tax notes Volume 145, Number 7

November 17, 2014

by J. Walker Johnson and Brigid Kelly Reprinted from Tax Notes, November 17, 2014, p. 791

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Tax Restrictions Can Impede the Use of Options to Manage Risk

tax notes™ Tax Restrictions Can Impede the Use of Options to Manage Risk IV.

By J. Walker Johnson and Brigid Kelly J. Walker Johnson is a tax partner in the Washington office of Steptoe & Johnson LLP, and Brigid Kelly is a tax associate in the firm’s New York office. Qualifying options receive favored tax treatment — the option premium the option J. Walker Johnson writer receives when the option is written is not taxed until the option holder either exercises the option or the option expires without being exercised. However, the IRS denies this treatment to contingent options, which can be exercised only upon the occurrence or nonoccurrence of specified events. Brigid Kelly Johnson and Kelly analyze the rulings and case law that address the conditions that disqualify an option from receiving favorable tax treatment. They also identify conditions that should not disqualify an option for tax purposes and suggest a standard for making that determination. Finally, the authors review code provisions that refer to options, such as the section 318(a)(4) option attribution rules, and analyze whether options that either qualify or do not qualify for tax deferral should be treated consistently for purposes of those statutory provisions. Table of Contents I.

II.

III.

The Tax Treatment of Options . . . . . . . . . . A. The Tax History of Options . . . . . . . . . . B. The Current Tax Treatment of Options . . C. Characteristics of Qualifying Options . . . D. Straight Options as Qualifying Options . Disqualified Tax Options . . . . . . . . . . . . . A. Leases With an Option to Purchase . . . . B. Bilateral Sales Agreements . . . . . . . . . . . C. Options Lacking Substance . . . . . . . . . . Conditional Options . . . . . . . . . . . . . . . . . A. Liquidated Damages Clauses . . . . . . . .

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791 791 792 793 793 794 794 795 797 798 798

V.

VI.

B. Rights of First Refusal . . . . . . . . . . . . . . C. Optionor Inaction Conditions . . . . . . . . D. Third-Party Action Conditions . . . . . . . . Qualifying Contingent Options . . . . . . . . . A. Administrative Conditions . . . . . . . . . . B. Property Value Conditions . . . . . . . . . . C. Economic Bargain Conditions . . . . . . . . D. Unrelated Conditions . . . . . . . . . . . . . . E. Summary . . . . . . . . . . . . . . . . . . . . . . . Options Under Specific Code Provisions . . A. Section 318(a)(4) Option Attribution . . . . B. Section 1234 Character Rules . . . . . . . . . C. Section 246 Dividends Received Deduction . . . . . . . . . . . . . . . . . . . . . . D. Section 1091 Wash Sale Losses . . . . . . . . E. Section 1563 Controlled Groups . . . . . . . Conclusion . . . . . . . . . . . . . . . . . . . . . . .

799 799 800 801 802 802 803 804 804 805 805 808 808 810 811 811

Options have many traditional uses, such as aiding transfers of property, as well as more modern and creative uses, such as managing risk. In drafting option agreements, whether in a traditional or creative context, the parties often negotiate terms and conditions that they view as necessary to define and maintain the economic bargain they have struck. Those terms and conditions may require that the option writer (W) (also known as the optionor), the option holder (H) (also known as the optionee), or some third party take or forgo a specified action as a condition to H’s ability to exercise the option.1 Although the inclusion of various types of terms and conditions is frequently prudent from an economic and risk management standpoint, it can jeopardize an agreement’s qualification as an option for tax purposes. The goal of this report is to alert taxpayers to the potential hazards when they lose sight of the applicable tax requirements in drafting options agreements to secure an economic result. I. The Tax Treatment of Options A. The Tax History of Options Under section 61, gross income includes ‘‘all income from whatever source derived,’’ including ‘‘gains from dealings in property.’’ The timing of the

1 In this report, ‘‘W’’ is used to refer to an option writer or a purported option writer. Similarly, ‘‘H’’ refers to the option holder or a purported option holder.

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SPECIAL REPORT

COMMENTARY / SPECIAL REPORT

2

Reg. section 1.451-1(a). The option premium (or option price) is the amount paid by H to W to acquire the option. The strike price (or exercise price) is the amount paid by H to W to exercise the option. 4 Virginia Iron Coal & Coke Co. v. Commissioner, 37 B.T.A. 195 (1938), aff’d, 99 F.2d 919, 921 (4th Cir. 1938) (premiums paid for a five-year option to purchase land rights were not included in W’s income until the year that the option lapsed). See also Pickard v. Commissioner, 46 T.C. 597 (1966). 5 99 F.2d at 921. 6 See LTR 9129002 (contract was held to be an option, so option premiums were not taxed until the year the option was exercised or lapsed); LTR 8011001 (accepting the Virginia Iron analysis). 3

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received, even when the recipient has a fixed right to retain the payments, because the character of those payments is uncertain until the option has been exercised or has lapsed.’’7 B. The Current Tax Treatment of Options As discussed above, an option premium is not taxable on receipt, but is taxable when H exercises the option or the contract lapses. If the option lapses, the premium is income to W in the tax year of the lapse.8 If H exercises the option, the treatment of the premium depends on whether it is a put or a call. When a put is exercised by H, the premium that was not immediately taxable to W as income reduces W’s basis in the property acquired. Thus, W’s basis is determined by taking into account the consideration W pays to H when the put is exercised (the option’s strike price), reduced by the option premium previously received.9 Rev. Rul. 58-234 explains that in determining net cost basis on a put, the option premium originally received is an offset against the option price paid upon its exercise. When a call option is exercised, the option premium is taken into account in calculating the amount of gain or loss recognized (amount realized minus basis) by W on the sale of the property. The amount realized by W includes not only the consideration paid for the property, but also the option premium previously received.10 As Rev. Rul. 58-234 states, the premium received by W for granting the call option is includable by W with the option price, which W received upon the option’s exercise, in the total amount realized for the assets that W sold. When W issues the option through an agent or broker, the commission paid to the agent or broker

7 Federal Home Loan Mortgage Corp. v. Commissioner, 125 T.C. 248, 258 (2005) (Freddie Mac). See also Elrod v. Commissioner, 87 T.C. 1046 (1986); Koch v. Commissioner, 67 T.C. 71 (1976); Kitchin v. Commissioner, T.C. Memo. 1963-332, aff’d, 353 F.2d 13 (4th Cir. 1965). 8 Virginia Iron, 99 F.2d at 921 (the option premiums were included in W’s income once H failed to extend the option and notified W that the option would not be exercised); Freddie Mac, 125 T.C. at 260-261 (the nonrefundable portion of premiums for put options to buy mortgages were not included in W’s income until the options expired); Rev. Rul. 58-234 (the premium received by W for a put or call option that is not exercised constitutes ordinary income to be included in W’s gross income only for the tax year in which the failure to exercise the option becomes final). 9 Freddie Mac, 125 T.C. at 268 (W properly treats the option premium as a reduction in the consideration that W pays for the mortgage if the option is exercised); Rev. Rul. 78-182. 10 See Commissioner v. Dill, 33 T.C. 196, aff’d, 294 F.2d 291 (3d Cir. 1961) (option premium was applied to purchase price and not a separate royalty payment); Rev. Rul. 58-234; Rev. Rul. 78-182.

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recognition of gross income is governed generally by section 451. Section 451(a) provides that ‘‘the amount of any item of gross income shall be included in the gross income for the taxable year in which received by the taxpayer, unless, under the method of accounting used in computing taxable income, such amount is to be properly accounted for as of a different period.’’ Accrual method taxpayers normally recognize income when all the events have occurred that fix the right to receive income and the amount of income can be determined with reasonable accuracy.2 Despite these general rules, it has long been settled that an option premium3 is not recognized as income when received, even though the recipient, W, has a fixed right to retain the premium.4 The Fourth Circuit in Virginia Iron Coal & Coke Co. v. Commissioner5 found that the tax treatment of W would differ depending on future events, and it held that the uncertainty made it impossible to tax the option premium in the year it was received. The IRS endorsed that result in Rev. Rul. 58-234, 1958-1 C.B. 279, explaining that there is ‘‘no closed transaction nor ascertainable income or gain realized by an optionor upon mere receipt of a premium for granting such an option.’’ The ruling states that no income, gains, profits, or earnings are derived from the receipt of either a put or call option premium until the option lapses or it is terminated upon the optionor’s payment of an amount less than the premium. The IRS reaffirmed that ruling in Rev. Rul. 78-182, 1978-1 C.B. 265. The guidance states that the premium received for writing a call or put is not included in W’s income at the time of receipt but is carried in a deferred account until (1) W’s obligation expires through the passage of time, (2) W sells or purchases the underlying asset in accordance with the exercise of a call or put, or (3) W engages in a closing transaction.6 Courts continue to accept and apply that rule. In 2005, for example, the Tax Court held that ‘‘payments of option premiums are not recognized when

COMMENTARY / SPECIAL REPORT

C. Characteristics of Qualifying Options To be treated as an option for tax purposes, the parties’ agreement must meet the technical tax definition of an option. Historically, a qualifying option contains ‘‘a continuing offer to do an act, or to forbear from doing an act, which does not ripen until accepted; and . . . an agreement to leave the offer open for a specified or reasonable period of time.’’12 An option contract can be more specifically described as a unilateral agreement entered into for consideration that binds W to buy or sell property and gives H the right, but not the obligation, to sell or buy that property for a specified price during a specified period.13 A put option allows H to sell property to W, while a call option allows H to buy property from W.14 D. Straight Options as Qualifying Options Case law on the tax treatment of options clearly requires that W provide H a unilateral and unfettered right to exercise the option. Stated differently, the general rule is that H’s ability to exercise an option must not be conditional or contingent on an act or event. A seminal decision is Virginia Iron, in which W sold H an option to purchase property for a fixed sum during a five-year period in exchange for annual cash payments. After the agreement was executed, W retained the use and possession of the property. The agreement provided that if H exercised its option, the payments previously made would be applied against the option exercise price. Alternatively, if H surrendered the option, W would retain the payments. H later failed to exercise the option, and W retained all payments previously made. Both the Tax Court and the Fourth Circuit

11

Rev. Rul. 58-234. 12 Freddie Mac, 125 T.C. at 259. 13 Id. at 261; see also Koch, 67 T.C. at 82; Rev. Rul. 58-234. Various other formulations have also been used. See, e.g., Old Harbor Native Corp. v. Commissioner, 104 T.C. 191, 201 (1995); Saviano v. Commissioner, 80 T.C. 955, 970 (1983), aff’d, 765 F.2d 643 (7th Cir. 1985); Joint Committee on Taxation, ‘‘Present Law and Analysis Relating to the Tax Treatment of Derivatives,’’ JCX-2108, at 5 (Mar. 4, 2008). 14 Rev. Rul. 58-234.

