Laying Claim to Options Expense Deductions

The IRS concludes that stock-option payments made to employees of a former subsidiary create a compensation expense and deduction that belong to the subsidiary, not the parent company.

Guidance from the Internal Revenue Service’s chief counsel, released last summer, opined on the tax treatment of stock-option payments made by a parent company to employees of a former subsidiary. The memo, referred to as a Chief Council Advice, found that these types of option payments give rise to capital losses. Here’s the situation as described in the memo (see CCA 200942038, June 26, 2009).

A parent corporation owned all of the stock of a current subsidiary (SubOne) and a former subsidiary (FormerSub). During January of Year2, the parent’s equity interest in FormerSub was canceled after FormerSub emerged from Chapter 11 bankruptcy proceedings. FormerSub’s creditors received all of the subsidiary’s equity interest, and the parent initially claimed a capital loss in the amount of the canceled FormerSub stock.

The parent had a stock-option plan that granted nonqualified options to certain employees of its subsidiaries. When an employee exercised his option — which included the right to receive payment of the “inherent” value of the option — the parent would sell newly issued shares sufficient to cover the payment. The parent would then use the sales proceeds to pay the value of the option, less applicable withholding taxes, directly to the option holder.

Prior to January of Year 2, the parent treated these option payments the same for both SubOne and FormerSub. That is, the parent would render payment to the option holder and treat the payment as a capital contribution to the subsidiary employing the option holder. The subsidiary, in turn, would take a compensation deduction. Beginning after January of Year 2, the parent began reporting capital losses for the amount of option payments made to former employee option holders of FormerSub. The parent also submitted a claim for refund, stating that the option payment should be an ordinary loss. The IRS rejected the claim, according to the June chief counsel memo.

Willens 08-16-10

“Relation Back”

According to the tax code — specifically Regulation Section 1.1032-3 — for certain transactions in which a corporation acquires money or other property in exchange for corporate stock, the acquiring entity is treated as purchasing the stock of the issuing corporation for fair-market value, with cash contributed by the issuing corporation to the acquiring corporation. As a result, Regulation Section 1.1032-3 enables a subsidiary to obtain a fair-market value basis in its parent’s stock — which is contributed to the subsidiary’s capital — if the subsidiary disposes of the parent stock immediately after it is received. Therefore, a subsidiary generally does not recognize gain or loss on the immediate transfer of parent stock to the subsidiary’s employees.

In the memo’s instant case, the parent issued nonqualified options in its stock to FormerSub’s employees when the company was the parent’s subsidiary. The employees, however, exercised the options after FormerSub was no longer affiliated with the parent. Under the relation back doctrine (the characterization of events that occur in later years should reflect the situation that existed in earlier years1), the treatment of these transactions should be the same (as far as possible) as they would be when the parent was affiliated with FormerSub.

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