PLR 200728038: Special dividend permits related stock option adjustments

Plain-English summary

A real estate investment trust paid shareholders a special dividend after selling an investment. It planned proportional adjustments to outstanding employee stock options, including options intended to qualify as incentive stock options, to reflect the distribution. The IRS ruled that the nonrecurring special dividend was a corporate transaction under the option regulations and that the contemplated adjustments would occur because of that transaction. It did not decide whether the options actually qualified as incentive stock options or how section 409A applied.

Ruling snapshot

• Question: Would the special dividend and related option adjustments meet the corporate transaction rules?
• Outcome: Approved: the dividend was a corporate transaction and the adjustments were related to it.
• Key authorities: IRC § 424(a); Treas. Reg. § 1.424-1(a)(3), (4)

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224

Number: 200728038
Third Party Communication: None
Release Date: 7/13/2007
Date of Communication: Not Applicable

Person To Contact:
Index Number: 424.01-00
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Telephone Number:
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Refer Reply To:
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CC:TEGE:EB:EC
------------------------------------------------ PLR-155649-06 Date:
April 05, 2007

LEGEND:
$A = -----------------
$B = -------------------
$C = -------------------
$D = --------
Corporation = ----------------------------
Date 1 = --------------------------
Month 1 = ------
Partnership = ---------------------------
Plan 1 = ----------------------------------------------------------------
Plan 2 = ----------------------------------------------------------------
Target = ------------------------------
X percent = -----------------
Y percent = -----------------
Year 1 = -------
Year 2 = -------

Dear ------------:

This letter is in response to the letter dated October 25, 2006, submitted by your authorized representative, requesting certain rulings under section 424 of the Internal Revenue Code (Code) regarding the adjustment, as the result of a particular transaction, of outstanding stock options intended to satisfy the requirements under section 422 of the Code concerning incentive stock options. The facts, as represented, are as follows.

Corporation owns approximately X percent of the common limited partnership units of Partnership. Corporation also owns preferred units of Partnership. Corporation’s overall ownership interest in Partnership (both common and preferred units) is Y percent.
PLR-155649-06
2

Corporation elected to be taxed as a real estate investment trust (REIT) as defined under section 856 of the Code. Virtually all of Corporation’s interests in properties and other assets are held through Partnership. Both Corporation and Partnership have common equity securities that are required to be registered under section 12 of the Securities Exchange Act of 1934 (Exchange Act).

Options intended to qualify as incentive stock options under section 422 of the Code have been granted to employees of Corporation under Plan 1 and Plan 2. Plan 1 and Plan 2 both include an adjustment provision under which the compensation committee or the board of trustees of Corporation “shall make such substitution or adjustment, if any, as it deems to be equitable” with respect to the number or kind of shares or other securities issued or reserved for issuance pursuant to Plan 1 or Plan 2, as applicable, and to outstanding awards in the event of any change in the outstanding shares of Corporation by reason of any share dividend or split, recapitalization, merger, consolidation, spinoff, combination or exchange of shares or other corporate change, or any distributions to common shareholders other than regular cash dividends.

During Year 1, Corporation acquired from Target for $A Target common shares and a derivative interest in Target common shares with an aggregate strike price of $B. In Month 1 of Year 2, Corporation disposed of all of its interest in Target realizing a capital gain of $C. As a result of the disposition, Corporation paid a special dividend (the “Special Distribution”) of $D per share on Date 1.

Corporation distributes a portion of its earnings to shareholders by paying four equal quarterly dividends each year. The Special Distribution is unlike the quarterly dividends because it is nonrecurring, not a part of a pattern of dividends or distributions and could not reasonably have been predicted until shortly before the Special Distribution was made. The Special Distribution is directly related to a capital transaction (i.e., the disposition of Corporation’s interest in Target) representing a nonrecurring event that is separate and apart from Corporation’s ordinary dividends and core business activities. The Special Distribution is not a payout of normal corporate earnings (as is the case with regular quarterly dividends). Further, the Special Distribution potentially reduced or diluted the value of the option holders’ interests relative to those of the shareholders who received the Special Distribution.

