Attorneys Suggests Tax Treatment for Options to Acquire Partnership Interests

To the extent that the holder of a partnership call option acquires an interest in partnership capital that exceeds the option's exercise price, Castanon says, that portion of the transaction, on exercise of the option, should be tested and taxed under the rules for disguised sales of partnership interests. That result, he says, is consistent with the legislative intent of section 707. Also, he notes, treating the exercise of a partnership call option as, in part, a sale of undivided interests in the assets of only one partnership may not be appropriate for all partnership call options.

[1] Enclosed are comments in response Notice 2000-29 regarding the tax treatment of the exercise of an option to acquire a partnership interest, the exchange of convertible debt for a partnership interest, and the exchange of a preferred interest in a partnership for a common interest in that partnership.

[2] Thank you for your attention in this matter.

[3] If you have any questions or comments regarding the enclosed comments, please contact the undersigned at (415) 983-1853 or castanon_r@pillsburylaw.com.

Respectfully submitted,

COMMENTS IN RESPONSE TO NOTICE 2000-29: PART 1

I. ACKNOWLEDGEMENTS

[4] The principal author of the comments was Richard Castanon. The author gratefully acknowledges substantial contributions by Tim Burns and Julie Divola.

II. SCOPE

[5] The focus of these comments is whether a capital shift can wellresult from the exercise of an option to acquire a partnership ¹ interest (a "partnership call option"), a conversion of a preferred interest in a partnership to a common interest in that partnership, or the conversion of a liability of a partnership into an equity interest in that partnership, and if so, the consequences to the partnership of such capital shifts.

III. OPTIONS TO ACQUIRE A PARTNERSHIP INTEREST

A. INTERESTS WHICH ARE OPTIONS

[6] For Federal tax purposes, an option to acquire property (a "call") is property separate from the property that is subject to the option ("the underlying property"). See Helvering v. San Joaquin Fruit and Investment Co., 297 U.S. 496 (1936); Helvering v. Southwest Consolidated Corp., 315 U.S. 194 (1942); Karl Hope v. Commissioner, 55 T.C. 1020 (1971).

[7] In certain situations, however the holder of the instrument may in substance be the holder of an equity interest. See FSA 19991095 (Aug. 18, 2000) (note and partnership call option issued by partnership to lender constituted partnership interest). See also Elrod v. Commissioner, 87 T.C. 1046, 1068-69 (1986) (grant of option to acquire land amounted to a sale of the land); Rev. Rul. 82-150, 1982-2 C.B. 110 (grant of option to acquire stock amounted to issuance of underlying stock). However, in the context of compensatory options, what little caselaw there is on such recharacterization is not consistent. See Morrison v. Commissioner, 59 T.C. 248, 260 (1972) (disregarding option in part and treating equity as issued on grant); Victorson v. Commissioner, 326 F.2d 264, 266 (2d Cir. 1964) (to the contrary, option respected).

[8] These comments assume that existing judicial doctrines will continue to apply to instruments or arrangements, such as certain deep in the money options, which are substantially equity ownership interests. In our view, it would not be beneficial (if even possible) to provide bright line guidance on this issue because tax products would no doubt be generated to exploit such guidance. These comments address solely instruments which are in substance options for federal income tax purposes.

B. GRANTS OF OPTION TO ACQUIRE PARTNERSHIP INTERESTS

1. OPTIONS NOT GRANTED IN CONNECTION WITH THE PERFORMANCE OF SERVICES

a. TAX CONSEQUENCES OF GRANT

[9] As noted previously, an option or other right to acquire equity is not, itself, equity. See, III.A. In addition, the portion of any premium paid on the grant of an option which is attributable to the "option value" of such option (i.e., the right to participate in appreciation of the underlying partnership interest without significant downside risk over a period of time), would seem to be theoretically incapable of being paid "in exchange" for the interest.

[10] Section 721 applies only to the contribution of property to a partnership in exchange for an interest in the partnership. A person who transfers money or other property to a partnership in exchange for a non-compensatory, partnership call option (regardless of whether the option is ultimately exercised) is not currently exchanging such property for an interest in the partnership. Rather, such person is exchanging such property for an equity security which, upon exercise, permit such an exchange.

[11] Nevertheless, the grant of a partnership call option in exchange for money or other property should not result in the current imposition of tax on either the grantor or the grantee of the option under the general rules applicable to options in other areas of tax law. See Rev. Rul. 78-182, 1978-1 C.B. 265; Rev. Rul. 58-234, 1958-1 C.B. 279, clarified by Rev. Rul. 68-151, 1968-1 C.B. 363. In general, under such authority, the payment of money or other consideration as an option premium (assuming, as noted above, see, supra, III.A., that the instrument is in substance an option) does not result in current income recognition for either the grantor or the grantee. Such recognition is typically deferred until such time as the option is exercised or the transaction is otherwise closed.

[12] It is, of course, permissible to transfer property to a partnership over a period of time and Section 721 should apply to such transfers. See Treas. Reg. Sec. 1.721-1(a); Parker Properties Joint Venture v. Commissioner, T.C. Memo. 1996-283; WILLIAM S. MCKEE, ET AL., FEDERAL TAX'N OF PARTNERSHIPS AND PARTNERS paragraph 4.02[3], 4-16 (3d ed. 1997). For example, a typical investment partnership might require capital contributions over ten or more years.

[13] However, the holder of a partnership call option has no OBLIGATION to transfer money or other property to the partnership. See Koch v. Commissioner, 67 T.C. 71, 82 (1976) (stating that "the clear distinction between an option and a contract of sale is that an option gives a person a right to purchase at a fixed price within a limited time but imposes no obligation on the person to do so, whereas a contract of sale contains mutual and reciprocal obligations, the seller being obligated to sell and the purchaser being obligated to buy[]"). The absence of such an obligation is significant. Admittedly, by a paying a premium for a partnership call option, the grantee acquires a right to participate in appreciation of the underlying partnership interest. Nonetheless, that right is only one factor relevant to determining the existence of a partnership interest. The grantee should not be treated as a partner due to the option until the option is exercised.

