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

• Author: Bloom, Gilbert D.

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...