New IRS Regulations Regarding Noncompensatory Partnership Options Effective Immediately

On February 4th, the IRS issued final and further proposed regulations regarding noncompensatory partnership options, effective immediately.

Overview

A “noncompensatory partnership option” is any contractual right (other than a right issued in connection with the performance of services) to acquire an interest in a partnership, including a call option, warrant, or other similar arrangement, the conversion feature of convertible debt or the conversion feature of convertible equity. The IRS defines a “partnership” as a limited liability company, general or limited partnership, statutory or other trust or other entity or contractual arrangement treated as a partnership for federal income tax purposes.

Which partnership and LLC agreements are affected?

These new regulations may affect allocation provisions of a partnership or LLC agreement even if there is no option currently outstanding under such agreement.

Which entities are not affected?

An LLC or other entity eligible to be treated as a partnership but that has “checked the box” to be treated as a corporation is not considered a partnership for these purposes. In addition, the regulations do not apply to compensatory partnership options or to options issued by single-member LLCs or other disregarded entities (as to which, in each case, different tax principles apply).

How should the new rule be addressed?

Any new partnership or LLC agreement should be prepared with the provisions of these new regulations in mind. Also, it may be advisable to review the partnership or LLC agreement of an existing partnership or LLC that has a noncompensatory option outstanding in order to determine whether change is necessary or appropriate in light of the regulations.

What if you have questions?

For any questions or for more information on these or any related matters, please contact any attorney in the firm’s tax practice group, including John Bonn (213-617-4160, jbonn@sheppardmullin.com) and Keith Gercken (415-774-3207, kgercken@sheppardmullin.com). Jason Schendel (650-815-2621, jschendel@sheppardmullin.com) and Lauren Lewis (650-815-2672, lalewis@sheppardmullin.com) participated in drafting this posting.