[14] Moreover, any deferred contribution approach would require complex rules coordinating the application of Section 721 to a deferred contribution with other provisions of subchapter K. The Treasury Department and the Service acknowledged similar concerns in rejecting a deferred sale approach for purposes of the disguised sale regulations under Section 707(a). See T.D. 8439, 1992-2 C.B. 126, 127 (preamble to the final regulations) (stating that if a deferred sale approach were adopted "rules would have to be provided to coordinate with other provisions of subchapter K, including the distribution provisions of section 731 and section 733, the basis adjustment provisions of section 734, and the provisions relating to disproportionate distributions of section 751 assets[]").

[15] For instance, if a person contributes appreciated property to a partnership in exchange for a partnership interest and the partnership transfers the property in a taxable disposition, Section 704(c)(1)(B) may require that the partnership allocate the contributor certain income or gain upon disposition of the property. Assume a person (who may or may not be a partner) transfers appreciated property to the partnership in exchange for a partnership call option. If the partnership sells the property in prior to exercise of the option, it is not clear that Section 704(c)(1)(A) could necessarily allocate any income or gain from the disposition to that person. After all, at the time one might expect Section 704(c)(1)(A) to allocate the person tax items arising from the disposition, the property is not Section 704(c) property ² and the person may not even be a partner. Similar problems might arise in the operation of Sections 704(c)(1)(B) (distributions of property paid as option premium), 737 (distributions of property to the grantee of a partnership call option), and 751(b) (Section 751 inventory items or unrealized receivables paid as option premium and distributed pro rata to partners before exercise).

[16] Admittedly, providing sale or exchange treatment for a premium paid to acquire a partnership interest would allow the grantee to recognize losses by paying such a premium in the form of property with unrealized depreciation. However, it may be appropriate to allow such loss recognition. Initially, the disguised sale provisions included a provision that would have restricted the ability of a person to recognize losses by transferring property with unrealized depreciation to a partnership in a sale. See PS- 163-84, 1991-1 C.B. 951, 959 (Section 1.707-3(e); multiple properties contributed pursuant to a plan). This rule was intended "to prevent a partner from selectively selling certain property (e.g., property with a high basis) and contributing other property to the partnership." Id. at 953 (preamble to the proposed regulations). The Treasury Department and the Service received comments criticizing this rule. See New York State Bar Ass'n Tax Section, NYBSA Reports on Proposed Rules for Partnerships' Related Party Transactions, 91 TNT 226-40 (Nov. 4, 1991); American Bar Ass'n Section of Tax'n, ABA Members Address Problems in Partnership Disguised Sale Regs., 91 TNT 209-64 (Oct. 9, 1991); Lary S. Wolf, Wolf Suggests Changes to Disguised Sale Regs., 91 TNT 195-35 (Sept. 19, 1991). The disguised sale regulations, in their final format, no longer include this rule. See Treas. Reg. Sec. 1.707-3, -4, -5, -6 & -7. If the disguised sale regulations do not so limit loss recognition with respect to disguised sales of property to a partnership, it is not obvious that such a restriction on loss recognition should apply to the transfer of property in exchange for a partnership call option.

b. SECTION 752 ISSUES PENDING EXERCISE

[17] Prior to the exercise of a partnership call option by a holder, it is not presently clear whether, the partnership's obligation (which is to issue its own interests) might be classified as a liability of the partnership for Section 752 purposes. The Service has taken the position that a partnership should take into account certain contingent partnership obligations for purposes of Section 752. See Rev. Rul. 95-26, 1995-1 C.B. 131 (short sale). But see TAM 7704269550A (Apr. 26, 1977) (contingent liability not a liability for purposes of Section 752). The Tax Court, however, has declined to treat an option to acquire partnership property granted by a partnership as a liability for purposes of Section 752. See Helmer v. Commissioner, 34 T.C.M. (CCH) 727 (1975) (grant of option to acquire partnership property was not a Section 752 liability). See also La Rue v. Commissioner, 90 T.C. 465, 479 (1988); Long v. Commissioner, 71 T.C. 1, 7 (1978).

[18] The fact that, in the case of a partnership call option, the property used to settle the option consists of an interest in the issuing partnership as opposed to other property, generally, should not affect the tax consequences of exercise. An option to acquire an interest in a partnership is, at least economically for the existing partners, the same as a right to acquire an undivided interest in the partnership's assets. On the other hand, there may be policy reasons similar to those noted in Notice 2000-44, 2000-36 I.R.B. 1, for not permitting a partnership to treat an option to acquire an interest as a liability, since such treatment might permit abusive manipulation of Section 705 basis. Similarly, it might be possible to obtain different results for actual debt (which is always carried at its principal amount for purposes of Section 752 purposes) and options (which presumably fluctuate based on their fair market values) if they were permitted to be treated as debt for Section 752 purposes.

[19] While we believe that the theoretically correct result would be to treat the option as a liability, and to permit it to be considered for Section 752 purposes, we understand that this result may not be practical at this time.

