Case Study:  Tax Ownership and Options

Introduction

I discussed tax ownership in the context of stock loan in my previous post.  There I concluded that in a “plain vanilla” stock loan the stock lender would not be treated as the owner of the stock that was loaned, even though the lender held something pretty close to the economic equivalent of owning the stock outright and even though the lender may be entitled to physical delivery of shares of the stock at the conclusion of the contract.

If that’s the case, we should be able to handle options in really short order then.  If stock lenders are not considered owners of the stock, then call option holders (or put option grantors) on stock should a fortiori not be treated as the owner of stock.  And, as a general matter this is true because (1) like stock loan, the option holder likely does not have control over the disposition of any identifiable property, and (2) the option is subject to significant condition precedents that a stock loan isn’t typically subject to.

Option holder cannot restrict the use of any specifically identifiable property

First, because an option generally does not give the call option holder (or put option grantor) the power to control/prevent the disposition of any identifiable property, it is unlikely that the call option holder (or put option grantor) should be viewed as the owner of the property.  This is similar to the stock loan example where the stock lender does not expect the return of the exact shares loaned cannot prevent the borrower from disposing of any particular shares.  They just expect the return of shares that are similar/Identical to the shares loaned at the end of the contract but retain no control for the duration of the contract. Consequently, if you have an option on a few IBM shares, you wouldn’t normally expected to be treated as the tax owner of any particular IBM shares even if there existed no condition precedents to your acquisition.  Why?  The person on the other side of the option retains full control over disposition of those shares (assuming your counterparty even has the shares) and there is no reason to think that the counterparty’s control over disposition of the shares is illusory.  (See, Rev. Rul. 80-238, 1980-2 C.B. 96, 1980-36 I.R.B. 10).

Some authors refer to this as funginess (fungibility? fungibility-ness? fungineity?).  Because the subject of the contract is fungible, there is no specific thing that you require to be delivered to you at the conclusion of the contract; the option holder would only require a “like” thing and can’t prevent the counterparty from disposing of any particular property.  Therefore, until you gain actual possession, you can’t claim any specific thing as your own.  Recall the analogy to a money loan—where you loan somebody money, there are no specific dollar bills that you can claim as your own and you can’t prevent the borrower from disposing of any dollars in their possession.

As a previous comment has pointed out, however, the ability to specifically identify the property is not the dispositive issue.  It merely supports the notion that the option holder doesn’t really have control over the disposition of any particular thing the option issuer may have in its possession from time-to-time.

Ultimately, this fits into the notion that control over property is really the core issue in the ownership analysis. The fact that the property is not “identifiable” makes it easy to believe that control didn’t really exist.

Condition precedent and condition subsequent.   

In addition to funginess (which may or may not be present), options have a significant condition precedents that make tax ownership less likely than stock loan.  First, the option may not be exercisable for some time.  Second, at the time the option is exercisable, the holder of the option may not choose to exercise it.  Third, even If the holder chooses to exercise the option, the call option holder (or put option grantee) must actually have the wherewithal to pay the strike price.  There may be more things than that, but that’s what I could come up with off the top of my head.

In any event, each of the foregoing act to preclude the ability of the option holder from enjoying possession of, and having the ability to control disposition of, the subject property.

But what do I mean by a condition precedent?  For those who went to law school, this is Contract 101 stuff.  For those who go on the internet, this is Wikipedia stuff.

In contract law, a condition precedent is an event which must occur before the performance of the contract becomes due.  This should be contrasted with a condition subsequent.  A condition subsequent is an event which terminates the duty of a party to perform.   It’s often difficult to distinguish a condition precedent from a condition subsequent in a real setting since the difference between them is pretty close to negligible.  If it makes it easier, you can think of the conditions of a contract as operating an on/off light switch.  When you enter into a contract, the performance of the duties of the contract is set to “off”.  The occurrence of a condition precedent switches the light on and the party whose performance was subject to the condition must now perform.  Once the light is on, the occurrence of a condition subsequent switches the light off and the party who was performing may stop performing.

Therefore, when I indicated that an option is subject to significant condition precedents, the party that owns the subject property is under no duty to perform (ie., deliver the property) until those condition precedents have flipped the light on.   Given significant condition precedents, it is difficult to see how the call option holder (or put option grantor) could be viewed as the owner of the subject property.   This is essentially the decision in the Supreme Court case Lucas v. Comm’r, 281 US 11 (1930).  The Court in Lucas was attempting to decide whether a sale of timber lands occurred in 1916 or 1917.  In that case, the seller had given the buyer a 10-day option to purchase the lands and the buyer was solvent and able to make the purchase.  Moreover, on December 30, 1916, the buyer notified the seller that it would exercise the option and was prepared to close once all the papers were prepared.   However, this would not occur until the transaction was closed in 1917 and consequently, “…unconditional liability of vendee for the purchase was not created in [1916].”    In other words, the contract remained subject to significant precedents and therefore ownership could not transfer until 1917.

