Final Regulations for Noncompensatory Partnership Options

By Lisa Wamboldt, J.D., Washington, D.C.

Editor: Annette B. Smith, CPA

Partners & Partnerships

The IRS in February issued final regulations (T.D. 9612) and proposed regulations (REG-106918-08) governing the issuance, exercise, lapse of, and accounting for a noncompensatory partnership option (NCPO). The final and proposed regulations are effective for NCPOs issued on or after Feb. 5, 2013. This item provides an overview of an NCPO’s life cycle and highlights the application of the final regulations to both the option holder and the partnership on issuance, exercise, and lapse of an NCPO.

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. For this purpose, an option is defined as a call option, warrant, or other similar arrangement; the conversion feature of convertible debt; or the conversion feature of convertible equity. The regulations provide that the IRS may treat other contractual arrangements—including a futures contract, forward contract, or notional principal contract—as an option.

Generally, the nonrecognition rules for partnership contributions under Sec. 721 do not apply to issuance of an NCPO, because the NCPO holder is not treated as having exchanged property for a partnership interest. Instead, issuance of an NCPO generally is governed by “open transaction” principles under which neither the issuing partnership nor the NCPO holder generally recognizes gain or loss. However, the NCPO holder recognizes gain or loss on a transfer of appreciated or depreciated property to the partnership in exchange for the NCPO.

In the case of convertible equity—that is, equity in a partnership that is convertible into a different equity interest in the issuing partnership—the final regulations consider the conversion right embedded in convertible equity as part of the underlying partnership interest. Thus, the NCPO regulations apply Sec. 721 to the contribution of property to a partnership in exchange for convertible equity in a partnership. The final regulations do not extend nonrecognition treatment to NCPOs that are issued by a disregarded entity that would become a partnership when the holder of an NCPO exercises its option. Also, under the final regulations, the issuance of an NCPO is a permissible revaluation event.

Exercise of an NCPO

On the exercise of an NCPO, the holder generally is viewed as contributing property in an amount equal to the option premium and the exercise price paid to the partnership in exchange for a partnership interest.

Example: X acquires an NCPO from partnership AB for $1, with the option to purchase a one-third interest in AB at the end of year 2 for $14. The option premium in this case is $1, and the exercise price is $14. When X exercises the NCPO, X is treated as contributing $15 for a one-third interest in partnership AB.

The capital account of the NCPO’s holder is equal to the consideration paid to the partnership to acquire the NCPO and the fair market value (FMV) of any property contributed to the partnership.

The NCPO regulations provide, contrary to the general revaluation requirements, that a partnership revalues its property immediately after the exercise of an NCPO instead of immediately prior to its exercise. This allows the partnership to book unrealized appreciation to prevent the exercise from being taxable and allows the partnership to maintain capital accounts that appropriately reflect the economic interests of the historic partners as well as those of the NCPO holder.

The final regulations provide that the partnership allocates unrealized gain or loss first to the exercising NCPO holder in an amount equal to the holder’s economic entitlement under the partnership agreement, and then to the historic partners, to reflect the manner in which the unrealized gain or loss in partnership property would be allocated among those partners if there were a taxable disposition of the property for its FMV on that date.

If there is not sufficient unrealized appreciation to allocate to the NCPO holder at the time of exercise, the partnership must make “corrective allocations” of gross income or loss to the partners in the year in which the NCPO is exercised to reflect the shift in the partners’ capital accounts that occurs as a result of a capital account revaluation. Corrective allocations are allocations of tax items that differ from the partnership’s allocations of book items. If there are not sufficient actual items in the year of exercise, additional corrective allocations are required in succeeding tax years until the reallocation has been fully taken into account.

Lapse of an NCPO

The lapse of an NCPO generally results in the recognition of income by the partnership and a loss to the holder of the lapsed NCPO in an amount equal to the NCPO premium paid by the holder. Under the proposed regulations, a partnership interest would be treated as a security for purposes of Sec. 1234(b) and, as a result, gain or loss from a lapse with respect to the NCPO for the grantor of the NCPO generally would be treated as gain or loss from the sale or exchange of a capital asset held for not more than one year. The character of gain or loss to the NCPO holder has the same character as the property to which the option relates in the hands of the taxpayer. As a result, an NCPO generally would be treated as a capital asset.

Characterization Rule

Regs. Sec. 1.761-3 provides the rule for when an NCPO will be respected as an option rather than treated as an interest in the underlying partnership. The final regulations provide that the NCPO holder will be treated as a partner if, on certain measurement event dates, the NCPO provides the holder with rights “substantially similar to the rights afforded to a partner.” A measurement event is defined as (1) the NCPO’s issuance, (2) an adjustment to the terms of the NCPO or of the underlying partnership interest, or (3) the transfer of the NCPO if either: (a) the NCPO’s term exceeds 12 months or (b) 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 the NCPO holder. 

The final regulations provide several factors for determining whether the facts and circumstances establish that an NCPO has rights substantially similar to those of a partner. If the NCPO is “reasonably certain to be exercised” or if the NCPO holder possesses “partner attributes,” the NCPO will be deemed to be exercised at the time of the measurement event. Interestingly, the fact that an NCPO is not treated as a partnership interest under the final regulations does not prevent the NCPO from being treated as a partnership interest under general principles of federal tax law. Thus, taxpayers will have to evaluate common law in determining whether an NCPO should be treated as an interest in the issuing partnership.

Safe Harbors Under the Characterization Rule

The final regulations provide two safe harbors under the characterization rule for when an NCPO will not be considered reasonably certain to be exercised:

  • The NCPO may be exercised no more than 24 months after the date of the applicable measurement event, and it has a strike price equal to or greater than 110% of the partnership interest’s FMV on the date of the measurement event.
  • The NCPO’s terms provide that its strike price is equal to or greater than the FMV of the underlying partnership interest on the exercise date.

However, these safe harbors do not apply if the parties to the NCPO had a principal purpose of substantially reducing the present value of the aggregate federal tax liabilities of the NCPO holder and the partners.


These long-awaited final regulations for NCPOs generally provide clarity for taxpayers on many issues with regard to these types of instruments. They give helpful guidance to avoid unintended consequences that could affect the NCPO holder as well as the historic partners if the holder is characterized as a partner for tax purposes.


Annette Smith is a partner with PwC, Washington National Tax Services, in Washington, D.C.

For additional information about these items, contact Ms. Smith at 202-414-1048 or

Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.

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