C. CAPITAL ACCOUNTING ISSUES PENDING EXERCISE

[20] Some commentators have taken the position that the grant of a partnership call option should not be taken into account for book purposes. Instead, they suggest that a partnership should create a deferred account until termination of the partnership's obligations under the option. See John B. Palmer III, "The Strange Case of Partnership Warrants," 2 J. Passthrough Entities 28, 30-31 (1999); William P. Bowers and Bryan W. Lee, Warrants and Convertible Partnership Interests for Partnerships and LLCs, in TAX PLANNING FOR DOMESTIC & FOREIGN PARTNERSHIPS, LLCS, JOINT VENTURES, & OTHER STRATEGIC ALLIANCES 468 PLI/Tax 723, 733-34 (2000). Essentially, for capital accounting purposes, they propose a type of open-transaction theory. Other commentators appear to have take the position that contingent liabilities should be taken into account for purposes of computing the book balance sheet of a partnership, which is consistent with the typical tax treatment of option premium payments. See Barksdale Hortenstine and Monte A. Jackel, Proposed Partnership Merger and Division Regulations-Analysis, Commentary and Examples, in TAX PLANNING & FOREIGN PARTNERSHIPS, LLCS, JOINT VENTURES & OTHER STRATEGIC ALLIANCES 468 PLI/Tax 637, 662 (2000); George B. Javaras et al., Partnership Joint Ventures of Operating Business, in TAX PLANNING & FOREIGN PARTNERSHIPS, LLCS, JOINT VENTURES & OTHER STRATEGIC ALLIANCES 465 PLI/Tax 9, 46 n.135 (1999); Joel Scharfstein, Joint Venture Topics, in TAX STRATEGIES FOR CORPORATE ACQUISITIONS, DISPOSITIONS, SPIN-OFFS, JOINT VENTURES, FINANCINGS, REORGANIZATIONS & RESTRUCTURINGS 448 PLI/Tax 1057, 1119 (1999). If the book balance sheet of a partnership is calculated with reference to its contingent liabilities and if such contingent liabilities include the partnership's obligations with respect to an option, then it would also seem appropriate to reflect the "option value" of the option on the partnership's book balance sheet. Initially, at least, the option value (i.e., the price for the right to participate in appreciation of the underlying partnership interest) ought to equal the premium paid for the option. As noted above, the value of a contingent obligation in the nature of an option (i.e., the "cost" to the partnership of fulfilling such obligation) will likely fluctuate over time. See, supra, III.B.1.b. This is presumably different from the result with most other "fixed" liabilities, which tend not to be adjusted to reflect their fair market value. Similarly, the assets shown on such book balance sheet, consistent with the capital accounting rules, are typically not reflected at their fair market value except immediately after contribution or a revaluation. This leads to the somewhat odd result that, if a partnership's assets appreciated and the appreciation were not reflected on the partnership's book balance sheet, the liability side of the balance sheet could balloon, while the asset side (following normal Section 704(b) capital accounting rules) remains the same. Although perhaps intellectually dishonest, if the premium paid for the option is reflected on the partnership's book balance sheet, we would propose that the asset side of the partnership's book balance sheet be adjusted over time to reflect the portion of the assets' unrealized appreciation which is (in a sense) subject to the option and which exceeds the original option value, in order to maintain parity between the liability and the asset side of the partnership's book balance sheet. Alternatively, if the premium paid for the option is not reflected on the partnership's book balance sheet, but is instead held in a deferred account, then we believe it would be inappropriate to reflect the option as a contingent liability, since to do so would distort the partner's book balance sheet. See Treas. Reg. Sec. 1.704- 1(b)(2)(iv)(q).

d. TAX CONSEQUENCES OF EXERCISE OF A PARTNERSHIP CALL OPTION

i. Potential Capital Shift May Occur Upon Exercise

[21] Section 721(a) generally provides that no gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership. Section 1032 generally provides that no gain or loss shall be recognized to a corporation on the receipt of money or other property in exchange for stock of such corporation. Section 1032 applies to the acquisition of stock upon exercise of a call option in the corporate context. See Rev. Rul. 90-15, 1990-1 C.B. 93; Rev. Rul. 72-198, 1972-1 C.B. 223, obsoleted by Rev. Rul. 86-9, 1986-1 C.B. 290.

[22] Some commentators have taken the position that the exercise of a call option in the partnership context ought to be afforded treatment similar to that provided in the corporate context. See Bowers and Lee, 468 PLI/Tax at 737. See also Javaras, 465 PLI/Tax at 49-50 (grant of a capital interest in a partnership in exchange for services); Henry Ordower, Taxing Service Partners to Achieve Horizontal Equity, 46 Tax Law. 19, 32-33 (1992) (same). In other words, the de facto shift in capital which results from the exercise of a call option in the corporate context ought also be tax-free in the partnership context.

[23] Section 1032 is a broad provision which generally exempts a corporation from recognizing gain in connection with the issuance of its stock. There are no limiting factors, such as a requirement that the stock be acquired "in exchange" for the contribution. In the case of an individual proprietorship, on the other hand, an individual who writes a call option on an undivided interest in the business' assets is not, generally, able to dispose of such assets upon the exercise of the an option without recognizing gain. The interesting issue, then, is which of these seemingly contrary approaches ought to apply in the context of a partnership call option.

[24] In the case of partnerships, Section 721 exempts "contributions of property" which are "in exchange for an interest." This covers the actual contribution which under capital accounting rules should constitute the sum total of such partner's capital account. Under existing caselaw, a disproportionate profits interest would generally not trigger a potentially taxable capital shift amongst the partners. See Campbell v. Commissioner, 943 F.2d 815 (8th Cir. 1991). See also Rev. Proc. 93-27, 1993-2 C.B. 343. However, if the terms of the option provide that, in addition to a profits interest, the person exercising the option will obtain a capital account in excess of the option's strike price, there would seem to be little statutory basis for taxing differently from a sale, pursuant to an option of either a pro rata share of the partnership's assets or an undivided partnership interest from each of the existing partners. Consequently, we believe that the result currently required under the statute is to require the recognition of gain or loss on the capital shift resulting from such exercise to the extent the holder of a partnership call option receives an interest in partnership capital that exceeds the exercise price of the option.

