One shareholder has a right of first refusal before other shareholder

[Guest Kim C]

I have a client who is a C Corp and the ownerships percentages of their stores are as follows:

Company 1

Owner 1 100%

Company 2

Owner 1 50%

Owner 2 50%

Owner 1 has "right of first refusal" of shares from owner 2. I am under the impression that this implied ownership constitutes a controlled group situation and thus the plans can be viewed and tested as one. Does anyone know where I can get actual documentation to support this concept?

Please help.

[pjkoehler]

Kim, take a look at the option attribution rules set forth in Code Sec. 1563(e)(1) and Reg. Sec. 1.1563-3(B)(1). You probably know that Code Sec. 414(B) incorporates most of Code Section 1563 by reference, including most of its constructive ownership rules. In general, these constructive ownership rules provide that a person holding an option to purchase shares of stock shall be treated as owning the shares. One issue with your example, is when does owner 1's right of first refusal ripen into an option. I assum that owner 1 cannot purchase the shares in Company 2 held by owner 2 until it receives notice from owner 2 of its intent to sell the shares to a third party at a specified price. Until that condition occurs, the right is arguably not an exercisable option. You could probably argue that current exercisability is a condition on the application of the option attribution rules. This is probably worth some research. Also, I would research guidance under the Sec. 318 attribution rules. While Sec. 318 is not directly relevant for Sec. 414(B) analysis, Code Sec. 318(a)(4) contains an option attribution rule that is word-for-word the same as 1563(e)(1)

[Guest Kim C]

Thanks, I will research those codes. Its a bear when you know the concept but have no reference to the code to back it up.

[imchipbrown]

I have to agree with PJK (or at least would argue the same). I think a similar situation is when a startup issues stock options to its employees. Typically, these options vest over time, say 25% per year. So, before your first complete year, you don't really have an option.

This can be important for determining who's a Key Employee. One half of one percent is a pretty low fence to get over.

[Edited by LCARUSI on 07-11-2000 at 04:39 PM]

[Kirk Maldonado]

Chip:

What is your authority for saying that an outstanding option is disregarded if it isn't vested?

[imchipbrown]

I think it's as clear as mud ;}

318(a)(4) says "If a person has an option to acquire stock..."

My (sole) argument is, if you're not vested, you don't have an option to acquire stock. The option is contingent on a future event, subject to a substantial risk of forfeiture.

I don't have the resources to back up my mouth on this one, but thanks for calling me on it. This must have come up before.

[Dave Baker]

An interesting Q&A in Derrin Watson's controlled group column on BenefitsLink might shed some light -- Using options to create controlled groups (click)

[Guest]

See Rev. Rul. 89-64 where the IRS says that an option is taken into account under the section 318 attribution rules even though it is not immediately exercisable.

[Guest Jamie scott]

But see TAM 8106008 where the Service ruled that a right of first refusal was not an option for purposes of the section 318 attribution rules.

[Guest Derrin Watson]

This is actually a fairly complex issue. I will post an analysis as Question 55 for my Who's the Employer column. Let's see if I can get the URL right: http://www.benefitslink.com/cgi-bin/qa.cgi...who_is_employer

Short answer:

A right of first refusal is not an option until your right to buy stock becomes unconditional. IOW, if you I give you a right of first refusal, it isn't an option until I choose to sell my stock. At that point, and not until, you have the option to buy my stock.

However, a right of first refusal can cause stock to be excluded from consideration for the controlled group rules, under the right conditions.

[imchipbrown]

Maybe this is beating a dead horse, but what about stock options that don't vest if you're not employed? It's more than a passage of time issue.

By the way, fine answers, especially the chap who dug up Rev Rul 89-64, and Derrin, of course.

[imchipbrown]

Rev. Rul 89-64 specifically states that "A" resigned from his position and still had an option after a fixed period of time. I'd like opinions on whether an option which has a time element (vesting over 4 years) but also an employment element (must be employed to vest) is or isn't a "Conditional Option", to cite Derrin's fine work.

(Sorry to post this again. My browser wasn't showing my previous post above, and I assumed I'd been "moderated out". Probably would serve me right!)

