Prop. Regs. Issued on Noncompensatory Partnership Options

In recent years, partnerships have issued options or convertible instruments to investors that entitle them to acquire an equity interest in the partnership by purchase or conversion. Notwithstanding the established guidance on the Federal tax treatment of corporate options, the tax consequences of partnership options remained unclear due to the lack of published guidance from Treasury and the IRS.

In an effort to formulate guidance in this area, the IRS requested commentary from the public on (1) the tax treatment of the exercise of an option to acquire a partnership interest, (2) the exchange of convertible debt for a partnership interest and (3) the exchange of a preferred interest in a partnership for a common interest; see Notice 2000-29. After receiving comments from numerous tax practitioners, the Service released proposed regulations on Jan. 21, 2003 (REG-103580-02) on the tax treatment of partnership noncompensatory options and convertible instruments.

The proposed regulations generally address the Federal income tax consequences as to the issuance, exercise, lapse and conversion of certain call options, warrants, convertible debt and convertible equity issued by partnerships, not in connection with the performance of services (i.e., noncompensatory options). In addition, they modify the capital account maintenance rules under the Sec. 704(b) regulations to account for noncompensatory options.

In general, the proposed regulations reach favorable conclusions. For example, the issuance and exercise of an option generally do not immediately result in the partnership, the existing partners or the option holder recognizing income or loss. Although income or loss may be recognized on lapse of an option, if the option is exercised, the proposed regulations provide only for special allocations of future partnership tax items. This item highlights the regulations major provisions.

Issuance of a noncompensatory option. Under general tax principles, the issuance of an option to purchase property at some time in the future at a specified price is deemed an open transaction for the issuer and a capital expenditure for the purchaser. Thus, the issuer generally recognizes no gain or loss on issuance of an option. The purchaser generally recognizes gain or loss on issuance only to the extent he or she uses appreciated or depreciated property to acquire the option; see generally Rev. Ruls. 57-40 and 78-182.

In the preamble to the proposed regulations, the Service confirmed that these general tax principles apply to the issuance of noncompensatory options by a partnership. Consequently, a partnership (i.e., the issuer) and, thus, its partners, generally do not recognize gain or loss on the issuance of a noncompensatory option. Similarly, the purchaser of a noncompensatory option generally does not recognize any gain or loss on issuance, except to the extent he or she uses appreciated or depreciated property to acquire the option.

Finally, the proposed regulations provide that the purchaser of an option will generally not be deemed a partner in the partnership as to the option until he or she exercises it. However, the proposed regulations provide a facts-and-circumstances test under which an option holder may be treated as a partner prior to exercise, if appropriate.

Exercise of a noncompensatory option. On the exercise of a noncompensatory option, the option holder generally contributes the exercise price to the partnership in exchange for a partnership interest. The fair market value (FMV) of the option holders partnership interest typically exceeds the option premium and the options exercise price.

Under Sec. 721, a partnership and its partners generally recognize no gain or loss on a contribution of property to the partnership in exchange for a partnership interest. However, to the extent that any partner gives up any part of his or her right to be repaid his or her contributions (as distinguished from a share in partnership profits) in favor of another partner as compensation for services (or in satisfaction of an obligation), Sec. 721 does not apply. Consequently, prior to the issuance of the proposed regulations, it was unclear whether Sec. 721 should apply to the option holders contribution to the partnership on exercise of the option.

Because the FMV of the option holders partnership interest generally exceeds the amount the option holder contributed for such interest, arguably the existing partners are giving up a portion of their rights to be repaid their capital contributions in satisfaction of the partnerships obligations under the option agreement. However, under general tax principles, the exercise of an option to acquire property is generally a nontaxable event to both the issuing entity (i.e., the partnership) and the option holder.

In the preamble to the proposed regulations, Treasury and the IRS provided that on exercise of an option, the option holder may be viewed as contributing property in the form of the option premium, the exercise price and the option privilege to the partnership in exchange for the partnership interest. Accordingly, under such characterization (a pooling of capital to conduct business operations jointly), Sec. 721 would apply to the exercise of a noncompensatory option. Thus, it should generally be a nonrecognition event for the partnership, the partners and the option holder.

Lapse of a noncompensatory option. The proposed regulations state that Sec. 721, however, does not apply to the lapse of a noncompensatory option. Instead, the lapse is taxed in accordance with general tax principles. Consequently, the issuing partnership will generally recognize gain on the lapse of a noncompensatory option. The option holder will generally recognize a loss equal to the premium paid to acquire the option.

Capital account maintenance rules. The proposed regulations modify the capital account maintenance rules under the Sec. 704(b) regulations to address the effect to the partners capital accounts on the exercise of noncompensatory options and on any revaluation of the partnerships property that occurs while the partnership has noncompensatory options still outstanding.

Generally, on the exercise of a noncompensatory option, the option holder receives a partnership interest with a value greater than the aggregate value of the premium and exercise price that the option holder contributes to the partnership. Accordingly, if the option holders initial capital account in the partnership reflects the holders right to partnership assets immediately after exercise, the holders initial capital account will be greater than the FMV of the property contributed with respect to the option. In this situation, the proposed regulations provide that the partners capital accounts are not maintained in accordance with the Sec. 704(b) rules, unless, immediately after (as opposed to before) the option holder exercises the option, the partnership:

1. Revalues its property;

2. Allocates any unrealized gain or loss inherent in the partnership assets first to the option holder, to the extent necessary to reflect the holders right to share in partnership capital under the partnership agreement (i.e., allocate unrealized items to the option holder to the extent necessary for the holders initial capital account to equal the amount that would be distributed to the holder if the partnership liquidated immediately after exercise), and allocates any remaining unrealized income or loss among the existing partners; and

3. If the amount of the unrealized gain or loss inherent in the partnerships assets is insufficient to credit the option holders capital account to reflect his or her share of partnership capital, (a) the partnership reallocates capital already reflected in the existing partners capital accounts to the option holders capital account (a capital shift); and (b) the partnership agreement provides for corrective allocations of gross income and gain (or gross loss and deduction) in the year in which the option is exercised (and potentially subsequent years) to account for any capital account reallocations made under these provisions (corrective allocations).

Accordingly, under the proposed capital account maintenance rules, the option holders Sec. 704(b) capital account immediately after exercise should generally reflect the amount that would be distributed to such holder if the partnership liquidated immediately after exercise. Any difference between the option holders Sec. 704(b) capital account and his tax basis capital account will generally be accounted for by the partnership either under Sec. 704(c) principles (because the option holders Sec. 704(b) capital account includes unrealized partnership items) or through corrective allocations of future gross items (because the option holders Sec. 704(b) capital account reflects a capital shift from the other partners).

The proposed regulations also provide rules for revaluations of the partners capital accounts that occur while noncompensatory options are outstanding. In general, they provide that, for purposes of revaluing the partners capital accounts, the FMV of partnership property has to be adjusted to account for the difference between the FMV of any outstanding noncompensatory options and the consideration paid by the option holders to acquire such options. Under this rule, before the exercise of any outstanding noncompensatory options, a revaluation of the existing partners capital accounts will generally not include the FMV of the partnerships assets that would be allocable to the option holders on liquidation of the partnership.

The proposed regulations provide a complex, but reasonable, framework for evaluating the Federal income tax consequences of noncompensatory partnership options. The IRS should be commended for tackling this complex area and providing some much-needed guidance on an increasingly common commercial transaction.

From Monica Odoy, MBA, CPA, Washington, DC, and HollyBelanger, J.D., CPA, Washington, DC