Appreciated stock in e-commerce companies, held for long periods of time, is subject to a substantial risk of loss, due to the extreme volatility of the stock of these companies. Stockholders are well-advised to hedge against such losses, using such techniques as short sales, puts, and collars. However, there are significant tax consequences to the use of these and other hedging techniques.

Having to Hold Stock
Owners of e-commerce companies that are acquired by public companies will often find themselves holding stock of the acquiring company that they cannot sell immediately. Securities law may require former owners to hold the stock of the acquirer for six months, a year or longer. Often, the stock held represents the majority of the individual's net worth. In addition, the basis of the stock, if received in a tax-free merger, will often have a minimal basis because it inherits the basis of the old company, which the individual may have founded, and which may have had little or no basis.

A popular benefit for employees is the incentive stock option. The great benefit of the ISO is that, after exercise of the ISO, the gain on eventual sale of stock is long term capital gain for federal purposes, taxed at 20 percent. To gain the benefit of long term capital gain rates on the sale of the stock, the stock must be held at least one year after exercise of the ISO.

Example: Jones, an employee of Yahoo, exercises an ISO entitling her to purchase 1,000 shares of stock at a cost of $5 per share, at a time when the market price of Yahoo is $200. If Jones exercises the option and immediately sells the shares, she will have income of $195,000, taxed as compensation.

Accordingly, this sum will be taxed at federal rates of up to 39.6 percent, and will also be subject to social security and Medicare taxes. Combined state and federal tax rates can exceed 50 percent. Alternatively, if Jones holds the Yahoo shares for a year before selling them, the federal tax rate is reduced to 20 percent. Depending on the state in which she lives, state rates may also be lower.

In the case of the company owner or employee, there may be either a requirement or a great benefit to holding stock. However, holding large amounts of stock in e-commerce companies is bad financial planning, assuming these holdings represent a large part of an individual's net worth. It can be disconcerting, in the least, for an individual to see his or her net worth drop by 30 percent or more in a day, which is the norm for many e-commerce companies.

Some individuals have no choice but to hold their shares because of security law restrictions. These individuals will need to consider using hedging techniques to protect against loss, as discussed below.

Holders of ISO shares do have a choice about holding their shares. The choice is, take the risk of holding the shares and gaining a possible tax benefit, or sell the shares immediately, paying the higher tax, but avoiding the risk of loss. Holders of ISO shares can also employ certain hedging techniques to protect against loss, however, the techniques are limited and the cost of hedging may negate a large part of the tax benefit from holding the stock.

Hedging Techniques
In this article I will discuss five hedging techniques: short sales, forward contracts, offsetting notional principal contracts, puts and collars. All of these techniques can be used successfully to hedge against loss on highly appreciated stock. Holders of non-ISO stock can use all of the techniques. Owners of ISO shares, however, can use only puts and--possibly--collars.

Short Sale
A short sale is the sale of stock that one does not own. To make a sale, the short seller must borrow stock, paying a premium for the privilege of doing so. In addition, if the stock pays a dividend, the short seller must usually pay to the owner of the stock any dividends received by the short seller. The short seller closes the transaction in the future by giving identical shares back to the lender.

There are two basic short sale techniques, a short sale "against the box," and a regular short sale. In this article we are concerned with a short sale against the box, which is a classic hedging strategy.

Example: Adams holds 1,000 shares of Y stock, currently trading at $150 per share. Adams, who wishes to protect against future losses on Y stock, borrows 1,000 shares of Y stock from Meyers and sells those shares at $150. Meyers charges Adams $1,500 each month for the privilege of borrowing the stock. At any time in the future Adams can use the 1,000 shares of Y that he owns to repay Meyers, thus closing the short sale. Alternatively, Adams can purchase other shares to use to repay Meyers.

A regular short sale occurs when an individual sells a security short and does not own an identical security. This is a speculative strategy, not a hedging strategy.

Forward Contract
A forward contract is a contract to deliver a security at a specific time in the future, at a specific price.

Example: Adams owns 1,000 shares of Z stock, currently valued at $100 per share. He contracts with Burrows to deliver 1,000 shares of Z stock, at $100 per share in three months.

Offsetting Notional Principal Contract
An offsetting notional principal contract is one where the holder of a security agrees to pay substantially all of the investment yield (interest, dividends, etc.) and appreciation from the security for a specified period, and also gives the holder the right to be reimbursed for substantially all of the loss of value in the security.

