It’s deceptively simple, but the IRS is now onto it. For the past several years, the $10 billion Medallion Fund run by James Simons’ Renaissance Technologies (RenTech) – owned entirely by RenTech staff since 2005 — has been employing an aggressive options strategy designed to convert its short-term trading profits into long-term capital gains. Instead of maintaining securities positions on its own books, RenTech has been buying two-year call options from foreign banks on baskets of securities that the banks have hired RenTech to manage on their behalf. For each basket, the bank contributes up to 90% of its initial value and RenTech puts up the balance as a “premium” for the option. Each call has a strike price equal to the initial value of the basket and is exercisable by RenTech at any time. Under its management agreements with the banks, RenTech buys and sells whatever securities it likes for the basket following its own investment strategy and, when it exercises its option, RenTech reaps the final value of the basket, less finance charges on the 90% initially provided by the bank. As long as RenTech maintains the option for at least a year, any net profits earned in the basket belong to it and are taxed as long-term capital gains. Until this year, the LTCG rate has been 15% compared to the maximum ordinary income rate of 35%, which would otherwise apply to any short-term trading profits in the basket (both rates were increased in 2013 to 20% and 39.6%, respectively). The Medallion Fund is known to be a frequent trader, so most of its portfolio gains are likely to have been short-term. Using this options ploy for at least a portion of its investments, RenTech has saved hundreds of millions of dollars in taxes, sweetening its 80% average annual gross returns, which are reportedly the highest by far in the global hedge fund industry.