Comm'r

*248 OPINION

RUWE, Judge: Respondent determined deficiencies in petitioner's Federal income taxes in docket No. 3941-99 as follows:

   Year          Deficiency

   ____          __________

   1985         $ 36,623,695

   1986          40,111,127

*249 Petitioner claims overpayments of $ 9,604,085 for 1985 and $ 12,418,469 for 1986.

Respondent determined deficiencies in petitioner's Federal income taxes in docket No. 15626-99 as follows:

   Year          Deficiency

   ____          __________

   1987         $ 26,200,358

   1988     *35      13,827,654

   1989          6,225,404

   1990          23,466,338

Petitioner claims overpayments of $ 57,775,538 for 1987, $ 28,434,990 for 1988, $ 32,577,346 for 1989, and $ 19,504,333 for 1990.

In this Opinion, we decide whether certain nonrefundable commitment fees that mortgage originators paid to petitioner to enter into Conventional Multifamily Prior Approval Purchase Contracts (prior approval purchase contracts) are to be recognized when those fees are paid or should be treated as premium for "put" options, which would defer recognition until after delivery or nondelivery of the underlying mortgages. ¹ This issue is one of several involved in these cases. ²

*36 Background

The parties submitted this issue fully stipulated pursuant to Rule 122. ³ The stipulations of fact and the attached exhibits are incorporated herein by this reference. At the time it filed the petitions, petitioner maintained its principal office in McLean, Virginia. At all relevant times, petitioner was a corporation managed by a board of directors.

*250 Petitioner was chartered by Congress on July 24, 1970, by title III (Federal Home Loan Mortgage Corporation Act) of the Emergency Home Financing Act of 1970, Pub. L. 91-355, 84 Stat. 450. Petitioner was established to purchase residential mortgages and to develop and maintain a secondary market in conventional mortgages. A "conventional mortgage" is a mortgage that is not guaranteed or insured by a Federal agency. The "primary mortgage market" is composed of transactions between*37 mortgage originators (lenders, such as savings and loan organizations) and homeowners or builders (borrowers). The "secondary market" generally consists of sales of mortgages by originators, and purchases and sales of mortgages and mortgage-related securities by institutional dealers and investors. Since its incorporation, petitioner has facilitated investment by the capital markets in single-family and multifamily residential mortgages. In the course of its business, petitioner acquires residential mortgages from loan originators. Petitioner's business is a high-volume, narrow-margin business.

   A. Multifamily Mortgage Program

A multifamily mortgage loan is a loan secured on a property consisting of an apartment building with more than four residences. Petitioner offered originators two programs for selling multifamily mortgages: (1) The immediate delivery purchase program, and (2) the prior approval conventional multifamily mortgage purchase program (prior approval program).

     1. Immediate Delivery Purchase Program

Petitioner designed the immediate delivery purchase program to accommodate the purchase of mortgages already closed and on an originator's*38 books at the time an originator enters into a purchase contract with petitioner. Although this program is designed for portfolio mortgages, an originator may enter into an immediate delivery purchase contract with petitioner before actually closing on the mortgage. However, if for some reason the mortgage cannot be delivered, petitioner can impose sanctions on an originator.

To participate in the immediate delivery purchase program, an originator telephones petitioner to make an offer *251 for a purchase contract. When petitioner receives a telephone offer from an originator, that offer is "an irrevocable offer that the [originator] may not modify." Petitioner may accept an offer within 2 business days of receiving the telephone offer. When petitioner accepts an offer, it executes two copies of the purchase contract and mails the contract to an originator. Within 24 hours of receiving the purchase contract, an originator must execute the contract and mail one copy along with a $ 1,500 nonrefundable application/review fee or 0.1 percent of the purchase contract, whichever is greater, to petitioner's applicable regional office. If an originator failed to acknowledge and submit a copy of*39 a purchase contract, petitioner may disqualify or suspend an originator as an eligible seller to petitioner. After completing a documentation review, underwriting, and property inspections, if any, petitioner's applicable regional office will contact an originator. The mortgages acceptable to petitioner will be identified and purchased.

