Final regulations were issued (T.D. 9612) effective February 5, 2013 on the treatment of noncompensatory options and convertible instruments issued by an entity taxable as a partnership under Subchapter K. The final regulations apply to warrants, call options, convertible debt and convertible equity which is issued to investors in comparison with such instruments being issued in connection with the performance of services. The final regulations essentially follow, with certain modifications, the proposed regulations which were issued in January 2003 (REG-103580-02).

As summarized in the Preamble, there are several highlights to the new set of regulations. Perhaps the central theme to the new rule-making is that, in general, the exercise of a noncompensatory option (“NCO”) does not result in the realization and recognition of immediate income or loss to either party, i.e., the issuing partnership or the option holder. The final regulations also modify the capital account maintenance rules and the determination of the partners’ distributive shares of partnership items under section 704(b). The final regulations also contain a characterization rule providing that the holder of a NCO is treated as a partner under certain circumstances. The final regulations will affect partnerships that issue, on or after February 5, 2013, NCOs, the partners of such partnerships, and the holders of such options. No position was made as to the treatment of NCOs, etc. under current law.

The final regulations apply only where the specific NCO, including call option, warrant, or conversion right, etc., grants the holder the right to acquire an interest in the issuer-partnership (or cash measured by the value of the interest). As with the proposed 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. In addition, the final regulations modify the regulations under section 704(b) regarding the maintenance of the partners' capital accounts and the determination of the partners' distributive shares of partnership items. Finally, the final regulations contain a characterization rule providing that the holder of a call option, warrant, convertible debt, or convertible equity issued by a partnership (or an eligible entity, as defined in Treas. Reg. § 301.7701-3(a), that would become a partnership if the option holder were treated as a partner) is treated as a partner under certain circumstances.

Proposed Regulations Issued in 2003

The 2003 NCO regulations provided that unless the option holder should be treated as a partner upon the issuance of the option, per Prop. Treas. Reg. §1.761-3, the issuance of an NCO by a partnership is treated under open transaction principles. In particular, as an “open transaction”, the issuance of the NCO is neither income to the issuing partnership or the purchaser or on payment of an option premium governed by generally applicable open transaction principles: There is no income to either the partnership or the buyer on issuance of the NCO or on payment of an option premium in cash.

In the event of a lapse of the NCO, the transaction is closed and the option premium or payment forfeited is taxable to the partnership as ordinary income. The option holder who allows the NCO to lapse realizes a loss in the amount of the cost of the option under §1234 in the taxable year that the lapse occurs. Where the NCO is exercised, the option holder is treated as having made a capital contribution under §721 in the amount of the option premium plus the exercise price. The partnership is not taxed on either the option premium or exercise price as a consequence of the exercise.  Where the exercise price exceeds the holder’s capital account on exercise, there is a benefit to the partnership and the other partners. The proposed regulations provided that in such case “the transaction will be given tax effect in accordance with its true nature.” Prop. Treas. Reg. §1.721-2(a).  If the party exercising the NCO pays part or all of the exercise price in property other than money, the proposed regulations did not treat this as a realization event in which the holder realized gain or loss. Instead, §721 would result in non-recognition treatment as part of the “exchange” of property for the partnership interest. On the other hand, the Service held the view that where the option premium was paid with appreciated property, there was Davis-Kenan gain realized by the party paying for the option. In such case, the partnership would have a fair market value basis in the property used to fund the option payment. This nonrecognition rule contrasts with the Service's refusal to allow nonrecognition with respect to payment of the option premium with appreciated property.

Final Regulations to Noncompensatory Partnership Options

A. Issuance of NCO[1]

In general the final regulations follow the proposed regulations. The final regulations provide that §721 does not apply to the transfer of property to a partnership in exchange for a NCO or with respect to the satisfaction of a partnership obligation by issuing an NCO. As under the proposed regulations, a transfer of appreciated or depreciated property to a partnership in exchange for a NCO generally will result in the recognition of gain or loss by the option recipient. Under open transaction principles applicable to noncompensatory options, the partnership will not recognize income for receipt of the property while the option is outstanding.

