For the most part, it has been conceded that substantial identity was a function of the "legal rights and entitlements" associated wit the instruments acquired and disposed of. Now, almost imperceptibly, the IRS appears to be attempting to expand the concept to focus on "economic substitutability." Thus,. if instruments with different legal rights and entitlements exhibit parallel market movements responding to the same economic stimuli, the IRS may take the position that the requisite substantial identity exists. Fortunately, this radical position seems destined to fail considering the Supreme Court s recent decision in Cottage Savings.(1) In that decision, the court's conception of the notion of materially different for purposes of the gain or loss recognition rules of Reg. Sec. 1.1001-1(a), is diametrically opposed to an approach that uses market action as a relevant tax criterion. As we will see later, the Cottage Savings decision, dealing with the taxation of mortgage pool swaps, affirms the notion that the key to ascertaining substantial identity is an examination and comparison of the legal attributes associated with debt or equity instrument. In fact, the Supreme Court expressly considered and flatly rejected a test that focused on market behavior as an indicator of substantial identity.

EVOLUTION OF

"SUBSTANTLALLY IDENTICAL"

The wash sale rule is grounded in the notion that losses should not be deductible in instances where, due to a prompt reacquisition of substantially, identical property, the taxpayer has not sufficiently altered his or her economic position. In effect, Sec. 1091 is an objective supplement to more general precepts e.g., Reg. Sec. 1.165.1(b) which prohibit deductions for losses that are not, in substance, actually sustained.

The rule, when analyzed by examining its components, has a wealth of nuances. Thus, initially, the rule only impacts losses arising from the disposition of stock or securities or rights to acquire or sell such securities.

Although the concept of stock is wellunderstood, the notion of securities is vague. For this purpose, debt instruments are certainly securities but, as in Secs. 351 and 354(a), debt paper with an original term of five years or less would likely not meet the statutory prescription. Moreover, Sec. 1236(c) in its general definition of the term "securities" treats rights to acquire stock or securities as equivalent to stock or securities. However, there has been substantial uncertainty in this area. The Gantner(2) decision, handed down by the Tax Court in 1988, clearly states as in Secs. 351 and 354(a) that rights to subscribe to stock or securities are not the same as the underlying properties themselves. The Gantner decision effectively rejected a longstanding IRS view regarding the nature of warrants. In Rev. Rul. 56- 406, the IRS stated that a loss on the sale of warrants could be disallowed if the underlying stock was purchased within the prescribed 61-day period. Sec. 1091 would be applicable if "the relative values and price changes" were so similar that the warrant was, in effect, a "fully convertible security."

The Gantner decision flatly rejected the idea that rights to acquire stock or securities could be equated to stock or securities and, at least implicitly, rejected the view (later confirmed in Cottage Savings) that market congruence could alter this result to confer substantial identity on investment instruments that are fundamentally dissimilar. This necessitated the separate reference to "contracts and options to acquire or sell stock or securities" that was added to Sec. 1091 at the end of 1988 to make it clear that purposes of the wash sale rule, options can he substantially identical to stock.

OPERATION OF SEC. 1091

For Sec. 1091 to operate, replacement property must be "acquired" or, alternatively, a contract or option to acquire must be "entered into." The term acquire has a broad sweep and is satisfied if property is obtained by purchase or taxable exchange. Thus, although a receipt of property via gift is likely not an acquisition, a receipt of shares as a bonus award was regarded as a prohibited acquisition because the value of the shares was included in taxable income upon receipt (Rev. Rul. 73- 329).

In many ways, the concept of acquisition for Sec. 1091 purposes is reminiscent of interpretations of the same word used in old Sec. 333. That section provided for postponement of liquidation gains, if, among other things, the liquidation was completed within one calendar month. However, immediate recognition was required with respect to distributions of money and stock or securities "acquired" after December 31, 1953. In Sec. 333, stock or securities with a Sec. 1223(1) holding period - because basis was determined by reference to the basis of the property exchanged therefore - was considered acquired when its holding period commenced (Rev. Ruls. 56-171 and 58-92). Conversely, stock or securities with a Sec. 1223(2) holding period - because the property obtained a carryover basis were deemed acquired on the date of receipt.(3) This, of course, could lead to the conclusion, if the analogy to Sec. 333 is accepted, that the receipt of stock or securities via gift during the wash sale period is a prohibited acquisition. To date, there is no documented evidence of such theory being pursued by IRS.

Adverse tax consequences also result under Sec. 1091 if the taxpayer enters into a contract or option to acquire stock or securities. Although the term "entered into" connotes some voluntary affirmative act on the part of the investor, it is by now well settled that a passive receipt of such an option or contract right, compensatory or otherwise, triggers wash sale consequences (Rev. Rul. 56-452), where a position in the underlying stock or security was sold at a loss.

What Is an Option?

