The Internal Revenue Service (IRS) recently released Advice Memorandum 2010-005 (the AM), in which it held that a so-called barrier option or “knock out option,” as described below, would not be respected as an option for U.S. federal income tax purposes and would cause the optionholder to be treated as the owner of the “optioned” securities.

Generally, when a taxpayer acquires an option, it is not treated as the owner of the securities underlying the option and is not required to recognize gain or loss until the option settles or expires. At the time of settlement, if the asset underlying the option is a capital asset, the optionholder will generally recognize long-term capital gain if it held the option for longer than one year. The IRS’s holding in the AM would require a “barrier” optionholder to accelerate recognition of income and gain, and may cause the optionholder to recognize short-term capital gain or ordinary income rather than longterm capital gain.