The U.S. Treasury Department recently released regulations on the tax treatment of noncompensatory options issued by a partnership, as well as proposed regulations addressing the threshold question of when a partnership option is, in substance, an interest in the issuing partnership. Both sets of regulations are effective for options issued on or after February 5, 2013.
On February 4, 2013, the U.S. Treasury Department finalized regulations under Sections 721, 704 and 761 (with conforming changes to regulations under Sections 171, 1272 and 1275) addressing the tax treatment of noncompensatory options issued by a partnership (Final Regulations), making only modest changes and clarifications to the proposed regulations issued in 2003 on the same subject (2003 Regulations). In a related development, Treasury concurrently released proposed regulations addressing, among other subjects, the threshold question of when a partnership option is, in substance, an interest in the issuing partnership (2013 Proposed Regulations). Set forth below is a brief summary of the Final Regulations and 2013 Proposed Regulations.
The Final Regulations generally describe the income tax consequences of issuing, transferring and exercising noncompensatory partnership options, both for the issuing partnership and the option holder. A noncompensatory option is an option issued by a partnership that is not issued in connection with the performance of services. For this purpose, an “option” is defined as a call option, warrant or other similar arrangement, to acquire an interest in the issuing partnership (or cash measured by the value of the interest), the conversion feature of convertible debt or the conversion feature of convertible equity. The Final Regulations do not apply to a noncompensatory option issued by a disregarded entity, such as a single-member LLC.
Issuance, Exercise or Lapse of a Noncompensatory Option
The Final Regulations generally follow the 2003 Proposed Regulations in applying general tax principles to noncompensatory options. Specifically, the issuance of a noncompensatory option is treated as an “open” transaction. Under the open transaction theory, the issuing partnership does not recognize income upon the receipt of the option premium, and the option holder’s investment in the option is a non-deductible capital expenditure. If the holder purchases the option with appreciated or depreciated property, however, the holder must recognize gain or loss on the disposition of the property in an amount equal to the difference between the fair market value of the property and the holder’s adjusted tax basis in such property.
The Final Regulations generally provide for nonrecognition treatment upon the exercise of a noncompensatory option. The option holder is treated as receiving the partnership interest in exchange for the sum of the option premium and the exercise price. Under Section 721, this exchange is generally not taxable to either the issuing partnership or the option holder (although the preamble notes that gain can be triggered to the holder of the option if Section 721(b) applies to the exercise of the option). The option holder is not accorded nonrecognition treatment, however, to the extent the option holder satisfies the exercise price by forgiving amounts owed by the partnership for unpaid rent, royalties or interest that accrued on or after the beginning of the option holder’s holding period for the obligation. Likewise, the option holder recognizes income upon conversion of convertible debt into a partnership interest to the extent the partnership interest satisfies the partnership’s indebtedness for unpaid interest on the convertible debt. In these two instances, Section 721 still applies at the partnership level such that the partnership does not recognize gain or loss on a deemed transfer of partnership property to a creditor. The diverging treatment at the option holder level was meant to prevent the conversion of a receivable that would generate ordinary income into a partnership interest (which is generally a capital asset).
If the option lapses without exercise, Section 721 does not apply. Instead, under general tax principles applicable to options, the issuing partnership recognizes income equal to the option premium, and the option holder recognizes a corresponding loss. Section 721 also does not apply if the option is cash settled. Rather, cash settlement of an option is treated as a sale or exchange of the option. Treasury rejected suggestions in comments to the 2003 Regulations that cash settlement should be treated as an exercise of the option for a partnership interest followed immediately by a cash redemption of the partnership interest.
Character of Gain or Loss
The 2003 Regulations did not directly address the character of the income or loss upon the lapse, repurchase, or sale or exchange of a noncompensatory option. The 2013 Proposed Regulations address this topic. From the option grantor’s perspective, the 2013 Proposed Regulations bring noncompensatory options within the scope of Section 1234(b). Specifically, the 2013 Proposed Regulations provide that the term “securities” as used in Section 1234(b)(2)(B) includes partnership interests. As a result, gain or loss recognized by a grantor of an option from a “closing transaction” generally is treated as short-term capital gain or loss.
From the option holder’s perspective, under Section 1234(a), gain or loss on the sale or exchange of, or loss on the failure to exercise, an option has the same character as the property to which the option relates would have in the hands of the option holder. The preamble to the 2013 Proposed Regulations seeks comment on whether the rules of Section 751 should apply to a holder’s gain on the disposition of a partnership option, the effect of which would recharacterize the portion of the gain attributable to Section 751 “hot assets” (unrealized receivables, appreciated inventory) as ordinary income.
Capital Account Maintenance Rules
Under the Final Regulations, the issuance of a noncompensatory option is a permissive capital account revaluation event under Treas. Reg. § 1.704-1(b)(2)(iv)(f). Such a revaluation would generally prevent unrealized gains and losses at the time of issuance from being shifted from existing partners to the option holder at the time of exercise. If a partnership revalues its properties while noncompensatory options are outstanding, the revaluation must take into account the fair market value of any outstanding but unexercised noncompensatory options. If such fair market value exceeds the consideration paid by the option holders to acquire the options, the value of partnership property must be reduced by that excess to the extent of the unrealized income or gain in partnership property not already reflected in the capital accounts. Such reduction is allocated only to those properties with unrealized appreciation in proportion to their respective amounts of unrealized appreciation. The converse rule applies if the price paid by the option holder exceeds the fair market value of the option, in which case the value of partnership property is increased by such excess, with such increase allocated only to properties with unrealized depreciation not already reflected in the capital accounts.
