This article highlights items that may be of interest to private equity funds regarding recently finalized regulations on the tax treatment of noncompensatory options issued by an entity taxed as a partnership, particularly for a private equity fund with tax-exempt and foreign investors that uses partnership options to minimize the risk of unrelated business taxable income or effectively connected income, respectively, that could otherwise arise if the fund held a partnership interest in the operating partnership.  The final regulations are effective, and proposed regulations issued at the same time are proposed to be effective, for options issued on or after February 5, 2013.  

In general, the final regulations (1) do not apply to compensatory options or options issued by a tax disregarded entity; (2) define “option” to include a call option, warrant or similar arrangement, as well as the conversion feature of convertible debt and convertible equity; (3) provide that the issuance and exercise of an option do not trigger immediate tax to the holder of the option and issuing partnership; (4) provide that the lapse of an option results in taxable income for the partnership and a loss by the option holder; and (5) retain the capital account mechanics for options, including a corrective rule that can allocate taxable income in the year of exercise to the holder following exercise.

The final regulations retain the proposed regulations’ characterization rule whereby an option holder will be treated as a partner if (1) the option holder’s rights are “substantially similar” to the rights afforded to a partner, and (2) as of the date the option is issued, transferred or modified (each a measurement event), there is a “strong likelihood” that the failure to treat the option holder as a partner would result in a substantial reduction in the present value of the partners’ and the option holder’s aggregate federal tax liabilities (substantial reduction test).

Rights are substantially similar to the rights afforded to a partner if either the option is reasonably certain to be exercised or the option holder possesses partner attributes.  Two new safe harbors provide that an option is not considered reasonably certain to be exercised under the following circumstances (unless a principal purpose of the option is to substantially reduce tax):

• Safe harbor #1:  The option may be exercised no more than 24 months after the date of the measurement event, and the strike price is equal to or greater than 110 percent of the fair market value of the underlying partnership interest on the date of the measurement event.
• Safe harbor #2:  The option terms provide that the strike price is equal to or greater than the fair market value of the underlying partnership interest on the exercise date.

For both safe harbors, a bona fide formula-based strike price may be considered equal to or greater than the fair market value of the underlying partnership interest on the exercise date.  Partner attributes are based on facts and circumstances, but negative covenants imposing reasonable restrictions on partnership distributions or dilutive issuances are not treated as partner attributes.

For exempt and foreign investors, it might be difficult for the fund to avoid violating the substantial reduction test, thus making it critical for the fund to structure the option so that it does not confer rights substantially similar to the rights of a partner.  Unfortunately, the new safe harbors may not be helpful in practice because of the limitations on duration and strike price of the option.

The characterization test applies upon (1) an option issuance, (2) an option transfer (other than transfers at death, between spouses or in a tax disregarded transaction) if the option term exceeds 12 months or is pursuant to a plan in place at the option issuance or modification with a principal purpose to substantially reduce taxes, and (3) a modification of the option or the underlying partnership interest (other than one that neither materially increases the likelihood of exercise nor provides the option holder with partner attributes, or one that changes the option strike price or the interests in the issuing partnership pursuant to bona fide reasonable adjustment formula intended to prevent dilution of the option holder).

Proposed regulations issued at the same time as the final regulations would expand the measurement events to include certain issuances, transfers or modifications of an interest in the issuing partnership or an interest in a look-through entity that owns the partnership option or owns an interest in the issuing partnership.

The final regulations state that any option recharacterization on a transfer takes effect immediately prior to the transfer.  If the transferor is treated as exercising the option and selling a partnership interest, then, for example, any realized gain on the sale would be treated as short-term capital gain, and such capital gain could be recharacterized as ordinary income to the extent attributable to “hot assets” inside the partnership.  A deemed exercise could also trigger deemed distributions to the other partners to the extent the issuance of the new interest reduces their share of partnership debt.