Tax Guidance on Partnership Options –

Many private equity funds structure their investments using debt or preferred equity to limit risk of loss and provide a fixed return, coupled with warrants, to assure participation in appreciation in the value of the investee company. With the general move to the limited liability company (treated as a partnership for tax purposes) as the entity of choice for organizing a private company, this investment structure has had to be re-evaluated in light of the tax consideration of the funds’ investors.

Proposed regulations (“Proposed Regulations”) released by the IRS earlier this year provide comprehensive guidance dealing with the issuance, exercise and lapse of options and convertible securities issued by partnerships (and other entities treated as partnerships for U.S. federal tax purposes). The Proposed Regulations dispel fears by some practitioners that the issuance of options may result in phantom income, similar to the original issue discount rules or the constructive dividend rules, or that the exercise of such options would result in taxable income to the option holder. While generally fair and sensible in their operation, the Proposed Regulations do contain rules that investors, funds and, in some cases, practitioners may find surprising.

Scope

The Proposed Regulations deal only with so-called noncompensatory options (NCOs). An option is defined to include a call option or warrant to acquire an interest in the issuing partnership, the conversion feature of a convertible debt obligation or the conversion feature of preferred equity issued by a partnership that is convertible into common equity in that same partnership.

Issuance of NCOs

Section 721 of the Internal Revenue Code of 1986 provides that no gain or loss is recognized by a partnership or any of its partners upon the contribution of property to a partnership in return for an interest in the partnership. However, Section 721 does not by its terms apply to the issuance of options by a partnership. The Proposed Regulations confirm that Section 721 does not cover the issuance of a NCO – general tax principals apply to the issuance of a NCO. The issuance of a call option or warrant generally is treated as an open transaction. The issuing partnership does not treat any premium received as income at the time of issuance, and the investor is required to capitalize (and not deduct) the premium at such time. The option privilege contained in convertible debt and convertible equity is treated as part of the underlying investment. If the holder of the NCO uses property other than cash to pay for the option, then gain or (subject to certain loss disallowance rules) loss may be recognized upon the transfer of property to a partnership in return for a NCO.

Lapse of NCOs

Upon the lapse of a NCO, the partnership will recognize as income, and the holder will deduct, the amount paid to acquire the NCO.

Exercise of NCOs

The issuance of a partnership interest upon the exercise of a NCO generally is tax-free pursuant to Section 721. The Proposed Regulations do not specifically provide tax-free treatment to the exercise of a NCO issued by a disregarded entity that becomes a partnership as a result of the exercise. Neither do the Proposed Regulations address the treatment of the conversion of partnership debt into a partnership interest to the extent of any accrued but unpaid interest on the debt. This leaves open the possibility that the investors and/or the partnership may recognize income to such extent on the conversion. Additionally, the Proposed Regulations state that if the exercise price of a NCO exceeds the capital account received by the option holder on the exercise of the NCO, the transaction will be given tax effect in accordance with its true nature.

Tax Accounting for NCOs

The Proposed Regulations are built on the premise that the built-in gain or loss inherent in the NCO at the time of exercise represents Section 704(c) gain or loss. Section 704(c) is designed to ensure that the gain or loss inherent in property contributed to a partnership at the time of contribution is taxed (or deducted) by the contributing partner. Similarly, regulations under Section 704(c) provide that gain or loss inherent in assets held by a partnership at the time the assets are revalued are taxed or deducted by the partners at the time of revaluation, and not by subsequent partners (or by the same partners in different proportions). As the asset (i.e., the option) bearing Section 704(c) gain when contributed to the partnership does not survive following the contribution, the Proposed Regulations allow the partnership to substitute built-in gain or loss in the partnership assets for the built-in gain or loss in the NCO. Investors may find that, although the exercise of a NCO is not a taxable event, the accounting rules cause an investor to recognize a disproportionately greater percentage of taxable income in the year of exercise and future years than its share of book income. In certain cases, the Proposed Regulations create taxable income.