[25] Several commentators have argued for different treatment if the obligation is not to compensate the holder for services. See Palmer, 2 J. Passthrough Entities at 34-35; Steven R. Schneider and Brian J. O'Connor, LLC Capital Shifts: Avoiding Problems When Applying Corporate Principles, 92 J. Tax'n 13, 21 (1999); Frost, 1 J. Passthrough Entities at 12. These commentators focus on language in Treasury Regulation Section 1.721-1(b)(1), which provides, "To the extent that any of the partners gives up any part of his right to be repaid his contributions (as distinguished from a share in partnership profits) in favor of another partner as compensation for services or in satisfaction of an obligation), section 721 does not apply." These commentators argue that Section 721 should not be rendered inapplicable if an interest in partnership capital satisfies a non-compensatory obligation of a partnership. We do not believe, however, that the language of the regulation is exclusive as to the situations where Section 721 is inapplicable, but rather, that this simply illustrates the appropriate treatment of transactions involving the issuance of a capital interest which is not in exchange for contributed property.

ii. Mechanics of a Capital Shift Triggered by Exercise of a Partnership Call Option

[26] If a capital shift occurs upon exercise of a partnership call option, commentators have proposed a few transactional models. The partnership might be treated as selling a partnership interest in satisfaction of the option. See Palmer, 2 J. Passthrough Entities at 34. The partnership might be treated as selling an undivided interest in partnership assets in satisfaction of the option, and the transferee might then be treated as immediately contributing the assets to the partnership in exchange for a partnership interest. See Bowers and Lee, 468 PLI/Tax at 736-37; Laurence E. Crouch, Revival of Choice of Entity Analysis: Use of Limited Liability Companies for Start-up Businesses, in TAX PLANNING FOR DOMESTIC & FOREIGN PARTNERSHIPS, LLCS, JOINT VENTURES & OTHER STRATEGIC ALLIANCES 469 PLI/Tax 483, 519 (2000); Palmer, 2 J. Passthrough Entities at 34. Additionally, with respect to compensatory options, it has been suggested that a partnership be treated as satisfying the option with cash, and the transferee then be treated as contributing the cash to the partnership in exchange for a partnership interest. See Crouch, 469 PLI/Tax at 529. See also Annaliese S. Kambour, Making Partner: A Practical Analysis of Equity Compensation by Partnerships, in TAX PLANNING FOR DOMESTIC & FOREIGN PARTNERSHIPS, LLCS, JOINT VENTURES & OTHER STRATEGIC ALLIANCES 465 PLI/Tax 177, 203-04 (2000) (grant of an interest in partnership capital in exchange for services); George B. Javaras, 465 PLI/Tax at 49-50 (same); Ordower, 46 Tax Law. at 33 (same).

[27] For the reasons discussed above, to the extent holder of a partnership call option receives a partnership interest other than in exchange for the strike price of the option, the holder technically does not receive a partnership interest for a contribution. The excess portion transferred is, in substance, a disguised sale of a partnership interest. Under Section 707(a)(2)(B), if related transfers of property to and from a partnership are properly characterized as a sale or exchange, "the transaction is to be treated (as appropriate) as a sale between the partners of property (including partnership interests), or as a partial sale and partial contribution of property to the partnership." See H.R. Conf. Rep. No. 861, 98th Cong., 2d Sess., at 861 (1984). See also H.R. Rep. No. 432, 98th Cong., 2d Sess., at 1220 (1984); STAFF OF THE JOINT COMM. ON TAX'N, GENERAL EXPLANATION OF THE REVENUE PROVISIONS OF THE DEFICIT REDUCTION ACT OF 1984, 98th Cong., 2d Sess., at 225 (1984).

[28] Congress suggested that the partners of a partnership rather than the partnership be treated as parties to a disguised sale of a partnership interest, rather than the partnership. Congress disapproved of the results in Jupiter Corporation v. United States, 2 Cl. Ct. 58 (1983) and Communications Satellite Corporation v. United States, 625 F.2d 997 (1980). See H.R. Rep. No. 432, at 1218; STAFF OF THE JOINT COMM. ON TAX'N, GENERAL EXPLANATION OF THE REVENUE PROVISIONS OF THE DEFICIT REDUCTION ACT OF 1984, at 225. In those cases, the Commissioner contended that certain transactions amounted to a disguised sale by a partner of a portion of that partner's partnership interest. See Jupiter Corp., 2 Cl. Ct. at 60; Communications Satellite Corp., 625 F.2d at 997. Congress' disapproval of the results in those cases suggests that aggregate concepts should govern the mechanics of a disguised sale of a partnership interest by treating the sale or exchange as one between or among partners.

[29] Consequently, upon exercise of the option, to the extent the holder of a partnership call option acquires an interest in partnership capital that exceeds the option's exercise price, we believe that such portion of the transaction ought to be tested and taxed under the rules relating to disguised sales of partnership interests. This is consistent with the apparent legislative intent under Section 707. See H.R. Rep. No. 432, at 1218; STAFF OF THE JOINT COMM. ON TAX'N, GENERAL EXPLANATION OF THE REVENUE PROVISIONS OF THE DEFICIT REDUCTION ACT OF 1984, at 225. Cf. MCKEE, paragraph 5.08[2][b] (applying such a model to the transfer of a interests in partnership profits and capital as compensation for services). But see Ordower, 46 Tax Law. at 32 (arguing that the aggregate treatment is inappropriate).

iii. Substantiality Considerations

[30] It might be argued that permitting effective capital shifts to option holders upon exercise of the option is inconsistent with the existing substantiality requirements of the regulations which generally are intended to require that the incidence of taxation from the partnership's income be borne by the party who is economically benefited. For example, consider a situation in which two tax indifferent parties form a partnership, but a tax-sensitive party elects to obtain an option (and funds it via debt)! Upon the exercise of the option, the tax-indifferent parties recognize gain, if any, but the tax-sensitive party ends up with a capital account "as if" it had always been a partner, but without bearing the incidence of taxation. It is not possible to defer the income allocations or to allocate them to any one other than the tax- indifferent parties, provided that, as discussed above, the option is in substance an option and not a current equity ownership interest. See, supra, III.A. & III.B.1.A. In general, however, similar issues are present in other option situations, such as an option to acquire the assets of a business. Accordingly, while we recognize that there is some potential for using options to potentially avoid the effect of the substantial economic effect rules, we believe that his is simply an inherent part of option theory. Significant abuses can likely be handled with existing judicial and regulatory doctrines.

