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

• Author: Lombardo, Mario E.

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...