OPTION PAYMENTS ARE NOT TAXABLE IN YEAR OF RECEIPT. (2024)

UIL Number(s) 0061.00-00, 1234.01-01

Date: March 26, 1991

1. Did B's limited right to enter onto A's property make B's annual payments to A rental payments that were taxable to A when received?

2. Did the amendment, dated May 31, 1985, terminate the original 1976 agreement between A and B and cause A to recognize income in 1985?

FACTS

On December 30, 1976, A signed an agreement with B. The agreement was entitled "Option to Purchase-Real Property Agreement."

Under the terms of this agreement, A granted to B an exclusive option to purchase M acres of real property at any time within the period beginning January 1, 1977, and ending December 31, 1986. In consideration for the option, B agreed to pay A $X per acre on or before February 1st of each year, beginning in 1977 and ending in 1985. The purchase price for the property was $Y per acre in the first year of the ten year option period; thereafter, the purchase price increased yearly at a rate of $X per year, per acre, until the purchase price reached a maximum of $Z per acre in the tenth year of the option period. B was entitled to full credit, against the total purchase price, for all option payments made.

The agreement authorized B to enter upon the property to make surveys of coal and other mineral deposits, to conduct soil and water tests, to examine existing structures, and to be present for other purposes related to mining. This work was to be supervised and done in a manner that caused the least possible disturbance to the possession of the property by A. B agreed to indemnify A for the negligent acts of its employees, agents, and any other persons who entered upon the land on B's behalf. B further agreed to give A, who owned the surface rights to the coal but not the coal itself, notice prior to entering the property.

The agreement did not provide that the term of the option could be extended, or that the amount of the annual installments or purchase price could be changed. It also did not specify the consequences of nonpayment of the annual installments. According to A, B advised A that it would not pay the installment due February 1, 1985, because the option exercise price and annual payment no longer reflected the value of the property.

On May 31, 1985, A and B signed a document described as an amendment to the option to purchase real property agreement. The amendment changed certain terms in the original option agreement and added a cancellation clause. Under the amended agreement, the "option period" is extended through December 31, 1997. The option payment is reduced to $.07X per acre, retroactive to February 1, 1985, and continued annually thereafter. The price for the property is lowered to $.52Z per acre during the "remaining term" of the "option period." At its sole option and for any reason, B may serve notice to A that it intends to cancel the agreement six months from the date of the notice. The amendment recited that all other terms of the original agreement were unchanged.

B has yet to exercise its option to purchase A's property. A has not included any of the annual payments from B into income.

APPLICABLE LAW

Under section 61 of the Internal Revenue Code, gross income means all income from whatever source derived, and includes rents and gains derived from dealings in property. Under section 1222(3), gain from the sale of a capital asset held for more than 1 year is generally long-term capital gain. Under section 1.1234-1(b) of the Income Tax Regulations, any gain to the grantor of an option arising from the failure of the holder to exercise it is ordinary income.

RATIONALE

Issue 1.

An option may be described as an agreement that gives a party a right to purchase property at a fixed price within a specified period of time. Koch v. Commissioner, 67 T.C. 71, 82 (1976), acq., 1980-2 C.B. 1. Option payments are not taxed until the option lapses or is exercised, because the tax consequences of the payments are not known before then. Virginia Iron Coal & co*ke Co. v. Commissioner, 99 F.2d 919, 921 (4th Cir. 1938), cert. denied, 307 U.S. 630 (1938). If the option lapses, the option payments are taxable as ordinary income in the year the option lapses. id. If the option is exercised, the option payments are considered to be part of the purchase price of the property and are subject to capital gains treatment in the year the option is exercised. id.