Example: Sanders owns 1,000 shares of B stock, valued at $100 per share. She contracts with Monroe as follows: Any dividends on the stock and any appreciation in value will be delivered to Monroe. In addition, Monroe will reimburse Sanders for any drop in value below $100 per share.

What the three hedging techniques above have in common is: The owner of the securities continues to hold the securities. All risk of loss--and opportunity for gain--on the securities is transferred from the owner to someone else. The owner has effectively disposed of the securities, while retaining nominal ownership.

Put
A put is an option contract that gives the holder the right to sell to the writer of the put a security at a specific price at any time during the contract period.

Example: Smith holds 10,000 shares of X stock, currently trading at $100 per share. Smith, who wants to hedge against loss on the stock, buys a put from Jones for $3,000. The put gives Smith the right to sell 100 shares of X stock to Jones at a price of $75 per share, thus limiting Smith's potential loss on the stock. The put, in this case, expires in three months, at which time Smith must buy another put in order to maintain his hedge.

Collar
A collar is a technique that uses offsetting puts and calls to limit an individual's gain and loss on a security. One type of collar is where a taxpayer sells a call on his stock, committing him to sell at a price higher than the current price of the stock, and also purchases a put on the same stock, permitting him to sell his stock at a price lower than the current price.

Example: Jones enters into a collar for a stock currently trading at $100 with a put strike price of $95 and a call strike price of $110. The effect of the collar is that Jones has transferred the rights to all gain above the $110 call strike price and all loss below the $95 put strike price. He has limited both his opportunity for gain and his risk of loss.

Constructive Sales
Generally, use of any of the first three techniques above (short sales, offsetting notional principal contracts and forward contracts) results in a "constructive sale" of a publicly traded appreciated security. No constructive sale results where the security is not appreciated.¹

In addition, these rules do not apply to any contract for sale of any stock, debt instrument or partnership interest, which is not a marketable security, if the contract settles within one year after the date such contract was entered into.²

The constructive sale rule preempts the general rule for hedging transactions, which provides that there is no taxable event until the transaction is closed.

The basic constructive sale rule requires recognition of gain (but not loss) upon a constructive sale of any "appreciated financial position" in stock, a partnership interest, or debt other than certain "straight" debt instruments. Section 1259(a) provides that a taxpayer must recognize gain on an appreciated stock (and other "financial positions") as if that stock were sold, if there is a constructive sale.

The Internal Revenue Code says that a short sale, an offsetting notional principal contract or a futures or forward contract results in a constructive sale.3 However, other transactions that are equivalent to the sale of a security may also result in a constructive sale. For there to be a constructive sale, the taxpayer must have given up all right to future income, gain or loss in the stock.

The IRS is expected to write rules in the future that create constructive sales from other financial arrangements that "have the effect of eliminating substantially all of the taxpayer's risk of loss and opportunity for income or gain with respect to the appreciated financial position."⁴ (Note: The rules for determining whether capital gain resulting from a short sale is short or long term are covered by a special set of rules, which I will not cover in this article.)⁵

Non-Constructive Sales
A put, which gives the holder of the put the right to sell the stock at a specific price is not a constructive sale.⁶ The holder of the put is not obligated to sell the stock in the future. Moreover, while the holder of the put is protected against future loss, the holder may still benefit from a future increase in the price of the stock. Accordingly, a put does not result in a taxable event until either the put expires or is exercised. On the issue of puts, the committee report that accompanied the 1997 law that created the constructive sale rules said:

"… it is intended that transactions that reduce only risk of loss or only opportunity for gain will not be covered (by the constructive sale rule). Thus, for example, it is not intended that a taxpayer who holds an appreciated financial position in stock will be treated as having made a constructive sale when the taxpayer enters into a put option with an exercise price equal to the current market price (an "at the money" option). Because such an option reduces only the taxpayer's risk of loss, and not its opportunity for gain, the above standard would not be met."⁷

Currently, the use of a collar is not considered a constructive sale unless the use of the collar is considered abusive.⁸ A collar reduces some, but not all, of a taxpayer's chance of gain or loss. The committee report that accompanied the constructive sale rules said that the IRS is expected to write regulations identifying those collars that result in constructive sales.

Example: Jones holds a stock with a market value of $200. She buys a put with a strike price of $195, and sells a call with a strike price of $205. She has eliminated substantially all of her risk of gain and loss on this security. Future regulations may call this a constructive sale.

The expected regulations relating to collars are to be applied prospectively, except in cases to prevent abuse. This statement in the committee report seems to be a warning to taxpayers that current transactions, which are considered abusive, may be taxed as constructive sales by future retroactive regulations.

