Some Proposals for Interpreting the Tax 'Straddle' Rules

Abstract

This article proposes a solution to a vexing problem of significance when the article was written in 2007, namely how to match up long and short positions in a tax straddle. It also addresses rarely discussed questions relating to the application of the tax straddle rules to liabilities and to positions in a corporation’s own stock, and proposes frameworks for answering those questions.

The tax “straddle” rules are important to taxpayers that engage in investment and trading activities because they are the principal rules of the Internal Revenue Code that deal with the hedging of positions in capital assets. The straddle rules are anti-abuse rules, generally intended to prevent taxpayers from deducting tax losses or expenses incurred with respect to an investment asset in the absence of corresponding economic costs, from aging the holding period for an investment asset from short-term to long-term in the absence of risk, and from converting unrelated short-term capital gain or ordinary income to long-term capital gain. They are very broad in scope. Their breadth is in some ways unfortunate, as they were extended only a few years after their original enactment to transactions in stock for which the rules are not ideally crafted.

There have been numerous changes in market practice and some changes in other related areas of the law since the straddle rules were first enacted in 1981. The most important amendments to the rules were made in 1986. In 2004, Congress made the first significant changes to the tax “straddle” rules in two decades. The 2004 amendments do not, for the most part, address some important conceptual questions that have arisen over the years, although the commentary on those amendments has made a number of them more visible. This article addresses some of those questions. The principal focus of the article is on the rules addressing timing and holding period arbitrage.

Part I discusses the history of the straddle rules and summarizes the rules. It is intended to give readers not familiar with the straddle rules a sense of how they have developed, without addressing many of the details important to applying the rules in practice. Readers familiar with the straddle rules may want to skim Part I, since it is intended to set up the issues and arguments made in Part II.

Part II of the article discusses the long-standing question of how to determine which positions held by a taxpayer are part of a straddle. It suggests a line of analysis that explains the limited answers we have to that question to date, and that provides answers consistent with most practitioners’ instincts for unanswered questions. Part III then considers some issues relating to the application of the straddle rules to liabilities. Part IV discusses the question of whether a position in a corporation’s own stock can give rise to a straddle.