This decision shouldn’t be unfamiliar to anyone that has entered into a contract to purchase a house which, until closing, remains subject to significant condition precedents.  It would be a rare thing indeed if the purchaser thought that they were the owner of the house prior to the satisfaction of those conditions and tried to sleep in the seller’s bed.

200 (4)

This conclusion should also not be unfamiliar to anyone who has taken out a nonrecourse loan to buy something.  A nonrecourse loan is essentially a loan where the lender takes a security interest in some specific property and on default, does not have recourse to any assets other than the specific property.  A nonrecourse is essentially identical to the lender granting a put option to the borrower because if the value of the property fell below the value of the amount owed by the borrower, the borrower would simply walk away and give/put the property to the lender.  Since the lender’s right to acquire the subject property remains subject to significant condition precedents (e.g., default/exercise of the put), the lender would not be considered the owner of the property. for tax purposes, which is what most “normals” would expect.

Therefore, due to the significant condition precedents contained in options, it is unlikely that actual ownership of the subject property will change hands until the condition precedents have been removed.  See, Rev. Rul. 71-265 1971-1 C.B. 223 (option to purchase exercisable only after death of the optionor).

The option references specific property and the absence of condition precedents?

It naturally follows from the above that if all condition precedents are removed and the option references specific property, then ownership likely does transfer.

Recall that in the introduction, I identified 3 significant condition precedents that are inherent in options (again, there are probably more but I’m trying to think through this fast):

  1. the option may not be exercisable for some time.
  2. at the time the option is exercisable, the holder of the option may not choose to exercise it.
  3. even If the holder chooses to exercise the option, the call option holder (or put option grantee) must actually have the wherewithal to pay the strike price.

Were these conditions present in Rev. Rul. 82-150, 1982-2 C.B. 110, 1982-33 I.R.B.   which held that the holder of the option was actually the holder of the underlying the stock?   In the ruling, B, a nonresident alien in a foreign country set up foreign corporation FX with 100,000x dollars, receiving all of the stock of FX.  A, a US citizen, paid 70,000x to B for an option to purchase all of FX stock, exercisable at A’s discretion at any time, at a price of 30,000x dollars.  Obviously, A acquired a very deep-in-the-money option since the value of the company was 100,000x dollars and the option strike price was 30,000x dollars.

Now, let’s compare it to some of the significant condition precedents that I identified.  First, the option is exercisable at any time—so out goes (1).  Second, the holder must choose to exercise it.  Well, I guess the holder has the “choice” to exercise it, but in this case, the choice is illusory.  Unless A is the stupidest person on the planet, they will exercise the option since they will be getting 100,000x dollars of value for a payment of 30,000x dollars.  We’ll skip (3) for now since I don’t have the facts to establish A’s ability to actually pay the 30,000x strike price but I have to imagine that wasn’t going to be a problem.   Lastly, the property referenced here is not exactly fungible property—that is, it is very specific property and B can’t substitute it with something else that is like the shares of FX Corporation.  Therefore, B likely has very little ability to actually control disposition of the property.  Therefore, it appears that the IRS came to the right conclusion here.

Finally, you also need to take some care in identifying whether the condition is actually a condition precedent or a condition subsequent.  If the “condition” is actually a condition subsequent, you can be assured that the transfer will likely have transferred.  For example, in Rev. Rul. 75-563 1975-2 C.B. 199, the taxpayer entered into an “irrevocable written option” for the purchase of certain real property which gave the taxpayer the right to (1) immediate possession of the property, (2) unrestricted use of the property, and (3) acquisition of title to the entire tract of land upon payment of 400x dollars.   If the taxpayer elected to continue the “option”, the taxpayer was required to pay 40x dollars on January 2, 1973, and each succeeding January 2 until 1982.  The IRS, unsurprisingly, held that ownership transferred.  Here, the option was more in the nature of a condition subsequent such that the contract had been executed but the exercise of the option turns off the contract.

To sum up, because ownership relates to control over disposition, where the derivative contract relates to something fungible, there is no specific property that the option holder (or stock lender) expects to be returned to them; therefore, they don’t control disposition over any specific thing.  Second, where there are significant condition precedents to obtaining property, the condition precedents keep one from exercising control.

One thought on “Case Study:  Tax Ownership and Options

  1. Pingback: Case Study: Tax Ownership and Stock Held in Prime Brokerage Accounts | Tax Pro Super Happy Fun Time - A Tax Blog

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