Short-term hedges are not covered by the constructive sale rules. A short-term hedge that would otherwise be covered by the rules (i.e., a short sale, notional contract or forward contract), will not be a constructive sale where:

• The transaction is closed before the end of the 30th day after the close of the taxable year.
• The taxpayer holds the appreciated financial position throughout the 60-day period beginning on the date such transaction is closed.

At no time during such 60-day period is the taxpayer's risk of loss with respect to such position reduced.9

Example: Jones holds 10,000 shares of X stock, valued at $100 per share, with a basis of $1 per share. On January 10, 1999, Jones enters into a short sale by borrowing and selling an additional 10,000 shares of X stock (this is a short sale against the box). Jones holds this position through all of 1999.

On January 29, 2000, Jones closes the short sale by buying 10,000 shares of X stock in the market and delivering these shares to the person from whom she borrowed the stock. As long as Jones holds his original shares for 60 days after closing this transaction, and as long as Jones does not hedge against loss on these shares during this period, the 1999 short sale will not be treated as a constructive sale.

Effect of Constructive Sales
A taxpayer, other than a holder of ISO stock, that must hold an appreciated security for a relatively short period of time may be able to use the above hedging techniques without serious tax consequences. A constructive sale may result from the hedging transaction, and this will accelerate the recognition of gain. However, the result may only be the payment of tax earlier than if there was no hedge.

Example: On March 10, 1999, Jones enters into a tax-free merger with X Corporation, receiving 10,000 shares of X stock in exchange for stock in the company she founded. Her basis in X stock is $1 per share, at a time when X stock, which is publicly traded, sells for $100. Jones must wait for one year before selling her X stock.

To protect against loss, Jones borrows and sells 10,000 shares of X stock on March 15, 1999. This results in a constructive sale on that date. Jones maintains the short until March 10, 2000, when she is allowed to sell her X shares. She uses the proceeds from the sale to pay taxes due on April 15, 2000, on the 1999 constructive sale.

The effect of this series of transactions is to cause the sale to be taxed in 1999, when it would otherwise have been taxable in 2000. This accelerates the payment of tax by one year. Accordingly, Jones' cost of hedging against loss is the sum of: (1) the cost of the short sale and (2) the time value of paying the tax a year early.

Holders of ISO stock lose the benefits of an ISO if there is a constructive sale. Accordingly, the three techniques that currently result in a constructive sale cannot be used. To receive the benefits of an ISO, stock acquired on exercise of an option must be held at least two years from the date of the granting of the option, and one year after the exercise of the option.¹⁰

Example: Smith is granted an ISO on January 1, 1998. If he exercises the option on February 10, 1999, and sells the stock on March 15, 2000, he gets long-term capital gain rates on the difference between the option price and the sales price of the stock. Assume, however, that he hedges against loss on the stock by shorting the stock on April 10, 1999. If he maintains the short until he sells the stock on March 15, 2000, he will lose the benefits of the ISO. The constructive sale in 1999 will result in gain that is taxed as ordinary compensation.

Holders of ISO stock can use puts and collars to hedge against loss. These techniques do not result in constructive sales. In addition, as discussed above, holders of ISO stock can use short-term hedging, which will not result in a constructive sale.

Hedging Using Non-Identical Stocks
A taxpayer may not be able to obtain a perfect hedge against the stock being held. As discussed above, certain hedges can result in constructive sales, which may be an undesirable result. For instance, a constructive sale may be a problem where a hedge must cover two or more years.

In addition, perfect hedges may not be available. For instance, a taxpayer may not be able to borrow stock the he or she can sell short. And, for many securities, puts are not available. Finally, top executives may not be able to short, or buy puts on company stock. There may be legal or political reasons that prevent this.

Where a taxpayer cannot find a perfect hedge, the taxpayer must find other securities or indexes that correlate to the securities being held. The taxpayer can short or buy puts on these securities as hedges without adverse consequences because they are not identical to the securities being held. If a security can be found that correlates to the security held, a short sale of correlating securities may be an effective hedge against risk, without triggering a constructive sale.

Conclusion
There is nothing simple about either the mechanics or the taxation of hedging transactions. In addition, certain hedging strategies can be quite expensive. However, for large amounts of highly appreciated securities, the difficulties and costs may be justified. This is certainly the case for stock in e-commerce companies, where a stock valued at $200 today could be worth $5 (or less) in six months.