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 th...
Robert WillensAugust 16, 2010

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.

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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.

If the two companies were affiliated when the parent paid cash to the employees of FormerSub, the payment would have been treated as a capital contribution by the parent to FormerSub. Accordingly, FormerSub would be treated as paying the cash to its employees, and the cash paid would have increased the basis of the parent’s stock in FormerSub.

So, when FormerSub went bankrupt and the parent lost ownership of that subsidiary, the increased basis would have increased the parent’s worthless stock deduction. As a result, the parent company’s loss from payment to the employees in the later year has the same character as the original worthless stock deduction — a capital loss under Section 165(g)(1) of the tax code.2

Abandoned Transaction?

The parent company argued that the decision in Santa Fe Pacific Gold Co. v. Commissioner, 132 T.C. No. 12 (2004), requires a conclusion that the parent’s loss is ordinary in nature. The IRS did not agree.

In the Santa Fe Pacific Gold case, the taxpayer paid a “termination fee” to a jilted merger suitor as the “price” for entering into an agreement with a “more acceptable” (i.e., well-heeled) suitor. The tax court held that the taxpayer obtained no long-term benefits from the payment that would require capitalization and, therefore, allowed an ordinary deduction under Section 162. As an alternative, the tax court allowed an ordinary loss under Section 165 because the taxpayer had abandoned a capital transaction.

In the case described in the 2009 memo, the parent contended that its payments to the employees of FormerSub produced no long-term benefits for the company, and therefore it could deduct the payments as ordinary deductions. Alternatively, the parent argued that the loss arose from an abandoned capital transaction and was therefore deductible under the auspices of Section 165. Again, the IRS did not agree.

The IRS noted, however, that the 2009 case did not concern a payment in a transaction that was canceled or abandoned. It also did not involve a payment for an expense of the parent itself. Rather, the expenses were FormerSub’s and not the parent’s.

Lastly, the IRS addressed the question of which entity is the proper party to take the deduction for the payment. The subsidiary, noted the IRS, is treated as compensating the employees. Therefore, FormerSub is the proper party to take the deduction. However, FormerSub had liquidated before the employees exercised the options that produced the tax deductions. The IRS suggested that FormerSub’s “successor-in-interest” may be the party “credited” with the tax deduction. One thing seems clear, however: the tax deduction cannot be claimed by the parent.

Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for


1 See Revenue Ruling 2002-1, 2002-1 C.B. 268.
2 Apparently, FormerSub did not constitute an “affiliate” of the parent, in which event the loss from the worthlessness of FormerSub’s stock would have been ordinary and, presumably, the contested payments would have also given rise to ordinary deductions. To be affiliated, the parent must own directly the amount of the subsidiary’s stock that is described in Section 1504(a)(2) (at least 80% of such stock, by vote and value, excluding stock of a kind described in Section 1504(a)(4)) and for all of its taxable years the subsidiary must have derived more than 90% of its aggregate gross receipts from sources other than those “passive” sources enumerated in the statute. See Section 165(g)(3).