Noncompensatory Partnership Options, 7997-8016 [2013-02259]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 78, Number 24 (Tuesday, February 5, 2013)]
[Rules and Regulations]
[Pages 7997-8016]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2013-02259]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9612]
RIN 1545-BA53


Noncompensatory Partnership Options

AGENCY: Internal Revenue Service (IRS), Department of the Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the tax 
treatment of noncompensatory options and convertible instruments issued 
by a partnership. The final regulations generally provide that the 
exercise of a noncompensatory option does not cause the recognition of 
immediate income or loss by either the issuing partnership or the 
option holder. The final regulations also modify the regulations under 
section 704(b) regarding the maintenance of the partners' capital 
accounts and the determination of the partners' distributive shares of 
partnership items. The final regulations also contain a 
characterization rule providing that the holder of a noncompensatory 
option is treated as a partner under certain circumstances. The final 
regulations will affect partnerships that issue noncompensatory 
options, the partners of such partnerships, and the holders of such 
options.

DATES: Effective Date: These regulations are effective on February 5, 
2013.
    Applicability Date: These regulations apply to noncompensatory 
options (as defined in Sec.  1.721-2(f)) that are issued on or after 
February 5, 2013.

FOR FURTHER INFORMATION CONTACT: Benjamin Weaver at (202) 622-3050 (not 
a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    This document contains amendments to 26 CFR part 1 under sections 
171, 704, 721, 761, 1272, 1273, and 1275 of the Internal Revenue Code 
(Code). On January 22, 2003, proposed regulations (REG-103580-02) 
relating to the tax treatment of noncompensatory options and 
convertible instruments issued by a partnership were published in the 
Federal Register (68 FR 2930). On March 28, 2003, corrections to the 
proposed regulations were published in the Federal Register (68 FR 
15118). Because no requests to speak were submitted by April 29, 2003, 
the public hearing scheduled for Tuesday, May 20, 2003, was cancelled 
(see 68 FR 24903). The Treasury Department and the IRS received a 
number of comments in response to the proposed regulations. After 
consideration of the comments, the proposed regulations are adopted as 
revised by this Treasury decision. The final regulations apply to 
certain call options, warrants, convertible debt, and convertible 
equity that are not issued in connection with the performance of 
services (noncompensatory options). All comments are available at 
www.regulations.gov or upon request.

Summary of Comments and Explanation of Provisions

    The final regulations describe certain of the income tax 
consequences of issuing, transferring, and exercising noncompensatory 
partnership options. The final regulations apply only if the call 
option, warrant, or conversion right grants the holder the right to 
acquire an interest in the issuer (or cash measured by the value of the 
interest). The final regulations generally provide that the exercise of 
a noncompensatory option does not cause recognition of gain or loss to 
either the issuing partnership or the option holder. In addition, the 
final regulations modify the regulations under section 704(b) regarding 
the maintenance of the partners' capital accounts and the determination 
of the partners' distributive shares of partnership items. Finally, the 
final regulations contain a characterization rule providing that the 
holder of a call option, warrant, convertible debt, or convertible 
equity issued by a partnership (or an eligible entity, as defined in 
Sec.  301.7701-3(a), that would become a partnership if the option 
holder were treated as a partner) is treated as a partner under certain 
circumstances.
    A number of comments were received regarding the proposed 
regulations. The comments included requests for clarification and 
recommendations relating to (1) the issuance and exercise of 
noncompensatory options; (2) accounting for noncompensatory options; 
(3) the characterization rule; (4) the convertible bond provision; and 
(5) the application of the original issue discount provisions. 
Significant comments are further discussed in this preamble.

1. Issuance, Exercise, Lapse, Repurchase, and Other Terminations of a 
Noncompensatory Option

    Like the proposed regulations, the final regulations under section 
721 define a noncompensatory option as an option issued by a 
partnership, other than an option issued in connection with the 
performance of services. For this purpose, an option is defined as a 
call option or warrant to acquire an interest in the issuing 
partnership, the conversion feature of convertible debt, or the 
conversion feature of convertible equity.
A. Application of Section 721 on Issuance of a Noncompensatory Option
    The proposed regulations provide that section 721 does not apply to 
a transfer of property to a partnership in exchange for a 
noncompensatory option. Several commenters observed that the proposed 
regulations do not exclude options issued in satisfaction of interest 
or similar items, such as unpaid rent or royalties. Accordingly, the 
final regulations provide that section 721 does not apply to the 
transfer of property to a partnership in exchange for a noncompensatory 
option, or to the satisfaction of a partnership obligation with a 
noncompensatory option. The final regulations contain an example 
illustrating that a transfer of appreciated or depreciated property to 
a partnership in exchange for a noncompensatory option generally will 
result in the recognition of gain or loss by the option recipient. 
Under open transaction principles applicable to noncompensatory 
options, the partnership will not recognize income for receipt of the 
property while the

[[Page 7998]]

option is outstanding. Notwithstanding the general rule, the Treasury 
Department and IRS believe it is appropriate to take into account the 
conversion right embedded in convertible equity as part of the 
underlying partnership interest. Accordingly, the final regulations 
provide that section 721 does apply to a contribution of property to a 
partnership in exchange for convertible equity in a partnership.
B. Application of Section 721 on Exercise of a Noncompensatory Option
i. Payment of the Exercise Price With Property or Cash
    The proposed regulations provide that section 721 applies to the 
holder and the partnership upon the exercise of a noncompensatory 
option issued by the partnership. The final regulations generally adopt 
this rule. However, in response to comments requesting clarification, 
the final regulations also provide that section 721 generally applies 
to the exercise of a noncompensatory option when the exercise price is 
satisfied with property or cash contributed to the partnership, 
regardless of whether the terms of the option require or permit a cash 
payment.
ii. Exercise of a Noncompensatory Option in Satisfaction of a 
Partnership Obligation
    The proposed regulations under section 721 do not apply to any 
interest on convertible debt that has been accrued by the partnership 
(including accrued original issue discount). A number of comments were 
received requesting clarification on the proper treatment of accrued 
but unpaid interest. Since the proposed regulations were issued and the 
comments received, final regulations under section 721 were published 
on November 17, 2011 (TD 9557) addressing certain partnership debt-for-
equity exchanges. Section 1.721-1(d)(2) provides:

    Section 721 does not apply to a debt-for-equity exchange to the 
extent the transfer of the partnership interest to the creditor is 
in exchange for the partnership's indebtedness for unpaid rent, 
royalties, or interest (including accrued original issue discount) 
that accrued on or after the beginning of the creditor's holding 
period for the indebtedness. The debtor partnership will not 
recognize gain or loss upon the transfer of a partnership interest 
to a creditor in a debt-for-equity exchange for unpaid rent, 
royalties, or interest (including accrued original issue discount).

The preamble to TD 9557 explains this provision as follows: ``The IRS 
and the Treasury Department believe that the exception to section 721 
for these items is necessary to prevent the conversion of ordinary 
income into capital gain.''
    The Treasury Department and the IRS believe that similar 
considerations arise in the context of the exercise of noncompensatory 
options. Accordingly, the final regulations provide that section 721 
does not apply to the transfer of a partnership interest to a 
noncompensatory option holder upon conversion of convertible debt in 
the partnership to the extent that the transfer is in satisfaction of 
the partnership's indebtedness for unpaid interest (including accrued 
original issue discount) on convertible debt that accrued on or after 
the beginning of the convertible debt holder's holding period for the 
indebtedness. Additionally, the final regulations provide that section 
721 does not apply to the extent that the exercise price is satisfied 
with the partnership's obligation to the option holder for unpaid rent, 
royalties, or interest (including accrued original issue discount) that 
accrued on or after the beginning of the option holder's holding period 
for the obligation.
    The proposed regulations do not specify whether, upon conversion of 
convertible debt in the partnership, the partnership is treated as 
satisfying its obligation for unpaid interest with a fractional 
interest in each partnership property. Under this ``vertical slice'' 
approach, the partnership could recognize gain or loss equal to the 
difference between the fair market value of each partial property 
deemed transferred to the creditor and the partnership's adjusted basis 
in that partial property. The Treasury Department and the IRS believe 
that approach would be difficult to administer and may inappropriately 
accelerate gain or loss recognition. Therefore, the final regulations 
provide that the partnership will not recognize gain or loss upon the 
transfer of a partnership interest to a noncompensatory option holder 
upon conversion of convertible debt in the partnership to the extent 
that the transfer is in satisfaction of the partnership's indebtedness 
for unpaid interest (including accrued original issue discount) on 
convertible debt that accrued on or after the beginning of the 
convertible debt holder's holding period for the indebtedness. 
Additionally, the final regulations also provide that the issuing 
partnership will not recognize gain or loss upon the transfer of a 
partnership interest to an exercising option holder in satisfaction of 
the partnership's obligation to the option holder for unpaid rent, 
royalties, or interest (including accrued original issue discount) that 
accrued on or after the beginning of the option holder's holding period 
for the obligation. This treatment is consistent with the rules under 
Sec.  1.721-1(d)(2).
iii. Options Issued by Disregarded Entities
    The rule in the proposed regulations providing for nonrecognition 
of gain or loss on the exercise of a noncompensatory option does not 
apply to any call option, warrant, or convertible debt issued by an 
eligible entity, as defined in Sec.  301.7701-3(a), that would become a 
partnership under Sec.  301.7701-3(f)(2) if the option, warrant, or 
conversion right were exercised. The Treasury Department and the IRS 
requested and received comments on whether the nonrecognition rule 
should be extended to such instruments. Commenters recommended that the 
nonrecognition rule should be extended to such instruments. However, 
some commenters noted that the extension of the proposed regulations to 
include a noncompensatory option issued by an eligible entity that 
would become a partnership under Sec.  301.7701-3(f)(2) upon exercise 
of the option would necessitate adjustments to the capital accounting 
requirements of the regulations, as applied to these entities. Without 
these adjustments, upon exercise of the option, the owner of the 
eligible entity would be treated as contributing all property owned by 
the eligible entity prior to exercise of the option to the new 
partnership, while the option holder would be treated as contributing 
only the exercise price and premium to the new partnership. The new 
partnership would have no unbooked unrealized gain in its property that 
it could allocate to the exercising option holder. Accordingly, the 
Treasury Department and the IRS have decided not to apply the rules of 
the final regulations to these instruments.
iv. Application of Section 721(b)
    One commenter requested clarification of whether section 721(b) 
could apply to the exercise of a noncompensatory option under the 
regulations. Section 721(b) provides that section 721(a) does not apply 
to gain realized on a transfer of property to a partnership that would 
be treated as an investment company (within the meaning of section 351) 
if the partnership were incorporated. The Treasury Department and the 
IRS believe that section 721, including the provisions of section 
721(b) and Sec.  1.721-1(a), applies to the exercise of noncompensatory 
options.

[[Page 7999]]

v. Cash Settled Options
    Several commenters requested guidance on the treatment of cash-
settled options, particularly regarding whether the cash settlement of 
an option is treated as a sale or exchange of the option or as an 
exercise of the option followed by an immediate redemption of the 
newly-issued partnership interest. The Treasury Department and the IRS 
believe that the cash settlement of a noncompensatory option should be 
treated as a sale or exchange of the option and taxed under the rules 
of section 1234, rather than as a contribution to the partnership under 
section 721, followed by an immediate redemption (although the latter 
may, in certain instances, be treated as a sale of the option under the 
disguised sale rules). The final regulations provide that the 
settlement of a noncompensatory option in cash or property other than 
an interest in the issuing partnership is not a transaction to which 
section 721 applies.
C. Lapse, Repurchase, Sale, or Exchange of a Noncompensatory Option
    The proposed regulations provide that section 721 does not apply to 
the lapse of a noncompensatory option. Accordingly, the lapse of a 
noncompensatory option generally results in the recognition of income 
by the partnership and loss by the holder of the lapsed option in an 
amount equal to the option premium. However, the proposed regulations 
do not address the character of the gain or loss recognized upon lapse, 
repurchase, sale, or exchange of the option.
    While section 1234(b) provides that gain or loss from any closing 
transaction generally is treated as short term capital gain or loss to 
the grantor of an option, commenters were uncertain whether section 
1234(b) applies to partnership interests because it is unclear whether 
partnership interests qualified as ``securities'' for purposes of 
section 1234(b). To eliminate this uncertainty, proposed regulations 
under section 1234(b) (REG-106918-08) are being published concurrently 
with these final regulations, which treat partnership interests as 
securities for this purpose. The preamble to those proposed regulations 
also addresses, and seeks comments on, the character of gain or loss to 
the option holder on the sale or exchange of, or loss on failure to 
exercise, an option.
D. Application of General Tax Principles in Certain Situations
    In the event that the exercise of a noncompensatory option is 
followed by a redemption of the exercising option holder's partnership 
interest, general tax principles, including the disguised sale rules of 
section 707(a)(2)(B), will apply in determining whether the transaction 
is actually a cash settlement of the noncompensatory option by the 
partnership.
    The proposed regulations provide that if the exercise price of a 
noncompensatory option exceeds the capital account received by the 
option holder on the exercise of the noncompensatory option, the 
transaction will be given tax effect in accordance with its true 
nature. Similarly, the final regulations provide that, if the exercise 
price of a noncompensatory option exceeds the capital account received 
by the option holder on the exercise of the option, then general tax 
principles will apply to determine the tax consequences of the 
transaction. The final regulations are based on the premise that the 
partnership and the option holder will act in an economically rational 
way, such that an option holder generally will not exercise the option 
unless the capital account received will equal or exceed the exercise 
price. It should be noted that a noncompensatory option could be 
economically viable to exercise when the option holder receives a right 
to share in partnership capital that is less than the sum of the 
premium paid for the option and the exercise price of the option, 
provided that the exercise price alone does not exceed the capital 
account received. This simply reflects the fact that the premium is a 
sunk cost at the time the option holder exercises the option.