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found that H had an unfettered right to exercise the option and held that the option qualified as such for tax purposes. Later cases have referred to options such as the one in Virginia Iron as straight options.15 Straight options have no terms or conditions that prevent them from meeting the strict, technical definition of a qualifying option. Although the courts have used varying language to describe a straight option, they agree that the three key aspects are (1) a unilateral agreement entered into for consideration (2) that binds W to buy or sell property and (3) gives H the right, but not the obligation, to sell or buy that property. Without these characteristics, an agreement will not qualify as an option for tax purposes. Section II discusses the requirement that the option be a unilateral agreement entered into for consideration. An agreement will not constitute an option if the consideration paid in a transaction is for a purpose other than a true option. This typically occurs when the purported option is in substance something else, such as a lease or a bilateral sales agreement. Section III discusses the requirement that W be unconditionally obligated to buy or sell if H exercises the option. In Holmes v. Commissioner, for example, the Tax Court held that an ‘‘option is the creation of an obligation by which one binds himself to sell and leaves it discretionary with the other party to buy. In other words, an option is a contract by which the owner of property agrees with another that he shall have the right to buy property at a fixed price within a time certain.’’16 In a similar vein, the Fourth Circuit in Halle v. Commissioner said that an ‘‘option requires a seller to keep his offer to sell property at a stated price open for a defined period.’’17 Sections III and IV discuss the requirement that a straight option cannot have a term or condition that compels or restricts H’s ability to exercise the option. For example, in Estate of Franklin v. Commissioner, the Tax Court said that a true option ‘‘gives the optionee no present estate . . . and imposes on him no obligation to consummate the transaction.

15 See Kitchin, 353 F.2d at 15; Dill, 33 T.C. 196; Perma-Rock Products Inc. v. United States, 373 F. Supp. 159, 164 (D.C. Md. 1973) (‘‘the straight option exists in an economic vacuum’’). See also ECC 201023055. 16 T.C. Memo. 1978-437. Typically, the cases have defined options by reference to call options, under which H can elect to purchase the optioned property. However, the definitions apply equally to put options, in which H can elect to sell the optioned property. 17 83 F.3d 649, 654 (4th Cir. 1996), rev’g and remanding Kingstowne LP v. Commissioner, T.C. Memo. 1994-630.

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is subtracted from the option premium in determining the net option premium received by W.11 If the option lapses, the amount W includes as income is the net option premium (the option premium minus the commission). Similarly, if H exercises a put, W’s basis in the property is the consideration paid for the property, reduced by the net option premium. Rev. Rul. 58-234 explains that regardless of whether the commissions are charged to W or to H, only the net amount received by W is considered the amount received for issuing the option.

COMMENTARY / SPECIAL REPORT

II. Disqualified Tax Options Given the deferred tax treatment of qualifying options, disputes arise over whether a purported option agreement is in fact something else.24 The cases described below consider whether a purported option is instead a lease with a purchase option, a bilateral sales agreement, or some other arrangement that economically differs from a unilateral option contract. The amounts received under those agreements are generally taxable on receipt. These cases also illustrate the broader proposition

that merely labeling an agreement as an option is insufficient to obtain deferred tax treatment. Courts will look beyond labels to assess the economic substance and operation of the agreement. A. Leases With an Option to Purchase An agreement will not be recognized as an option for tax purposes if it is actually a lease of property with an option to purchase. The lease may bear a superficial resemblance to an option (that is, H makes payments that may be applied to the exercise price), but the transactions are economically dissimilar. In Kitchin v. Commissioner,25 the Tax Court considered equipment leases under which the lessee had a purchase option. Under the leases, the lessee paid monthly rent at rates the court found were competitive with those offered by other equipment rental companies. If the lessee exercised the purchase option, the lessor would retain all payments previously paid, and those payments would be applied to the purchase price. Upon exercise, the lessee also was obligated to reimburse the lessor for major maintenance expenses incurred by the lessor during the lease period. The lessor contended that the lease agreements qualified as options for tax purposes and that the monthly payments were not taxable when received. The court disagreed, finding that two aspects of the arrangement distinguished it from the straight option in Virginia Iron. First, while H in Virginia Iron was permitted to explore the land and remove ore for test purposes, W otherwise retained full control over the property. In contrast, the lessee in Kitchin obtained the full use and possession of the equipment. Second, while H’s payments in Virginia Iron were solely for the purpose of retaining the option, the primary purpose of the payments in Kitchin was as rentals for the use of property. The Tax Court held that this distinction was crucial: ‘‘The primary purpose of the payment is to control its nature for tax purposes.’’26 The Fourth Circuit agreed, holding that the rent payments in Kitchin ‘‘represented a fair return for the use of the equipment’’ and that the lease agreements ‘‘were exactly what they purported to be; i.e., leases with options to purchase.’’27

18

64 T.C. 752, 762 (1975), aff’d, 544 F.2d 1045 (9th Cir. 1976). 422 F.2d 887, 895 (Ct. Cl. 1970). 20 Holmes, T.C. Memo. 1978-437. 21 Halle, 83 F.3d at 654. 22 Saviano, 765 F.2d at 651; Carter v. Commissioner, 36 T.C. 128, 130 (1961). 23 Old Harbor, 104 T.C. at 201. 24 Although taxpayers generally prefer option treatment, it is not unheard of for the IRS to seek option treatment over a taxpayer’s objection. See Virginia Iron, 37 B.T.A. 195 (the years in which the payments were received were closed, but the year in which the option was terminated was open). 19

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25

T.C. Memo. 1963-332. In Kitchin, the Fourth Circuit noted that when H has possession of the option property, there is a ‘‘tax-necessity of differentiating between the amount paid for the privilege of the option and that paid as consideration for the thing optioned,’’ i.e., rent. 353 F.2d at 15. 27 Id.; see also Howlett v. Commissioner, 56 T.C. 951 (1971) (same result). As noted above, H’s ability to exercise the option was conditioned on its reimbursing W for maintenance expenses incurred. This may have constituted a condition to exercise the option. 26

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He has the choice of exercising the option or allowing it to lapse.’’18 The predecessor of the Court of Federal Claims, in U.S. Freight Co. v. United States, emphasized that H must have ‘‘the truly alternative choice’’ of exercising the option or allowing it to lapse.19 Similarly, the Tax Court explained in Holmes that H must not be constrained to exercise or not exercise the option; an option grants H a choice of whether to buy the optioned property at a specified price within the specified period.20 The Fourth Circuit echoed the same theme in Halle, stating that the ‘‘would-be purchaser of the property thus pays a premium for the choice of whether to proceed with the purchase of the property. Inherent in that choice is the absence of any obligation to proceed.’’21 Thus, H’s obligation differs significantly from W’s obligation. While an option must be inflexibly binding on W, it must give H a discretionary yet unconditional power of acceptance.22 The Tax Court emphasized that difference in Old Harbor, observing that the option’s primary legal effect is that it limits the promisor’s power to revoke his offer while creating an unconditional power of acceptance in the offeree.23 The foregoing discussion has focused on the technical definition of a generic straight option. The courts and the IRS have had to apply that technical definition to actual fact patterns and decide when agreements are sufficiently different from straight options that they fail to qualify as options for tax purposes.

COMMENTARY / SPECIAL REPORT

A situation factually distinguishable but similar in result to Virginia Iron was addressed in Commissioner v. Dill.30 There, W licensed rights in a product to H in exchange for royalty payments, also giving H an option to purchase those rights for $350,000 before a specified date. H could extend the license and option period by paying $50,000, in which case the option exercise price would be reduced to $300,000. If the option was not exercised, the $50,000 payment would be forfeited. The IRS contended that the $50,000 payment was an additional royalty paid to extend the license agreement. Attempting to factually distinguish the case from Virginia Iron, the IRS argued that in an ordinary option agreement, the purchaser of the property does not have the use of the property until he decides to purchase it and the payments’ only significance is to keep the purchase offer open, whereas under the lease-option arrangement at issue in Dill, the royalty payments (including the $50,000 payment) are designed to compensate the lessor for the use of his property before an exercise of the purchase option. The court rejected the assertion that the $50,000 payment was an additional royalty. It noted that Virginia Iron involved a straight option, while here the licensee actually had use of the trademark. ‘‘The fact that the licensee here paid the stipulated royalties for that use must not be overlooked.’’31 The court held that the $50,000 payment was both a payment to extend the option agreement and a credit on the $350,000 option exercise price. It further held that because the $50,000 payment was a credit on the option exercise price in the event that

28

Perma-Rock, 373 F. Supp. 159. Id. at 166. 30 294 F.2d 291 (3d Cir. 1961). 31 Id. at 301. 29

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the option was exercised, it was not taxable until the option was exercised or expired.32 The IRS indicated its agreement with the analysis in these cases in LTR 9129002. In the letter ruling, W granted H an exclusive option to purchase real property during a specified period for a specified price per acre. Under the arrangement, H did not have possession of the property but could, upon notice and provision of an indemnity against liability, enter the property to perform surveys, tests, and inspections. Citing Howlett v. Commissioner33 and Kitchin, the IRS noted that an agreement that gives H exclusive control over the property before the exercise of the option may be treated as a lease in substance. Under the facts at issue and based on Virginia Iron, the IRS concluded that H’s right of access to the land at all times was ‘‘too limited to cause its annual payments to be characterized as rental payments and taxed when received,’’ and it treated the agreement as an option for tax purposes. In sum, to determine if these types of arrangements are a qualifying option for tax purposes, the key factors are whether H has too much possession or control over the option property before the option is exercised and, if so, whether separate and sufficient rent or royalty payments are being made for that possession and control. Those two factors explain why there was a qualifying option in Virginia Iron and Dill, but not in Kitchin and PermaRock. B. Bilateral Sales Agreements An agreement also will not be recognized as an option for tax purposes if it is actually a completed sales contract under which there are ‘‘mutual obligations on the part of the seller to sell and the buyer to buy.’’34 The contract may be drafted to resemble an option, with payments to W and an option to purchase in the hands of H. However, as with the lease transactions discussed earlier, the transactions are economically different from an option. Unlike H, who is subject to no enforceable obligation to pay the purchase price and has the choice of exercising the option or allowing it to lapse, the purchaser in a bilateral contract is liable for full contract damages if it fails to perform.35

32

The taxpayer also argued that if the $50,000 payment was indeed both a credit on the $350,000 option exercise price and a payment to extend the license agreement, it should be allocated between those two purposes. The courts held that the payment was not susceptible to allocation and was a credit on the purchase option exercise price. Id. 33 Howlett, 56 T.C. 951. 34 Estate of Franklin, 64 T.C. at 763. 35 Id. at 762-763.

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In another case, Perma-Rock Products Inc. v. United States, the parties executed a lease with an option to purchase, under which H paid an initial rent deposit and periodic rental payments thereafter.28 H could exercise the option by paying an exercise price, reduced by rent previously paid. The court held that the agreement was a lease and that the purported option premiums were ‘‘fairly bargained amounts relating to the use of leased machinery and equipment.’’29 Thus, the initial rent deposit and other rents paid were included in W’s income when received, while the final balance of the option exercise price (after reduction by rent paid) was included in W’s income upon exercise of the option.

