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February 5, 2013

IRS Finalizes Noncompensatory Partnership Option Regulations (article)

The IRS has issued final regulations relating to the tax treatment of noncompensatory options and convertible instruments issued by a partnership. A noncompensatory option is defined by the final regulations as an option issued by a partnership, other than an option issued in connection with the performance of services. An option is defined for this purpose as a call option or warrant to acquire an interest in the issuing partnership, the conversion feature of convertible debt, or the conversion feature of convertible equity. The final regulations apply only if the call option, warrant, or conversion right grants the holder the right to acquire an interest in the issuer, or cash measured by the value of the interest. In this case, the exercise of a noncompensatory option does not cause the recognition of immediate income or loss by either the issuing partnership or the option holder.

The new regulations modify regulations under Code Sec. 704(b) on maintenance of the partners' capital accounts and the determination of the partners' distributive shares of partnership items. The final regulations include a characterization rule providing that the holder of a noncompensatory option is treated as a partner under some circumstances. These regulations will affect partnerships that issue noncompensatory options, the partners of these partnerships, and option holders.

The IRS has also proposed modifications to newly issued final regulations (T.D. 9612) relating to the tax treatment of noncompensatory options and convertible instruments issued by a partnership. This means an option issued by a partnership, other than an option issued in connection with the performance of services. If the option grants the holder the right to acquire an interest in the issuer, or cash measured by the value of the interest, the exercise of a noncompensatory option does not cause the recognition of immediate income or loss by either the issuing partnership or the option holder under the final regulations.

The final regulations include a characterization rule providing that the holder of a noncompensatory option is treated as a partner under some circumstances. A noncompensatory option is treated as a partnership interest if, on the date of a measurement event, the option provides the holder with rights similar to a partner's rights, and it is likely that not treating the holder as a partner would result in a substantial reduction in the tax liabilities of the holder and the partners. A measurement event under the final regulations can include issuance of a noncompensatory option, modification of the option's terms or the underlying partnership interest, or transfer of the option under some circumstances. The proposed regulations expand the characterization rule measurement events to include certain transfers of interests in the issuing partnership and other look-through entities. They also provide additional guidance in determining the character of the grantor's gain or loss as a result of a closing transaction with respect to, or a lapse of, an option on a partnership interest. The proposed regulations will affect partnerships that issue noncompensatory options, the partners in these partnerships, and option holders.


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