2. Accounting for Noncompensatory Options

A. Accounting for the Issuance of a Noncompensatory Option
    Under the proposed regulations, issuance of a noncompensatory 
option is not a permissive or mandatory revaluation event under Treas. 
Reg. Sec.  1.704-1(b)(2)(iv). One commenter noted that, as a result, 
unrealized gain in partnership property arising prior to the issuance 
of the option could be inappropriately shifted to the option holder 
upon exercise. The Treasury Department and the IRS agree. Therefore, 
the final regulations provide that the issuance by a partnership of a 
noncompensatory option (other than an option for a de minimis 
partnership interest) is a permissible revaluation event.
B. Revaluations While a Noncompensatory Option is Outstanding
    Under the proposed regulations, any revaluation during the period 
in which there are outstanding noncompensatory options generally must 
take into account the fair market value of any outstanding 
noncompensatory options. If the fair market value of outstanding 
noncompensatory options as of the date of the adjustment exceeds the 
consideration paid by the option holders to acquire the options, then 
the value of partnership property reflected on the partnership's books 
must be reduced by that excess to the extent of the unrealized income 
or gain in partnership property (that has not been reflected in the 
capital accounts previously). This reduction is allocated only to 
properties with unrealized appreciation in proportion to their 
respective amounts of unrealized appreciation. Conversely, if the price 
paid by the option holders to acquire the outstanding noncompensatory 
options exceeds the fair market value of the options as of the date of 
the adjustment, then the value of partnership property reflected on the 
partnership's books must be increased by that excess to the extent of 
the unrealized deduction or loss in partnership property (that has not 
been reflected in the capital accounts previously). This increase is 
allocated only to properties with unrealized depreciation in proportion 
to their respective amounts of unrealized depreciation.
    The Treasury Department and the IRS have decided to retain these 
rules with certain modifications. The final regulations continue to 
provide that the adjustments to the value of partnership property 
reflected on the partnership's books should generally be made to 
partnership properties on a pro rata basis. Several comments were 
received requesting additional guidance when certain properties are 
subject to special allocations to existing partners. The Treasury 
Department and the IRS agree that the final regulations should take 
into account the economic arrangement of the parties. Therefore, the 
final regulations provide that the adjustments must take into account 
the economic arrangement of the partners with respect to the property.
    One commenter noted that, while the proposed regulations do not 
state how the fair market value of the outstanding option should be 
computed, the value that is consistently used in the examples in the 
proposed regulations is the liquidation value of the option assuming

[[Page 8000]]

exercise. The commenter requested additional guidance on the 
determination of the fair market value of outstanding options. The 
Treasury Department and the IRS believe that additional guidance on the 
determination of fair market value is unnecessary and believe that the 
examples sufficiently illustrate that the fair market value of an 
outstanding option may be based on the liquidation value of the option 
assuming exercise.
C. Accounting for the Exercise of a Noncompensatory Option
    The proposed regulations provide that an exercising noncompensatory 
option holder's initial capital account is equal to the consideration 
paid to the partnership to acquire the noncompensatory option and the 
fair market value of any property (other than the option) contributed 
to the partnership upon the exercise of the noncompensatory option. The 
proposed regulations provide that upon the conversion of convertible 
equity, the fair market value of property contributed to the 
partnership includes the converting partner's capital account 
immediately before the conversion. Because the converting partner's 
pre-conversion capital account will not be eliminated because of the 
conversion, the Treasury Department and the IRS believe that this 
provision from the proposed regulations is unnecessary and could cause 
confusion. Therefore, the Treasury Department and the IRS have decided 
to remove this provision to eliminate confusion; no substantive change 
is intended by this revision.
    Additionally, the proposed regulations provide that the capital 
account of a holder of convertible debt is credited with the adjusted 
basis of the debt and the accrued but unpaid qualified stated interest 
on the debt immediately before the conversion of the debt. One 
commenter noted that the regulations should credit the debt holder's 
capital account with the adjusted issue price rather than the adjusted 
basis of the debt. Using adjusted issue price avoids creating a 
different tax result in cases in which the debt is converted by the 
original debt holder versus cases in which the debt is converted after 
a transfer of the debt at a price that reflected unrealized gain or 
loss attributable to the conversion right and/or changes in market 
interest rates. The Treasury Department and the IRS agree with this 
comment and, therefore, the final regulations credit the capital 
account of a convertible debt holder with the adjusted issue price of 
the debt and the accrued but unpaid qualified stated interest on the 
debt immediately before the conversion of the debt.
    The proposed regulations require a partnership to revalue its 
property immediately following the exercise of a noncompensatory 
option, after the option holder has become a partner. The partnership 
must allocate the unrealized income, gain, loss, and deduction from 
this revaluation, first, to the noncompensatory option holder on 
exercise to the extent necessary to reflect the option holder's right 
to share in partnership capital under the partnership agreement and, 
then, to the historic partners, to reflect the manner in which the 
unrealized income, gain, loss, or deduction in partnership property 
would be allocated among those partners if there were a taxable 
disposition of the property for its fair market value on that date. To 
the extent that unrealized appreciation or depreciation in the 
partnership's property has been allocated to the capital account of the 
noncompensatory option holder on exercise, the holder will, under 
section 704(c) principles, recognize any income or loss attributable to 
that appreciation or depreciation as the underlying properties are 
sold, depreciated, or amortized. The final regulations adopt these 
provisions with some modifications.
    Under the current section 704(b) regulations, a revaluation of 
partnership property pursuant to Sec.  1.704-1(b)(2)(iv)(f) is based on 
the fair market value of partnership property as of the date of the 
revaluation, as determined under Sec.  1.704-1(b)(2)(iv)(h). Several 
commenters to the proposed regulations recommended that the section 
704(b) regulations be revised to permit revaluations of partnership 
property based on the fair market value of the partnership interest, 
rather than the fair market value of the partnership's property. These 
values may differ because of restrictions on the transferability or 
liquidity of the partnership interest or other factors. The Treasury 
Department and the IRS have decided to continue requiring that 
revaluations be based on the fair market value of the partnership's 
property. The Treasury Department and the IRS believe that changing the 
rules for all revaluations is beyond the scope of these final 
regulations.
    Several comments were received requesting additional guidance on 
adjusting capital accounts upon exercise of an option when certain 
partnership properties are subject to special allocations to existing 
partners. The final regulations clarify that the allocations must take 
into account the economic arrangement of the partners with respect to 
the property.
    Furthermore, several commenters requested additional guidance on 
how to adjust capital accounts upon exercise when the partnership owns 
multiple properties with unrealized income, gain, loss, or deduction. 
The final regulations clarify that allocations should be made on a pro 
rata basis from partnership property, subject to the requirement that 
the allocations take into account the economic arrangement of the 
partners. Thus, if the exercising partner's right to share in 
partnership capital under the partnership agreement exceeds the sum of 
the premium and exercise price, then only income or gain may be 
allocated to the exercising partner from partnership properties with 
unrealized appreciation, in proportion to their respective amounts of 
unrealized appreciation (subject to the requirement that the 
allocations take into account the economic arrangement of the 
partners). Conversely, if the exercising partner's right to share in 
partnership capital under the partnership agreement is less than the 
premium and exercise price, then only loss may be allocated to the 
exercising partner from partnership properties with unrealized loss, in 
proportion to their respective amounts of unrealized loss (subject to 
the requirement that the allocations take into account the economic 
arrangement of the partners).
    One commenter recommended that the final regulations provide that 
the partnership may revalue its assets immediately before the exercise 
of the option (in addition to the revaluation that occurs immediately 
following the exercise of the option). This comment was made in 
response to one issue that arises when a revaluation event under Sec.  
1.704-1(b)(2)(iv)(f) or (s) occurs while a noncompensatory option is 
outstanding and certain partnership property has increased in value. 
If, following the revaluation, but prior to the exercise of the option, 
the same property declines in value before the option is exercised, 
there may be insufficient unrealized income or gain in partnership 
property (that has not been allocated to the capital accounts of other 
partners) to allocate to the option holder's capital account upon 
exercise. To address this issue, one commenter recommended that, for 
purposes of partnership property revaluations, the portion of the 
unrealized gain that is treated as ``reflected in the capital accounts 
previously'' be reduced by the historic partners' share of the decline 
in asset value. The Treasury Department and the IRS have decided not to 
adopt these changes because the increased

[[Page 8001]]

complexity that these new rules would add to the regulations outweighs 
the potential benefit.
    Under the proposed regulations, if, after the allocations of 
unrealized gain and loss items to an exercising option holder, the 
exercising option holder's capital account still does not reflect his 
right to share in partnership capital under the partnership agreement, 
the partnership must reallocate capital between the existing partners 
and the exercising option holder (a ``capital account reallocation''). 
This capital account reallocation provision has been retained from the 
proposed regulations.
D. Corrective Allocations
    The proposed regulations require the partnership to make corrective 
allocations of gross income or loss to the partners in the year in 
which the option is exercised so as to take into account any shift in 
the partners' capital accounts that occurs as a result of a capital 
account reallocation pursuant to the exercise of a noncompensatory 
option. Corrective allocations are allocations of tax items that differ 
from the partnership's allocations of book items. If there are not 
sufficient actual partnership items in the year of exercise to conform 
the partnership's tax allocations to the capital account reallocation, 
additional corrective allocations are required in succeeding taxable 
years until the capital account reallocation has been fully taken into 
account.
    A number of comments were received regarding the requirement of 
corrective allocations in the proposed regulations. Some commenters 
recommended eliminating or substantially limiting the scope of 
corrective allocations. The Treasury Department and the IRS considered 
other alternatives but believe that corrective allocations are the most 
administrable alternative means to address the potential problem of 
income shifting when, prior to the exercise of a noncompensatory 
option, a partnership recognizes gain or loss that is, in part, 
economically attributable to the option holder, but is allocated 
entirely to the existing partners. Therefore, the final regulations 
retain the requirement for corrective allocations in certain 
circumstances.
i. Corrective Allocations When Historic Partners Depart
    The final regulations require corrective allocations to be made so 
as to take into account any capital account reallocation upon exercise 
of a noncompensatory option. Therefore, partnership items may be 
correctively allocated to the exercising option holder only of items 
properly allocable to a partner that suffered a capital account 
reduction and only to the extent such partner suffered a capital 
account reduction. This approach may result in corrective allocations 
not being fully made if a partner that suffered a capital account 
reduction on exercise is no longer a partner in the issuing partnership 
at the time a corrective allocation would otherwise be made.
ii. Character Matching for Corrective Allocations
    The proposed regulations provide that corrective allocations are 
pro rata allocations of gross income and gain or gross loss and 
deduction. The proposed regulations do not require any matching of 
character between the income or loss that is correctively allocated, 
and gains or losses that were allocated to existing partners prior to 
the option's exercise, but that were economically attributable to the 
option holder. Several commenters recommended that the regulations 
provide some type of matching requirement. The Treasury Department and 
the IRS believe that the complexity that could arise from a character 
matching requirement would outweigh the potential benefit of obtaining 
a more precise tax result for corrective allocations in some cases. 
Accordingly, the final regulations do not provide for a character 
matching requirement.
iii. Corrective Allocations Using Combinations of Income and Loss
    Additionally, some commenters requested guidance on making 
corrective allocations in a year in which the partnership has both 
gross income and gain and gross loss and deduction. In some cases, a 
corrective allocation that completely takes into account the capital 
shift may not be possible in a given year if only gross income and 
gain, or gross loss and deduction, are used. However, commenters noted 
that it may be possible to more fully take into account the capital 
shift if corrective allocations are made using a combination of gross 
income and gain and gross loss and deduction. The Treasury Department 
and IRS agree that combinations of gross income and gain and gross loss 
and deduction should be available for corrective allocations.
    Accordingly, the final regulations provide a mechanism for making 
corrective allocations using combinations of gross income and gain and 
gross loss and deduction in certain circumstances. If the capital 
account reallocation is from the historic partners to the exercising 
option holder, then the corrective allocations must first be made with 
gross income and gain. If an allocation of gross income and gain alone 
does not completely take into account the capital account reallocation 
in a given year, then the partnership must also make corrective 
allocations using a pro rata portion of items of gross loss and 
deduction as to further take into account the capital account 
reallocation. Conversely, if the capital account reallocation is from 
the exercising option holder to the historic partners, then the 
corrective allocations must first be made with gross loss and 
deduction. If an allocation of gross loss and deduction alone does not 
completely take into account the capital account reallocation in a 
given year, then the partnership must also make corrective allocations 
using a pro rata portion of items of gross income and gain as to 
further take into account the capital account reallocation.
iv. Application of Section 706 to Corrective Allocations
    One commenter requested clarification on the application of section 
706 to the corrective allocation provisions. Because the exercise of a 
noncompensatory option may cause the partners' interests in the 
partnership to vary, the Treasury Department and the IRS believe that 
section 706 should apply in determining which items may be used for 
corrective allocations. Therefore, the final regulations also clarify 
that section 706 and its regulations and principles apply in 
determining the items of income, gain, loss, and deduction that may be 
subject to corrective allocation.
E. The Impact of Partnership Mergers, Divisions, and Terminations on 
Outstanding Noncompensatory Options
    The proposed regulations do not address the impact of partnership 
mergers, divisions, and section 708 technical terminations on 
outstanding noncompensatory options. Some commenters requested guidance 
on these situations. The Treasury Department and the IRS believe that 
these issues are beyond the scope of these final regulations.

