The Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) issued final regulations (the Final Regulations), effective February 5, 2013, concerning the tax consequences of noncompensatory options and convertible instruments issued by a partnership. The Final Regulations modify and expand the proposed regulations issued January 22, 2003. Treasury and the IRS also released related proposed regulations (the Proposed Regulations) on the character of gain or loss recognized upon a lapse, repurchase, sale or exchange of noncompensatory options and providing additional testing dates for determining when options should be characterized as partnership interests.
The Final Regulations provide that the exercise of a noncompensatory option generally does not result in the immediate recognition of income or loss by either the issuing partnership or the option holder. The Final Regulations modify the Treasury regulations under section 704(b) of the Internal Revenue Code regarding the maintenance of the partners’ capital accounts and the determination of the partners’ distributive shares of partnerships items to account for exercised and outstanding noncompensatory options. The Final Regulations also include a characterization rule to determine whether a noncompensatory option is treated as a direct interest in the issuing partnership.
The Proposed Regulations list additional testing dates upon which a noncompensatory option must be tested to determine whether it should be treated as a partnership interest and clarify that the lapse of a noncompensatory option would result in short-term capital gain or loss to the issuing partnership. The Proposed Regulations also solicit comments 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.
The Final Regulations will cause funds with foreign and tax-exempt investors to revisit their procedures for determining whether and how to acquire options in portfolio companies to which they make loans. A summary of key provisions of the Final and Proposed Regulations follows.
Issuance, Exercise, Lapse, Repurchase and other Terminations of a Noncompensatory Option
The Final Regulations apply general tax principles under section 721 to the issuance of a noncompensatory option. The issuance of a noncompensatory option is generally an open transaction for the issuer. The issuer’s income or loss will not become fixed and determinable until the lapse, exercise, repurchase or other termination of the option. The option holder is treated as investing in the option—making a capital expenditure that is neither taxable to nor deductible by such holder at the time of investment. However, if the holder transfers depreciated or appreciated property to acquire the option, the holder will recognize gain or loss under general tax principles as a result of the disposition of the property.
Notwithstanding the general rule, the Final Regulations provide that section 721 of the Internal Revenue Code does not apply to (i) the transfer of a partnership interest to a noncompensatory option holder upon conversion of convertible debt to the extent that the transfer is in satisfaction of the partnership’s indebtedness for unpaid interest (including accrued original issue discount), or (ii) 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).
Capital Account Maintenance
The Final Regulations provide new rules for maintenance of capital accounts when noncompensatory options are issued or outstanding. The Final Regulations, unlike the 2003 proposed regulations, provide that the issuance by a partnership of a noncompensatory option (other than an option for a de minimis partnership interest) is a permissible revaluation event (also known as “book-up” event). If a revaluation occurs while a noncompensatory option is outstanding, the Final Regulations require that adjustments to capital accounts take into account the economic arrangements of the partnership with respect to partnership property. In general, the value of the property for purposes of determining the amount of the gain or loss from the revaluation must be adjusted to take into account the difference between the fair market value of the outstanding noncompensatory options and the consideration paid by the option holder.
Consequences of the Exercise of an Option
Under the Final Regulations, a revaluation event occurs immediately after the exercise of an option. Book gain or loss from the revaluation is to be first allocated to the former option holder to cause its capital account to reflect the former option holder’s right to share in the partnership capital. If there is insufficient book gain or loss to allocate, a “capital account reallocation” must occur resulting in corrective allocations of gross income or loss. As a result, an option holder may recognize phantom income upon the exercise of a noncompensatory option.
Characterization of a Noncompensatory Option as a Partnership Interest
The Final Regulations provide that a noncompensatory option is treated as a partnership interest for all federal income tax purposes if, on the date of a “measurement event,” the following two conditions are satisfied: (i) the noncompensatory option provides the holder with rights that are substantially similar to rights afforded to a partner and (ii) there is a strong likelihood that the failure to treat the holder of the 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 holder of an option that is reasonably certain to be exercised is treated as having rights that are substantially similar to the rights afforded to a partner. Accordingly, when a penny warrant or other option with a low-exercise price is issued, the partnership will have to apply the present value test to determine if the warrant holder or option holder holds a partnership interest for federal tax purposes. If a noncompensatory option is treated as a partnership interest, the holder is to receive a distributive share of the partnership’s income, gain, loss, deduction and credit in accordance with the holder’s interest in the partnership.
The Final Regulations identify three “measurement events”: the issuance of a noncompensatory option, modification of the terms of the option or the underlying partnership interest, and the transfer of the option if it can be exercised more than 12 months after issuance or the transfer is pursuant to a tax avoidance plan.
The Final Regulations apply to options issued on or after February 5, 2013.
Expansion of Characterization Rule
The Proposed Regulations expand the characterization rule implemented by the Final Regulations by adding the following three additional measurement events: (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 noncompensatory option; 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. These apply only if the event is pursuant to a tax motivated plan in existence at the time of issuance or modification of the noncompensatory option.
Character of Gain or Loss on Lapse, Sale, or Exchange of an Option
Section 1234(b) of the Internal Revenue Code provides that, in the case of the grantor of an option, gain or loss from the lapse, sale or exchange of an option shall be treated as gain or loss from the sale or exchange of a capital asset held not more than one year. The Proposed Regulations provide that the lapse of a noncompensatory option generally results in the recognition of income by the partnership and loss by the holder in an amount equal to the option premium.
The Proposed Regulations seek comments 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. The notice of proposed rulemaking asks whether the section 751 “hot asset” rules should apply to the sale, exchange or redemption of an option. If section 751 were to apply, a portion of the gain recognized on the sale or redemption of an option could be taxable as ordinary income.
The Final Regulations can be found here, and the Notice of Proposed Rulemaking can be found here. Patton Boggs has prepared a detailed outline of the regulations with commentary focusing on items of interest to mezzanine debt and other funds that in connection with loans acquire warrants with low exercise prices.