[Federal Register Volume 68, Number 14 (Wednesday, January 22, 2003)]
[Proposed Rules]
[Pages 2930-2941]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-872]



[[Page 2930]]

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-103580-02]
RIN 1545-BA53


Noncompensatory Partnership Options

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations relating to the 
tax treatment of noncompensatory options and convertible instruments 
issued by a partnership. The proposed regulations generally provide 
that the exercise of a noncompensatory option does not cause the 
recognition of immediate income or loss by either the issuing 
partnership or the option holder. The proposed regulations also modify 
the regulations under section 704(b) regarding the maintenance of the 
partners' capital accounts and the determination of the partners' 
distributive shares of partnership items. Additionally, the proposed 
regulations contain a characterization rule providing that the holder 
of a noncompensatory option is treated as a partner under certain 
circumstances. This document also provides a notice of public hearing 
on these proposed regulations.

DATES: Written or electronic comments must be received by April 29, 
2003. Requests to speak and outlines of oral comments to be discussed 
at the public hearing scheduled for May 20, 2003, at 10 a.m. must be 
received by April 29, 2003.

ADDRESSES: Send submissions to: CC:ITA:RU (REG-103580-02), room 5226, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. Submissions may be hand delivered Monday through Friday 
between the hours of 8 a.m. and 4 p.m. to: CC:ITA:RU (REG-103580-02), 
Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue, 
NW., Washington, DC. Alternatively, taxpayers may submit comments 
electronically directly to the IRS internet site at http://www.irs.gov/regs. The public hearing will be held in room 4718, Internal Revenue 
Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Audrey W. 
Ellis, (202) 622-3060; concerning submissions, the hearing, and/or to 
be placed on the building access list to attend the hearing, Treena 
Garrett, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

    In a variety of situations, partnerships issue options or 
convertible instruments that allow the holder to acquire by purchase or 
conversion an equity interest in the partnership. On June 5, 2000, 
Treasury and the IRS issued Notice 2000-29 (2000-1 C.B. 1241) inviting 
public comment on the Federal income 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.
    In response to Notice 2000-29, Treasury and the IRS received a 
number of comments. Many commentators requested guidance on the 
treatment of options and other instruments that are issued by 
partnerships in connection with the performance of services 
(compensatory options).
    These proposed regulations apply to certain call options, warrants, 
convertible debt, and convertible preferred equity that are not issued 
in connection with the performance of services (noncompensatory 
options). To expedite the issuance of guidance, these regulations do 
not address compensatory options. Nothing in the proposed regulations 
should be construed as creating any inference regarding the proper 
Federal income tax treatment of compensatory options. However, Treasury 
and the IRS are working on future guidance that will address the 
Federal income tax consequences of compensatory options and invite 
comments. In particular, Treasury and the IRS request comments on the 
proposed amendment to Sec.  1.721-1(b)(1) that was published in the 
Federal Register on June 3, 1971 (36 FR 10787), and, more particularly, 
on the application of section 83 to the issuance of compensatory 
options and partnership capital interests in connection with the 
performance of services. In addition, Treasury and the IRS request 
comments on how to coordinate the tax treatment of partnership profits 
interests issued in connection with the performance of services (see 
Rev. Proc. 93-27 (1993-2 C.B. 343), as clarified in Rev. Proc. 2001-43 
(2001-34 I.R.B. 191)) with the tax treatment of options to acquire 
partnership capital interests issued in connection with the performance 
of services.

Explanation of Provisions

1. Scope of Proposed Regulations

    The proposed regulations describe certain of the income tax 
consequences of issuing, transferring, and exercising noncompensatory 
options. These proposed regulations apply only if the call option, 
warrant, or conversion right entitles the holder to the right to 
acquire an interest in the issuer (or to cash or property having a 
value equal to the value of such an interest).
    The proposed regulations generally provide that the exercise of a 
noncompensatory option does not cause recognition of gain or loss to 
either the issuing partnership or the option holder. In addition, the 
proposed regulations modify the regulations under section 704(b) 
regarding the maintenance of the partners' capital accounts and the 
determination of the partners' distributive shares of partnership 
items. Finally, the proposed regulations contain a characterization 
rule providing that the holder of a call option, warrant, convertible 
debt, or convertible preferred equity issued by a partnership (or an 
eligible entity, as defined in Sec.  301.7701-3(a), that would become a 
partnership if the option holder were treated as a partner) is treated 
as a partner under certain circumstances.
    The rule providing for nonrecognition of gain or loss on the 
exercise of a noncompensatory option does not apply to any call option, 
warrant, or convertible debt issued by an eligible entity, as defined 
in Sec.  301.7701-3(a), that would become a partnership under Sec.  
301.7701-3(f)(2) if the option, warrant, or conversion right were 
exercised. Treasury and the IRS request comments on whether the 
nonrecognition rule should be extended to such instruments.