3. Characterization Rule

    The proposed regulations generally respect noncompensatory options 
as such and do not characterize them as partnership equity. However, 
the proposed regulations characterize the holder of a noncompensatory 
option as a partner if the option holder's rights are substantially 
similar to the rights afforded to a partner. This rule under the 
proposed regulations applies only if, as of the date that the 
noncompensatory

[[Page 8002]]

option is issued, transferred, or modified, 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. 
The proposed regulations use a facts and circumstances test to 
determine whether a noncompensatory option holder's rights are 
substantially similar to the rights afforded to a partner. The facts 
and circumstances for making this determination under the proposed 
regulations include, but are not limited to, whether the option is 
reasonably certain to be exercised and whether the option holder has 
partner attributes. The Treasury Department and the IRS have decided to 
retain these rules with certain modifications.
A. The ``Substantially Similar'' Test
    Some commenters criticized the breadth of the language in the 
proposed regulations that provides that all facts and circumstances 
will be considered in determining whether a noncompensatory option 
provides the holder with rights that are substantially similar to the 
rights afforded to a partner, suggesting instead that an exclusive list 
of factors be used. The Treasury Department and the IRS agree that the 
regulations should more specifically describe the circumstances in 
which an option holder will be considered to possess these rights. 
Therefore, the final regulations provide that a noncompensatory option 
provides its holder with rights that are substantially similar to the 
rights afforded to a partner if the option is reasonably certain to be 
exercised or if the option holder possesses partner attributes.
I. The ``Reasonably Certain To Be Exercised'' Test
    The proposed regulations list a number of non-exclusive factors 
that are used to determine whether a noncompensatory option is 
reasonably certain to be exercised, including the fair market value of 
the partnership interest that is the subject of the option, the 
exercise price of the option, the term of the option, the 
predictability and stability of the value of the underlying partnership 
interest, the fact that the option premium and exercise price (if the 
option is exercised) will become property of the partnership, and 
whether the partnership is expected to make distributions during the 
term of the option. With one exception, the final regulations adopt 
these factors and clarify that any other arrangements affecting or 
undertaken with a principal purpose of affecting the likelihood that 
the noncompensatory option will be exercised will be considered a 
factor in determining whether an option is reasonably certain to be 
exercised. Because the option premium represents a sunk cost to the 
option holder, and because the fact that the exercise price becomes 
property of the partnership is already reflected in the value of the 
partnership interest subject to the option, the final regulations do 
not include as a factor in the reasonable certainty test the fact that 
the option premium and exercise price will become property of the 
partnership.
    Some commenters suggested that the characterization rule in the 
regulations adopt standards similar to those found in Sec.  1.1361-1(l) 
for determining whether there is a second class of stock in an S 
corporation, or those found in Sec.  1.1504-4 for determining whether a 
corporation is a member of an affiliated group. Commenters also 
recommended that the regulations provide for certain safe harbors and 
bright line tests for determining whether an option holder's rights are 
substantially similar to the rights afforded to a partner, and whether 
there is a strong likelihood that the failure to treat the holder as a 
partner would result in a substantial reduction in the present value of 
the partners' and the holder's aggregate tax liabilities. After careful 
consideration of these comments, the Treasury Department and the IRS 
believe that limited safe harbors should be provided to limit the 
administrative burdens of the characterization rule. Accordingly, the 
final regulations provide two objective safe harbors, which are similar 
to two of the safe harbors in Sec.  1.1504-4 and Sec.  1.1361-1(l). 
However, these safe harbors apply only to the determination of whether 
a noncompensatory option is reasonably certain to be exercised, and not 
to the determination of whether a noncompensatory option holder 
possesses partner attributes.
    The first safe harbor provides that a noncompensatory option is not 
considered reasonably certain to be exercised if it may be exercised no 
more than 24 months after the date of the applicable measurement event 
and it has a strike price equal to or greater than 110 percent of the 
fair market value of the underlying partnership interest on the date of 
the measurement event. The second safe harbor provides that a 
noncompensatory option is not considered reasonably certain to be 
exercised if the terms of the option provide that the strike price of 
the option is equal to or greater than the fair market value of the 
underlying partnership interest on the exercise date. For purposes of 
these safe harbors, an option whose strike price is determined by a 
formula is considered to have a strike price equal to or greater than 
the fair market value of the underlying partnership interest on the 
exercise date if the formula is agreed upon by the parties when the 
option is issued in a bona fide attempt to arrive at the fair market 
value on the exercise date and is to be applied based on the facts and 
circumstances in existence on the exercise date.
    The safe harbors do not apply, however, if the parties to the 
noncompensatory option had a principal purpose of substantially 
reducing the present value of the aggregate Federal tax liabilities of 
the partners and the noncompensatory option holder.
    The final regulations provide that failure of an option to satisfy 
one of these safe harbors does not affect the determination of whether 
the option is treated as reasonably certain to be exercised. Thus, 
options that do not satisfy the safe harbors may still be treated as 
not reasonably certain to be exercised under the facts and 
circumstances. Notwithstanding that an option is treated as not 
reasonably certain to be exercised on the date of one measurement event 
under either the safe harbors or the facts and circumstances test, the 
option may be treated as reasonably certain to be exercised at the time 
of a subsequent measurement event if the safe harbors and facts and 
circumstances test are no longer satisfied. Furthermore, even if an 
option is not reasonably certain to be exercised under either the safe 
harbors or the facts and circumstances test, the noncompensatory option 
may still be found to provide its holder with rights substantially 
similar to those afforded a partner under the partner attributes test.
    The proposed regulations contain an example describing an option 
issued by a partnership with reasonably predictable earnings and 
concluding, based on the facts of the example, that the option 
described is reasonably certain to be exercised. Commenters stated that 
the example involved unrealistic facts demonstrating reasonably 
predictable earnings, and that the example wrongly implied that low 
volatility suggests a reasonable certainty of exercise. Upon further 
consideration of this example, the Treasury Department and the IRS have 
decided to delete the example from the final regulations.
ii. The ``Partner Attributes'' Test
    The proposed regulations provide that partner attributes include 
the extent to

[[Page 8003]]

which the option holder shares in the economic benefit and detriment of 
partnership income and loss and the extent to which the option holder 
has the right to control or restrict the activities of the partnership. 
Some commenters requested clarification of this definition of partner 
attributes. Because all options issued by a partnership allow the 
holder to share, to some extent, in the economic benefit and detriment 
of partnership income and loss, the Treasury Department and the IRS 
agree that this language should be clarified.
    The final regulations provide that the determination of whether a 
noncompensatory option holder possesses partner attributes is based on 
all the facts and circumstances, including whether the option holder, 
directly or indirectly, through the option agreement or a related 
agreement, is provided with voting or managerial rights in the 
partnership. Additionally, the final regulations provide that an option 
holder has partner attributes if, based on all the facts and 
circumstances, (1) the option holder is provided with rights (through 
the option agreement or a related agreement) that are similar to rights 
ordinarily afforded to a partner to participate in partnership profits 
through present possessory rights to share in current operating or 
liquidating distributions with respect to the underlying partnership 
interest; or (2) the option holder, directly or indirectly, undertakes 
obligations (through the option agreement or a related agreement) that 
are similar to obligations undertaken by a partner to bear partnership 
losses. In this way, the Treasury Department and the IRS believe that 
the final regulations clarify that the economic benefits and burdens 
relevant to the partner attributes test are those beyond the economic 
benefits and burdens inherent in basic option transactions.
    As to an option holder's ability to control or restrict the 
activities of the partnership, some commenters stated that an option 
holder should not be considered to possess partner attributes solely 
because the holder has the ability to restrict partnership 
distributions or dilutive issuances of partnership equity while the 
option is outstanding. Option holders often are given such rights as a 
means of protecting the value of the option holder's potential future 
partnership interest. The Treasury Department and the IRS agree that 
such rights are reasonable restrictions that, by themselves, should not 
automatically lead to a conclusion that the option holder possesses 
partner attributes. Accordingly, the final regulations provide that a 
noncompensatory option holder will not ordinarily be considered to 
possess partner attributes solely because the noncompensatory option 
agreement significantly controls or restricts, or the noncompensatory 
option holder has the right to significantly control or restrict, a 
partnership decision that could substantially affect the value of the 
underlying partnership interest. In particular, the following rights of 
the option holder will not be treated as partner attributes: (1) the 
ability to impose reasonable restrictions on partnership distributions 
or dilutive issuances of partnership equity or options while the 
noncompensatory option is outstanding; and (2) the ability to choose 
the partnership's section 704(c) method for partnership properties.
    Some commenters requested clarification on the analysis of partner 
attributes for an option holder who is also a partner in the issuing 
partnership. The proposed regulations provide that rights possessed by 
an option holder solely by virtue of owning a partnership interest and 
not by virtue of holding a noncompensatory option are not taken into 
account in determining whether the option holder has partner 
attributes, provided those rights are no greater than those held by 
other partners owning substantially similar interests. Commenters noted 
that, in some cases, there may be partners, such as managing or general 
partners, with unique interests that are not comparable to the 
interests of any other partners. The Treasury Department and the IRS 
agree that the regulations should address these situations. 
Accordingly, the final regulations provide that rights in the issuing 
partnership possessed by a noncompensatory option holder solely by 
virtue of owning an interest in the issuing partnership are not taken 
into account, provided that those rights are no greater than the rights 
granted to other partners owning substantially similar interests in the 
partnership and who do not hold noncompensatory options in the 
partnership. Additionally, the final regulations provide that if all of 
the partners owning substantially similar interests in the issuing 
partnership also hold noncompensatory options in the partnership, or if 
none of the other partners owns substantially similar interests in the 
partnership, then all facts and circumstances will be considered in 
determining whether the rights in the partnership possessed by the 
option holder are possessed solely by virtue of owning a partnership 
interest. If those rights are possessed solely by virtue of owning a 
partnership interest, the final regulations provide that they are not 
taken into account.
    Additionally, in response to comments, the final regulations 
provide that for purposes of determining whether an option holder has 
partner attributes, the option holder will be treated as owning all 
partnership interests and noncompensatory options issued by the 
partnership that are owned by any person related to the option holder. 
For example, if the holder of a noncompensatory option is related to a 
person that owns an interest in the issuing partnership, and the 
interest provides the related person with partner attributes that are 
greater than the rights granted to other partners owning substantially 
similar interests in the partnership, the option will be characterized 
as a partnership interest under the final regulations if the strong 
likelihood test is satisfied. This provision is intended to prevent 
avoidance of the partner attributes test by planning among related 
parties. The Treasury Department and the IRS continue to study the 
extent to which financial instruments and partnership interests owned 
by related persons should be taken into account under the reasonable 
certainty test.
    The proposed regulations contain an example describing a deep in 
the money option and concluding, based on the facts of the example, 
that the option holder possesses partner attributes. Commenters stated 
that the example added little to the existing guidance provided by the 
common law rule. Upon further consideration of this example, the 
Treasury Department and the IRS have decided to delete the example from 
the final regulations.
B. The ``Strong Likelihood'' Test
    The Treasury Department and the IRS received a number of comments 
regarding the provision in the proposed regulations that the 
characterization rule applies only if 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 
holder's aggregate tax liabilities. Some commenters recommended that 
the regulations adopt language similar to that contained in Sec.  
1.704-1(b)(2)(iii)(b)(2) and (c)(2), which provides that, in 
determining whether there is a reduction in the partners' total tax 
liability, tax consequences that result from the interaction of the 
allocation(s) with partner tax attributes that are unrelated to the 
partnership are taken into account. Similarly, in

[[Page 8004]]

determining whether there would be a substantial reduction in the 
present value of the partners' and option holder's aggregate tax 
liabilities, commenters noted that it is appropriate to consider 
partner and option holder tax attributes that are unrelated to the 
partnership, and the interaction of those attributes with the option.
    The Treasury Department and the IRS agree that it would be helpful 
for the regulations to specify certain factors that are considered in 
determining whether there is a strong likelihood that the failure to 
treat a noncompensatory 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. The final 
regulations provide that all facts and circumstances should be 
considered in making this determination, including: (1) The interaction 
of the allocations of the issuing partnership and the partners' and 
noncompensatory option holder's Federal tax attributes (taking into 
account tax consequences that result from the interaction of the 
allocations with the partners' and noncompensatory option holder's 
Federal tax attributes that are unrelated to the partnership); (2) the 
absolute amount of the Federal tax reduction; (3) the amount of the 
reduction relative to overall Federal tax liability; and (4) the timing 
of items of income and deductions.
    Additionally, to more specifically address the application of the 
strong likelihood test when a look-through entity (as defined in Sec.  
1.704-1(b)(2)(iii)(d)(2)) is a party, the final regulations provide 
that if a partner or option holder is a look-through entity, such as a 
partnership or an S corporation, then the tax attributes of that 
entity's ultimate owners (that are not look-through entities) will be 
taken into account in determining whether there is a strong likelihood 
of a substantial tax reduction. The final regulations also provide 
that, if a partner is a member of a consolidated group, then tax 
attributes of the consolidated group and of another member with respect 
to a separate return year will be taken into account in determining 
whether there is a strong likelihood of a substantial tax reduction.
C. Events That Trigger Testing Under the Characterization Rule
    The proposed regulations test a noncompensatory option under the 
characterization rule upon issuance, transfer, or modification of the 
option. A number of comments were received recommending clarification, 
or narrowing of the list, of events that will trigger a testing of the 
option after original issuance. Several commenters argued that only 
material modifications of an option should lead to re-testing under the 
characterization rule. Several commenters also recommended restricting 
the types of transfers that will trigger testing of the option under 
the characterization rule, or removing the requirement to test upon 
transfer entirely. In response to these comments, the final regulations 
provide a more detailed description of the events that will trigger 
application of the characterization rule to a noncompensatory option.
    The final regulations provide that the characterization rule will 
be applied upon the occurrence of a measurement event with respect to 
the noncompensatory option. The final regulations define a measurement 
event as: (1) Issuance of the noncompensatory option; (2) an adjustment 
of the terms (modification) of the noncompensatory option or of the 
underlying partnership interest (including an adjustment pursuant to 
the terms of the noncompensatory option or the underlying partnership 
interest); or (3) transfer of the noncompensatory option if either (A) 
the term of the option exceeds 12 months, or (B) the transfer is 
pursuant to a plan in existence at the time of the issuance or 
modification of the noncompensatory option that has as a principal 
purpose the substantial reduction of the present value of the aggregate 
Federal tax liabilities of the partners and the noncompensatory option 
holder.
    Additionally, in response to the comments, the Treasury Department 
and the IRS believe that it is appropriate to limit testing under the 
characterization rule to provide certainty for both taxpayers and the 
IRS, particularly in circumstances in which there is little potential 
for abuse. Therefore, the final regulations do not treat the following 
events as measurement events: (1) A transfer of the noncompensatory 
option that would otherwise be a measurement event if the transfer is 
at death or between spouses or former spouses under section 1041, or in 
a transaction that is disregarded for Federal tax purposes; (2) a 
modification that neither materially increases the likelihood that the 
option will be exercised nor provides the option holder with partner 
attributes; (3) a change in the strike price of a noncompensatory 
option, or in the interests in the issuing partnership that may be 
issued or transferred pursuant to the option, made pursuant to a bona 
fide, reasonable adjustment formula that has the intended effect of 
preventing dilution of the interests of the option holder; and (4) any 
other event as provided in guidance published in the Internal Revenue 
Bulletin. The Treasury Department and the IRS believe that these 
limitations will minimize the burden on taxpayers that could arise from 
frequent testings under the characterization rule in many situations, 
while preserving the ability of the IRS to enforce the characterization 
rule in appropriate circumstances.
    Some commenters also requested that the regulations clarify whether 
the issuance, transfer, or modification of one noncompensatory option 
would trigger testing under the characterization rule of all other 
outstanding noncompensatory options issued by the same partnership. 
Under the final regulations, testing under the characterization rule 
occurs only on the date a measurement event occurs with respect to a 
particular noncompensatory option. Measurement events should be 
determined individually for each noncompensatory option issued by a 
partnership. For example, the modification of one noncompensatory 
option generally would be a measurement event for that particular 
option, and it would not be a measurement event for all other 
noncompensatory options issued by the partnership.
    In addition, to address transfers of interests in the issuing 
partnership and situations involving look-through entities, proposed 
regulations under section 761 (REG-106918-08) are being published 
concurrently with these final regulations. Those proposed regulations 
would add three measurement events to the list above, but apply only if 
those measurement events are pursuant to a plan in existence at the 
time of the issuance or modification of the noncompensatory option that 
has as a principal purpose the substantial reduction of the present 
value of the aggregate Federal tax liabilities of the partners and the 
noncompensatory option holder. The proposed measurement events are: (1) 
Issuance, transfer, or modification of an interest in, or liquidation 
of, the issuing partnership; (2) issuance, transfer, or modification of 
an interest in any look-through entity that directly, or indirectly 
through one or more look-through entities, owns the noncompensatory 
option; and (3) issuance, transfer, or modification of an interest in 
any look-through entity that directly, or indirectly through one or 
more look-through entities, owns an interest in the issuing 
partnership. The Treasury Department and the IRS believe that the first 
of these proposed

