PAYMENTS RECEIVED UNDER OPTION AGREEMENT ARE NOT TAXED UNTIL EXERCISE OR LAPSE
“An option is a contract which gives the Optionee a right to buy, sell, lease, or the like within a certain period of time.”
An option payment is not recognized as income at the time the payment is paid or received. Instead, the option payment is recognized only upon the exercise or lapse of the option. In Dill Co. v. Commissioner, the taxpayer entered into a five-year license agreement, which also gave the licensee an option to purchase the taxpayer’s trademark or to extend the license and option to purchase for an additional five years by making a payment of $50,000. The Tax Court held that the payment would not be taken into income until the option to purchase was exercised or lapsed because, until that time, the amount and character of the gain/loss cannot be calculated.
IF AN ORIGINAL OPTION AGREEMENT IS EXTENDED OR SUBSTANTIALLY MODIFIED, WILL THE ORIGINAL OPTION BE CONSIDERED: (i) TERMINATED AND THE EXTENDED OR MODIFIED AGREEMENT BE CONSIDERED A NEW OPTION; OR (ii) WILL THE ORIGINAL OPTION BE CONSIDERED AS CONTINUING?
If a modification or extension to an option agreement is so material that it is treated as a new agreement, then the original option agreement will lapse, resulting in the recognition of income to the Optionor and a deduction to the Optionee. If an option lapses, the Optionee recognizes a loss in the amount of payments made, while the Optionor recognizes a gain of an equal amount. In addition, if the original option agreement is deemed terminated, the holding period will not tack onto the extended or modified option agreement; instead, the holding period of the extended or modified agreement will be measured from the date of execution. So, it is important to know the point when extensions or modifications to an option agreement become so material that the agreement is treated as a new one.
EXTENSION OF AN OPTION AGREEMENT
In some instances, an “extension” to an option agreement will be treated as a new, separate agreement. For example, in Reily v. Commissioner, the taxpayer secured an option to lease land. Over several years the parties entered into a series of “extensions,” which were often executed after expiration of the prior agreement. For example, if the prior extension terminated on January 1, 2010, the new extension might not have been executed until January 5, 2010. The taxpayer sold the option as last extended and modified before six months had passed since its execution. The taxpayer “tacked” the holding periods of the prior option agreements and reported the sale as a long-term capital gain. The IRS disagreed and argued the last extension and modification was a “new” option agreement.
The tax court sided with the IRS and held that the holding period of the option as last extended and modified ran from the date of execution of that extension and did not relate back to the execution of the original option as the taxpayer advocated.
In Reily, the last extension was executed after the prior extension had expired. The simple interpretation of Reily is that you cannot extend an expired option. This is a bright line test which should be followed.
The problem with the opinion in Reily is that the court did not rely solely on the fact that the prior extension had expired. The last extension also had involved the following factors: (i) an additional option payment was made by the Optionee; (ii) it was negotiated separately—i.e., was not authorized in the original option agreement; (iii) the manner of exercise was completely different; and (iv) the contract stipulated that “time was of the essence.” It is the Reily court’s reliance upon these additional factors that renders the decision unclear. What if these additional factors were not present but the last extension was still executed after the expiration of the last extension? What if the last extension was an amendment to the prior extension and was executed before the prior extension expired? What if only some of these factors were present but not others?
The next case addressing this issue is Brown v. Commissioner 56 T.C.M. (CCH) 1568. The facts of Brown are also messy as to the timing of the execution of extensions to the option. The underlying option provided for one extension of 90 days and it is factually unclear whether that extension was timely exercised. The parties executed a second extension which was not authorized in the original option and under that second extension : (i) separate consideration was paid for the extension; (ii) the purchase price was increased; and (iii) the term of the option was extended. The Brown court did not rely on the fact that the original option expired before the execution of the extension, but relied on the holding of the court in Reily that the second extension was separately negotiated and therefore was a new agreement separate from the original option.
The decisions in Reily and Brown are unsatisfying because it is difficult to tell what factors are critical to the holdings of the court. Brown is a memorandum opinion which indicates that the court viewed the case as a “factual dispute” as opposed to a legal issue: i.e., whether factually the extended and modified option was an extension of the original option rather than a new agreement. The Brown court cited Reily as established law and did not even discuss the fact that the extension and modification in Reily was executed after the expiration of the prior extension. Therefore, taxpayers are left with a nebulous “facts and circumstances” test in trying to correctly report the tax consequences in circumstances where an option is extended or modified. Some of the salient facts to be considered are as follows:
- Was the extension/modification executed before the expiration of the last extension?
