White Paper
White Paper
By Mark Leeds
04.23.25
In Advice Memorandum 2010-005,[1] the Internal Revenue Service (IRS) set out its position that “basket options” conveyed so many attributes of ownership over the securities referenced in these options to the optionee that the optionee should be treated, for federal income tax purposes, as the owner of the basket securities.[2] This piercing of the basket option results in a loss of the tax benefits that taxpayers expected from the open transaction treatment afforded to financial options—specifically, deferral of income and gains and conversion of ordinary income and short-term capital gains into long-term capital gains. Just in case the Advice Memorandum was not enough of a deterrence to keep taxpayers away from basket options, the IRS designated these transactions as listed transactions in 2015.[3]
As taxpayers know, however, a properly structured transaction can achieve tax benefits even if the IRS has expressed its displeasure with the transaction. But in the case of basket options, on April 16, 2025, in GWA, LLC[4] the Tax Court agreed with the IRS that a series of 10 basket options transactions should be taxed as common law constructive ownership transactions. The court then tagged the taxpayer with a $500 million tax bill for 2009 and 2010 for misreporting these transactions. The tax bill included over $100 million in penalties because the taxpayer could not substantiate that it obtained any tax advice supporting its filing positions and should have known the differences between a genuine call option and de facto ownership of the basket securities.[5] The opinion also addressed certain nuances for taxpayers electing mark-to-market accounting that are likely to resonate well past this particular decision. In this article, we’ll attempt to condense the court’s 139-page opinion into its essential elements.
Certain Relevant Features of the Basket Option Transactions
The taxpayer was a partnership that was a sophisticated financial markets trader with substantial amounts of money under active management. It employed quantitative trading strategies for its customers who invested through a typical hedge fund structure. The taxpayer decided to invest for the managers’ own account through basket option transactions, using the same trading strategies that it employed directly for its hedge fund. Under the terms of the options, the underlying positions were ostensibly owned by the investment bank that wrote the options, but, in almost all cases, the gain or loss inured to the taxpayer as optionee. The taxpayer told its money management clients that the advisors “invest their capital in a separate legal structure [the options] which is managed pari passu to the [hedge fund into which the clients invest].”
The use of the basket options enabled the taxpayer to achieve a level of leverage that it could not obtain due to securities law restrictions on the use of traditional leverage (borrowing). The options provided the taxpayer with a leverage ratio of 10x (sometimes 20x) the value of the underlying positions. If it had simply held the positions outright and borrowed against them, securities law limitations would have limited borrowings to a 6.5x (or lower) leverage ratio.
Over time, the taxpayer purchased long positions under ten 12-year call option contracts from a prominent investment bank.[6] Each of the 10 option contracts referenced a basket of hundreds or thousands of securities. The taxpayer had the unilateral right, and exercised this right “on a daily or hourly basis,”[7] to move securities in and out of the basket.[8] The taxpayer’s trading strategy was successful, with the result that its position under the options became more valuable as the trading gains were realized. The taxpayer took the position that the increase in the value of the options would not be taxable to it until it cashed out its position under the options (open transaction treatment). Since the option holding periods would have exceeded the one-year threshold limit (although positions in the basket securities were held for less than one year), it reported the gains as tax-favored-long-term capital gains.
Although the taxpayer did not have an explicit right to terminate the options at will (the options were styled as European options with a fixed exercise date), it effectively retained this right through its ability to cause the investment manager, a GWA affiliate, to sell the basket portfolio and convert it to cash. When the basket securities were reduced to cash, the cash would begin accruing interest at the Treasury rate plus 5%. The investment bank, who could not invest the cash at anything near that yield, would then be economically compelled to exercise its right to terminate the options. In the case of several of the options, the taxpayer represented to the investment bank that the basket had been reduced to cash and terminated the option when, in fact, the basket still had substantial securities within it. In one case, the taxpayer terminated an option exactly one year and one day after it had opened by transferring the basket securities to new basket options. It then took the position for federal income tax purposes that the “old” options had terminated and generated long-term capital gains.
The options also contained a “knock-out feature.” The taxpayer paid a premium of 10% of the value of the basket securities. If the value of the basket securities approached that amount, the options would automatically terminate. The automatic termination feature helped ensure that the investment bank was able to liquidate the basket securities without itself incurring a loss. The taxpayer could defeat the knock-out feature by placing additional premium with the investment bank.