[pjkoehler]

I think we should be careful framing questions in the abstract about compensatory arrangments that are inherently contractual and which, therefore, vary greatly. I've never heard of a stock option time-vesting arrangement other than in the context of the optionee's performance of future services (whether as an employee or nonemployee). So I don't understand the distinction you're making between time vesting and service-based vesting. Vesting is usually either future service-based or performance-based or both.

Also bear in mind that vesting and the right to exercise are by no means linked. For example, the concept of "reverse vesting" or permitting the optionee to exercise prior to satisfying the vesting requirements is gaining increasing popularity as a means of facilitating the early exercise of an Sec. 83(B) election.

While it can be argued that nonvested option grants should be disregarded under the applicable option attribution rules for determining controlled group status until the lapse of substantial restrictions or the options become freely transferrable by analogy to the Section 83 rules that defer the inclusion in gross income until such time, there's no compelling need in theory for symmetry between the timing of the inclusion in gross income of property transferred for the performance of services and the attribution of shares for controlled group determination purposes.

It is common for a stock option plan to provide that all unvested options granted to an employee expire automatically on termination of employment (or shortly thereafter) and for a stock option agreement to provide that any unexercised vested options are automatically cancelled within a time certain (recall the ISO rule that requires cancellation within 90 days of termination). So you could argue that options that might expire should also be ignored. But that is the nature of an option. It might not be exercised.

I think the better rationale is that having been granted, the shares subject to the option end up being attributed to the optionee until the option lapses or is otherwise forfeited.[Edited by PJK on 07-31-2000 at 06:05 PM]

[Guest Derrin Watson]

Let's go back. Rev Rul 68-601 deals with company issued debentures. The IRS held "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."

Now, 318 is a different set of attribution rules, but there is no reason for option to mean one thing there and a different thing in 1563. I think that paragraph gives you as clear a definition of option as you will find in regulatory guidance.

Rev Rul 89-64 modifies this ruling only slightly. It deals with a circumstance in which a person sold stock but retained an option to repurchase which became effective after a fixed period of time, with no other conditions. The IRS ruled "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."

In other words, whether you can put down the money and get the stock today, or you can wait a year and then put down your money and get the stock, you still have an option. There's nothing else that has to be in place, no other conditions other than lapse of time which are needed.

Now, if there are conditions -- such as continuing employment -- particularly conditions that are not totally in the control of the option holder (or have independent significance), under both of these rulings you don't have an option. Employment is generally regarded as such a condition, particularly if you are talking about someone who doesn't directly or indirectly control the company.

Can I construct "conditions" that are illusory? Sure. Do I think those will prevent an option from forming? Of course not. But most real conditions are going to keep something from being an option, because of the express wording of these rulings and just the general legal definition of option.

[pjkoehler]

Derrin, I think you're argument by analogy that official guidance applicable to the language of Sec. 318(a)(4) that is verbatim identical to the language of Sec. 1563(e)(1) ought to apply with equal force is logical. But in the absence of official guidance on point, I don't think you can say that IRS acquiesence on audit is free from doubt. I doubt there are many law firms that would provide an opinion letter or accounting firms that would provide a tax opinion based purely on an analogy argument at more than a more probable than not level of authority.

I think you're previous analysis misses a key issue. RR 89-64, in clarifying the phrase "at the election of the shareholder" as used in RR 68-601, says that it is intended to distinquish between a unilateral right to acquire stock (as the ruling ultimately holds regardless of whether or not there is a delay in the right to exercise) and a "bilateral contract." The issue is whether or not a compensatory stock option granted pursuant to a stock option agreement entered into between an employee or nonemployee and the issuer of the securities is a "bilateral contract." Certainly, any first year law school student should analyze the traditional compensatory stock option granted to an employee as a bilateral contract, rather than a unilateral contract (such as a proprietary stock option traded on the open market) where the employee must perform future services in order to obtain the issuer's performance under the agreement. So one way the IRS could limit the holding in RR 89-64, is to take the position that it applies only to proprietary option contracts bought and sold on the open market; not to most compensatory stock option grants, which, of course, is what this thread is focused on. [Edited by PJK on 08-02-2000 at 01:34 PM]

