Long-Awaited Final Regs. Issued on Noncompensatory Partnership Options

On Monday, the IRS issued regulations (T.D. 9612) finalizing proposed regulations (REG-103580-02), which were issued in January 2003, on the treatment of certain call options, warrants, convertible debt, and convertible equity that are not issued in connection with the performance of services, i.e., noncompensatory partnership options.

The final regulations apply to noncompensatory options that are issued on or after Feb. 5, 2013, the day they are scheduled to be published in the Federal Register.

The final rules, which explain the income tax consequences of issuing, transferring, and exercising noncompensatory partnership options, 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 interest’s value). The exercise of a noncompensatory option generally will not cause either the issuing partnership or the option holder to recognize gain or loss.

In addition, the final rules amend the Sec. 704(b) regulations governing the maintenance of the partners’ capital accounts and the determination of the partners’ distributive shares of partnership items. Finally, the final regulations contain a rule providing that the holder of a call option, warrant, convertible debt, or convertible equity issued by a partnership (or an entity eligible to elect to be treated as a partnership under Regs. Sec. 301.7701-3(a) that would become a partnership if the option holder were treated as a partner) is treated as a partner under certain circumstances, which are called measurement events (preamble to T.D. 9612).

In a related development, the IRS issued proposed rules (REG-106918-08) intended to be added to the final regulations discussed above. Under the final regulations, the holder of a noncompensatory option is recharacterized as a partner under certain circumstances. The final rules contain a number of measurement events for determining when this recharacterization occurs, and the proposed rules add three measurement events involving certain transfers of interests in the issuing partnership and lookthrough entities.

The second change in the proposed rules is to the Sec. 1234(b) regulations, clarifying that for purposes of this section a security includes a partnership interest (preamble to REG-106918-08). The proposed rules are intended to apply the same day the final regulations are effective, Feb. 5.