Payments (or "Premiums") received by a taxpayer for the granting of an option to purchase property owned by the taxpayer have long received special (and favorable) tax treatment. Normally, an item of income is includible in a taxpayer's gross income no later than the year in which it is received. However, payments received for the granting of an option are generally not taken into account until the year in which the option is exercised or is allowed to lapse. In addition to this "deferral" benefit, there is a "characterization" benefit as well -- if the option is exercised, the option premium is added to the amount realized on the sale of the property by the taxpayer and may, therefore, qualify for favorable capital gain. If the option lapses, the premium is taken into account as ordinary income in the year of lapse. (These are the rules for options on real property; different rules apply to options with respect to stock and certain similar property.)
The reason for the "deferral" rule is grounded in the "characterization" rule. Once it is conceded that the character of the income arising from granting the option depends on whether the option is (or is not) exercised, it becomes impossible to account for the option premium until that contingency is resolved; determination of the tax consequences is therefore deferred until that time.
This favorable treatment is restricted to the grant of rights which fall into the category of "options"; in contrast, premiums received for the granting of other sorts of rights, such as "rights of first refusal," are currently taxable. In a recent case, the Tax Court had occasion to reaffirm this distinction between "options" and other rights and concluded that the particular arrangement in issue was not an "option" for purposes of the deferral rule.
Old Harbor Native Corp. v. Commissioner (January 31, 1995) -- Old Harbor Native Corporation ("Old Harbor") is an Alaska native corporation formed under the Alaska Native Claims Settlement Act. Under that Act, Old Harbor was granted surface estates in approximately 35,000 acres of land located in the KodiakWildlife Refuge and approximately 65,000 acres of land located in the Alaska Maritime National Wildlife Refuge. Commencing in 1985, Old Harbor entered into negotiations with the Department of the Interior for the exchange of these surface estates for subsurface rights in oil and gas located in the Arctic National Wildlife Refuge (the "ANWR"). Although no agreement was ever signed by the Secretary of the Interior, Old Harbor and the Interior Department did negotiate a proposed agreement, under which such an exchange would occur. By its terms, the proposed agreement, even if it had been signed, would have been contingent on the enactment, prior to 1994, of certain implementing legislation by Congress and approval by Old Harbor's shareholders.
In early 1987, Old Harbor entered into an agreement with Texaco, Inc., under which Old Harbor agreed to transfer to Texaco, at Texaco's option, all of the subsurface rights that Old Harbor might receive in the ANWR under Old Harbor's proposed agreement with the Interior Department.
Old Harbor's agreement with Texaco was, like the proposed Interior Department agreement, contingent on the enactment of implementing legislation by Congress and the option had to be exercised during the 15- to 40-day period following enactment.
The Texaco agreements required that Texaco make certain payments to Old Harbor when Old Harbor's shareholders approved the Interior Department and Texaco agreements and quarterly thereafter; additional payments were required when Old Harbor designated (at Texaco's direction) the particular rights in the ANWR to be acquired by Old Harbor and transferred to Texaco. The total of these payments to Old Harbor by Texaco was $5,050,000 during 1987 and $270,000 during 1988. Old Harbor did not include any of these amounts in gross income, on the theory that they constituted option premiums. Texaco terminated the agreement during late 1993, at a time when the legislation on which it was conditioned had not yet been enacted.
The Internal Revenue Service argued that Old Harbor was not entitled to exclude from its income the Texaco payments received in 1987 and 1988, on the theory that the rights granted by Old Harbor to Texaco did not constitute an "option." The Tax Court agreed with the Service.
The Court noted that prior cases had established that an offer to transfer property would be considered an "option" only if the holder had the present ability to accept the offer; for example, a right of first refusal is not an "option." In this case, Old Harbor's agreement with Texaco was unenforceable by Texaco until Old Harbor acquired ownership of subsurface rights in the ANWR. Therefore, Texaco's rights were too vague and uncertain to constitute an "option."
In fact, the Court pointed out, Texaco never had more than a "mere expectancy" of receiving rights that Old Harbor might acquire in the ANWR. The contingencies on which turned the ability of Old Harbor (first) and Texaco (subsequently) to acquire rights in the ANWR were not within the control of Old Harbor, but rather within the control of Congress and the Secretary of the Interior. In this regard, it is curious that the Court also found relevant a 1983 case, in which the taxpayer's granting of a right to buy any gold extracted from a mine owned by the taxpayer was not considered to be an "option," since the taxpayer was not obligated to mine any gold and the purported "optionee's" ability to exercise its right was thus wholly within the taxpayer's control; such a situation seems quite distinguishable from one in which the taxpayer is obligated to transfer property upon the occurrence of conditions outside of the taxpayer's control.
In any event, the Court held that Old Harbor's agreement with Texaco "did not contain an unconditional right for Texaco to [acquire] a subsurface right in the ANWR that petitioner owned or had a vested right to receive." Therefore, Texaco made its payments to Old Harbor in exchange for rights under an "inchoate contract" not rising to the level of an "option" and Old Harbor was not entitled to exclude those payments from its gross income.
While the Court's discussion regarding the contingent nature of the transactions between Old Harbor and Texaco is not overly troubling, some of the statements made in the course of the opinion in this case may contain the seeds of substantial confusion in the future. In particular, a reference made by the Court to an option's requiring the "present ability to accept the offer" may raise questions about the ability of payments made for an option unconditionally exercisable in the future to qualify for exclusion from gross income. There seems to be no reason to treat such payments differently from those received for an immediately exercisable option.
In any event, the distinctions drawn by this opinion are quite fine and not always intuitively obvious. Any taxpayer contemplating granting any option de, parting from the "plain vanilla" would be well advised to consider the implications of this case before proceeding with such a transaction.
Ronald A. Morris and Elliot Pisem, members of thebar, are partner's in the law firm of Roberts & Holland, New York City and Washington, D.C.