An originator must deliver the mortgages to petitioner within the 30-calendar-day commitment period. In most cases, the penalty for nondelivery is disqualification or suspension of an originator from eligibility to sell mortgages to petitioner. ⁴

*40 Under the immediate delivery purchase program, petitioner established its required net yield when originators offered the contracts. The required net yield is the interest rate that petitioner will receive from the mortgage it purchases from an originator. Petitioner did not charge an upfront commitment fee in its immediate delivery purchase program.

     2. Prior Approval Program

Alternatively, originators may sell multifamily mortgages to petitioner under the prior approval program, which began in 1976. Under this program, petitioner entered into contracts *252 with originators to purchase a multifamily mortgage before the closing date of the mortgage. In general, each executed prior approval purchase contract pertained to a single mortgage, as opposed to a pool of mortgages. Petitioner's promotional pamphlets state that this program offered originators the "peace of mind" of knowing that petitioner would purchase the loan once it closed. The pamphlets also explain that once an originator entered into a prior approval purchase contract with petitioner, "delivery of the loan is still optional, so [the originators] don't have to worry if the deal hits a snag or falls*41 through completely."

Under the prior approval program, originators were not obligated to deliver the multifamily mortgage to petitioner. Petitioner's Sellers' & Servicers' Guide is part of the contract between an originator and petitioner. Petitioner's Sellers' & Servicers' Guide states: "Delivery under this program is optional. However, unless the optional delivery contract is converted to a mandatory delivery contract within the 60-day optional delivery period, the mortgage may not be delivered and [petitioner] will retain the entire 2-percent commitment fee required pursuant to section 3004." The Sellers' & Servicers' Guide also provides:

   The optional delivery date stated in the purchase

   contract will be within 60 days from the date [petitioner]

   issues the purchase contract plus the 10-business-day period in

   which the [originator] may accept the purchase contract. During

   the 60-day period, if the [originator] intends to deliver the

   mortgage(s) to [petitioner], the [originator] must convert the

   optional delivery purchase contract to a 30-day mandatory

   delivery purchase contract. * * *

To receive a prior*42 approval purchase contract from petitioner, an originator must submit a request for prior approval of a specific multifamily project. Along with the request, an originator paid a nonrefundable loan application fee of the greater of $ 1,500 or 0.10 percent of the original principal amount of the mortgage (but not in excess of $ 2,500). After completion of processing, including underwriting and property inspections, petitioner would determine if the mortgage is acceptable. Id. If acceptable, petitioner would execute a prior approval purchase contract (also called Form 6), which it mailed to an originator. An originator wishing to participate in the prior approval program *253 would execute the Form 6, and mail or deliver it to petitioner no later than 10 business days from the date of petitioner's offer. Form 6 would set forth details of the specific mortgage that an originator could deliver.

Between 1985 and 1991, petitioner required an originator to submit a 2-percent commitment fee with the executed prior approval purchase contract. During the years at issue, the 2-percent commitment fee consisted of a 0.5-percent nonrefundable portion and a 1.5-percent portion that was refundable if*43 an originator delivered the mortgage under the prior approval purchase contract. ⁵ Petitioner was entitled to keep the nonrefundable portion when it entered into the agreement. The 0.5-percent portion of the commitment fee received by petitioner was not held in trust or escrow and was subject to unfettered control by petitioner.

