Originally published in 2003
Howard E. Abrams is Of Counsel to Steptoe & Johnson (DC) where he is head of the partnership and real estate tax group. He is a corporate and partnership tax specialist, receiving his BA from the University of California (Irvine) and his JD from Harvard University. He has written four books and dozens of articles on taxation and is a frequent speaker at seminars and tax institutes. Mr. Abrams has been a professor of law at Emory University since 1983 and spent the 1999-2000 academic year with the national office of Deloitte & Touche, LLP, as the Director of Real Estate Tax Knowledge. He teaches regularly at the University of Georgia and at Leiden University in the Netherlands and is a member of the American Law Institute and the California and District of Columbia bars.
I. Introduction
There is a wealth of information available on the proposed noncompensatory options, much of it very good. However, little of it goes beyond what the proposed noncompensatory option regulations say, and those regulations are woefully short on guidance speaking to realistic transactions. What follows is a description of the guidance we have along with an attempt to apply that guidance to more complex fact patterns.
II. What We Know: What the Proposed Regulations Say
A. Definitions: The proposes regulations define a host of specialized terms, in some cases eschewing more common usage. These terms are:
1. Common Equity: An interest in the partnership other than an interest that gives the holder a preferential return on capital. Prop. Reg. §1.721-2(e)(3).
2. Convertible Debt: Any indebtedness of a partnership that is convertible into an interest in that partnership. Prop. Reg. §1.721- 2(e)(2).
3. Convertible Equity: Preferred equity that is convertible into common equity. Prop. Reg. §1.721-2(e)(3).
4. Exercise: The exercise of an option (called a "call option") or warrant or the conversion of convertible debt or convertible equity. Prop. Reg. §1.721-2(e)(4).
5. Exercise Price: Under Prop. Reg. §1.721-2(e)(5), this definition includes three sub-definitions.
- As to a Call Option or Warrant: The exercise price of the call option or warrant.
- As to Convertible Debt: The adjusted issue price of the debt as defined in Reg. §1.1275-1(b), increased by accrued but unpaid qualified stated interest and by the fair market value of cash or other property contributed to the partnership in connection with the conversion.
- As to Convertible Equity: The holder’s capital account with respect to the convertible equity, increased by the fair market value of cash or other property contributed to the partnership in connection with the conversion. Note that this "with respect to" seems inconsistent with longstanding regulations that provide "a partner who has mo re than one interest in a partnership shall have a single capital account that reflects all such interests, regardless of the class of interest owned by such partner . . . and regardless of the time or manner in which such interests were acquired." Reg. §1.704-1(b)(2)(iv)(b).
6. Noncompensatory Option: A option issued by a partnership other than in connection with the performance of services. Prop. Reg. §1.761-3(b)(1).
7 Option: A call option or warrant to acquire an interest in the issuing partnership, the conversion feature on convertible debt, or the conversion feature of convertible equity. Prop. Reg. §1.731- 2(e)(1).
8. Option Privilege: The "option privilege" refers to the right conferred upon the holder of a noncompensatory option to acquire an interest in the partnership by exercising the option (or by converting the convertible debt or convertible preferred equity interest).
9. Option Premium: As used in the preamble to the proposed regulations, the "option premium" is the cost of the noncompensatory option.
10. Preferred Equity: A partnership interest that entitles the partner to a preferred return on capital. Prop. Reg. §1.721-2(3).
B. The Definition of a "Noncompensatory Option"
The rules governing "noncompensatory options" apply to options other than those issued "in connection with" the performance of services. Prop. Reg. §1.721-2(b). In this context an "option" includes not only the stand alone right to acquire an interest in a partnership but also the conversion feature of convertible debt and convertible equity. Prop. Reg. §§1.721- 2(e)(1), 1.761-3(b)(1). "Convertible debt," unsurprisingly, is "any indebtedness of a partnership that is convertible into an interest in that partnership," Prop. Reg. §1.721-2(e)(2), while "convertible equity" is "preferred equity in a partnership that is convertible into common equity in that partnership, Prop. Reg. §1.721-2(e)(3). Note that a noncompensatory option can be issued by a disregarded entity even though exercise of the option will cause the entity to become regarded as a partnership. Prop. Reg. §1.761-3(b)(1).
