April 01, 2013 | By Keith Martin in Washington, DC

Options to purchase partnership interests may have tax consequences, the IRS said.

The agency explained the tax consequences of “noncompensatory” options in final regulations in February. Regulations on “compensatory” options that are given as compensation for providing services will probably not follow until Congress addresses the tax treatment of carried interests that managers hold in private equity funds.

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). Debt that can be converted into a partnership interest is also considered such an option.

In general, no income tax is triggered when such an option is granted or exercised.

However, someone contributing appreciated or depreciated property for an option will have a gain or loss on the difference in value between the option and his basis in the contributed property.

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 the existing partners may be reset, if the partners choose when the option is granted, so that they add up to the current fair market value of the partnership assets after adjusting for the option. If the option is “in the money” so that it is worth more than the option holder paid for it, then the capital accounts of existing partners would be reduced. If the holder paid more for the option than it is worth, then the capital accounts would be increased. However, once the option is exercised, the capital accounts must be reset to reflect the claim that each partner has over partnership assets should the partnership liquidate. Certain “corrective allocations” will also have to be made when the option is exercised. These are allocations of gross income or loss to help put the capital accounts in the right ratio.

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 may treat an option holder as already a partner if he has rights that are “substantially similar to the rights afforded to a partner.” He has such rights if the option is reasonably certain to be exercised or the option holder possesses partner attributes. Options to purchase for fair market value at time of exercise or that must be exercised within 24 months at a strike price that is at least 110% of the value of the underlying partnership interest are not considered reasonably certain to be exercised. An example of where the option holder already has partner rights might be where he already has some voting rights and cash distributions to him after exercise will give him a share in the economic returns during the period the option was outstanding. 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.

However, the IRS will take the position that an option holder is already a partner only if there is a “strong likelihood” that failure to treat him immediately as a partner will lead to a substantial reduction in the aggregate tax liabilities of the option holder and existing partners.

Options must be retested for whether the option holder has rights substantially similar to a partner on each date an option is issued, transferred or modified. However, only some transfers and modifications trigger retesting.