COMMENTARY / SPECIAL REPORT

gation on H to complete the transaction. Third, because the lease was a triple net lease with W responsible for maintenance, insurance, and taxes, H did not acquire the burdens and benefits of ownership. In sum, the sales agreement and lease, when considered together, at most gave H an option to buy the property at the end of the transaction. A similar result was reached on different facts in Koch v. Commissioner.37 W and H entered into a contract granting H a series of options to purchase property owned by W. The contract specified purchase prices for the property as well as nonrefundable contract payments that were percentages of those purchase prices. The payments were due quarterly and were required in order to keep the purchase options effective. The IRS contended that the parties’ agreement was not an option and that the contract payments constituted interest payments on the purchase price. The court disagreed with the IRS and held that the agreement was an option because W had made a binding commitment to hold the property available for purchase during the option period and because H was permitted but not required to purchase the property during that period. The court further held that H had no indebtedness to W on which interest could accrue because H had no fixed obligation to W to purchase any property. In the court’s view, the fact that the contract payments were based on a percentage of the purchase prices did not mandate their treatment as interest. A final issue gave the court more pause. The parties’ agreement did not provide that the contract payments would be applied to reduce the option exercise purchase prices. In prior cases, the fact that option premiums would be applied to reduce the option exercise purchase price was integral to the justification for option treatment on the theory that ‘‘only upon termination of the option would it be apparent whether the payments represented clear gain to the taxpayer rather than a return of capital.’’38 As the court held in Virginia Iron,39 use of the option payments to reduce the purchase price was a condition attached to their receipt — that single condition was the determining factor in that case. Until that condition was removed, the question of the recipient’s liability for income tax on the payments had to be held in abeyance. The Koch court, however, reasoned that it is unnecessary for option payments to reduce the purchase price if the negotiated purchase price was in fact less than it would have been if the option payments had been used to

37

67 T.C. 71. Id. at 86. Virginia Iron, 37 B.T.A. at 199.

38 36

87 T.C. 1046.

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Elrod v. Commissioner36 is an illustrative case. The parties entered into what they labeled as an optional sales contract. They agreed to a $4.3 million sales price for the option property, and H agreed to pay W an $825,000 down payment at closing, which equaled approximately 20 percent of the $4.3 million option exercise price. W also received notes with an aggregate principal amount of approximately $3.5 million. Thus, the down payment plus the principal of the notes approximately equaled the option exercise price. H also agreed to pay monthly option extension premiums in an amount equal to 6 percent of the aggregate of the notes’ principal amounts. W contended that the agreement was an option, under which H could satisfy the notes when due and purchase the property or withdraw and forfeit the down payment and any option extension premiums paid. The court disagreed, finding that an option price equal to 20 percent of the purchase price was excessive and that H received the benefits and burdens of ownership in the option property. At the closing, H received deeds and obtained title insurance, which led the court to conclude that the conveyances made under the contract constituted a completed sale. Estate of Franklin involved different facts and reached the opposite result. In that case, H entered into agreements with W purporting that H would purchase property from W and lease it back to W. In connection with the purchase, H made an initial cash deposit and agreed to pay the balance of the purchase price (which was not in an amount specified at closing) in monthly installments of principal and interest. Under the lease, W was obligated to pay monthly rent and was responsible for maintenance, insurance, and taxes. H claimed annual losses consisting of interest and depreciation. The IRS disallowed the losses, alternatively claiming either that the arrangement was a sham or that H had acquired an option to buy the property. The court held that the arrangement was not a contract for sale but that the sales agreement and the lease together created an option. The court relied on several factors to reach that conclusion. First, the sales price could not be determined until the end of the transaction, and until then, no cash changed hands except for the initial deposit, because H’s monthly payments and W’s monthly rent were equal in amount and were simply offset. Second, H was not obligated to purchase the property at the end of the transaction and owed no damages if the property was not purchased. Those facts brought the case within the rule of many decisions holding that an option imposes no obli-

COMMENTARY / SPECIAL REPORT

C. Options Lacking Substance In addition to meeting the technical requirements of an option, an agreement must possess the economic substance of a true option. An essential part of any option, according to the courts, is that its potential value to H and its potential future detriment to W depend on the uncertainty of future events. ‘‘An optionee is willing to pay for potential future value, and the optionor is willing to accept a potential future detriment for a price.’’41 That economic substance analysis is critical, and it focuses on the economic bargain that the parties have struck regarding perceived risks and benefits. In a typical put option, for example, H pays a premium to W for the right to sell property to W at an agreed price sometime in the future. If the market value of the property falls below the agreed exercise price, H can sell the property to W for a price greater than the property’s value at the exercise date. H has reduced its risk associated with the value of the property, while W has increased its risk. This is the economic substance of put options. As discussed in Sections II.A and II.B, leases with purchase options and bilateral sales agreements lack the economic substance of an option. Other agreements that are cast as options in form also may in fact perform some other economic function and not qualify as an option in substance. An example is found in Berry Petroleum v. Commissioner,42 in which H reached a tentative agreement with W to purchase stock for $5 million. The parties later agreed to an alternative structure, under which H would buy the same stock for $3.8 million and also purchase an option from a related entity for $1.2 million. The option exercise price (after credit of the $1.2 million option payment) was more than $6.96 million, but the court found that the option property was worth only approximately $3 million. Based on these facts, the court held that in substance the $1.2 million was not paid for an option, but was instead disguised additional consideration paid for the stock.

A second example is Saunders v. United States,43 in which H located an investment property and assembled a group of investors. H made a relatively small investment and received a special option to purchase an additional interest in the property for himself. However, a defeasing proviso permitted the other investors to purchase H’s special option before its exercise. H then gave notice that he would exercise the special option, whereupon the other investors exercised their defeasing proviso. H reported the amount received from the other investors as capital gain resulting from the sale of his special option. The court denied capital gain treatment, holding that ‘‘the so-called Special Option was not a bona fide Commitment by Owners to sell an interest in real property, but instead was in reality a bare promise to pay money cleverly clothed in deceptive legal garb in an effort to effect a tax saving.’’44 The court concluded that the special option, viewed with the defeasing proviso, was ‘‘essentially illusory as an obligation to convey and that what the parties in reality intended, when they settled upon its terms, was the eventual implementation of the proviso’’ — a way to convert a payment for services, which is taxable as ordinary income, into capital gain.45 Without using the term ‘‘economic substance,’’ the court determined that the special option was an option in form only.46 In the same vein, other courts, while primarily focusing on contingencies as the basis for disallowing option tax treatment, have suggested that the substance of the agreements at issue differs from that of a true option. In Saviano v. Commissioner,47 for example, the Seventh Circuit said that labeling a contract as a gold option and creating the possibility of future payments was an ineffective attempt to achieve deferral of income. The court concluded that the purported option was instead a right of first refusal. Similarly, in Old Harbor, while holding that the agreements at issue were not taxable as options because of the existence of contingencies, the Tax Court also found that part of the purported option payments was consideration for having W promote

43

450 F.2d 1047 (9th Cir. 1971). Id. at 1050. 45 Id. 46 The court also said that because of the defeasing proviso, the property owners were not bound to sell and convey the property covered by the special option; they were given an alternative. Thus, the special option was not a unilateral agreement inflexibly binding on W. (See Section III, below.) 47 765 F.2d at 654. 44

40 Koch, 67 T.C. at 87. Rev. Rul. 58-234 concluded that an agreement was a qualifying option even though the option payments were not applied to reduce the purchase price. 41 Freddie Mac, 125 T.C. at 263. 42 104 T.C. 584 (1995).

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reduce that price if the option was exercised, because then the option payments effectively served as a reduction of purchase price.40 Stated differently, using an option exercise price of $90 and not crediting option premiums to the price is the equivalent of using an option exercise price of $100 and crediting $10 of option premiums to reduce the option price to $90.

COMMENTARY / SPECIAL REPORT

III. Conditional Options As described above, courts have defined straight options as options that H has an unfettered right to exercise or not. The Tax Court in Freddie Mac relied on Old Harbor for the proposition that an option creates an unconditional power of acceptance in H, and it held that an agreement that is contingent or otherwise conditional on some act of W is not an option.49 Citing U.S. Freight, the court also reaffirmed that H must have a ‘‘truly alternative choice’’ to exercise the option or allow it to lapse.50 In recent years, the IRS has maintained that the case law supports a somewhat expansive view of what constitutes a contingent or conditional option. Certainly, the IRS often has a clear basis for disqualifying contingent options as options for tax purposes. How far that position should extend, however, is open to debate. One way to analyze the issue is to examine the case law that the IRS relies on for its broad ‘‘contingent option’’ position. A. Liquidated Damages Clauses In considering whether H’s ability to exercise its option is unfettered, courts have examined arrangements in which W is bound to sell and H, although not bound to purchase, is subject to a liquidated damages clause if it fails to purchase. Despite H’s right not to exercise the option, courts have held that these agreements do not constitute options for tax purposes if the liquidated damages clause effectively compels H to exercise its option, thus depriving it of an unfettered choice. In U.S. Freight, H agreed to purchase property from W, made a $500,000 down payment, and agreed that if it defaulted, it would pay W the $500,000 as liquidated damages. The court noted that in form, the arrangement was a bilateral buy

48 Old Harbor, 104 T.C. 191. A court may determine that a transaction in which options are involved lacks economic substance as a whole, without making a holding specific to the options. For example, in Blum v. Commissioner, T.C. Memo. 2012-16, aff’d, 737 F.3d 1303 (10th Cir. 2013), the courts considered an offshore portfolio investment strategy tax shelter transaction that involved call and put options and the section 318(a)(4) option attribution rules. While noting that the options were overpriced, the courts did not rely on that finding. They instead held that although the transaction complied with the literal terms of the code, as a whole it was a subterfuge that lacked economic substance. 49 Freddie Mac, 125 T.C. at 258-259. 50 Id. at 259.

