowa).

/77/ Paul Samuelson, 'Tax Deductibility of Economic Depreciation to Insure Invariant Valuations,' 72 J. Pol. Econ. 604 (1964), is the pioneering article. For lawyer's reexplanations, see, e.g., Alvin Warren, 'Accelerated Capital Recovery, Debt, and Tax Arbitrage,' 38 Tax Law 549 (1985); Calvin Johnson, 'Soft Money Investing Under the Income Tax, '1989 Ill. L. Rev. 1019, 1039-1053 (1990); Pamela Gann, 'Neutral Taxation of Capital Income: An Achievable Goal?' 48 Law & Contemp. Probs. 77, 108-113 (1985).

/78/ This rationale would give TP a less generous rule than the 'boot model.' TP would be entitled to recover basis only if basis was in excess of the strike price.

/79/ Section 351(b)(2), 1031(c).

/80/ Treas. reg. section 1002-1 (1994). In absence of specific identification a FIFO (first-in, first-out) convention is used, although for mutual fund holdings, the taxpayer can also elect to user average cost convention (spreading total cost of all shares evenly across all shares held).

/81/ See Department of Treasury, Treasury Explanation of Administration Tax Proposals Proposed as part of the administration's fiscal 1997 budget (March 21, 1996); Sheryl Stratton, 'Average Cost Basis: An Idea Whose Time Has Come?' Tax Notes, Apr. 1, 1996, p. 21.

/82/ Shuldiner, supra note 31, at 245; Richard Brealey and Stewart Myers, Principles of Corporate Finance 161-163 (4th ed. 1991).

/83/ See, e.g., Michael Graetz, Federal Income Taxation: Principles and Policies 216 (2d ed. 1988) (borrowing is not taxed because borrowed amounts offset by obligation).

/84/ Assume that TP will incur expense of amount, E, in n years, deductible at rate t. The after-terminal value of the expense will be E*(1-t). Now allow a deduction for the present value of E at year 0, computing the present value using TP's real after-tax discount rate, d. The value of the deduction at year 0 will be E*(1-t)/(1+d)(to the nth power). The terminal value of the immediate deduction will be [E*(1-t)/(1+d)n]*(1+d)n] or E*(1-t), which is the same terminal value in the case of deferring the deduction. Discounting at a pretax discount rate and allowing an interest deduction would give an early deduction an advantage over a deferred deduction, but if TP appropriately bears tax on the interim returns, the PRETAX discounting would be inappropriate.

/85/ See, e.g., sections 83 (compensation in property), 301(b) (dividend includes fair market value of distributed property), 2031(b) (unlisted stock included in taxable estate), and 2503 (gifts subject to gift tax).

/86/ Treas. reg. section 20.2031-1(b) (1963), cited with approval, e.g., by United States v. Cartwright, 411 U.S. 546, 551 (1973).

/87/ TP will have $60 gain under the core hypothetical ($100 option premium and $126.04 strike price) only when TP's basis is $166.04, that is $40 over current value.

/88/ Hort v. Commissioner, 313 U.S. 28 (1941) (basis may not be used against landlord's receipt for freeing tenant from lease; receipt was rent); Reggio v. United States, 151 F. Supp. 740, 741 (Ct. Cl. 1957) (bondholder may not use basis in bonds against settlement paid when issuer reduced interest rate; bondholder held to have combination of in-lieu-of interest income and unrealized loss on the bond).

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