The final regulations do provide that §721 will apply to a contribution of property to a partnership in exchange for convertible equity in a partnership. In other words, the Treasury and IRS were of the view that it is appropriate to take into account the conversion right that is contained in the convertible equity as part of the underlying partnership interest. Accordingly, the final regulations provide that section 721 does apply to a contribution of property to a partnership in exchange for convertible equity in a partnership.

B. Exercise of NCO and Section 721

As set forth in the proposed regulations, §721 applies to both the holder exercising the option and the partnership with respect to the exercise of the NCO. The final regulations clarify that this treatment further applies where the exercise price is satisfied with property or cash contributed to the partnership, regardless of whether the terms of the option require or permit a cash payment.

Where the exercise of the NCO is in satisfaction of a partnership obligation, the proposed regulations stated, for example, that §721 did not apply to any interest on convertible debt that has been accrued by the partnership (including accrued original issue discount).  Final regulations on this matter were published in TD 9557 (11/17/2011) concerning partnership debt-for-equity exchanges.

Section 1.721-1(d)(2) provides:

“Section 721 does not apply to a debt-for-equity exchange to the extent the transfer of the partnership interest to the creditor is in exchange for the partnership's indebtedness for unpaid rent, royalties, or interest (including accrued original issue discount) that accrued on or after the beginning of the creditor's holding period for the indebtedness. The debtor partnership will not recognize gain or loss upon the transfer of a partnership interest to a creditor in a debt-for-equity exchange for unpaid rent, royalties, or interest (including accrued original issue discount).”

The rationale for this treatment was to prevent the conversion of ordinary income into capital gain.

In similar fashion, the final NCO regulations provide that §721 does not apply to the transfer of a partnership interest to a NCO holder upon conversion of convertible debt in the partnership to the extent that the transfer is in satisfaction of the partnership's indebtedness for unpaid interest (including accrued original issue discount) on convertible debt that accrued on or after the beginning of the convertible debt holder's holding period for the indebtedness. The final regulations further provide that §721 does not apply to the extent that the exercise price is satisfied with the partnership's obligation to the option holder for unpaid rent, royalties, or interest (including accrued original issue discount) that accrued on or after the beginning of the option holder's holding period for the obligation.

A complex issue not addressed in the proposed regulations was whether, upon conversion of convertible debt in the partnership, the partnership is treated as satisfying its obligation for unpaid interest with a fractional interest in each asset of the partnership. Were this the proper treatment, i.e., a so-called "vertical slice" approach, the partnership could recognize gain or loss equal to the difference between the fair market value of each partial property deemed transferred to the creditor and the partnership's adjusted basis in that partial property.

The Preamble to the final regulations commented that the “vertical slice” asset sale concept would be administratively burdensome and difficult and may inappropriately accelerate gain or loss recognition. The final regulations therefore take the position that a partnership will not recognize gain or loss upon the transfer of a partnership interest to a NCO holder upon conversion of convertible debt in the partnership to the extent that the transfer is in satisfaction of the partnership's indebtedness for unpaid interest (including accrued original issue discount) on convertible debt that accrued on or after the beginning of the convertible debt holder's holding period for the indebtedness. The issuing partnership will not recognize gain or loss upon the transfer of a partnership interest to an exercising option holder in satisfaction of the partnership's obligation to the option holder for unpaid rent, royalties, or interest (including accrued original issue discount) that accrued on or after the beginning of the option holder's holding period for the obligation. [2]

C. NCOs Issued by Disregarded Entities

The proposed regulations carved out nonrecognition treatment on the exercise of an NCO issued by a disregarded (eligible) entity per Treas. Reg. §301.7701-3(a) despite the outcome that upon exercise the entity would become a partnership. [3] After fielding comments on this issue, there was a thought that the same open transaction principle should apply and that nonrecognition under §721 would follow. A problem with such outcome was that adjustments to capital accounts would have to be taken into account for the period of time that the option was outstanding. Otherwise, the single owner would have a fair market (book) capital account on exercise and the NCO holder exercising the option would only have a cost basis capital account for the option premium and exercise price. The new partnership would have no unbooked unrealized gain in its property that it could allocate to the exercising option holder. After such further review the Treasury Department and the IRS decided not to apply the rules of the final regulations to NCOs issued by single member LLCs. Does that leave us with an deemed asset sale and §721 transfer by two transferors under Rev. Rul. 99-5?

