STOCK OPTIONS THAT ARE EXERCISABLE ONLY AFTER A LAPSE OF TIME ARE NEVERTHELESS TREATED AS OPTIONS FOR CONSTRUCTIVE OWNERSHIP RULES.

Rev. Rul. 89-64

ISSUE

If an option is exercisable only after the lapse of a fixed period of time, is it an option within the meaning of section 318(a)(4) of the Internal Revenue Code and, therefore, must it be taken into consideration in determining whether a redemption qualifies as substantially disproportionate within the meaning of section 302(b)(2)?

FACTS

X, a domestic manufacturing corporation, had outstanding solely 100 shares of voting common stock. A, an officer of X, held 30 shares of this stock. A resigned from X in order to devote time and money to an unrelated endeavor, and X redeemed 15 shares of A's X stock. A received in the redemption cash plus an option to purchase 15 shares of X stock. This option was exercisable only after the lapse of a fixed period of time following the redemption. Except for the provision that the option could not be exercised until the fixed period of time had elapsed, there were no limitations on the exercise of the option. The fair market value of the X stock surrendered by A was equal to the fair market value of the cash and option that A received from X in exchange therefor.

The redemption constituted a substantially disproportionate redemption of stock within the meaning of section 302(b)(2) of the Code, provided that the option received by A did not constitute an option within the meaning of section 318(a)(4).

LAW AND ANALYSIS

The treatment of distributions in redemption of stock is governed by the provisions of section 302 of the Code. Pursuant to section 302(c)(1), the constructive ownership rules of section 318(a) are applicable in determining the ownership of stock for purposes of section 302.

Section 318(a)(4) of the Code provides that, if a person has an option to acquire stock, this stock is considered as owned by this person. Neither section 318 of the Code nor the regulations thereunder define the term "option." Moreover, neither section 302 of the Code nor the regulations thereunder specifically address the question of how section 318(a)(4) is to be interpreted for section 302 purposes.

Rev. Rul. 68-601, 1968-2 C.B. 124, dealing with the effect of warrants and convertible debentures on the substantially disproportion computation of section 302(b)(2) of the Code states:

In order for a warrant to acquire stock to qualify as an option, the holder must have the right to obtain the stock at his election. When this right to acquire stock exists, warrants or convertible debentures are not realistically different from options as referred to in section 318(a)(4) of the Code. In each instance, stock may be acquired at the election of the shareholder and there exist no contingencies with respect to such election.

The phrase "at the election of the shareholder" in Rev. Rul. 68-601 is intended to distinguish situations where the holder of a warrant, convertible debenture, or 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).

In the present situation, the delay does not prevent A from being viewed as having a right to receive 15 shares of X stock at A's election. 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 302(b)(2). The option distributed by X to A in redemption of A's X stock constitutes an option within the meaning of section 318(a)(4); accordingly, A owned, directly and constructively, the same number of shares of X stock after the redemption that A owned before the redemption.

HOLDING

The option distributed by X to A in redemption of A's X stock, though exercisable only after the lapse of a fixed period of time following the redemption, is an option within the meaning of section 318(a)(4) of the Code and must be taken into consideration in determining whether the redemption qualified under section 302(b)(2). As a result of owning the option, A is considered as owning the stock covered by the option and, thus, fails to meet the requirement of section 302(b)(2).

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 68-601 is clarified.

DRAFTING INFORMATION

The principal author of this revenue ruling is Michael Danbury of the Office of Chief Counsel (Corporate). For further information regarding this revenue ruling contact Mr. Danbury on (202) 566-3544 (not a toll-free call).