Hello,
I have a few question about proper tax accounting for options on publicly traded Master Limited Partnerships (MLPs).
TD Ameritrade classifies options on MLPs as Section 1256 Contracts, and not as Equity Options. As a result the tax treatment of MLP options is different from the tax treatment of Equity Options.
Strangely, Schwab classifies and taxes options on MLPs as Equity Options, so TD's method is not universally used. Schwab does not call MLP options Section 1256 Contracts, and Schwab reports them on the 1099 the same way Equity Options are reported.
What is the proper tax treatment of exercising an in the money call on an MLP?
For example, lets say the MLP ticker is ABC, the MLP price on day of call exercise is $10, the strike of the call is $5, and the buyer (me) of that $5 call paid $1.00 premium for the call contract when purchased. With an equity option the owner of the call would buy ABC stock for $5.00, and the cost basis of ABC would be $6 since the call premium gets added to the transaction cost.
But.....ABC is an MLP, therefore the contact is a Section 1256 contract, and not an equity option. TD also tells me that in reporting the purchase to the partnership (which determines and/or adds to my partnership basis in my ABC current account) they do not take the $1.00 premium into account, they only report that I bought MLP ABC for $5.00 per unit.
So.....what is the proper tax treatment of exercising a Section 1256 contract which does not settle for cash (like most section 1256 contracts), but instead settles for taking ownership of the MLP ABC?
Option 1 - The Section 1256 contract profit/loss is a loss of $1.00 (the premium paid). I purchase units of MLP ABC for $5.00, the $5.00 purchase price is reported to the partnership to add to my basis, and the units are worth $10. When I sell the units, the tax affect of buying for $5 and selling for whatever price I sell for will be realized.
Option 2 - The Section 1256 contract has a realized taxable profit of $4.00 on exercise, because I am receiving $10 value ABC units at a cost of $6.00 ($5 strike + $1 premium paid). My cost basis on the newly purchased ABC units is reported to the partnership as $5.
TD is telling me Option 2 is how they're doing it. I think that is correct accounting when Section 1256 contracts settle for cash, but incorrect when they settle for taking ownership of the underlying as happens with MLP options. Since my cost basis with the partnership is equal to the strike, I think the taxable affect of closing the in the money section 1256 contract is that the premium is a taxable obligation, and the offsetting gain is nil.
Any thoughts? If there is another way to account for exercising Section 1256 call contracts which resulting in a purchase of an MLP, please share.
