Question on proper mark to market accounting of exercising an in the money Call option on an Master Limited Partnership (MLP)

[MLP_Banana]

Options on MLPs are classified by my broker as section 1256 contracts.  These MLP options do not settle for cash, they settle for units in the underlying MLP.  Since they are classified by the broker as section 1256 contracts they do mark to market accounting on exercise. 

When an MLP call is exercised only the amount paid for the MLP units it reported to the partnership.  The option transaction is not reported to the partnership at all.

For example – I own a $2.50 Call on an MLP with a current price of $5.50.  I paid $1.00 premium expense for the call a few months ago.  The current “mark to market” value of the $2.50 call is $3.00.  I exercise the call.  The broker reports to the partnership that I purchase units of MLP for $2.50, and the broker reports nothing to the partnership about the call option.

What is “mark to market” tax accounting for this call exercise?

1-My broker’s opinion (on the 1099) is …..Mark to Market value = $3.00 (gain) - $1.00 premium paid (cost) = $2.00 section 1256 (gain) for each contract.

2-My opinion is … (Mark to Market value = $3.00 (gain) – MLP option (now worth zero) loss of $3.00) - $1.00 premium paid (cost) = $1.00 section 1256 (loss) for each contract.

I think since the MLP option does not settle for cash, the mark to market gain is offset by the equivalent loss of the option asset from the account, leaving the premium paid (or received) to be the section 1256 gain or loss.

The difference between the two opinions is whether or not the fact that the exercised call option has gone from it's pre-exercise value ($3.00) to it's post exercise value (zero) is part of the gain/loss calculation.  Since the value of the options DOES NOT flow into the partnership units Cost Basis, I think the answer the loss of the option value MUST be part of the tax accounting.  

Who is correct?

[nexchap]

Consider a more extreme example:  an MLP is trading for $1000/share.  You spend $999 to buy an option with a $1 strike price, and immediately exercise it.  Your argument is that you should report a $999 loss to the IRS (the premium lost), and carry the MLP share on your books at a $1 cost basis.  That's not how this works.

So going to your example:

- If this was a regular equity option, you'd exercise at $2.50, add the cost of the premium to your basis, and carry it on your books at $3.50.  There'd be no taxable event this year, and you'd have a $2 unrecognized gain which would be taxed when you eventually sold.

- Because this is being treated as a 1256 contract, you're paying tax on the $2 now.  But that also means you have to record a cost basis of $5.50 so you don't have any additional tax owed if you were to sell tomorrow.  If your broker refuses to report the acquisition at market price, you'll have to maintain your own records.

[MLP_Banana]

I agree with your statement if the broker adds the Call Premium into the MLP unit purchase then their method of mark to market accounting would be logical.

But they don't add the section 1256 mark to market value into the MLP cost basis.  Because the MLP is a pantnership rather than a stock they only use the actual unit purchase amount (ie, the strike price)  as the amount of capital contributed to the partnership for the purchased units in the call execution.  The partnership knows nothing about the option.

Therefore I think the option should be treated as a standalone  transaction.  I bought an option for $1.50, and when it was worth $3 I exercised it and it was then worth zero.  Section 1245 gain loss on that standalone transaction is (+$3 mark to market) + ((negative $3) option goes to zero loss) + (-($1) call premium paid) for a loss of $1.00 as the section 1256 loss on the standalone option transaction.  The purchased units get a cost basis of $2.50.  That makes complete sense.

What is the reason that the fact that the section 1256 option contract (my asset) - which has gone from it's value (the Mark to Market gain number) to zero - is NOT part of the section 1256 calculation?  Pre exercise I had an option worth $3.00 (in the money that amount) and post exercise that option asset is worth zero.  (in other words, it's a $3.00 loss). 

Why is the loss of that option asset not part of the section 1256 profit / loss calculation?

Do you know where in the tax code it says to exclude the loss of the option in the section 1256 gain/loss calculation?  Without it, the taxation doesn't make sense as the option premium doesn't get reported to the partnership at any brokerage. and the MLP and call option holders gets double taxed, once on exercise and again when I sell the low cost basis units.  With it, the taxation makes complete sense.

I understand your opinion, but where in the tax code the basis of your opinion?

[Mike9241]

my initial issue is whether or not a long call option on an MLP is a 1256 contract. I think that the option would be an equity option, not a nonequirty option (because it represents a partnership investment rather than a stock investment)  so ask the broker what definition in IRC 1256(b)  does that option meet.   I put it this way because if long call options are 1256 contracts then short options on MLPs should also fall under 1256 ( I would think). My broker does not treat such short options as 1256 contracts.

if your broker is right then the investment in the MLP should be $5.50. the $1 you paid originally. the $2.50 you paid to buy the MLP  and the $2.00 gain the broker says you have.  

my "opinion" is you have a $3.50 cost basis for the MLP and no gain or loss on the option.

certainly what the broker reports is illogical because the books don't balance as they say in accounting.     

[MLP_Banana]

Yes, whether or not MLP options are Section 1256 Contracts is part of the issue.  TD, E-Trade and Fidelity say that they are Section 1256 Contracts.  Schwab says that they are not, they are "short term transactions", but Schwab does not report them to the IRS (??).

It seems the Tax Code is sort of unclear on the topic.

TD says MLP options are Section 1256 Contracts, and TD is the broker which created the 1099, so I'm trying to get them to create it correctly.  If the MLP option is a Section 1256 contract then I think the call premium does not go into the MLP purchase;  rather, it is included in the Mark to Market calculation of the section 1256 contract exercise.

