Tax Treatment of Commodity Futures and Options

Overview

Farmers and ranchers buy and sell commodity futures and options to hedge against fluctuating prices. They also buy and sell commodity futures and options to speculate with fluctuating prices.  They also enter into cash forward grain contracts and hedge-to-arrive contracts.    The tax issues associated with commodity trading are important to understand, and are the focus of today’s post.

Hedging or Speculation

A hedging transaction is defined as a transaction that a taxpayer enters into in the normal course of the taxpayer’s trade or business, primarily to reduce (as opposed to simply managing) the risk of price changes or currency fluctuations with respect to ordinary property, or to reduce the risk of interest rate or price changes or currency fluctuations with respect to borrowing or ordinary obligations.  I.R.C. §1221; Treas. Reg. §1.1221-2(b).  To receive tax treatment as a hedge, the transaction must be identified by the taxpayer as a hedging transaction before the close of the day the hedge is entered into. I.R.C. §1221(a)(7); Treas. Reg. §1.1221-2(f)(1).  The item being hedged must be identified no more than 35 days after the hedging transaction.  Treas. Reg. §1.1221-2(f)(2)(ii).  If the transaction is not timely identified as a hedge, the straddle rules and mark-to-market rules may apply. I.R.C. §§1092; 263(g); I.R.C. §1256.

A taxpayer uses a hedge to lock in a position in a particular commodity. Once locked in, if the physical commodity increases in value, the taxpayer’s value of the futures position should go down – one should offset the other with the net result that the hedge maintains the taxpayer’s position.

Speculation involves a commodity transaction entered into other than in the context of the taxpayer’s trade or business.  Speculation can be illustrated by the farmer who harvests corn, sells the corn, and buys futures in the marketplace in anticipation of prices rising and believing this strategy is better than storing the commodity. This is speculation and is subject to the mark-to-market rules of I.R.C. §1256.  The mark-to-market rules require taxpayers to report on Form 6781 gains and losses from regulated futures contracts and other “Section 1256 contracts” on an annual basis under the mark-to-market rule. These rules close out speculative transactions as of December 31. They are marked to market by treating each contract held by the taxpayer as if it were sold for fair market value on the last business day of the tax year, thereby requiring profit or loss to be reported on the taxpayer’s income tax return. The net gain or loss is allocated 40 percent to short-term capital gain (or loss) and 60 percent to long-term capital gain (or loss).

Tax difference.  Gain and loss from transactions that are hedges generate ordinary income and loss and are not subject to the loss deferral rules and the “mark-to-market” rules that apply to speculative transactions.  I.R.C. §1221 and Treas. Reg. §1.1221-2. Because a hedge is entered into in the normal course of the taxpayer’s business (such as to lock-in a position in a particular commodity), any resulting gain is subject to self-employment tax. 

However, if the transaction involves speculation, resulting gains and losses are treated as capital gains and losses.  Capital gains can offset capital losses, but capital losses deductible

against ordinary income are capped at $3,000 per year.  In addition, corporations are not eligible for the $3,000 deduction against ordinary income.  Also, speculative transactions are subject to the loss deferral and “mark-to-market” rules.   Speculative transactions do not trigger self-employment tax.

Farmers and ranchers will often buy options.  When a put option is purchased by the producer of a commodity, the producer acquires the right to sell the commodity at a future point in time.  If the sale occurs just before the crop is planted or while the crop is growing, the transaction is a hedge.  If the right to sell is triggered after the crop is sold, the transaction is speculative.  

A farmer or rancher may also buy a call option.  A call option gives the producer the right to buy the commodity at some future point in time.  Transactions involving the purchase of a call option for the purchase of a commodity by a crop producer are speculative regardless of when the option is exercised. However, a livestock farmer may enter into a call option for feed, or a crop farmer may enter into a call option for crop inputs. The question of whether a transaction is a hedge or is speculation turns on whether it was entered into in the normal course of the taxpayer’s business to reduce risk.

Tax Accounting

Any income, deduction, gain or loss from a hedging transaction is matched with the income, deduction, gain or loss on the item being hedged. Also, in some situations, the hedge timing rules apply irrespective of whether the transaction has been identified as a hedge.  Rev. Rul. 2003-127, 2003-2 C.B. 1245.  In essence, the tax rules for hedging transactions address both character and timing, and are designed to match the character and timing of a hedging transaction with the character and timing of the item being hedged.  The timing Farmers participating in true hedging programs likely have multiple transactions for a single crop and may combine option purchases and sales to minimize the cost of these programs or to create both a ceiling and a floor for prices.  Properly identifying and reporting these many transactions is a challenge for the taxpayer and tax preparer and IRS Pub. 550 can be helpful.

