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The tax treatment of exchanges of warrants for stock appears tranquil at first, but closer examination reveals significant pockets of uncertainty. The IM promulgation in 1998 of regulations treating stock rights as securities for purposes of 354 has notably lessened this uncertainty.
Under sec 1032, an issuing corporation does not recognize gain or loss when it trades in its stock and warrants to acquire its stock. Other than that, the treatment of a taxpayer's dealings in warrants has generally been thought to be governed by the rules that apply to an investor's dealings in any other call right. Those rules, along with those applying broadly to issuers and holders of puts, calls and straddles, are set forth in Rev. Rul. 78-182.1 That ruling provides that the holder of a call option, such as a warrant, realizes no taxable income upon the exercise of the option, and its basis in the call is added to the basis of the property purchased through the exercise. When the grantor of the call is also the issuer of the stock into which it is exercisable, this nonrealization conclusion is further supported by the holding in Rev. Rul. 72 265,2 in which the IRS ruled that a holder of a convertible debenture does not realize taxable income upon the conversion of the debenture into stock of the issuer pursuant to the conversion feature.
Before going very far with an analysis of the tax treatment of a warrant exercise, it is quite important to first determine whether one is dealing with an option held by an investor or by a service provider The discussion herein is limited to the holder of a warrant or similar option who received it in connection with an investment transaction and not in a compensatory context. The treatment of a taxpayer who receives a stock option in connection with the performance of services is governed either by sec 421 et seq. with respect to incentive (qualified) stock options, or by sec 83 with respect to nonqualified options. Generally, under Regs. sec 1.83-7, a service provider (whether an employee or independent contractor, individual, partnership or corporation) receives open transaction treatment on the receipt of a nonqualified option, and is taxed upon exercise in an amount equal...