There’s a bevy of financial instruments to trade on securities and futures exchanges around the world, and derivatives and swaps exchanges offering binary options and swap contracts are increasingly becoming part of the mix. How are these unique instruments treated come tax-time? Can they be considered Section 1256? Let’s delve into binary options and swaps in more detail. (For more background on Section 1256 and its qualified board or exchange requirement, see Tax treatment for foreign futures.”)
Dodd-Frank changed the law
A principal focus of the Dodd-Frank Wall Street Reform and Consumer Protection Act law enacted in July 2010 is better regulation and control of the several-hundred-trillion-dollar derivatives and swaps marketplace. Dodd-Frank requires many privately negotiated derivatives and swaps contracts to clear on derivatives and swaps exchanges to insure collection of margin and to prevent another financial crisis. Remember, AGI wrote too many derivatives and swaps contracts, which it did not have sufficient capital or margin to pay out when markets melted down and counterparties demanded payment in 2008.
Dodd-Frank synchronized regulation and tax law, requiring the IRS to exclude swap contracts from Section 1256. Although Congress required private derivative contracts to clear on Section 1256 exchanges, it didn’t want to reward derivatives contracts with Section 1256 tax advantages.
Before Dodd-Frank, the CFTC had more leeway in designating instruments as “options.” According to a CFTC lawsuit, the CFTC used a limited definition of what constituted an option; e.g. it trades like an option (more on this lawsuit later). According to a CFTC official, “After Dodd-Frank, unless the option expires into a futures contract, the CFTC categorizes it as a swap contract. If the contract expires into cash, it’s a swap contract.”
Regulators don’t drive tax treatment
The Securities and Exchange Commission (SEC) regulates securities and the IRS treats sales of securities with short-term and long-term capital gain/loss tax treatment based on realized gains subject to wash sale loss deferral rules. The Commodity Futures Trading Commission (CFTC) regulates commodities, futures, forex and derivatives and the IRS has varying tax treatment for these different types of financial instruments.
Regulated futures contracts and nonequity options are Section 1256 contracts afforded lower 60/40 capital gains tax rates with MTM accounting reporting realized and unrealized gains and losses at year-end (reported on Form 6781).
If an investor sells physical commodities, capital gain/loss treatment applies and there is no MTM. Conversely, if a farmer sells physical commodities, ordinary treatment applies, but again, there is no MTM.
Forex (interbank spot and forward contracts) falls under Section 988 ordinary gain and loss on realized transactions. Traders may file a contemporaneous “capital gains election” to opt out of Section 988, whereas manufacturers may not.
Notional principal contracts defined as two or more periodic payments — commonly called swaps — receive ordinary gain or loss treatment and MTM accounting applies.
IRS proposed regulations on swaps
In connection with Dodd-Frank, the IRS issued proposed regulations “Notice of Proposed Rulemaking and Notice of Public Hearing Swap Exclusion for Section 1256 Contracts” (REG-111283-11) on Oct. 17, 2011. Excerpts are provided below, with our notes in italics:
• Summary: .. describe swaps and similar agreements that fall within the meaning of section 1256(b)(2)(B). This document also contains proposed regulations that revise the definition of a notional principal contract under §1.446-3 (Note that swaps generally fall within the definition of “Notional Principal Contracts”.)
• Dodd-Frank Act added section 1256(b)(2)(B), which excludes swaps and similar agreements from the definition of a section 1256 contract. Section 1256(b)(2)(B) provides that the term “section 1256 contract” shall not include— any interest rate swap, currency swap, basis swap, interest rate cap, interest rate floor, commodity swap, equity swap, equity index swap, credit default swap, or similar agreement. (All swaps are effectively excluded.)
• Congress enacted section 1256(b)(2)(B) to resolve uncertainty under section 1256 for swap contracts that are traded on regulated exchanges. .. increased exchange-trading of derivatives contracts by clarifying that section 1256 of the Internal Revenue Code does not apply to certain derivatives contracts transacted on exchanges. (Nadex binary options trade on a regulated exchange.)
• Option on a notional principal contract
Section 1256(b)(2)(B) raises questions as to whether an option on a notional principal contract that is traded on a qualified board or exchange would constitute a “similar agreement” or would instead be treated as a nonequity option under section 1256(g)(3). Since an option on a notional principal contract is closely connected with the underlying contract, the Treasury Department and the IRS believe that such an option should be treated as a similar agreement within the meaning of section 1256(b)(2)(B). (If a Nadex binary option were deemed an option on a NPC, it would be excluded as a NPC per this rule.)
• Ordering rule
The proposed regulations provide an ordering rule for a contract that trades as a futures contract regulated by the Commodity Futures Trading Commission (CFTC), but that also meets the definition of a notional principal contract. The Treasury Department and the IRS believe that such a contract is not a commodity futures contract of the kind envisioned by Congress when it enacted section 1256. (We don’t think the IRS will view Nadex binary options as a futures contract; therefore, will view it as a NPC.)