The option premium was set at 10% of the initial fair market value of the basket securities. Approximately 88% of the premium was paid upfront in cash. The remaining 12% accrued over the life of the option and, to the extent unaccrued, would remain unpaid if the option terminated prior to its stated maturity.
Upon settlement of the options, the taxpayer received the performance of the basket securities, reduced by a financing charge imposed by the investment bank on the embedded leverage, and increased by a premium settlement amount. The premium settlement amount was debited by the accrued portion of the unpaid option premium. But the internal leverage charge was decreased by the same amount over time. As a result, the taxpayer received back (or was credited) its entire premium upon an option termination. In other words, except to the extent the underlying portfolio generated net-investment losses, the taxpayer did not face an economic risk that it would ever forfeit its option premiums.
In order to expedite trading, the investment bank regularly sold positions within the securities basket underlying the basket options to the hedge fund managed by the taxpayer and vice versa. In addition, under a master-netting agreement, the taxpayer was entitled to use the net-equity value inherent in the basket options as equity capital in other transactions, including its affiliate’s prime brokerage account. Through this ability to add the value of the basket options to its net-posted collateral, the taxpayer was able to borrow against the build-up in value of the basket options.
Several of the baskets terminated in 2010, and the taxpayer was aware of the position of the IRS in AM2010-005. It nonetheless reported the gains from the basket options that terminated in 2010 as long-term capital gains.
The Tax Court’s Analysis of the Basket Options
The Tax Court began its analysis with reference to the tried-and-true rule that whether the basket options would be treated as options would be determined by the substance of the transactions, not their form. The Tax Court identified five characteristics that a contract must have to be treated as an option for federal income tax purposes:
The court found that the substance of the basket options failed these tests and, for this reason, should not be treated as options for federal income tax purposes. Instead, the taxpayer, as optionee, was treated as the owner of the securities referenced in the basket option.
Contract to Buy (Optionality). In the view of the Tax Court, an option must provide the optionee with the “truly alternative choice of whether to exercise the option or allow it to lapse.”[10] The Tax Court held that the basket options did not offer the taxpayer this choice because if it allowed a basket option to lapse, even if the portfolio experienced investment losses, the taxpayer would not receive back its option premium. On the other hand, even if the portfolio experienced losses (up to the premium paid), the taxpayer would be incentivized to exercise the option to receive back the portion of the premium not debited by such losses. Accordingly, because there was no realistic possibility that GWA would allow the options to lapse, it was economically compelled to buy the basket securities.
The Tax Court found that Basket Contracts also lacked optionality because they offered the taxpayer no meaningful downside protection. If the value of the underlying property is less than the option strike price, the optionee loses its premium. In contrast, an investor who buys property is exposed to the property’s full downside risk. In the case of the basket options, even if the underlying portfolio fell in value, the taxpayer would still exercise the option to obtain the portion of its premiums that was not lost through investment losses. Furthermore, the options’ termination features ensured that the value of the underlying portfolio would fall below the option premium. As a result, unlike the holder of a typical call option, the terms of the basket options offered downside protection to the taxpayer.
In addition, since the strike price of the basket options was set at the fair market value of the initial basket and the option premium was fully refundable, the investment bank received no compensation for the time value of the option.[11] In other words, the investment bank was not compensated for the fact that the taxpayer could obtain the underlying basket at any time during the options’ 12-year term. The Tax Court found this fact to be supportive of the conclusion that the basket options were disguised prime brokerage accounts with leverage.
Duration and Early Termination. The Tax Court held that the 12-year durations of the basket options were suspect because of the virtual impossibility of pricing options with such a long duration over publicly traded stocks. It noted that even the longest dated traded options have terms of only 18 months. The Tax Court noted that 12 years would be an “eternity” in the stock markets and options with 12-year durations would be “unicorns.”
As described above, the Tax Court concluded that the investment bank effectively could terminate the basket options at will. The Tax Court held that this right was fundamentally inconsistent with option treatment because, in a true option, the optionee is paying for the right to exercise the option for an agreed period of time. If the option writer can terminate the option at will, the optionee has not obtained the rights under the option that would make the option valuable.