E. Investment Partnership Provision Under Section 721(b)

Section 721(b) provides that §721(a) does not apply to gain realized on a transfer of property to a partnership that would be treated as an investment company (per §351(e)) if the partnership were incorporated. The Preamble provides that §721, including §721(b) and Treas. Reg. §1.721-1(a), applies to the exercise of NCOs. This could lead to some traps for the unwary. Perhaps the Treasury and the Service should give this matter a second thought at least to exclude the option premium from the §721(b) and §351(e) diversification test.

F. Treatment of Cash Settled  Noncompensatory Partnership Options

In response to questions that were submitted to the Treasury and IRS, the final regulations provide that the cash settlement of a NCO should be treated as a sale or exchange of the option and taxed under the rules of §1234, rather than as a contribution to the partnership under §721, followed by an immediate redemption (although the latter may, in certain instances, be treated as a sale of the option under the disguised sale rules).  Accordingly, the final regulations provide that the settlement of a NCO in either in cash or property other than an interest in the issuing partnership is not a transaction to which §721 applies.

G. Treatment of a Lapse, Repurchase, Sale or Exchange of a Noncompensatory Partnership Option

As mentioned, and as consistent with general principles of income taxation, the proposed regulations provided that §721 does not apply to the lapse of a NCO. The lapse of a NCO will therefore result in ordinary income to the partnership and a loss to the holder for the amount of the option premium. What about other realization events?

Section 1234(b) provides that gain or loss from any closing transaction generally is treated as short term capital gain or loss to the grantor of an option. Some tax practitioners making comments to the proposed regulations believed it was uncertain whether §1234(b) applies to partnership interests based on whether partnership interests qualified as "securities" for purposes of §1234(b). The Service and Treasury stated that proposed regulations under §1234(b) (REG-106918-08) published concurrently with the final regulations, treat partnership interests as securities for purposes of §1234(b) although comment is invited on the character of gain or loss to the option holder on the sale or exchange of, or loss on failure to exercise, an option.

H. Step-Transaction Notions Pertaining to Dispositions of Noncompensatory Partnership Options.

In the event that the exercise of a NCO part of a planned redemption of the exercising option holder's partnership interest, general tax principles, including the disguised sale rules of  §707(a)(2)(B), will apply in determining whether the transaction is actually a cash settlement

As to exercise price premiums paid in excess of the capital account received by the NCO holder, the final regulations provide that general tax principles will apply to determine the tax consequences of the transaction. The outcome will be based on all relevant facts and circumstances.

I. Impact on Capital Accounts for Issuance of Noncompensatory Options

Under the proposed regulations, issuance of a noncompensatory option is not a permissive or mandatory revaluation event under Treas. Reg. § 1.704-1(b)(2)(iv). This made it possible, for example, to inappropriately shift unrealized gain in partnership property arising prior to the issuance of the option to the option holder upon exercise.The final regulations provide that the issuance by a partnership of a NCO (other than an option for a de minimis partnership interest) is a permissible revaluation event for capital account purposes.

While the NCO is outstanding, the proposed regulations took the position that any revaluation of capital accounts occurring such time period generally must take into account the fair market value of any outstanding NCOs. Where the FMV of the NCOs outstanding as of the revaluation date is greater than the consideration paid by the option holders to acquire the options, then the FMVof partnership property should be reduced by that excess to the extent of the unrealized income or gain in partnership property (that has not been reflected in the capital accounts previously). This reduction is allocated only to properties with unrealized appreciation in proportion to their respective amounts of unrealized appreciation. Conversely, if the price paid by the option holders to acquire the outstanding NCOs is greater than the FMV  of the options as of the date of the adjustment, the value of partnership property reflected on the partnership's books should be increased by that excess to the extent of the unrealized deduction or loss in partnership property (that has not been reflected in the capital accounts previously). This increase is allocated only to properties with unrealized depreciation in proportion to their respective amounts of unrealized depreciation.

