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SAR's are not Sec. 382 "options." (stock appreciation rights do not qualify as stock options)

One of the most worrisome rules dealing with the limitation on the use of losses under Sec. 382 is the option rule.

The option rule

Stated simply, the rule generally deems an option exercised if such treatment results in an ownership change. This deemed exercise results in the option holder being treated as a shareholder (i.e., as acquiring the stock subject to the option) for purposes of determining Sec. 382 ownership changes. The operation of this rule is generally unfavorable for a taxpayer in that it cannot prevent an ownership change; rather, the rule operates only if it causes an ownership change.

The definitional worry

While the rule itself is clear and understandable, what is not clear (and is therefore worrisome) is the all-embracing definitional reach of an "option" for purposes of the rule.

Neither Sec. 382 nor its regulations define the term "option." However, the regulations define "an interest that is similar to an option" to include warrants, rights, convertible debt instruments, convertible stocks, puts, contracts to acquire or sell stock, and "other similar interests." For purposes of the definition, most contingencies are disregarded. Thus, it is immaterial whether the option is in-(or out-of)-the-money, is subject to a number of conditions precedent or is not exercisable for 30 days (or months or years).

Because of the inherently broad reach of this definition, the tax practitioner must constantly be on the alert for situations that involve the question of whether and when an option or "other similar interest" has been created. The test simply is not a bright line one and its application by the IRS is not always readily predictable. For example, the Service has ruled that an option was created when the board of directors of two corporations approved a sale (Letter Ruling 8847067) or agreed to merge (Letter Ruling 8903043); a loss corporation announced publicly that it would exchange stock for debt (Letter Ruling 8917007); a corporation entered into a standby agreement with an investor if stock was available after a conversion of a thrift association (Letter Ruling 9108032); a debtor entered into a tentative restructuring agreement evidenced by a term sheet (Letter Ruling 9111064); or a shareholder pledged stock as security for a loan (Letter Ruling 9148015).

SARS ate not options

or other similar interests

One issue that generated considerable concern in this area was the question of whether stock appreciation rights (SARs) rose to the level of an option. The concern was recently alleviated by the Service in a letter ruling, the facts of which follow. * The SARs were given to employees as incentives for their continued employment with the corporate issuer. * They entitled the holder to receive an amount equal to the difference between the closing price of a share of issuer's stock on the effective date of the employment agreement and the closing price of a share of issuer's stock on the earlier of the date of the employee termination or the date the employee's terminated the SAR. * They were not transferable. * They provided no rights to receive or vote any stock of the issuer.

On these facts, the Service ruled in Letter Ruling 9147031 that the SARs were not options "or other similar interests" for purposes of the ownership change rules of Sec. 382. The SARs described in the ruling appear to be typical ones; thus, the ruling is a generic one with broad application. Hopefully, it will be published as a revenue ruling.


IRS Letter Ruling 9147031 is also important for the many questions it does not address. For example: What if the SARs are issued by a closely held loss corporation to its employees/shareholders? What if they are issued to nonemployees? What if they are deep-in-the-money? What if they are not compensatory in character? What if they contain a right to obtain stock in a corporation related to the issuer? What if they give the issuing corporation the right to "pay off" the SARs in cash or stock? What if the SAR holders had the right to elect a member of the board of directors?

Currently, the only risk-free solution to these and other definitional questions involving whether and when an option is created under Sec. 382 is to obtain a ruling from the Service. Not to do so may jeopardize the client's full use of its valuable losses.
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Article Details
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Author:Lombardo, Mario E.
Publication:The Tax Adviser
Date:Jun 1, 1992
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