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New Tax Regulation On Noncompensatory Options

21 Mar 2013
The IRS recently issued finalised Treasury Regulation 1.761-3 on the tax treatment of noncompensatory options issued by partnerships in circumstances unrelated to the performance of services. Taxand USA investigates what changes are brought forward by the regulation.

The final regulations continue to apply the standard tax treatment to a noncompensatory option issued by a partnership. Income or loss would not become fixed or determinable until the lapse, exercise, repurchase or termination of the options. Therefore, the issuer does not recognise gain or loss until the arrangement is closed. In the case of the option holder, the purchase would be treated as an investment in an option that would not be taxable or deductible to the holder except in the case where the holder transfers appreciated or depreciated property to purchase the option.

The final regulations were also coupled with additions to the Section 704(b) regulations dealing with capital account maintenance issues for noncompensatory partnership options. The initial capital account of an option holder would equal the consideration paid to the partnership to acquire the option in addition to cash or fair market value of property contributed to the partnership upon option exercise. However, depending on the terms of the option, the holder may be entitled to a capital account that is greater or less than the option holder's initial capital account.

Discover more: New regulation on the tax treatment of noncompensatory options

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Taxand's Take

The final regulations provide some closure and certainty into the tax treatment of noncompensatory options. The overall treatment does not differ significantly from the 2003 proposed regulations and, in most cases, also continues to treat the issuance of a noncompensatory option as a nontaxable event. As a result, partnerships are still able to use noncompensatory options as a tool in obtaining venture capital. However questions about the treatment of noncompensatory options and related complex financial instruments still remain, particularly for investors with warrants and mezzanine debt.

Taxand's Take Author