The final regulations stay the course taken in the proposed regulations and provide that the adjustments to the value of partnership property reflected on the partnership's books should generally be made to partnership properties on a pro rata basis. The final regulations  further provide that the adjustments must take into account the economic arrangement of the partners with respect to the property.

The proposed regulations require a partnership to revalue its property immediately following the exercise of a NCO and the option holder has become a partner. This may result in reverse §704(c) allocations to the other partners unless the option holder is provided a capital account greater than the option premium and exercise price.  The final regulations require that the allocations must take into account the economic arrangement of the partners with respect to the property.

Therefore, where the exercising partner's right to share in partnership capital under the partnership agreement exceeds the sum of the premium and exercise price, then only income or gain may be allocated to the exercising partner from partnership properties with unrealized appreciation, in proportion to their respective amounts of unrealized appreciation (subject to the requirement that the allocations take into account the economic arrangement of the partners). Conversely, if the exercising partner's right to share in partnership capital under the partnership agreement is less than the premium and exercise price, then only loss may be allocated to the exercising partner from partnership properties with unrealized loss, in proportion to their respective amounts of unrealized loss (subject to the requirement that the allocations take into account the economic arrangement of the partners).

Under the proposed regulations, if, after the allocations of unrealized gain and loss items to an exercising option holder, the exercising option holder's capital account still does not reflect his right to share in partnership capital under the partnership agreement, the partnership must reallocate capital between the existing partners and the exercising option holder (a "capital account reallocation"). The capital account reallocation provision is included in the final regulations.  

J. Corrective Allocations of Gross Income or Loss in Year of Exercise

The proposed regulations require the partnership to make corrective allocations of gross income or loss to the partners in the year in which the option is exercised to account for any shift in the partners' capital accounts that occurs as a result of a capital account reallocation pursuant to the exercise of a NCO. Corrective allocations are allocations of tax items that differ from the partnership's allocations of book items. If there are insufficient actual partnership items in the year of exercise to conform the partnership's tax allocations to the capital account reallocation, additional corrective allocations are required in succeeding taxable years until the capital account reallocation has been fully taken into account. While some commentary received wanted the corrective allocation rule discarded as too complex and burdensome, the final regulations retain the rule in certain instances to prevent improper income shifting where a partnership recognizes gain or loss that is in part economically attributable to the option holder but is allocated entirely to the existing partners.

The provisions of the final regulations pertaining to corrective allocations are quite complex and should be read carefully.

K. Characterization of Noncompensatory Partnership Option as Partnership Equity

The proposed regulations characterize the holder of a noncompensatory option as a partner if the option holder's rights are substantially similar to the rights afforded to a partner. The test employed under the proposed regulations is if, only as of the date that the noncompensatory option is issued, transferred, or modified, there is a strong likelihood that the failure to treat the option holder as a partner would result in a substantial reduction in the present value of the partners' and the option holder's aggregate Federal tax liabilities. This is based on a facts and circumstances test. This approach was retained in the final regulations with some modifications.

The final regulations do provide greater clarity to determining whether an NCO holder is really a partner. In this regard the final regulations provide that a NCO provides its holder with rights that are substantially similar to the rights afforded to a partner if the option is reasonably certain to be exercised or if the option holder possesses partner attributes.

Whether a NCO is reasonably certain to be exercised takes into account the FMV of the partnership interest that is the subject of the option, the exercise price, option term, the predictability and stability of the value of the underlying partnership interest, and whether the partnership is expected to make distributions during the term of the option. The final regulations essentially adopted the factors cited in the proposed regulations but eliminated the factor (under the reasonably certain to exercise test) that the option premium and exercise price will become property of the partnership.