An agreement that gives an optionee exclusive control over the option property prior to exercise of the option may be treated not as a true option but as a lease in substance, and the payments made pursuant to it may be taxed as rental income. In Howlett v. Commissioner, 56 T.C. 951 (1971), the taxpayer couples occupied housing "free from rent" under similar agreements that gave each couple an option to purchase the property. In order to continue occupying the residential property, each couple was required to make monthly payments. The court held that the monthly option payments were rental payments and the option agreement was essentially a rental agreement, only incidentally giving the tenant-optionee an option to purchase the property they were occupying. In Kitchin v. Commissioner, 353 F.2d 13 (4th Cir. 1965), the taxpayers supplied equipment under an agreement that gave the user an opportunity to purchase the equipment, with credit for prior payments, at an agreed price within a stated period. The taxpayers excluded the equipment payments from gross income until they were advised by the user whether it intended to purchase the equipment. The court held that the equipment payments were taxable when received. In so holding, the court distinguished the agreement before it from the agreement in Virginia Iron Coal & co*ke Co., which permitted the optionee to explore the land subject to the option and to remove ore for test purposes but did not otherwise affect possession of the property. That agreement, according to the court, was a "straight option," which caused no appreciable change in the ownership or possession of property. Kitchin, 353 F.2d at 15. This distinction was reiterated in Perma-Rock Products, Inc. v. United States, 373 F.Supp. 159 (D.Md. 1973), where the court concluded that payments pursuant to a lease- option for machinery and equipment under the optionee's complete control were rental income when received.

Like the optionee in Virginia Iron Coal & co*ke Co., in this case B had only a limited right to use A's property during the term of the original option agreement: B could enter A's property only with prior notice and for specified purposes related to mining. B has the same limited rights during the term of the amended option agreement. In contrast to the taxpayers in Howlett, Kitchin, and Perma-Rock Products, Inc., B did not have exclusive possession of the option property at any time during the term of the original option agreement, and does not have exclusive possession of the option property at any time during the term of the amended option agreement. Therefore, B's right of access to the land at all times was too limited to cause its annual payments to be characterized as rental payments and taxed when received.

Issue 2.

The duration of the option as well as several other material terms of the original 1976 agreement between A and B were changed by the amendment dated May 31, 1985. A maintains that the amendment continues the original option without causing income to be recognized.

Defined at its most basic level, an option is simply a contract to keep an offer open. 1 S. Williston, A Treatise on the Law of Contracts section 5:15 at 710 (R. Lord 4th ed. 1990). A negotiated extension of the term of the offer is, as the taxpayer maintains, a modification of the original contract. Such a modification, however, does not continue the original option contract, but instead creates a new and separate agreement. Broadwell v. Smith, 152 Ga. 161, 108 S.E. 609 (1921); Ide v. Leiser, 10 Mont. 5, 24 P. 695 (1890); Ratner v. Coral Television Corp., 139 So.2d 437, 438 (Fla. Dist. Ct. App. 1962). An agreement when amended by the mutual consent of the parties becomes a new agreement that takes the place of the old. Barrett v. Lawrence, 110 Ill. App.3d 587 442 N.E.2d 599, 601 (App. Ct. 1982); Beacon Terminal Corp. v. Chemprene, Inc., 75 A.D.2d 350, 429 N.Y.S.2d 715, 717-718 (App. Div. 1980).

When there is a change [in an agreement] the minds of the parties have met again and by the fact of the change, a new agreement arises. The minds of the parties may thus meet upon the terms of the old agreement with but the slightest change, yet the agreement then made is a new one.

Barrett, 442 N.E.2d at 602 (quoting Mahaffey v. Wisconsin Central Ry. Co., 147 Ill.App. 43, 46 (App. Ct. 1909)).

Consistent with this line of authority, the Tax Court in Reily v. Commissioner, 53 T.C. 8, 12 (1969), ruled that each option has its own identity and is separate and distinct from every other option. The petitioner in Reily argued that its option to lease a tract of land was essentially a continuation of a prior option, so that its holding period for the later option could be tacked on to its holding period for the prior option and proceeds from the sale of the option were taxable as long-term capital gain. As in this case, amounts paid under the earlier agreement were credited under the new agreement. The court concluded that the bilaterally negotiated extension of the earlier option contract was a new and different option. It accordingly held that tacking was not allowed and that gain from the sale of the later option was short-term capital gain. In Brown v. Commissioner, T.C. Memo. 1989-133, the Tax Court followed Reily and concluded that a separately negotiated agreement, which changed the term and cost of an option and the purchase price of the option property, was a separate agreement rather than a continuation of the original agreement. It should also be noted that in both Reily and Brown, the Tax Court based its decision on the difference in the terms between the old and the new agreements, rather than on a failure by the parties to label the new agreement as a "continuation" of the old agreement.

