Tips and traps under the Sec. 382 option attribution rules.

The option attribution rules in Sec. 382(1)(3) and Temp. Regs. Sec. 1.382-2T(h)(4) continue to frustrate taxpayers by causing unexpected ownership changes that impair the use of net operating loss (NOL) and other tax attribute carryovers. An understanding of these complex rules, including the pitfalls and planning opportUnities, is needed to help loss corporations with capital restructurings, equity issuances, acquisitions, tax compliance and accrual reviews.

Option defined

Temp. Regs. Sec. 1.382-2T(h)(4)(v) provides a nonexclusive list of instruments that are considered options: warrants, convertible debt instruments, instruments other than debt that are convertible into stock, puts, stock interests subject to risk of forfeiture and contracts to acquire or sell stock. Other examples (not identified in the regulations) include certain buy-sell arrangements, certain rights of first refusal, binding letters of intent to acquire stock, merger agreements, pledges of stock as security on debt from nonqualified lenders including non-U.S. banks), etc. The fact that an option is contingent on certain defined events (the likelihood or remoteness of which is not considered), or not currently exercisable pursuant to its terms, is ignored (Temp. Regs. Sec. 1.382-2T(h)(4)(iii)). This creates a broad and expansive definition of an option subject only to certain very limited exceptions (see Temp. Regs. Sec. 1.382-2T(h)(4)(x)). Noteworthy, however, is the Service's recent ruling that stock appreciation rights (SARs) would not be treated as interests similar to an option (Letter Ruling 9147031).

A loss corporation on the verge of an ownership change may exercise some control over the timing of a potential ownership change by drafting documents in a manner that avoids option status. The IRS has established a standard for determining when an instrument becomes an option. Under this standard, an instrument becomes an option when it is nonwithdrawable both from a legal and practical standpoint.

Treatment of an option deemed exercised

In testing for an ownership change, stock subject to an option will be treated as having been acquired on any testing date if the deemed acquisition would result in an ownership change (Temp. Regs. Sec. 1.382-2T(h)(4)(i)). For this purpose, the deemed exercise rules apply separately to each class of options and to each 5% shareholder, each holder of an option who could be a 5% shareholder if the option were deemed exercised, and each combination of such persons. The effect of this rule is to maximize the probability of triggering an ownership change by minimizing the potential dilutive effect of multiple options.

Example 1: L, a loss corporation, has 30 shares outstanding with individuals A, B and C, who own 10 shares each. L issues options to each shareholder to acquire 100 shares. If all options are deemed exercised, no ownership change would result as A, B and C's relative interests remain the same. The regulation, however, requires L to test the options of A, B and C separately. Deeming only A's option as exercised would result in an ownership change with A's interest increasing 52% (85% [110 (10 + 100) / 130 (30 + 100)] - 33% [10 / 30]].

Once deemed exercised, an option is disregarded for subsequent testing dates under an exception from the option attributes rules referred to as the "before and after" rule (Regs. Sec. 1.382-2T(h)(4)(x)(F)). See Example 2.

Even though there has been an ownership change by virtue of the deemed exercise of the warrants and the corporation's outstanding shares are .deemed increased, the actual value of the corporation cannot be increased for any of the consideration that the corporation would have received had the options been exercised Temp. (Regs. Sec. 1.382-2T(h)(4)(vii)(C)). This is because the general prohibition of Sec. 382(1)(1)(B)ignores capital contributions made two years before the change date.

Note this same result would happen whether or not the 1,100 options (in Example 2) were granted to the same lender that received the initial 500 options. Furthermore, the "before and after" rule is not limited to options deemed exercised. All options in existence immediately before and after an ownership change (whether or not deemed exercised) are disregarded, but only if they continue to be owned by the same 5% shareholder. Actual exercise of previously deemed exercised options

In Example 2, the second ownership change could be avoided by having the warrant holders exercise (if possible) their original 500 warrants. The actual exercise of a previously deemed exercised option (or an option in existence before and after an ownership change whether or not deemed exercised in connection with such change) is not a testing event for Sec. 382 purposes, provided the option is exercised by the same 5% shareholder who owned the option immediately before and after such ownership change (Temp. Regs. Sec. 1.382-2T(h)(4)(vi)). A strict reading of the regulations, particularly the parenthetical reference in Temp. Regs. Sec. 1.382-2T(h)(4)(xii), seems to preclude including in the corporation's outstanding shares those shares actually issued pursuant to the exercise of an option by the same 5% shareholder who held the option before and after the ownership change. The better result would be that the actual exercise increases the number of shares outstanding, providing a loss corporation with additional equity transfer capacity without triggering an ownership change.