• Definition of Regulated Futures Contract (RFC)
Section 1256(g)(1) defines a regulated futures contract as “a contract (A) with respect to which the amount required to be deposited and the amount which may be withdrawn depends on a system of marking to market, and (B) which is traded on or subject to the rules of a qualified board or exchange.” The apparent breadth of section 1256(g)(1) has raised questions in the past as to whether a contract other than a futures contract can be a regulated futures contract. (The IRS is trying to clean up some loose definitions in the past.)
Trading binary options on Nadex
The derivatives exchange based in the U.S. is the North American Derivatives Exchange (Nadex) which offers retail traders an online trading platform for limited-risk “binary options and spread contracts” based on stock indices, commodities, forex and financial events. Make a speculation and hold it through expiration for an “all or nothing” pay off, which some pundits say is akin to making a bet. Or trade the contract before expiration to cash it in at the current market price fluctuating on Nadex. Most Nadex contracts settle in one hour or one day, and the rest settle in a week or longer.
There is active trading on the Nadex platform/exchange similar to trading platforms on securities and futures exchanges. A trader may not notice much difference, but there are important differences in regulation and tax treatment.
Nadex issued 1099Bs using Section 1256 treatment
For tax years 2004 through 2013, Nadex issued direct members a Form 1099-B reporting Section 1256 tax treatment.
As pointed out in our first blog in this series, Nadex is a domestic board of trade — a category 2 qualified board or exchange (QBE) since it’s a CFTC-regulated “Designated Contract Market”. But that alone is not enough; Nadex binary options still must meet the definition of Section 1256 contracts. In February 2014, Nadex emailed us the following statement: “Nadex has recently been advised by staff of the Commodity Futures Trading Commission that its instruments are considered ‘commodity options’ categorized as ‘swaps.’”
We feel that Nadex binary options probably don’t qualify for Section 1256
Nadex binary options don’t seem to meet the definition of inclusion in Section 1256 as either a regulated futures contract or a nonequity option, and they seem to meet the definition of exclusion from Section 1256 as a swap contract.
Nadex binary options don’t meet the definition of Section 1256 for “regulated futures contract” (RFC). A Nadex binary option requires full payment in advance — it’s not collateral — and there is no withdrawals based on MTM. Nadex binary options are prepaid bets. There seems to be consensus on this point.
Nadex binary options probably do not meet the definition of Section 1256 for “nonequity options” as they don’t seem to meet the definition of “options” in the tax code (Section 1234a) (see further discussion below). We haven’t seen a private letter ruling, tax opinion letter or tax research supporting a nonequity option argument for Nadex binary options.
Nadex binary options probably are excluded from Section 1256 as swap contracts. The CFTC said they are “commodity options” categorized as swaps. Dodd Frank law enacted Section 1256(b)(2)(B) into law effective July 2011. Section 1256(b)(2)(B) excludes swap contracts from Section 1256 tax breaks. Proposed regs for Section 1256(b)(2)(B) are not yet effective and they define swaps based on the IRS definition of “notional principal contracts” (NPC). NPC normally require two payments whereas Nadex binary options have one payment. The difference between one versus two payments does not seem material to us.
The IRS proposed regulation excludes all notional principal contracts (swaps) from Section 1256. But, the IRS received many comments arguing that exchange-traded swap contracts, as opposed to off-exchange OTC swaps, should not be excluded since the commenters believed they had Section 1256 tax treatment before Dodd-Frank. Until the final regulation 1256(b)(2)(B) is issued, we won’t know the final outcome. Nadex binary options are exchange-traded swaps, not OTC. Even if in final IRS regulations Nadex binary options are not excluded as exchange-traded swaps, they still must qualify as a non-equity option and we don’t think they do.
We suggested to Nadex that they file for a private letter ruling to support using Section 1256 on 1099Bs for Nadex binary option transactions.
CFTC definition of “option”
The Nadex email says the CFTC referred to their binary options as “commodity options.” They are bets that rise or fall based on an underlying market or financial event, they are based on option pricing models and they trade like options. Before Dodd-Frank, the CFTC could use this narrow definition. The issue of whether binary options are “options” in accordance with CFTC regulation came up in court in 2013. As reported on Goodwingaming, “The binary option trading platform Banc de Binary currently faces a civil lawsuit in the District of Nevada brought by the CFTC for allegedly violating ‘the Commission’s ban on trading options off-exchange.’ The regulatory authority of the CFTC covers ‘options’ which are adroitly defined as ‘transaction(s) .. . held out to be of the character of, or . . commonly known to the trade as option(s).’” The defendant argued their binary options are not options per the CFTC’s full regulatory definition. The CFTC argued that only the first part of the definition counts: “What makes an option an option is the first of these three components — price speculation.” This sounds similar to Nadex’s options pricing.
