Are ETF Options Section 1256 Contracts?

May 23, 2010 • Posted in Equity Options

Reader Jeff Partlow passed along the question of whether options on Exchange-Traded Funds (ETF) are Section 1256 contracts, qualifying for 60% long-term and 40% short-term capital gains treatment. Using applicable parts of U.S. Code Section 1256 and IRS Publication 550, we find that:

The safe answer is “consult your tax advisor.” Nevertheless…

Part (b) of U.S. Code Section 1256 defines five types of qualifying contracts, as follows:

  • (1) any regulated futures contract,
  • (2) any foreign currency contract,
  • (3) any nonequity option,
  • (4) any dealer equity option, and
  • (5) any dealer securities futures contract.

Options on ETFs are not futures contracts, foreign currency contracts or dealer securities futures contracts, ruling out qualifications (1), (2) and (5). Unless the taxpayer is an options dealer, item (4) does not qualify options on ETFs. The residual question is whether item (3) qualifies options on ETFs as nonequity options.

IRS Publication 550 elaborates and provides Internal Revenue Service (IRS) interpretations of U.S. Code Section 1256. Some relevant points are:

Nonequity option. This is any listed option (defined later) that is not an equity option. Nonequity options include debt options, commodity futures options, currency options, and broad-based stock index options. A broad-based stock index is based upon the value of a group of diversified stocks or securities (such as the Standard and Poor’s 500 index).”

Cash-settled options. Cash-settled options based on a stock index and either traded on or subject to the rules of a qualified board of exchange are nonequity options if the Securities and Exchange Commission (SEC) determines that the stock index is broad based. This rule does not apply to options established before the SEC determines that the stock index is broad based.”

Equity option. This is any option to buy or sell stock, or that is valued directly or indirectly by reference to any stock or narrow-based security index. Equity options include options on a group of stocks only if the group is a narrow-based stock index.”

“An ‘options dealer’ is any person registered with an appropriate national securities exchange as a market maker or specialist in listed options.”

The examples of nonequity options do not include ETFs, which may be derived from indexes but are not themselves indexes. Also, options on ETFs are not cash-settled. There may be some wiggle-room under the definition of equity option with respect to options on those ETFs derived from broad-based stock indexes, but it may be risky to assert Section 1256 status without specific guidance/rulings from the IRS. In any case, the wiggle room appears applicable only to options on ETFs derived from those stock indexes specified as broad-based by the SEC.

The following articles, which mostly advise against treating options on ETFs as Section 1256 contracts, provide a sense of the wiggle room:

From 5/24/07: “Stock Index Options – Determining When They Are Subject to the Mark-to-Market Rule”

From 5/19/08, page 4: “LBR Group and Roy F. Glassberg, CPA presents a Tax Summary for Traders”

From February 2009: “Losses on an ETF (or Index Fund)?”

In summary, claiming options on ETFs as Section 1256 contracts appears risky pending a specific IRS ruling. Those considering doing so should consult their tax advisors and decide for themselves rather than rely on the above discussion.

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