Perhaps more noteworthy is the final regulations adoption of two “objective safe harbors” under the reasonably certain to be exercised test. One is under Treas. Reg. § 1.1504-4 and  the other under the one class of stock regulations to Subchapter S, Treas. Reg. § 1.1361-1(l). The final regulations warn that the safe harbors apply only to the determination of whether a NCO is reasonably certain to be exercised, and not to the determination of whether a NCO holder possesses partner attributes. The safe harbors do not apply, however, if the parties to the NCO had a principal purpose of substantially reducing the present value of the aggregate Federal tax liabilities of the partners and the noncompensatory option holder.

The final regulations provide that failure of an option to satisfy one of these safe harbors does not affect the determination of whether the option is treated as reasonably certain to be exercised. Thus, options that do not satisfy the safe harbors may still be treated as not reasonably certain to be exercised under the facts and circumstances. Notwithstanding that an option is treated as not reasonably certain to be exercised on the date of one measurement event under either the safe harbors or the facts and circumstances test, the option may be treated as reasonably certain to be exercised at the time of a subsequent measurement event if the safe harbors and facts and circumstances test are no longer satisfied. Furthermore, even if an option is not reasonably certain to be exercised under either the safe harbors or the facts and circumstances test, the NCO may still be found to provide its holder with rights substantially similar to those afforded a partner under the partner attributes test.

Under the attributes as a partner test, the proposed regulations provide that partner attributes include the extent to which the option holder shares in the economic benefit and detriment of partnership income and loss and the extent to which the option holder has the right to control or restrict the activities of the partnership. The final regulations attempt to clarify this standard. The test is grounded on examining all facts and circumstances,  including whether the option holder, directly or indirectly, through the option agreement or a related agreement, is provided with voting or managerial rights in the partnership. Factors mentioned include: (i) whether the option holder is provided with rights (through the option agreement or a related agreement) that are similar to rights ordinarily afforded to a partner to participate in partnership profits through present possessory rights to share in current operating or liquidating distributions with respect to the underlying partnership interest; or (ii) whether the option holder, directly or indirectly, undertakes obligations (through the option agreement or a related agreement) that are similar to obligations undertaken by a partner to bear partnership losses.

In further responding to comments made to the proposed regulations, the final regulations provide that a NCO holder will not, in general, be considered to possess partner attributes solely because the NCO agreement significantly controls or restricts, or the NCO holder has the right to significantly control or restrict, a partnership decision that could substantially affect the value of the underlying partnership interest. In particular, the following rights of the option holder will not be treated as partner attributes: (i) the ability to impose reasonable restrictions on partnership distributions or dilutive issuances of partnership equity or options while the noncompensatory option is outstanding; or (ii) the ability to choose the partnership's section 704(c) method for partnership properties.

As to how the partner attributes test was to be applied where the NCO holder is also a partner, the final regulations provide that rights held by a NCO holder by virtue of owning a partnership interest  are not taken into account, provided that those rights are no greater than the rights granted to other partners owning substantially similar interests in the partnership and who do not hold NCOs in the partnership. The final regulations further provide that if all of the partners owning substantially similar interests in the issuing partnership also hold NCOs in the partnership, or if none of the other partners owns substantially similar interests in the partnership, then all facts and circumstances will be considered in determining whether the rights in the partnership possessed by the option holder are possessed solely by virtue of owning a partnership interest. If those rights are possessed solely by virtue of owning a partnership interest, the final regulations provide that they are not taken into account.

A related party rule is contained in the final regulations. Specifically, in determining whether an option holder has partner attributes, the final regulations provide that the option holder will be treated as owning all partnership interests and NCOS issued by the partnership that are owned by any person related to the option holder. For example, if the holder of a NCO is related to a person that owns an interest in the issuing partnership, and the interest provides the related person with partner attributes that are greater than the rights granted to other partners owning substantially similar interests in the partnership, the option will be characterized as a partnership interest under the final regulations if the strong likelihood test is satisfied.

The proposed regulations contain an example describing a “deep in the money” option and concluding, based on the facts of the example, that the option holder possesses partner attributes. This example was deleted from the example set forth in the final regulations.

