Currently, taxpayers can sell short securities which they own, and in so doing lock in economic gain but defer taxable gain indefinitely. Stocks exhibiting significant downside potential may be attractive candidates for short sales. To consummate a short sale, an investor first contracts to borrow stock, which he then immediately sells on the open market. The borrowed stock is subsequently repaid to the lender at the “closing” date.
Taxable profit (or loss) in the short sale is the difference between the amount realized in the initial sale, and the investor’s cost basis in the replacement stock surrendered at the closing date. Typically, the replacement stock is purchased at the closing date. The investor may, however, have already owned the replacement stock at the time of the initial short sale. In such a case, the short sale is termed a “sale against the box.” Short sales generate only capital (as opposed to ordinary) gains and losses which, depending on the holding period of the replacement stock, may be either long or short term.
The tax treatment of a short sale may be quite favorable. Since no taxable event occurs until the closing date, short sales “against the box” permit the investor to close his economic position (which occurs at the time of the initial short sale) before his tax position (which does not occur until the later closing date). This deferral of taxation may be advantageous where economic considerations dictate sale of the stock, but tax considerations do not.
Consider the following illustration: Believing tobacco stocks are high, the investor enters into a contract on October 1, 1996 to sell short 1,000 shares of Philip Morris. The stock is then sold on the open market for $90 per share, which nets the investor $90,000. Six months later, Philip Morris has dropped to $80 per share, and the investor decides to close his position. He therefore repurchases the stock for $80,000 on April 1, 1997, and closes his position the next day. His profit of $10,000 is a short term capital gain, since he held the replacement stock for only six months. Short term capital gains, depending on the taxpayer’s bracket, are subject to a maximum tax rate of 31%.
Now assume the same facts, except that as of October 1, 1996, the investor already owns 1,000 shares of Philip Morris which he purchased at $40 in 1989. Assume further that the taxpayer has already fully utilized his 1996 capital losses, and that further long term capital gains in 1996 would be taxed at 28%. The taxpayer would like to close out his economic position in Philip Morris, but does not wish to recognize the $50,000 capital gain, which would result in an additional tax of $14,000, payable on April 1, 1997.
Both of the investor’s objectives can be met: By selling short 1,000 shares of Philip Morris on October 1 (instead of simply closing out his existing position), the investor will be selling short “against the box”. In so doing, he will be terminating his long economic position in Philip Morris as of October 1, 1996. Yet, by deferring the closing date until April 1, 1997, gain recognition will be deferred until 1997, and payment of the capital gains tax deferred until 1998. Moreover, by the end of 1997, the investor may have generated additional capital losses with which to offset the capital gains.
President Clinton proposes requiring recognition of gain (but not loss) upon entering into any “constructive sale of any appreciated position in stock, a debt instrument, or a partnership interest.” A constructive sale would occur where the taxpayer (or related party) substantially eliminates the risk of loss and opportunity for gain by entering into one or more positions with respect to the same or substantially identical property. The proposal would be effective for constructive sales entered into after the date of enactment.
If President Clinton wins reelection and this proposal is enacted by Congress, short sales against the box entered into now would, in all likelihood, still benefit from the unusually favorable tax treatment accorded presently to these transactions.