If an originator did not deliver the specific mortgage to petitioner, it forfeited the 1.5-percent refundable portion of the commitment fee. Forfeiture of the refundable portion*44 of the fee in the event of nondelivery functioned as a delivery incentive consistent with petitioner's business preference to buy mortgages in the secondary market. ⁶

Under the prior approval program, an originator had the right, but not the contractual obligation, to elect at any time during the ensuing 60 days (or in some cases 15 days), to enter into a mandatory commitment to deliver a conforming mortgage to petitioner. Under this program, petitioner committed to purchasing a mortgage when an originator delivered it to petitioner within the delivery period. ⁷

*45 Petitioner required originators to service the mortgages they sold to petitioner. Originators received compensation for performing this service (the compensation is known as the minimum servicing spread). For the years at issue, the minimum servicing fee (the originator's retained spread over the *254 life of the mortgage) was 25 basis points (bps) ⁸ on mortgages less than $ 1 million, 12.5 bps on mortgages between $ 1 and $ 10 million, and was negotiable on mortgages more than $ 10 million.

To exercise its delivery right under a prior approval purchase contract, an originator was required to give notice of conversion to petitioner and enter into a 30-day "mandatory delivery contract" on Form 64A, Conventional Multifamily Immediate Delivery Purchase Contract and Prior Approval Conversion Amendment. An originator could elect to deliver the multifamily mortgage at petitioner's maximum required net yield or at an alternate required net yield. ⁹ Petitioner's required net*46 yield was the rate at which originators could contract to deliver a mortgage under the immediate delivery purchase program. The maximum required net yield was the fixed rate, or locked-in interest rate, that petitioner and an originator had previously agreed upon in Form 6. ¹⁰ The alternate required net yield was the rate at which an originator could contract to deliver a mortgage to petitioner under the immediate delivery purchase program as quoted by petitioner on any day during the 60-day (or 15-day) optional delivery period; if the required net yield moved downward, an originator could select the lower required net yield. The purchase price and net yield to petitioner became fixed upon an originator's selection of either the maximum required net yield, or the alternate required net yield on any day during the 60-day (or 15- day) period that an originator elected an alternate required net yield. The purchase price either would reflect a discount from par (100 percent of unpaid principal balance (UPB)) or would be at par, depending on the relationship of the rate on the mortgages (coupon rate) actually tendered by an originator to the "minimum gross yield", which *255 was the sum of*47 the required net yield selected and the minimum servicing spread. ¹¹

*48 For example, suppose an originator and petitioner entered into a prior approval purchase contract with respect to a mortgage in the maximum amount of $ 6 million. The originator paid the 2-percent commitment fee in the amount of $ 120,000. The mortgage was subject to a maximum mortgage interest rate of 12.595 percent and the maximum required net yield to petitioner was 12.470 percent. The difference, 0.125 percent or 12.5 bps, represents the minimum spread to be retained by an originator for servicing the mortgage, or $ 7,500/year. If an originator contemplated selling the subject mortgage to another buyer in lieu of petitioner, it would have to consider the effect of forfeiting the otherwise refundable portion of the commitment fee, or $ 90,000, in comparison to the spread it could obtain with another purchaser.

In the event that petitioner's required net yield on any day during the 60-day (or 15-day) period exceeded the "maximum required net yield", petitioner could be required on that day to contract to purchase conforming mortgages at the maximum required net yield stated on the Form 6, instead of at its current day required net yield. This arrangement effectively ensured that*49 an originator could make a mortgage loan to a borrower at a particular rate, and would be protected against having to sell it to petitioner at a discount from par, or at an additional discount as a result of an increase in petitioner's required net yield during the 60-day (or 15-day) period. Because it could select the maximum required net yield if market rates increased, an originator was assured of dealing at a rate that was no higher than was specified in the prior approval purchase contract. Thus, an upward movement in interest rates normally would not prevent an originator from delivering a mortgage under the prior approval program. Alternatively, if interest rates went down, an originator would have the benefit (whether in the form of a greater spread or less of a discount from UPB) of selecting an alternate required net yield in lieu of the higher maximum *256 required net yield as stated in the prior approval purchase contract. ¹²

*50 If an originator selected an alternate required net yield, it was required to give notice of this selection no later than the date of conversion to mandatory delivery. If an originator failed to give notice of conversion to a mandatory commitment within 5 business days of selecting an alternate required net yield, the prior approval purchase contract would be terminated, and petitioner would retain the entire 2-percent commitment fee.

