Tax leakage through holes in basket option contracts

Executive summary:

Seeking to defer taxation of short-term gains and instead report long-term capital gain years later, a taxpayer entered into an option agreement covering a basket of securities. The taxpayer directed trades of the securities in the basket but did not report income from the gains realized on those trades. The Tax Court held that the Tax Court ruled that the taxpayer’s “transactions” were not true options but instead constituted substantive ownership of the underlying securities. The court required the taxpayer to recognize over $500 million of underreported gains from those securities trades. This decision aligns with the IRS’s enforcement efforts, including proposed regulations that would classify similar basket transactions as listed transactions that are summarized in our article: Proposed regulations to treat basket transactions as listed transactions.

Tax Court rules against taxpayer in basket contract dispute

Background

The taxpayer in GWA, LLC v. Commissioner,^[1] entered into contracts called barrier options. These contracts were designed to defer the taxpayer’s recognition of trading gains, prevent recognition of short-term gains and result only in recognition of long-term capital gains taxable at a later date and at a lower rate.

The IRS asserted that the taxpayer had to recognize short term capital gains each year because contracts conferred ownership of the underlying securities on the taxpayer. The Tax Court agreed, holding that the taxpayer underreported income by over $500 million.

Facts

GWA, LLC entered into a series of barrier option contracts with investment banks. These contracts functioned as follows:

• A bank held nominal title to a reference basket of securities. GWA maintained discretionary trading authority over the securities. Through its investment advisor and affiliate, GWA directed frequent trades of the securities within the basket, using the same long/short strategies it employed in other accounts.
• The bank provided 10-to-1 leverage on the initial amount of option premium paid by GWA with the amount GWA paid serving as collateral on the loan.
• GWA bore market risk up to a defined knock-out threshold. If the net asset value of the reference basket dropped to a warning level, GWA could pay an additional premium to keep the contract alive; otherwise, the contract would terminate, and the bank could liquidate the basket—i.e., sell the securities for cash. This structure ensured that the bank would be repaid before losses exceeded the amount of collateral GWA had posted, effectively eliminating the Deutsche Bank’s downside risk.

Although the securities trading activity in the reference basket generated significant gains, GWA did not report those gains for tax purposes. Instead, GWA reported long term capital gain many years later, when the barrier option contracts were exercised or terminated.

Tax Court decision

The Tax Court concluded that GWA should be treated as the owner of the securities in the basket because contracts provided GWA with the benefits and burdens of ownership of the securities. Key facts supporting this conclusion included:

• GWA directed all trading activity and could liquidate the portfolio at will: GWA had discretion over the composition and trading of the reference baskets. It could also trigger early termination of the contracts, giving it de facto control over final sale of all securities in the basket.
• GWA received dividends on long positions and paid borrowing costs on shorts: Although the bank held legal title to the securities, GWA received the economic benefit of dividends on long positions and bore the cost of dividends on short positions—hallmarks of ownership.
• The premium paid to the bank was not option premium: The banks’ compensation, although termed option premium in the contracts, did not constitute option premium. The option premium was refundable to GWA if the contract closed out at a gain. Unlike true option premium, it did not represent compensation for forgoing upside potential on the subject securities. The court engaged in a lengthy analysis contrasting option economics with the economics of the barrier contracts.
• Gains and losses were fully absorbed by GWA, not Deutsche Bank: GWA captured 100 percent of the upside and bore virtually all of the downside risk with respect to the basket of securities. The banks were insulated from loss through contractual barriers and margin-like protections.
• The assets were integrated into GWA’s broader trading strategy and could be cross-collateralized: GWA used the equity value of the Barrier Contracts to support borrowing in other accounts, and the trading strategies mirrored those used across its other portfolios, reinforcing that the assets were functionally part of GWA’s own investment operations.

Based on these facts the Court found that the arrangement lacked true optionality and that GWA bore the economic reality of ownership. Accordingly, the gains were taxable annually to GWA. GWA’s underreported its income for 2009 and 2010 by over $500 million.

The court further held that IRS could assess tax on the underreported income by way of requiring a section 481 adjustment to income because the taxpayer used an impermissible method of tax accounting. The court also upheld the IRS’ imposition of the 20 percent accuracy-related penalty under section 6662, concluding that GWA did not have reasonable cause for its understatement of tax.

Conclusion

The GWA decision underscores the federal income tax principle that economic substance can prevail over contractual form. It shows how basket option contracts designed to postpone taxation and achieve a lower tax rate may fail. In 2024, the IRS issued proposed regulations under that would treat certain basket contracts as listed transactions subject to mandatory disclosure. For further discussion of basket contracts and a summary of the proposed regulations, see our article: Proposed regulations to treat basket transactions as listed transactions.

[1] T.C. Memo 2025-34.