[31] One situation where partnership characterization as opposed to direct acquisition of assets, might lead to differing results is where the partnership has significant amounts of cash or cash equivalents. However, we believe it would be inappropriate to adopt any blanket rule treating such amounts as resulting in current gain recognition, since certain businesses may require significant amounts of cash for their operations, and appropriate adjustments for liabilities and similar items (such as hedges) ought not be taken into account.

COMMENTS IN RESPONSE TO NOTICE 2000-29: PART 2

I. ACKNOWLEDGEMENTS

[32] The principal author of these comments was Richard Castanon.

II. SCOPE

[33] The comments are intended to illustrate the tax consequences of a capital shift, if any, triggered by exercise of a partnership call option (i.e., an option to acquire an interest in a partnership), the conversion of a preferred partnership interest to a common interest, and the conversion of partnership debt to a common interest.

[34] These comments are intended to be read in conjunction with accompanying comments (the "Accompanying Comments") submitted by Richard Castanon in response to Notice 2000-29, 2000-22 I.R.B. 1, on the issuance of a partnership call option and on whether a capital shift results on exercise of a partnership call option.

III. MECHANICS OF A CAPITAL SHIFT TRIGGERED BY EXERCISE OF A PARTNERSHIP CALL OPTION

A. NON-COMPENSATORY PARTNERSHIP CALL OPTIONS

[35] The following example is intended to illustrate the federal income tax consequences of the exercise of a partnership call option, which upon exercise, provides the holder an interest in partnership capital with a value that exceeds the option's exercise price.

[36] EXAMPLE 1:

(i) Assume the following for purposes of this example. Partnership AB has two members, A and B, each of whom has a fifty percent interest in profits and capital. AB has assets X and Y. Each asset has a fair market value and adjusted basis of $200. X and Y are capital assets, and neither is in any part a Section 751 inventory item or unrealized receivable. AB has no partnership liabilities. All contributions to the partnership have been cash. The form of the transactions described are respected under the various judicial doctrines.

(ii) At the beginning of Year 1, AB grants a partnership call option to C in exchange for $20 in cash. The option allows C to acquire a one-half interest in AB's profits and capital in exchange for transferring $400 cash to the partnership. AB uses the option premium to make capital expenditures of $10 with respect to X and of $10 with respect to Y. At the beginning of Year 3, X and Y have both appreciated and each has a fair market value of $410. At this time, C transfers $400 to AB to exercise C's partnership call option.

(iii) Upon exercise of the partnership call option, AB transfers C a one-half interest in the partnership's profits and capital with a value of $610. The transfer is bifurcated. C is treated as receiving an interest in partnership profits and capital with a value of $400 in exchange for a contribution in the form of the $400 cash paid to exercise the option. Additionally, C is treated as receiving a $210 interest in partnership profits and capital in satisfaction of AB's obligation under the option.

(iv) Under Section 721, the transfer of an interest in partnership capital in exchange for the $400 exercise price is not taxable to AB, its partners, or C. The transfer of the remaining $210 of partnership capital is a taxable disposition. Consequently, AB is treated as disposing of an undivided interest in AB's assets to C in satisfaction of AB's obligation under the option. In other words, AB is treated as transferring undivided interests in X and Y, each with a fair market value of $105, and an adjusted tax basis of $55. As a result of the transfers of interests in X and Y, AB recognizes $50 of gain (i.e., $105 less $55), amounting to a total gain of $100. The gain is allocated to half to A and half to B, in accordance with Sections 704 and 706. In accordance with the usual treatment of holders exercising an in the money option, C recognizes no gain with respect to the interests in partnership assets that C receives in satisfaction of the option and acquires a Section 1012 cost basis of $20 in the undivided interests.

(v) Immediately after the deemed sale, C is treated as contributing the undivided interests to AB in exchange for a partnership interest in AB. Under Section 722 acquires C acquires an adjusted basis of $420 in C's partnership interest in AB by contribution under Section 722 (attributable to C's actual and constructive contributions to AB). Additionally, under Section 724, the partnership receives a basis of $20 in the undivided interests in X and Y that C contributes to AB. Note, Section 704(c)(1)(A) (in conjunction with Sections 704(c)(1)(B) and 737) will tend to impose upon C the burden of the built-in gain in the undivided interests in X and Y that C is deemed to contribute to AB.

[37] Treating the exercise of a partnership call option as, in part, a sale of undivided interests in the assets of only one partnership may not appropriate for all partnership call options.

[38] Under certain circumstances, if a partnership has sharing ratios in profits with respect to assets or groups of assets ("tracked" assets) that differ sufficiently (perhaps in excess of a 90/10 split), it may be appropriate to treat the purportedly single partnership as more than one partnership. See Terence Floyd Cuff, Series LLCs and the Abolition of the Tax System, 2 No. 1 Bus. Entities 26, 29-44 (2000); Barksdale Hortenstine and Gregory J. Marich, An Analysis of the Rules Governing Disguised Sales to Partnerships: Section 707(a)(2)(B), in TAX PLANNING FOR DOMESTIC & FOREIGN PARTNERSHIPS, LLCS, JOINT VENTURES & OTHER STRATEGIC ALLIANCES 467 PLI/Tax 567, 644, 647-58 (2000). See also Priv. Ltr. Rul. 98-47-013 (Nov. 20, 1998) (different series of a series trust treated as separate entities for federal tax purposes); Priv. Ltr. Rul. 98-37-005 (June 9, 1998) (same); Priv. Ltr. Rul. 98-19-002 (May 8, 1998) (same).