The court also noted that the taxpayer essentially had the right to terminate the option at will, as well. All American-style options possess this feature. But the court concluded that the consideration received by the investment bank did not compensate it for the additional risk posed by American-style options to the writer of the options. In other words, the options were priced like European-style options, which do not allow the optionee an early termination right.
Consideration. In the view of the Tax Court, the option premium (consideration) compensates the writer of the option for the risk that the option will be exercised and “is never refunded or returned to the optionee.” The Tax Court then determined that the arrangements in place with respect to the basket options, including the fact that any premium forfeited by the taxpayer was returned to it as an offset to the internal funding costs, ensured that the taxpayer would always receive back its option premium. The Tax Court concluded that since the investment bank agreed to return the option premium to the taxpayer, the bank regarded the transaction as a financing and not as an option transaction. Furthermore, the Tax Court determined that the pricing of the basket options did not consider the normal factors that an option writer would take into account and the taxpayer’s ability to defeat an option knock-out by paying additional premium was inconsistent with option treatment.[12]
The Tax Court held that the fact that the taxpayer benefited from dividends paid on stocks within the securities basket was indicative of constructive ownership.[13] This particular conclusion seems overreaching inasmuch as all equity options are usually priced to consider dividends on the referenced stocks during the option period and provide adjustments for extraordinary dividends. Thus, this feature in the basket options was not bespoke; it was in accordance with market practice.
The Tax Court also stressed the fact that the investment bank did not bear the risks that an investor writing a call option would face (and wasn’t compensated for assuming such risks). Specifically, it found that the bank effectively did not bear upside risk (the risk that it would suffer a loss under the option for appreciation in the reference basket) or downside risk (the risk that the referenced securities would decline in value below the consideration earned in the transaction). By agreeing to refund the full premium to GWA upon exercise of the options, the investment bank effectively waived its compensation for upside risk, and the court found that no rational option writer would do so if it was bearing upside risk. Moreover, the contracts required the investment bank to “purchase” the basket securities, so it would always be hedged against the risk on the basket options that the basket securities would appreciate. The court also found that the investment bank had no downside risk because, if the basket securities declined in value, the basket options would automatically terminate before the premium had been exhausted. Essentially, the investment bank would be repaid in full for the funds that it, in effect advanced to GWA.
This portion of the court’s reasoning is odd, because it ignores the fact that the investment bank was not acting as an investor. The investment bank was acting as a dealer. As such, the bank would have done everything it could to hedge away these risks and be left with a dealer profit, and this is customary for dealers who act as option writers. Accordingly, this portion of the Tax Court’s opinion seems to rest upon a faulty assumption. But the court is correct in its holding that the investment bank was not compensated for hedging these risks.
Closed Taxable Years
Given the duration of the tax litigation, the taxpayer’s tax years prior to 2009 were closed when the GWA, LLC decision was rendered on April 17, 2025. The taxpayer sought to take advantage of a statute of limitations defense to include the income from the basket security transactions in years prior to 2009. The IRS countered, and the Tax Court agreed, that the change in the characterization of the basket options from options to constructive ownership transactions was a change in accounting method. The change in accounting method rules require taxpayers to consider, in the current tax years, items with respect to closed tax years.[16] An adjustment to a taxpayer’s income is a change in accounting method if the adjustment affects when (and not whether) an item of income is taxable.[17]
The Tax Court stated that its decision that the basket options were constructive ownership transactions affected the timing of when the income from these transactions would be recognized. As constructive ownership transactions, the taxpayer recognized the income as earned. In contrast, if the basket options had been respected as options, the income and gains from the underlying basket securities would have been recognized when the basket options were terminated.[18] The Tax Court specifically held the fact that its decision changed the character of the income (from long-term capital gains to dividend income and short-term capital gains) did not affect its conclusion that the change from open transaction treatment to current ownership constituted a change in accounting method. Concomitantly, the court concluded that the “recharacterization” of the transactions from options to ownership did not affect its conclusion that the change was a change in accounting method. As such, the full amount of the differences was includible in the taxpayer’s income for 2009.[19]
This portion of the Tax Court decision may be subject to challenge. A change in accounting method does not include a change in treatment resulting from a change in underlying facts.[20] Arguably, the change from derivative exposure to common law constructive ownership is a change in underlying facts. For example, in Decision, Inc. v. Comm’r.,[21] the Tax Court refused to treat the taxpayer's change in billing policy as a change in accounting method. The court found that although the change had consequences in the annual determination of income, these consequences were not produced by the accounting system. Moreover, the court colorfully noted that the “kind of business policy change was no different from a decision to lower prices or halt production for a year” and to hold that the taxpayer changed its method of accounting as a result of that “would have the effect of denying a business the right to determine the terms of sale of its product without clearing the matter with the Commissioner …, clearly an odious propagation of the tentacles of the Government anemone."
