Partnership Noncompensatory Options (Portfolio 721)

Tax Management Portfolio, Partnership Noncompensatory Options, No. 721, describes the tax consequences that flow from the issuance by a partnership of a noncompensatory option. To view this Portfolio, visit Bloomberg Tax for a free trial.


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Tax Management Portfolio, Partnership Noncompensatory Options, No. 721, describes the tax consequences that flow from the issuance by a partnership of a noncompensatory option. Tax implications to both the partnership and to the option holder are considered from the various stages in the life of such an option including issuance, sale or exchange, exercise (including cash settlement), and lapse. In addition, the effect of an outstanding noncompensatory option on the operations of the partnership is discussed.

Because the rules specific to noncompensatory options do not fully displace the law of options more generally, the Portfolio begins with an examination of both the common law and statutory tax rules applicable to options. Where appropriate, reference in the partnership-specific portion of the Portfolio is made to these more general rules.

This Portfolio may be cited as Abrams, 721 T.M., Partnership Noncompensatory Options.


Howard E. Abrams, Esq.

Howard E. Abrams is the William K. Jacobs Visiting Professor at Harvard Law School. Professor Abrams is a partnership and corporate tax specialist, receiving his B.A. from the University of California (Irvine) and his J.D. from Harvard University. He has written four books, the BNA Tax Management Portfolios on Disregarded Entities and on Partnership Options, and more than 50 articles on taxation. Professor Abrams taught at Emory University from 1983 until 2013, spent the 1999–2000 academic year with the national office of Deloitte Tax as the Director of Real Estate Tax Knowledge, and from January 2003 through August 2004 was of counsel to Steptoe & Johnson in Washington, DC. He teaches regularly at Leiden University in the Netherlands and is a member of the American Law Institute and the California and DC Bars. Prior to joining the Emory faculty, Professor Abrams was a law clerk to Chief Judge Theodore Tannenwald, Jr., of the United States Tax Court and practiced in Los Angeles with the firm of Brobeck, Phleger & Harrison. Professor Abrams has taught as a Visiting Professor at Cornell, Berkeley, and Yale law schools. He was Warren Distinguished Professor and Director of Tax Programs at the University of San Diego School of Law from 2014–2017.

Extensive assistance was provided by Mr. Robert Crnkovich who deserves much of the credit and none of the blame for this Portfolio.

Table of Contents

Detailed Analysis
I. Introduction
II. Options: Definitions and Uses
A. Option Defined
B. An Option Compared to Other Legal Rights and Instruments
1. An Option Compared to a Forward Contract
2. An Option Compared to a Nonrecourse Borrowing
3. An Option Compared to a Conditional Sale
4. An Option Compared to an Installment Purchase
5. An Option Compared to a Swap Contract
C. Relevant Terms
1. Option
a. Call Option
b. Put Option
2. Option Price (Cost)
3. Underlying
4. Expiration Date (Expiry)
5. Strike (Exercise) Price
6. Time of Exercise
a. American-Style Option
b. European-Style Option
c. Bermuda-Style Option
7. Settlement
a. Physical Settlement
b. Cash Settlement
8. Lapse
9. Exotic Options
a. Barrier Options
b. Compound Options
c. Digital Option
d. Chooser Option
D. Option Examples
1. Protective Put
2. Covered Call
3. Option Pairs
a. Equity Collar
b. Short Straddle
E. Option Equivalents (Synthetic Options)
F. Option Valuation
III. Taxation of Noncompensatory Options
Introductory Material
A. Issuance of an Option and Characterization as an Option
1. In Exchange for Cash or Property
a. Tax Consequences to the Option Writer
b. Tax Consequences to the Option Purchaser
2. Distribution of a Call Option by the Issuer
a. Corporate Distribution of a “Property” Option
b. Corporate Distribution of an “Equity” Option
c. Partnership Distribution of a “Property” Option
d. Partnership Distribution of an “Equity” Option
B. Continuing Payments
1. Extension Payments
2. Lease with an Option to Buy
C. Exercise or Lapse of an Option
1. Option Exercise
a. Physical Settlement
(1) Taxation of the Option Holder
(2) Taxation of the Option Writer
b. Cash Settlement
(1) Taxation of the Option Holder
(2) Taxation of the Option Writer
c. Other Closing Transactions
2. Option Lapse
a. Taxation of the Option Holder
b. Taxation of the Option Writer
D. Sale or Exchange of an Option
E. Special Tax Provisions
1. Straddles
a. Definitions
b. Recognition of Income and Deferral of Loss
c. Holding Period
d. Mixed Straddles
2. Constructive Sales
3. Section 1256 Contracts and Securities Futures Contracts
4. Options Subject to §1231 Treatment
5. Hedging Transactions
6. Qualified Covered Call Options and Deep-in-the Money Options
IV. Taxation of Noncompensatory Partnership Options
A. Introduction
B. Definitions
1. Convertible Debt
2. Convertible Equity
3. Exercise
4. Exercise Price
5. Option
6. Option Premium
7. Option Privilege
8. Option Value
C. Scope of the Regulations
D. Grant of the Option
1. Tax Consequences to the Granting Partnership
a. Recognition of Gain or Loss
b. The Books of the Partnership
(1) Capital Accounts
(2) Outside Basis
2. Tax Consequences to the Option Purchaser
a. Recognition of Gain or Loss
b. Basis of the Acquired Option
E. Accounting for a Noncompensatory Option While the Option Is Outstanding
1. Revaluations of Partnership Property
a. General Rule
b. Distributions of Appreciated and Loss Property
2. Testing for Equity Characteristics of Outstanding Options
a. When an Outstanding Option Must Be Tested
(1) Measurement Events Under the Final Regulations
(2) Extension of the Measurement Events
b. Characterization of an Option as Equity
(1) Rights That Are “Substantially Similar to the Rights Afforded a Partner”
(a) The “Reasonably Certain to Be Exercised” Standard
(i) The “Reasonably Certain to Be Exercised” Example
(ii) The “Reasonably Certain to Be Exercised” Safe Harbors
(b) The “Possesses Partner Attributes” Standard
(2) “Substantial Reduction in the Present Value of the Partners’ and the Option Holder's Aggregate Federal Tax Liabilities”
(3) Application of General Tax Principles
c. Consequences of Equity Characterization
d. Extension of the Measurement Events
F. Exercise, Lapse and Other Dispositions of a Noncompensatory Partnership Option
1. Exercise
a. Capital Account Adjustments
b. Corrective Allocations
c. Cash Settlement
(1) Tax Consequences to the Issuing Partnership
(2) Tax Consequences to the Option Holder
d. Special Circumstances
(1) Accrued Rents, Royalties and Interest
(2) Cancellation of Indebtedness
2. Lapse
a. Tax Consequences to the Option Holder
b. Tax Consequences to the Issuing Partnership
3. Sales and Exchanges
a. Taxable Sales and Exchanges
b. Tax-Free Dispositions

Working Papers

Table of Worksheets
Worksheet 1 Preamble to the Partnership Noncompensatory Option Regulations
Worksheet 2 Suggested Language for a Partnership Agreement
Worksheet 3 Checklist for Measurement Events