We had a reader ask the following question:
"I am looking at options to put floor prices in for my corn and soybeans. I have a few questions on the accounting for income taxes. Is the cost of options an expense for income tax the year you buy them? If you sell the option the following year, are the proceeds from the option taxable in the year sold?"
The tax treatment of options on futures such as corn, soybeans, wheat, cattle contracts are treated in a unique manner compared to other investments. The taxation of these types of contracts is spelled out in Sections 1092 and 1256 of the Tax Code. This section was put into place to prevent taxpayers from entering into two futures positions that completely offset the risk. The taxpayer would sell the one with loss at the end of the year and then sell the other one the following year. Congress felt this was being abused.
Under this section, all futures contracts including options on futures (except those treated as hedges) are reported at the end of the year as if they were sold for fair market value. So to answer our reader's question, the cost of the option is not recognized when purchased, but the value of the option at year-end is compared to the cost of the option and the difference is considered to be gain or loss.
For example, assume the farmer purchased a call option of 5,000 bushels of corn for $5,000. At the end of the year, the option is worth $10,000. The farmer has a $5,000 gain that will be recognized that year. If next year, when the farmer sells the option for $7,500, the farmer recognizes a $2,500 loss in that year. The total gain was $2,500, but $5,000 was reported the first year and loss of $2,500 was reported the second year.
If this is not a hedging transaction, the gain is automatically treated as 60% long-term and 40% short-term. The above rules don’t apply if the farmer uses this as a hedge . Because of the offsetting positions, Section 1092 applies. Section 1092 delays the reporting of a loss until the year in which gain is recognized on offsetting positions.
Remember, even if you are a farmer and you think all of your futures transactions are hedges, this only applies to crops that you raise or feed. For example, if you grow corn and beans, an option contract for these two crops would be a hedge, but if you purchase or sell an option on wheat or cotton, these are speculative investments and the 60/40 long-term/short-term gain or loss rule applies. Likewise, if you raise wheat (and have no livestock), an option to purchase wheat would not be a hedge.