Answer: The following is an excerpt from Chapter 7 of my book, Who's the Employer?:
What is an option?
An option is the right to purchase stock from the corporation or its shareholders. Such a right cannot be subject to any conditions, other than the lapse of time or payment of the purchase price. (See Rev. Rul. 68-601, 1968-2 CB 124, Rev. Rul. 89-64, 1989-1 CB 91.) This is illustrated by the following examples:
Option from Company. I have the right to buy 100 shares of X company stock from X company. I have an option. I am deemed to own the 100 shares.
Option from Shareholder. I have the right to buy 100 shares of X company from Fred for a price of $100 per share. Currently, the price is $80 per share. I have an option. I am deemed to own the 100 shares.
Delayed Option. I have the right to buy 200 shares of X company stock. However, this option is not exercisable until January 1, 2005, but is otherwise not subject to any conditions. I have an option. I am deemed to own the 200 shares.
Conditional Option. I have the right to buy 200 shares of X company stock from Bill if Bill divorces my daughter. The option is subject to restrictions not within my control and not related to passage of time. It is not an option for attribution purposes.
Satisfied Condition. Same facts as the prior example, except Bill divorces my daughter (the scoundrel!). I now have an option and am deemed to own the 200 shares.
Right of First Refusal. I have a right of first refusal on Mary's stock. If Mary wants to sell the stock, she must first offer it to me at the same price at which she proposes to sell it, and I have 25 days in which to buy the stock. I do not have an option. My rights are subject to restrictions not within my control (Mary deciding to sell the stock).
Right of Refusal Exercised. Same facts as the prior example, except Mary tells me she wants to sell the stock. During the 25 day period, technically I have an option to buy the stock. I have the right to buy the stock from Mary, and there are now no conditions that must be satisfied other than paying the price. Thus, I have an option and am deemed to own the stock.
Put-Call Agreement. Esther and I are equal shareholders of a corporation. We have a shareholder's agreement. The agreement gives me the option to give Esther a notice at any time naming a price for my stock, and demand that Esther either buy my stock at that price or sell me her stock at that price. Esther has a similar option. Although my right to give the notice is unconditional, I do not know when I do so whether I will buy her stock or she will be buying mine. Accordingly, until one of us gives notice, it is not an option, since is it subject to the condition of the other party choosing to sell rather than to buy.
Put-Call Notice Given. Continuing the last example, suppose Esther gives me a notice and demands that I buy her stock at $100/share or sell mine at the same price. I now have an option to buy her stock, since my right to buy it is unconditional. She still does not have an option to buy mine, because whether she buys or sells is in my control, even though she gave the notice.
It should be noted that the definition given here mirrors the definition used for options under IRC §318, the attribution rules for highly compensated employees and affiliated service groups. In fact, the IRS has not issued any regulations or rulings defining options under §1563, and there are no reported court decisions interpreting the option rule for that purpose. However, there is no logical reason for there to be a difference in the meaning of "option" for the two sets of attribution rules which use the term. In any case, the §318 definition fits with the commonly accepted legal definition of the term.
So, if a right of first refusal is not an option, does it have an effect? It can. An right of first refusal is a restriction on transfer. Under the right conditions, that can cause the stock to be excluded under IRC §1563(c)(2)(B)(ii). This is also a complex issue and is discussed in Q 8:7-8:9 of Who's the Employer?. The bottom line is that if the stock can be ignored in determining if a controlled group exists if:
- 5 or fewer shareholders own at least half of the stock of the company,
- The right of first refusal runs in favor of one of those shareholders or the company itself,
- The right of first refusal is not reciprocal (i.e., I have a right of first refusal on you, but you don't have one on me), and
- The stock subject to the right is held by an employee of the company.