Here's how they structured their affairs to claim long-term capital gains (via Sen. Carl Levin's testimony [0]):

The key financial product involved in these fictions is called a ``basket option.'' ...basket option basics worked like this: The bank sold its hedge fund client a structured financial product, called an ``option,'' whose payoff equaled the profits generated by a ``basket'' of securities held in a designated account at the bank. The basket here is key. It was an open account with ever-changing contents. Technically, the account and the securities it contained were held in the name of the banks in its own trading account. The hedge fund put up 10 percent of the cash needed to buy the securities, and the bank lent the other 90 percent.

This arrangement included a number of fictions which defied reality, but resulted in big profits for the hedge funds and the banks.

First, though the structure was designed to create the appearance that the bank owned the assets in the basket option account, the hedge fund made all the trading decisions for those accounts--and in fact, used the bank's computerized trading system to execute trades in the account. RenTec estimates that its trading through basket options accounts averaged more than 100,000 trades each day, or about 30 million trades a year. Also, the hedge fund reaped all of the trading profits, even though the financial structure created the illusion that the bank owned the assets. The beneficial owner, the real owner, was the hedge fund.

Now, second, the hedge fund's control of all the trading for the basket option account demolishes the fiction of a legitimate option. So the hedge funds set up new entities, which they controlled, to serve one function, and that was to act as the option holder. The hedge funds would then claim that their control of the option holder was totally independent of their role in making the trading decisions for the basket option account. Documents that we will explore today show the extraordinary lengths to which RenTec and the banks went to perpetuate the illusion that the option holder and trader were somehow independent, when in fact the hedge fund, RenTec, played both roles.

The fictional option was structured so that it could be exercised more than 1 year after it was created. Under that structure, the hedge funds claimed that trading profits from the account were long-term capital gains and thereby qualified for the reduced long-term capital gains tax rate.

The Tax Code gives long-term capital gains a reduced rate on the theory that it provides an incentive for investors to risk their capital on the kind of long-term investments that grow the economy and create jobs. The high-volume trading that, for example, RenTec conducted through its basket options does not meet that test. When securities are held for weeks or days or even seconds, it is surreal to characterize those trading profits as long-term capital gains.

But that is what the hedge funds did. The banks and hedge funds used the fictional option structure to collapse millions of individual trades into one transaction, the execution of an option. As if by magic, the option structure transforms what would be short-term capital gains from an ordinary trading account into long-term capital gains subject to lower taxes.

[0] https://www.govinfo.gov/content/pkg/CHRG-113shrg89882/html/C...