“In a parallel lawsuit brought by the Securities and Exchange Commission, Judge Robert Jones (District of Nevada) agreed, explaining: With a binary option, . . . the purchaser receives neither the stock itself nor the right to purchase the stock in the future. Binary options are in substance pure gambling bets. . . . Binary option givers and buyers do not purport to trade interests in securities any more than tellers and gamblers at a racetrack purport to trade interests in horses. . . . The Court simply cannot agree that a contract under which the purchaser has no putative right to obtain the security is an ‘option.’”
IRS definitions of “option” is different
The tax code definition of an option sounds like the SEC argument rather than the CFTC argument in the above court cases. The main problem with saying that a Nadex binary option is a nonequity option for Section 1256 is that there is no right to receive property, or alternatively to receive cash equal to the right to receive property (in the case of a cash settled option).
Tax court cases and very limited IRS guidance
Industry professionals equate binary options with “digital options” and “paired options.” These terms came up in just a few tax court cases, which are about tax avoidance, not options. We don’t see any statements in these cases that indicate the court viewed binary options as true options. Section 1256 tax treatment is not used on binary options in any of these tax court cases. These cases do not connect the dots for supporting a Section 1256 position.
In The Markell Company, Inc. v. Commissioner, TC Memo 2014-86, “taxpayer/partner wasn’t entitled to multimillion dollar loss on complicated basis-inflating paired options/Son of BOSS (tax shelter) transaction using newly formed LLC/partnership.”..”Paired Options. The paired options in this case consisted of short and long European digital call options. These cash-or-nothing options can be valued by multiplying the present value of the cash payoff amount by the probability calculated from the Black-Scholes-Merton (BSM) model that the digital option will be in the money at the expiration date.” While Markell used paired options, the case is about tax avoidance transactions based on purposely mispricing paired options. (This case does provide tax guidance for treating binary options based on currencies as Section 988 ordinary gain or loss. There is a connection between the binary option and the underlying instrument it’s meant to mimic in price.)
In Douglas R. Griffin, (TC Memo 2011-61), “HydroTemp timely filed a return for the tax year ending June 30, 2003, reporting a $7,524,153 long-term capital gain from the asset sale to Pentair and a $7 million short-term capital loss from the sale of binary options (i.e., options in which the payoff is structured to be either a fixed amount of compensation if the option expires in the money or nothing at all if the option expires out of the money). .. IRS’s position. IRS disallowed HydroTemp’s losses from its claimed binary options sale.” In this case, the court accepted the binary option transactions as legitimate and the taxpayer won the case. (This case may provide tax guidance for treating the sale of binary options before they expire as being capital gain or loss on realized transactions; however, the IRS attorneys did not seem to have focused on the tax treatment of the options, but simply questioned the legitimacy of the transaction . When terminating a binary option short of expiration, perhaps capital gains and loss treatment is applicable, as discussed below.)
In an IRS Coordinated Issue Paper explaining IRS Notice 2003-81 (Tax Shelters), ,the IRS discusses “option premium” on binary options. “Gain and loss on options is accounted for on an open transaction basis. As explained in Notice 2003-81, the justification for open transaction treatment is that the gain or loss on an option cannot be finally accounted for until such time as the option is terminated. Thus, premium income is not recognized until an option is sold or terminated. Rev. Rul. 58-234.… explains that this is the treatment for the option writer because the option writer assumes a burdensome and continuing obligation, and the transaction therefore stays open without any ascertainable income or gain until the writer’s obligation is finally terminated. When the option writer’s obligation terminates, the transaction closes, and the option writer must recognize any income or gain attributable to the prior receipt of the option premium.” This should be the rule for the receipt of option premium whether the instrument is truly an option or not. This IRS guidance seems weak for building a case that a binary option is treated as a true option and therefore a nonequity option in Section 1256. (In Notice 2003-81, the binary options discussed were based on foreign currency transactions and Section 988 ordinary gain or loss on realized transactions applied by default on the binary options, not Section 1256.)
Tax compliance and planning
In general, we think binary options start off with ordinary gain or loss treatment. In Highwood Partners v. Commissioner (133 TC 1, 2009), digital options based on currency transactions were Section 988 ordinary gain or loss treatment. If you have a Nadex 1099B reporting Section 1256 treatment from binary options based on currencies, you should use Section 988 ordinary gain or loss treatment and not Section 1256, thereby overriding the 1099B.
Swap tax treatment calls for ordinary gain or loss tax treatment, too. Ordinary losses can generate large tax refunds since traders are not subject to the $3,000 capital loss limitation. Caution, large ordinary losses without qualification for trader tax status (business treatment) can lead to some wasted losses and wasted itemized deductions; as those ordinary losses are not a capital loss carryover or a net operating loss carryback or forward.
When a trader sells a Nadex binary option (not based on currency) before expiration, the IRS may view the proceeds as a “termination payment” on the sale of a capital asset, rather than a “period payment” on a swap contract. Normally, termination payments on capital assets are capital gains.
Tax attorneys Mark Feldman and Roger Lorence, and Darren Neuschwander, CPA contributed to this blog.