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 Rev. Rul. 73-26

1973-1 C.B. 204

Section 422 -- Qualified Stock Options
Section 425 -- Stock Option Definitions
Section 7805 -- Authority to Prescribe Rules

IRS Headnote

Application of section 422 of the Code to "tandem" qualified and nonstatutory stock options; Revenue Rulings  69-428 and 71-81 revoked;  Revenue Ruling 71-62 amplified.

Full Text

Rev. Rul. 73-26

The Internal Revenue Service has reconsidered the conclusions reached in Revenue Ruling 71-81, 1971-1 C.B. 134; Revenue Ruling 71-62, 1971-1 C.B. 135, and Revenue Ruling 69-428, 1969-2 C.B. 103. These rulings considered variations of the so-called "tandem" stock option, a term used informally to refer to a purported separate grant, either at the same time or at different times, of a qualified stock option and a nonstatutory stock option under terms that provide that the exercise of one option reduces the number of shares for which the other option can be exercised. The reduction in the number of shares may be mutual as between the "separate" options, or may operate only from one option to the other.

In Revenue Ruling 69-428, a qualified stock option and a nonstatutory stock option were purportedly granted simultaneously. Both options were granted at the same option price and for the same number of shares. The qualified option had a 5-year term. The nonstatutory option had a 10-year term but could not be exercised until 5 years and one day after the date on which such option was granted. The number of shares that could be purchased under the nonstatutory option was reduced by the number of shares that the employee purchased under the qualified option. Revenue Ruling 69-428 held that the qualified status of the qualified option under section 422 of the Internal Revenue Code of 1954 was not adversely affected by this arrangement.

Revenue Ruling 71-81 held that when a qualified stock option and a nonstatutory stock option were purportedly granted simultaneously to the same person for the same number of shares, both options being exercisable during the 5-year period after grant, and when the exercise of one option automatically cancelled the optionee's right to buy the same number of shares under the other option, the only tax effect was that any qualified option that is cancelled is subject to the "prior outstanding option" rule of Code section 422(b)(5). The qualified option was exercisable for only a 5-year period. The nonstatutory option was exercisable for a 10-year period. The nonstatutory option was at all times exercisable at a lower price than the qualified option.

Revenue Ruling 71-62 held that a qualified stock option was modified within the meaning of section 425(h) of the Code when, in the year following grant of qualified stock options to employees, the employer adopted an alternate plan under which it granted certain rights to the holders of qualified options. These rights entitled the grantee to receive without charge a number of shares of the corporation's stock computed according to a formula based on the number of shares that the grantee could have purchased pursuant to exercise of the unexercised portion of his qualified option at the time it expired. The rights were exercisable for a 30-day period beginning on the first day after the qualified stock option expired.

Section 422(b) of the Code sets forth the statutory requirements that must be satisfied in order for a stock option granted to an employee to be a qualified stock option. Section 422(b)(3) provides that an option may be a qualified stock option only if the option by its terms is not exercisable after the expiration of 5 years from the date on which it is granted. Section 422(b)(4) of the Code provides (subject to the special rule of section 422(c)(1)) that an option may be qualified only if the option price is not less than the fair market value of the stock at the time the option is granted.

Section 1.421-7(b)(3)(i) of the Income Tax Regulations provides that the determination whether an option is a statutory (qualified) option is made as of the date on which the option is granted. An option that is a statutory option when granted does not lose its character as such by reason of subsequent events, and an option that is not a statutory option when granted does not become such an option by reason of subsequent events.

Section 425(h)(1) of the Code provides that if the terms of a statutory option to purchase stock are modified, extended, or renewed, such modification, extension, or renewal shall be considered the grant of a new option. Section 425(h)(3) of the Code provides that the term "modification" means (with certain exceptions not relevant here) any change in the terms of the option that gives the employee additional benefits under the option.

Section 422(b) of the Code provides, in part, that "the term 'qualified stock option' means an option . . . to purchase stock. . . ." In effect, this language means that the term "qualified stock option" requires an arrangement that does not provide any rights that are alternative to the right to purchase stock.

The legislative history of section 422 of the Code indicates that the purpose of the favorable tax treatment accorded qualified stock options in 1964 was to enable corporate employees to acquire a proprietary interest in the business of the employer company so that they would have an incentive to expand and improve the profit position of the business. Prior to the time the option is exercised, Congress also desired "to decrease the compensatory nature of the existing [pre-1964] stock option provisions and to place greater emphasis on the employee's efforts to improve his company's business and thereby raise the price level of the stock." Senate Report 830, Eighty-eighth Congress, Second Session, 1964-1 (Part 2) C.B. 505 at 593-94; House Report 749, Eighty-eighth Congress, First Session, 1964-1 (Part 2) C.B. 125 at 189.

Among the specific rules designed to achieve this latter objective are the provisions of section 422(b)(4) of the Code, which require the exercise price of options to be not less than 100 percent of the market price of the stock at the date on which the option is granted, and the provisions of sections 422(b)(5) and 422(c)(6) which, in effect, prevent an option price from being reset downward when the market price of the employer's stock declines after a qualified stock option has been granted. See Senate Report 830, supra, at 594.