Nondelivery generally occurred when the borrower repudiated or defaulted on its arrangement with the originator so that the originator did not have the mortgage to deliver. ¹³ Unlike originators who entered into an immediate delivery purchase program, when an originator participating in the prior approval program failed to deliver a mortgage, it was not disqualified or suspended as an eligible seller of mortgages to petitioner.

*51 In computing its taxable income for the years 1985 through 1991, petitioner treated the 0.5-percent nonrefundable portion of the commitment fees as premium received for writing put options in favor of the various mortgage originators. Petitioner generally did not include in taxable income amounts received for the 0.5-percent nonrefundable portion of the commitment fee in the year of receipt. Petitioner deducted such nonrefundable amounts from the cost basis of mortgages purchased when originators delivered mortgages to petitioner. Petitioner amortized these amounts into income over multiyear periods of 7 or 8 years (i.e., the estimated life of the mortgages in petitioner's hands). ¹⁴ If an originator failed to elect mandatory delivery of the specified mortgages within the prescribed period, petitioner recognized the nonrefundable portion of the commitment fee in the current year *257 if the last day of the 60-day (or 15-day) period was within the current year.

*52 During the years 1985 through 1991, petitioner received the 0.5-percent nonrefundable portion of the commitment fees pursuant to the prior approval program in amounts totaling $ 9,506,398, $ 16,489,524, $ 9,408,907, $ 4,525,606, $ 4,892,445, $ 2,805,392, and $ 41,257, respectively. On its corporate returns for the years 1985 through 1993, petitioner included taxable income of $ 5,636,762, $ 16,627,101, $ 2,035,928, $ 2,601,628, $ 3,213,184, $ 3,563,858, $ 3,569,015, $ 3,569,015, and $ 3,569,015, respectively. The adjustments in dispute in the 1985-90 taxable years are the net differences between the amounts of nonrefundable commitment fees received and reported for tax purposes, as follows:

 Nonrefundable                      Amount in

Commitment Fees     Received     Reported     Dispute 1985-90

_______________     ________     ________     _______________

   1985      $ 9,506,398    $ 5,636,762      $ 3,869,636

   1986       16,489,524    16,627,101       (137,577)

   1987       9,408,907     2,035,928     *53   7,372,979

   1988       4,525,606     2,601,628       1,923,978

   1989       4,892,445     3,213,184       1,679,261

   1990       2,805,392     3,563,858       (758,466)

In computing its taxable income for the year 1985, petitioner overstated its income attributable to such receipts under its method of accounting in the amount of $ 883,638 as a result of a computational error.

During the years 1985 through 1988, and 1990, originators failed to deliver at least 67 mortgages specified in prior approval purchase contracts to petitioner. ¹⁵ See appendix, which lists these 67 contracts. As a result, the 1.5-percent refundable portion of the 2-percent commitment fee was forfeited to petitioner. During the relevant period, these 67 contracts represent approximately 1 percent (by value and number) of all the contracts that petitioner entered into in the prior approval program. Petitioner was not necessarily informed of the precise reason for the nondelivery; petitioner *258 believes that the typical reason for nondelivery was failure of the underlying mortgage to have been consummated.

*54 Discussion

Petitioner argues that the 0.5-percent nonrefundable portions of the commitment fees that originators paid to enter into prior approval purchase contracts constitute "put" option ¹⁶ premiums, the tax treatment of which could not be determined until originators either exercised the options or allowed them to lapse. Respondent disagrees arguing that the 0.5-percent nonrefundable portions of the commitment fees are not option premium because the prior approval purchase contracts are not option contracts. Respondent argues that petitioner had a fixed right to the nonrefundable portion of the commitment fees when the prior approval purchase contracts were executed and that section 451 requires petitioner, as an accrual basis taxpayer, to recognize the nonrefundable commitment fees in the year of receipt because its right to retain the commitment fees was fixed and determined.