This definition of a "noncompensatory option" presents a least three significant issues. First, the definition tacitly defines a "compensatory" option as one issued "in connection with" services rather than one issued "in exchange for" services. Second, it speaks to "preferred" and "common" equity. Third, under some circumstances what would otherwise be a noncompensatory option is treated as an interest in the partnership even prior to exercise.
1. "In Connection With" Services
Suppose a partnership whose members consist entirely of the members of an extended family hires unrelated individual X as an employee. While the partnership has never been open to outsiders, in order to align X’s interest with that of the partnership, X is told that if he continues to work for the partnership for one year, X will be entitled to purchase a 5% interest in the venture for the then-fair market value of the interest.
On these facts, the option has no value (because the right to purchase an asset for fair market value is itself valueless). Thus, the option has not been issued in exchange for services. But if X would not be permitted to acquire an interest in the venture but for X’s status as an employee, it seems as if this option has in fact been issued in connection with services and so is not subject to the "noncompensatory option" rules.
This distinction between "in connection with" services and "in exchange for" services first arose in the context of section 83, another provision that uses the "in connection with" language. See §83(a). In that context, the Tax Court broadly construed "in connection with" to extend to the fact pattern described above, and that decision was affirmed on appeal. Alves v. Commissioner, 79 T.C. 864 (1982), aff’d, 734 F.2d 478 (9th Cir. 1984). The language also appears in section 162(k) (initially enacted as section 162(l), and the Tax Court has been willing to read this language broadly in that context as well. Fort Howard Corp. v. Commissioner, 103 T.C. 345 (1994), although Congress retroactively reversed that case on its particular facts by adding section 162(k)(3)(A)(ii), see Fort Howard Corp. v. Commissioner, 107 T.C. 187 (1996).
Whether "in connection with" should be read more broadly than "in exchange for" likely will be resolved when regulations are promulgated that address compensatory options. Until then, largely because it makes no sense to exclude from application of the proposed noncompensatory any options issued for property, it makes sense to read "in connection with" as narrowly as possible despite the analogous authority in other contexts.
2. "Preferred" and "Common" Partnership Interests
The proposed regulations make clear that a right to convert a preferred common interest into a common equity interest is treated as a "noncompensatory option." Unfortunately, the proposed regulations should not speak to the quality of the interests but rather to any agreed upon change in allocations.
Consider the following examp le. P and C form the PC partnership by contributing cash of $500 apiece. P is entitled to a an annual return of 10% on P’s contributed capital (that is, $50 per year) while C is entitled to everything else. Assume that both P and C are properly treated as partners so that P has a pure preferred partnership interest while C has the only common interest. Assume further than P can at any time elect to convert his interest to a 50% interest in all profits and losses of the partnership; that is, P can elect to convert his interest from a pure preferred interest into a common interest.
Assume that the partnership uses its $1,000 to purchase an asset, and during the first two years of the partnership, the asset generates $80 per year of income, allocated $50 to P and $30 to C. In year three, when the asset is worth $1,400, P exercises the conversion right. What are the tax consequences of that exercise?
To answer this, we must know the non-tax consequences of the exercise. Assume that if the asset is now sold and the partnership is immediately liquidated, P will be entitled to one half of the partnership’s cash of $1,560 (sale price of $1,400 plus two years earnings at $80 per year). Thus, the effect of the exercise is to increase P’s share of the partnership from $600 to $780; that is, to give P a $180 share of the appreciation in the asset.
We did not need new regulations to tell us the tax consequences of the "exercise" because all that has happened is that the partners have modified their partnership agreement as to the allocation of unrealized partnership gain. Such changes are expressly permitted by statute, see §§704(b) and 761(c), and there is no authority imposing any tax consequences on the partners other than those arising from the allocations themselves. So is there any room here for the proposed regulations?
