How does a butterfly spread work? How can a butterfly or any other tax straddle cut your taxes?
Suppose you are one of the lucky ones. Last October, you bought 1,000 shares of the new gene-splicing stock Genentech at $35 a share and sold it $80 on the first day it was offered to the public.
You made a killing: a $45,000 profit in a matter of hours. But you have to share most of it with Uncle Sam. If you are in the top tax bracket, the government will claim 70 percent, and you'll get to keep only $13,500.
You are the most common candidate for a tax straddle, someone who wants to avoid taxes on windfall income. If the Internal Revenue Service lets you get away with it, you might be able to increase the amount left after taxes on your Genetech profits from $13,500 to $32,400. Or you may be able to postpone paying taxes on the profits until next year.
A commodity tax straddle can convert ordinary income that's taxed at 70 percent into a long-term capital gain taxed at 28 percent and also delay the tax liability for a year or more.
The basic technique is to create an artificial loss that can be deducted from this year's taxes, then recoup that loss with a profit that's taxed next year at a lower rate.
The silver butterfly is one of the most complex tax transactions yet devised. It is so arcane that only a handful of specialists are adept at it. Most Wall Street firms prohibit rank-and-file brokers from even attempting a butterfly and channel all the business through a specialist at headquarters.
A commodity specialist who arranged tax straddles at a major brokerage firm said there are myriad ways they can be constructed. The favorite is called a butterfly spread, because a diagram of the deal looks like a butterfly with bifurcated wings.
The butterfly is tailored to the specific needs of the customer. The butterfly specialist has to understand federal (and state) income tax laws well enough to know how to minimize the customer's tax liability and to be good enough at commodity trading to insure that the deal works in the market as well as on paper.
Some basics: First, ordinary income -- wages, interest, etc. -- is taxed at higher rates than capital gains. The maximum rate on "earned income" such as salaries or wages is 50 percent; on "unearned income" such as interest, the maximum is 70 percent; for long-term capital gains the limit is 28 percent. So if you can convert ordinary income to capital gains, you pay less taxes.
Second, most investments have to be held for a full year to qualify for long-term capital gains treatment, but commodity investments qualify for capital gains rates after only 6 months. Finally, you can only deduct losses from the same kinds of profits; you can't use a capital loss to offset ordinary income.
In this case, the customer needs a $45,000 short-term capital loss to deduct from 1980 taxes and offset the Genentech profit. The butterfly will create that loss and simultaneously create a $45,000 profit next year that will be taxed at a maximum 28 percent rate.
The basic technique for using commodities to reduce your tax bill is called putting on a spread or a straddle. That means simultaneously buying and selling a commodity for delivery sometime in the future.
The commodity futures markets make that easier by establishing formal contracts that define the quantity and quality of the commodity and the time and place for delivery.
A simple spread could involve buying 5,000 ounces of silver to be delivered next June and at the same time selling 5,000 ounces of silver and promising to deliver it in July.
No matter whether the price of silver rises or falls by next summer, you'll make money on one deal and lose on the other.
If silver prices go up, you'll profit on the contract to buy, because the silver you get will be worth more than it was when you made the deal and set the price. But the silver you sell will be worth more than you'll collect for it, and you'll lose on that "leg" of the straddle.
If prices go down, the silver you sold will be worth more than you get paid for it, but you'll make money by getting the other batch of silver for less than it's current price.
Over all, you break even, but it doesn't have to look that way on the income tax returns, where you can deduct the losses from other income and cut your tax bill.
gWhat you want to do is arrange to lose money on one of the deals this year and wait to claim your profit on the other deal next year.
If prices are going up, that's easy enough to work out -- just sell silver for December delivery at a loss and buy it back at a profit in January.
But what if prices go down? Then you trade is backward, you'll make money delivering silver in December, but that will produce more income and more taxes to pay. You'll qualify for a tax write-off next February, but that won't do any good on the first year's taxes.
When prices are going down, you'll want to arrange to buy silver for December delivery, so you'll lose on that deal. Then sell an identical amount for delivery in January, earning a profit to offset the December loss. a
A "butterfly spread" works by covering both bets at once -- simultaneously buying and selling four contracts for silver in a pattern that assures you'll get profits and losses at the desired time.
To set up a typical silver butterfly, you first buy 5,000 ounces of silver for delivery in March and simultaneously sell another 5,000 ounces, promising to deliver in July. Then sell another 5,000 ounces for July and balance it with an order to buy for delivery in December.
No matter how much the price of the metal rises or falls, the silver butterfly will foat along, making money on two of its wings and losing an identical amount on the other two.
So you watch the market price move up or down, and wait. When you've lost as much as you want, you close out the unprofitable contracts and tell the tax man you've got a deduction.
To protect the profits made on the other wings, you have to set up a second butterfly and keep it alive until next year. If you hold the contracts more than six months, they qualify for long-term capital gains and the 28 percent maximum tax rate.
Even that tax can be avoided by repeating the butterfly process the second year and "rolling forward" the profits to 1982. In theory, at least, it can be kept up indefinitely, so you stall the taxes forever.
Generating a $45,000 loss to offset the hypothetical Genentech profit probably will require setting up a multiple-contract butterfly, because the price of one 5,000-ounce contract usually won't move up or down by that much.
One specialist figures the maximum price change a butterfly trader can count on is $3,500 a contract, so creating a $45,000 loss will take 12 or 13 contracts.
A large number of butterflies may be needed if the price of the commodity is very stable or if there isn't time to wait. An investor who gets a windfall in December, for example, needs to lose money quickly. If the price of silver drops 10 cents an ounce, a 5,0000 ounce contract will $500. At that rate, it would take 90 butterfly straddles to lose $45,000.
Commodity straddles were not invented to bedevil the Internal Revenue Service. They have many legitimate uses for professional commodity traders, who can make money where there is a change in the difference between the prices of a commodity in two different months.
Last week there was a 10-cents-a-bushel difference between the price of soybeans for delivery in January and for delivery in March. If demand for soybeans in March suddenly increases, that differential could increase to 20 cents a bushel. On 5,000 bushels of beans, the widening spread could mean a profit of loss of $500.
The two wings of the butterfly, however, tend to minimize the effect of changes in the spread prices. A study prepared for the Internal Revenue Service contends there's only one chance in 40 that a butterfly spread will make enough money to pay the commission a commodity broker charges for placing the buy and sell of orders.
The only way most people make money on a butterfly straddle is on the tax deduction it provides.