[39] In particular, if tracked partnership assets or groups of tracked partnership assets are insulated from each other's liabilities, it may be appropriate to treat the assets as held by separate partnerships. See Cuff, 2 No. 1 Bus. Entities at 29-44. See also Priv. Ltr. Rul. 98-47-013 (different series of a series trust treated as separate partnerships); Priv. Ltr. Rul. 98-37-005 (same); Priv. Ltr. Rul. 98-19-002 (same). Such liability insulation can be achieved by holding each tracked partnership asset or each group of tracked partnership assets within a separate, disregarded LLC. Additionally, such results could be achieved by holding tracked partnership assets within different series of a series LLC. For instance, Delaware's LLC statute permits a Delaware LLC to hold its assets within separate series of the LLC and to insulate the assets of each series of the liabilities of the others. See Del. Code Ann. tit. 6, Sec. 18-215 (2000). See also, Cuff, 2 No. 1 Bus. Entities at 27-28; Larry E. Ribstein, Limited liability Unlimited, 24 Del. J. Corp. L. 407, 425-26 (1999).

[40] If the purportedly single partnership interest that underlies a partnership call option should be treated as interests in more than one partnership, upon exercise of the option the holder should be treated as acquiring interests in more than one partnership. For instance, under some circumstance, if an option entitles the holder to acquire an interest in partnership profits and capital based on different percentages with respect to tracked partnership assets or groups of tracked partnership assets, it may be appropriate to treat the holder as acquiring an undivided interest in the assets of more than one partnership.

[41] The following example is intended to illustrate one potential tax treatment of exercising such a partnership call option.

[42] EXAMPLE 2:

(i) Assume the facts of the example 1(i-iii), except as otherwise indicated. Assume the following. AB holds X and Y each in separate LLCs that are disregarded for Federal tax purposes. C's option entitles C to acquire an interest in AB's capital in an amount equal to ninety percent of the value of X and ten percent of Y upon exercise. The $20 option premium paid by C is disposed of by making capital expenditures of $18 with respect to X and $2 with respect to Y. At the beginning of Year 3, the fair market value of X is $418, and the fair market value of Y is $402. The purportedly single partnership interest underlying the option would be treated as interests in two separate partnerships if granted outright: a ninety percent interests in the profits and capital of a partnership with A and B (ABx) that owns asset X, and a ten percent interest in a partnership with A and B (ABy) that owns asset Y.

(ii) Upon exercising the option, C is treated as acquiring an interest in ABx and ABy. C's exercise price is apportioned between the two interests in proportion to the fair market value of the underlying interests in ABx and ABy at the time C acquired the option. Accordingly, $360 is apportioned to the acquisition of an interest in ABx and the remaining $40 to the acquisition of an interest in ABy.

(iii) AB could be treated as contributing X and AB's obligation under the option with respect to X to a new partnership, ABx, and contributing Y and AB's obligation under the option with respect to Y to another new partnership, ABy. Immediately thereafter, AB could be treated as liquidating by making pro rata distributions of interests in ABx and ABy to A and B. (Such a treatment would be consistent with the characterization of a Section 708(b)(1)(B) termination of a partnership. See Treas. Reg. Sec. 1.708- 1(b)(2)(iv).) For purposes of this example, assume such a characterization is appropriate.

(iv) Upon exercising the option, C receives an interest in ABx's profits and capital with a fair market value of $549 in ABx and an interest in ABy's profits and capital with a fair market value of $61. Under Section 721, to the extent of C's exercise price, the transfers are not be taxable to ABx, ABy, their partners (A or B), or C. Thus, C is treated as contributing $360 to ABx in exchange for an interest in ABx and contributing $40 to ABy in exchange for an interest in ABy. However, to the extent C receives a capital interest in either partnership in excess of C's contribution to that partnership, that partnership is treated as disposing of a capital interest in a taxable transaction. Specifically, ABx is treated as transferring an undivided interest in X with a fair market value of $189 and an adjusted basis of approximately $98.60, and ABy is be treated as transferring an undivided interest in Y with a fair market value of $21 and an adjusted basis of approximately $10.55. As a result of the transfers, AB recognizes approximately $100.85 of gain (i.e., $210 less $109.15). The transfer of an interest in X generates approximately $90.40 of gain, and the transfer of an interest in Y generates approximately $10.45 of gain. The gain is allocated to half to A and half to B, in accordance with Sections 704 and 706. In accordance with the usual treatment of holders exercising an in the money option, C recognizes no gain with respect to the interests partnership assets that C receives in satisfaction of the option and acquires a Section 1012 cost basis of $20 in the undivided interests.

(v) Immediately after the deemed sale, C is treated as contributing the undivided interests to ABx and ABy in exchange for interests in the partnerships. Under Section 722, C acquires an adjusted basis of $378 in C's partnership interest in ABx by contribution (attributable to C's actual and constructive contributions to ABx). Similarly, C acquires an adjusted basis of $42 in C's partnership interest in ABy under Section 722 (attributable to C's actual and constructive contributions to ABy). Additionally, under Section 724 ABx receives a basis of $18 in the undivided interest in X that C contributes to ABx. Similarly, ABy receives a basis of $2 in the undivided interest in Y that C contributes to ABy. As noted in Example 1, Section 704(c)(1)(A) (in conjunction with Sections 704(c)(1)(B) and 737) will tend to impose upon C the burden of the built-in gain in the undivided interests in X and Y that C is deemed to contribute to ABx and ABy, respectively.

[43] Similar results should arguably obtain in EXAMPLE 2 if instead of tracking allocations with respect to X or Y, the option provided its holder a preferred return, operating cash flow distributions, or guaranteed payments attributable to the performance of asset X or asset Y.

