Effect of subsequent events on an option deemed exercised under the final Sec. 382 option regulations.

• Author: Bloom, Gilbert D.

Background

With few exceptions, the temporary option regulations under Sec. 382 (effective for the period Jan. 1, 1987 until Nov. 4, 1992) disregarded all contingencies as to time and event, and treated the creation and transfer of an option as a transfer of the underlying stock, provided that deemed exercise of the option (either standing alone or coupled with other owner shifts) resulted in an ownership change. Under the temporary regulations, seemingly innocuous options could be treated as options deemed exercised.

Under Regs. Sec. 1.382-4(d)(2), issued on Mar. 17, 1994 (and retroactive for all owner shifts occurring on or after Nov. 5, 1992), options are considered the equivalent of the underlying stock (i.e., are deemed exercised) so as to contribute to an ownership change under Sec. 382 only if they run afoul of an ownership test, a control test or an income test. These three tests share a common factor: a principal purpose of the issuance, transfer or structuring of the option is to avoid or ameliorate the impact of an ownership change of the loss corporation (a "prohibited purpose"). The ownership test is triggered if the prohibited purpose is coupled with the transfer of a substantial portion of the attributes of ownership of the underlying stock. The control test is triggered if the prohibited purpose is coupled with the option holder owning more than 50% of the stock of the loss corporation. The income test is triggered if the prohibited purpose is coupled with the creation of income or value before the exercise or transfer of the option.

The determination of whether an option is treated as stock is made on the date the option is issued or transferred. If the option is deemed stock on that date, it is treated as stock on any subsequent testing date until it contributes to an ownership change. Thereafter, it will not be treated as exercised and it will not contribute to a further ownership change, even on later actual exercise.

Options treated as exercised

Under the temporary regulations, options were deemed exercised only if they contributed to an ownership change. Under the final regulations, options can be deemed stock even if they do not presently cause an ownership change. Moreover, the transfer of an option previously deemed exercised but that has not yet caused an ownership change will be treated as the transfer of the underlying stock.

Under the temporary regulations, the lapse or forfeiture of an option that contributed...