As to what constitutes an option, it is likely that the traditional definition prevails. That is, an option is an instrument that permits the holder to obtain stock at his or her election, provided no restrictions exist with respect to such election (Rev. Rul. 68-601).

Sec. 1091 options do not include all instruments that satisfy the option definition for purposes of Sec. 382. Thus, contingencies and the like, while disregarded in Sec. 382, remove a right from option designation when Sec. 1091 is at issue. It has been concluded - in Rev. Rul. 77-201 - that convertible preferred stock (and, doubtless, convertible debentures) are options if the stock or debentures are convertible at the holder's election and no restrictions exist with respect to such election.

In the ruling, a taxpayer sold common stock at a loss and, on the same day, purchased convertible preferred. Sec. 1091 was triggered because the preferred was an option. In addition, as a sort of "makeweight", the ruling concludes that convertible preferred is substantially identical to common if the former acts in the market as a "common stock equivalent." Such a designation is apt if the instruments trade at prices that do not vary significantly from the conversion ratio and the price of one rapidly adjusts to fluctuations in the price of the other. Thus, when taken together with the reasoning employed in Rev. Rul. 56- 406, the germ of IRS'S current theories regarding market behavior as a guide to substantial identity is clearly seen.

The IRS also considers the sale of a put option as the equivalent of holding a call option, at least in cases where the option is "deep in the money," so that, all things considered, there is no substantial likelihood such option will not be exercised. For example, a taxpayer who sells a put providing that he will purchase the stock at a price substantially above its current market value is virtually assured that he will wind up owning the stock before the expiration of the put option. This approach, of course, is consistent with Sec. 1091's underlying thesis to prevent a loss deduction in cases where the taxpayer retains an economic interest in the stock or securities ostensibly disposed of However, the ruling (Rev. Rul. 85-87) espousing this position is uncomfortably vague as to when a put is sufficiently deep in the money to warrant application of the wash sale rule. it seems likely, however, that an investor can look to the concept of a qualified covered call option for guidance.

A covered call is qualified if it is not deep in the money, is listed on national securities exchange, and has a term of at least 31 days at the time it is sold. For this purpose, a call with a strike price not below the "benchmark" passes muster. The benchmark is generally the highest available strike price below the applicable stock price Sec. 1092 (e)(4)(c)). Thus, in the case of writing puts, an investor has a basis for comfort if the put is struck at the next highest available exercise price above the price of the stock.

Determining "Substantiauy

Identical"

Sec. 1091 is only brought into play if the properties disposed of and acquired can be characterized as substantially identical. In general, substantial identity is lacking if there is a substantial difference in any material feature or slight differences in several material features taken together. In Rev. Rul. 76-346 Treasury obligations were not regarded as substantially identical where they differed with respect to interest rates, maturity dates, and in their ability to be used as currency to defray estate tax obligations. Most important, substantial identity has, since the seminar Hanlin(4) decision, been a function of the legal rights and entitlements associated with various investment instruments, rather than a question of similarity of market behavior.

Other aspects of the wash sale rules are more mechanical in nature. Thus, if a taxpayer sells multiple blocks of stock or securities and, within the wash sale period, purchases a number of replacement shares equal to the number contained within a block, the loss disallowed is the earliest sustained Reg. Sec. 1.1091-1(b). If such an identification cannot be readily made, the loss affected by Sec. 1091 is the loss associated with the block acquired earliest.

Sec. 1091 eschews netting. Accordingly, if a gain block and a loss block are sold, and a prohibited reacquisition occurs, the gain is fully recognized and the loss is disallowed (Rev. Rul. 70-231). As is the case in Sec. 356(c) or Sec. 1491, the wash sale rules bifurcate a plan or arrangement and surgically ferrets out losses for disallowances (Rev. Ruls. 68-23 and 71-433).

For a time, the wash sale rules could circumvent the following strategy: A taxpayer would sell short a number of shares equal to his long position (a short sale against the box) and immediately reacquire an identical number of shares. More than 30 days later, the investor would close out the short sale at a loss by delivering his original shares. This strategy worked because a short sale is not consummated unit it is closed via delivery of the covering shares, so here no sale and purchase occurred within the statutory period.(5) This technique, however, was circumvented with the promulgation of Reg. Sec. 1.1091-1(g) which provides that a short sale occurs when it is entered into if 1) the taxpayer owns at that time an equivalent long position and 2) such long position is utilized to close the short sale.

As indicated, Sec. 1091 is activated if a taxpayer replaces stock with a call option and, in the aftermath of Gantner, a wash sale has taken place if a call (or put) option disposed of at a loss is replaced by a substantially identical option. However, Rev. Rul. 58-384 indicates that a taxpayer who disposes of a call option will not run afoul of Sec. 1091 if he later invests in common stock. The ruling states, as a legal proposition, that a call option and the shares underlying such an option are never substantially identical.

