Tender offer considered an option under Sec. 382 option attribution rule.

In today's business environment, it is not uncommon for historically profitable corporations to be generating net operating losses (NOLs). Under Sec. 382, if a corporation with loss carryovers experiences a greater-than-50% change in its stock ownership, the amount of NOL carryovers it can utilize is limited. In determining if such a change in ownership has occurred, certain options and other agreements can be treated as stock under Sec. 382. To the extent an exercise would cause an ownership change, options are deemed to be exercised under Sec. 382--this is the option attribution rule of Sec. 382(1)(3)(A)(iv) and Temp. Regs. Sec. 1.382-2T(h)(4)(i). The IRS has held that many different agreements are considered options and can cause an ownership change under the deemed exercise rule; however, a recent letter ruling may go too far in applying this rule.

Under Sec. 382(k)(6)(B)(i), the Treasury Secretary may prescribe regulations under which options and other similar interests will be treated as stock or treated as not being stock for Sec. 382 purposes. Temp. Regs. Sec. 1.382-2T(h)(4)(v) states that an interest similar to an option and subject to the option attribution rule includes, but is not limited to, "a warrant, a convertible debt instrument, an instrument other than debt that is convertible into stock, a put, a stock interest subject to risk of forfeiture, and a contract to acquire or sell stock."

Not all agreements with the characteristics of an option are treated as such. Temp. Regs. Sec. 1.382-2T(h)(4)(x) provides that certain agreements are not to be treated as options and not subject to the option attribution rule. Included are stock purchase agreements entered into between the owners of an entity and exercisable only on the owner's death, complete disability or mental incompetency (Temp. Regs. Sec. 1.382-2T(h)(4)(x)(D)) and stock purchase agreements between noncorporate owners who actively participate in the management of a business that is not a loss corporation at the time the agreement is entered into and is exercisable only on the owner's retirement (Temp. Regs. Sec. 1.3822T(h)(4)(x)(H)).

The definition of an option for Sec. 382 purposes has been further interpreted in a series of letter rulings. In IRS Letter Ruling 8917007, a public announcement by a corporation of an offer to exchange outstanding debt for new stock was considered an option. Extending the option attribution rule even further, Letter Ruling

.032 held that a redemption agreement was considered an option. In both of these cases, the option attribution rule was triggered when the loss corporation or its existing shareholders entered into an agreement.

In Letter Ruling 9211028, the Service has gone further Still. The ruling holds that a public tender offer was considered an option which could, under the deemed exercise rule, cause a change in ownership and a limitation on the use of a loss corporation's NOLs. The IRS offered little reasoning except that, on the date the offer was made public and became nonwithdrawable, it became an "interest similar to an option" under Sec. 382.

Following the rationale of this ruling, it appears a loss corporation and its existing shareholders cannot completely control when an ownership change has occurred. Apparently, a corporate raider could trigger a limitation on NOL utilization by merely offering to purchase a majority interest of a loss corporation's stock.

Could a corporate raider coerce a loss corporation by threatening to make such a public offer and thereby cause a limitation on NOL utilization? Under the ruling, that may be possible. May the Service go even further in concluding that other even more indirect transactions or arrangements are subject to the option attribution rule? That may also be possible.

Keep in mind that if the option lapses or is forfeited, it will be treated as if it had never been issued, so any ownership change arising from a deemed option exercise will be retroactively eliminated (Temp. Regs. Sec. 1.382-2T(h)(4)(viii)). Additionally, note that this is only a letter ruling and is not authoritative for other taxpayers. However, it is an indication of the current IRS thinking on the subject. As such, it may be prudent to consider the ramifications of the ruling and whether such a transaction could limit NOL use.

From Barret Johnson, CPA, Chicago, HI.