IRS Revenue Ruling
2002-1

 Code Sec. 355

<<FULL TEXT>>

26 CFR 1.355-1: Distribution of stock and securities of a controlled
corporation.
(Also sections: 1.83-6, 1.1032-3).

Options and spin-off. Income tax treatment of options and restricted
stock in spin-offs, under the facts presented.


REV. RUL. 2002-1

ISSUE

Under the facts presented below, after a distributing corporation (D)
distributes the stock of a controlled corporation (C) in a transaction to
which section 355(c) of the Internal Revenue Code applies,

(1) Does D recognize gain or loss when restrictions lapse on C stock
held by D employees that is received in connection with the section 355
transaction? Does D recognize gain or loss when stock options for C stock
held by D employees that are received in connection with the section 355
transaction are exercised?

(2) Does C recognize gain or loss when restrictions lapse on D stock
held by C employees that is received before the section 355 transaction?
Does C recognize gain or loss when stock options for D stock held by C
employees that are received in connection with the section 355 transaction
are exercised?

(3) Who is entitled to deductions for amounts includible in employees'
income as a result of the lapse of restrictions on D and C stock and the
exercise of options to acquire D and C stock described above?


FACTS

D is a domestic corporation of which A is an employee at all times
relevant to this ruling. C is a wholly-owned domestic subsidiary of D of
which B is an employee at all times relevant to this ruling.

In Year 1, D implements a plan to attract and retain qualified
personnel and to provide incentives for continued performance of services
by providing additional compensation to its employees and to the employees
of C in the form of: (i) stock of D that is not transferable and is
subject to a substantial risk of forfeiture, as defined in section 83(c),
for a period of five years beginning in Year 1 (restricted stock); and
(ii) non-statutory options to purchase shares of D stock (the pre-division
options). The plan is not implemented in anticipation of a spin-off.

Under the plan, in Year 1 D issues restricted D stock to A, and to B on
behalf of C, for the employees' services performed for their respective
employers. In the event of forfeiture, the restricted stock would revert
to D. A and B do not make an election in Year 1 pursuant to section 83(b)
with respect to the restricted stock. Also in Year 1, D grants to A, and
to B on behalf of C, pre-division options for their services. The options
do not have a readily ascertainable fair market value (within the meaning
of section 1.83-7(b) of the Income Tax Regulations) at the time they are
issued.

In Year 3, D distributes the stock of C pro rata to D's shareholders in
a transaction that qualifies for nonrecognition of gain to D under section
355(c) (hereinafter referred to as the spin-off). In the spinoff, the
shareholders of D receive one share of C stock for each share of D stock.

Although, under section 83, A and B are not treated as the owners of
the restricted D stock for Federal tax purposes, A and B have rights in
the D stock and receive, in connection with the spin-off, a distribution
of C stock with restrictions identical to the restrictions on the D stock
in order to preserve their pre-spin-off economic interest in the
pre-spin-off restricted D stock. In the event of forfeiture, the
restricted D stock would revert to D and the restricted C stock would
revert to C. Thus, after the spin-off, A and B each hold restricted stock
in both D and C.

Also as part of the spin-off, the pre-division options held by A and B
are canceled and replaced with new options (the post-division options) to
acquire stock in D from D and stock in C from C. Pursuant to the terms of
the post-division options, the post-division options' exercise price is
paid directly to the issuing corporation in exchange for the stock. Except
to the extent that the post-division options separate the pre-division
options into two instruments, the post-division options are designed to
preserve the economic terms of the pre-division options. The total
exercise price of the post-division options held by each of A and B,
respectively, is equal to the total exercise price of the pre-division
options held by each of A and B, respectively. The total number of shares
of D stock subject to the post-division options held by each of A and B,
respectively, is equal to the total number of shares of D stock subject to
the pre-division options held by each of A and B, respectively. The total
number of shares of C stock subject to the post-division options held by
each of A and B, respectively, is equal to the total number of shares of D
stock subject to the pre-division options held by each of A and B,
respectively. Finally, the ratio of (a) the exercise price for each share
subject to a post-division option to acquire D stock to (b) the exercise
price of each share subject to a post-division option to acquire C stock
is equal to the ratio of (x) the estimated fair market value of all of the
outstanding D stock, excluding the estimated fair market value
attributable to D's ownership of C stock immediately prior to the spin-off
to (y) the estimated fair market value of all of the outstanding C stock
immediately prior to the spin-off.

In Year 6, the restrictions lapse on the restricted stock held by A and
B. Also in Year 6, A and B exercise all of their post-division options.


