Tips and traps under the Sec. 382 option attribution rules.

• Author: Sheahen, Paul F.

The option attribution rules in Sec. 382(1)(3) and Temp. Regs. Sec. 1.382-2T(h)(4) continue to frustrate taxpayers by causing unexpected ownership changes that impair the use of net operating loss (NOL) and other tax attribute carryovers. An understanding of these complex rules, including the pitfalls and planning opportUnities, is needed to help loss corporations with capital restructurings, equity issuances, acquisitions, tax compliance and accrual reviews.

Option defined

Temp. Regs. Sec. 1.382-2T(h)(4)(v) provides a nonexclusive list of instruments that are considered options: warrants, convertible debt instruments, instruments other than debt that are convertible into stock, puts, stock interests subject to risk of forfeiture and contracts to acquire or sell stock. Other examples (not identified in the regulations) include certain buy-sell arrangements, certain rights of first refusal, binding letters of intent to acquire stock, merger agreements, pledges of stock as security on debt from nonqualified lenders including non-U.S. banks), etc. The fact that an option is contingent on certain defined events (the likelihood or remoteness of which is not considered), or not currently exercisable pursuant to its terms, is ignored (Temp. Regs. Sec. 1.382-2T(h)(4)(iii)). This creates a broad and expansive definition of an option subject only to certain very limited exceptions (see Temp. Regs. Sec. 1.382-2T(h)(4)(x)). Noteworthy, however, is the Service's recent ruling that stock appreciation rights (SARs) would not be treated as interests similar to an option (Letter Ruling 9147031).

A loss corporation on the verge of an ownership change may exercise some control over the timing of a potential ownership change by drafting documents in a manner that avoids option status. The IRS has established a standard for determining when an instrument becomes an option. Under this standard, an instrument becomes an option when it is nonwithdrawable both from a legal and practical standpoint.

Treatment of an option deemed exercised

In testing for an ownership change, stock subject to an option will be treated as having been acquired on any testing date if the deemed acquisition would result in an ownership change (Temp. Regs. Sec. 1.382-2T(h)(4)(i)). For this purpose, the deemed exercise rules apply separately to each class of options and to each 5% shareholder, each holder of an option who could be a 5% shareholder if the option were deemed exercised, and...