[[Page 8005]]

measurement events is necessary because it is inconsistent to test a 
noncompensatory option under the characterization rule upon transfer of 
the noncompensatory option, but not upon transfer of an interest in the 
issuing partnership, because either type of transfer may change the 
analysis of whether 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 option holder's 
aggregate tax liabilities. The Treasury Department and the IRS believe 
that the second and third proposed measurement events are necessary to 
prevent avoidance of the characterization rule through the use of look-
through entities.
D. Timing of Characterization
    Some commenters requested clarification regarding the timing of the 
characterization of a noncompensatory option as a partnership interest 
under the regulations. For example, some commenters questioned whether 
an option that was characterized as a partnership interest upon 
transfer would be treated as transferred and then exercised by the 
transferee or exercised by the transferor and then transferred. The 
Treasury Department and the IRS believe that the tax consequences to 
the transferor and transferee upon a transfer of the option should be 
similar to the tax consequences upon a transfer of the underlying 
partnership interest. Accordingly, the final regulations provide that 
characterization of an option as a partnership interest under the 
regulations applies upon the issuance of the option, or immediately 
before any other measurement event that gave rise to the 
characterization. Under this approach, if the characterization rule 
applied upon a transfer of a noncompensatory option, a section 743 
adjustment for the benefit of the transferee would be made if the 
issuing partnership had a section 754 election in effect.
E. Effect of Characterization
    Some commenters questioned whether, once a noncompensatory option 
was characterized as a partnership interest under the characterization 
rule, the characterization rule could ever operate to re-characterize 
the interest as a noncompensatory option once again. The Treasury 
Department and the IRS believe that the characterization rule operates 
to treat noncompensatory options as partnerships interests in 
appropriate circumstances, and it should not be interpreted to treat 
partners as noncompensatory option holders. Accordingly, the final 
regulations provide that once a noncompensatory option is treated as a 
partnership interest, in no event may it be characterized as an option 
thereafter.
F. Continuing Applicability of General Tax Principles
    Finally, some commenters questioned whether general tax principles 
would continue to apply to the characterization of a noncompensatory 
option that, in substance, represents a current partnership interest. 
Because these rules in the final regulations are intended to supplement 
rather than supplant general tax principles, the Treasury Department 
and the IRS believe it is appropriate for general tax principles to 
continue to apply, in addition to the characterization rule of the 
regulations. Thus, the final regulations clarify that an option that is 
not treated as a partnership interest under the regulations may still 
be treated as a partnership interest under general principles of law. 
For example, if upon the issuance of a noncompensatory option, the 
option in substance constitutes a partnership interest under general 
tax principles, then the option will be treated as a partnership 
interest for Federal tax purposes, even if it is unlikely that the 
aggregate tax liabilities of the option holder and partners would be 
substantially reduced by the failure to treat the option holder as a 
partner. For this purpose, general tax principles include principles of 
tax law derived from the Internal Revenue Code, Treasury Regulations, 
case law, and administrative guidance issued by the IRS.

4. Convertible Bond Provision

    Section 171(b)(1) provides that the amount of bond premium on a 
convertible bond does not include any amount attributable to the 
conversion features of the bond. A holder of partnership convertible 
debt who purchases the debt at a premium would generally be subject to 
the section 171 bond premium amortization rules. One commenter 
suggested that the regulations under Sec.  1.171-1(e)(1)(iii) be 
clarified to state that such regulations apply to debt that is 
convertible into an interest in the partnership issuing the debt. The 
final regulations adopt this comment.

5. Original Issue Discount Provisions

    The original issue discount (OID) provisions provide special rules 
for debt instruments convertible into the stock of the issuer or a 
party related to the issuer. See Sec. Sec.  1.1272-1(e), 1.1273-2(j), 
and 1.1275-4(a)(4). The proposed regulations proposed to apply these 
special rules to debt instruments convertible into partnership 
interests. These final regulations adopt these proposed amendments. 
Accordingly, the final regulations amend the OID provisions to treat 
partnership interests as stock for purposes of the special rules for 
convertible debt instruments. Treating convertible debt issued by 
partnerships and corporations differently for purposes of these special 
rules could create unjustified distinctions between the taxation of 
instruments that are economically equivalent.

Effective/Applicability Date

    These final regulations apply to noncompensatory options that are 
issued on or after February 5, 2013.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866, as 
supplemented by Executive Order 13563. Therefore, a regulatory 
assessment is not required. It also has been determined that section 
553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does 
not apply to these regulations, and because the regulations do not 
impose a collection of information requirement on small entities, the 
Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. 
Pursuant to section 7805(f) of the Code, the notice of proposed 
rulemaking preceding these regulations was submitted to the Chief 
Counsel for Advocacy of the Small Business Administration for comment 
on its impact on small businesses, and no comments were received.

Drafting Information

    The principal author of these regulations is Benjamin Weaver of the 
Office of the Associate Chief Counsel (Passthroughs and Special 
Industries). However, other personnel from the IRS and Treasury 
Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of the Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:


[[Page 8006]]


    Authority:  26 U.S.C. 7805 * * *


0
Par. 2. Section 1.171-1 is amended by adding a sentence at the end of 
paragraph (e)(1)(iii)(C) to read as follows:


Sec.  1.171-1  Bond premium.

* * * * *
    (e) * * *
    (1) * * *
    (iii) * * *
    (C) * * * For bonds issued on or after February 5, 2013, the term 
stock in the preceding sentence means an equity interest in any entity 
that is classified, for Federal tax purposes, as either a partnership 
or a corporation.
* * * * *


0
Par. 3. Section 1.704-1 is amended as follows:
0
1. Paragraph (b)(0) is amended by adding entries to the table in 
numerical order for paragraphs (b)(2)(iv)(d)(4), (b)(2)(iv)(h)(1), 
(b)(2)(iv)(h)(2), (b)(2)(iv)(s), (b)(4)(ix), and (b)(4)(x).
0
2. The paragraph heading for paragraph (b)(1)(ii) is revised and a 
sentence is added at the end of the paragraph.
0
3. Paragraph (b)(2)(iv)(d)(4) is added.
0
4. Paragraph (b)(2)(iv)(f)(1) is revised.
0
5. Paragraph (b)(2)(iv)(f)(5)(iii) is amended by removing the ``.'' at 
the end of the paragraph and adding in its place ``, or''.
0
6. Paragraph (b)(2)(iv)(f)(5)(iv) is redesignated as paragraph 
(b)(2)(iv)(f)(5)(v).
0
7. New paragraph (b)(2)(iv)(f)(5)(iv) is added.
0
8. Paragraph (b)(2)(iv)(h) is redesignated as (b)(2)(iv)(h)(1) and a 
new paragraph heading is added for paragraph (b)(2)(iv)(h)(1).
0
9. Paragraph (b)(2)(iv)(h)(2) is added.
0
10. The undesignated text following paragraph (b)(2)(iv)(r)(2) is 
designated as paragraph (b)(2)(iv)(r)(3), and a paragraph (b)(2)(iv)(s) 
is added after the newly designated paragraph (b)(2)(iv)(r)(3).
0
11. Paragraphs (b)(4)(ix) and (b)(4)(x) are added.
0
12. Paragraph (b)(5) is amended by adding Examples 31 through 35.
    The additions and revisions read as follows:


Sec.  1.704-1  Partner's distributive share.

* * * * *
    (b) * * *
    (0) * * *

------------------------------------------------------------------------
            Heading                              Section
------------------------------------------------------------------------
 
                              * * * * * * *
Exercise of noncompensatory      1.704-1(b)(2)(iv)(d)(4).
 options.
 
                              * * * * * * *
In general.....................  1.704-1(b)(2)(iv)(h)(1).
Adjustments for noncompensatory  1.704-1(b)(2)(iv)(h)(2).
 options.
 
                              * * * * * * *
Adjustments on the exercise of   1.704-1(b)(2)(iv)(s).
 a noncompensatory option.
 
                              * * * * * * *
Allocations with respect to      1.704-1(b)(4)(ix).
 noncompensatory options.
Corrective allocations.........  1.704-1(b)(4)(x).
 
                              * * * * * * *
------------------------------------------------------------------------

     (1) * * *
    (ii) Effective/applicability date. * * * In addition, paragraph 
(b)(2)(iv)(d)(4), paragraph (b)(2)(iv)(f)(1), paragraph 
(b)(2)(iv)(f)(5)(iv), paragraph (b)(2)(iv)(h)(2), paragraph 
(b)(2)(iv)(s), paragraph (b)(4)(ix), paragraph (b)(4)(x), and Examples 
31 through 35 in paragraph (b)(5) of this section apply to 
noncompensatory options (as defined in Sec.  1.721-2(f)) that are 
issued on or after February 5, 2013.
* * * * *
    (2) * * *
    (iv) * * *
    (d) * * *
    (4) Exercise of noncompensatory options. Solely for purposes of 
paragraph (b)(2)(iv)(b)(2) of this section, the fair market value of 
the property contributed on the exercise of a noncompensatory option 
(as defined in Sec.  1.721-2(f)) does not include the fair market value 
of the option privilege, but does include the consideration paid to the 
partnership to acquire the option and the fair market value of any 
property (other than the option) contributed to the partnership on the 
exercise of the option. With respect to convertible debt, the fair 
market value of the property contributed on the exercise of the option 
is the adjusted issue price of the debt and the accrued but unpaid 
qualified stated interest (as defined in Sec.  1.1273-1(c)) on the debt 
immediately before the conversion, plus the fair market value of any 
property (other than the convertible debt) contributed to the 
partnership on the exercise of the option. See Examples 31 through 35 
of paragraph (b)(5) of this section.
* * * * *
    (f) * * *
    (1) The adjustments are based on the fair market value of 
partnership property (taking section 7701(g) into account) on the date 
of adjustment, as determined under paragraph (b)(2)(iv)(h) of this 
section. See Example 33 of paragraph (b)(5) of this section.
* * * * *
    (5) * * *
    (iv) In connection with the issuance by the partnership of a 
noncompensatory option (other than an option for a de minimis 
partnership interest), or
* * * * *
    (h) Determinations of fair market value--(1) In general. * * *
    (2) Adjustments for noncompensatory options. The value of 
partnership property as reflected on the books of the partnership must 
be adjusted to account for any outstanding noncompensatory options (as 
defined in Sec.  1.721-2(f)) at the time of a revaluation of 
partnership property under paragraph (b)(2)(iv)(f) or (s) of this 
section. If the fair market value of outstanding noncompensatory 
options (as defined in Sec.  1.721-2(f)) as of the date of the 
adjustment exceeds the consideration paid to the partnership to acquire 
the options, then the value of partnership property as reflected on the 
books of the partnership must be reduced by that excess to the extent 
of the unrealized income or gain in partnership property (that has not 
been