Upon the exercise of a NCO, the exercising partner’s capital account is credited with (1) the premium paid for the NCO and (2) the fair market value of the property (other than the NCO) contributed to the partnership to exercise the NCO. The agreement among the parties may (and generally will) provide that the exercising partner’s right to share in the capital of the partnership will differ from this amount initially credited to the exercising partner’s capital account. Accordingly, for book purposes the partnership must revalue its assets immediately after the exercise of a NCO. Any unrealized income, gain, loss or deduction in the partnership assets (not already reflected in the capital accounts of the partners) is allocated first to the exercising partner to the extent necessary to reflect that partner’s right to share in the partnership capital under the partnership agreement. Any additional unrealized income, gain, loss or deduction is allocated to the remaining partners in the proportions as though there were a taxable disposition of such property for its fair market value on the date of revaluation.

If there is insufficient unrealized gain or loss in the partnership’s assets at the time of the exercise of the NCO to fully reflect the exercising partner’s right to share capital, the exercise of the NCO results in a capital shift from the existing partners to the exercising partner. For book purposes, the capital accounts are actually reallocated among the partners so that they reflect the partners’ relative interests in the capital of the partnership. Beginning in the year of exercise, and in succeeding taxable years, the partnership must make corrective allocations of gross taxable income, gain, loss or deduction until the amount of capital shifted to the exercising partner is fully taken into account.

Assume that in Year 1, A and B each contribute $10,000 to LLC in exchange for 100 units therein. LLC purchases property X for $20,000. LLC also issues a NCO to acquire 100 units of LLC to C for $15,000. C pays $1,000 for the NCO. In Year 1, LLC sells Property X for $40,000, recognizing gain of $20,000, which is allocated (but not distributed) equally among A and B, and uses the proceeds to purchase Property Y for $40,000. C exercises the NCO in Year 2 when Property Y is worth $41,000. C’s initial capital account is $16,000 (exercise price plus the premium). LLC’s total assets are $57,000 ($41,000 for property Y, plus $16,000 cash), of which C’s one-third share is $19,000. C’s capital account must be increased from $16,000 to $19,000 by first allocating the unrecognized gain in property Y ($1,000) to C, and second, by shifting $1,000 from the capital account of each of A and B to C.

Assume that in Year 2, LLC has gross income of $3,000 and a deduction of $1,500. Although for book purposes, the $1,500 net income is shared equally among A, B and C, for tax purposes the entire $3,000 of gross income (but only one-third of the deduction) is allocated to C. At the end of Year 2, C’s book capital account will have increased to $19,500 (the original $16,000, plus $1,000 revaluation gain, plus $2,000 capital shift, plus $500 share of net income). C’s tax capital account will have increased from $16,000 to $18,500 (the initial $16,000, plus $3,000 taxable gross income, less $500 share of deductions). The remaining $1,000 disparity between book and tax capital accounts represents the $1,000 revaluation gain that has not yet been recognized for tax purposes. C will be taxable on this when property Y is sold.

Option Holder or Partner?

The Proposed Regulations treat the holder of a NCO as a partner of the partnership if the NCO provides the holder with rights that are substantially similar to the rights afforded to a partner. All facts and circumstances must be considered. Most important are those facts indicating that the NCO is reasonably certain to be exercised and facts indicating the extent to which the holder of the NCO will share in the economic benefit of partnership profits and the economic detriment associated with the partnership’s losses. One example given is a deep in the money NCO.

This provision applies only if, at the time of issuance, modification or transfer of the NCO, there is a strong likelihood that the failure to treat the holder as a partner would result in a substantial reduction in the present value of the partners’ and the holder’s aggregate tax liabilities. This condition likely is small comfort, because it is rare that all partners and option holders are taxable in the United States at the same tax rates. Moreover, the Proposed Regulations, as written, may result in a NCO that is treated as an option on the date of issuance being treated as a partnership interest at the time of transfer. (Note: We understand there still is debate at the IRS as to whether the transferor of a NCO treated as an option at the time of issuance may be deemed to transfer the underlying partnership interest.) The treatment of a NCO as equity in the partnership may have serious adverse effects, including causing a disregarded entity to be treated as a partnership, the recognition of UBTI by a tax-exempt NCO holder, the recognition of effectively connected income by a foreign NCO holder, reduction of holding periods, and the replacement of capital gain with ordinary income.

The Proposed Regulations provide much needed guidance. However, an investor or fund must carefully consider the effects of acquiring and exercising options in non-corporate vehicles to ensure the tax effects are consistent with the intended economic results.

Steven D. Bortnick is tax counsel in the New York office of Swidler Berlin Shereff Friedman. His practice extends into private equity and hedge funds.