Tax Alert

Final Regulations Issued on Tax Treatment of Partnership Noncompensatory Options

The U.S. Department of the Treasury on Feb. 4, 2013, issued final regulations regarding the federal income tax treatment of a noncompensatory option (NCO) to acquire a partnership interest. NCOs include call options, warrants, and the conversion features of convertible debt and preferred equity that are issued by a partnership and not connected to the performance of services.

The regulations generally treat the exercise of an NCO as tax-free to both the partnership and the option holder when the exercise price is satisfied with property or cash. The regulations do not provide tax-free treatment to the transfer of a partnership interest in satisfaction of unpaid interest (including accrued original issue discount (OID)), rent, royalties, or upon conversion of debt in satisfaction of interest (including accrued OID). Furthermore, the lapse of an NCO will result in the recognition of income by the partnership and loss by the option holder.

The regulations provide rules on how to maintain capital accounts and determine distributive shares with respect to NCOs. Issuing an NCO generally is a permissible revaluation event, while exercising an NCO requires the partnership to revalue is property to reflect each partner’s share of the proceeds that would be available in a hypothetical liquidation of the partnership.

The regulations allow an NCO holder to be treated as a partner in specified instances. Partner treatment is determined through a combination of facts and circumstances tests with limited safe harbor options. The regulations are applicable to NCOs issued on or after Feb. 5, 2013.


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A.J. Schiavone

Kristy Rempalski

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