*55 Section 451(a) generally provides that "The amount of any item of gross income shall be included in the gross income for the taxable year in which received by the taxpayer, unless, under the method of accounting used in computing taxable income, such amount is to be properly accounted for as of a different period." Accrual method taxpayers normally recognize income when "all the events have occurred which fix the right to receive" income and the amount of income "can be determined with reasonable accuracy." Sec. 1.451-1(a), Income Tax Regs. However, as more fully explained, infra, payments of option premiums are not recognized when received, even when the recipient has a fixed right to retain the payments, because the character of those payments is uncertain until the option has been exercised or has lapsed. E.g., Old Harbor Native Corp. v. Commissioner, 104 T.C. 191, 200 (1995). Because of the unique facts in this case, we must examine the rules governing the tax treatment of option premiums and the policy underlying those rules to decide *259 whether a prior approval purchase contract constitutes an option for Federal income tax purposes.

"An option*56 has historically required the following two elements: (1) A continuing offer to do an act, or to forbear from doing an act, which does not ripen into a contract until accepted; and (2) an agreement to leave the offer open for a specified or reasonable period of time." Id. at 201 (citing Saviano v. Commissioner, 80 T.C. 955, 970 (1983), affd. 765 F.2d 643 (7th Cir. 1985)). "The primary legal effect of an option is that it limits the promisor's power to revoke his or her offer. An option creates an unconditional power of acceptance in the offeree." Id. (citing 1 Restatement, Contracts 2d, sec. 25(d) (1981)). An option normally provides a person a right to sell or to purchase "' at a fixed price within a limited period of time but imposes no obligation on the person to do so'". See Elrod v. Commissioner, 87 T.C. 1046, 1067 (1986) (quoting Koch v. Commissioner, 67 T.C. 71, 82 (1976)). An agreement that purports to be an "option", but is contingent or otherwise conditional on some act of the offering party, is not an option. Saviano v. Commissioner, supra at 970.

An option*57 contract grants the optionee the right to accept or reject an offer according to its terms within the time and manner specified in the option. Estate of Franklin v. Commissioner, 64 T.C. 752, 762 (1975), affd. on other grounds 544 F.2d 1045 (9th Cir. 1976); 1 Williston on Contracts, sec. 5:16 (4th ed. 2004). Options have been characterized as unilateral contracts because one party to the contract is obligated to perform, while the other party may decide whether or not to exercise his rights under the contract. U.S. Freight Co. v. United States, 190 Ct. Cl. 725, 422 F.2d 887, 894 (1970). Courts have found that the holder of an option must have a "truly alternative choice" to exercise the option or to allow it to lapse. Id. at 895; see also Halle v. Commissioner, 83 F.3d 649, 654 (4th Cir. 1996), revg. and remanding Kingstowne L. P. v. Commissioner, T.C. Memo. 1994- 630; Koch v. Commissioner, supra at 82. Thus,

  the clear distinction between an option and a contract of sale

   is that an option gives a person a right to purchase [or sell]

   at a fixed price within a limited period of*58 time but imposes no

   obligation on the person to do so, whereas a contract of sale



   contains mutual and reciprocal obligations, the seller being



   obligated to sell and the purchaser being obligated to buy.

   [Koch v. Commissioner, supra at 82.]

*260 Option payments are not includable in income to the optionor until the option either has lapsed or has been exercised. Kitchin v. Commissioner, 353 F.2d 13, 15 (4th Cir. 1965), revg. T.C. Memo. 1963-332; Va. Iron Coal & Coke Co. v. Commissioner, 99 F.2d 919 (4th Cir. 1938), affg. 37 B. T. A. 195 (1938); Elrod v. Commissioner, supra at 1066-1067; Koch v. Commissioner, supra at 89. In Rev. Rul. 58-234, 1958-1 C.B. 279, 283-284, the Commissioner has reiterated these same principles:

