Options as a shield against a sec. 382 ownership change.

Example 1: Individual A had owned all 100 shares of Loss Corporation (Loss). Within the previous three years, A sold 30 shares of Loss to B. Today, also within three years, investor C is about to buy 50 newly issued shares of Loss. After C's purchase, Loss will have 150 shares outstanding: A with 70 shares (47%), B with 30 shares (20%) and C with 50 shares (33%). Therefore, an ownership change takes place (since there is a 53 percentage point increase within the three-year testing period).

Is there anything that can be done to avoid a limitation on the use of Loss's net operating, built-in and Sec. 383 losses?

Example 2: What if concurrently with C's purchase of Loss stock, Loss were to issue an option to A that would entitle A to acquire 10 shares of Loss stock in the future? If the option were deemed exercised, A would own 80/160 (50%) and B and C would have increased their interests in Loss by exactly 50%.

Under Temp. Regs. Sec. 1.382-2T(h)(4)(i), options are only considered exercised if they cause an ownership change. The rules are a "one-way street" for the IRS's benefit. The Service would disregard the 10 shares that A could receive on the exercise of the option and B and C would have increased their ownership by 53%. (In other words, the number of outstanding Loss shares would still be 150.)

The new proposed regulations, however, provide for different results. Options are disregarded unless they are "abusive." When finalized, the deemed exercise rule of Temp. Regs. Sec. 1.382-2T(h)(4)(i) will not apply on any testing date on or after Nov. 5, 1992. Thus, there is no discretion on the part of the taxpayer or the Government--an abusive option will be treated as exercised.

Under the proposed regulations, a principal purpose is "abusive" if it manipulates the timing of an owner shift to ameliorate or avoid the impact of a loss corporation's ownership change by --providing the option with a substantial portion of the underlying stock's ownership attributes, or --facilitating the creation of income to absorb the corporation's losses prior to exercise of the option.

The proposed regulations state that the determination of principal purpose is to be based on facts and circumstances. Six factors provide evidence of such a purpose.

1. The option is "deep-in-the-money" on the date the option is issued or transferred. if the exercise price were at least 90% of fair market value, this factor would not be met.

2. The option holder can participate in the loss corporation's management (other than through a bona fide employment arrangement).

3. The option includes rights ordinarily afforded the owner of the underlying stock (e.g., voting, dividend or liquidation rights).

4. The option holder has a call option with respect to the loss corporation's stock and the loss corporation has a matching put option to sell the stock to the option holder.

5. In connection with the issuance or transfer of the option, the loss corporation receives a capital contribution (either in exchange for stock or otherwise).

6. In connection with the issuance or transfer of the option, the loss corporation enters into a transaction with a view to accelerating income into the period prior to the option's exercise.

The existence of these factors would not create a conclusive presumption of abuse. However, if any one of these factors is present and the loss corporation does not treat the option as exercised, disclosure on the loss corporation's return would be required.

Can an abusive option be crafted? Assume A's option to buy 10 shares is "deep-in-the-money"; the option also grants A shareholder rights (vote), permits A to participate in management (A is already an officer), and was acquired by A in exchange for cash contributed to the corporation (factor 5). If these four factors are present the option should be considered abusive. In fact it would be hard to imagine that the IRS would conclude otherwise and disregard the option.

The preamble to these regulations provides that "an option does not meet the principal purpose test if it is issued with the intent that it be treated as exercised to prevent an ownership change." However, there is no similar language in the actual regulations. To counter any assertion that this is a sham option that should be disregarded, the taxpayer might allege that C would want A to have this option so that C's interest in Loss would be increased by the value of an unrestricted net operating loss. Moreover, A could certainly argue that a 47% interest in a corporation is materially different from a potential 50% interest.

Thus, while the temporary regulations unequivocally disregard options that help a taxpayer avoid an ownership change, under the new proposed regulations the option could be allowed (or perhaps is required) to be counted to avoid an ownership change.

One caveat is that the new proposed regulations are not valid until they become final. Moreover, there is no retroactive election to apply the new rules. At hearings, it was argued that these new rules, which are easier to administer and more favorable to the taxpayer, should be applied retroactively. Eventually they may be. In any event, when they are finalized it appears they will permit taxpayers to use options to avoid ownership changes.