The IRS has issued proposed regulations under Sections 721 and 704(b) of the Internal Revenue Code regarding the federal income tax treatment of noncompensatory options or warrants issued by a partnership. The proposed regulations generally provide that no gain or loss will be recognized by either the issuing partnership or the option holder on issuance or exercise of the option. This treatment is also applicable to convertible debt and convertible preferred equity of a partnership. The proposed regulations do not address the treatment of compensatory options issued by a partnership.

Issuance of Noncompensatory Options

The proposed regulations provide that the issuance of a noncompensatory option by a partnership in exchange for property is not recognized or taken into account under tax laws. As such, the issuance is treated as an open transaction to which the federal income tax consequences will not be determined until either the lapse, exercise or repurchase of the option. For the option holder, the issuance is treated as a nondeductible capital expenditure. The option holder takes an adjusted basis in the option equal to the amount or value paid in exchange for the option. The option holder will, however, recognize gain or loss in the event appreciated or depreciated property is used to acquire the option from the partnership.

Exercise of Noncompensatory Options

The proposed regulations provide that on the exercise of the noncompensatory option, the option holder will be treated as contributing property consisting of the option premium and the exercise price in exchange for a partnership interest. The exchange is treated as a tax-free contribution of property in exchange for a partnership interest. The holder's tax basis in the interest will equal the basis of the option plus the exercise price paid. The proposed regulations therefore eliminate the concern that the exercise would be interpreted as a taxable shift of partnership capital from the preexisting partners to the option holder upon exercise of a noncompensatory option.

Under the proposed regulations, the partnership will, for capital account purposes, revalue its property immediately following the exercise of a noncompensatory option and allocate unrealized appreciation first to the capital account of the option holder until it reflects the option holder's share of partnership capital. Future taxable income and loss of the partnership must then be made among the partners taking into account this allocation of unrealized appreciation under existing tax principles. In the event there is insufficient unrealized appreciation in the partnership's assets to accomplish this, the proposed regulations provide that capital will be shifted from the other partners to the option holder to the extent necessary to cause the capital account balances of the partners to reflect their economic rights in the partnership. Furthermore, to the extent capital has been shifted, corrective allocations of items of taxable income, gain, loss or deduction for the year of exercise (and future years if necessary) must be made among the partners to account for such shift. This may result in the option holder recognizing a larger than proportionate share of taxable income in the year of exercise.

Lapse of Noncompensatory Options

The proposed regulations provide that a lapse of a noncompensatory option results in the recognition of ordinary income by the partnership in an amount equal to the value of any property that was received in exchange for the issuance of the noncompensatory option. For the option holder, the lapse results in the recognition of capital loss in the same amount.

Characterization of Option Holders

Generally, the proposed regulations do not characterize noncompsenatory options as partnership equity and do not require partnership income to be allocated to option holders prior to exercise. Under certain circumstances, however, the proposed regulations treat the option holder as an equity partner if the option holder's rights are substantially similar to the rights of a partner. This determination is based on consideration of all facts and circumstances, including (i) whether the option is reasonably certain to be exercised and (ii) the extent to which the option holder has the right to participate in management. If an option holder is treated as a partner, the option holder may, under the proposed regulations, recognize an allocable share of partnership income and loss prior to the exercise of such option.

Original Issue Discount Provisions

The proposed regulations amend the original issue discount regulations to treat partnership interests as stock for purposes of applying the special original issue discount rules for convertible debt instruments. This change is intended to eliminate any differences between the treatment of convertible debt issued by a partnership and convertible debt issued by a corporation.

Compensatory Options Not Addressed

The proposed regulations do not address the federal income tax treatment of compensatory options issued by a partnership. The proposed regulations also do not address the federal income tax consequences of convertible debt to the extent of any accrued but unpaid interest. The IRS intends to provide guidance on these issues at a future date.

Proposed Effective Date

The proposed regulations will apply to noncompensatory options that are issued on or after the date the proposed regulations become final. Recognize that proposed regulations are simply guidelines and have no authoritative consequence prior to becoming final. We will keep you apprised of the developments relating to these regulations.