2013-Issue 12—The IRS recently issued finalized Treasury Regulation 1.761-3 on the tax treatment of noncompensatory options issued by partnerships in circumstances unrelated to the performance of services. The final regulations are similar to the proposed 2003 regulations but add more clarity, modify 704(b) regulations and retain the characterization rule under which options can be treated as partnership interests. The regulations also offer additional guidance, including providing safe harbors under which option treatment will be maintained under the characterization rule.
The noncompensatory option remains a potentially useful tool for a partnership to attract investors and venture capital, as long as the option does not incorporate too many equity features that may cause the option to be recharacterized as partnership interest. The regulations apply not only specifically to options but also to other financial instruments, including warrants and convertible debt.
Any partnership that uses financial instruments that meet the definition of a noncompensatory option should play close attention to the recharacterization rules and potential problems that could be caused. Investors, specifically those who use mezzanine debt with equity kickers to fund investments, should pay close attention to rules for the characterization of noncompensatory options and whether the option has enough equity features to be immediately characterized as a partnership interest (equity) instead of debt. This could trigger an array of problems as it relates to a partnership, including inadequate debt allocations for the historical partners to cover negative capital accounts, as well as possible termination and unforeseen related-party issues, to name a few. Problems for the investor could include understatement penalties for not picking up partnership income and unanticipated tax compliance complexity.
This edition of Tax Advisor Weekly walks through the general treatment of noncompensatory options, the changes in partnership accounting under 704(b) related to the new regulations and a rundown on the recharacterization rule.
General Tax Treatment of Noncompensatory Options
The final regulations continue to apply the standard tax treatment to a noncompensatory option issued by a partnership. Income or loss would not become fixed or determinable until the lapse, exercise, repurchase or termination of the options. Therefore, the issuer does not recognize gain or loss until the arrangement is closed. In the case of the option holder, the purchase would be treated as an investment in an option that would not be taxable or deductible to the holder except in the case where the holder transfers appreciated or depreciated property to purchase the option.
Carryover-basis treatment under Section 721 applies to the option holder and partnership upon the exercise of an option issued by a partnership. When an option is exercised, the option holder is treated as contributing the exercise price and option premium to the partnership in exchange for a partnership interest. If an option was to expire, the partnership would recognize income and the option holder would recognize a loss. The IRS issued proposed regulations under 1.1234-3 to allow partnership interests to be treated as securities under 1234(b) in order for general tax principles to apply upon the lapse of an noncompensatory option.
The final regulations spell out two instances in which nonrecognition treatment under Section 721 does not apply:
- Upon the conversion of convertible debt to a partnership interest to the extent of unpaid interest or accrued original issue discount (OID) on the convertible debt, Section 721 does not apply. This treatment is consistent with the final 2011 Section 721 regulations dealing with debt for equity exchanges.
- Section 721 also does not apply to the extent the exercise price of the option 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.
Accounting for Noncompensatory Options
The final regulations were also coupled with additions to the Section 704(b) regulations dealing with capital account maintenance issues for noncompensatory partnership options. However, the concepts are similar to the 2003 proposed regulations and should not be foreign to those familiar with Section 704(b). The initial capital account of an option holder would equal the consideration paid to the partnership to acquire the option in addition to cash or fair market value of property contributed to the partnership upon option exercise. However, depending on the terms of the option, the holder may be entitled to a capital account that is greater or less than the option holder's initial capital account. Consistent with the proposed regulations, the final regulations state the partnership would revalue or book up or book down its property immediately after the exercise of the option and allocate the unrealized gain or loss as a result of the revaluation as follows: first to the option holder to the extent the option holder is entitled, and then to the remaining partners to reflect their unrealized gain or loss as of the revaluation event.
The final regulations include a clarification that the underlying economic arrangements of the partners, including special allocations, should be taken into account as part of the revaluation. The option holder would recognize income or loss attributable to the revaluation event in a manner consistent with the 704(c) treatment of the underlying assets. Practically speaking, this is more of a clarification rather than a rule change.