One problem is TD has (I think) done this calculation wrong for EVERY MLP contract that their customers have executed, and changing all of their 1099s (at this point in time) is likely arduous.

[nexchap]

@MLP_Banana I can't find anything specific on whether an MLP should be a 1256 contract or not -- it definitely seems to be ambiguous right now -- but here's one article that discusses the topic (some forms of PTPs are definitely 1256, but MLPs aren't mentioned).  I suspect that the broker is wrong on this, since an equity option (which 1256 doesn't cover) includes any option "That is valued directly or indirectly by reference to any stock or narrow-based security index."  That would seem to apply to any option on a single MLP.  https://www.forbes.com/sites/greatspeculations/2019/05/30/trading-futures-other-section-1256-contrac...

As to the tax code on valuing an exercised option, see Pub 550 and the discussion of "sale or trade" and "how to figure gain or loss".  It formalizes the difference between your option leaving your account as worthless / unexercised (reported as a loss of the premium) and your option leaving your account because its being traded for something else of value.  "Amount realized includes the money you receive plus the fair market value of any property or services you receive" https://www.irs.gov/pub/irs-pdf/p550.pdf

One final note:  you can change the cost basis reported to the partnership at any time.  They don't care, since you (the partner) are responsible for tracking your own cost basis.  So if you wind up paying tax on the option as a 1256 contract, you can contact them to change the basis to $5.50 regardless of what the broker reports.  If this gets treated as an equity option (not taxed), then you'd have the partnership change the basis to $3.50.

[MLP_Banana]

Thanks for your comments.  As you seem to disagree with the broker about whether or not MLP options are A) equity options, or B) section 1256 contracts, it makes the discussion sort of moot.  Your comments about me adjusting my cost basis despite the broker's reporting is helpful.

Just a few comments in reply to what you wrote:

You - "As to the tax code on valuing an exercised option..." 

Me - the broker is saying the MLP option is not an option, it is instead a Section 1256 Contract (which in this case does not settle for cash).  Option tax law does not apply.  I wonder where in the tax code it says that the Mark to Market accounting for the exercise of a Section 1256 Contract which does NOT settle for cash does not include the loss of value of the Section 1256 Contract in the gain/loss calculation?  When I exercise a Section 1256 Contract worth $3 I lose the $3 asset, it seems to me, and the mark to market gain ($3) and option loss (-$3) should offset, leaving only the premium. 

Where in the tax code does Section 1256 expiration (when not settled for cash) gain/loss calculation process say I'm wrong and the broker (which does not count the loss of value as the contract goes to zero worth) is right?

You - I suspect that the broker is wrong on this, since an equity option (which 1256 doesn't cover) includes any option "That is valued directly or indirectly by reference to any stock or narrow-based security index."  That would seem to apply to any option on a single MLP.  

Me - The broker is saying an MLP unit is not a stock, it is a partnership unit.  C Corporations have stock, partnerships have publicly traded.......units.  They're nitpicking, but they seem to have made up their mind.  This decision by them (that MLPs are not stocks) is what produces the entire problem......

[nexchap]

@MLP_Banana Again, look at Pub 550.  There's a whole section on calculating gain or loss.  I think the flaw in your reasoning is thinking about your contract as going from being worth $3, to being worth $0:  "losing a $3 asset".  That's not actually what happens:  you're getting a unit of the MLP for $2.50 PLUS that contract.  You're exchanging it, not losing it.  That's why its leaving your account (no one would just sell you the MLP for just $2.50 -- the seller is demanding both $2.50 and the contract).  Since you only paid $1 for the contract, that exchange is a $2 profit.

[MLP_Banana]

"Again, look at Pub 550.  There's a whole section on calculating gain or loss."

If the MLP option is classified as an Equity Option, I agree, and there is no issue.

Because the MLP option is classified as a Section 1256 contract, Mark to Market tax accounting is being applied to the Section 1256 gain/loss on the 1099.  Section 1256 contract Mark to Market tax accounting is different from regular Option accounting (I think).  I think you are using the tax code's discussion of option tax accounting to discuss what is (in TD's opinion and on my 1099) Section 1256 contract accounting.  

TD wants the Section 1256 contract tax accounting to have nothing to do with the purchase of the underlying asset.  As a result, I think I have to account for the "loss of the option" upon exercise to have it make any sense.

Section 1256 tax code does say that execution of the Section 1256 contract for delivery of the underlying requires Mark to Market accounting.  MOST section 1256 contracts settle for cash rather than the underlying,  and in that case the Mark to Market account is easy - cash received minus call premium paid = 1256 gain or loss. 

There's nothing in the Section 1256 contract tax code that says anything about putting premium paid to buy a section 1256 Contract into the cost basis of the underlying received.  It just says upon exercise of a section 1256 contract "the previously discussed" mark to market rules apply.

I agree if these 1256 contracts were taxed like options it would make sense to pay the gain on exercise, and also have an equivalent higher cost basis.  But the cost basis of the MLP is not being increased as a result of  buying the contract - TD says the contract and the MLP purchase are separately taxed items.

So....the only way for it to make sense is for the loss of the contract to offset equally the gain of the mark to market.  Otherwise, I'm taxed twice.

Anyways, I understand what you're saying, my issue is with TD reporting of the call exercise.