No constructive receipt of income to employees when an employer offers to repurchase compensatory stock options.

In a ruling that may have considerable utility in corporate acquisitions, the IRS has held for the first time that an offer to buy out compensatory stock options for cash will not result in constructive receipt for the option holder who declines the offer. In Letter Ruling 9422048, an employer company issued stock options that allowed a participant to purchase shares of its common stock. The company proposed to modify the terms of the options. Certain participants, however, could make a one-time election to receive cash equal to the option's fair market value in lieu of accepting the modification. The Service concluded that if the participants elected to modify their options, their alternative right to receive cash would not cause them to recognize the amount of cash that they could have otherwise received in their gross incomes under the rules of Sec. 451.

Regs. Sec. 1.451-2 generally states that income is "constructively received" when made available to a taxpayer, unless the taxpayer's control of its receipt is subject to substantial limitations or restrictions. Rev. Rul. 80-300 has interpreted this rule in a non-qualified deferred compensation setting involving stock appreciation rights (SARs). Under that ruling, exercise of the SARs would have resulted in the loss of the right to benefit from future appreciation in the employer's stock without risking any capital. The ruling held that forfeiture of that valuable right was a substantial limitation on the right to receive the income from the SARs, and precluded constructive receipt of that income.

Extending the reasoning of Rev. Rul. 80-300 to the instant situation, the IRS reasoned that in order to receive cash, the optionees would have to give up a valuable right, namely, the right under their options to benefit from future appreciation in the optioned stock without risking any capital. The resulting forfeiture of that right on election of the cash was viewed as a substantial limitation on receipt of that cash, again precluding its constructive receipt.

This ruling may have considerable utility in a corporate acquisition setting when the acquiring company and the target company would like to give compensatory option holders of the target company the choice between being cashed out of their options or exchanging them for comparable options in the acquiring company.