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Noncompensatory Partnership Options: Tax Treatment of Issuance, Exercise, and Lapse of Option of NCPOs and Warrants

Avoiding Partnership Treatment on Hybrid Instruments and Convertible Equity

Note: CLE credit is not offered on this program

Recording of a 110-minute CPE webinar with Q&A

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Conducted on Thursday, October 10, 2019

Recorded event now available

This course will provide tax advisers to partnerships and LLCs with a practical guide to the special rules governing the tax treatment of noncompensatory partnership options (NCPOs). The panel will detail the tax consequences to both the granting partnership and the optionee throughout the life cycle of the option, from grant through exercise or lapse, and discuss available strategies including basis adjustment elections to minimize the tax impact of noncompensatory option grants.

Description

Partnerships and LLCs often utilize NCPOs and other financial instruments such as warrants or convertible debt to attract investment capital. Appropriately structured, NCPOs provide tax deferral benefits to both the issuing partnership and the NCPO holder, particularly where an investor does not wish to become a full ongoing partner.

The issuance of a noncompensatory partnership option or other exercisable contract right, generally defined as options issued in the circumstances other than "in connection with" the performance of services, is typically exempt from current tax, except when the option holder exchanges appreciated or depreciated property in exchange for the option. The issuance is treated as an "open transaction," rather than a contribution of property in exchange for a partnership interest as provided for in Section 721.

However, in circumstances where the NCPO has sufficient features to be considered equity, the issuance can be recharacterized as the purchase of a partnership interest, with the option holder being treated as a partner for tax purposes. Tax advisers to partnerships issuing NCPOs or other warrants in a capital raising scheme must know the rules to avoid unwanted tax consequences for both the optionor and optionee.

Listen as our expert panel offers a thorough and practical guide to planning considerations and reporting requirements in partnership and LLC grants of equity compensation.

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Outline

  1. Definition of noncompensatory partnership options (NCPOs)
    1. "Not issued in connection with performance of services" standard
    2. Treated as an "open transaction" rather than a non-recognition exchange of property for partnership interest
    3. Conversion rights from preferred common interest into common equity interest treated as NCPO
    4. Changes in allocation
    5. Issuance of NCPO as a permissible revaluation event
  2. Financial instruments treated as NCPOs
  3. Book and tax accounting for partnership when an NCPO is outstanding
  4. Circumstances where an NCPO will be recharacterized as an equity interest in the partnership for the optionee
    1. Section 721 rules
    2. Exchange of gain or loss property for option
    3. Examples of contract rights or financial instruments containing sufficient equity characteristics to cause option holder to be treated as partner
  5. Tax reporting through life cycle of option
    1. At issuance
    2. Lapse
    3. Continuation payments
    4. Sale of option during hold period
    5. Exercise of option

Benefits

The panel will review these and other key issues:

  • How is gain or loss treated on the lapse, exercise or termination of an NCPO?
  • What features of financial interests treated as NCPOs can lead to recharacterization of the transaction and treatment of the option holder as a equity partner?
  • How to determine if an option holder's rights are substantially similar to those held by existing partners

Faculty

Ferguson, Justin
Justin Ferguson
Managing Director
Grant Thornton

Mr. Ferguson is part of the Firm's National Partnership Capital Account Maintenance (PCAM) Group. The PCAM group...  |  Read More

Larvick, Matthew
Matthew P. Larvick
Shareholder
Vedder Price

Mr. Larvick is a Shareholder in the firm’s Corporate Practice Area, specifically corporate taxation. His practice...  |  Read More

Mandarino, Joseph
Joseph C. Mandarino
Partner
Smith Gambrell & Russell

Mr. Mandarino's practice focuses on corporate, tax and finance law. He is involved with a wide variety of...  |  Read More