The Mark-to-Market Election
In addition to the basket option transactions, the taxpayer engaged in active securities trading through a wholly owned subsidiary that was treated as a disregarded entity for U.S. federal income tax purposes. Taxpayers whose trading activities rise to a level that causes them to be treated as “traders in securities”[22] may elect to use the mark-to-market method of accounting. Beginning in 1998, the taxpayer elected—for the disregarded entity alone—to use the mark-to-market method of accounting. It’s worth noting that if the election had extended to the basket options, all gain and loss on the basket options would have been ordinary instead of long-term capital gains.[23] The basket options would not have been subject to the mark-to-market election if they had no connection to the securities trading and were timely and clearly identified by the taxpayer as not being subject to the election.[24]
The court rejected GWA’s argument that the election, if valid, was made only for the disregarded entity. The Tax Court held that the disregarded entity subsidiary was not a person for federal income tax purposes eligible to make a market-to-market election. As a disregarded entity, the subsidiary should have been treated as a branch or division of the taxpayer. Accordingly, the election, if valid, would have been made for the taxpayer’s entire securities trading operation.[25] The court further noted that the basket option transactions did not qualify for the mark-to-market exception if the election was valid. The fact that the basket option transactions were part of the taxpayer’s securities trading operations was more than evidenced by the fact that positions moved fluidly between these accounts.
However, in what can only be regarded as a pyrrhic victory for the taxpayer, the court held that the mark-to-market election made by the disregarded entity owned by the taxpayer was invalid for two reasons. First, it held that the election was invalid because the disregarded entity was not a person eligible to make such an election. Second, the election can only be made by a person who is also a taxpayer, and a disregarded entity is not a taxpayer.
The court went on the hold that the election itself was invalid. The election, by only relating to the securities held by the disregarded entity subsidiary, attempted to selectively elect mark-to-market treatment. Since the mark-to-market rules do not allow such selective elections, the court held that the election itself was invalid.[26]
Takeaways
The GWA, LLC opinion is silent on the substance of the tax advice received by the taxpayer. The failure by the taxpayer to furnish this advice in litigation appeared to be a substantial factor in the Tax Court’s determination that the taxpayer’s reporting of the basket options was negligent. This negligence resulted in a 20% understatement penalty. The taxpayer would have been a much stronger position if it had obtained reasoned tax advice supporting its position. In addition, there seem to be a number of modifications to the terms of the basket options that would have strengthened the taxpayer’s position that the transactions should have been treated as options. It appeared that the taxpayer’s business objectives overwhelmed its desire to structure the transactions in a more conservative manner for tax purposes.
The court’s conclusion that the taxpayer’s mark-to-market election was invalid is likely to strike many observers as surprising. Many observers believed that the court would conclude that the election made by the disregarded entity bound its regarded owner.
The mark-to-market issue could have been easily addressed if the disregarded entity subsidiary of the taxpayer had been structured as a partnership instead of a disregarded entity. If the subsidiary had issued a .1% interest to a third party or regarded affiliate of the taxpayer, the subsidiary would have constituted a separate taxpayer eligible to make a mark-to-market election without jeopardizing the tax positions taken by the taxpayer itself. Taxpayers undertaking multiple securities-related businesses should carefully monitor if and how they navigate the use of the elective mark-to-market rules.
Mark Leeds (mark.leeds@pillsburylaw.com; (212) 858-1080) is a tax partner with the New York office of Pillsbury Winthrop Shaw Pittman LLP). The views expressed herein are solely those of the author and should not be imputed to his employer. As a matter of full disclosure, Mark was a Managing Director at Deutsche Bank AG, the counterparty to the basket options addressed in the Tax Court opinion, during certain of years to which the GWA, LLC opinion relates. Mark expresses his thanks to Vadim Novak (Vadim.novak@jpmchase.com; (212) 552-4964) is the Head of US Tax Advisory for the Corporate and Investment Bank at JP Morgan Chase in New York and to Nora Burke (nora.burke@pillsburylaw.com; (212) 858-1275) for their helpful thoughts and comments. Mistakes and omissions, however, remain the sole responsibility of the author.