A maintains, however, that the controlling judicial authority applicable to the present case is the Board of Tax Appeals' decision in Virginia Iron Coal & co*ke Co., 37 B.T.A. 195 (1938), aff'd, 99 F.2d 919 (4th Cir. 1938), cert. denied, 307 U.S. 630 (1938). In that case the optionee had failed to make a payment required in 1932. The parties subsequently entered into supplemental contracts that extended the time for further payment. In 1933 the optionee notified the petitioner that it would not exercise the option. Before the Board of Tax Appeals, but apparently not on appeal, the petitioner argued that if gain was recognized when the option expired, then it was recognized in 1932 when the option lapsed. The Board of Tax Appeals rejected the petitioner's argument, reasoning, without citing authority, that "the parties, by further agreement, revived the option and continued it, so that the payments theretofore made were not forfeited at that time [1932]." Virginia Iron Coal & co*ke Co., 37 B.T.A. at 199. The Board of Tax Appeals held that income was recognized in 1933, when the option was abandoned. The Tax Court followed the Board of Tax Appeals' decision in Hicks v. Commissioner, T.C. Memo. 1978-373.

The duration of the option in Virginia Iron Coal & co*ke Co. was not changed by the supplemental contracts the parties had entered into. In its opinion the Board of Tax Appeals accordingly did not consider whether the same option is continued when its DURATION is changed by a separately negotiated agreement. However, this is at issue here, and was at issue in Reily, where the Tax Court viewed the subsequent agreement not as a continuation of the original agreement but instead as a separate option contract. In Reily the court rejected the view that a lapsed option can be continued for an extended term by a subsequently executed agreement. To the extent the opinions of the Board of Tax Appeals and the Tax Court differ concerning whether the same option is continued by a subsequent agreement modifying the terms of the original contract, the reasoning of the court in the Reily opinion is well-grounded in contract law and persuasive.

A has also argued that A's position in this case is consistent with the results reached by the courts and the Service in other areas of federal tax law, such as the disposition of installment obligations for purposes of section 453B of the Code, income from the discharge of indebtedness (now governed by section 108(e)(5)), and the allowance of losses under section 165. We have carefully considered A's arguments. However, in the light of clear judicial authority holding that bilaterally negotiated changes in the terms of an option agreement create a new option, we are not persuaded that analogies to different tax law areas are warranted in this case.

In summary, in this case A, in 1976, had granted B an option to purchase certain land. A and B had agreed at that time that the option would terminate in 1986. Until the start of 1985, A and B had complied with the terms of their original agreement. In 1985 they signed an agreement that extended the term of the option for 11 years and substantially reduced both the annual option payment and the purchase price of the property. Under the authority we have cited, this new agreement was a separate option, not a continuation of the original agreement. The original agreement thus terminated in 1985, when the second and succeeding option agreement was signed. Accordingly, under section 1.1234-1(b) of the regulations, A must recognize ordinary income in 1985 in the cumulative amount of all annual option payments that A received under the unexercised original 1976 agreement.

CONCLUSIONS

1. B's limited right to enter onto A's property did not make B's annual payments to A rental payments that were taxable to A when received.

2. The amendment dated May 31, 1985, terminated the original option agreement and caused A to recognize ordinary income in 1985 in the cumulative amount of all annual option payments that A received under the unexercised original 1976 agreement.

A copy of this technical advice memorandum is to be given to the taxpayer. Section 6110(j)(3) of the Code provides that it may not be used or cited as precedent.