[Guest Derrin Watson]

Originally posted by PJK

I think you're previous analysis misses a key issue.  RR 89-64, in clarifying the phrase "at the election of the shareholder" as used in RR 68-601, says that it is intended to distinquish between a unilateral right to acquire stock (as the ruling ultimately holds regardless of whether or not there is a delay in the right to exercise) and a "bilateral contract."  The issue is whether or not a compensatory stock option granted pursuant to a stock option agreement entered into between an employee or nonemployee and the issuer of the securities is a "bilateral contract."  Certainly, any first year law school student should analyze the traditional compensatory stock option granted to an employee as a bilateral contract, rather than a unilateral contract (such as a proprietary stock option traded on the open market) where the employee must perform future services in order to obtain the issuer's performance under the agreement.

I disagree. The issue on the nature of the contract is not how the right arose, but rather what rights are granted. We need to distinguish from options (where you can exercise your rights regardless of what the other person does) with rights of first refusal or other conditional situations.

Consider that a company grants a stock option to an employee, as the result of work the employee does. That comes as the result of a contract, it is true -- an employment contract. Compare that with an option bought and sold on the open market. That also comes as the result of a contract. The only difference is what is being traded for the option. In one case it is labor. In the other it is money.

But I don't think the Code cares about what consideration was given for the option. I think the only issue is the rights conferred on the option holder, and applicable limitations on those rights.

[imchipbrown]

Phil and Derrin

You guys are great! The amount of time you've spent on this is truely appreciated.

I've got a real world, not hypothetical (and seemingly increasingly common) situation. The employer is a high tech startup. As part of the compensation package, the employees have been given options to buy company stock. Employee X might have an option to buy 10,000. The big BUT is, he must be with the company one year before he can exercise his option on 2,500, another year for the next 2,500, etc.

Why this is of any concern to me is in determining whether Employee X is a key employee for Top-Heavy testing.

How can it be determined if Employee X "owns 1/2% interest in value" of the company? What is the value of the option?

We've established a 401(k) Plan. If Employee X is the only one to make a deferral, how do I tell the employer, the kid down the hall just made the Plan Top-Heavy, and you need to come up with 3% of pay for all non-key employees?

Sorry for rambling.

[Guest Derrin Watson]

For top heavy, key employee, and HCE issues, we are dealing with 318, not 1563. I think you can make a pretty good option, under either Phil's understanding or mine that what you just described is not an option. Phil can speak for himself, but let me elaborate from my standpoint.

The worker's continued employment is a condition. It is a condition that is only partially in his control. He can quit, but even if he chooses to stay, he can't guarantee that the company will still want him 11 months from now. Since there are conditions outside his control, I would say that this is not an option, and hence he is not deemed to own the underlying stock under 318.

[pjkoehler]

". . . The only difference is what is being traded for the option. In one case it is labor. In the other it is money. . . ."

I agree with Derrin's conclusion regarding option attribution for purposes of HCE and Key Employee determination, but his comments are inconsistent with his previous analogy of proprietary and compensatory stock options regarding the holding in RR 89-64. The necessary "condition" to which he refers is the employee's performance of future service in exchange for the right to exercise the option. This is precisely what makes the traditional compensatory option a bilateral, rather than a unilateral contract. When an investor purchases a publicly traded option on the open market, he possesses the enforceable right to exercise before the option expiration date, which is the subject matter of the contract. But when an employer grants an employee a compensatory option in exchange for the employee's future employment, that "condition" makes the contract executory on both sides, i.e. the employee does not have the enforceable right to exercise until the condition lapses. Thus, the contract is executory on both sides, i.e. bilateral. The investor's purchase of the option contract for money is a completed transaction, but an employee cannot tender future services, thus leaving its obligation performable, but far from fully performed. Keep in mind that this is an extension of the holding of RR-89-64, which is fine for HCE and Key Employee determination purposes, but not free from doubt for "controlled group" determination purposes.[Edited by PJK on 08-02-2000 at 05:55 PM]

[Guest Derrin Watson]

Phil, I think we'll have to agree to disagree on this one.