Final regulations for noncompensatory partnership options.

Author:Wamboldt, Lisa

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...

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