[1] November 12, 2010.
[2] Your authors analyzed AM2010-005 at the time of its release by the IRS. See Leeds, Dealer's Choice: AM 2010-005 Pierces Option Contract To Find Ownership of Referenced Managed Account by Optionee (Daily Tax Report (230 DTR J-1).
[3] Notice 2015-73, 2015-46 IRB 660 and Notice 2015-74, 2015-46 IRB 663.
[4] GWA, LLC v. Comm’r, TC Mem. 2025-34
[5] GWA and the IRS stipulated that GWA solicited and received tax opinions with respect to the basket option structure in 2009 and 2011. However, during discovery, GWA asserted the attorney-client privilege to avoid disclosing any of its subsequent communications with the attorneys who drafted the opinions; the court concluded that GWA was inappropriately seeking to invoke the attorney-client privilege selectively.
[6] As described later, 9 of the 10 basket options were terminated prior to their stated maturity.
[7] In the view of the Tax Court, the taxpayer traded the basket components “with great gusto.”
[8] The taxpayer was paid a fee from the equity in the option for directing this trading. In light of the fact that the same persons who owned the taxpayer also received the fee, the court concluded that “those advisory fees had no economic significance.”
[9] Citing Freddie Mac v. Comm’r, 125 TC at 261.
[10] Freddie Mac, 125 T.C. at 259 (quoting U.S. Freight Co. & Subs. v. United States, 422 F.2d 887, 895 (Ct. Cl. 1970); see Halle v. Commissioner, 83 F.3d at 653-54(first citing Restatement (Second) of Contracts §25 cmt. a (1979); and then citing Estate of Franklin, 64 T.C. at 762-63).
[11] In other words, the basket options generally were delta one with respect to the basket securities (i.e., the value of the options would generally change dollar-for-dollar with changes in the value of the basket securities); a delta one “option” has no time value.
[12] These factors that determine the magnitude of the premium include time until expiration (theta), sensitivity to the volatility of the underlying asset (vega), prevailing interest rates (rho), sensitivity to changes in the price of the underlying asset (delta), and sensitivity to changes in the rate of change in the price of the underlying asset (gamma).
[13] Conversely, the Tax Court held the fact that GWA was economically liable for dividends on reference assets that were “sold short” was a strong indication that GWA was in substance the borrower, and hence the short-seller, of those shares.
[14] Quoting Frank Lyon v. Comm’r, 435 US at 583-4.
[15] Here, the court cited the report of the Senate Permanent Subcommittee on Investigations’ 2015 investigation into basket options. See Staff of S. Perm. Subcomm. on Investigations, 113th Cong., at 81.
[16] Suzy’s Zoo v. Comm’r, 273 F3d 875 (9thCir. 2001), aff’g 114 TC 1 (2000).
[17] Rankin v. Comm’r, 138 F.3d at 1288.
[18] Although the court found that GWA’s treatment of the basket options was erroneous, GWA applied it consistently throughout the terms of the options. This consistent treatment, which continued for eight years, established a “method of accounting.”
[19] Code § 481(a).
[20] Treas. Reg. § 1.446-1(e)(2)(ii)(b).
[21] 47 T.C. 58, 64 (1966) acq., 1967-2 C.B. 2.
[22] See Code § 475(f).
[23] Id.
[24] Code § 475(f)(1)(B).
[25] The court rejected GWA’s argument that the Code § 7701(a) definition of “person” meant that only its disregarded entity, not GWA, was “a person . . . engaged in a trade or business as a trader in securities.” The court read Code § 475 as a whole, and concluded that Congress used the terms “taxpayer” and “person” interchangeably. The Tax Court further noted that accepting GWA’s argument that the election stopped at the disregarded entity level would permit taxpayer selectivity—i.e., regarded owners could transfer securities to and from disregarded entities without tax consequences and apply mark-to-market treatment (or not) for securities at will.
[26] As the Tax Court held in Plumb v. Commissioner, 97 T.C. 632, 640 (1991), “a taxpayer who attempts to make an election that is not legally available to him will be treated as having made no election.”