The market for equity options and related derivatives is staggering, covering trillions of dollars worth of assets. As a result, the taxation of these instruments is inherently important. Moreover, the importance is made even more acute by the use of options in creating more complex transactions and in avoiding taxes. Consider an equity call option, which entitles, but does not obligate, its holder to buy stock at a set price at a set time in the future. Option theory gives us a way to break the option down into more fundamental units. For example, an equity call option over 10,000 shares of stock might be equivalent to buying 7500 shares of stock itself. This financially equivalent synthetic option should serve as the model for taxing an actual option. That is not the approach of current law. Nevertheless, a Monte-Carlo simulation I wrote shows that current law does a good job of approximating the tax liability generated by the synthetic option - but only when we view the option in isolation. The results are radically different when the investor already owns some of the stock subject to the option. If such an investor sells (rather than buys) a call option, she has effectively sold a portion of the owned stock at fair market value. For example, the issuer of a call option over 10,000 shares may have effectively sold 7500 shares that she already owns. Option theory gives us a way to measure how much stock she has effectively sold. Taxing the sale of stock implied by many option and related contracts would reflect economic reality and curtail tax-motivated investments.

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27 Virginia Tax Review 135-202 (2007)