Possibly. Suppose that some event occurred in year that permitted the partnership to revalue its assets. See generally Reg. § 1.704- 1(b)(2)(iv)(f); Prop. Reg. §1.704-1(b)(2)(iv)(f)(5)(iii). As part of that revaluation, the partnership is required to restate the capital accounts of the partners to reflect how they have agreed to share the unrealized gain in the partnership’s asset. Reg. §1.704- 1(b)(2)(iv)(g). As described below, the proposed regulations require that some of the unrealized gain be allocated to the outstanding option. The capital account maintenance rules are, of course, entirely creatures of the regulations: the statute does not so much as mention partnership capital accounts. Accordingly, if the government wishes to modify the capital account maintenance rules to take into account pre-arranged agreements to reallocate future partnership tax items, it is hard to see that effort as improper. Accordingly, if the regulations in this context mean only that the value of P’s conversion privilege should be reflected in the capital accounts upon revaluation of the partnership’s assets, that is unobjectionable. Revaluation of partnership assets is discussed below.
Now suppose that P does not exercise the option in year 3 but that the partnership in facts sells its asset during that year. As a result, the partnership has gain of $200, allocable $80 to P and $120 to C.
(The statute does speak to allocation of tax items.) In year 4, P elects to conve rt, and as a result of the conversion P’s interest of the partnership’s cash of $1,560 increases from $740 to $780.
Such a change in the economic relationship between P and C is not equivalent to a simple change in future tax allocations. Rather, it reflects a shift of previously taxed partnership items. Current regulations do not address the possibility of reallocating previously taxed items, and this aspect of the proposed noncompensatory option regulations is a welcome addition (discussed below). Note that while the regulations can and should provide the taxation of such a shift in the economic relationship of the partners, they cannot prohibit such a shift: while section 704(b) gives the Treasury authority to provide the circumstances under which partnership tax items are allocated to one partner or to another, there is no similar authority to constrain or reallocate the non-tax relationships among partners.
Note that this issue can arise without there being an "preferred" interests in the partnership. For example, suppose X and Y each contribute $1,000 to the XY partnership in exchange for a 50% interests in profits and losses. However, X is given a two-year right to contribute and additional $500 in exchange for a fully retroactive increase in profits and losses to 60%. This agreed-upon shift in allocations raises the same issues as the conversion of a "preferred" interest into a "capital" interest, yet the proposed noncompensatory option regulations apparently do not see it. The final noncompensatory option regulations should be extended to include any prearranged provision by which a partner can increase his share in the existing capital of the partnership by contributing additional funds to the venture.
3. Noncompensatory Option Treated as an Interest in the Partnership
A noncompensatory option will be treated as an interest in the partnership prior to exercise if the option provides the holder "with rights that are substantially similar to the rights afforded to a partner." Prop. Reg. §1.761-3(a). However, this recharacterization is limited to cases where, when the option is issued, modified, or transferred, the failure to treat the holder of the option as a partner would result in a substantial reduction in the present value of the aggregate tax liability of the partners and the option holder. Id. Note that if the issuer of such an option is a disregarded entity, treating the option as an interest in the venture will cause the issuing entity to be regarded and treated as a partnership. Id.
While the proposed regulations do not expressly state that only the Commissioner can recharacterize an option as a partnership interest, that is the clear import of the requirement that recharacterization is permissible only if failing to do so results in an aggregate tax savings. Presumably, if the Commissioner opposes treating a particular option as a partnership interest, it is because the option treatment increases government revenue. And under that assumption, recharacterization is not permitted.
While the proposed regulations refer only to "rights" similar to that of a partner, the examp les make clear that both benefits and burdens are relevant. In the first example of the proposed regulations, a noncompensatory option is issued under circumstances in which the option is not certain to be exercised and the price of the option is less than half the cost of the exercise price. The terms of the option prohibit partnership distributions while the option is outstanding, thereby ensuring that if the option is exercised, no value will have been lost by the option holder during the period the option was outstanding. In concluding that this option should not be treated as an interest in the partnership prior to exercise, the regulations explain: "[I]t is not reasonably certain that [the option] will be exercised. Furthermore, although the option provides [the holder] with substantially the same economic benefit of partnership profits as would a direct investment in [the partnership, the holder] does not share in substantially the same economic detriment of partnership losses as would a partner in [the partnership.]" Prop. Reg. §1.761-3(d) (example 1) (emphasis added).
If an option is substantially certain to be exercised, it is more likely to be treated as providing the holder with rights that are substantially similar to the rights afforded to a partner. This is especially true if the initial cost of the option is relatively large in comparison with the cost of exercise (that is, if the option is deep in the money).
