Internal Revenue Service
Revenue Ruling

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 Rev. Rul. 73-92

1973-1 C.B. 208

Sec. 425
Sec. 7805

IRS Headnote

During the three-year holding period for stock obtained through the exercise of a qualified stock option, a short-sale transaction involving identical borrowed stock constitutes a disposition of the option stock.

Full Text

Rev. Rul. 73-92

Advice has been requested whether a disposition of stock occurred within the meaning of section 425(c) of the Internal Revenue Code of 1954 under the circumstances described below.

The taxpayer acquired stock through the exercise of a qualified stock option as defined in section 422(b) of the Code. Prior to the lapse of the three-year holding period required in section 422(a)(1) of the Code and at a time when the stock had increased in value, the taxpayer entered into a short sale stock transaction through a broker whereby he borrowed from the broker and immediately resold to a third party shares of identical stock in the same corporation as the one that had issued him the shares acquired through his exercise of the qualified stock option. At this time the shares acquired through exercise of the qualified stock option were the only shares in the corporation owned by the taxpayer. As security the taxpayer delivered to the broker cash and shares of stock in another corporation, the broker being authorized to lend the endorsed certificates to his customers in the ordinary course of his trade or business and to have such certificates cancelled and reissued in his own name. During the period of the loan, the taxpayer purchased additional stock of the corporation that had previously issued him his option stock, and at the expiration of the three-year holding period, the taxpayer closed the short sale with that stock.

Section 421(a) of the Code states general rules with respect to certain qualifying transfers. Section 422(a)(1) of the Code provides, in part, that section 421(a) shall apply with respect to the transfer of a share of stock to an individual pursuant to his exercise of a qualified stock option if no disposition of such share is made by such individual within the three-year period beginning on the day after the day of the transfer of such share. Section 425(c)(1) of the Code provides, in pertinent part, that the term "disposition" includes a sale, exchange, gift, or a transfer of legal title, but no comprehensive definition of the term is given.

The Revenue Act of 1964, P.L. 88-272, 1964-1 (Part 2) C.B. 6, enacted a comprehensive revision of the existing law pertaining to the various types of stock option plans. Congress recognized that stock options as they existed were little more than devices by which employee compensation could be increased at bargain tax rates. The most significant change was the lengthening of the holding period for qualified stock options from six months, beginning the day after the option was exercised, to three years beginning on such date. This change was designed

* * * to give assurance that the key employees actually are acquiring a 'stake in the business' and are not merely turning the stock over as fast as the options can be exercised. Senate Report No. 830, Eighty-Eighth Congress, Second Session, 1964-1 (Part 2) C.B. 505, at 593.

It is thus evident that the amendments to the existing option provisions were designed to assure that key employees are given an incentive to perform by acquiring and maintaining a "stake in the business" for a minimum of three years. Under the present facts, however, the taxpayer's "stake in the business" terminated when he sold the borrowed stock because subsequent market fluctuations with respect to the option stock (up to the time the short sale was closed) would have no affect on him.

Accordingly, the sale of the borrowed stock in the instant case is a disposition of the option stock for purposes of sections 425(c)(1) and 422(a)(1) of the Code.

Pursuant to the authority contained in section 7805(b) of the Code, this Revenue Ruling will not be applied to short sale transactions entered into on or before February 20, 1973.