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IRS Issues Final Regulations on Tax Treatment of Noncompensatory Partnership Options


On February 5, 2013, the IRS issued final regulations on the tax treatment of noncompensatory options and convertible instruments issued by a partnership, effective immediately. The regulations generally allow the tax-free exercise of an option by the partner and partnership. Certain options, however, may cause an option holder to be treated like a partner for all federal tax purposes.

Suggested Action:

Please contact a CohnReznick tax professional to determine how these regulations may affect you or your business.


Generally, the exercise of a “noncompensatory option” will not cause immediate recognition of taxable income or loss by either the issuing partnership or the option holder. A noncompensatory option is an option issued by a partnership, other than an option issued in connection with the performance of services. This could be a call option, a warrant to acquire an interest in the issuing partnership, the conversion feature of convertible debt, or the conversion feature of convertible equity. For example, the exercise of a warrant that gives the holder the right to acquire an interest in the issuing partnership will be tax-free under the new regulations. However, if the partnership issues equity to satisfy any unpaid interest component of convertible debt, tax-free treatment does not apply. Likewise, a cash settled option is treated as a sale or exchange of the option rather than a deemed exercise of the option that receives tax-free treatment.

The final regulations also modify the regulations regarding the maintenance of the partners’ capital accounts and determination of the partners’ distributive share of partnership items. Issuance of a noncompensatory option by a partnership is now a permissible revaluation event.

Finally, the regulations state that an option holder is treated as a partner for all federal tax purposes if a test is met. The test has two requirements:

  • The noncompensatory option gives the option holder rights that are “substantially similar” to an existing partner’s rights. Whether a right is “substantially similar” to a partner’s interest is based on the facts and circumstances of the option.
  • There is a strong likelihood that failure to treat the option holder as a partner would result in a substantial reduction in the existing partners’ and option holder’s income tax liabilities.

These rules do not apply to exercise of options in disregarded entities.


For more information, please visit the CohnReznick website and contact Thomas Nice, Partner, at 301-961-5542 or Brian Newman, Partner, at 860-678-6009.


Circular 230 Notice: In compliance with U.S. Treasury Regulations, the information included herein (or in any attachment) is not intended or written to be used, and it cannot be used, by any taxpayer for the purpose of i) avoiding penalties the IRS and others may impose on the taxpayer or ii) promoting, marketing, or recommending to another party any tax related matters.

This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

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