The Internal Revenue Service (IRS) has issued final regulations on the tax treatment on noncompensatory options and convertible instruments issued by a partnership.  The regulations generally provide that the exercise of a noncompensatory option does not cause recognition of gain or loss to either the issuing partnership or the option holder. The regulations also modify Internal Revenue Code Section 704(b) regulations on the maintenance of partners’ capital accounts and the determination of partners’ distributive shares of partnership items. In addition, the final regulations provide a characterization rule under which the holder of a call option, warrant, convertible debt, or convertible equity issued by a partnership is treated as a partner under certain circumstances.

A noncompensatory option is defined by the final regulations as an option issued by a partnership, other than an option issued in connection with the performance of services. An option is defined for this purpose as a call option or warrant to acquire an interest in the issuing partnership, the conversion feature of convertible debt, or the conversion feature of convertible equity.

Background. Under Code Section 721, a partner’s contribution to a partnership, whether being formed or operating, in exchange for a partnership interest usually does not result in recognized gain or loss to any partner or to the firm. However, this section applies only to contributions, and not to sales, loans, or other transactions between a partner individually and the firm.

Partnerships often issue options or convertible instruments that allow the holder to acquire by purchase or conversion an equity interest in the partnership. However, there was no clear guidance of the tax consequences of these options until the IRS issued proposed regulations in January 2003. The proposed regulations, which addressed the tax treatment of noncompensatory options and convertible instruments used by partnerships, have now been finalized, with some modifications.

Overview of final regulations. The final regulations generally provide that the exercise of a noncompensatory option does not cause recognition of gain or loss to either the issuing partnership or the option holder. The final regulations apply only if the call option, warrant, or conversion right grants the holder the right to acquire an interest in the issuer (or cash measured by the value of the interest).

Capital accounts and determination of partners’ distributive shares. The final regulations modify the regulations under Code Section 704(b) on the maintenance of the partners’ capital accounts and the determination of the partners’ distributive shares of partnership items. The regulations provide that the issuance by a partnership of a noncompensatory option (other than an option for a de minimis partnership interest) is a permissible revaluation event.

Characterization rule. The final regulations contain a characterization rule that provides that the holder of a call option, warrant, convertible debt, or convertible equity issued by a partnership is treated as a partner under certain circumstances. A  noncompensatory option is treated as a partnership interest for all federal tax purposes if, on the date of a measurement event, with respect to the option: (1) the noncompensatory option (and any agreements associated with it) provides the option holder with rights that are “substantially similar” to the rights afforded a partner; and (2) there is a strong likelihood that the failure to treat the holder of the noncompensatory option as a partner would result in a substantial reduction in the present value of the partners’ and noncompensatory option holder’s aggregate federal tax liabilities.

Safe harbors. Two safe harbors are provided in the regulations. The first safe harbor provides that a noncompensatory option is not considered reasonably certain to be exercised if it may be exercised no more than 24 months after the date of the applicable measurement event and it has a strike price equal to or greater than 110 percent of the (FMV) of the underlying partnership interest on the date of the measurement event. The second safe harbor provides that a noncompensatory option is not considered reasonably certain to be exercised if the terms of the option provide that the strike price of the option is equal to or greater than the FMV of the underlying partnership interest on the exercise date.

Applicability date. The final regulations apply to noncompensatory options issued on or after February 5, 2013.

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