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and sell contract, and it concluded that the existence of the liquidated damages clause did not convert the bilateral contract into an option. The court held that for the arrangement to be an option, H must have ‘‘the truly alternative choice of exercising the option, or allowing it to lapse.’’51 With a genuine option, an H that does not exercise its option forfeits only the option price. If a party to a bilateral contract with a liquidated damages clause fails to perform, it owes the liquidated damages. The ‘‘compared interests do not have . . . the same economic effect,’’ the court said.52 Thus, the obligation to pay liquidated damages deprives H of a meaningful choice not to exercise the option. These issues also were considered in Halle, in which H and W entered into an agreement under which H made a $3 million deposit and obtained ‘‘an existing, unconditional, and legally enforceable obligation to purchase’’ property from W for $29 million (with the balance of $26 million due at closing).53 The agreement imposed at least $3 million of liquidated damages on H if it failed to purchase the property, but it did not expressly give H the option to withdraw from the transaction. The IRS maintained that H had purchased the functional equivalent of a call option to purchase the property because H could walk away from the deal at any time and refuse to pay the remaining $26 million. The court rejected that argument, holding that the agreement’s terms imposed on H an unconditional and legally enforceable obligation to purchase the property — an obligation that reflected the economic reality of the arrangement. Importantly, the court recognized that with an option, H must have the choice of whether to proceed. The court initially focused on the amount of the liquidated damages, observing that ‘‘the greater the sanction for failing to discharge a contractual obligation, the less free the obligor is to walk away from the deal.’’54 It held that the amount of liquidated damages was sufficient to restrict H’s choice and to prevent treatment of the agreement as a true option. Similarly, in finding a lack of choice, the court emphasized that H assumed burdens of owning the property by incurring $500,000 of development expenses. The court found this significant because

51

U.S. Freight, 422 F.2d at 895. Id. 53 Halle, 83 F.3d at 658. 54 Id. at 655. See Williams v. Commissioner, 1 F.3d 502, 507 (7th Cir. 1993) (as the amount of liquidated damages approaches the purchase price, ‘‘a point is reached at which the sale is not of the call but of the’’ option property). 52

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legislation and consummate a proposed agreement.48 Although facts concerning the substance of purported options may have influenced the courts, that does not render their contingent option holdings moot or irrelevant.

COMMENTARY / SPECIAL REPORT

Thus, these cases suggest that the presence of a liquidated damages clause will prevent the existence of an option for tax purposes only if the specified damages are large enough to influence H’s decision whether to exercise the option. B. Rights of First Refusal Various cases have considered purported option arrangements under which W must perform or refrain from an act before H may exercise the option. The courts have uniformly held that no option exists because H lacks an unconditional ability to exercise the option. The first category of these cases involves rights of first refusal. In Holmes, two shareholders, W and H, agreed that if one of them obtained a written offer to sell their stock to a third party, that person would give the other party a right of first refusal (that is, the right to purchase the stock in lieu of its sale to the third party making the written offer). H gave W $52,500 as consideration for the right of first refusal granted to W, which W claimed was an option premium excluded from income when received. The court began its analysis by noting that in a call option, W ‘‘binds himself to sell and leaves it discretionary with the other party to buy.’’57 Thus, there must be an irrevocable offer to sell. The court held, however, that in the arrangement at issue, H could purchase the stock under the right of first refusal only if W first received a written offer and decided to sell. If W received no written offer or received an offer but decided not to sell, H had no right to exercise the option. The agreement did not inflexibly bind W to sell the stock, and H had no unconditional option to purchase the stock. Thus, the agreement was not an option for tax purposes. This treatment of rights of first refusal is well established.58

In other situations involving rights of first refusal, option treatment also has been denied because W must perform some activity before H can exercise the purported option. In Saviano, H acquired from W a gold claim in French Guiana. As part of the arrangement, W sold H a purported option to purchase gold mined from the claim in the event that W actually mined any gold. Because W had to mine gold before H could purchase it, W could prevent H from exercising the option by deciding not to mine for gold. Accordingly, the Tax Court concluded that W, rather than H, was the party with a choice. It held that W’s action in mining the gold was a condition precedent to the exercise of the option that negated its validity for tax purposes. The Tax Court said that if H’s power to accept depends on some further act of W, there is no unconditional option contract; rather, H has ‘‘nothing more than a conditional preferential right of first refusal.’’59 On appeal, the Seventh Circuit agreed that the purported gold option was not a true option because it did not create ‘‘an unconditional power of acceptance’’ in H.60 Old Harbor involved three contingencies affecting H’s right to exercise an option, the first of which involved W.61 Under lease agreements, W granted H a purported option to lease subsurface rights that W had not yet acquired. W still needed to execute an agreement with the federal government to obtain them — an event that never occurred. The IRS characterized the purported option as a future and conditional election and a right of first refusal. The court agreed, holding that the arrangement was not an option because W had to first obtain ownership of the subsurface rights before it could sell them to H, and the lease agreements were otherwise unenforceable until that happened. Accordingly, H had no unconditional power of acceptance, and the lease agreements were not an option for tax purposes. C. Optionor Inaction Conditions H’s ability to exercise its option also may be conditioned on W’s failure to act or, stated differently, failure to maintain the status quo. Recall that in Saunders, W granted H a special option to purchase an interest in property. The agreement contained a defeasing proviso under which W could purchase the special option at any time before H was able to exercise it. The Ninth

55

Halle, 83 F.3d at 657. 96 T.C. 724 (1991), aff’d sub nom. Noguchi v. Commissioner, 992 F.2d 226 (9th Cir. 1993). 57 Holmes, T.C. Memo. 1978-437 (emphasis in the original). 58 See, e.g., Anderson v. United States, 468 F. Supp. 1092 (D.C. Minn. 1979); Saviano, 765 F.2d 643; LTR 8106008; and LTR 8038048. 56

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59

Saviano, 80 T.C. at 970. Saviano, 765 F.2d at 651. See also Becker v. Commissioner, 868 F.2d 298 (8th Cir. 1989). 61 The other two contingencies are discussed in Section III.D, below. 60

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one ‘‘who invests significant, unrecoverable resources in property that he does not legally own . . . is less likely to hold merely an option in that property.’’55 A different result was reached in Midkiff v. Commissioner,56 in which the Ninth Circuit found that the damages for non-exercise of an option were nominal. The court determined that the damages were so slight that H could back out of the deal at any time.

COMMENTARY / SPECIAL REPORT

D. Third-Party Action Conditions The question also arises whether arrangements are options if a third party must perform an act before H may exercise the option. The case law is unsettled on this issue, and a decisive analysis is difficult because the courts have considered both call and put options. In Old Harbor, which involved a call option, the court noted that H’s ability to exercise the option was subject to various contingencies outside W’s control. One was that W first obtain the subsurface rights — an act that would require legislation authorizing the Interior Department to grant W access. As the court observed, ‘‘The power to enact this legislation always remained completely in the hands of Congress.’’62 Moreover, even if Congress passed the necessary law, W could not acquire the subsurface rights unless the Interior Department exercised the authority granted to it. Thus, H had no unilateral and unconditional ability to exercise the call, and the contract was not an option for tax purposes.63 Freddie Mac, by contrast, involved a put option. Freddie Mac (W) and a mortgage originator (H) entered into an agreement under which H paid a premium to W in exchange for W’s obligation to purchase a mortgage from H if H was able to make the mortgage loan to a third party and exercised the option.64 W contended that this arrangement constituted a put option for tax purposes. The IRS disagreed, focusing on the fact that H would forfeit the premium paid to purchase the option if it was unable to consummate the loan and thus unable to

62

Old Harbor, 104 T.C. at 202. See also FSA 1993-1200 (Apr. 2, 1993) (an option that could be exercised only if approved by a bankruptcy court was held not to be an option). 64 Under a less expensive arrangement, a loan originator could enter into a contract committing to sell and deliver a loan to Freddie Mac. If the loan was not consummated and the originator was unable to fulfill that delivery commitment, the originator would be disqualified or suspended from selling mortgages to Freddie Mac. At issue in the case was an alternative option arrangement under which, for a higher premium, the originator would not be penalized for failing to deliver a mortgage to Freddie Mac. 63

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put the loan to W. Citing Halle, the IRS contended that the potential forfeiture was onerous enough that it was ‘‘virtually certain that the mortgage sale [would] be consummated, negating any real option for the originator.’’65 Citing U.S. Freight, the court recognized that an essential characteristic of an option is that H must have a truly alternative choice of whether to exercise its rights under the contract. One can assume that H strongly desired to close the loan transaction and put the loan to W and that H took all necessary steps to accomplish that result. If the loan failed to close, it would be because the borrower repudiated or defaulted on its arrangement with H, and H thus had no mortgage to deliver.66 H’s ability to exercise the option therefore depended primarily on the action of a third party. To determine whether the parties’ agreement constituted an option for tax purposes, the court looked to the formal requirements of the contract, as well as to the economic substance of the contract and the rationale for granting it open contract treatment. It found that the parties’ agreement (1) unconditionally obligated W to purchase a mortgage if H exercised its rights under the contract, (2) specified a formula to determine the exercise price, (3) specified a period during which the option could be exercised, and (4) required the payment of consideration to obtain the option. The court held that the agreement thus contained the formal requirements of an option for tax purposes. On the economic substance and rationale questions, the court held that the parties’ agreement functioned economically as a typical put option. It noted that the option served to protect H against uncertain future events, such as a change in interest rates before H could deliver the mortgage to W, and the risk that H might not close on the mortgage and thus be unable to make the sale to W. The court referred to the latter uncertainty as a future contingency. It concluded that this future contingency (based on a third party’s actions) did not mean that H lacked an unconditional power of acceptance.67 While recognizing that that potential loss of the

65

Freddie Mac, 125 T.C. at 265. Also, H could decide not to enter into the mortgage loan because of a change in the creditworthiness of the borrower, a change in general economic circumstances, or a change in regulatory requirements. 67 Distinguishing Halle, 83 F.3d 649, the Tax Court found that the amount of the consideration paid for the option, which was forfeited if the option was not exercised, was not large enough to make ‘‘it virtually certain that the mortgage sale will be consummated, negating any real option for an originator.’’ Freddie Mac, 125 T.C. at 265. The situation could be analogized to a small amount of liquidated damages for failure to exercise the option. 66

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Circuit found that W was not irrevocably obligated to sell and convey the property to H and that the arrangement was not a unilateral agreement inflexibly binding on W, the purported seller. W was given an alternative: to prevent H’s exercise of the option by purchasing it. Stated differently, H’s ability to exercise the option was conditioned on W not changing the status quo by invoking the defeasing proviso. Thus, the agreement was denied option treatment for tax purposes.

COMMENTARY / SPECIAL REPORT

68

Id. at 265-266. The court also held that the rationale for open transaction treatment existed because W’s treatment of the premium received would differ depending on whether the option was exercised. 70 Indeed, as mentioned above, the court in Old Harbor questioned whether the parties’ agreement was actually an inducement for W to lobby in support of proposed legislation. 69

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In sum, the case law allows for the conclusion that if option contingencies are under H’s control, preserve the parties’ reasonable economic bargain, and rationally manage risk, the agreement should be treated as a qualifying option for tax purposes. This is explored further in the following section. IV. Qualifying Contingent Options The cases and other authorities discussed above establish the general proposition that if H’s exercise of a purported option is not unfettered but is either effectively compelled or contingent or otherwise conditional on some act to be performed, the agreement may not constitute an option for tax purposes.71 That proposition has sometimes been applied inflexibly and without nuance. The line between a qualifying straight option and a nonqualifying compelled or contingent option need not and should not be drawn so boldly. This discussion is of more than academic interest. Options are useful tools for parties to reduce the risks resulting from future uncertainties. To be effective risk management tools, options should be allowed to reflect the economic bargain struck between the parties. In some circumstances, the parties to an option may want to preserve the economic bargain they have reached by imposing conditions. Then they may structure a contingent option that operates in a manner consistent with the economic substance of an option. For options to effectively serve their function, those conditions must not automatically disqualify the agreement from being treated as an option for tax purposes. How then should permissible conditions be distinguished from disqualifying conditions? The required determination should touch first on the elements of options that the courts have applied to determine whether a purported option qualifies for tax purposes (that is, whether the formal requirements of an option are present). Second, when a condition exists that may impel or impede exercise of the option, the determination should consider whether the arrangement preserves the economic bargain struck by the parties while comporting with the economic substance of an option. Thus, terms and conditions in an option that preserve the bargain that the parties have struck and that maintain the economic substance of an option should be permissible. The IRS, however, likely will continue to object to terms and conditions that require either action or inaction by the parties before H may exercise the option if that

71

E.g., Freddie Mac, 125 T.C. at 253, 259.

