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Congress, Not IRS, Must Provide Tax Relief from Flash Crash

By Jim Hamilton

Absent the enactment of a relief provision by Congress, the IRS is not authorized to provide for the non-recognition of gain for stop-loss orders executed on the day of the flash crash in the markets, May 6, 2010. An SEC-CFTC report said that the flash crash was triggered by large trader automated sell algorithms triggered during a an unusually turbulent day for the markets. According to an IRS Information Letter, 2010-0188, various non-recognition provisions in the Code are not applicable to the situation. Section 1031 provides for deferral of recognition of gain on like-kind exchanges of property held for productive use in a trade or business or held for investment, but specifically excludes stocks, bonds, and notes from its scope. Section 1033, which provides for deferral of gain if property is compulsorily or involuntarily converted into property similar or related in service or use to the property so converted, or to money, applies only to dispositions resulting from destruction, theft, seizure, or requisition or condemnation.

On the day of the flash crash, many investors had their holdings sold because of stop-loss orders and that, in some cases, they realized gains subject to tax. Some securities industry professionals have asked the IRS if these investors could be allowed to reinvest in the stock sold and that the replacement stock be given the same basis as the stock originally held, and that the investors be excused from recognizing gain.

Stop-loss orders direct a broker to sell a stock at the best price currently available if the stock reaches a specified price. As the flash crash progressed, many stop-loss orders were triggered and the paucity of bids for many stocks resulted in sales at prices significantly below those of prior trades. Many investors incurred losses as the result of such sales, although stock prices
rebounded significantly thereafter. The dramatic recovery in stock prices was a source of frustration to investors whose stock holdings were liquidated as the result of the execution of stop-loss orders. The closing price for many stocks was higher than either the price at which investors? stop-loss orders were triggered or the price realized on the sale of stock as a result of the triggering of a stop
loss order.

Reinvestment in securities sold at a loss in some circumstances requires application of the wash sale rules set forth in section 1091 of the Internal Revenue Code, so that the loss cannot be recognized fully for federal income tax purposes. An example is if an investor bought 1,000 shares of X Co. stock at $70.00 at the opening of the market on May 6, 2010, and placed a stop-loss order at $66.50 (5% below the cost of the stock). When the stock declined to $66.50, the investor?s stop-loss order became a market order. As a market order, the order was executed at $61.00, the best available price. The sale resulted in a loss of $9.00 per share to the investor. If the investor, within 30 days before or after the sale of the X Co. stock, purchased X Co. stock, the wash sale rules would apply to limit or deny deduction of the loss. The amount of the disallowed loss would be reflected in the investor?s basis in the X Co. stock purchased within 30 daysbefore or after the sale under the stop-loss order.

But, explained IRS staff, there is no similar rule allowing non-recognition of gain on the sale of stock if an investor purchases replacement stock within a prescribed period. For example, an investor who had purchased X Co. stock on July 20, 2009, at a cost of $40.00 per share had placed a stop-loss order at $66.50 (5% below the closing market price of the stock on May 5, 2010). During the flash crash, the investor?s stop-loss order was triggered, and the investor?s X Co. stock was sold at $66.50 per share. The investor realized a gain of $26.50 per share on the stock and would be required to recognize the realized gains, i.e., include the gains in gross income, irrespective of whether the investor acquired X Co. stock within a prescribed period, e.g., 30 days, before or after
the sale at a loss.

Full post as published by Jim Hamilton's World of Securities Regulation on October 19, 2010 (boomark / email).