Upon the exercise of a noncompensatory option, the option holder’s initial capital account is equal to the sum of the option premium and the option exercise price. For convertible debt, the Final Regulations provide that the fair market value of the property contributed on exercise of the option is the adjusted issue price of the debt and the accrued but unpaid qualified stated interest on the debt immediately before the conversion, plus the fair market value of any property (other than the convertible debt) contributed to the partnership on the exercise of the option. The Final Regulations require the issuing partnership to revalue its property immediately after the exercise of a noncompensatory option. The partnership must then allocate the unrealized income, gain, loss and deduction from this revaluation among the partners (including the option holder). The first allocation is made to the option holder’s capital account so that it equals such holder’s share in partnership capital under the partnership agreement. Remaining unrealized items are allocated to the historic partners’ capital accounts based on how they would share such items had the partnership disposed of its property for fair market value on the date that the option is exercised.
The 2003 Regulations created a “corrective allocation” mechanism to deal with situations in which a partnership lacks sufficient unrealized income or unrealized loss to equalize the option holder’s capital account with the holder’s share of partnership capital upon the exercise of the option. Such a situation could arise if a partnership recognized gain on the disposition of an appreciated asset prior to the option exercise. If such gain is economically attributable to the option holder but is allocated entirely to the historic partners, then, according to Treasury, taxable income has been effectively shifted from the option holders to the historic partners. To remedy this, the Final Regulations follow the 2003 Regulations in requiring capital to be reallocated from the existing partners to the option holder so that the option holder’s capital account equates with its share of partnership capital. This capital shift is then matched with corrective allocations of gross income items to the option holder in the year of exercise and, to the extent necessary, in succeeding years until the full capital shift has been taken into account. In the (unlikely) event that the capital shift is from the exercising option holder to the existing partners, corrective allocations of gross loss and deduction are made to the option holder until the full capital shift has been taken into account. The Final Regulations contain special rules for making corrective allocations from a combination of gross income and gain and gross loss and deduction in certain circumstances.
The 2003 Regulations generally respected a noncompensatory option as an option rather than as an interest in the partnership. However, the 2003 Regulations contained a characterization rule under which the holder of a noncompensatory option is treated as a partner if, on the date of a measurement event, the option holder’s rights are substantially similar to the rights afforded to a partner and there is a strong likelihood that the failure to treat the holder of a noncompensatory option as a partner would result in a substantial reduction in the present value of the partners’ and option holder’s aggregate federal tax liabilities. The Final Regulations generally retain this two-part characterization rule but provide more specific guidance on its application.
For the first prong of the characterization test, the Final Regulations provide that an option confers substantially similar rights if either the option is “reasonably certain to be exercised” or the option holder has “partner attributes.” As to whether an option is “reasonably certain to be exercised,” the Final Regulations provide a facts-and-circumstances test and specify several relevant factors, including the fair market value of the partnership interest underlying the option, the exercise price, the duration of the option, the expected volatility in value of the partnership interest and whether the partnership expects to make distributions while the option is outstanding. The Final Regulations also provide two objective safe harbors, which are similar in concept to those contained in the Treasury regulations for determining whether corporations are part of a consolidated group and the regulations for determining whether an S corporation has a prohibited second class of stock. 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 date and it has a strike price equal to or greater than 110 percent of the current fair market value of the 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 is equal to or greater than the fair market value of the underlying partnership interest on the exercise date. A formula strike price will be deemed to be equal to or greater than fair market value if agreed by the parties when the option is issued in a bona fide attempt to arrive at the fair market value. Importantly, these two safe harbors do not apply if the option had a principal purpose of substantially reducing the present value of the aggregate federal tax liabilities of the option holder and the partners.
Whether an option confers on its holder “partner attributes” also is based on all facts and circumstances, including whether the option holder has managerial or voting rights in the partnership and whether the option holder is provided with rights that are similar to rights ordinarily afforded to a partner to participate in partnership profits. In short, the partner attribute test turns on whether the economic benefits and burdens of the option holder go beyond the economic benefits and burdens inherent in a basic option transaction. The Final Regulations do allow an option holder to possess the ability to restrict certain partnership actions as a means of protecting the option holder’s future partnership interest (e.g., restrictions on distributions or dilutive issuances of partnership equity, or the ability to choose the Section 704(c) method for partnership properties).
If the rights of a noncompensatory option holder are substantially similar rights to the rights of a partner, then a noncompensatory option will not be respected as such if there is a strong likelihood that failure to treat the option holder as a partner would result in a substantial reduction in the present value of the partners’ and option holder’s overall federal tax liabilities. This second prong of the characterization rule also is evaluated based on all relevant facts and circumstances, including the interaction of the allocations of the issuing partnership and the partners’ and option holder’s federal tax attributes, the absolute amount of the federal tax reduction, the amount of the reduction relative to the overall tax liability, and the timing of items of income and deduction. If the option holder is a pass-through entity, then the tax attributes of that entity’s ultimate owners are taken into account in determining whether there is a substantial federal tax reduction.
Under the Final Regulations, the characterization rule is applied upon the occurrence of a measurement event. A measurement event is defined as the issuance of the option, an adjustment to the terms of the option, and the transfer of the option if either the term of the option exceeds 12 months or the transfer is pursuant to a plan in existence at the time of the issuance or modification that has as a principal purpose the substantial reduction of the present value of the aggregate federal tax liabilities of the partners and noncompensatory option holder. If an option is characterized as a partnership interest upon a measurement event, it may not thereafter be characterized as an option upon a subsequent measurement event.
The Proposed Regulations add three additional measurement events for application of the characterization rule, generally involving issuance or modification of interests in either the issuing partnership or a pass-through entity that holds the option. However, these measurement events require a re-testing of the option only if a principal purpose of the event is a substantial tax reduction.
The Final Regulations are effective, and the 2013 Proposed Regulations are proposed to be effective, for options issued on or after February 5, 2013.