Just as important as the matching principle with commodity transactions is what constitutes “property.”  I.R.C. §1001 governs the computation of gain or loss on the sale or exchange of property, with gain being the excess of the amount realized over the adjusted basis of the property, and the loss is the excess of the adjusted basis of the property over the amount realized.  Thus, for gain or loss to be computed on a transaction, the taxpayer must know the identity and amount of property that will be delivered.  That isn’t known until the contract is settled.

Recent Case

In Estate of McKelvey v. Comr., 148 T.C. No. 13 (2017), the decedent had entered into contracts to sell corporate stock to Bank of America and Morgan Stanley & Co., International. The contracts were structured as variable prepaid forward contracts (VPFC) that required the banks to pay a forward price (discounted to present value) to the decedent on the date the contracts were executed, rather than the date of contract maturity. Accordingly, the decedent received a cash prepayment from Bank of America of approximately $51 million on September 14, 2007. On September 27, 2017, the decedent received a cash prepayment from Morgan Stanley & Co. of slightly over $142 million. The prepayments obligated the decedent to deliver to the banks stock shares pledged as collateral at the time of contract formation, and certain other stock shares that weren’t pledged as collateral or an equal amount of cash. The actual number of shares or their cash equivalent is determined via a formula that accounts for stock market changes.

Under the contracts as originally executed in September of 2007, the decedent was to deliver to the banks every day for 10 consecutive business days in September of 2008. Each day, one-tenth of the total number of shares agreed to be transferred was to be delivered as determined by adjusting the number of shares by the ratio of an agreed floor price over the stock closing price for that particular day, or a cash equivalent to the stock. However, in July of 2008, the banks agreed to extend the settlement dates to early 2010. To get the extension, the decedent paid Morgan Stanley & Co. slightly over $8 million on July 15, 2008, for delivery over 10 consecutive days in early January of 2010, and paid Bank of America approximately $3.5 million on July 24, 2008, for delivery over 10 consecutive days in early February of 2010.

For tax purposes, the decedent treated the original transactions as “open” transactions in accordance with Rev. Rul. 2003-7, 2003-1 C.B. 363 and did not report any gain or loss for 2007 related to the contracts. In addition, the decedent did not report any gain or loss related to the contract extensions that were executed in 2008 on the basis that the extensions also involved “open” transactions. The decedent died in late 2008, and on July 15, 2009, the decedent’s estate transferred shares of stock to settle the Morgan Stanley & Co. contracts. The estate filed a Form 1040 for the decedent’s taxable year 2008, and the IRS issued a deficiency notice for over $41 million claiming that when the decedent executed the extensions in 2008, he triggered a realized capital gain of slightly over $200 million comprised of a short-term capital gain of $88 million and $112 of long-term capital gain from the constructive sale of shares pledged under the contracts. The IRS claimed that the decedent had no tax basis in the stock pledged as collateral.

The court disagreed with the IRS on the basis that the “open transaction” doctrine applied because of the impossibility of computing gain or loss with any reasonable accuracy at the time the contracts were entered into. In addition, the court rejected the argument of the IRS that the extensions of the original contracts closed the contracts which triggered gain or loss at the time the extensions were executed. The court specifically noted that, in accordance with Rev. Rul. 2003-7, VPFCs are open transactions at the time of execution and don’t trigger gain or loss until the time of delivery because the taxpayer doesn’t know the identity or amount of property to be delivered until the future settlement date arrives and delivery is made. Until delivery, the only thing that the decedent had was an obligation to deliver; this was not property that could be exchanged under I.R.C. §1001. The court also noted that the open transaction doctrine applied because the identity and adjusted basis of the property sold, disposed of or exchanged was not known until settlement occurred. The court also stated that an option is a “familiar” type of open transaction from which we can distill applicable principles.” 

Conclusion

Many commodity transactions in which farmers engage are “open” transactions, with the producer holding merely a contractual obligation at the time of contract execution.  An option, for example, is a type of “open transaction.”  See, e.g., Rev. Rul. 78-182, 1978-1 C.B. 256.  Forward grain contracting, hedge-to-arrive contracts, and other types of commodity transactions may also delay tax consequences until the contract requirements are fulfilled.  The Tax Court’s recent decision helps confirm that point.