Prop. regs. issued on noncompensatory partnership options.

• Author: Madden, David

In recent years, partnerships have issued options or convertible instruments to investors that entitle them to acquire an equity interest in the partnership by purchase or conversion. Notwithstanding the established guidance on the Federal tax treatment of corporate options, the tax consequences of partnership options remained unclear due to the lack of published guidance from Treasury and the IRS.

In an effort to formulate guidance in this area, the IRS requested commentary from the public on (1) the tax treatment of the exercise of an option to acquire a partnership interest, (2) the exchange of convertible debt for a partnership interest and (3) the exchange of a preferred interest in a partnership for a common interest; see Notice 2000-29. After receiving comments from numerous tax practitioners, the Service released proposed regulations on Jan. 21,2003 (REG-103580-02) on the tax treatment of partnership noncompensatory options and convertible instruments.

The proposed regulations generally address the Federal income tax consequences as to the issuance, exercise, lapse and conversion of certain call options, warrants, convertible debt and convertible equity issued by partnerships, not in connection with the performance of services (i.e., noncompensatory options). In addition, they modify the capital account maintenance rules under the Sec. 704(b) regulations to account for noncompensatory options.

In general, the proposed regulations reach favorable conclusions. For example, the issuance and exercise of an option generally do not immediately result in the partnership, the existing partners or the option holder recognizing income or loss. Although income or loss may be recognized on lapse of an option, if the option is exercised, the proposed regulations provide only for special allocations of future partnership tax items. This item highlights the regulation's major provisions.

Issuance of a noncompensatory option. Under general tax principles, the issuance of an option to purchase property at some time in the future at a specified price is deemed an open transaction for the issuer and a capital expenditure for the purchaser. Thus, the issuer generally recognizes no gain or loss on issuance of an option. The purchaser generally recognizes gain or loss on issuance only to the extent he or she uses appreciated or depreciated property to acquire the option; see generally Rev. Ruls. 57-40 and 78-182.

In the preamble to the proposed...