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option premium was intended to encourage an originator to sell the mortgage to Freddie Mac if there was a mortgage to sell, the court found that ‘‘originators were apparently willing to pay a premium for the option because they were uncertain about when or whether they would in fact have a mortgage to sell to’’ Freddie Mac.68 The court appears to have reasoned that it was enough that H could decide whether to exercise its rights under the contract and that W was obligated to perform if H was able and wanted to exercise the put.69 It is helpful to contrast the facts in Old Harbor and Freddie Mac and the courts’ analyses in those contingent option cases. In the Freddie Mac put situation, H could not exercise its option unless H and a third party acted to allow H to acquire property. The court observed that H’s ability to deliver a mortgage that has not closed constitutes a future contingency. In that situation, the risk that H would be unable to exercise its put option was in the realm of H, not W. H was aware that it might be unable to exercise the option, but it was still willing to accept that risk as a part of its economic bargain with W. Moreover, that economic bargain comported with the economic substance of true options because the option managed the risks between the parties. Thus, the existence of a contingency that could affect H’s ability to exercise a put option was held to be an acceptable option term, rather than a disqualifying abrogation of H’s unconditional power of acceptance. In Freddie Mac H was fully aware of the contingency it faced and entered into the put option to protect itself against an unwanted economic result. In the Old Harbor call situation, H could not exercise its option unless W and third parties acted to allow W to acquire the option property. Thus, H had no unilateral right to exercise the option since W and a third party could effectively veto its exercise right. Many optionees would consider this an untenable economic arrangement. Moreover, it is arguable whether the arrangement would function economically to manage risk as a traditional option does.70 Even if H were willing to accept such an arrangement, the agreement would constitute a right of first refusal, and it would be difficult to overcome the established precedent that rights of first refusal are not qualifying options.

COMMENTARY / SPECIAL REPORT

A. Administrative Conditions As a starting point, none of the cases cited above stand for the proposition that option terms and conditions governing how and when the option can be exercised make the option contingent. In fact, the cases acknowledge that all options contain terms and conditions for exercise. A good place to start is with the Tax Court’s statement in Freddie Mac that ‘‘an option contract grants the optionee the right to accept or reject an offer according to its terms within the time and manner specified in the option.’’72 For example, an option may specify that it can be exercised only beginning on some future date and ending on some other future date. This is clearly encompassed in the definition of an option, which specifies that an option must be exercisable ‘‘on or before a specific future date or within a specified time period.’’73 In Rev. Rul. 89-64, 1989-1 C.B. 91, the IRS approved an option even though it was exercisable only after the lapse of a fixed period.74 Likewise, an option may specify how it can be exercised, such as through the provision of written notice, to a specific location, or to a particular person.75 All options must have terms and conditions governing their exercise. That H must exercise an option in accordance with reasonable terms and conditions cannot mean that H lacks the unfettered ability to exercise the option. B. Property Value Conditions It is also reasonable for the parties to an option to agree on conditions concerning the physical condition and value of the option property.

72

Id. at 259 (emphasis added). Id. at 261 (citing other cases). See also LTR 8936016 (options were not currently exercisable, but ‘‘where the only such contingency is the passage of time, a right to obtain stock will nonetheless be considered an option’’); FSA 200244003 (specifying that a limited time to exercise the option is not a contingency or a limitation on the right to exercise). 75 See Rev. Rul. 71-265, 1971-1 C.B. 223 (option exercised by ‘‘giving notice to the proper person within a certain period of time’’). 73

Koch contains an example of terms concerning the option property. W granted H a call option to purchase specified real property. The agreement provided that within 30 days of exercise of the option, W was required to establish that it had good, marketable, and insurable title. Arguably, this conditioned exercise of the option on W’s obtaining and maintaining clear title by, for example, not permitting liens to be placed on the property or by requiring the removal of any existing liens. The court, however, held that the purported option to purchase was an option for tax purposes. Likewise, in LTR 9129002, W granted H a call option to purchase property containing coal and other mineral deposits. The option agreement allowed H to enter the property to make surveys and conduct tests, but only upon notice to W and subject to H’s indemnification of W for any negligent acts while on the property. (The ruling does not state what would happen to the option agreement if H violated any of those terms.) Even though the option terms imposed those requirements on H and potentially exposed it to the loss of the ability to exercise the option (for example, if H entered the property without notice or for reasons unrelated to mining), the option was held valid for tax purposes. These results are consistent with the parties’ economic bargain. When the parties entered into the call option, H paid an option premium for the right to purchase property having a specified condition and value. If W was not required to preserve the property’s condition and value, the parties’ economic bargain would not be maintained. Moreover, the agreement between the parties would not manage risk like a true option. This characteristic should distinguish Old Harbor in which W sold a call option on subsurface rights it did not yet own. There, the obligation imposed on W was not simply to maintain the status quo but to perform affirmative acts, the success of which was uncertain and beyond its control. While it must be assumed that H understood the uncertainty and that the amount of the option premium reflected that uncertainty, the fact that H’s ability to exercise the option depended on acts yet to be performed by W led the court to deny option treatment. In contrast, in Freddie Mac, H also faced uncertainty, but it was centered on acts to be performed by H rather than W.

74

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Other situations are easily envisioned. Suppose W grants H a put option under which H can elect to have W purchase a commercial building and business from H at a specified price. Further assume that H can exercise the put option only if H makes specified repairs, the building remains in good condition, the building’s fixtures remain installed, TAX NOTES, November 17, 2014

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action or inaction is deemed too intrusive, especially when the conditions are perceived to be unrelated to the parties’ economic bargain reflected in the option (for example, an act that economically disadvantages H and is immaterial to the parties’ economic bargain). Often, the line between these qualifying and disqualifying terms and conditions will be blurred and subject to disagreement. The following sections suggest considerations that should apply in making the determination.

COMMENTARY / SPECIAL REPORT

C. Economic Bargain Conditions The parties to an option may agree to terms that condition H’s ability to exercise the option but are not directly related to the physical condition and value of the option property. Nevertheless, the parties may view these conditions as necessary to preserve their economic bargain. Even though H’s ability to exercise the option is not completely unfettered, the option should qualify for tax purposes in these situations. Again, a touchstone for this analysis should be whether the terms or conditions motivate or constrain the parties’ actions in a way that preserves the economic bargain they struck to manage risk and uncertainty through use of the option or whether the terms or conditions are immaterial to that economic bargain. For example, W in Freddie Mac charged a high premium for the put option to encourage an originator to sell the mortgage to W. TAX NOTES, November 17, 2014

Thus, this term was designed to influence H’s behavior and make its right to exercise the option less unfettered. Nevertheless, that term was part of the economic bargain reached by the parties. Freddie Mac (W) wanted to purchase mortgages, and the mortgage originator (H) wanted to sell mortgages but feared it might suffer adverse consequences if it was unable to fulfill its commitment to sell. Use of the option balanced the interests of both parties and facilitated the transaction. Thus, the court was able to distinguish Halle, in which an agreement with a liquidated damages clause that encouraged exercise of a purported option was held not to be an option for tax purposes. A similar result was reached in U.S. Freight in which W selected a large liquidated damages amount to make it as certain as possible that H would go through with the stock purchase. In Halle and U.S. Freight, the contract term in question was consistent with the economic substance of a bilateral sales contract but inconsistent with the economic substance of an option. Among the terms that should not disqualify options for tax purposes are those that condition when options can be exercised. These are found in so-called barrier options, which include both knock-in and knockout options. A barrier option is an option on property that can be exercised only if the property reaches a specified value (knock-in option) or can no longer be exercised if the property reaches a specified value (knockout option). For example, W may sell a call option that allows H to purchase the option property for $100, but only if the property’s value exceeds $120. Obviously, the knock-in feature conditions H’s right to exercise the option. However, the occurrence of the condition is not within W’s or H’s control; it is instead determined by market forces. That neither party controls the condition should make it less problematic for option tax qualification purposes. Moreover, the condition does not detract from the economic substance of the option, since the option manages risk in the same manner (albeit not to the same degree) as an unconditional option. And the condition clearly relates to the economic bargain that the parties have struck. H acquires less risk mitigation than under an option without the barrier feature but pays a lower option premium. Thus, the option should qualify as an option for tax purposes. Although the IRS could contend that barrier conditions should not qualify under Old Harbor because H lacks an unfettered right to exercise the option, Freddie Mac seems to justify the opposite result. In this analysis, the fact that a condition requires W to act should not be automatically disqualifying. For example, assume that W grants H a call option 803

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the property is not subject to liens or other encumbrances, and business revenues remain at a specified level. These terms unquestionably condition H’s ability to exercise the option. Under Freddie Mac, all these conditions should be permissible because they relate to the property and the business, they apply to H rather than W, and H has accepted the economic bargain. Old Harbor should be distinguishable because H is simply required to maintain the status quo and perform activities necessary to maintain the option property. In sum, the conditions preserve the parties’ economic bargain and manage risk consistent with the economic substance of options. Thus, while these terms and conditions require action or inaction on the part of H, they do so in a manner that is consistent with the traditional option definition and economic substance of options for tax purposes. Finally, assume the same put option, except that H can exercise it only if an adjacent parking garage owned by an unrelated third party and used by employees of the business remains in existence. Thus, H’s exercise of the option is conditioned not on its own actions but on the actions of a third party. These facts are analogous to those in Freddie Mac in which H’s ability to deliver a mortgage could be thwarted if a third party failed to close on a loan. Therefore, under Freddie Mac, it can be argued that the third-party condition in the hypothetical does not prevent qualification as an option. Option treatment also would be consistent with the fact that the condition preserves the parties’ economic bargain and manages risk in accordance with the economic substance of options. The parties struck a deal over the optioned property and a business with adjacent parking. Imposing conditions to preserve that bargain should not disqualify the agreement from option treatment.