- Was the extension permitted under the terms of the original option agreement?
- Was separate consideration paid for the option extension which was not included in the terms of the original option agreement?
- Were the reciprocal basic business covenants modified in the extension? As examples: (a) was the purchase price changed?; (b) was the property changed, such as a reduction in acres?; (c) was the manner in which the option must be exercised changed?; or (d) was the term of the option substantially modified?
LESSONS TO BE LEARNED
WKBKY believes that it is fairly clear that if the option has expired before the extension is executed, the extension will not be viewed as a continuation of the original option. The original option will be deemed to have terminated with the attendant tax results.
WKBKY further believes that if extensions are specifically authorized in the original option, that the extended options will be considered part of the original option if timely exercised provided that no substantial modifications to the basic business covenants are made.
WKBKY believes that if an extension is negotiated during the term of an original option but which is not specifically authorized under the original option, the courts will look at all the terms and conditions of the extension to determine if it is a “separate option.” For example, if the only change is the term without consideration, then it is more likely the extension will be viewed as a continuation of the existing option. On the other hand, if separate consideration is paid and if basic business covenants are changed, then the extension will more likely be considered a new option. There are an infinite number of “changes” which may be made to an option as part of an extension and those “changes would have to be evaluated on a case-by-case basis to determine if the extension amounts to a “new agreement.”
SOME DRAFTING THOUGHTS
WKBKY believes that if extensions are provided for in the original option, even in general terms, then any extensions which are negotiated prior to the expiration of the term of the original option will more likely be viewed as an extension of the original option. For example, the following language may be helpful:
The parties acknowledge that unknown circumstances may arise which may require additional time to allow the Optionee to exercise this option. The parties intend that if they mutually agree in writing to extend this option during the term hereof, that this option will not terminate or lapse as a result of any such extension but shall be a continuous uninterrupted option agreement through the extended term.
There is no guaranty that any such language will work. Furthermore, because of the requirement of good faith and fair dealing, which is implied in every contract in California, attorneys may have concern about including such general language because it might make the term of the option uncertain. One of the advantages about using option agreements is that the time limitations in option agreements are generally more strictly enforced by the courts than the time limits in a purchase and sale agreement. If the general language suggested above is included in an option agreement, an Optionee could argue, for example, that additional time was needed and the Optionor did not act reasonably in giving an extension. So the inclusion of any such language in an option agreement must be seriously elucidated.
INSTALLMENT SALE AGREEMENTS
It is hard to reconcile the court’s stance on options with the decisions relating to installment sales. The rules developed under IRC §453B for determining whether one or more modifications to an installment sale agreement result in a deemed disposition of the obligation are considerably more liberal than the Reily or Brown tests. Many kinds of modifications or changes affecting an installment obligation will not constitute deemed dispositions of the obligations. For example, the IRS has ruled that the modification of the terms of an installment obligation to defer dates of payment by five years, to raise the interest rate from 6% to 7%, and to relinquish the right to demand payment did not result in a deemed disposition of the obligation. Additionally, a reduction of the purchase price and the balance of the installment payments is not a disposition of an installment obligation. Similarly, the Tax Court has held that there was no taxable disposition where the obligations of the buyer were assumed by the buyer’s related corporation. WKBKY believes that the rules relating to disposition of installment obligations should be considered by the courts in deciding option extension questions and that the courts should create some bright line tests which can be more easily applied by taxpayers.
An extension to an option agreement is treated as a new and separate option agreement when the option is separately negotiated, there are substantial and material differences in the basic business terms between the old and new agreements, and the option is extended beyond any date contemplated in the original agreement. The courts have adopted a facts and circumstances test which is difficult to apply with any certainty. Care should be taken when an option agreement is extended or modified to make sure that the extension or modification is executed prior to the expiration of the prior agreement. If basic terms are significantly changed and new consideration is paid, there is a significant risk that the original option will be deemed terminated and the extension/modification will be considered a new agreement for tax purposes.
 Reily v. Commissioner, 53 T.C. 8 (1969).
 Rev. Rul. 78-182, 1978-1 CB 265.
 Dill Co. v. Commissioner, 33 T.C. 196 (1959).
 Reily v. Commissioner, 53 T.C. 8, 12 (1969).
 Rev. Rul. 68-419.
 Cunningham v. Com’r, 44 T.C. 103 (1965).