Identified Straddle Rules Fixed by Technical Corrections
The recent technical corrections legislation signed into law on Dec. 29, 2007, the Tax Technical Corrections Act of 2007, Pub. L. 110-172, contains a provision that improves the identified straddle
rules. The identified straddle rule of section 1092(a)(2) permits a taxpayer to select positions in a straddle and thereby avoid surprise applications of the straddle rules by the IRS on audit.
Background—The Basic Straddle Rules
The basic thrust of the section 1092 straddle rules is to defer the recognition of losses on positions in a straddle where the taxpayer continues to hold gain positions of the straddle that were offsetting to the loss positions. Offsetting positions result where a taxpayer has a substantial diminution of risk of loss in personal property by reason of the holding of one or more other positions (i.e., a hedge). Where a company may have numerous offsetting positions, it is useful to be able to identify the offsetting positions in a straddle to ensure the application of the loss deferral rules will be as anticipated. Otherwise, insurance companies could find themselves in a difficult position upon an IRS examination where they sold derivatives at a loss. For example, the IRS could take the position on audit that a short position is a straddle with the company’s
entire bond portfolio, and thereby attempt to disallow the loss “permanently” as long as there was unrecognized gain in the company’s bonds. The IRS could adopt this position even though the offsetting positions were “unbalanced,” i.e., where the derivative positions were small as
compared to the entire bond portfolio.
Although the straddle rules as originally enacted in 1981 contained a provision that allowed taxpayers to identify positions in a straddle, it was not a practical solution. This is because the provision applied only where all the positions of the straddle were acquired on the same day and
they had to be disposed of on the same day. Due to these practical limitations, the identified straddle rules were not used. Instead, taxpayers resorted to “self-help” identification for hedges of capital assets that do not qualify for the tax hedging exception from the straddle rules. Support for the self-help approach could be found in PLR 199925044 (June 28, 1999), where the IRS National Office stated that in the absence of regulations providing rules for dealing with unbalanced positions under section 1092(c)(2)(B), it was permissible for taxpayers to identify shares of stock that were part of a straddle. However, with these type of selfhelp attempts, there was no certainty that such identification would be respected by the IRS, or apply more broadly to other types of straddles.
30 Taxing Times, Volume 4, Issue 2 (September 2008)