  An optionor, by the mere granting of an option to sell (" put"),

   or buy (" call"), certain property, may not have parted with any



   physical or tangible assets; but, just as the optionee thereby



   acquires a right to sell, or buy, certain property at a fixed

   price during a specified future period*59 or on or before a

   specified future date, so does the optionor become obligated to



   accept, or deliver, such property at that price, if the option

   is exercised. Since the optionor assumes such obligation, which

   may be burdensome and is continuing until the option is



   terminated, without exercise, or otherwise, there is no closed



   transaction nor ascertainable income or gain realized by an



   optionor upon mere receipt of a premium for granting such an



   option. The open, rather than closed, status of an unexercised



   and otherwise unterminated option to buy (in effect a "call")

   was recognized, for Federal income tax purposes, in A. E.

  Hollingsworth v. Commissioner, 27 B.T.A. 621, * * * (1933).

It is manifest, from the nature and consequences of "put" or

   "call" option premiums and obligations, that there is no Federal

   income tax incidence on account of either the receipt or the



   payment of such option premiums, i.e., from the standpoint of



   either the optionor or the optionee, unless and until the

   options have been terminated, by failure to exercise, *60 or

   otherwise, with resultant gain or loss. The optionor, seeking to



   minimize or conclude the eventual burden of his option



   obligation, might pay the optionee, as consideration for



   cancellation of the option, an amount equal to or greater than



   the premium. Hence, no income, gain, profits, or earnings are



   derived from the receipt of either a "put" or "call" option



   premium unless and until the option expires without being



   exercised, or is terminated upon payment by the optionor of an



   amount less than the premium. Therefore, it is considered that



   the principle of the decision in North American Oil

  Consolidated v. Burnet, 286 U.S. 417, 52 S. Ct. 613, 76 L. Ed. 1197, 1932-1 C.B. 293 * * * (1932), which

   involved the receipt of "earnings," is not applicable to

   receipts of premiums on outstanding options.

Rev. Rul. 58-234, supra at 284, 285, summarizes the tax treatment of put option premiums as follows:

  [T]he amount (premium) received by the writer (issuer or

   optionor) of a "put" or "call" option which is not exercised

   constitutes ordinary income, for Federal income tax purposes,

*61    under section 61 of the Internal Revenue Code of 1954, *261 to be

   included in his gross income only for the taxable year in which

   the failure to exercise the option becomes final.

           *   *   *   *   *   *   *

  [W]here a "put" option is exercised, the amount (premium)

   received by the writer (issuer or optionor) for granting it

   constitutes an offset against the option price, which he paid

   upon its exercise, in determining his (net) cost basis of the

   securities that he purchased pursuant thereto, for subsequent

   gain or loss purposes. * * *

See also Rev. Rul. 78-182, 1978-1 C.B. 265.

A contract is an option contract when it provides (A) the option to buy or sell, (B) certain property, (C) at a stipulated price, (D) on or before a specific future date or within a specified time period, (E) for consideration. W. Union Tel. Co. v. Brown, 253 U.S. 101, 110, 40 S. Ct. 460, 64 L. Ed. 803 (1920); Halle v. Commissioner, supra at 654; Old Harbor Native Corp. v. Commissioner, 104 T.C. at 201; Estate of Franklin v. Commissioner, supra at 762-763;*62 Rev. Rul. 58-234, supra. To determine whether a contract constitutes an option, courts look at the contractual language and the economic substance of the agreement. Halle v. Commissioner, supra.

Petitioner's prior approval purchase contracts exhibit the following characteristics of an option for tax purposes: (1) The prior approval purchase contracts satisfy the formal requirements of option contracts; (2) the economic substance of the prior approval purchase contracts indicates that the contracts are an option; and (3) the rationale for granting open transaction treatment to option premium applies to petitioner's transactions.

     1. Formal Requirements of the Option

Petitioner's prior approval purchase contracts provide for the optional delivery of mortgages by an originator. The Sellers' and Servicers' Guide states: "Delivery under this program is optional. However, unless the optional delivery contract is converted to a mandatory delivery contract within the 60- day optional delivery p