Finally, where Sec. 1091 applies, basis and holding rules come into play that further the notion that there has been no change in the substance of the taxpayer's investment status. Thus, Sec. 1091(d) provides that basis in the replacement property is equal to the basis of the discarded property plus or minus the amount by which the cost of the replacement property exceeds or is less than the proceeds derived from the sale of the original position. In essence, Sec. 1091(d) is the mirror image of Sec. 1033(b), where the basis of replacement property is the amount expended minus the unrecognized gain. Here, of course, basis is determined bv adding to the cost of replacement property the amount of the loss which Sec. 1091 eliminates. In a similar vein, Sec. 1223(4) provides a "tacking" rule so that the holding period of replacement property includes that of the property whose sale set the Sec. 1091 wheels in motion.

MARKET MOVEMENT AND

SUBSTANTLU IDENTITY

In a recent letter ruling (LTR 9128050, 4/4/91), the IRS evaluated the efficacy of a dividend capture strategy. The taxpayer purchased a basket of dividend paying stocks and, simultaneously, sold short a basket of such stocks. No stock of any company was in both baskets. The avowed purpose of the trade, which clearly has the potential to generate a pre- tax profit, was to earn tax-sheltered dividends from the long basket while creating ordinary deductions out of the payments in lieu of dividends made to the lender of the stock in connection with the short basket (Rev. Rul. 72-521).

In attacking the trade, with a view towards disallowing the dividends received deduction (DRD) on the long dividends and requiring capitalization of the short payments, the IRS turned to Sec. 246(c)(1)(B). At the time of the trade, that section disallowed a DRD if the corporate taxpayer was under an obligation to make corresponding payments with respect to substantially identical securities. Since July 18, 1984, the provision applies where there is an obligation to make related payments with respect to positions in substantially similar or related property. Prior, the only documented application of this obscure rule involved a taxpayer engaged in a "deferred delivery" sale of stock. In that case, a DRD was denied for dividends accrued during the interim between the contract date and the closing date because the contract price was adjusted downward (such adjustment was regarded as a corresponding payment) to reflect such dividends (LTR 8535010, 5/25/89).

The ruling at issue, however, finds that the baskets were indeed substantially identical. Such an interpretation - which was prefaced by a statement that the phrase, substantially identical, has the same meaning in Sec. 246 (c)(1)(b) that it has in Sec. 1091 - was based upon the IRS's desire to implement the purpose of Sec. 246(c)(1)(b). Such purpose is to prevent taxpayers from claiming an ordinary deduction equal to an amount of dividend income with respect to which a DRD is claimed. Accordingly, substantial identity existed simply because the market performance of the long basket mimicked that of the short basket. In essence, substantial identity was created out of the notion that "economic substitutes" fit the statutory description.

IS A MARKET MOVEMENT

THEORY DESTINED TO FAIL?

However, this novel theory seems destined to fail. Fortuitously, the ruling was published to coincide with the arrival of the Supreme Court's decision in Conage Savings Association. There, it was concluded that an effective swap, structured as a reciprocal sale of mortgage pools, created a realized loss that no nonrecognition provision prohibited. The pools were specifically structured to be economic substitutes and, for regulatory accounting purposes, the losses did not have to be booked because the pools were regarded as substantially identical properties. For tax purposes, however, the standard was different, and the Supreme Court endorsed the notion embodied in Reg. Sec. 1.1001-1(a) that an exchange creates a realization event only if the property received is "materially different" in kind or extent from the property swapped therefor. The court found such a material difference by adopting a decision model that focused on the existence of "legally distinct entitlements" as opposed to economic substitutability and market perception. Here, of course, legally distinct entitlements were present because each mortgage within each pool featured a different obligor, and perforce was secured by different collateral.

If the proposition is accepted that materially different items cannot be substantially identical, it seems clear that the Supreme Court would find that baskets of stocks of different issuers cannot be substantially identical. Accordingly, the incipient expansion of the wash sale provisions, to potentially encompass the acquisition of the stock of one company within an industry within 30 days of a loss sale of the stock of a different company within such industry, seems clearly at odds with the Supreme Court's directive. The IRS would be well-advised to refrain from pursuing this tack for the purpose of expanding the coverage of Sec. 1091.

(1) Cottage Savings Association v. Commissioner, 111 SCI 1512 (1991). (2) Gantner v. Commissioner, 905 F.2d 241(8th Cir. 1990). (3) See Rev. Rul. 78-350, 1978-2 C.E. 135 and Knowlton v. Commissioner, 791 F. 2nd 1506 (11th Cir. 19860. (4) Hanlin v. Commissioner, 108 F. 2d 429 (3rd Cir. 1939). (5) Doyle v. Commissioner, 286 F. 2d 654(7th Cir. 1961).