C. Issuance of a Noncompensatory Option
The proposed regulations provide that the transfer of cash or property to a partnership in exchange for a noncompensatory option is not a transaction described in section 721. Prop. Reg. §1.721-2(b). As a result, general principles of tax law apply. In particular, if a taxpayer transfers appreciated or loss property to the partnership in exchange for the option, the transferor will recognize gain or loss on the transaction.
Once acquired, the option is property like any other property. Thus, it should take a cost basis and if subsequently sold or exchanged will yield gain or loss. Because a partnership interest is a capital asset, §741, gain or loss from the disposition of the option should produce capital gain or loss. §1234(a)(1). However, it is possible that a court would look through the partnership interest to the assets held by the partnership to bifurcate the gain or loss based on the proportions of ordinary income assets held by the partnership. This approach is consistent with the application of section 751(a) to an actual sale of a partnership interest and finds support in the language of section 741 which does not, as a technical matter, specify that a partnership interest is a "capital asset."
If a noncompensatory option is sold or exchanged or if the holder dies, the transferee may take a basis in the option greater or less than the adjusted basis of the transferor. Nonetheless, any change in basis of the option cannot be pushed into the inside basis of the partnership’s assets under section 743(b) because the option is not treated as a partnership interest. However, if the option is exercised, the option holder will take an outside basis in the partnership interest so acquired equal to the sum of (1) the option holder’s adjusted basis in the option plus (2) the amount paid by the option holder to exercise the option. A subsequent transfer of the partnership interest – even a subsequent tax-free transfer such as the contribution of the interest of a controlled corporation or a contribution of the interest to an upper-tier partnership under section 721 – will allow the option holder to push its outside basis into the partnership’s asset if a section 754 election is in effect (or is made) at the time of the transfer of the partnership interest.
As to the partnership, the issuance of the option in exchange for property should be treated as an open transaction. As a result, there should be neither income nor deduction until the transaction is closed by lapse or issuance.
D. Partnership Accounting When an Option is Outstanding
Unless an outstanding option is treated as an interest in the partnership prior to exercise because it gives the holder "rights that are substantially similar to the rights afforded to a partner," see Prop. Reg. §1.761-3(a), no allocation of distributive share can be made to the option holder in that capacity. Of course, if the option holder also has an existing interest in the partnership, allocations can be made on the partnership interest.
The proposed regulations provide that no allocation of distributive share can have "substantial economic effect" within the meaning of section 704(b) while a noncompensatory option is outstanding. The rationale for this provision is that if the option is exercised, some portion of prior distributive share will inure to the benefit of the option holder, and so those tax prior allocations cannot correspond to the economics of the partnership. The proposed regulations further provide that if certain tests are met, allocations of distributed share made while one or options is outstanding will be treated as if they had substantial economic effect. As a result, if these test are not satisfied, partnership tax allocations must be determined in accordance with the partners’ interests in the partnership taking account of all facts and circumstances, a standard only poorly defined in the regulations and extremely unlikely to be desired by the partners.
For allocations of distributive share to be treated as having economic effect while a noncompensatory option is outstanding, the following must be true: (a) the option must not properly be treated as an existing interest in the partnership; (b) the partnership agreement must include for the special revaluation of assets rules contained in the proposed regulations; and (c) all allocations "not pertaining to" noncompensatory options must comply with the substantial economic effect requirement imposed by section 704(b). Despite inartful drafting, presumably this last item should be understood as meaning that the allocations would be treated as satisfying the "substantial economic effect" test were the outstanding options ignored.
The proposed regulations make a significant change to the rules governing capital account maintenance when assets are revalued and capital accounts adjusted. In general, a partnership is permitted to book its assets to fair market value only in connection with the contribution of new equity to the partnership or in connection with the distribution of property (including cash) to a partner with respect to the partnership interest. See Reg. §1.704- 1(b)(2)(iv)(f). Though optional, such revaluations (called "Reverse Allocations") best preserve the economic relationship among partners when relative shares of capital shift.
http://www.steptoe.com/publications/Noncompensatory_Options.pdf
Copyright © Steptoe & Johnson LLP. All Rights Reserved.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
