Capital Assets Classification of Gains or Losses

Capital Assets

Classification of Gains or Losses on Futures Contracts

Facts: Taxpayer: In order to properly account for the loss that she took on her futures, Haig Simmons must understand the difference between a capital loss (or gain) and an ordinary loss (or gain). In her situation, the coal futures were a something that she entered into as a hedge in order to protect herself against fluctuations in the price of coal. This year, she has recorded a loss on the futures contract.

Is the futures contract considered a capital loss or an operating loss?

May the taxpayer deduct the loss on the futures contract from operating income?

Yes, the taxpayer may deduct the loss on the futures contract from her operating income.

In this situation, the futures contract was indicated to be a hedge at the time of the purchase. This means that it is not a capital asset.

Analysis: In this situation,

Title 26, Subtitle A, Chapter 1, Subchapter P, Part III, § 1221 of the U.S. Tax Code defines capital asset for the purposes of income tax reporting (LII, no date). The code states that

For the purposes of this subtitle, the term "capital asset" means property held by the taxpayer (whether or not connected with his trade or business), but does not include

(7) Any hedging transaction which is clearly identified as such before the close of the day on which it was acquired, originated, or entered into (or such other time as the Secretary may by regulations prescribe.)

There are two important components. The first is that it is not relevant whether the futures contract in question is related to Simmons' business. The second is that derivatives contracts that are clearly identified as hedges are not considered to be capital assets. This would indicate that according to the relevant code, this particular futures contract is not considered to be a capital asset. It was identified as a hedge at the time of the purchase ("before hand").

The determination that Haig Simmons' coal transaction is upheld by Corn Products Refining Co. v. Commissioner 350 U.S. 46 (1955). The facts of that case are very similar to the facts of this case -- the company had purchase corn futures as a hedge on risk faced in the course of its true business. Likewise, Haig's coal futures were integral to her true business, which is coal retailing (assuming that her futures contract was for an amount similar to the amount she sold to her customers).