COMMENTARY / SPECIAL REPORT

D. Unrelated Conditions Finally, the parties may want to impose conditions that are not clearly related to either the value and condition of the option property or to the economic bargain reflected in the option. The IRS has indicated that in those situations, conditions that seek to compel or impede H’s actions for reasons unrelated to the economic bargain are disqualifying. Thus, the IRS will likely challenge option status on the grounds that conditions that are neither material to the parties’ economic bargain nor consistent with the economic substance of options are covered squarely by the case law on contingent options. For example, assume that as a condition to H’s ability to exercise the option, H is required to perform an act that economically disadvantages H but is arguably immaterial to the parties’ economic bargain. W grants H a put option under which H can require W to purchase H’s business for a specified price during a specified period. H’s ability to exercise the option, however, is conditioned on H’s agreeing not to start a business that would compete with a separate and different business operated by W. The IRS would likely contend that the noncompete condition is separate from and not material to the parties’ economic bargain reflected in the put, that existence of the condition means that 804

H does not have an unfettered choice to exercise the option or allow it to lapse, and that, as a result, option tax status should be denied. Unlike in Freddie Mac, in which H wanted to address the risk that it would be unable to deliver a mortgage, the condition here addresses no risk or economic bargain related to the optioned business and seems to lack the economic substance of an option. E. Summary When a taxpayer and the IRS disagree whether a condition in an option contract disqualifies the option for tax purposes, three considerations should be decisive.76 First, it must be determined whether the condition is onerous enough to deprive H of a truly alternative choice. In Freddie Mac, the court did not consider whether forfeiture of a high option price, which was intended to encourage option exercise, unduly constrained H’s choice to exercise the option. The court distinguished Halle in which a large amount of liquidated damages was held to constrain H’s choice. In contrast, the court in Midkiff held that nominal damages for non-exercise did not prevent qualification as an option. Thus, the impact on H must be carefully analyzed. Second, the condition should be related to the parties’ economic bargain and operate to preserve their allocation of risk. In Freddie Mac, the condition concerned the optioned property (the mortgage) and reflected the bargain the parties had struck regarding the mortgage. If the condition relates to the economic bargain, operates to the mutual benefit of the parties, and is reflected in the option premium, there is no reason to disqualify the agreement from option treatment. A different result may occur if the condition does not directly relate to the optioned property or the parties’ bargain. Third, it must be considered whether the agreement has the economic substance of an option. Economic substance exists when the option provides potential value to H and potential future detriment to H, both of which depend on the uncertainty of future events. The IRS will likely contend that the first requirement is the key and perhaps sole requirement for a true option. If the condition requires that a party (particularly W or a third party) either act or not act in order for the option to be exercised, the IRS will probably assert that the agreement is not an option because H’s exercise decision is not unfettered. Under the proper standard, however, that inflexible result should be tempered by the fact that the condition relates to an economic bargain concerning

76 This assumes that W has an unconditional obligation to perform if the option is exercised.

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under which H can purchase W’s business for a specified price during a specified period. For H to exercise the option, W must first apply for regulatory approval to transfer to H a license to operate the business. Here, although the contingency is in the control of W, it reflects the economic bargain, and the same analysis should apply. Other conditions may give the IRS a stronger argument that option treatment is unavailable even though the condition relates to the parties’ economic bargain. Assume that W grants H a call option under which H can purchase W’s business for a specified price during a specified period. Further assume that H’s ability to exercise the option is conditioned on W’s obtaining favorable rulings on the tax treatment of the transaction. This condition may serve W’s interest in obtaining the tax treatment it seeks to achieve in the transaction, but it less clearly serves to allocate risk between the parties and less clearly preserves the nontax economic bargain that the parties have struck. Thus, under the rationale of Old Harbor, the IRS could contend that this contingency, which references acts to be performed by W and a third party, should prevent qualification of the option for tax purposes. Simply, the economic effects of the option may not be sufficient to overcome the precedent holding that H must have an unfettered right to exercise the option.

COMMENTARY / SPECIAL REPORT

V. Options Under Specific Code Provisions The foregoing discussion addressed the general question whether conditions imposed on purported options affect the timing of income for option premiums — in other words, whether the existence of option conditions prevents the application of the favorable tax deferral rules applicable to straight options. This section concerns the treatment of conditional options under specific code provisions that refer to options. Under some of these provisions, taxpayers may or may not prefer option treatment, depending on the situation. For example, in redemptions individuals will likely prefer capital gain treatment to dividend treatment and they may challenge the IRS’s position that a putative option qualifies for option attribution purposes.77 If the taxpayer is a corporation, it will likely prefer dividend treatment and a dividends received deduction, causing it to argue for option attribution. For example, in the Seagrams/DuPont transaction, DuPont issued warrants to Seagrams before Seagrams turned in its DuPont stock to DuPont in exchange for cash, notes, and warrants. Seagrams contended that the warrants were options for section 318(a)(4) purposes, putting the IRS in an awkward position. For contingent options, the IRS has three choices: (1) argue consistently that contingent options never qualify as options, (2) maintain that contingent options can qualify for some statutespecific reasons, or (3) assert that some other reason justifies inconsistent treatment of a contingent option as an option for tax purposes. As described below, this must be taken into account in the statutory analysis. A. Section 318(a)(4) Option Attribution Section 318(a)(4) provides that if a person has an option to acquire stock, that person is treated as owning the stock.78 The section 318(a)(4) option attribution rule is incorporated in many other code provisions, as reflected by section 318(b), which

77

See, e.g., Rev. Rul. 89-64. Rev. Rul. 69-562, 1969-2 C.B. 47, considers section 318(a)(4) in isolation and concludes that a corporation with an option to acquire its own stock from a 25 percent shareholder is not considered the owner of that stock for purposes of making a 50 percent shareholder the indirect owner of that stock. The ruling justified its conclusion by stating that ‘‘the corporation does not acquire voting or other rights as a shareholder by acquiring its own stock through exercise of the option.’’ See also TAM 201419013. Thus, the ruling does not provide that the corporation’s option is not a qualifying option but simply concludes that the option attribution rule should not apply to that option. 78

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cross-references sections 302, 304, 306(b)(1)(A), 338(h)(3), 382(l)(3), 856(d), 958(b), and 6038(e)(2). The following sections review whether the treatment of a conditional option as a qualifying option varies depending on which statute is crossreferencing section 318(a)(4) and, if so, why. 1. Section 302 redemptions. Section 318(a)(4) applies in determining whether a redemption qualifies as substantially disproportionate under section 302(b)(2). The IRS has issued two seminal rulings in this area: Rev. Rul. 68-601, 1968-2 C.B. 124, and Rev. Rul. 89-64. In Rev. Rul. 68-601, the IRS embraced the straight option standard, ruling that H must have the right to obtain the stock at its election and concluding that the purported option at issue was a qualifying option because there were no contingencies regarding that election. The ruling cites no authority for this conclusion and notes that section 318 does not define the term ‘‘option.’’ Rev. Rul. 68-601 was clarified in Rev. Rul. 89-64, which addressed a situation in which a taxpayer redeemed 15 shares of X stock and received cash plus an option to purchase 15 shares of X stock. The option, however, could be exercised only after the lapse of a fixed amount of time. Otherwise, there were no limitations on its exercise. The question addressed was whether an option constitutes an option for section 318(a)(4) purposes, even though it is exercisable only after a specified period has elapsed. In answering that question, the ruling stated: In enacting section 302(b)(2) of the Code, Congress intended not only that certain specific limitations be met at the time of the transaction, but also that the circumstances of the redemption offer some assurance that the redeemed shareholder will sustain the required contraction of equity with a degree of permanence. Here, the option not only meets the literal wording of section 318(a)(4) but also prevents the transaction from meeting this intent underlying section 301(b)(2). Thus, the ruling first determines that the delay contingency is consistent with the term ‘‘option’’ as used in section 318(a)(4). In other words, the ruling concludes that in the context of section 318 and 302, some types of contingent options are permissible. The ruling then determines that treating the agreement as an option is also consistent with the congressional intent underlying section 302(b)(2). The latter is important because it indicates that the straight option rule can be overcome by other considerations such as statutory purpose. Regarding Rev. Rul. 68-601, Rev. Rul. 89-64 stated: 805

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the optioned property and the fact that the agreement has the economic substance of an option.

COMMENTARY / SPECIAL REPORT

Thus, Rev. Rul. 89-64 concluded that the IRS in Rev. Rul. 68-601 meant only to distinguish unilateral options from bilateral contracts. This is relevant given the line of cases determining whether contracts that are bilateral in form with liquidated damages clauses can be options. That precedent reveals that such a contract will not be an option if the liquidated damages amount is substantial enough to discourage default (U.S. Freight, Halle, and Elrod) but will be an option if the liquidated damages amount would not prevent default (Estate of Franklin, Midkiff, and Williams v. Commissioner79). This is important because those authorities recognize that whether option exercise was compelled is not a bright line but a continuum that depends on how much influence the condition has on H’s right to exercise, a fact that supports the contingent option analysis suggested in Section IV, above. LTR 8908062 also analyzed section 318(a)(4) in a section 302 redemption setting. The ruling considered a restructuring in which debentures would be issued that could be converted into common stock if there was an acquisition or a primary public offering. The ruling cited Rev. Rul. 68-601 and concluded that the debentures were not options because ‘‘contingencies exist other than the mere passage of time which are out of the holder’s control which prevent the holder from converting the debentures at his or her option.’’ The phrase ‘‘out of the holder’s control’’ seems important because it suggests that a contingency that is in H’s control would not disqualify a contingent option. Alternatively, the language could be viewed as simply a description of the situation presented, in which the contingency was out of H’s control. As discussed in the following section, another 1989 letter ruling contains similar language that clarifies this issue. GCM 35176 (Dec. 19, 1972) considered warrants (which were treated as options) that were nonexercisable for a specified period. Citing Rev. Rul. 68-601, the memorandum referred to ‘‘one standard, that the passage of time before a warrant may be exercised will not change the fact that an option

79

1 F.3d 502.

806

exists for purposes of Code section 318(a)(4), and one guideline, that any contingencies with respect to an election must be serious precedent conditions which could result in a substantial risk of forfeiture of the right to exercise the option.’’ The memorandum thus expressly recognized that contingencies must be serious and pose a substantial risk that the option cannot be exercised. This is fully consistent with the analysis in Section IV, above, and it strongly supports the conclusion that not all option exercise contingencies are disqualifying. Although the conclusion reached in these authorities references the general notion of a straight option, the rulings suggest that any rule whereby contingent options do not qualify as options for tax purposes is flexible. 2. Section 958(b) constructive ownership. Section 958(b) incorporates the section 318(a)(4) option attribution rule for purposes of sections 951(b), 954(d)(3), 956(c)(2), and 957. LTR 8936016 addresses section 958(b) in a manner that sheds light on both Rev. Rul. 68-601 and Rev. Rul. 89-64. LTR 8936016 considered the acquisition of the stock of two domestic corporations by a foreign corporation that was not a section 957 controlled foreign corporation. Two U.S. resident individuals (collectively, H) each owned 10 percent of the stock of the foreign corporation, and each owned significant amounts of the stock of the two domestic corporations. The ruling considered three options held by H to purchase stock of the foreign corporation: one immediately exercisable, a second exercisable only after a delay period and conditioned on the continued employment of H at the issuing corporation, and a third exercisable only if the issuing corporation issued additional stock. The ruling stated that a purported option will qualify as an option if there are no conditions or contingencies attached to the election that are beyond the control of H. Under that standard, the first unconditional and immediately exercisable option obviously qualified as a straight option. The ruling concluded that the second purported option (which had a delay provision) qualified as well, citing Rev. Rul. 89-64 and noting that when the only contingency is the passage of time, a right to obtain stock will still be considered an option.80 The third purported option, being conditioned on the issuance of additional stock by the issuing corporation, did not qualify as an option. Thus, the ruling reiterated the IRS’s position that the general notion of a straight

80 The ruling failed to analyze the fact that this option was conditioned on H’s continued employment. However, it said that that contingency is ‘‘beyond the control of the holder.’’

