Every year as April 15th rolls around many taxpayers seem to think that there is magic bullet or loophole in the tax law that everyone is taking advantage to save taxes of but them.  Well thanks to Senate Finance Committee ranking member Ron Wyden, D-Ore., he has issued a report identifying six “tax avoidance strategies” that we can all benefit from.  Wyden has called on Congress, Treasury and the IRS to take action to combat these techniques and said that reform could generate billions of dollars in revenues over the next 10 years.

“Wyden wants to highlight the problems in our current tax system and build support for tax reform,” Steven Rosenthal, Senior Fellow, Urban-Brookings Tax Policy Center, Washington, D.C., told Wolters Kluwer. “Financial products are a fine place to start. The tax rules operate in a complex fashion; the results are opaque; and they are only available to those who have access to banks and tax planners.”

Financial products

Taxpayers are using derivative contracts to lock in stock gains (or losses), while manipulating the timing of any taxes paid and minimizing the taxes paid, the report indicates. Five of the six strategies involve financial products; one involves deferred compensation. The financial product strategies include using:

  • Collars to avoid paying capital gains taxes;
  • Wash sales to time the recognition of capital gains;
  • “Basket options” to convert short-term capital gains into long-term gains;
  • Derivatives to convert ordinary income into capital gains, or capital losses into ordinary losses; and
  • Derivatives to avoid the constructive ownership rules for partnership interests.

Collars, wash sales and basket options

Collars. Owners of appreciated stocks use a “collar” to lock in the gain by purchasing simultaneous options to buy and sell the stock to avoid risk and to hedge against any price fluctuation. This allows taxpayers to lock in capital gain without selling the stock. Congress enacted Code Sec. 1259 to require the recognition of gain when entering into certain derivative transactions, such as collars and to treat collars as constructive sales, but Treasury has not issued any regs, the report indicated.

Wash sales. Taxpayers with depreciated stocks can realize capital losses without changing their economic position by selling a security and immediately purchasing a substantially similar security. The report indicates that current wash sale rules deny recognizing the loss if the identical stock is purchased within 30 days of the sale, but the rules do not address similar techniques that use financial instruments like forward contracts and swaps. The report describes a technique of entering into a derivative contract for a basket of stocks that is somewhat different from the stocks sold. The report suggests that Congress update the Code Sec. 1091 wash sale rules, and that legislation or regs address similar techniques.

Basket options. Foreign banks exercise basket options held for more than a year (to achieve long-term rates), while the underlying assets in the basket or portfolio are typically held for less than a year. The IRS has characterized these transactions as an account holding securities, not an option. The law is clear that basket options are a tax shelter; the report recommends that the IRS issue a tax shelter notice imposing appropriate penalties.


Derivatives and other contracts on capital assets that are held to maturity generate ordinary income. However, if the contract is terminated before maturity by a sale of the underlying asset, the proceeds are capital gain (or loss). This dichotomy allows taxpayers to manipulate the timing and amount of taxes owed. A comprehensive solution would be to enact legislation that marks-to-market all derivative instruments and treats the resulting gains or losses as ordinary.

“Marking-to-market all derivatives and treating the income as ordinary would provide a comprehensive solution,” Rosenthal said. “A global approach is the right approach. This is the most significant proposal in the report and would address the present gaming of derivatives. There would be no opportunity to defer income and change its character. The other proposals are addressing tax loopholes.”

Swaps or other derivatives can be used to “mimic” ownership of an investment partnership. Taxpayers report long-term capital gains on the income. Code Sec. 1260 limits the long-term capital gain from derivatives involving partnership interests as the underlying asset. Congress enumerated instruments subject to the provisions and authorized the IRS to identify other instruments. The government has not issued final regs, so taxpayers continue to use some partnership-based derivatives to avoid ordinary income treatment.

“Derivatives derive their value by reference to other assets and can be used to mimic any other asset,” Rosenthal said. “Where the tax rules diverge, taxpayers can game the system.”

There you have it, tax loopholes that we can all take advantage of.