LAW AND ANALYSIS

Under section 83(a), when property is transferred to a person in
connection with the performance of services, the service provider must
include in gross income an amount equal to the fair market value of such
property, less the amount (if any) paid for the property. However, if the
property transferred is not transferable and is subject to a substantial
risk of forfeiture in the hands of the service provider, the fair market
value of the property, less the amount (if any) paid for the property, is
not includible in the service provider's gross income until the property
is transferable or is not subject to a substantial risk of forfeiture,
unless the service provider elects to include such amount in gross income
at the time of the transfer under section 83(b). Section 83(e)(3) provides
that section 83 does not apply to the grant of an option without a readily
ascertainable fair market value.

Under section 83(h), the service recipient is allowed a deduction under
section 162 in an amount equal to the amount included in the service
provider's gross income under section 83(a). Where the property is not
substantially vested on transfer, the deduction is allowed for the taxable
year of the service recipient in which or with which ends the service
provider's taxable year in which the amount is included in the service
provider's gross income. See section 1.83-6(a)(1), (2) of the Income Tax
Regulations. Where property is substantially vested on transfer, the
deduction is allowed in accordance with the service recipient's method of
accounting (in conformity with sections 446 and 461). See section
1.83-6(a)(3).

Section 1.83-6(b) states that, except as provided in section 1032, at
the time of a transfer of property in connection with the performance of
services, the transferor recognizes gain to the extent that the transferor
receives an amount that exceeds its basis in the property. In addition, at
the time a deduction is allowed under sections 83(h) and 1.83-6(a), the
transferor recognizes gain or loss to the extent of the difference between
(1) the sum of the amount paid plus the amount allowed as a deduction
under section 83(h), and (2) the sum of the transferor's basis in the
property plus any gain recognized at the time of the transfer.

Section 1032(a) provides, in part, that no gain or loss is recognized
to a corporation on the receipt of money or other property in exchange for
stock (including treasury stock) of such corporation. Under section
1.1032-1(a), for purposes of section 1032(a), a transfer by a corporation
of its own stock as compensation for services is considered a disposition
for money or other property. Thus, when a corporation compensates
employees with its own stock, the corporation does not recognize gain or
loss under section 1032.

Section 1.1032-3 generally provides that in certain transactions in
which a corporation (the acquiring entity) acquires money or other
property in exchange, in whole or in part, for stock of a corporation (the
issuing corporation), the acquiring entity is treated as purchasing the
stock of the issuing corporation from the issuing corporation for fair
market value with cash contributed to the acquiring entity by the issuing
corporation. If the issuing corporation receives money or other property
in payment for its stock, the amount of cash deemed contributed is the
difference between the fair market value of the issuing corporation stock
and the amount of money or fair market value of other property that the
issuing corporation receives as payment. Section 1.1032-3 generally
enables a corporate subsidiary to obtain a fair market value basis in
parent stock contributed to the subsidiary's capital if the subsidiary
disposes of the parent stock in a taxable transaction immediately after it
is received from the parent. Thus, as a result of the operation of section
1.1032-3, a subsidiary generally does not recognize gain or loss on the
immediate transfer of parent stock to the subsidiary's employee.

A and B recognize income in Year 6 under the rules of section 83 when
the restrictions on the D and C stock lapse and when they exercise their
options to acquire D and C stock. The following discussion addresses the
Federal income tax consequences to D and C when these events occur.

The characterization of the events that occur in Year 6 should reflect
the relationship of D and C that existed in Year 1 and continued until
immediately before the spin-off. Cf. Rev. Rul. 83-73, 1983-1 C.B. 84
(applying a relation-back principle to characterize indemnity payments
made by former shareholders of a merged corporation to the acquiring
corporation). Specifically, to determine whether D recognizes gain or loss
in Year 6 when the restrictions lapse on the restricted C stock held by A,
whether C recognizes gain or loss in Year 6 when the restrictions lapse on
the restricted D stock held by B, whether D recognizes gain or loss in
Year 6 when A exercises the post-division options for C stock, and whether
C recognizes gain or loss in Year 6 when B exercises the post-division
options for D stock, it is appropriate to take into account the terms of
the original arrangement created in Year 1, and the parent-subsidiary
relationship between D and C that existed in Year 1 and continued until
immediately before the spin-off.

