Noncompensatory Partnership Options: Treasury and IRS Issue Final and Proposed Regulations on Noncompensatory Options, Warrants and Convertible Instruments Issued by Partnerships

Sullivan & Cromwell LLP - February 8, 2013

On February 4, 2013, Treasury and the Internal Revenue Service issued final and proposed regulations (the “Final Regulations” and the “Proposed Regulations”, respectively) governing the tax treatment of certain noncompensatory options, warrants and convertible instruments issued by partnerships (collectively referred to as “options”). These regulations apply only to options that are not issued in connection with the performance of a service; regulations governing options that are issued in connection with the performance of a service (for example, options issued to employees as compensation) were proposed in 2005 and were subject to additional comment in 2011, but have not yet been finalized. The Final Regulations modify and expand the proposed regulations issued January 22, 2003 (the “2003 Proposed Regulations”), discussed in our client publication dated January 30, 2003, entitled “Proposed Regulations Regarding Tax Treatment of Noncompensatory Options and Convertible Instruments Issued by a Partnership”.

The Final Regulations, similar to the 2003 Proposed Regulations, provide that the exercise of a noncompensatory option generally does not result in the immediate recognition of income or loss by either the issuing partnership or the option holder. The Final Regulations modify the Treasury regulations that govern the maintenance of partners’ capital accounts and the determination of partners’ distributive shares of partnership items, to account for exercised and outstanding noncompensatory options. The Final Regulations also provide a more comprehensive test, including multiple testing dates, to determine whether a noncompensatory option is treated as a direct interest in the issuing partnership.

The Proposed Regulations clarify that the lapse of a noncompensatory option would result in the recognition of income to the issuing partnership. The Proposed Regulations solicit comments from the public regarding whether the rule that recharacterizes a portion of a partner’s capital gain from the disposition of a partnership interest as ordinary income based on the proportion of “hot assets” of the partnership (described below) should be broadened to cover the sale, exchange or lapse of an option. The Proposed Regulations also list additional testing dates upon which a noncompensatory option must be evaluated to determine whether it should be treated as a partnership interest.