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Partnership Noncompensatory Options (Portfolio 721)
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, On February 4,the U. Treasury Department finalized regulations under Sectionsand with conforming changes to regulations under Sectionsand addressing the tax treatment of noncompensatory options issued by a partnership Final Regulationsmaking only modest changes and clarifications to the proposed regulations issued in on the same subject Regulations.
In a partnership option development, Treasury concurrently released proposed regulations addressing, among other subjects, the threshold question of when a partnership option is, in substance, partnership option interest in the issuing partnership Proposed Regulations. Set forth below is a brief summary of the Final Regulations and Proposed Regulations.
Scope 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.
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 Proposed Regulations in applying general tax principles to noncompensatory options.
Partnership option Final Regulations generally provide for nonrecognition treatment upon the exercise of a partnership option 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 Sectionthis 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 b applies to the exercise of the option. In these two instances, Section 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 does not apply.
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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 also does not apply if the option is cash settled.
Rather, cash settlement of an option is treated as a sale or partnership option of the option. Treasury rejected suggestions in comments to the Regulations that cash settlement should be treated as an exercise partnership option the option for a partnership interest followed immediately by a cash redemption of the partnership interest.
Noncompensatory Partnership Options
Character of Gain or Loss The 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 Proposed Regulations address this topic. Capital Account Maintenance Rules Under the Final Regulations, the issuance of a noncompensatory option is a permissive capital account revaluation event under Treas.
Such a revaluation would generally prevent unrealized gains and losses at partnership option 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 partnership option 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.
Final Regulations for Noncompensatory Partnership Options
The converse rule applies if the price paid by the option holder exceeds the fair market value partnership option 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.
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 partnership option option.
- Final Regulations for Noncompensatory Partnership Options
- Partnership Noncompensatory Options (Portfolio ) | Bloomberg Tax & Accounting
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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.
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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, partnership option to Treasury, taxable income has been effectively shifted from the option holders to partnership option historic partners. This capital shift is then matched with corrective partnership option 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. Characterization The Regulations generally respected a noncompensatory option as an option rather than as an interest in the partnership.
Federal Register :: Noncompensatory Partnership Options
The Final Regulations generally retain this two-part characterization rule but provide more specific guidance on its application. 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 partnership option harbor provides that a noncompensatory option is not partnership option 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 percent of the current fair market value of the partnership interest on the date of the measurement event.
The second safe harbor provides that partnership option noncompensatory option is not considered reasonably certain to be exercised if the terms of the option provide that the strike price is equal partnership option or greater than the fair market value of the underlying partnership interest on the exercise date.
Editor: Annette B. Issuance of an NCPO An NCPO is defined under the final regulations as an option issued by a partnership to acquire a partnership interest in the partnership that is not issued in connection with the performance of services.
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 partnership option 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.
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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. Under the Final Regulations, the characterization rule is applied upon the occurrence of a measurement event.
Presentation This webinar will provide tax advisers to partnerships and LLCs with a practical guide to the special rules governing the tax treatment of noncompensatory partnership options NCPOs. The panel will detail the tax consequences to both the granting partnership and the optionee throughout the life cycle of the option, from grant through exercise or lapse, and discuss available strategies including basis adjustment elections to minimize the tax impact of noncompensatory option grants. Description Partnerships and LLCs often utilize NCPOs and other financial instruments such as warrants or convertible debt to attract investment capital. Appropriately structured, NCPOs provide tax deferral benefits to both the issuing partnership and the NCPO holder, particularly where an investor does not wish to become a full ongoing partner. The issuance of partnership option noncompensatory partnership option or other exercisable contract right, generally defined as options issued in the circumstances other than "in connection with" the partnership option of services, is typically exempt from current tax, except when the option holder exchanges appreciated or depreciated property in exchange for the option.
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 partnership option upon a subsequent measurement event.
Noncompensatory Partnership Options: Tax Treatment | CPE Webinar | Strafford
The Proposed Regulations add three additional measurement events for application of the characterization rule, generally involving issuance or modification of interests partnership option 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. Effective Date The Final Regulations are effective, and the Proposed Regulations are proposed to be effective, for options issued on or after February 5,