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The phrase ‘‘at the election of the shareholder’’ in Revenue Ruling 68-601 is intended to distinguish situations where the holder of . . . [an] option has a unilateral right to acquire stock, from situations where there is a bilateral contract. This phrase does not address the question here at issue of whether a delay in the right to exercise prevents an otherwise valid option from constituting an option for purposes of section 318(a)(4).

COMMENTARY / SPECIAL REPORT

81 See also TAM 6804300650A (‘‘an option may not be considered to be an option for section 318(a)(4) purposes when its exercise is dependent on certain contingencies beyond the control of’’ H). 82 53 F.3d 95 (5th Cir. 1995).

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transfer shares without written permission. Citing Rev. Rul. 68-601 and Rev. Rul. 89-64, the IRS found that the restricted transfer rights did not confer on a shareholder the unilateral right to obtain shares, and it concluded that those rights ‘‘do not constitute an option . . . as that term is used under section 318(a)(4).’’ LTR 8312038 also involved sections 318(a)(4) and 304. There, two corporate shareholders each held a right of first refusal regarding the stock they owned in a jointly owned corporation. Citing Rev. Rul. 68-601, the ruling concluded that the right of first refusal did not constitute an option for purposes of section 318(a)(4). The conclusions in these authorities reflect on the general notion that only straight options qualify as options for tax purposes and do not meaningfully affect the contingent option analysis in Section IV, above. 4. Section 334 corporate liquidations. The IRS also considered section 318(a)(4) in LTR 8106008 in determining whether an acquisition of stock qualified as a purchase under former section 334(b)(3)(C), which cross-referenced section 318(a). The question was whether a shareholder’s right of first refusal to purchase stock in the liquidating corporation should be considered an option, so that section 334(b)(1) would apply rather than section 334(b)(2). Citing Rev. Rul. 68-601, the ruling concluded that because the shareholder could not exercise his right to acquire the stock without any contingencies, the right of first refusal was not an option within the meaning of section 318(a)(4). Like the authorities discussed above, that conclusion reflects the general notion that only straight options qualify as options for tax purposes and does not meaningfully affect the contingent option analysis in Section IV. 5. Section 280G parachute payments. Further afield, FSA 199915007 considered section 318(a)(4) in analyzing a purported option in determining stock ownership for purposes of section 280G, applicable to parachute payments. The field service advice noted that then-proposed Treasury regulations incorporated section 318 in determining stock ownership. Citing Rev. Rul. 68-601, the memorandum stated that ‘‘contingencies that remove the election from the optionee’s unilateral control generally prevent attribution.’’ Reflecting the language of GCM 35176, the memorandum concluded that ‘‘there are serious conditions precedent which could result in a substantial risk of forfeiture of Purchaser’s right to exercise the option, and so he cannot be said to have the right to obtain the underlying stock at his election’’ (emphasis in the original). That conclusion reflects the general notion that only straight options qualify as options for tax 807

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option controls for purposes of section 318(a)(4) but that imposition of a time condition on exercise is not disqualifying. The ruling, however, did limit its reference to disqualifying contingencies as those ‘‘beyond the control of the holder.’’ Again, the significance of this limiting phrase is unclear. Previously, in LTR 8038048, the IRS considered a right of first refusal in the context of sections 958 and 1249. That ruling cites Rev. Rul. 68-601 and its language that ‘‘the holder must have the right to obtain the stock at his election’’ and the broader statement that ‘‘there exist no contingencies with respect to such election.’’ As previously mentioned, in the section 302 setting, LTR 8908062 described a contingency that was ‘‘out of the holder’s control,’’ but that language could be explained away as a mere description of the facts rather than a statement of principle. In contrast, LTR 8936016 uses the ‘‘beyond the control of the holder’’ language in its description of the applicable legal principle. Thus, LTR 8936016 supports the conclusion that the IRS considered contingencies in the control of H outside the scope of disqualifying contingencies.81 The conclusion reached in these rulings, while reflecting the general notion that only straight options qualify as options for tax purposes, supports the position that not all option exercise contingencies are disqualifying. 3. Section 304 redemptions. Section 318(a)(4) also was at issue in Insilco Corp. v. United States,82 this time in the context of section 304. The court considered the taxpayer’s contention that it was in control of a corporation under section 304(c)(2)(A) by virtue of section 318(a)(4) option attribution. The court primarily dismissed the taxpayer’s argument because it was raised for the first time on appeal. Nevertheless, the court said that in any event the purported option could not be considered an unconditional option because its exercise was conditioned on other transactions. As authority, the court cited Rev. Rul. 68-601, quoting it as follows: ‘‘To qualify as an option, the holder must have the right to obtain the stock at his election . . . [with] no contingencies with respect to such election.’’ It is likely that this was the government’s position asserted in briefing. LTR 9410003 also considered section 318(a)(4) in the context of section 304. There, a shareholder agreement provided that no shareholder could

COMMENTARY / SPECIAL REPORT

B. Section 1234 Character Rules Section 1234 provides rules governing the character of gain or loss realized upon the sale, exchange, or termination of an option to buy or sell property.83 Several courts have considered contingent option questions under section 1234. In U.S. Freight, the court of claims considered a stock purchase agreement under which the taxpayer made a $500,000 down payment, which was to be forfeited as liquidated damages if the taxpayer failed to complete the purchase. The purchase was never consummated, and the taxpayer claimed a $500,000 ordinary deduction. The government asserted that the taxpayer’s loss was a capital loss under section 1234, stating, ‘‘albeit there is an important distinction between an option and a bilateral contract in many contexts . . . there can be no such distinction for purposes of section 1234 . . . because both have the same economic effect.’’84 Thus, even though the agreement was a bilateral contract, the government claimed option treatment based on the perceived policy underlying section 1234. The court, however, held that the government’s position was ‘‘not well taken,’’ noting that section 1234 refers expressly to options and that the legislative history contains no indication that Congress intended for the provision to apply to bilateral contracts.85 Applying the definition of an option as a unilateral contract in which H has the truly

83 A 1954 House report noted in its section on proposed changes to section 1234 that ‘‘an option is no more than a right to buy or sell property and, in determining whether or not a capital transaction is involved, the character of the property to which the option relates should be controlling.’’ H.R. Rep. No. 83-1337, at A279 (1954). This same House report — along with a corresponding 1954 Senate report — also provided the following regarding section 1234: Present law does not count as a part of a holding period any period in which a taxpayer is both long and short with respect to substantially the same investment. Moreover, present law provides a presumption that a ‘‘put’’ (an option to sell an asset at a fixed price) is a short sale. This prevents the use of a ‘‘put’’ to artificially extend a speculative commitment beyond 6 months. However, if a ‘‘put’’ is purchased with the stock which is to be used to exercise it in order to hedge against a decline in its value, the taxpayer is denied long-term capital gains treatment. To avoid this result a ‘‘put’’ is not to be presumed a short sale if, among other things, it is purchased at the same time as the stock to be used to fulfill the contract. Id. at 83; S. Rep. No. 83-1622, at 113 (1954). 84 U.S. Freight, 422 F.2d at 894. 85 Id.

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alternative choice of exercising the option or allowing it to lapse, the court held that the agreement was not an option, even given the existence of the liquidated damages provision. Thus, the general definition of an option controlled for section 1234 regardless of the government’s argument based on the resulting economic effect. A similar result was reached in Saunders in which H’s exercise of its option could be prevented by W’s exercise of a defeasance proviso and payment of $200,000. H claimed that the agreement was a qualifying option and that the money received was entitled to capital gain treatment under section 1234. Applying the definition of an option, the court held that because the agreement was not a unilateral agreement ‘‘inflexibly binding upon the purported vendor,’’ it was not a qualifying option.86 This decision was not based on the congressional intent behind section 1234, but the court was disinclined to allow capital gain treatment for a payment that ‘‘was in reality a bare promise to pay money [as compensation for services] cleverly clothed in deceptive legal garb.’’87 Similarly, the court in Anderson v. United States held that capital gain treatment under section 1234 was not available to an amount received for the release of a right of first refusal, holding that ‘‘rights of refusal have traditionally not been viewed as option contracts.’’88 Thus, the court looked to the general definition of an option and not to any policy specifically related to section 1234. The decisions in these cases reflect the general principle that qualifying options must be unilateral agreements. Other than the Anderson court, the courts were not faced with and did not consider any contingent option question. It is relevant, however, that the court in U.S. Freight refused to treat a bilateral contract as an option based on the government’s statutory purpose argument. Although the IRS could contend that this holding supports the position that all conditions are disqualifying for tax purposes regardless of economic considerations, the court’s decision seems narrowly focused on section 1234. C. Section 246 Dividends Received Deduction Under section 246(c)(4), a corporate taxpayer must hold stock for the prescribed holding period in order to get a dividends received deduction.89 A taxpayer’s holding period, however, is reduced for any period in which the taxpayer holds an option to

86

Saunders, 450 F.2d at 1049. Id. at 1050. 88 Anderson, 468 F. Supp. at 1092. 89 Section 246(c)(4) also is incorporated into section 901(k) by section 901(k)(5). 87

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purposes and is consistent with the contingent option analysis in Section IV, which concludes that only some ‘‘serious conditions’’ should jeopardize tax qualification.

COMMENTARY / SPECIAL REPORT

90 The language referenced in the ruling as being in former section 246(c)(3) is now in section 246(d). Deficit Reduction Act of 1984, section 53.

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call options would be in the money if the strike price were $100 rather than $130. The ruling reasons that in that situation, the exercise of the options ‘‘may be virtually guaranteed and the element of risk is either greatly reduced or eliminated.’’ While not expressly stated, it can be presumed that the ruling’s reasoning is that because the in-the-money call option is virtually certain to be exercised by H, it can be considered in substance as a contractual obligation to sell within the statute.91 While wrapped in an ‘‘intendment of the statute’’ analysis, this conclusion could also have been reached by simply interpreting the statutory phrase ‘‘contractual obligation to sell’’ to include in-the-money call options.92 In Progressive Corp. v. United States,93 the court adopted the same position. It considered whether the taxpayer’s simultaneous purchase of stock and sale of in-the-money call options on the same stock similarly resulted in a suspension of the holding period. Citing Rev. Rul. 80-238, the court distinguished between at-the-money and out-of-themoney call options (which do not suspend the holding period) and in-the-money call options (which can suspend the holding period). The court said that revenue rulings are entitled to ‘‘great deference’’ and accepted Rev. Rul. 80-238’s conclusion regarding in-the-money call options. The court therefore agreed with the government that in-themoney call options can be the equivalents of the contractual options to sell mentioned in section 264(c)(4). The court realized, however, that there was no bright-line test and remanded the case to the trial court to determine whether the call options were so deep in the money that they were equivalent to contractual obligations to sell. Thus, the court eschewed any bright-line test and held that the degree of compulsion was the key to resolving the issue.