A loss corporation on the verge of a second ownership change may decide to include previously deemed exercised shares actually exercised and to include such shares as outstanding in owner shift testing. While this position likely represents a good faith challenge to the regulations in view of apparent congressional intent, it would contravene the regulations and, therefore, would require disclosure on Form 8275-R, Disclosure Statement-Regulations, to avoid the substantial understatement penalty if the corporation ultimately lost on this issue. Change date determination Generally, the testing date on which the deemed exercise of an option creates an ownership change is the change date for Sec. 382 purposes. The loss corporation may elect to treat the date that the options are actually exercised as the change date if it occurs within 120 days of the deemed exercise date (Temp. Regs. Sec. 1.382-2T(h)(4)(vi)(B)). The election is made on the Sec. 389, disclosure statement that loss corporations must file with their return disclosing testing dates and owner shifts. One narrow extension of the 120-day rule is contained in Prop. Regs. Sec. 1.1502-96(b)(21. Under this provision, if pursuant to a bilateral contract, an option is granted by a corporation to purchase its tax consolidated subsidiary that otherwise would be deemed exercised under the option rule, the actual sale date is used as the change date if it occurs within one year of the option date.

Evergreen effect

An option generally remains subject to the deemed exercise rule for the life of the option unless subject to the "before and after" rule. Accordingly, a loss corporation must consider all outstanding options regardless of their issuance date. Thus, the loss corporation must consider the continuing effect of a deemed exercise of outstanding options in calculating whether an ownership change has occurred on any subsequent testing date.

Unlike owner shifts attributable to transfers of stock, the lapse of a testing period does not cleanse an owner shift(s) attributable to unexercised options. Options remain subject to the deemed exercise rule while outstanding.

Example 3: Assume that on date 1, loss corporation L issues an option to acquire 10% of its stock/or 10 years to H. Two years later, on date 2, unrelated individual A acquires 30% of L. L does not experience an ownership change with only a 40% owner shift. Five years after date 2, on date 3, individual B acquires 41% of L. A's acquisition on date 2 is no longer in the three-year testing period and is therefore not considered. The option issued to H on date 1 (seven years earlier) is still subject to the deemed exercise rule, assuming it has not previously been exercised in a "closed" testing period. L experiences an ownership change on date 3 when H's deemed exercise of the 10% of L stock is combined with B's 41% acquisition of L.

Treatment of an option on lapse or forfeiture

If an option that is treated as exercised lapses unexercised pursuant to its terms, or the owner of such option irrevocably forfeits his right to acquire stock pursuant to such option, the option shall be treated for Sec. 382 purposes as if it never had been issued (Temp. Regs. Sec. 1.382-2T(h)(4)(viii)) In such cases, previous ownership changes are eliminated and amended tax returns may be filed (subject to the applicable statute of limitations).

Example 4: L previously experienced an ownership change attributable to the issuance of options to management. After issuance, L's business declined, driving the options out of the money (assume none of the options have been exercised). L is expecting a significant amount of taxable income attributable to a debt restructuring, but will not be able to completely shelter such income with its NOL due to the previous Sec. 382 limitation. L's management derives a plan by which L will repurchase the options for a nominal amount in an effort to cleanse the previous change. The IRS has ruled (most recently in Letter Ruling 9203014) that the repurchase of deemed exercised options, whether in the money or not, by a loss corporation will not be considered a lapse or forfeiture. To be considered a lapse or forfeiture, the Service believes no consideration may be received by the option holder. Note, however, that an option not previously deemed exercised may be repurchased/or consideration.

Grandfathered options

Options issued before May 6, 1986 are not subject to the attribution rules unless transferred by or to a 5% shareholder after issuance. In relying on this exception, each option should be analyzed to ensure that it has not been modified so as to constitute a rescission and reissuance.

Options on subsidiaries in affiliated groups filing consolidated returns Proposed regulations were published on Jan. 29, 1991 providing rules for applying Sec. 382 in a consolidated return context. The new rules generally treat an affiliated group filing a consolidated return as a single entity (i.e., as if the group's subsidiaries were unincorporated divisions of a single company). The group generally experiences an ownership change when the parent experiences an ownership change. Prop. Regs. Sec. 1.1502-96(b)(1)(i) however, provides special rules for subsidiaries. A subsidiary will experience an ownership change with respect to loss group or loss subgroup attributes (defined in Prop. Regs. Sec. 1.1502-91(c)(1) and (d)) when the deemed exercise of an option to acquire more than 20% of a subsidiary results in its ownership change (subject to the one-year rule previously discussed).

Conclusion

The option attribution rules are complex and can provide unanticipated results. The definition of an option is extremely broad, encompassing a wide variety of instruments and arrangements. As noted, certain narrow and limited exceptions to the option rule are prescribed in Temp. Regs. Sec. 1.382-2T(h)(4)(x). Temp. Regs. Sec. 1.382-2T(h)(4)(x)(Z) authorizes the IRS to prescribe more exceptions, which it has not yet seen fit to do. Hidden options, if undiscovered, could trigger an unanticipated ownership change, potentially placing a severe limitation on NOL utilization.

From Paul F. Sheahen, CPA, New York, N.Y., Ross S. Friedman, CPA, Washington, D.C., and Todd F. Crawford, CPA, Houston, Tex.