Also consistent with the 2003 regulations, the partnership is required to account for any outstanding noncompensatory options upon a revaluation event. This is done by treating the outstanding options as contingent liabilities. The contingent liability is then taken into account by adjusting the built-in gain or loss in the partnership's assets that is allocated to the partners' capital account as part of the revaluation. The regulations do not provide guidance on determining the fair market value of the option, but the examples in the regulations use the liquidation value of the underlying partnership interests, assuming the option is exercised.
In general, the final regulations follow the proposed regulations in determining whether a noncompensatory option should be treated as a partnership interest. Under the final regulations, a noncompensatory option is treated as a partnership interest under the following scenarios:
- The option provides the holder with rights that 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.
Additional guidance is provided by the final regulations with respect to this two-prong test. An option grants holders rights that are substantially similar to the rights afforded to a partner if either:
- The option is reasonably certain to be exercised; or
- The option holder possesses partner attributes.
Whether the option is reasonably certain to be exercised is determined by facts and circumstances. All factors would be taken in account, including the fair market value of the partnership interest subject to the option, the strike price and term of the option, the predictability and stability of the value of the partnership interest to which the option relates, and whether the partnership is expected to make distributions during the term of the option. Fortunately, the final regulations add two safe harbors under which an option would not be treated as reasonably certain to be exercised:
- If the latest exercise date is within 24 months and the exercise price is equal to or greater than 110 percent of the current fair market value of the partnership interest to which the option relates; or
- If the terms of the option provide that the exercise price is at least equal to the fair market value of the partnership interest on the exercise date or is based on a formula that was developed by the parties on the issue date of the option as a means of approximating the fair market value of the partnership interest on the exercise date and is applied based on the facts and circumstances on the exercise date.
Even if an option does not meet the above safe harbor standards, it may still be treated as not being reasonably certain to be exercised. Partner attributes are based on a facts and circumstances test as well. The regulations describe factors to be considered, including whether the option holder can participate in the management of the partnership and has a current right to income of the partnership or has undertaken obligations similar to the obligations by the partner to bear losses. However, the new regulations do allow for rights for an option holder to restrict a partnership decision that could substantially affect the value of the underlying partnership interest. The following rights were cited as examples that will not be treated as partnership attributes:
- The ability to impose reasonable restrictions on partnership distributions or dilutive issuance of partnership equity or options while the noncompensatory option is outstanding; and
- The ability to choose the partnership's Section 704(c) method for partnership properties.
In determining whether there is a strong likelihood that the failure to treat the holder of an 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 regulation states this is also based on all the facts and circumstances. Items cited by the regulations include the interaction of the allocations of the issuing partnership and partners' and noncompensatory option holder's federal tax attributes (including consequences and attributes unrelated to the partnership), the absolute amount of federal tax reduction, the amount of reduction relative to overall federal tax liability, and the timing of items of income and deductions. Additionally, in the event the option holder is a partnership or S-corporation, the regulations require that you look through to the underlying individual owner and their tax attributes and tax liability.
Under the final regulations, noncompensatory options testing under the characterization rule is performed when a measurement event occurs. A measurement event is defined as following:
- Issuance of the noncompensatory option;
- An adjustment of the terms of the noncompensatory option or of the underlying partnership interest; or
- Transfer of the noncompensatory 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 of the noncompensatory option that has as a principal purpose the substantial reduction of the present value of the aggregate federal tax liabilities of the partners and the noncompensatory option holder.
Once an option is characterized as a partnership interest, it can never be recharacterized as an option under any circumstances.
The final regulations are in effect for all noncompensatory options issued on or after February 5, 2013.
Alvarez & Marsal Taxand Says:
The final regulations provide some closure and certainty into the tax treatment of noncompensatory options. The overall treatment does not differ significantly from the 2003 proposed regulations and, in most cases, also continues to treat the issuance of a noncompensatory option as a nontaxable event. As a result, partnerships are still able to use noncompensatory options as a tool in obtaining venture capital. However, questions about the treatment of noncompensatory options and related complex financial instruments still remain, particularly for investors with warrants and mezzanine debt. Investors, especially those utilizing mezzanine debt with enough equity characteristics, must consider the impact of these regulations when structuring new acquisitions. Investors may want to ensure the option instruments conform to the safe harbors in the final regulations and may want to avoid the use of noncompensatory options when the risk of potentially characterizing the option holder as a partner can cause adverse consequences to the partnership or partner.
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