As a result of the Special Distribution, Corporation intends to make a proportional adjustment of outstanding options, including options intended to qualify as incentive stock options under section 422 of the Code, under both Plan 1 and Plan 2 as soon as practicable following receipt of a favorable response to its ruling request. The adjustment would apply to all options that were outstanding when the Special Distribution was paid. The options would cover the same stock before and after the contemplated adjustments.
PLR-155649-06
3

Section 424(a) of the Code provides that the term “issuing or assuming a stock option in a transaction to which section 424(a) applies” means a substitution of a new option for the old option, or an assumption of the old option, by an employer corporation, or a parent or subsidiary of such corporation, by reason of a corporate merger, consolidation, acquisition of property or stock, separation, reorganization or liquidation, if (1) the excess of the aggregate fair market value of the shares subject to the option immediately after the substitution or assumption over the aggregate option price of such shares is not more than the excess of the aggregate fair market value of all shares subject to the option immediately before such substitution or assumption over the aggregate option price of such shares, and (2) the new option or the assumption of the old option does not give the employee additional benefits which he did not have under the old option.

Section 1.424-1(a)(4)(i) of the Income Tax Regulations (Regulations) provides that in order for a change in an option or issuance of a new option to qualify as a substitution or assumption, the change must occur by reason of a “corporate transaction” as defined in section 1.424-1(a)(3).

Section 1.424-1(a)(4)(ii) of the Regulations provides that generally a change in an option or issuance of a new option is considered to be by reason of a corporate transaction unless the relevant facts and circumstances demonstrate that such change or issuance is made for reasons unrelated to such corporate transaction. A change in an option or issuance of a new option will be considered to be made for reasons unrelated to a corporate transaction if there is an unreasonable delay between the corporate transaction and such change in the option or issuance of a new option or if the corporate transaction serves no substantial corporate business purpose independent of the change in options.

Section 1.424-1(a)(4)(iii) of the Regulations provides that a change in an option or issuance of a new option is by reason of a distribution or change in the terms or number of the outstanding shares of a corporation only if the option as changed, or the new option issued, is an option on the same stock as under the old option.

Section 1.424-1(a)(3)(ii) of the Regulations provides that the term corporate transaction includes a distribution (excluding an ordinary dividend or a stock split or stock dividend described in section 1.424-1(e)(4)(v)) or change in the terms of number of outstanding shares of a corporation.

Based solely on the facts presented, we rule as follows:

1. The Special Distribution was a “corporate transaction” within the meaning of that term
   as used in section 1.424-1(a)(3) of the Regulations.
   PLR-155649-06 4

2. The contemplated adjustment of options intended to qualify as incentive stock options
   that were granted pursuant to Plan 1 and Plan 2 to reflect the Special Distribution will be treated as occurring “by reason of” a “corporate transaction” (within the meaning of those terms as used in section 1.424-1(a)(3) and (4) of the Regulations).

No opinion is expressed or implied regarding whether options granted under Plan 1 or Plan 2 satisfy the requirements of section 422 of the Code. No opinion is expressed or implied concerning the tax consequences of the proposed transactions under any other provision of the Code or regulations or the tax treatment of any conditions existing at the time of, or effects resulting from, the proposed transactions that are not specifically covered by the above rulings. In particular, no opinion is expressed or implied concerning the application of section 409A of the Code to the proposed transactions.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code provides that it may not be used or cited as precedent.

A copy of this letter must be attached to any income tax return to which it is relevant.

The rulings contained in this letter are based upon information and representations submitted by the taxpayer and accompanied by a penalty of perjury statement executed by an appropriate party. While this office has not verified any of the material submitted in support of the request for rulings, it is subject to verification on examination.

In accordance with the Power of Attorney on file with this office, a copy of this letter is being sent to your authorized representative.

Sincerely,

WILLIAM C. SCHMIDT
Senior Counsel, Executive Compensation Branch (Employee Benefits)
(Tax Exempt & Government Entities)