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By Charles C. Hwang and Jennifer A.
Crowell & Moring, Washington, DC
Tax regulations finalized in March 20131 can have serious
consequences for options (including warrants or convertible debt)
to purchase equity in a partnership or an LLC treated as a
partnership for tax purposes. These regulations affect both the
partnership and the lender, especially where the lender itself is a
In certain situations, the new regulations treat unexercised
options as an equity interest in the partnership. For example, any
partnership (or LLC treated as a partnership) that issues an equity
kicker to a lender may cause the lender to be treated as a partner
for tax purposes, which will change the expected tax allocations
and reporting. Furthermore, where a mezzanine fund makes a loan to
a portfolio company treated as a partnership for federal tax
purposes, and receives penny warrants in connection with the loan,
these regulations may treat the mezzanine fund as a partner in the
portfolio company, with potentially serious consequences for the
These regulations are effective for options issued on or after
February 5, 2013.
Consequences for Partnership Borrower
The recharacterization rule will have a significant impact on
partnerships or LLCs that provide an equity kicker (such as penny
warrants or convertible debt with a favorable conversion price) in
connection with a borrowing. If the lender is treated as a partner,
the lender must be allocated its share of partnership income and
loss. Failure to treat the lender as a partner where required by
these new regulations will cause the partnership to make incorrect
allocations to all of its partners. If the IRS reallocates the
partnership's income or loss on audit, every partner would then be
required to file an amended federal income tax return and may owe
interest and penalties.
Consequences for Lender
The new rule can also have severe consequences where the lender
is itself a partnership, such as a mezzanine fund.
Specifically, it can cause the mezzanine fund's partners to have
unrelated business taxable income (UBTI) or effectively connected
income (ECI). Investment funds with tax-exempt and foreign
investors should consider the impact of these new regulations to
equity kickers they receive in connection with loans.
General Discussion of Recharacterization
Generally, a noncompensatory option with respect to a
partnership interest is treated as a partnership interest (that is,
the option is treated as exercised) for tax purposes if two
conditions are met:
1. the option provides the option holder with rights that are
"substantially similar" to the rights afforded a partner, and
2. there is a "strong likelihood" that failure 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.
The first condition is met if either the option is reasonably
certain to be exercised or the option holder possesses partner
attributes (such as the right to vote or participate in
management). An option with an exercise price substantially
lower than its fair market value (such as a "penny warrant") would
likely satisfy the first condition and thus would be treated as
equity in the partnership if it also meets the second
The "strong likelihood" condition depends on the timing and
amount of partnership income and loss allocations that would be
made to the partners of the borrower both with and without treating
the option holder as a partner, and depends on the federal tax
attributes of each partner and the option holder. In the case of a
mezzanine fund that is itself a partnership for tax purposes, the
tax attributes of its partners must be taken into account for this
purpose. In general, in evaluating a loan to be made to a
partnership, the question is whether net income of the partnership
would likely be subject to more tax if allocated to the lender (and
through the lender to the lender's partners) rather than to the
actual partners in the borrower.
This "strong likelihood" test is likely to be immensely
complicated to apply in practice and will depend on whether the
borrower partnership is expected to generate income or losses, the
character (capital or ordinary) of the income or losses, and the
tax attributes of the actual partners in the borrower partnership
and of the option holder's own partners. The analysis will depend
on a number of factors:
Even if the lender's option is not recharacterized as equity
under these rules, if the lender does exercise the option, the new
regulations require special allocations to be made to the lender
(and in some cases, the borrower's other partners).
A partnership issuing an equity kicker in connection with a loan
to a partnership, or a mezzanine fund receiving such an equity
kicker, should consult with its tax advisors to determine the
impact of these new regulations.
For more information, in the Tax Management Portfolios, see
Manning, 710 T.M., Partnerships - Conceptual Overview,
Manning, 711 T.M., Partnerships - Formation and
Contributions of Property or Services, Needham, 735 T.M.,
Private Equity Funds, and Needham and Brause, 736 T.M.,
Hedge Funds, and in Tax Practice Series, see ¶4030, Formation
of a Partnership, and ¶4010, Partnership Taxation -
© Crowell & Moring LLP 2013
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