IRS guidance severely restricts hedge fund use of basket options

This article discusses the recent IRS focus on basket options.

Some hedge funds have recently received scrutiny for their use of basket options to avoid paying the high tax rate associated with short-term capital gains.

A basket option gives the holder the right to buy or sell a group of underlying assets at a certain price before a named date. The IRS concern arises when the taxpayer (the hedge fund) enters into a contract with a financial institution to obtain a return based on the performance of assets held by the financial institution in name but managed by the hedge fund. Hedge funds could then claim on their tax returns that the profits came from exercising the options rather than from gains made by short-term trading.

Last year, a U.S. Senate subcommittee reported that at least a dozen major hedge funds were using basket options to avoid federal taxes. According to the U.S. Senate Permanent Subcommittee on Investigations, one hedge fund saved well over $6 billion using basket options over several years.

And the basket options were not really options, according to the subcommittee. "The law is very clear in this area - basket options are a tax shelter," said Senator Ron Wyden, the top Democrat in the Senate Finance Committee, in a statement released shortly after the IRS issued its guidance. In fact, in 2010 the IRS issued an internal memo calling basket options "simply an account of securities owned by the alternative investment vehicle." However, the memo had no legal authority and banks and hedge funds have continued to use basket options to avoid paying short-term capital gains tax on assets held for less than one year.

New joint guidance from Treasury, IRS closes "loophole"

In a July 8, 2015 IRS and Treasury guidance, the agency notified hedge funds that it is now viewing basket option contracts as "listed transactions," meaning they must be reported on tax returns. Organizations investing in alternatives must report them on returns and correct them on their past tax returns or face penalties.

The IRS has yet to press any cases but may do so for hedge funds which fail to list basket options on their returns.

The IRS notice applies to transactions as far back as 2011. Since last year's Senate subcommittee report, several prominent banks have ceased offering basket options for hedge funds.

Help with compliance and penalty relief

Profits from short-term gains are currently taxed at 43.4 percent, while long-term capital gains are taxed at 23.8 percent. This disparate treatment has created vast incentive to categorize investments as long-term capital gains. However, the IRS is looking closely at hedge funds, private equity firms and other financial investors who are seeking to lower their tax burden.

Insight Law is a Seattle firm specializing in tax litigation, collection and IRS disputes for individuals and businesses.