[[Page 8007]]

reflected in the capital accounts previously). This reduction is 
allocated only to properties with unrealized appreciation in proportion 
to their respective amounts of unrealized appreciation. If the 
consideration paid to the partnership to acquire the outstanding 
noncompensatory options (as defined in Sec.  1.721-2(f)) exceeds the 
fair market value of such options as of the date of the adjustment, 
then the value of partnership property as reflected on the books of the 
partnership must be increased by that excess to the extent of the 
unrealized loss in partnership property (that has not been reflected in 
the capital accounts previously). This increase is allocated only to 
properties with unrealized loss in proportion to their respective 
amounts of unrealized loss. However, any reduction or increase shall 
take into account the economic arrangement of the partners with respect 
to the property.
* * * * *
    (s) Adjustments on the exercise of a noncompensatory option. A 
partnership agreement may grant a partner, on the exercise of a 
noncompensatory option (as defined in Sec.  1.721-2(f)), a right to 
share in partnership capital that exceeds (or is less than) the sum of 
the consideration paid to the partnership to acquire and exercise such 
option. Where such an agreement exists, capital accounts will not be 
considered to be determined and maintained in accordance with the rules 
of this paragraph (b)(2)(iv) unless the following requirements are met:
    (1) In lieu of revaluing partnership property under paragraph 
(b)(2)(iv)(f) of this section immediately before the exercise of the 
option, the partnership revalues partnership property in accordance 
with the provisions of paragraphs (b)(2)(iv)(f)(1) through (f)(4) of 
this section immediately after the exercise of the option.
    (2) In determining the capital accounts of the partners (including 
the exercising partner) under paragraph (b)(2)(iv)(s)(1) of this 
section, the partnership first allocates any unrealized income, gain, 
or loss in partnership property (that has not been reflected in the 
capital accounts previously) to the exercising partner to the extent 
necessary to reflect that partner's right to share in partnership 
capital under the partnership agreement, and then allocates any 
remaining unrealized income, gain, or loss (that has not been reflected 
in the capital accounts previously) to the existing partners, to 
reflect the manner in which the unrealized income, gain, or loss in 
partnership property would be allocated among those partners if there 
were a taxable disposition of such property for its fair market value 
on that date. For purposes of the preceding sentence, if the exercising 
partner's initial capital account as determined under Sec.  1.704-
1(b)(2)(iv)(b) and (d)(4) of this section would be less than the amount 
that reflects the exercising partner's right to share in partnership 
capital under the partnership agreement, then only income or gain may 
be allocated to the exercising partner from partnership properties with 
unrealized appreciation, in proportion to their respective amounts of 
unrealized appreciation. If the exercising partner's initial capital 
account, as determined under Sec.  1.704-1(b)(2)(iv)(b) and (d)(4) of 
this section, would be greater than the amount that reflects the 
exercising partner's right to share in partnership capital under the 
partnership agreement, then only loss may be allocated to the 
exercising partner from partnership properties with unrealized loss, in 
proportion to their respective amounts of unrealized loss. However, any 
allocation must take into account the economic arrangement of the 
partners with respect to the property.
    (3) If, after making the allocations described in paragraph 
(b)(2)(iv)(s)(2) of this section, the exercising partner's capital 
account does not reflect that partner's right to share in partnership 
capital under the partnership agreement, then the partnership 
reallocates partnership capital between the existing partners and the 
exercising partner so that the exercising partner's capital account 
reflects the exercising partner's right to share in partnership capital 
under the partnership agreement (a capital account reallocation). Any 
increase or decrease in the capital accounts of existing partners that 
occurs as a result of a capital account reallocation under this 
paragraph (b)(2)(iv)(s)(3) must be allocated among the existing 
partners in accordance with the principles of this section. See Example 
32 of paragraph (b)(5) of this section.
    (4) The partnership agreement requires corrective allocations so as 
to take into account all capital account reallocations made under 
paragraph (b)(2)(iv)(s)(3) of this section (see paragraph (b)(4)(x) of 
this section). See Example 32 of paragraph (b)(5) of this section.
* * * * *
    (4) * * *
    (ix) Allocations with respect to noncompensatory options--(a) In 
general. A partnership agreement may grant to a partner that exercises 
a noncompensatory option (as defined in Sec.  1.721-2(f)) a right to 
share in partnership capital that exceeds (or is less than) the sum of 
the amounts paid to the partnership to acquire and exercise the option. 
In such a case, allocations of income, gain, loss, and deduction to the 
partners while the noncompensatory option is outstanding cannot have 
economic effect because, if the noncompensatory option is exercised, 
the exercising partner, rather than the existing partners, may receive 
the economic benefit or bear the economic detriment associated with 
that income, gain, loss, or deduction. However, allocations of 
partnership income, gain, loss, and deduction to the partners while the 
noncompensatory option is outstanding will be deemed to be in 
accordance with the partners' interests in the partnership only if--
    (1) The holder of the noncompensatory option is not treated as a 
partner under Sec.  1.761-3;
    (2) The partnership agreement requires that, while a 
noncompensatory option is outstanding, the partnership comply with the 
rules of paragraph (b)(2)(iv)(f) of this section and that, on the 
exercise of the noncompensatory option, the partnership comply with the 
rules of paragraph (b)(2)(iv)(s) of this section; and
    (3) All material allocations and capital account adjustments under 
the partnership agreement would be respected under section 704(b) if 
there were no outstanding noncompensatory options issued by the 
partnership. See Examples 31 through 35 of paragraph (b)(5) of this 
section.
    (b) Substantial economic effect under sections 168(h) and 
514(c)(9)(E)(i)(ll). An allocation of partnership income, gain, loss, 
or deduction to the partners will be deemed to have substantial 
economic effect for purposes of sections 168(h) and 514(c)(9)(E)(i)(ll) 
if--
    (1) The allocation would meet the substantial economic effect 
requirements of paragraph (b)(2) of this section if there were no 
outstanding noncompensatory options issued by the partnership; and
    (2) The partnership satisfies the requirements of paragraph 
(b)(4)(ix)(a)(1), (2), and (3) of this section.
    (x) Corrective allocations--(a)--In general. If partnership capital 
is reallocated between existing partners and a partner exercising a 
noncompensatory option under paragraph (b)(2)(iv)(s)(3) of this section 
(a capital account reallocation), then the partnership must, beginning 
with the

[[Page 8008]]

taxable year of the exercise and in all succeeding taxable years until 
the required allocations are fully taken into account, make corrective 
allocations so as to take into account the capital account 
reallocation. A corrective allocation is an allocation (consisting of a 
pro rata portion of each item) for tax purposes of gross income and 
gain, or gross loss and deduction, that differs from the partnership's 
allocation of the corresponding book item. See Example 32 of paragraph 
(b)(5) of this section.
    (b) Timing. Section 706 and the regulations and principles 
thereunder apply in determining the items of income, gain, loss, and 
deduction that may be subject to corrective allocation.
    (c) Allocation of gross income and gain and gross loss and 
deduction. If the capital account reallocation is from the historic 
partners to the exercising option holder, then the corrective 
allocations must first be made with gross income and gain. If an 
allocation of gross income and gain alone does not completely take into 
account the capital account reallocation in a given year, then the 
partnership must also make corrective allocations using a pro rata 
portion of items of gross loss and deduction as to further take into 
account the capital account reallocation. Conversely, if the capital 
account reallocation is from the exercising option holder to the 
historic partners, then the corrective allocations must first be made 
with gross loss and deduction. If an allocation of gross loss and 
deduction alone does not completely take into account the capital 
account reallocation in a given year, then the partnership must also 
make corrective allocations using a pro rata portion of items of gross 
income and gain as to further take into account the capital account 
reallocation.
    (5) * * *

    Example 31. (i) In Year 1, A and B each contribute cash of 
$9,000 to LLC, a newly formed limited liability company classified 
as a partnership for Federal tax purposes, in exchange for 100 units 
in LLC. Under the LLC agreement, each unit is entitled to 
participate equally in the profits and losses of LLC. LLC uses the 
cash contributions to purchase a nondepreciable property, Property 
A, for $18,000. Later in Year 1, at a time when Property A is valued 
at $20,000, LLC issues an option to C. The option allows C to buy 
100 units in LLC for an exercise price of $15,000 in Year 2. C pays 
$1,000 to LLC to purchase the option. Assume that the LLC agreement 
satisfies the requirements of paragraph (b)(2) of this section and 
requires that, on the exercise of a noncompensatory option, LLC 
comply with the rules of paragraph (b)(2)(iv)(s) of this section. 
Also assume that C's option is a noncompensatory option under Sec.  
1.721-2(f), and that C is not treated as a partner with respect to 
the option. Under paragraph (b)(2)(iv)(f)(5)(iv) of this section, 
LLC revalues its property in connection with the issuance of the 
option. The $2,000 unrealized gain in Property A is allocated 
equally to A and B under the LLC agreement. In Year 2, C exercises 
the option, contributing the $15,000 exercise price to the 
partnership. At the time the option is exercised, the value of 
Property A is $35,000.

------------------------------------------------------------------------
                                                         Basis    Value
------------------------------------------------------------------------
Year 1 After Issuance of the Option
------------------------------------------------------------------------
Assets:
  Cash Premium........................................   $1,000   $1,000
  Property A..........................................   18,000   20,000
                                                       -----------------
    Total.............................................   19,000   21,000
                                                       =================
Liabilities and Capital:
  Cash Premium........................................    1,000    1,000
  A...................................................    9,000   10,000
  B...................................................    9,000   10,000
                                                       -----------------
    Total.............................................   19,000   21,000
------------------------------------------------------------------------
Year 2 After Exercise of the Option
------------------------------------------------------------------------
 
Assets:
  Property A Cash.....................................   18,000   35,000
  Premium.............................................    1,000    1,000
  Exercise Price......................................   15,000   15,000
                                                       -----------------
    Total.............................................   34,000   51,000
                                                       =================
Liabilities and Capital:
  A...................................................    9,000   17,000
  B...................................................    9,000   17,000
  C...................................................   16,000   17,000
    Total.............................................   34,000   51,000
------------------------------------------------------------------------


     
    (ii) In lieu of revaluing LLC's property under paragraph 
(b)(2)(iv)(f) of this section immediately before the option is 
exercised, under paragraph (b)(2)(iv)(s)(1) of this section LLC must 
revalue its property under the principles of paragraph (b)(2)(iv)(f) 
of this section immediately after the exercise of the option. Under 
paragraphs (b)(2)(iv)(b) and (b)(2)(iv)(d)(4) of this section, C's 
capital account is credited with the amount paid for the option 
($1,000) and the exercise price of the option ($15,000). Under the 
LLC agreement, however, C is entitled to LLC capital corresponding 
to 100 units of LLC (\1/3\ of LLC's capital). Immediately after the 
exercise of the option, LLC's properties are cash of $16,000 ($1,000 
premium and $15,000 exercise price contributed by C) and Property A, 
which has a value of $35,000. Thus, the total value of LLC's 
property is $51,000. C is entitled to LLC capital equal to \1/3\ of 
this value, or $17,000. As C is entitled to $1,000 more LLC capital 
than C's capital contributions to LLC, the provisions of paragraph 
(b)(2)(iv)(s) of this section apply.
    (iii) Under paragraph (b)(2)(iv)(s)(2) of this section, LLC must 
increase C's capital account from $16,000 to $17,000 by, first, 
revaluing LLC property in accordance with the principles of 
paragraph (b)(2)(iv)(f) of this section. The unrealized gain in 
LLC's property (Property A) which has not been reflected in the 
capital accounts previously is $15,000 ($35,000 value less $20,000 
book value). Under paragraph (b)(2)(iv)(s)(2) of this section, the 
first $1,000 of this gain must be allocated to C, and the remaining 
$14,000 of this gain is allocated equally to A and B in accordance 
with the LLC agreement. Because the revaluation of LLC property 
under paragraph (b)(2)(iv)(s)(2) of this section increases C's 
capital account to the amount agreed on by the members, LLC is not 
required to make a capital account reallocation under paragraph 
(b)(2)(iv)(s)(3) of this section. The $17,000 of unrealized booked 
gain in Property A ($35,000 value less $18,000 basis) is shared 
$8,000 to each A and B, and $1,000 to C. Under paragraph 
(b)(2)(iv)(f)(4) of this section, the tax items from the revalued 
property must be allocated in accordance with section 704(c) 
principles.

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                         A                               B                               C
                                                         -----------------------------------------------------------------------------------------------
                                                                Tax            Book             Tax            Book             Tax            Book
--------------------------------------------------------------------------------------------------------------------------------------------------------
Capital account after exercise..........................          $9,000         $10,000          $9,000         $10,000         $16,000         $16,000
Revaluation amount......................................               0           7,000               0           7,000               0           1,000
                                                         -----------------------------------------------------------------------------------------------
    Capital account after revaluation...................           9,000          17,000           9,000          17,000          16,000          17,000
--------------------------------------------------------------------------------------------------------------------------------------------------------

    Example 32. (i) Assume the same facts as in Example 31, except 
that, in Year 2, before the exercise of the option, LLC sells 
Property A for $40,000, recognizing gain of $22,000. LLC does not 
distribute the sale proceeds to its partners and it has no other 
earnings in Year 2. With the proceeds ($40,000), LLC purchases 
Property B, a nondepreciable property. Also assume that C exercises 
the noncompensatory option at the beginning of Year 3 and that, at 
the time C exercises the option, the value of Property B is $41,000. 
In Year 3, LLC has gross income of $3,000 and deductions of $1,500.

[[Page 8009]]



 
------------------------------------------------------------------------
                                                         Basis    Value
------------------------------------------------------------------------
                   Year 2 After Purchase of Property B
------------------------------------------------------------------------
Assets:
  Cash Premium........................................   $1,000   $1,000
  Property B..........................................   40,000   40,000
                                                       -----------------
    Total.............................................   41,000   41,000
                                                       =================
Liabilities and Capital:
  Cash Premium........................................    1,000    1,000
  A...................................................   20,000   20,000
  B...................................................   20,000   20,000
                                                       -----------------
    Total.............................................   41,000   41,000
------------------------------------------------------------------------
                   Year 3 After Exercise of the Option
------------------------------------------------------------------------
Assets:
  Property B..........................................   40,000   41,000
  Cash................................................   16,000   16,000
                                                       -----------------
    Total.............................................   56,000   57,000
                                                       =================
Liabilities and Capital:
  A...................................................   20,000   19,000
  B...................................................   20,000   19,000
  C...................................................   16,000   19,000
                                                       -----------------
    Total.............................................   56,000   57,000
------------------------------------------------------------------------


     
    (ii) Under paragraphs (b)(2)(iv)(b) and (b)(2)(iv)(d)(4) of this 
section, C's capital account is credited with the amount paid for 
the option ($1,000) and the exercise price of the option ($15,000). 
Under the LLC agreement, however, C is entitled to LLC capital 
corresponding to 100 units of LLC (\1/3\ of LLC's capital). 
Immediately after the exercise of the option, LLC's properties are 
$16,000 cash ($1,000 option premium and $15,000 exercise price 
contributed by C) and Property B, which has a value of $41,000. 
Thus, the total value of LLC's property is $57,000. C is entitled to 
LLC capital equal to \1/3\ of this amount, or $19,000. As C is 
entitled to $3,000 more LLC capital than C's capital contributions 
to LLC, the provisions of paragraph (b)(2)(iv)(s) of this section 
apply.
    (iii) In lieu of revaluing LLC's property under paragraph 
(b)(2)(iv)(f) of this section immediately before the option is 
exercised, under paragraph (b)(2)(iv)(s)(1) of this section LLC must 
revalue its property under the principles of paragraph (b)(2)(iv)(f) 
of this section immediately after the exercise of the option. Under 
paragraph (b)(2)(iv)(s) of this section, LLC must increase C's 
capital account from $16,000 to $19,000 by, first, revaluing LLC 
property in accordance with the principles of paragraph 
(b)(2)(iv)(f) of this section, and allocating all $1,000 of 
unrealized gain from the revaluation to C under paragraph 
(b)(2)(iv)(s)(2). This brings C's capital account to $17,000.
    (iv) Next, under paragraph (b)(2)(iv)(s)(3) of this section, LLC 
must reallocate $2,000 of capital from the existing partners (A and 
B) to C to bring C's capital account to $19,000 (the capital account 
reallocation). As A and B shared equally in all items from Property 
A, whose sale gave rise to the need for the capital account 
reallocation, each member's capital account is reduced by \1/2\ of 
the $2,000 reduction ($1,000).
    (v) Under paragraph (b)(2)(iv)(s)(4) of this section, beginning 
in the year in which the option is exercised, LLC must make 
corrective allocations so as to take into account the capital 
account reallocation. In Year 3, LLC has gross income of $3,000 and 
deductions of $1,500. Under paragraph (b)(2)(x)(c), LLC must 
allocate the book gross income of $3,000 equally among A, B, and C, 
but for tax purposes, however, LLC must allocate all of its gross 
income ($3,000) to C. LLC's book and tax deductions ($1,500) will 
then be allocated equally among A, B, and C. The $1,000 unrealized 
booked gain in Property B has been allocated entirely to C. Under 
paragraph (b)(2)(iv)(f)(4) of this section, the tax items from 
Property B must be allocated in accordance with section 704(c) 
principles.

