Attorney Suggests Changes to Partnership Guidance

Dear Bill:

[1] As promised in our telephone conversation last week, the following are some suggestions concerning the treatment of non- compensatory options to acquire partnership interests.

[2] I understand that the basic position is that the option holder recognizes no income upon exercise of the option. While such an approach is consistent with the general rule regarding option exercises, and probably sound tax policy, the position presents challenging issues to be addressed in any guidance. My comments are not intended to address all of the issues, but only a few that I believe are important to insure that neither the government nor the taxpayer is subjected to inappropriate tax benefits or detriments.

[3] Capital Accounts. Upon exercise of the option, the option holder (now partner) should be credited with a capital account equal to the fair market value of his interest in the partnership. To give the option holder a capital account equal only to his contribution seems to exalt form and ignore the economic reality. Under a pure aggregate theory, an option holder, who exercises an option to acquire an interest in the partnership, is exercising an option to acquire an interest in each of the partnership's assets. If the option exercise occurred outside the partnership and the assets were then contributed to the partnership, the option holder would have fair market value capital account and built in gains to be dealt with under section 704(c). The result should be no different if the assets were held by the partnership at the time of exercise of the option.

[4] Technically, this result could be reached by requiring an adjustment to the capital account balances under Treas. Reg. § 1.704-1(b)(2)(iv)(f) immediately before the contribution and explicitly recognizing the capital shift from the other partners to the option holder. This capital shift would be treated as having substantial economic effect for purposes of the section 704(b) regulations. Consistent with the general non-taxable theory for option exercise, that capital shift would not be taxable immediately. Rather, the income tax consequences of the capital shift would be determined using section 704(c) principles which reflect the difference between the option holder's tax basis for the interest in the assets acquired and its fair market value.

[5] An approach which credits the exercising option holder with a capital account equal to only the amount paid upon exercise (plus any premium paid to acquire the option) without recognizing the capital shift would seem to yield results inconsistent with general capital account rules. If the partnership were to elect to adjust capital account balances to reflect the value of the assets upon contribution a partnership liquidation immediately after the option exercise would yield distributions under the business arrangement inconsistent with the capital account balances. If no adjustment were made, the exercising option holder and partnership would need to rely on the existence of sufficient unrealized gain (or loss) to correct the capital account balances.

[6] Section 704(c) Issues. The basis of the analysis should be that the exercising option holder has acquired an interest in each of the partnership's assets for an aggregate amount equal to the exercise price and premium, if any, paid for the option. As a policy matter, that aggregate purchase price should equal the option holder's share of the partnership's inside basis for its property. This situation should be no different than the situation in which the option holder has acquired an interest in the assets outside the partnership at a discount and contributed that interest to the partnership. In that situation, section 704(c) would apply on an asset by asset basis in accordance with the method selected by the partnership.

[7] In this situation, the "built-in gain" for the exercising option holder is equal to the amount of the capital shift. Similarly, the capital shift represents an item of "built-in loss" which has been incurred by the other partners. While both have been recognized economically through shifts in their capital accounts, the issue is the timing and manner of recognition for tax purposes. One alternative, which I think provides equitable results, is to allocate the built-in gain and built-in loss over all of the assets, in proportion to their respective fair market values. The income tax recognition would then occur either upon disposition of the asset¹ or through cost recovery or amortization deductions.² Then section 704(c) allocations would apply in addition to other allocations required under section 704(c), including, without limitation, the allocations required as a result of the capital account adjustments made immediately before the contribution by the exercising option holder.

[8] This suggestion can be illustrated through the following examples.

[9] Example 1. Assume option holder C has a non- compensatory option to acquire a 50% partnership interest in AB Partnership for $50. A and B are currently equal partners. AB Partnership has the following assets at time of exercise and no liabilities:

                    Tax Basis           Fair Market Value

                       Tax         Fair Market Value

          Stock 1       95.00

[13] Example 2. Assume same facts as Example 1, but instead of selling Stock 1, AB Partnership sells Stock 2 for $300, recognizing no gain for book purposes and a tax gain of $100. The entire tax gain of $100 would be allocated to A and B under section 704(c) principles. A, B and C would also each recognize their share of the built-in gain or built-in loss resulting from the option exercise and attributable to Stock 2. Thus, C would have a gain of $142.50; while A and B would each have a loss of $71.25, resulting in the allocation of an aggregate loss to each of them of $21.25. This result corresponds with A and B's economic position with respect to Stock 2. They have realized a gain of $100 from the appreciation of the asset from $200 to $300 and then disposed of a 50% interest for $7.50, resulting in a loss of $142.50. On a net tax basis, in the aggregate A and B have a loss of $42.50.

[14] Example 3. Assume the same facts as Example 1, except that instead of selling Stock 1, AB Partnership sells Stock 3 for $300, recognizing a book loss of $200 and no tax gain or loss. In this case, the book loss would be allocated $100 to C and $50 to each of A an B. There would be no corresponding tax items. Even though there is no taxable income, at least a portion of the "built-in gain" and "built-in loss" from the option exercise should still be recognized. Economically, C has acquired an interest in Stock 3 for $12.50 on which it has realized $150; similarly, A and B have sold C that economic interest for the same price. While it may be unfair (although simpler) to have A, B and C recognize the entire built-in gain and built-in loss from the option exercise attributable to Stock 3 on the partnership's disposition of the asset, some built-in gain and loss needs to be recognized, even if the partnership has no income. While it may be more complicated, the guidance could reach the correct result by providing for an adjustment to the built-in gain or loss upon disposition of the asset when there is a loss which is realized for book purposes and there is no corresponding tax loss.

[15] This approach I think should result in minimizing potentials for abuse. As the last example demonstrates, C recognizes the appropriate amount of income, corresponding to his economic profit, even where the partnership has no income. Reliance on a system which requires an allocation of the first dollars of gross income to the exercising option holder to make up his built-in gain may not work where there is no gross income (or realization is delayed). Consider the AB Partnership example above, but assume that the option is exercised immediately after all the stock has been sold and the proceeds reinvested in U.S. Treasuries.³ It would not be hard to turn that situation into an abusive tax loss generator for C in which no gross income is recognized for an extended period of time. Such a rule would also encourage the partners to pick and choose the type or character of the income to be recognized, with clear temptation to engage in mischief. An additional issue with the use of a special allocation of gross income is that such an approach could result in an acceleration of income to the option holder where the recognition should be limited only to the specific asset which is the subject of the partnership transaction.

[16] I hope these comments are helpful. Please feel free to give me a call if you wish to discuss the issue.

Eric Solomon

Deborah Harrington

²Cost recovery or amortization would be handled in the same manner as other assets with book/tax disparity. In short, cost recovery or amortization deductions of the partnership with respect to the asset would be allocated to match the book deductions to which the partner with the built-in loss would be entitled, both by treating the amount of the built-in loss as an increase in basis and giving effect to any other adjustments required under section 704(c).

³A separate anti-abuse rule may be appropriate where at the time of the option exercise the partnership holds substantial amounts of cash.