7623 / How is a "constructive ownership transaction" treated for tax purposes?

For purposes of the constructive ownership transaction rules, net underlying long-term capital gain means the aggregate net capital gain that the taxpayer would have had if (1) the financial asset had been acquired for fair market value on the date the transaction was opened and sold for fair market value on the date the transaction was closed; and (2) only gains and losses that would have resulted from the deemed ownership under (1) were taken into account. If the taxpayer does not establish the amount of the net underlying long-term capital gain with respect to any financial asset by clear and convincing evidence, the amount of such gain will be treated as zero.²

If any gain is treated as ordinary income for any taxable year on account of these rules, the tax imposed for that year is increased by imposing interest at the underpayment rate for every prior tax year in which any portion of the constructive ownership transaction was open.³ The calculation of the interest is explained in IRC Section 1260(b)(2). No credits are allowed against the increase in tax.⁴

To the extent that gain is treated as long-term capital gain after the application of IRC Section 1260(a)(1) (i.e., instead of being recharacterized as ordinary income), it will be subject to the capital gain tax in the same manner as is the net underlying long-term capital gain.⁵ See Q 702 for the treatment of capital gains and losses.

Special rule where taxpayer takes delivery. Generally, if a constructive ownership transaction is closed by reason of taking delivery, the constructive ownership rules will be applied as if the taxpayer had sold all the contracts, options, or other positions that are part of the transaction for fair market value on the closing date. The amount of gain recognized under the preceding sentence will not exceed the amount of gain treated as ordinary income under IRC Section 1260(a). The IRC states that proper adjustments will be made in the amount of any gain or loss subsequently realized for gain recognized and treated as ordinary income under this special rule.⁶

The intended effect of IRC Section 1260 is to limit the amount of long-term capital gain a taxpayer can recognize from derivative transactions with respect to certain pass-through entities. The amount that may be treated as long-term capital gain is limited to the amount of such gain the taxpayer would have had if the taxpayer owned a direct interest in the pass-through entity during the term of the derivative contract. Any gain in excess of this amount is treated as ordinary income. In addition, an interest charge is imposed on the amount of gain that is treated as ordinary income. The provision does not alter the amount of gain that is not treated as ordinary income.⁷