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                         A                               B                               C
                                                         -----------------------------------------------------------------------------------------------
                                                                Tax            Book             Tax            Book             Tax            Book
--------------------------------------------------------------------------------------------------------------------------------------------------------
Capital account after exercise..........................         $20,000         $20,000         $20,000         $20,000         $16,000         $16,000
Revaluation.............................................               0               0               0               0               0           1,000
                                                         -----------------------------------------------------------------------------------------------
    Capital account after revaluation...................          20,000          20,000          20,000          20,000          16,000          17,000
Capital account reallocation............................               0         (1,000)               0         (1,000)               0           2,000
                                                         -----------------------------------------------------------------------------------------------
    Capital account after capital account reallocation..          20,000          19,000          20,000          19,000          16,000          19,000
Income allocation (Yr. 3)...............................               0           1,000               0           1,000           3,000           1,000
Deduction allocation (Yr. 3)............................           (500)           (500)           (500)           (500)           (500)           (500)
                                                         -----------------------------------------------------------------------------------------------
    Capital account at end of year 3....................          19,500          19,500          19,500          19,500          18,500          19,500
--------------------------------------------------------------------------------------------------------------------------------------------------------

    Example 33. (i) In Year 1, D and E each contribute cash of 
$10,000 to LLC, a newly formed limited liability company classified 
as a partnership for Federal tax purposes, in exchange for 100 units 
in LLC. Under the LLC agreement, each unit is entitled to 
participate equally in the profits and losses of LLC. LLC uses the 
cash contributions to purchase two nondepreciable properties, 
Property A and Property B, for $10,000 each. Also in Year 1, at a 
time when Property A and Property B are still valued at $10,000 
each, LLC issues an option to F. The option allows F to buy 100 
units in LLC for an exercise price of $15,000 in Year 2. F pays 
$2,000 to LLC to purchase the option. Assume that the LLC agreement 
satisfies the requirements of paragraph (b)(2) of this section and 
requires that, on the exercise of a noncompensatory option, LLC 
comply with the rules of paragraph (b)(2)(iv)(s) of this section. 
Also assume that F's option is a noncompensatory option under Sec.  
1.721-2(f), and that F is not treated as a partner with respect to 
the option.

 
------------------------------------------------------------------------
                                                         Basis    Value
------------------------------------------------------------------------
                              End of Year 1
------------------------------------------------------------------------
Assets:
  Cash................................................
  Premium.............................................   $2,000   $2,000
  Property A..........................................   10,000   10,000
  Property B..........................................   10,000   10,000
                                                       -----------------
    Total.............................................   22,000   22,000
                                                       =================
Liabilities and Capital:
  Cash................................................
  Premium.............................................    2,000    2,000
  D...................................................   10,000   10,000
  E...................................................   10,000   10,000
                                                       -----------------
    Total.............................................   22,000   22,000
------------------------------------------------------------------------

     
    (ii) In year 2, prior to the exercise of F's option, G 
contributes $18,000 to LLC for 100 units in LLC. At the time of G's 
contribution, Property A has a value of $32,000 and a basis of 
$10,000, Property B has a value of $5,000 and a basis of $10,000, 
and the fair market value of F's option is $3,000. In year 2, LLC 
has no item of income, gain, loss, deduction, or credit.
    (iii) Upon G's admission to the partnership, the capital 
accounts of D and E (which were $10,000 each prior to G's admission) 
are, in accordance with paragraph (b)(2)(iv)(f) of this section, 
adjusted upward to reflect their shares of the unrealized 
appreciation in the partnership's property. Property A has $22,000 
of unrealized gain and Property B has $5,000 of unrealized loss. 
Under paragraph (b)(2)(iv)(f)(1) of this section, the adjustments 
must be based on the fair market value of LLC property (taking 
section 7701(g) into account) on the date of the adjustment, as 
determined under paragraph (b)(2)(iv)(h) of this section. The fair 
market value of partnership property must be reduced by the

[[Page 8010]]

excess of the fair market value of the option as of the date of the 
adjustment over the consideration paid by F to acquire the option 
($3,000 -$2,000 = $1,000) (under paragraph (b)(2)(iv)(h)(2) of this 
section), but only to the extent of the unrealized appreciation in 
LLC property that has not been reflected in the capital accounts 
previously ($22,000). This $1,000 reduction is allocated entirely to 
Property A, the only asset having unrealized appreciation not 
reflected in the capital accounts previously. Therefore, the book 
value of Property A is $31,000. Accordingly, the revaluation 
adjustments must reflect only $16,000 of the net appreciation in 
LLC's property ($21,000 of unrealized gain in Property A and $5,000 
of unrealized loss in Property B). Thus, D's and E's capital 
accounts (which were $10,000 each prior to G's admission) must be 
adjusted upward (by $8,000) to $18,000 each. The $21,000 of built-in 
gain in Property A and the $5,000 of built-in loss in Property B 
must be allocated equally between D and E in accordance with section 
704(c) principles.

----------------------------------------------------------------------------------------------------------------
                                                                                      Option
                                                       Basis           Value        adjustment      704(b) Book
----------------------------------------------------------------------------------------------------------------
Assets:
Property A......................................         $10,000         $32,000        ($1,000)         $31,000
Property B......................................          10,000           5,000               0           5,000
Cash............................................           2,000           2,000               0           2,000
                                                 ---------------------------------------------------------------
    Subtotal....................................          22,000          39,000         (1,000)          38,000
Cash Contributed by G...........................          18,000          18,000               0          18,000
                                                 ---------------------------------------------------------------
        Total...................................          40,000          57,000         (1,000)          56,000
----------------------------------------------------------------------------------------------------------------


 
                                                                        Tax            Value        704(b) Book
----------------------------------------------------------------------------------------------------------------
Liabilities and Capital:
Cash Premium (option value).....................................         $ 2,000         $ 3,000         $ 2,000
D...............................................................          10,000          18,000          18,000
E...............................................................          10,000          18,000          18,000
G...............................................................          18,000          18,000          18,000
                                                                 -----------------------------------------------
    Total.......................................................          40,000          57,000          56,000
----------------------------------------------------------------------------------------------------------------

      (iv) In year 2, after the admission of G, when Property A 
still has a value of $32,000 and a basis of $10,000 and Property B 
still has a value of $5,000 and a basis of $10,000, F exercises the 
option. On the exercise of the option, F's capital account is 
credited with the amount paid for the option ($2,000) and the 
exercise price of the option ($15,000). Under the LLC agreement, 
however, F is entitled to LLC capital corresponding to 100 units of 
LLC (1/4 of LLC's capital). Immediately after the exercise of the 
option, LLC's properties are worth $72,000 ($15,000 contributed by 
F, plus the value of LLC property prior to the exercise of the 
option, $57,000). F is entitled to LLC capital equal to 1/4 of this 
value, or $18,000. As F is entitled to $1,000 more LLC capital than 
F's capital contributions to LLC, the provisions of paragraph 
(b)(2)(iv)(s) of this section apply.
    (v) Under paragraph (b)(2)(iv)(s) of this section, LLC must 
increase F's capital account from $17,000 to $18,000 by, first, 
revaluing LLC property in accordance with the principles of 
paragraph (b)(2)(iv)(f) of this section and allocating the first 
$1,000 of unrealized gain to F. The total unrealized gain which has 
not been reflected in the capital accounts previously is $1,000 (the 
difference between the actual value of Property A, $32,000, and the 
book value of Property A, $31,000). The entire $1,000 of book gain 
is allocated to F under paragraph (b)(2)(iv)(s)(2) of this section. 
Because the revaluation of LLC property under paragraph 
(b)(2)(iv)(s)(2) of this section increases F's capital account to 
the amount agreed on by the members, LLC is not required to make a 
capital account reallocation under paragraph (b)(2)(iv)(s)(3) of 
this section. The ($5,000) of unrealized booked loss in Property B 
has been allocated ($2,500) to each D and E, and the $22,000 of 
unrealized booked gain in Property A has been allocated $10,500 to 
each D and E, and $1,000 to F. Under paragraph (b)(2)(iv)(f)(4) of 
this section, the tax items from Properties A and B must be 
allocated in accordance with section 704(c) principles.

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                              D                         E                         G                         F
                                                 -------------------------------------------------------------------------------------------------------
                                                      Tax          Book         Tax          Book         Tax          Book         Tax          Book
--------------------------------------------------------------------------------------------------------------------------------------------------------
Capital account after admission of G............      $10,000      $18,000      $10,000      $18,000      $18,000      $18,000            0            0
Capital account after exercise of F's option....       10,000       18,000       10,000       18,000       18,000       18,000       17,000       17,000
Revaluation.....................................            0            0            0            0            0            0            0        1,000
                                                 -------------------------------------------------------------------------------------------------------
    Capital account after revaluation...........       10,000       18,000       10,000       18,000       18,000       18,000       17,000       18,000
--------------------------------------------------------------------------------------------------------------------------------------------------------

    Example 34. (i) On the first day of Year 1, H, I, and J form 
LLC, a limited liability company classified as a partnership for 
Federal tax purposes. H and I each contribute $10,000 cash to LLC 
for 100 units of common interest in LLC. J contributes $10,000 cash 
for a convertible preferred interest in LLC. J's convertible 
preferred interest entitles J to receive an annual allocation and 
distribution of cumulative LLC net profits in an amount equal to 10 
percent of J's unreturned capital. J's convertible preferred 
interest also entitles J to convert, in Year 3, J's preferred 
interest into 100 units of common interest. If J converts, J has the 
right to the same share of LLC capital as J would have had if J had 
held the 100 units of common interest since the formation of LLC. 
Under the LLC agreement, each unit of common interest has an equal 
right to share in any LLC net profits that remain after payment of 
the preferred return. Assume that the LLC agreement satisfies the 
requirements of paragraph (b)(2) of this section and requires that, 
on the exercise of a noncompensatory option, LLC comply with the 
rules of paragraph (b)(2)(iv)(s) of this section. Also assume that 
J's right to convert the preferred interest into a common interest 
qualifies as a noncompensatory option under Sec.  1.721-2(f), and 
that, prior to the exercise of

[[Page 8011]]

the conversion right, the conversion right is not treated as a 
partnership interest.
    (ii) LLC uses the $30,000 to purchase Property Z, a property 
that is depreciable on a straight-line basis over 15 years. In each 
of Years 1 and 2, LLC has net income of $2,500, comprised of $4,500 
of gross income and $2,000 of depreciation. It allocates $1,000 of 
net income to J and distributes $1,000 to J in each year. LLC 
allocates the remaining $1,500 of net income equally to H and I in 
each year but makes no distributions to H and I.

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                         H                               I                               J
                                                         -----------------------------------------------------------------------------------------------
                                                                Tax            Book             Tax            Book             Tax            Book
--------------------------------------------------------------------------------------------------------------------------------------------------------
Capital account upon formation..........................         $10,000         $10,000         $10,000         $10,000         $10,000         $10,000
Allocation of income Years 1 and 2......................           1,500           1,500           1,500           1,500           2,000           2,000
Distributions Years 1 and 2.............................               0               0               0               0         (2,000)         (2,000)
                                                         -----------------------------------------------------------------------------------------------
Capital account at end of Year 2........................          11,500          11,500          11,500          11,500          10,000          10,000
--------------------------------------------------------------------------------------------------------------------------------------------------------

     (iii) At the beginning of Year 3, when Property Z has a value 
of $38,000 and a basis of $26,000 ($30,000 original basis less 
$4,000 of depreciation) and LLC has accumulated undistributed cash 
of $7,000 ($9,000 gross receipts less $2,000 distributions), J 
converts J's preferred interest into a common interest. Under 
paragraphs (b)(2)(iv)(b) and (b)(2)(iv)(d)(4) of this section, J's 
capital account after the conversion equals J's capital account 
before the conversion, $10,000. On the conversion of the preferred 
interest, however, J is entitled to LLC capital corresponding to 100 
units of common interest in LLC (\1/3\ of LLC's capital). At the 
time of the conversion, the total value of LLC property is $45,000. 
J is entitled to LLC capital equal to \1/3\ of this value, or 
$15,000. As J is entitled to $5,000 more LLC capital than J's 
capital account immediately after the conversion, the provisions of 
paragraph (b)(2)(iv)(s) of this section apply.

 
------------------------------------------------------------------------
                                                      Basis      Value
------------------------------------------------------------------------
Assets:
Property Z........................................    $26,000    $38,000
Undistributed Income..............................      7,000      7,000
                                                   ---------------------
    Total.........................................     33,000     45,000
                                                   =====================
Liabilities and Capital:
H.................................................     11,500     15,000
I.................................................     11,500     15,000
J.................................................     10,500     15,000
                                                   ---------------------
    Total.........................................     33,000     45,000
                                                   =====================
------------------------------------------------------------------------

     (iv) Under paragraph (b)(2)(iv)(s) of this section, LLC must 
increase J's capital account from $10,000 to $15,000 by, first, 
revaluing LLC property in accordance with the principles of 
paragraph (b)(2)(iv)(f) of this section, and allocating the first 
$5,000 of unrealized gain from that revaluation to J. The unrealized 
gain in Property Z is $12,000 ($38,000 value less $26,000 basis). 
The first $5,000 of this unrealized gain must be allocated to J 
under paragraph (b)(2)(iv)(s)(2) of this section. The remaining 
$7,000 of the unrealized gain must be allocated equally to H and I 
in accordance with the LLC agreement. Because the revaluation of LLC 
property under paragraph (b)(2)(iv)(s)(2) of this section increases 
J's capital account to the amount agreed on by the members, LLC is 
not required to make a capital account reallocation under paragraph 
(b)(2)(iv)(s)(3) of this section. The $12,000 of unrealized booked 
gain in Property Z has been allocated $3,500 to each H and I, and 
$5,000 to J. Under paragraph (b)(2)(iv)(f)(4) of this section, the 
tax items from the revalued property must be allocated in accordance 
with section 704(c) principles.

