Example 1

1. Example 1 Alice has held 1,000 shares of AT&T stock for 30 years. Her basis is $5 a share and AT&T is currently trading for $35 a share. In a time of market turmoil like the recent financial crisis, Alice is concerned that the stock may decline significantly. She does not want to sell the stock because she likes getting the dividend. So she buys a put with a strike price of $25 a share. • Current law: Alice has no gain or loss from buying the put. • Draft proposals: Alice is treated as selling her AT&T stock for $35 a share, with a resulting taxable gain of $20,000. Alice will need to come up with the cash to pay the tax.

2. Example 2 Fred buys one share of Intel stock for $20. After holding the Intel stock for 3 months and at a time when Intel is trading at $25, Fred writes a 60-day, $30 call for $2 to generate some additional income. Assume that the option expires worthless after 60 days and that Intel is trading for $26 when the option expires. • Current law: Fred has no gain or loss when he writes the covered call. He has a $2 short-term capital gain when the call expires. Fred’s holding period in the stock continues to accrue while the written call is outstanding. • Draft proposals: Fred is treated as selling his Intel stock for $25 when he writes the call and he recognizes $5 of short-term capital gain at that time. When the option expires, Fred recognizes $2 of ordinary income on the option and $1 of ordinary income on the stock (because the stock appreciated from $25 to $26 while the option was outstanding). Fred is treated as having a basis of $26 in the Intel stock for purposes of computing subsequent gain or loss and has a 3-month holding period in the stock. (His holding period is suspended during the 60-day period in which the written call was outstanding.)

3. Example 3 Sticking with Fred, assume that one month later, Intel has declined from $26 to $22. Fred now writes a 31-day, $25 call for $1. Assume that after 31 days, the call expires and Intel is trading at $19. • Current law: Fred’s basis in his Intel stock remains $20 a share (his original basis). Fred has no gain or loss when he writes the option. He has $1 short-term capital gain when the option expires. His holding period in the stock continues to accrue while the written option is outstanding. • Draft proposals: Fred has a loss of $4 in his Intel stock for tax purposes at the time the option is written, but unlike in Example 2 where there was a built-in gain, the loss is not triggered by writing the call. When the call expires, Fred has $1 of ordinary income from the call and a $3 ordinary loss on his Intel stock (which declined from $22 to $19 while the call was outstanding). Going forward, Fred has a tax basis in his Intel stock of $23 (the $20 original basis increased by $6 as a result of writing the call in Example 2 and reduced by the $3 loss during the period the written call in this example was outstanding). He has a holding period of 4 months in the stock (3 months plus the month between the time the first call expired and when he wrote the second call).

4. Example 4 Two months later, when Intel is trading at $15 a share, Fred writes a 45-day $20 call for $2. On the expiration date, when Intel is trading for $25 a share, Fred is assigned on the call. At this time, the call is worth $5. Fred delivers his Intel stock and receives the exercise price of $20. • Current law: Fred is treated as receiving $22 a share for his stock (the $20 exercise price of the option plus the $2 of premium he received for writing the option). His basis is $20 (his original basis which has not changed) and he has $2 of short-term capital gain. There is no separate gain or loss on the option. • Draft proposals: When Fred wrote the call, he had a built-in loss in the stock of $8 (the difference between his $23 basis coming out of Example 3 and the $15 trading price of Intel when he wrote the call). The loss is not triggered by writing the call. When the call is assigned to Fred, he will recognize a $3 ordinary loss on the call (its value of $5 when it is assigned minus the $2 of premium he received for writing the call). The treatment of his stock is bifurcated: He has a short-term capital loss of $8 a share (the excess of his $23 adjusted basis over $15 value of Intel when the call was written) and he has $10 of ordinary income (equal to the increase in the value of the stock while the call was outstanding).

5. Summary of Examples 2-4 Current Law Ex. 2 $2 short-term gain on call Ex. 3 $1 short-term gain on call Ex. 4 $2 short-term gain on stock Total: $5 short-term gain Draft Proposals • $5 short-term gain on stock • $2 ordinary income on call • $1 ordinary income on stock • $1 ordinary income on call • $3 ordinary loss on stock • $3 ordinary loss on call • $10 ordinary income on stock • $8 short-term loss on stock • $3 short-term loss • $8 ordinary income