Options to purchase partnership interests may have tax consequences | Norton Rose Fulbright
The agency has been studying such options for more than a year. It explained the tax consequences of “noncompensatory” options — or options that are most likely to be held by institutional investors — in proposed regulations in late January. Regulations on “compensatory” options that are given as compensation for providing services will follow later in the year.
The regulations address options issued directly by the partnership and that give the holder a right to buy an interest in the partnership (or to receive cash or property having an equivalent value).
In general, no income tax is triggered when such an option is exercised.
However, letting an option lapse without exercising it will have tax consequences. In that case, the holder of the option can claim a loss for whatever he paid for the option. The partnership must report the original payment for the option as income at that time. (It did not have to be reported as income earlier because it was viewed as part of an “open transaction.”)
The capital accounts of all the partners will have to be adjusted so that they add up to the current fair market value of the partnership assets when the option is exercised. A partner’s capital account is the claim he has on partnership assets if the partnership were to liquidate. In some cases, a disproportionate share of taxable income will have to be allocated to the new partner initially to set his capital account at the right level in relation to the other partners.
Careful tax counsel will want to keep an eye on options when assessing whether a partnership has terminated for tax purposes. That’s because the IRS reserved the right to treat an option holder as already a partner if he has rights that are “substantially similar to the rights afforded to a partner.” An example might be where he already has some voting rights and — because of infrequent partnership distributions — he is expected to have exercised the option in time to share in the economic returns during the option period. A partnership will terminate for tax purposes if 50% of more of the interests in partnership profits and capital are transferred within a 12-month period.
The IRS said it is still studying whether to treat the holder of an option as already a partner in one other circumstance. This would occur where the option is in a limited liability company, or LLC, that has only one owner. If exercise of the option would make the LLC have at least two owners, then the IRS is considering treating the holder of the option as a partner even before the option is exercised. It has asked for comments.