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                         H                               I                               J
                                                         -----------------------------------------------------------------------------------------------
                                                                Tax            Book             Tax            Book             Tax            Book
--------------------------------------------------------------------------------------------------------------------------------------------------------
Capital account prior to conversion.....................         $11,500         $11,500         $11,500         $11,500         $10,000         $10,000
Revaluation on conversion...............................               0           3,500               0           3,500               0           5,000
                                                         -----------------------------------------------------------------------------------------------
    Capital account after conversion....................          11,500          15,000          11,500          15,000          10,000          15,000
--------------------------------------------------------------------------------------------------------------------------------------------------------

    Example 35. (i) On the first day of Year 1, K and L each 
contribute cash of $10,000 to LLC, a newly formed limited liability 
company classified as a partnership for Federal tax purposes, in 
exchange for 100 units in LLC. Immediately after its formation, LLC 
borrows $10,000 from M. Under the terms of the debt instrument, 
interest of $1,000 is unconditionally payable at the end of each 
year and the $10,000 stated principal is repayable in five years. 
Throughout the term of the indebtedness, M has the right to convert 
the debt instrument into 100 units in LLC. If M converts, M has the 
right to the same share of LLC capital as M would have had if M had 
held 100 units in LLC since the formation of LLC. Under the LLC 
agreement, each unit participates equally in the profits and losses 
of LLC and has an equal right to share in LLC capital. Assume that 
the LLC agreement satisfies the requirements of paragraph (b)(2) of 
this section and requires that, on the exercise of a noncompensatory 
option, LLC comply with the rules of paragraph (b)(2)(iv)(s) of this 
section. Also assume that M's right to convert the debt into an 
interest in LLC qualifies as a noncompensatory option under Sec.  
1.721-2(f), and that, prior to the exercise of the conversion right, 
M is not treated as a partner with respect to the convertible debt.
    (ii) LLC uses the $30,000 to purchase Property D, property that 
is depreciable on a straight-line basis over 15 years. In each of 
Years 1, 2, and 3, LLC has net income of $2,000, comprised of $5,000 
of gross income, $2,000 of depreciation, and interest expense 
(representing payments of interest on the loan from M) of $1,000. 
LLC allocates this income equally to K and L but makes no 
distributions to either K or L.

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                         K                               L                               M
                                                         -----------------------------------------------------------------------------------------------
                                                                Tax            Book             Tax            Book             Tax            Book
--------------------------------------------------------------------------------------------------------------------------------------------------------
Initial capital account.................................         $10,000         $10,000         $10,000         $10,000               0               0
Year 1 net income.......................................           1,000           1,000           1,000           1,000               0               0
Years 2 net income......................................           1,000           1,000           1,000           1,000               0               0
Years 3 net income......................................           1,000           1,000           1,000           1,000               0               0
                                                         -----------------------------------------------------------------------------------------------

[[Page 8012]]

 
    Year 4 initial capital account......................          13,000          13,000          13,000          13,000               0               0
--------------------------------------------------------------------------------------------------------------------------------------------------------

      (iii) At the beginning of year 4, at a time when Property D, 
LLC's only asset, has a value of $33,000 and basis of $24,000 
($30,000 original basis less $6,000 depreciation in Years 1 through 
3), and LLC has accumulated undistributed cash of $12,000 ($15,000 
gross income less $3,000 of interest payments) in LLC, M converts 
the debt into a \1/3\ interest in LLC. Under paragraphs 
(b)(2)(iv)(b) and (b)(2)(iv)(d)(4) of this section, M's capital 
account after the conversion is the adjusted issue price of the debt 
immediately before M's conversion of the debt, $10,000, plus any 
accrued but unpaid qualified stated interest on the debt, $0. On the 
conversion of the debt, however, M is entitled to receive LLC 
capital corresponding to 100 units of LLC (\1/3\ of LLC's capital). 
At the time of the conversion, the total value of LLC's property is 
$45,000. M is entitled to LLC capital equal to \1/3\ of this value, 
or $15,000. As M is entitled to $5,000 more LLC capital than M's 
capital contribution to LLC ($10,000), the provisions of paragraph 
(b)(2)(iv)(s) of this section apply.

------------------------------------------------------------------------
                                          Basis              Value
------------------------------------------------------------------------
Assets: Liabilities and Capital
  Property D......................            $24,000            $33,000
  Cash............................             12,000             12,000
                                   -------------------------------------
    Total.........................             36,000             45,000
                                   =====================================
Liabilities and Capital:
  K...............................            $13,000            $15,000
  L...............................             13,000             15,000
  M...............................             10,000             15,000
                                   -------------------------------------
    Total.........................             36,000             45,000
------------------------------------------------------------------------

     
    (iv) Under paragraph (b)(2)(iv)(s) of this section, LLC must 
increase M's capital account from $10,000 to $15,000 by, first, 
revaluing LLC property in accordance with the principles of 
paragraph (b)(2)(iv)(f) of this section, and allocating the first 
$5,000 of unrealized gain from that revaluation to M. The unrealized 
gain in Property D is $9,000 ($33,000 value less $24,000 basis). The 
first $5,000 of this unrealized gain must be allocated to M under 
paragraph (b)(2)(iv)(s)(2) of this section, and the remaining $4,000 
of the unrealized gain must be allocated equally to K and L in 
accordance with the LLC agreement. Because the revaluation of LLC 
property under paragraph (b)(2)(iv)(s)(2) of this section increases 
M's capital account to the amount agreed upon by the members, LLC is 
not required to make a capital account reallocation under paragraph 
(b)(2)(iv)(s)(3) of this section. The $9,000 unrealized booked gain 
in property D has been allocated $2,000 to each K and L, and $5,000 
to M. Under paragraph (b)(2)(iv)(f)(4) of this section, the tax 
items from the revalued property must be allocated in accordance 
with section 704(c) principles.

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                         K                               L                               M
                                                         -----------------------------------------------------------------------------------------------
                                                                Tax            Book             Tax            Book             Tax            Book
--------------------------------------------------------------------------------------------------------------------------------------------------------
Year 4 capital account prior to exercise................         $13,000         $13,000         $13,000         $13,000               0               0
Capital account after exercise..........................          13,000          13,000          13,000          13,000          10,000          10,000
Revaluation.............................................               0           2,000               0           2,000               0           5,000
                                                         -----------------------------------------------------------------------------------------------
    Capital account after revaluation...................          13,000          15,000          13,000          15,000          10,000          15,000
--------------------------------------------------------------------------------------------------------------------------------------------------------


0
Par. 4. Section 1.704-3 is amended by revising the first sentence of 
paragraph (a)(6)(i) to read as follows:


Sec.  1.704-3  Contributed property.

    (a) * * *
    (6) * * *
    (i) * * * The principles of this section apply to allocations with 
respect to property for which differences between book value and 
adjusted tax basis are created when a partnership revalues partnership 
property pursuant to Sec.  1.704-1(b)(2)(iv)(f) or 1.704-1(b)(2)(iv)(s) 
(reverse section 704(c) allocations). * * *
* * * * *

0
Par. 5. Section 1.721-2 is added to read as follows:


Sec.  1.721-2  Noncompensatory options.

    (a) Exercise of a noncompensatory option--(1) In general. 
Notwithstanding Sec.  1.721-1(b)(1), section 721 applies to the 
exercise (as defined in paragraph (g)(4) of this section) of a 
noncompensatory option (as defined in paragraph (f) of this section). 
Except as provided in paragraph (a)(2) of this section, section 721 
applies to the exercise of a noncompensatory option when the holder 
pays the exercise price with either property or cash, regardless of 
whether the terms of the option require or permit cash payment. 
However, if the exercise price (as defined in paragraph (g)(5) of this 
section) of a noncompensatory option exceeds the capital account 
received by the option holder on the exercise of the option, then 
general tax principles will apply to determine the tax consequences of 
the transaction.
    (2) Exception. Section 721 does not apply to the exercise of a 
noncompensatory option to the extent that the exercise price is 
satisfied with the partnership's obligation to the option holder for 
unpaid rent, royalties, or interest (including accrued original issue 
discount) that accrued on or after the beginning of the option holder's 
holding period for the obligation. The issuing partnership will not 
recognize gain or loss upon the transfer of a partnership interest to 
an exercising option holder in satisfaction of such unpaid rent, 
royalties, or interest (including accrued original issue discount).

[[Page 8013]]

    (b) Transfer of property or satisfaction of an obligation in 
exchange for a noncompensatory option--(1) In general. Except as 
provided in paragraph (b)(2) of this section, section 721 does not 
apply to a transfer of property to a partnership in exchange for a 
noncompensatory option, or to the satisfaction of a partnership 
obligation with a noncompensatory option.
    (2) Exception. Section 721 does apply to a transfer of property to 
a partnership in exchange for convertible equity (as defined in 
paragraph (g)(3) of this section).
    (c) Lapse of a noncompensatory option. Section 721 does not apply 
to the lapse of a noncompensatory option.
    (d) Cash settlement of a noncompensatory option. Section 721 does 
not apply to the settlement of a noncompensatory option in cash or 
property other than a partnership interest in the issuing partnership.
    (e) Issuance of a partnership interest in satisfaction of 
indebtedness for interest on convertible debt. Section 721 does not 
apply to the transfer of a partnership interest to a noncompensatory 
option holder upon conversion of convertible debt in the partnership to 
the extent that the transfer is in satisfaction of the partnership's 
indebtedness for unpaid interest (including accrued original issue 
discount) on the convertible debt that accrued on or after the 
beginning of the convertible debt holder's holding period for the 
indebtedness. The debtor partnership will not, however, recognize gain 
or loss upon such conversion. For rules in determining whether a 
partnership interest transferred to a creditor is treated as payment of 
interest or accrued original issue discount, see Sec. Sec.  1.446-2 and 
1.1275-2, respectively.
    (f) Scope. The provisions of this section apply only to 
noncompensatory options. For purposes of this section, the term 
noncompensatory option means an option (as defined in paragraph (g)(1) 
of this section) issued by a partnership (the issuing partnership), 
other than an option issued in connection with the performance of 
services.
    (g) Definitions. The following definitions apply for the purposes 
of this section:
    (1) Option means a contractual right to acquire an interest in the 
issuing partnership, including a call option, warrant, or other similar 
arrangement, the conversion feature of convertible debt (as defined in 
paragraph (g)(2) of this section), or the conversion feature of 
convertible equity (as defined in paragraph (g)(3) of this section). To 
achieve the purposes of this section, the Commissioner can treat other 
contractual agreements, including a futures contract, a forward 
contract, or a notional principal contract, as an option. A contract 
that otherwise constitutes an option will not fail to be treated as an 
option for purposes of this section merely because it may or must be 
settled in cash or property other than a partnership interest.
    (2) Convertible debt is any indebtedness of a partnership that is 
convertible into an interest in the partnership that issued the debt.
    (3) Convertible equity is equity in a partnership that is 
convertible into a different equity interest in the partnership that 
issued the convertible equity.
    (4) Exercise means the exercise of an option in exchange for an 
interest in the issuing partnership or the conversion of convertible 
debt or convertible equity into an interest in the issuing partnership.
    (5) Exercise price means, in the case of a call option, the 
exercise price of the call option; in the case of convertible equity, 
the converting partner's capital account with respect to that 
convertible equity, increased by the fair market value of cash or other 
property contributed to the partnership in connection with the 
conversion; and, in the case of convertible debt, the adjusted issue 
price (within the meaning of Sec.  1.1275-1(b)) of the debt converted, 
increased by accrued but unpaid qualified stated interest on the debt 
and by the fair market value of cash or other property contributed to 
the partnership in connection with the conversion.
    (h) Example. The following example illustrates the provisions of 
this section:

    Example. In Year 1, L and M form general partnership LM with 
cash contributions of $5,000 each, which are used to purchase land, 
Property D, for $10,000. In that same year, LM issues an option to N 
to buy a one-third interest in LM at any time before the end of Year 
3. The exercise price of the option is $5,000, payable in either 
cash or property. N transfers Property E with a basis of $600 and a 
value of $1,000 to the partnership in exchange for the option. N 
provides no other consideration for the option. Assume that N's 
option is a noncompensatory option under paragraph (f) of this 
section and that N is not treated as a partner with respect to the 
option. Under paragraph (b) of this section, section 721(a) does not 
apply to N's transfer of Property E to LM in exchange for the 
option. In accordance with Sec.  1.1001-1, upon N's transfer of 
Property E to the partnership in exchange for the option, N 
recognizes $400 of gain. Under open transaction principles 
applicable to noncompensatory options, the partnership does not 
recognize any income for the premium (the property received in 
exchange for the option). The partnership has a basis of $1,000 in 
Property E. In Year 3, when the partnership property is valued at 
$16,000, N exercises the option, contributing Property F with a 
basis of $3,000 and a fair market value of $5,000 to the 
partnership. Under paragraph (a) of this section, neither the 
partnership nor N recognizes gain upon N's contribution of property 
to the partnership upon the exercise of the option. Under section 
723, the partnership has a basis of $3,000 in Property F. The 
partnership does not recognize income for the premium (Property E) 
upon exercise of the option. See Sec.  1.704-1(b)(2)(iv)(d)(4) and 
(s) for special rules applicable to capital account adjustments on 
the exercise of a noncompensatory option.

    (i) Effective/applicability date. This section applies to 
noncompensatory options that are issued on or after February 5, 2013.

0
Par. 6. Section 1.761-3 is added to read as follows:


Sec.  1.761-3  Certain option holders treated as partners.

