Proposed regulations address basket transactions
What is a “basket transaction”
Basket contract transactions or substantially similar transaction (collectively “basket transactions”) involve use of options (or other derivative contracts) structured to defer income and convert short-term capital gains (“STCG”) into long-term capital gains (“LTCG”).
In a basket transaction, a taxpayer enters into a contract with a third party to earn returns based on a mix, or basket, of different assets. Those assets may be stocks, commodities, digital currencies or other personal property. The taxpayer typically pays a certain amount upfront, usually between 10% and 40% of the basket's value and often retains control over the assets in the basket and can change the assets held in the basket.
Here is an example of a basket contract transaction:
- The taxpayer, T, enters an option contract with a counterparty, C. Pursuant to the contract, T will receive a return based on the performance of a notional basket of referenced actively-traded assets. T, or someone designated by T, will determine what assets are in the basket and/or select a trading algorithm which determines which assets are in the basket. T retains the right to change or request that C change the assets in the basket or change the trading algorithm. The basket contract has a term of over one year but can be terminated by either party with proper notice.
- The amount paid to T on expiration or termination of the contract is based on the performance of the assets in the basket, based on a formula that commonly would return to T their initial payment plus or minus any net gains or losses. T may opt to take the appreciated property from the basket in lieu of a payout. If losses reach the upfront payment amount, the contract is terminated with no payout. The contract also includes safeguards to protect C, who holds the legal title to the assets in the basket.
As noted above, the goal of these transactions is usually to delay when income is recognized and/or to turn STCG, which is taxed at a higher rate, into LTCG that is taxed at a lower rate. The IRS has raised concerns regarding the use of basket contract transactions for tax avoidance.
What is a listed transaction?
The IRS has designated certain transactions as listed transactions that the IRS has concluded are abusive and having potential for tax evasion. Taxpayer must disclose their participation in listed transactions on Form 8886. Material advisors who assist taxpayers with structuring, advising, and marketing with respect to Listed Transactions also are subject to IRS disclosure requirements.
Generally, participation in a listed transaction results in increased scrutiny from the IRS. Additionally, significant penalties may apply for failing to properly disclose participation in a listed transaction (section 6707A) or for understatement of tax attributable to participation in a listed transaction (section 6662A).
Prior IRS Notices addressing Basket Transactions
In 2015, the IRS issued Notices labelling some basket transactions as listed transactions subject to disclosure requirements. Notice 2015-73 designated some basket transactions as listed transactions (tax avoidance transactions), and Notice 2015-74 designated others as “transactions of interest” (transactions with the potential for tax avoidance or evasion).1
In 2022 the Tax Court upheld a challenge to another listed transaction designation the IRS made via a Notice rather than following the Administrative Procedures Act and issuing a notice of proposed regulations. See Green Valley Investors, LLC v. Commissioner.2 In the wake of Green Valley the Treasury Department and the IRS have recently issued proposed regulations that identify basket contracts and similar transactions as listed transactions.
Proposed Regulation 6011-16
The proposed regulations describe a basket contract transaction as one in which:
- The taxpayer enters into a contract with a counterparty denominated as an option or notional principal contract, for returns based on a reference basket of assets;
- The contract has a term of more than one year or spans multiple tax years;
- The taxpayer or their designee has discretion to change the assets in the reference basket;
- The transaction results in a tax benefit for the taxpayer, such as deferral of income or conversion of the character of the gain;
- The transaction is not covered by any of the exceptions outlined in the regulations.
Exceptions include:
- Contracts traded on regulated national or foreign exchanges;
- Contracts treated as contingent payment debt instruments or variable rate debt instruments under federal tax regulations;
- Situations where the counterparty has obtained certain certifications from the taxpayer, indicating that no specified tax benefit will be claimed.
Once the proposed regulations are finalized, basket contract transactions generally will fall into the listed transaction category without regard to whether the IRS previously viewed them as listed transactions or transactions of interest.
Effective date
If finalized as proposed, these regulations generally would require taxpayers who have participated in a basket contract transaction to disclose their participation on Form 8886 filed with the IRS within 90 days of the date the regulation is issued in final format. However, taxpayers that previously disclosed their participation in basket contract transactions by filing Form 8886 would not need to file Form 8886 again to disclose the same participation.
Conclusion
For taxpayers, the proposed basket contract transaction regulations means continued IRS scrutiny of basket transactions. Taxpayers and their tax advisers should review transactions to determine if disclosure will be required under these regulations once they are finalized.