Prior to the spin-off, the stock of D reflected an interest in C.
Although, prior to the spin-off, A was not treated as the owner of the
restricted D stock for Federal tax purposes, A had valuable economic
rights with respect to that stock and, indirectly, with respect to D's
stock ownership interest in C. Similarly, although the pre-division
options did not give A ownership in D stock, the pre-division options did
give A valuable economic rights with respect to D stock by reason of the
right to acquire D stock at a fixed price, which would have included an
indirect ownership interest in C if the spin-off had not occurred. Thus,
A's receipt in connection with the spin-off of the restricted C stock and
the post-division options to acquire D and C stock preserved A's economic
rights with respect to the entire pre-spin-off D enterprise, which
included C.

Because the restricted C stock and the post-division options to acquire
C stock are a substitute in part for pre-spin-off restricted D stock and
the pre-division options, it is appropriate for purposes of sections 1032
and 355 to treat a post-spin-off lapse in restrictions on the restricted C
stock held by A and A's exercise of post-division options to acquire C
stock in the same manner under sections 1032 and 355 as a pre-spin-off
lapse of restrictions on the restricted D stock held by A and A's
pre-spin-off exercise of pre-division options, respectively, would be
treated followed by the spin-off. Accordingly, because D would have
recognized no gain or loss under section 1032 by reason of the pre-spinoff
lapse of restrictions on D stock held by A and A's pre-spin-off exercise
of the pre-division options to acquire D stock, and because section 355(c)
applies to the spinoff in Year 3, in Year 6 D recognizes no gain or loss
with respect to the C stock by reason of the lapse of restrictions on the
restricted C stock issued to A and on A's exercise of the post-division
options to acquire C stock. Further, under section 83(h), in Year 6 D is
entitled to a deduction under section 162 in the amount that A includes in
income under section 83(a) as a result of the lapse in restrictions on the
C stock and the exercise of the post-division options to acquire C stock.

Similarly, it is appropriate for purposes of section 1032 to treat a
post-spin-off lapse in restrictions on the restricted D stock held by B
and B's exercise of post-division options to acquire D stock in the same
manner under section 1032 as a pre-spin-off lapse of restrictions on the
restricted D stock held by B and B's pre-spin-off exercise of pre-division
options, respectively, would be treated followed by the spin-off. C would
have recognized no gain or loss under section 1032 by reason of the
pre-spinoff lapse of restrictions on D stock held by B and B's
pre-spin-off exercise of the pre-division options to acquire D stock. See
sections 1.83-6(d) and 1.1032-3; see also section 1.1032-3(e), exs. 6, 8.
Consistent with this analysis, the consequences of the post-spin-off lapse
of restrictions on the restricted D stock held by B and B's post-spin-off
exercise of D options are characterized by reference to the
parent-subsidiary relationship between D and C that existed in Year 1 and
continued until immediately before the spin-off. Accordingly, in Year 6,
for purposes of section 1032, C is treated as if it bought the D stock
from D at fair market value after a shareholder capital contribution from
D, with the result that C recognizes no gain or loss with respect to the D
stock by reason of the lapse of restrictions on the restricted D stock
issued to B and on B's exercise of the post-division options to acquire D
stock. See sections 1.83-6(d) and 1.1032-3. Under section 83(h), in Year 6
C is entitled to a deduction under section 162 in the amount that B
includes in income under section 83(a) as a result of the lapse of
restrictions on the D stock and the exercise of post-division options to
acquire D stock.

Under section 1032, in Year 6 D recognizes no gain or loss when the
restrictions lapse on the restricted D stock held by A and B and when A
and B exercise the post-division options to acquire D stock. In addition,
under section 1032, C recognizes no gain or loss when the restrictions
lapse on the restricted C stock held by A and B and when A and B exercise
the post-division options to acquire C stock.


HOLDING

Under the facts presented above, after D distributes the stock of C in
a transaction to which section 355(c) applies,

(1) D recognizes no gain or loss when restrictions lapse on the C stock
held by A that is received in connection with the spin-off; D recognizes
no gain or loss when stock options for C stock held by A that are received
in connection with the spin-off are exercised;

(2) C recognizes no gain or loss when restrictions lapse on D stock
held by B that is received before the spin-off; C recognizes no gain or
loss when stock options for D stock held by B that are received in
connection with the spin-off are exercised; and

(3) D is entitled to deductions for amounts includible in A's income as
a result of the lapse of restrictions on D and C stock and the exercise of
options to acquire D and C stock, and C is entitled to deductions for
amounts includible in B's income as a result of the lapse of restrictions
on D and C stock and the exercise of options to acquire D and C stock.


DRAFTING INFORMATION

For further information regarding this revenue ruling, contact Mark
Weiss of the Office of Associate Chief Counsel (Corporate) at 202-622-7790
(not a toll-free call).

<<END RULING>>

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