[44] More importantly, the sharing ratios in capital provided in C's option are important to the result in EXAMPLE 2. The exercise of the option results in a transfer a portion of unrealized appreciation inherent in partnership assets that accrued prior to exercise of the option. The ratios in which the option holder and the partners of the partnership economically share in this appreciation is in part governed in part by the capital interest specified in the option. Furthermore, any allocations of unrealized appreciation (upon recognition) after exercise of the option would be limited by the substantiality rules of Section 704(b), and thus, an option's sharing ratio in profits may be of less concern than its sharing ratio in capital. Similarly, because any provisions for tracking allocations, preferred returns, operating cash flow distributions, or guaranteed payments after exercise of the option would be limited by the disguised sale rules of Section 707(a)(2), such arrangements may also be of less concern than an option's sharing ratio in capital.

B. COMPENSATORY PARTNERSHIP CALL OPTIONS

[45] With respect to partnership call options granted in exchange for services, these comments are limited to the whether there is a capital shift, and if so, what the tax consequences are for the partnership subject to the option. A number of commentators have taken the position that Section 83 should apply to partnership call options granted in connection with the performance of services. See Kambour, 465 PLI/Tax at 198; Friedman, 1 Fla. Tax Rev. at 542; James R. Hamill, Using Options to Compensate Service Providers at the Formation of a New Entity, 23 J. Tax'n 138, 140-41 (1992). The applicability of Section 83 to partnership call options is beyond the scope of these comments. For purposes of these comments, it is assumed that Section 83 applies the partnership call option described in the following example.

[46] As discussed in the case of non-compensatory partnership call options, upon exercise of a partnership call option, to the extent a partnership transfers an interest partnership capital interest with a value that exceeds the options exercise price, Section 721 should not apply to the transfer. See II.B.1.d.i. of the Accompanying Comments. Consequently, the transfer should be a taxable disposition. The following example is intended to illustrate the tax consequences of such a disposition.

[47] EXAMPLE 3:

(i) Assume the facts of Example 1(i-ii) unless otherwise specified. At the beginning of Year 1, AB grants a partnership call option to C solely in exchange for C's agreeing to perform services for AB. Upon grant, for purposes of Treas. Reg. Sec. 1.83-7(b), the option is neither actively traded on an established public market nor in possession of a value that can otherwise be measured with reasonable accuracy. The services that C agrees to perform are such that payment for them in cash is deductible under Section 162. The form of the transactions described are respected under the various judicial doctrines.

(ii) Upon exercise of the partnership call option, AB transfers C a one-half interest in the partnership's profits and capital with a value of $610. The transfer is bifurcated. C is treated as receiving an interest in partnership profits and capital with a value of $400 in exchange for a contribution in the form of the $400 cash paid to exercise the option. Additionally, C is treated as receiving a $210 interest in partnership profits and capital in satisfaction of AB's obligation under the option.

(iii) Under Section 721, the transfer of an interest in partnership capital in exchange for the $400 exercise price is not taxable to AB, its partners, or C. The transfer of the remainder of the capital interest (worth $210) is a taxable event for C, AB, and AB's partners (A and B). Aggregate concepts govern this transfer, and accordingly, AB is treated as transferring undivided interests in both X and Y to C. With respect to these transfers, C realizes gross income of $210 under Sections 61 and 83(a), and AB is entitled to a corresponding deduction of $210 under Sections 83(h) and 162. AB recognizes gain in an amount of $100. Treas. Reg. Sec. 1.83- 6(b). The gain is allocated to half to A and half to B, in accordance with Sections 704 and 706. Finally, C acquires a basis of $105 in each of the undivided interests (i.e., an amount equal to the gross income recognized on receipt). See Treas. Reg. Secs. 1.61-2(d)(2) & 1.83- 4(b)(1).

(iv) Immediately after the deemed sale, C is treated as contributing the undivided interests to AB in exchange for a partnership interest in AB. Under Section 722, acquires C acquires an adjusted basis of $610 in C's partnership interest in AB (attributable to C's actual and constructive contributions to AB). Additionally, under Section 724, the partnership receives a basis of $105 in each of the undivided interests in X and Y that C contributes to AB.

[48] As noted in the discussion of non-compensatory partnership call options, the transfer of a purported partnership interest upon exercise a partnership call option should not necessarily be treated as a transfer of a partnership interest in a single partnership. See II.B.1.d.ii. of the Accompanying Comments.

IV. PREFERRED PARTNERSHIP INTERESTS CONVERTIBLE TO COMMON

[49] The right to convert a preferred interest ³ in a partnership to a common interest in the partnership ⁴ should be treated as a separate property right upon grant.

[50] In the context of corporate reorganizations, conversion rights with respect to preferred stock against the issuer are treated as rights inherent in the preferred stock rather than as property separate from the preferred stock. See Rev. Rul. 69-265, 1969-1 C.B. 109. However, that reasoning should not apply for purposes of a conversion right with respect to a preferred interest in a partnership. To do so would be inappropriate for reasons similar to those that it would be inappropriate to treat a partnership call option as a partnership interest. See II.A. of the Accompanying Comments.

[51] Upon exercise of a conversion right with respect to a preferred partnership interest, assume the partnership subject to the conversion right transfers an interest in its capital in excess of the holder's interest in capital immediately prior to the exercise (and in addition to any exercise price). In that case, the transfer should be treated as a taxable disposition of an interest in the partnership. This is because, to the extent the holder's interest in capital is increased (beyond any exercise price), the transfer is not in exchange for a contribution of property to the partnership. This result should obtain for reasons similar to those that, under certain circumstances, a transfer of an interests in partnership capital in satisfaction of a partnership call option should be treated as a taxable disposition of the interest rather than a transfer of an interest in exchange for a contribution of property to the partnership for purposes of Section 721. See II.B.1.d.i. of the Accompanying Comments.

[52] EXAMPLE 4:

(i) D and E form partnership DE by each contributing $200 cash. DE uses the cash to purchase asset T, which is a capital asset and is not in any part a Section 751 inventory item or unrealized receivable. In exchange for the contributions, D receives a preferred interest that entitles D to an annual preferred distribution and matching allocation of income or gain of 10 percent of D's contribution (i.e., $20). The preferred interest also provides D a $200 interest in partnership capital and a conversion right that allows the holder to convert the interest into 50 percent interest in the partnership's profits and capital. Assuming the fair market value of the conversion right is $10 upon grant, $10 of the $200 D transfers to DE is treated as a purchase price for the conversion right. E receives an interest in DE's residual profits and distributions and receives a $200 interest in partnership capital. The form of the transactions described are respected under the various judicial doctrines.