On the part of the test related to the "strong likelihood" that the failure to treat the option holder as a partner would result in a substantial reduction in the present value of the partners' and the holder's aggregate tax liabilities the  final regulations provide that all facts and circumstances should be considered in making this determination, including: (i) the interaction of the allocations of the issuing partnership and the partners' and NCO holder's Federal tax attributes (taking into account tax consequences that result from the interaction of the allocations with the partners' and NCO holder's Federal tax attributes that are unrelated to the partnership); (ii) the absolute amount of the Federal tax reduction; (iii) the amount of the reduction relative to overall Federal tax liability; and (iv) the timing of items of income and deductions.

The final regulations also provide that if a partner or option holder is a pass-thru entity, such as a partnership or an S corporation, the tax attributes of that entity's ultimate owners will be taken into account in determining whether there is a strong likelihood of a substantial tax reduction. Where a partner is a member of a consolidated group, the tax attributes of the consolidated group and of another member with respect to a separate return year will be taken into account in determining whether there is a strong likelihood of a substantial tax reduction.

L. Events Requiring Testing Under the Characterization Rule

As mentioned, the proposed regulations test a NCO option under the characterization rule upon issuance, transfer, or modification of the option. The final regulations provide a more detailed description of the events, i.e., “measurement events”, that will trigger application of the characterization rule to a NCO. The final regulations define a measurement event as: (i) issuance of the NCO; (ii) an adjustment of the terms (modification) of the NCO or of the underlying partnership interest (including an adjustment pursuant to the terms of the NCO or the underlying partnership interest); or (iii) transfer of the NCO if either (A) the term of the option exceeds 12 months, or (B) the transfer is pursuant to a plan in existence at the time of the issuance or modification of the NCO that has as a principal purpose the substantial reduction of the present value of the aggregate Federal tax liabilities of the partners and the  NCO holder.

In response for a limitation to the potential set of “measurement events” that do not pose the potential for abuse, the final regulations exclude from the term “measurement event”: (i) a transfer of the NCO that would otherwise be a measurement event if the transfer is at death or between spouses or former spouses under §1041, or in a transaction that is disregarded for Federal tax purposes; (ii) a modification that neither materially increases the likelihood that the option will be exercised nor provides the option holder with partner attributes; (iii) a change in the strike price of a NCO, or in the interests in the issuing partnership that may be issued or transferred pursuant to the option, made pursuant to a bona fide, reasonable adjustment formula that has the intended effect of preventing dilution of the interests of the option holder; and (iv) any other event as provided in guidance published in the Internal Revenue Bulletin.

Under the proposed regulations under §761 being published concurrently with the final regulations, three measurement events would be added, but would only apply where those measurement events are pursuant to a plan in existence at the time of the issuance or modification of the NCO that has as a principal purpose the substantial reduction of the present value of the aggregate Federal tax liabilities of the partners and the NCO holder. The proposed measurement events are: (i) issuance, transfer, or modification of an interest in, or liquidation of, the issuing partnership; (ii) 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 NCO; and (iii) 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.

M. Effective Date of Characterization of Noncompensatory Partnership Option as a Partnership Interest.

The final regulations provide that characterization of an option as a partnership interest under the regulations applies upon the issuance of the option, or immediately before any other measurement event that gave rise to the characterization. Where the characterization rule applied upon a transfer of a NCO, a §743 adjustment for the benefit of the transferee would be made if the issuing partnership had a §754 election in effect. The final regulations provide that once a noncompensatory option is treated as a partnership interest, in no event may it be characterized as an option thereafter.

In Closing.

With the noncompensatory partnership option final regulations just having been issued, it is obvious that tax practitioners involved in partnership taxation will be looking over the details and examples contained in the final regulations and looking through the proposed regulations as well. While the final regulations have thoughtfully responded to comments and criticism lobbied at the 2003 proposed regulations, the characterization rule as well as the corrective allocation rule as set forth in the final regulations, will be burdensome for lawyers and tax advisors to properly interpret and guide clients through. Consider what the tax opinion to the issuance of an economically sizeable NCO or set of NCOs will have to consider or evaluate. What about the annual  tax compliance burdens associated with making sure a characterization (“measurement event”) has not resulted in one or more NCOs to be treated as partners. And, in the same vein, what must be done from a compliance standpoint if a change in NCO status has occurred.