The Internal Revenue Service (IRS) has issued proposed regulations relating to the tax treatment of noncompensatory options and convertible instruments issued by a partnership that would expand the list of “measurement events” upon which a holder of a noncompensatory option may be characterized as a partner. The proposed regulations also provide additional guidance in determining the character of the option grantor’s gain or loss as a result of certain closing transactions. The proposed regulations would apply to options issued on or after February 5, 2013, the date final regulations on noncompensatory partnership options took effect.

Definitions. Internal Revenue Code Section 761 provides definitions of several terms, including “partnership” and “partner.” A partner is broadly defined as a member of a partnership. In general, a member can be a natural person, a trust, another partnership, a corporation, or a joint venturer. Code Section 1234(b)(2)(B) defines the term “property” to mean stock and securities (including stocks and securities dealt with on a when-issued basis), commodities, and commodity futures.

Corresponding final regulations. The final regulations contain a characterization rule providing that the holder of a noncompensatory option is treated as a partner under certain circumstances. Under this rule, a noncompensatory option is treated as a partnership interest if, on the date of a “measurement event,” (1) the noncompensatory option 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.

The final regulations define a “measurement event” as the (1) issuance of the noncompensatory option; (2) an adjustment of the terms (modification) of the noncompensatory option or of the underlying partnership interest; or (3) transfer of the noncompensatory option if either (A) the option may be exercised (or settled) more than 12 months after its issuance, or (B) the transfer is pursuant to a plan in existence at the time of the issuance or modification of the noncompensatory option that has as a principal purpose the substantial reduction of the present value of the aggregate federal tax liabilities of the partners and the noncompensatory option holder.

Additional measurement events under proposed regulations. The proposed regulations would add the following three measurement events to those listed in the final regulations:

      • issuance, transfer, or modification of an interest in, or liquidation of, the issuing partnership
      • issuance, transfer, or modification of an interest in any look-through entity that directly, or indirectly through one or more look-through entities, owns the noncompensatory option
      • issuance, transfer, or modification of an interest in any look-through entity that directly, or indirectly through one or more look-through entities, owns an interest in the issuing partnership

Other changes in proposed regulations. The proposed regulations also provide that the term “securities,” as used in Code Section 1234(b)(2)(B), includes partnership interests. Under the proposed regulations, in the case of the grantor of an option on a partnership interest, gain or loss from any closing transaction with respect to, and gain on lapse of, the option would generally be treated as gain or loss from the sale or exchange of a capital asset held not more than one year (i.e., short-term capital gain).

Under Code Section 1234(a), gain or loss on the sale or exchange of, or loss on failure to exercise, an option is considered gain or loss from the sale or exchange of property that has the same character as the property to which the option relates would have in the hands of the taxpayer. Although a partnership interest is generally considered a capital asset, Code Section 751(a) may apply to recharacterize a portion of a partner’s gain on the sale or exchange of a partnership interest as ordinary. The IRS is seeking comments on whether Code Section 751(a) applies to the lapse, repurchase, sale, or exchange of a noncompensatory option, and on the computation of the resulting income or loss to the option holder and partner.

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