Tax Court Calls Bluff On Hedge Fund's Basket Option Contracts

The Tax Court recently held that a hedge fund's basket option contracts were in substance tax ownership of the underlying basket securities. The hedge fund, through its affiliated entities, entered into 10 basket option contracts with a bank over several years. The fund and the bank characterized these contracts as call options that were taxable upon exercise, and also treated any gain on exercise as long-term capital gain if exercised after a holding period of more than one year. The IRS examined the fund's 2009 and 2010 tax returns and assessed a total ordinary income adjustment in excess of $500 million for 2009 and 2010, plus penalties. The fund challenged the IRS's determination.

The Tax Court held that the 'option' form of the fund's basket option contracts should be disregarded, and that the fund should be treated, in substance, as directly owning the securities in the underlying reference baskets. The Court explained that the fund's basket option contracts are not options because they lack the economic substance and legal characteristics of options.

Basket Option Contracts

The Court listed eight discrepancies between the fund's basket option contracts and true options.

1. An option premium is typically not refunded or returned, but the fund received a full refund of the premiums upon termination of the basket option contracts and thus enjoyed 100% of the upside potential of the securities.
2. The price of an option is usually heavily influenced by the characteristics of the underlying asset, but the premium on the basket contract options was priced at 10% of the maximum amount of capital that the bank would extend to the fund and the bank retained an ability to demand additional premium from the fund.
3. The fund's basket option contracts had a 12-year term or more, which is unusually long for an equity call option.
4. The underlying property specified for the basket option contracts was ill-defined and constantly changing because the fund had wide discretion to trade securities as it saw fit, with little or no oversight by the bank.
5. An option contract affords the right to buy or sell specific property on or before a specific future date or within a specified period of time, but the bank could terminate its options at any time and the fund essentially terminated 9 out of 10 contracts early.
6. In a call option, the optionor typically enjoys the economic benefits of its ownership of the underlying securities unless and until the option is exercised, but upon payout, the fund received the economic value of the dividends paid on the underlying securities.
7. The bank bore neither the upside risk on the option nor the downside risk on the underlying securities.
8. The fund had no optionality, meaning the option contracts provided the fund no true alternative choices about whether it would exercise its option or allow it to lapse.

Given these discrepancies, the Court concluded that the fund was the direct owner of the underlying securities and was obligated to take into account gains from the underlying securities as those gains were realized, rather than waiting until the options were exercised, resulting in short-term capital gains when the long-term capital gains holding period was not met.

Other Rules Affecting Basket Contracts

The IRS has been scaling back on its regulations and rules on basket contracts. In 2015, the IRS issued two notices designating basket option contracts as listed transactions and basket contracts as transactions of interest. In separate cases, the 6th Circuit, the 11th Circuit and the Tax Court each held that IRS notices regarding reportable transactions issued after the American Jobs Creation Act of 2004 required notice-and-comment rulemaking procedures under the Administrative Procedures Act. In accordance with these precedents, the IRS, in an Action on Decision published on December 23, 2024, stated that it would no longer defend reportable transaction notices and confirmed that it would not enforce disclosure and reporting requirements or assess penalties. Most recently, on April 14, 2025, the IRS issued Notice 2025-22, which obsoleted nine pieces of guidance that the IRS believes to be no longer useful, including Notice 2015-73, which listed basket option contracts as listed transactions. The IRS apparently obsoleted Notice 2015-73, which had already been rendered ineffective by the Action on Decision, to comply with the executive order that directed federal agencies to identify extraneous and unnecessary guidance for elimination.

However, on July 12, 2024, the IRS issued proposed regulations that identified certain basket contract transactions as well as transactions substantially similar thereto as "listed transactions," which we discussed here. When issued, the final regulations will be effective as of the date of publication in the Federal Register and the basket transactions from prior years will be required to be disclosed if the statute of limitations has not lapsed before the date of the final regulations. Thus, the effect of Action on Decision and Notice 2025-22, effectively obsoleting basket contract reporting, may be short-lived.

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