In essence, Congress intended an optionee to occupy a position similar to a shareholder; he will benefit if the price of the stock increases above the exercise price, but, if the price of the stock declines below the exercise price, the employee will not benefit from the option. In light of this objective, it is inconsistent with the purpose of section 422 of the Code to apply the provisions of that section to an acquisition of stock by an employee pursuant to an option that is part of an arrangement that gives the optionee any rights to purchase, or otherwise to receive, stock or other property as an alternative to the right to buy stock under terms and conditions that satisfy the requirements of section 422 of the Code.

Whether an option and other rights are alternative depends upon the particular facts and circumstances of the individual case. In general, if the exercise of the option affects the exercisability or value of other rights, or if the exercise of such rights affects the exercisability of the option, the option and the rights are alternative. For this purpose, it is not material that such rights entitle the optionee to money, stock of the grantor corporation or other property, or that such rights are not evidenced in the same document evidencing the option or are not granted contemporaneously with the option.

Section 1.421-7(a)(3) of the regulations states that an arrangement between a corporation and an employee may involve more than one option. For example, according to the regulation, if a corporation on June 1, 1964, grants to an employee the right to purchase 1,000 shares of its stock on or after June 1, 1965, another 1,000 shares on or after June 1, 1966, and a further 1,000 shares on or after June 1, 1967, all shares to be purchased before June 1, 1968, provided the employee at the time of exercise of any of the purchase rights is employed by the corporation, such an arrangement will be considered as the grant to the employee on June 1, 1964, of three options, each of the purchase of 1,000 shares. However, if a corporation grants to an employee on January 1, 1965, the right to purchase 1,000 shares of its stock at $65 a share during 1965 or at $75 per share during 1966 or at $85 per share during 1967, such an arrangement will be considered as the grant to the employee on January 1, 1965, of but one option for the purchase of 1,000 shares, which ceases to be outstanding when fully exercised at the price in effect at the time of exercise.

A "tandem" stock option arrangement under which the exercise of one option reduces the number of shares for which the other option can be exercised, whether or not mutually as between the "separate" options, is similar to the second example in section 1.421-7(a)(3) of the regulations. As such, the "tandem" feature renders the arrangement, in substance, merely a form of granting a single option with alternative purchase terms on a given quantity of the employer's stock. Given a tandem feature, it is immaterial whether purported separate options are granted at the same time or at different times; whether purported separate options are granted under the same or under different "plans"; whether the option prices of the two options are the same or different; or whether the options are exercisable simultaneously or only consecutively.

In the fact situations considered in  Revenue Ruling 69-428 and Revenue Ruling 71-81, to the extent that the employee exercises the purported qualified stock option, he cannot exercise the nonstatutory option. Accordingly, in each fact situation, the purported qualified stock option and the nonstatutory option are alternative, and the purported qualified stock option is not a qualified stock option.

In addition to the problem of alternative rights, the purported qualified stock option and the nonstatutory stock option in Revenue Ruling 69-428 and Revenue Ruling 71-81, in substance, constitute a single option which, at the time of grant, is exercisable for a period exceeding 5 years and, therefore, fails to satisfy the requirement of section 422(b)(3) of the Code. Similarly, constituting a single option, the purported qualified stock option and the nonstatutory stock option in Revenue Ruling 71-81 violate the requirements of section 422(b)(4) of the Code because it is exercisable, at the employee's election, at a price below the fair market value of the stock at the date the option was granted.

In the fact situation considered in Revenue Ruling 71-62, the grant of rights to holders of previously granted qualified stock options gave the holders of such options rights to acquire stock of the grantor corporation other than by the exercise of such options. Because the exercisability of such rights depends upon the extent to which such options are not exercised, such options and such rights are alternative. The creation of this arrangement constituted a modification of the previously granted options, which is considered the grant of new options. So viewed, at the time of the grant, the new options were not qualified stock options because they were part of an arrangement with alternative rights. For purposes of the prior outstanding option rule of section 422(b)(5) of the Code, the qualified options before their modification and extension will be considered to remain outstanding until they would have expired by reason of the lapse of time. See section 1.422-2(f)(3)(i) of the regulations.

In addition to the problem of alternative rights in Revenue Ruling 71-62, the grant of the new option, which is considered to have occurred by virtue of the modification, included both the original qualified option and the right to receive stock without charge. As a single option, the new option was also not a qualified option because it violated the pricing requirement of section 422(b)(4) of the Code. Under the alternate terms of the new option, the employee could acquire stock without making any payment at all.

If the grant of alternate "rights" considered in Revenue Ruling 71-62 had occurred simultaneously with the original grant of a "separate" qualified option, the single option would fail from the outset to constitute a qualified stock option. The terms of the single option would fail to satisfy both the 5-year duration requirement of section 422(b)(3) of the Code and the pricing requirement of section 422(b)(4) of the Code.

In accord with the foregoing, Revenue Ruling 69-428 and Revenue Ruling 71-81 are revoked. Revenue Ruling 71-62 is amplified.

Options granted after January 2, 1973, under plans permitting the grant of tandem options will not fail to be qualified stock options if they otherwise meet the requirements of section 422(b) of the Code, provided the options are not granted in tandem with a non-statutory options as described herein.

Pursuant to the authority provided by section 7805(b) of the Code, this Revenue Ruling will not be applied to stock options of the types described in Revenue Rulings 69-428 and 71-81 granted on or before January 2, 1973.