Who's the Employer?

Answers are provided by S. Derrin Watson, JD, APM

Convertible Stock Constituting An Option

(Posted April 6, 2002)

Question 151: Company A owns 66% of the common stock of Company B and 100% of the nonvoting convertible preferred stock of Company B. The remaining common stock is owned by an unrelated entity. If Company A were to convert all of the preferred stock into common stock, Company A would own more than 80% of the common stock of Company B. Are Company A and Company B in a controlled group? In other words, is convertible preferred stock treated like an option for purposes of the attribution rules?

Answer: You've hit the issue squarely on the head.

We start with concept that nonvoting preferred stock is generally excluded in determining controlled group status. But, in this case, it is convertible.

What does that conversion right mean? It means that when A chooses to do so, A has the ability to acquire X shares more of the common stock of B. Instead of paying for this new common stock in cash, A will pay for it by surrendering its nonvoting preferred stock.

To me, that meets every test for an "option." So what if the option price isn't payable in cash? A can acquire, by its own choice, more stock in B, with no conditions other than surrendering a preagreed price.

So, because of the constructive ownership rules of Code section 1563, A is deemed to own more than 80% of the common stock of B. Thus A and B are a parent-subsidiary controlled group. This would be true both for retirement plan purposes and ordinary income tax purposes.

The option attribution rule is discussed at length as a part of Chapter 7 of my book, Who's the Employer.

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