91 See Rev. Rul. 82-150, 1982-2 C.B. 110, in which a taxpayer purchased an option to acquire stock, paying an option premium equal to 70 percent of the stock’s value, which option had a strike price equal to 30 percent of the stock’s value. The ruling concludes that under former section 554(a)(3), the taxpayer had assumed the risks of investing in the stock and was considered its owner. See also Rev. Rul. 2003-97, 2003-2 C.B. 380. 92 Of Rev. Rul. 80-238, a JCT report from 1984 observed: ‘‘Although the Internal Revenue Service noted that different considerations apply to a covered call option with a strike price below the current market value, because, the Internal Revenue Service reasoned, it is almost certain that such an option will be exercised, the revenue ruling provided no guidance regarding the circumstances in which the holding period of the underlying stock would be suspended in this case.’’ JCT, ‘‘General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984,’’ JCS-41-84, at 138 (Dec. 31, 1984). 93 970 F.2d 188 (6th Cir. 1992).

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sell (or is under a contractual obligation to sell) or is the grantor of an option to buy substantially identical stock or securities. Several authorities address what constitutes an option for section 246 purposes. In Rev. Rul. 80-238, 1980-2 C.B. 96, the taxpayer purchased stock and then sold call options on the stock. In the example in the ruling, the taxpayer purchased stock at $110 per share. Later, when the market price of that stock had increased to $120 per share, the taxpayer sold a call option on the stock for a premium of $10 per share, with a $130 strike price. The ruling concluded that the call options did not come within the reach of section 246(c)(4). The IRS noted that the statutory language refers to situations in which the taxpayer has an option to sell, and it determined that ‘‘the sale of a call option does not create in the seller an option to sell the underlying stock since consummation of the stock sale is under control of the person to whom the call was sold.’’ The ruling further concluded that ‘‘although the writing of a call option on stock owned could be deemed to be a contractual obligation to sell, the legislative history of section 246(c) indicates that, for purposes of section 246(c)(3),90 it is not.’’ At this point, the ruling’s conclusion followed from the statutory language: The call option is neither an option to sell nor a contractual option to sell under section 246(c)(4). Interestingly, the ruling later cited the legislative history, noting that the purpose of section 246(c)(4) was ‘‘to reduce a taxpayer’s holding period for any interval during which the taxpayer is both in a ‘long’ and a ‘short’ position,’’ thus ensuring ‘‘that the taxpayer is at the risk of the market for the entire holding period.’’ The ruling then said that the writing of the call options in question gave W no protection against loss, beyond the option price received, if the underlying stock declined in value. As a result, the ruling concluded that because the writing of the options did not place W in a risk-free position, it did not fall within the intent of section 246(c)(4). However, this statutory purpose justification for the ruling on the call options seems more like a bridge to the second conclusion than a second basis for concluding that section 246(c)(4) does not apply to call options. The ruling’s second conclusion is that statutory intent considerations would not apply if the options were in the money. A call option is in the money if it is sold with a strike price below the market price on the date the option is written. In this case, the

COMMENTARY / SPECIAL REPORT

D. Section 1091 Wash Sale Losses Section 1091(a) precludes a loss on the sale of securities if, within a 61-day period, the taxpayer 810

has acquired or entered into a contract or option to acquire substantially identical securities. In that situation, two key elements should be considered: (1) There must be a contract or an option, and (2) that contract or option must give the taxpayer the right to acquire securities. In G.I.C. Corp. v. United States,94 a taxpayer sold stock and provided the buyer an option to put the shares back to the taxpayer. On these facts, the district court held that the wash sale rule of section 1091 does not apply when an option rests with the buyer rather than the seller of securities. Simply, the option gave the taxpayer no right to acquire the stock. Similarly, in Rev. Rul. 85-87, 1985-1 C.B. 268, a taxpayer sold 100 shares of X Corp. stock and nearly simultaneously sold a put option obligating the taxpayer to buy 100 shares of X stock if H exercised the put. The analysis in G.I.C. Corp. would at first seem applicable because the put option, in form, was not an option to acquire stock for section 1091(a) purposes since the option to put the stock to the taxpayer was held by H. However, when the put was sold, the market price of X stock was substantially lower than the exercise price of the put option, meaning that the put was in the money. The ruling found that on the facts, there was ‘‘no substantial likelihood that the put would not be exercised.’’ The ruling then stated that the substance, rather than the form of the transaction, governs the tax consequences. On this point, the ruling concluded that for purposes of section 1091(a), the put sold was in substance a contract to acquire stock. In other words, although the put was in form an option, in substance (given its likely exercise) it was a contract under which the taxpayer would acquire the stock. If the taxpayer held a straight call option to acquire substantially similar securities, that option would be an option to acquire stock under section 1091(a). Because both of the foregoing authorities addressed put options, neither answers whether a contingent call option, which might not qualify as an option for deferral of income purposes, would constitute an option for purposes of section 1091(a). If there were conditions on the taxpayer’s right to exercise the call option, the taxpayer could contend that there is no qualifying option and section 1091(a) does not apply. The IRS would then have to either accept that result or assert that contingent options nevertheless qualify for section 1091(a) purposes. Nothing in the language of section 1091(a) itself (such as, for example, the contract language

94 No. 95-0168 (S.D. Fla. 1996), aff’d on another issue, 121 F.3d 1447 (11th Cir. 1997).

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The government in Progressive argued that the call options were contractual obligations to sell under section 264(c)(4). When citing Rev. Rul. 80238, the court omitted the ruling’s ‘‘intendment of the statute’’ language and focused solely on whether a call option could be so deep in the money as to constitute a contractual obligation. Thus, the case seems to involve statutory interpretation and not statutory purpose considerations. The court in Progressive also considered whether the taxpayer’s simultaneous purchases of stock and put options on the same stock resulted in a suspended holding period for section 246(c)(4) purposes. It held that the put options held by the taxpayer were options to sell for section 246(c)(4) purposes, resulting in a suspension of the holding period. The put options were straight options without contingencies. If that taxpayer purchased a contingent put option, the question would arise whether it also had an option to sell for section 246(c)(4) purposes. The taxpayer could argue that, consistent with some contingent option precedent, there is no qualifying option and section 246(c)(4) does not apply. In response, the IRS would either have to accept that result or contend that the contingent option nevertheless constitutes an option to sell under section 246(c)(4). In this situation, however, unlike a straight option, the existence of the condition in the contingent option arguably increases the taxpayer’s market risk to the extent that the contingency makes the option less likely to be exercisable. As a result, the IRS would seem to be asserting a tenuous policy argument that the contingent put should be treated as an option despite the contingent option precedent. The same analysis should apply if a taxpayer sold a contingent put option and the question arose whether it would be a grantor of an option to buy for section 246(c)(4)(B) purposes. Again, to the extent the contingency would make the option less exercisable, market risk would be increased compared with a straight put, and it would be difficult for the IRS to make a statutory purpose argument. These authorities adopt the position that there is a range of in-the-money options, some of which will compel option exercise and some of which will not. This is similar to the situation of bilateral contracts with liquidated damages provisions, some of which will compel option exercise and some of which will not. These authorities support the position that not all contingencies should be disqualifying, but the contingency’s economic effect on option exercise must be considered.

COMMENTARY / SPECIAL REPORT

E. Section 1563 Controlled Groups Section 1563 defines the term ‘‘controlled group’’ for purposes of the code, and section 1563(e)(1) provides that if any person has an ‘‘option to acquire stock,’’ that stock is treated as owned by that person. In Mid-America Industries Inc. v. United States,95 a parent corporation and its subsidiaries claimed separate surtax exemptions. The government contended that the separate surtax exemptions were improper because the corporations were members of a section 1563 controlled group. The employees of the various subsidiaries owned stock in them, and a separate securities corporation had a right of first refusal to purchase any employee’s stock in a proposed sale. The government argued that the securities corporation had an option under section 1563(e)(1), with the result that it should be deemed to own all the subsidiaries’ outstanding stock. Citing Rev. Rul. 68-601, the court held that ‘‘to constitute an option to purchase stock, the rights in question must enable the holder to purchase the stock ‘presently at his election.’’’96 Thus, the court concluded that the right of first refusal was not within the generally accepted meaning of an option because it would not come into existence until the

95

341 F. Supp. 597 (W.D. Ark. 1972). Id. at 607.

96

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occurrence of one of the specified contingencies, and the securities corporation had no control over the occurrence of those contingencies. As discussed above, rights of first refusal are not options for tax purposes because the holder of that right has no unconditional right of exercise. If the taxpayer held a straight call option to acquire the relevant stock, that option would be an option to acquire stock under section 1563(e)(1). As with section 1091(a), if there were conditions on the taxpayer’s right to exercise the call option, the taxpayer could argue that there is no qualifying option and that section 1563(e)(1) does not apply. The IRS would have to either accept that result or assert that contingent options nevertheless qualify for section 1091(a) purposes. However, nothing in the language of section 1563(e)(1) appears to support an inconsistent position, so the IRS would need to justify an inconsistent position by relying on the general policy behind the statute. VI. Conclusion Although the tax deferral that results from the open transaction treatment given to options is attractive, that treatment could be lost if the option agreement includes terms and conditions that unduly condition the exercise of the option. The application of this principle may be clear when a condition significantly affects the option exercise and it seems unrelated to the parties’ economic bargain. However, the IRS will probably closely scrutinize all terms or conditions that require action or inaction by W, H, or a third party to determine whether H’s right to exercise the option is truly unfettered. Terms or conditions that require action or inaction and that seem unrelated to the parties’ economic bargain likely will be viewed by the IRS as disqualifying. Based on Freddie Mac and other authorities, however, taxpayers can justifiably assert that the parties are free to incorporate terms and conditions that protect their economic bargain in a manner that preserves the economic substance of true options. In short, there is no bright-line rule but, more likely, a facts and circumstances test that will produce uncertain and possibly conflicting results.

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used in Rev. Rul. 85-87) would support that position. Instead, the IRS would need to justify its position by relying on the general policy behind the denial of wash sale losses. However, given that the existence of the condition could make the taxpayer’s exercise of the option less likely to occur than if the option were a straight option, that policy argument could be difficult to defend. Rev. Rul. 85-87 is consistent with the argument that there is a range of in-the-money options, some of which will compel option exercise and some of which will not. Thus, the ruling supports the position that not all contingencies should be disqualifying, but that the contingency’s economic effect on option exercise must be considered.