Financial Services Insights – December 2013 - Non-Compensatory Options Granted by Partnerships: Issues, Definitions and Tax Event Triggers
Early this year, the U.S. Treasury Department finalized regulations governing the taxation of non-compensatory options for partnerships where guidelines are set for the tax treatment of such options. The Treasury has long had rules in place to prevent transactions where taxpayers can enjoy the ownership benefits of a partnership without having the corresponding tax consequences. In light of these new regulations, and the complex tax issues that may arise from options granted by partnerships, we’ve prepared this article to help define certain terms and address frequently asked questions.
As the name suggests, non-compensatory options are options issued for other than compensation purposes. The term option for this purpose would include call options, warrants, futures contracts or any other similar arrangements granted by a partnership.
A call option is defined as a right to purchase an underlying property at a specified time for a specified price. While the definition of a call option on a traded security is the same as a call option on the purchase of a partnership interest, the tax treatment can be quite different; mainly because a partnership does not itself pay tax but flows income and losses directly to its partners (who are then subject to tax on the income), where the allocation of such income can be cause for manipulation.
We begin with the premise that an option holder is just that – a holder of an option to purchase a partnership interest. The holder should not enjoy any rights afforded to a partner, such as voting or managerial rights. The holder should not be able to participate in the partnership profits. If any of these elements are present, the option holder is deemed to hold a partnership interest rather than an option.
Note that if the option holder is deemed to hold an option, the normal tax rules relating to an option would apply. In other words, the option would be eligible for a capital loss in the event of a lapse, and the grantor of the option would have income with respect to the option premium.
An option also cannot be structured where the exercise is “reasonably certain.” To meet this standard, an offering is judged based on all facts and circumstances, including eight specific provisions. However, the regulations provide for two safe harbor measures that, if met, are deemed to have avoided the “reasonably certain” threshold:
- First, the option has no more than a 24-month exercise period and the strike price is equal to or greater than 110% of the underlying partnership’s fair market value at grant date, or
- Second, the terms of the option provide that the strike price is equal to or greater than the fair market value of the underlying partnership interest on the exercise date.
An allowance is given if a formula is used to determine the strike price to meet the equal to or greater than requirement, but it must have been agreed upon during the time of issuance and done on a bona fide basis. A facts and circumstances test is used for this application.
An example provided by the regulations indicates that even if one of the safe harbor conditions is not met, it does not necessarily affect the reasonably certain determination:
Example: PRT Partnership LLC (PRT) is engaged in an active real estate business where income/loss cannot be reasonably predicted. Mrs. A is given an option to purchase 10% of PRS for $110 during a three-year period. The cost of the option is $10.00 and at the time of issuance, the fair market value of 10% of the partnership interest is $100.00. Based on the assumption that the value of PRT’s business in three years cannot be reasonably predicted, and there are no other factors that may influence the option’s exercise, this option would not constitute a partnership interest.
In the event of an exercise, the option holder should be aware of certain tax consequences where the option is in the money.
A revaluation of partners’ capital accounts is required after an exercise of an option. The partnership would book up or book down any appreciation/depreciation of the partnership value at the time of exercise. The new partner’s capital account would be credited for the amount paid under the option, including the premium price. If the value of the interest purchased is higher than the purchase price, a shift of capital occurs where the new partner would receive an additional amount of capital to bring the capital account to their allocable share of the total partnership value. This would mean that the new partner is allocated additional unrealized appreciation. For tax purposes, this additional amount will be taxable to the new partner to the extent the partnership generates gross income after exercise.
Frequently asked questions:
Q: What if the buyer of the option contributes appreciated property to purchase the option?
A: There are non-recognition rules available for contributions of appreciated property in exchange of partnership interest; however, because the purchase of an option is not in exchange of a partnership interest, non-recognition rules will not apply. Take the above example: if Mr. C used property with a FMV of $1,000 and basis of $500 as payment for the premium of the option, he would have recognized gain in the amount of $500.
Q: What if appreciated property is used at the exercise of the option in exchange for the partnership interest?
A: Because the appreciated property is used in exchange of the partnership interest, the non-recognition rules would apply. For example, if Mr. C above used property at FMV of $15,000 with a basis of $5,000 in exercise of the option, he will not have gain recognition on the exchange. The partnership will have $5,000 in the basis of the property contributed. If the partnership immediately sells the property, the $10,000 gain will be allocated specifically to him.
Q: Is the exercise of the option and the payment of the stock purchase taxable to the partnership?
A: If the option is exercised the amount of the premium paid and the exercise price is not taxable to the partnership. This is treated as a capital contribution by the option holder. If the option is not exercised and the option lapses, any premium collected will be capital gain to the partnership.
The holder of the lapsed option will have a capital loss for the same amount if the option in the hands of the holder is a capital asset.
Q: When is the partnership property “revalued” when an option is exercised? Using the pre-exercise value or post-exercise value? Will it be taxable?
A: The revaluation is done immediately after the exercise of the option. Let’s look at the below example:
|Year 1 Contribution||$9,000||$9,000||0||$18,000 (Purchased Property A)|
|Year 2 FMV||$10,000||$10,000||0||$20,000 (FMV Property A)|
|Year 2 – issues option to C for $1,000 premium, with strike price of $15,000 for a 1/3 interest|
|Year 2 FMV||$35,000(FMV Property A)|
|C exercises option & pays $15,000 for a 1/3 interest|
|Year 2 FMV after exercise||$51,000 ($35K+15K+1K)|
|Year 2 capital||$17,000||$17,000||$17,000||$51,000|
|Because C’s 1/3 capital is $17,000 and his total contribution was $16,000, C will be
allocated the first $1,000 gain on Property A.
Financial Services Insights – December 2013