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Proposed regulations treat options as exercised only if issued or transferred for an abusive principal purpose.

Sec. 382. may severely limit the amount of net operating loss (NOL) carryforward a corporation may use to offset income in any future year. In order for Sec. 382 to apply, the loss corporation must have undergone a more-than-50-percentage-point change in ownership as defined under the Code. All actual and constructive changes in ownership are considered. For these purposes Temp. Regs. Sec. 1.382-2T(h)(4) states that stock options, warrants, convertible debentures, or any other instrument that would entitle its holder to stock, are considered to be exercised only if they were to produce an ownership change; this "deemed exercise rule" is applied separately to each class of options, each option holder and each combination of holders. In addition, only positive increases are counted toward the 50-percentage-point change; any actual or otherwise deemed decreases in ownership are disregarded.

These rules require a loss corporation to consider numerous combinations in which various options might be considered exercised. More often than not, extensive calculations are required, making it extremely difficult to determine whether the deemed exercises of options have actually caused an ownership change.

In response to this difficulty, on Nov. 5, 1992, the Service issued proposed regulations that ease the application of the option rules. Under the proposed regulations, options are treated as exercised only if they were issued or transferred for an abusive principal purpose. An abusive principal purpose is defined as the issuance of an option for the principal purpose of manipulating the timing of an owner shift to avoid or improve the impact of an ownership change either by - providing the holder of an option prior to its exercise with a substantial portion of the attributes of stock ownership, or - facilitating the creation of income to absorb the corporation's losses prior to exercise of the option.

The determination of whether an option is issued or transferred for an abusive principal purpose is based on all relevant facts and circumstances. The proposed regulations include the following nonexclusive list of factors that evidence an abusive principal purpose. * An exercise price substantially less than the value of the underlying stock at the time the option is issued or transferred. The regulations provide a safe harbor if the options' exercise price is at least 90% of the fair market value (FMV) of the corporation's stock. (The Service has yet to issue guidance if the FMV of the corporation's stock is not readily available.) * Participation by the option holder in the management of the corporation other than through a bona fide employment agreement. * Giving the option holder rights that ordinarily would be afforded to owners of the underlying stock (e.g., dividend or voting rights, or rights to proceeds on liquidation). * Matching call and put options. * Contributions to the capital of the loss corporation. By contributing additional capital to the loss corporation, the corporation's earnings capability could be increased, which could result in the creation of additional prechange income, thereby reducing the corporation's NOL carryover subject to the Sec. 382 limits. * Other transactions entered into by the loss corporation that would serve to accelerate income or defer deductions, losses or credits into the postchange period.

If a loss corporation does not treat an option to which one of the specific abuse factors applies as exercised, the corporation must disclose to the Service the terms of the option and all relevant facts and circumstances that affect the treatment of the option under the regulations.

The option rules provided in the proposed regulations generally would apply to testing dates on or after Nov. 5, 1992. However, certain transitional rules may apply.

Although the proposed regulations have simplified the deemed exercise treatment of options under Sec. 382, they eliminated other transactions that were considered exempt under Temp. Regs. Sec. 1.382-2T(h)(4)(x). Some of the more notable transactions that are no longer exempt are: * The right to receive, or obligation to issue, a fixed dollar amount of value of stock on maturity of certain corporate debt. * The right to receive, or obligation to issue, stock as interest or dividends (e.g., loss corporation issues stock in lieu of making its semiannual interest payment on its corporate debentures). * The right of a domestic bank to acquire loss corporation stock pursuant to a default under a loan agreement. The right to acquire stock of a corporation by a bank solely as the result of a default under a loan agreement in and of itself may not be considered an option issued for an abusive principal purpose. However, if the loan agreement provides for the bank's participation in the management of the corporation or gives the bank rights normally afforded to shareholders (e.g., preferential rights to proceeds on liquidation), the loan agreement might be considered an option issued for an abusive principal purpose and thereby considered exercised for the purpose of testing whether or not the loss corporation has experienced an ownership change.

As a final note, there are two additional aspects of the proposed regulations that deserve special mention.

First, under Temp. Regs. Sec. 1.382-2T(g)(4)(viii), if an option that was originally treated as exercised lapses or is irrevocably forfeited, the option is treated as if it had never been issued. In that case, the loss corporation may file amended tax returns for all prior tax years in which the presumed ownership change adversely affected its NOL deduction - subject to the statute of limitations. Under the new proposed regulations, no such procedure exists.

And finally, the proposed regulations modify the treatment of options outstanding before and after an ownership change. Under the old rules, options in existence immediately before and after an ownership change (whether or not considered exercised) were considered to be exempt for the purpose of calculating any future ownership changes so long as the option continues to be owned by the same 5% shareholder.

Under the proposed regulations, if an option was not deemed to have been exercised (i.e., is not considered abusive) as of a particular change date, it is not exempt from future exercise - deemed or otherwise. In addition, there is an alternative lookback rule for options exercised within three years after an ownership change.
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Author:Tarquinio, Andrew
Publication:The Tax Adviser
Date:Feb 1, 1993
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