Income tax laws and regulations may have significant unintended consequences on investors or lenders if non-compensatory options or warrants are issued in connection with a financing transaction. For example, when a partnership (or limited liability company that is treated as a partnership for income tax purposes) issues penny warrants to a lender as a “sweetener” in a financing transaction, these warrants could cause the lender to be considered a partner in the partnership for federal income tax purposes.
Under Treasury Regulation 1.761-3 (issued in 2013), a non-compensatory option holder will be considered a partner in a partnership if both of the following conditions are met:
- The option holder has the rights that are substantially similar to the rights of a partner AND
- There is a strong likelihood that failing 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 federal tax liabilities.
An option holder that is deemed to be a partner will receive its distributive share of the partnership’s income, gains, losses, deductions, and credits. Failure to treat the options holder as a partner could potentially allow the IRS to reallocate the partnership’s activity, and could provide tax exposure to the lender members.
Rights Similar to Owners:
A non-compensatory options holder has rights similar to that of a partner if:
- Either the options holder is reasonably certain to be exercised OR
- The options holder possessed partner attributes.
While determining whether an options holder is reasonably certain to be exercised is based on a variety of facts and circumstances, it should be noted that if the options strike price is less than or equal to the fair market value of the underlying partnership interest, then the investment option would be considered reasonably certain to be exercised. For example, a lender investor that receives penny warrants from a partnership would be deemed to have rights similar to that of a partner because the strike price of the warrants would most likely be less than the fair market value of the underlying partnership interest and therefore reasonably certain to be exercised.
Substantial Tax Reduction:
All facts and circumstances are considered when determining whether treating an options holder as a partner would result in a substantial reduction in the present value of the partners’ and option holder’s aggregate federal tax liabilities. The regulations indicate that the following facts and circumstances are considered:
- Tax attributes of the partnership, partners, and options holders,
- The absolute amount of the federal tax reduction,
- The amount of the tax reduction compared to the overall federal tax liability and
- Timing of income and deduction items.
The Regulations provide no examples of what would be considered a “substantial” reduction.
When determining if a substantial tax reduction has occurred, it is not just the tax attributes of the partnership, partners and options holder that are considered. The tax attributes of the ultimate taxpayer must also be considered. This means that if the options holder or members of the partnership are a pass-through entity then the tax attributes considered must be the attributes of owners of the pass-through entity. These tax attributes may be difficult to determine since this would require tax information from entities and individuals who do not actively participate in the partnership’s operations and who might not want to freely hand over their tax information.
This article touches on the basic factors that are considered when determining if non-compensatory option holders are determined to be partners. Other factors may also play a role in determining whether a particular option or warrant will pass or fail the various tests. We recommend consulting with your tax advisor if you going to consider entering any agreement with a partnership that includes un-exercised options.
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The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.