    (a) Noncompensatory option treated as a partnership interest--(1) 
General rule. A noncompensatory option (as defined in paragraph (b)(2) 
of this section) is treated as a partnership interest for all Federal 
tax purposes if, on the date of a measurement event (as defined in 
paragraph (c) of this section) with respect to the option--
    (i) The noncompensatory option (and any agreements associated with 
it) provides the option holder with rights that are substantially 
similar to the rights afforded a partner (as determined under paragraph 
(d) of this section); and
    (ii) There is a strong likelihood that the failure to treat the 
holder of the noncompensatory option as a partner would result in a 
substantial reduction in the present value of the partners' and 
noncompensatory option holder's aggregate Federal tax liabilities (as 
determined under paragraph (e) of this section).
    (2) Continuing applicability of general principles of law. The fact 
that an option is not treated as a partnership interest under this 
section does not prevent the option from being treated as a partnership 
interest under general principles of Federal tax law.
    (3) Timing of characterization. If a noncompensatory option is 
treated under this section as a partnership interest, that treatment 
applies, as the case may be, upon the issuance of the option, or 
immediately before any other measurement event that gave rise to the 
characterization under paragraph (a)(1) of this section.
    (4) Effect of characterization. If a noncompensatory option is 
treated as a partnership interest under this section

[[Page 8014]]

or under general principles of law, the option holder will be treated 
as a partner with respect to the partnership interest and will receive 
a distributive share of the partnership's income, gain, loss, 
deduction, or credit (or items thereof), as determined in accordance 
with that partner's interest in the partnership (taking into account 
all facts and circumstances) in accordance with Sec.  1.704-1(b)(3). 
Once a noncompensatory option is treated as a partnership interest, in 
no event may it be characterized as an option thereafter.
    (b) Definitions. For purposes of this section:
    (1) Look-through entity. Look-through entity means an entity 
described in Sec.  1.704-1(b)(2)(iii)(d)(2).
    (2) Noncompensatory option. Noncompensatory option means an option 
(as defined in paragraph (b)(3) of this section) issued by a 
partnership, other than an option issued in connection with the 
performance of services. For purposes of applying this section, an 
option that would be a noncompensatory option under this paragraph if 
it had been issued by a partnership is a noncompensatory option if the 
option was issued by an eligible entity (as defined in Sec.  301.7701-
3(a)) that would become a partnership under Sec.  301.7701-3(f)(2) if 
the noncompensatory option holder were treated as a partner. Also for 
purposes of applying this section, if a noncompensatory option is 
issued by such an eligible entity, then the eligible entity is treated 
as a partnership.
    (3) Option. An option is a contractual right to acquire an interest 
in the issuing partnership, including a call option, warrant, or other 
similar arrangement. In addition, an option includes convertible debt 
(as defined in Sec.  1.721-(g)(2)) and convertible equity (as defined 
in Sec.  1.721-(g)(3)). To achieve the purposes of this section, the 
Commissioner can treat other contractual agreements, including a 
forward contract, a futures contract, or a notional principal contract, 
as an option. A contract that otherwise constitutes an option will not 
fail to be treated as an option for purposes of this section merely 
because it may or must be settled in cash or property other than a 
partnership interest.
    (4) Underlying partnership interest. Underlying partnership 
interest means the interest in the issuing partnership that would be 
acquired by the noncompensatory option holder upon exercise of the 
noncompensatory option.
    (c) Measurement event--(1) General rule. Except as provided in 
paragraph (c)(2) of this section, a measurement event with respect to a 
noncompensatory option is any of the following events:
    (i) Issuance of the noncompensatory option;
    (ii) An adjustment of the terms (modification) of the 
noncompensatory option or of the underlying partnership interest (as 
defined in paragraph (b)(4) of this section) (including an adjustment 
pursuant to the terms of the noncompensatory option or the underlying 
partnership interest);
    (iii) Transfer of the noncompensatory option if either:
    (A) The option may be exercised (or settled) more than 12 months 
after its issuance, or
    (B) The transfer is pursuant to a plan in existence at the time of 
the issuance or modification of the noncompensatory option that has as 
a principal purpose the substantial reduction of the present value of 
the aggregate Federal tax liabilities of the partners and the 
noncompensatory option holder (under paragraph (a)(1)(ii) of this 
section);
    (2) Events not treated as measurement events. A measurement event 
does not include the following events:
    (i) A transfer of the noncompensatory option at death, between 
spouses or former spouses under section 1041, or in a transaction that 
is disregarded for Federal tax purposes;
    (ii) A modification that neither materially increases the 
likelihood that the noncompensatory option will be exercised (as 
described in paragraph (d)(2) of this section) nor provides the 
noncompensatory option holder with partner attributes (as described in 
paragraph (d)(3) of this section);
    (iii) A change in the strike price of a noncompensatory option or 
in the interests in the issuing partnership that may be issued or 
transferred pursuant to the noncompensatory option, made pursuant to a 
bona fide, reasonable adjustment formula that has the intended effect 
of preventing dilution of the interests of the noncompensatory option 
holder;
    (iv) Any other event as provided in guidance published in the 
Internal Revenue Bulletin.
    (d) Rights substantially similar to partner rights--(1) In general. 
A noncompensatory option provides the holder with rights that 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.
    (2) Reasonable certainty of exercise--(i) General rule. The 
determination of whether a noncompensatory option is reasonably certain 
to be exercised at the time of a measurement event is based on all the 
facts and circumstances, including--
    (A) The fair market value of the partnership interest that is the 
subject of the noncompensatory option;
    (B) The strike price of the noncompensatory option;
    (C) The term of the noncompensatory option;
    (D) The volatility of the value or income of the issuing 
partnership or the underlying partnership interest;
    (E) Anticipated distributions by the partnership during the term of 
the noncompensatory option;
    (F) Any other special option features, such as a strike price that 
fluctuates;
    (G) The existence of related options, including reciprocal options; 
and
    (H) Any other arrangements affecting or undertaken with a principal 
purpose of affecting the likelihood that the noncompensatory option 
will be exercised.
    (ii) Safe harbors--(A) General rule. Except as provided in 
paragraph (d)(2)(ii)(C) of this section, a noncompensatory option is 
not considered reasonably certain to be exercised if, as of the date of 
a measurement event with respect to the noncompensatory option--
    (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; or
    (2) The terms of the option provide that the strike price of the 
option is equal to or greater than the fair market value of the 
underlying partnership interest on the exercise date.
    (B) Options exercisable at fair market value. For purposes of 
paragraph (d)(2)(ii)(A) of this section, an option whose strike price 
is determined by a formula is considered to have a strike price equal 
to or greater than the fair market value of the underlying partnership 
interest on the exercise date if the formula is agreed upon by the 
parties when the option is issued in a bona fide attempt to arrive at 
the fair market value on the exercise date and is to be applied based 
on the facts and circumstances in existence on the exercise date.
    (C) Exception. The safe harbors of paragraph (d)(2)(ii)(A) of this 
section do not apply if the parties to the noncompensatory option had a 
principal purpose described in paragraph (c)(1)(iii)(B) of this section 
with respect to a measurement event for that option (or, if multiple 
options were issued pursuant to a plan, a

[[Page 8015]]

measurement event with respect to any option issued pursuant to that 
plan).
    (D) Failure to satisfy safe harbor. Failure of an option to satisfy 
one of the safe harbors of paragraph (d)(2)(ii)(A) does not affect the 
determination of whether an option is treated as reasonably certain to 
be exercised.
    (3) Partner attributes--(i) General rule. The determination of 
whether a holder of a noncompensatory option possesses partner 
attributes is based on all the facts and circumstances, including 
whether the option holder, directly or indirectly, through the option 
agreement or a related agreement, is provided with voting rights or 
managerial rights in the partnership.
    (ii) Certain factors that conclusively establish partner 
attributes. For purposes of this section, a noncompensatory option 
holder has partner attributes if, based on all the facts and 
circumstances--
    (A) The option holder is provided with rights (through the option 
agreement or a related agreement) that are similar to rights ordinarily 
afforded to a partner to participate in partnership profits through 
present possessory rights to share in current operating or liquidating 
distributions with respect to the underlying partnership interests; or
    (B) The option holder, directly or indirectly, undertakes 
obligations (through the option agreement or a related agreement) that 
are similar to obligations undertaken by a partner to bear partnership 
losses.
    (iii) Special rules. The following rules apply for purposes of 
paragraphs (d)(3)(i) and (d)(3)(ii) of this section:
    (A) Rights in the issuing partnership possessed by a 
noncompensatory option holder solely by virtue of owning an interest in 
the issuing partnership are not taken into account, provided that those 
rights are no greater than the rights granted to other partners owning 
substantially similar interests in the partnership and who do not hold 
noncompensatory options in the partnership.
    (B) If all of the partners owning substantially similar interests 
in the issuing partnership also hold noncompensatory options in the 
partnership, or if none of the other partners owns substantially 
similar interests in the partnership, then all facts and circumstances 
will be considered in determining whether the rights in the partnership 
possessed by the option holder are possessed solely by virtue of owning 
a partnership interest. If those rights are possessed solely by virtue 
of owning a partnership interest, they are not taken into account.
    (C) A noncompensatory option holder will not ordinarily be 
considered to possess partner attributes solely because the 
noncompensatory option agreement significantly controls or restricts, 
or the noncompensatory option holder has the ability to significantly 
control or restrict, a partnership decision that could substantially 
affect the value of the underlying partnership interest. In particular, 
the following abilities of the option holder will not be treated as 
partner attributes:
    (1) The ability to impose reasonable restrictions on partnership 
distributions or dilutive issuances of partnership equity or options 
while the noncompensatory option is outstanding.
    (2) The ability to choose the partnership's section 704(c) method 
for partnership properties.
    (D) When the applicable measurement event is a transfer described 
in paragraph (c)(1) of this section, the partner attributes of the 
transferee, not the transferor, are taken into account.
    (E) The option holder will be treated as owning all partnership 
interests and noncompensatory options issued by the partnership that 
are owned by any person related to the option holder. For purposes of 
the preceding sentence, a person related to the option holder is 
defined as any person bearing a relationship to the option holder 
described in section 267(b) or 707(b).
    (e) Substantial tax reduction requirement--(1) General rule. The 
determination of whether there is a strong likelihood that the failure 
to treat a noncompensatory option holder as a partner would result in a 
substantial reduction in the present value of the partners' and the 
noncompensatory option holder's aggregate Federal tax liabilities is 
based on all the facts and circumstances, including--
    (i) The interaction of the allocations of the issuing partnership 
and the partners' and noncompensatory option holder's Federal tax 
attributes (taking into account tax consequences that result from the 
interaction of the allocations with the partners' and noncompensatory 
option holder's Federal tax attributes that are unrelated to the 
partnership);
    (ii) The absolute amount of the Federal tax reduction;
    (iii) The amount of the reduction relative to overall Federal tax 
liability; and
    (iv) The timing of items of income and deductions.
    (2) Special rules. For purposes of applying paragraph (e)(1) of 
this section to a partner or noncompensatory option holder that is--
    (i) A look-through entity (as defined in paragraph (b)(1) of this 
section), the Federal tax consequences that result from the interaction 
of allocations of the partnership and the Federal tax attributes of any 
person that is an owner, or in the case of a trust or estate, the 
beneficiary, of an interest in such a partner or noncompensatory option 
holder, whether directly, or indirectly through one or more look-
through entities, must be taken into account; or
    (ii) A member of a consolidated group (within the meaning of Sec.  
1.1502-1(h)), the tax consequences that result from the interaction of 
the issuing partnership's allocations and the tax attributes of the 
consolidated group and the tax attributes of another member with 
respect to a separate return year must be taken into account.
    (f) Examples. The following examples illustrate the provisions of 
this section. For purposes of all examples, assume that PRS is a 
partnership for Federal tax purposes, none of the noncompensatory 
option holders or partners are related persons, and that general 
principles of law do not apply to treat the noncompensatory option as a 
partnership interest. The examples read as follows:

    Example 1. Active trade or business. PRS is engaged in an active 
real estate business, the amount of income, gain, loss, and 
deductions from which cannot be predicted with any reasonable 
certainty. In exchange for a premium of $100x, PRS issues a 
noncompensatory option to A to acquire a 10 percent interest in PRS 
for $110x at any time during a 3-year period commencing on the date 
on which the option is issued. At the time of the issuance of the 
noncompensatory option, a 10 percent interest in PRS has a fair 
market value of $100x. Due to the nature of PRS's business, the 
value of a 10 percent PRS interest in 3 years is not reasonably 
predictable as of the time the noncompensatory option is issued. 
Assuming there are no other facts affecting the certainty of the 
option's exercise, it is not reasonably certain that A's option will 
be exercised. Therefore, assuming that A does not possess partner 
attributes as described in paragraph (d)(3) of this section, A's 
noncompensatory option is not treated as a partnership interest 
under paragraph (a)(1) of this section.

    (g) Effective/applicability date. This section applies to 
noncompensatory options issued on or after February 5, 2013.

0
Par. 7. Section 1.1272-1 is amended by adding a sentence at the end of 
paragraph (e) to read as follows:


Sec.  1.1272-1  Current inclusion of OID in income.

* * * * *
    (e) * * * For debt instruments issued on or after February 5, 2013, 
the term stock in the preceding sentence means an equity interest in 
any entity that is

[[Page 8016]]

classified, for Federal tax purposes, as either a partnership or a 
corporation.
* * * * *
0
Par. 8. Section 1.1273-2 is amended by adding a sentence at the end of 
paragraph (j) to read as follows:


Sec.  1.1273-2  Determination of issue price and issue date.

* * * * *
    (j) * * * For debt instruments issued on or after February 5, 2013, 
the term stock in the preceding sentence means an equity interest in 
any entity that is classified, for Federal tax purposes, as either a 
partnership or a corporation.
* * * * *

0
Par. 9. Section 1.1275-4 is amended by adding a sentence at the end of 
paragraph (a)(4) to read as follows:


Sec.  1.1275-4  Contingent payment debt instruments.

    (a) * * *
    (4) * * * For debt instruments issued on or after February 5, 2013, 
the term stock in the preceding sentence means an equity interest in 
any entity that is classified, for Federal tax purposes, as either a 
partnership or a corporation.
* * * * *

Steven T. Miller,
Deputy Commissioner for Services and Enforcement.
    Approved: January 24, 2013.
Mark J. Mazur,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2013-02259 Filed 2-4-13; 8:45 am]
BILLING CODE 4830-01-P