Final regulations on non compensatory partnership options

The Internal Revenue Service (IRS) has finally issued final regulations on the tax treatment of non-compensatory options and convertible instruments issued by a partnership. These rules are particularly interesting to companies that have formed as LLCs taxed as a partnership for tax efficiencies but have adopted capital structures that mimic the economics given to preferred investors in corporations.  For example, venture backed corporations often issue securities with warrants attached or debt that is convertible into equity. In the corporate context, the tax treatment of such instruments is not generally troublesome or complex. In the partnership (or LLC taxed as a partnership [“LLC”]) world, the possibilities for tax significance, and tax and accounting complexity, are large, depending on which of a variety of entity vs. aggregate metaphors one seeks to apply to a partnership or LLC.  The new regulations do not follow the simplest path, but avoid requiring complex allocations in many areas. Generally, the exercise of a non compensatory option will not result in gain or loss to the partnership or LLC or the optionee (much like its corporate analogue). Importantly the regs set forth standards under which an “in the money” option will be treated as an interest in the partnership or LLC itself. This latter point will require an analysis of both the value of the optioned interest and the tax positions of the partnership or LLC’s members’ relative tax positions, which is unfortunate since rarely do financed companies grant such instruments as a means of tax avoidance. As the business world moves closer to LLC-standard, the tax regs continue to provide guidance.

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Roger Royse
rroyse@rroyselaw.com

Roger Royse, the founder of the Royse Law Firm, works with companies ranging from newly formed tech startups to publicly traded multinationals in a variety of industries. Roger regularly advises on complex tax structuring, high stakes business negotiations and large international financial transactions. Practicing business and tax law since 1984, Roger’s background includes work with prominent San Francisco Bay area law firms, as well as Milbank, Tweed, Hadley and McCloy in New York City. Read My Full Bio

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