(ii) In Years 1 and 2, DE has $20 of net profits which is allocated to D and $20 of positive cash flow which is distributed to D. At the beginning of Year 3, T has appreciated to have a value of $800. At that time D exercises the conversion right in the preferred interest.

(iii) To the extent D receives an interest in partnership capital not in excess of D's interest in DE's capital immediately prior to exercise of the conversion right, the transfer is treated as a contribution of D's preferred interest to DE in exchange for a distribution of a common interest in DE. However, the remainder of the capital interest transferred to D is treated as transferred to D in satisfaction of DE's obligation under the conversion right. The aggregate theory of partnerships governs the transfer. Accordingly, DE is treated as transferring an undivided interest in T with a fair market value of $200 and an adjusted basis of $100, resulting in a gain of $100, which should be allocated to E under Sections 704 and 706 (except to the extent F should be allocated the gain as part of D's preferred return). Under the usual rules applicable to the exercise of a conversion right, D does not recognize income with respect to the property received in exchange for the conversion right. D receives an adjusted basis of $10 in the distributed interest in T. Immediately thereafter, D is treated as contributing the undivided interest in T to DE in exchange for an interest in DE, and DE acquires a $10 basis in the undivided interest. Section 704(c)(1)(A) (in conjunction with Sections 704(c)(1)(B) and 737) will tend to impose upon D the burden of the built-in gain in the undivided interests in T that D is deemed to contribute to DE.

V. CONVERTIBLE PARTNERSHIP DEBT

[53] The right of a holder of partnership debt to convert the debt into an interest in the partnership should be treated as property separate from the partnership debt upon grant. For purposes of determining the extent to which a debt instrument is original issue discount, a conversion right with respect to the debt instrument against the issuer is not treated as property separate from the debt instrument. See Chock Full O'Nuts Corp. v. United States, 453 F.2d 200, 305 (2d Cir 1971). However, that reasoning should not apply with respect to the right of a holder of partnership debt to convert the debt into an interest in the partnership. To do so would be inappropriate for the reasons similar to those that it would be inappropriate to treat a partnership call option as a partnership interest. See II.A. of the Accompanying Comments.

[54] Upon exercise of a conversion right with respect to a partnership debt, assume the partnership subject to the conversion right transfers an interest in its capital in excess of the unpaid principal under the debt. In that case, the transfer should be treated as a taxable disposition of an interest in the partnership. See II.B.1.d.i. of the Accompanying Comments. To the extent the holder receives in interest in partnership capital in excess of the unpaid principal, the transfer of an interest in the partnership is not in exchange for a contribution of property to the partnership. This result should obtain for reasons similar to those that the exercise of a partnership call option should be a taxable event under certain circumstances. Id. But see Parker Properties Joint Venture, T.C. Memo. 1996-283 (income to the extent the remaining principal of the loan exceeded the fair market value of the partnership interest transferred in satisfaction of the loan); MCKEE, paragraph 4.02[3], 4-16 (conversion of a loan into a partnership capital interest should be governed by Section 721).

[55] EXAMPLE 5:

(i) F and G form partnership FG by each contributing $200 cash. FG uses the cash to purchase asset U, which is a capital asset and is not in any part a Section 751 inventory item or unrealized receivable. In exchange for the contributions, F and G each receive one half interests in FG's profits and capital. FG issues a note to H in exchange for $420 cash. The note entitles its holder to payments of 10 percent interest each year for five years and at the end of the fifth year repayment of all stated principal ($420). The note also entitles the holder to convert the note into a 50 percent interest in FG's profits and capital. Assume the fair market value of the conversion right is $20 upon grant. The form of the transactions described are respected under the various judicial doctrines.

(ii) In Years 1 and 2, DE has $20 of profits which is used to make interest payments with respect to H's note. At the beginning of Year 3, U has appreciated to have a value of $800. At that time H exercises the conversion right provided in H's note.

(iii) To the extent H receives an interest in partnership capital not in excess of the unpaid principal with respect to H's note immediately prior to exercise of the conversion right, the transfer is treated as a contribution of the unpaid principal to FG in exchange for a partnership interest in FG. However, the remainder of the partnership interest transferred to H is treated as transferred to H in satisfaction of FG's obligation under the conversion right. The aggregate theory of partnerships governs the transfer. Accordingly, FG is treated as transferring an undivided interest in T with a fair market value of $190 and an adjusted basis of $95, resulting in a gain of $95, which is allocated equally between F and G. Under the usual rules applicable to the exercise of a conversion right in other contexts, H does not recognize income with respect to the property received in exchange for the conversion right. H receives an adjusted basis of $20 in the distributed interest in U. Immediately thereafter, H is treated as contributing the undivided interest in U to FG in exchange for an interest in FG. Under Section 722, H acquires an adjusted basis of $420 in H's partnership interest. Additionally, under Section 724, FG acquires an adjusted tax basis of $20 in the interest in U that is deemed contributed to FG. Section 704(c)(1)(A) (in conjunction with Sections 704(c)(1)(B) and 737) will tend to impose upon H the burden of the built-in gain in the undivided interests in U that H is deemed to contribute to FG.

² Section 704(c) property is property transferred to a partnership in a Section 721 exchange if at the time of the exchange the property's fair market value differs from the transferor's adjusted tax basis in the property. See Treas. Reg. Sec. 1.704- 3(a)(3)(i).

³ By preferred interest in a partnership, what is meant is a limited participation in profits and appreciation of a partnership that is preferred to common interests.

⁴ By common interest in a partnership, what is meant is a participation residual profits and appreciation of a partnership.