2. Issuance, Exercise, and Lapse of Noncompensatory Options

    Section 721(a) and Sec.  1.721-1 provide that, with certain 
exceptions, no gain or loss is recognized to a partnership or any of 
its partners on the contribution of property to a partnership in 
exchange for an interest in the partnership. However, Sec.  1.721-1 
does not provide clear guidance as to the tax consequences to the 
holder of a noncompensatory option and the partnership upon the 
issuance, lapse, and exercise of a noncompensatory option to acquire a 
partnership interest. Many taxpayers have requested guidance clarifying 
the tax consequences of these transactions.
    Generally, the proposed regulations do not treat the issuance of a 
noncompensatory option as a

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transaction described in section 721. Therefore, the issuance of a 
noncompensatory option is taxed under general tax principles. Under 
these principles, the issuance of a noncompensatory call option or 
warrant (stand-alone option) is generally an open transaction for the 
issuer. The issuer's income or loss from the noncompensatory stand-
alone option does not become fixed and determinable until the lapse, 
exercise, repurchase, or other termination of the option. For the 
holder of the noncompensatory stand-alone option, the purchase of the 
option is merely an investment in the option--a capital expenditure 
that is neither taxable to nor deductible by the holder. See Rev. Rul 
78-182 (1978-1 C.B. 265). However, if the holder uses appreciated or 
depreciated property (property with a value greater or less than the 
holder's basis in the property) to acquire the noncompensatory stand-
alone option, then the holder recognizes gain or loss in accordance 
with the provisions of section 1001, subject to the generally 
applicable rules governing the allowance of losses, such as section 
707(b).
    The proposed regulations do not change the rules relating to the 
issuance of convertible debt or convertible equity. Under general tax 
principles, the conversion right embedded in convertible debt or 
convertible equity typically is taken into account for tax purposes as 
part of the underlying instrument.
    The proposed regulations also provide guidance on the tax 
consequences resulting from the exercise of a noncompensatory option. 
Section 1.721-1(b) provides that, to the extent that a partner gives up 
his right to be repaid all or a portion of his capital contribution in 
favor of another partner ``as compensation for services (or in 
satisfaction of an obligation),'' section 721 does not apply. Some 
commentators have expressed a concern that this regulation could be 
read to exclude from the application of section 721 a shift in 
partnership capital from the historic partners to the holder of the 
noncompensatory option in satisfaction of the partnership's option 
obligation upon exercise of the option. If this were the case, the 
partnership could be deemed to have sold a portion of each of its 
assets to the holder in a taxable exchange. Alternatively, the 
partnership could be deemed to have sold a partnership interest with a 
$0 basis to the option holder in a taxable exchange.
    Despite these concerns, most commentators believe that Sec.  1.721-
1(b)(1) should not cause the issuance of a partnership interest upon 
exercise of a noncompensatory option to be taxable. They assert that 
the exercise of such an option should be nontaxable to the holder and 
the partnership, both under general tax principles applicable to 
noncompensatory options and under the policy of section 721 to 
facilitate business combinations through the pooling of capital.
    Treasury and the IRS agree that, in general, the issuance of a 
partnership interest to the holder of a noncompensatory option should 
not be taxable to the holder or the partnership. Upon exercise, the 
option holder may be viewed as contributing property in the form of the 
premium, the exercise price, and the option privilege to the 
partnership in exchange for the partnership interest. Generally, this 
is a transaction to which section 721 should apply--a transaction 
through which persons join together in order to conduct a business or 
make investments. Accordingly, the proposed regulations generally 
provide that section 721 applies to the holder and the partnership upon 
the exercise of a noncompensatory option issued by the partnership.
    The proposed regulations do not describe the tax consequences (to 
the partnership or the holder) of a right to convert partnership debt 
into an interest in the issuing partnership to the extent of any 
accrued but unpaid interest on the debt (including accrued original 
issue discount). On the one hand, based on Carman v. Commissioner, 189 
F.2d 363 (2d Cir. 1951), it might be argued that the interest 
obligation is inseparable from the debt and that both are property for 
purposes of section 721. On the other hand, it may be appropriate to 
require a partnership to recognize gain to the extent of the accrued 
but unpaid interest, because the issuance of the partnership interest 
satisfies a deductible (or capital) expense of the partnership. As this 
issue is closely related to the tax treatment of the exercise of 
compensatory options, Treasury and the IRS have decided to consider 
this issue in the course of preparing guidance on compensatory options. 
Treasury and the IRS request comments on the proper treatment of the 
exercise of convertible debt to the extent of accrued, but unpaid, 
interest (including original issue discount) on the debt.
    The proposed regulations also clarify that section 721 does not 
apply to the lapse of a noncompensatory option. If a noncompensatory 
option lapses, the former option holder does not contribute property to 
the partnership in exchange for an interest in the partnership. 
Accordingly, consistent with general tax principles, the lapse of a 
noncompensatory option generally results in the recognition of income 
by the partnership and the recognition of loss by the former option 
holder.

3. Accounting for Noncompensatory Options

    The proposed regulations also contain rules to assist partnerships 
in properly accounting for any shifts in capital that may result from 
the exercise of noncompensatory options.
    Generally, upon the exercise of a noncompensatory option, the 
option holder receives a partnership interest with a value that is 
greater or less than the aggregate value of the premium and exercise 
price that the option holder contributes to the partnership. In other 
words, the option privilege represents an asset with built-in gain or 
loss, i.e., an asset to which section 704(c) would apply. However, 
because the option privilege terminates upon its contribution to the 
partnership, the partnership cannot allocate gain or loss from the 
option privilege to the option holder under section 704(c)(1)(A). To 
address this problem, the proposed regulations generally allow 
partnerships to substitute built-in gain or loss in the partnership's 
assets for the built-in gain or loss in the option.
    The proposed regulations achieve this result by providing that a 
noncompensatory option holder's initial capital account is equal to the 
consideration paid to the partnership to acquire the noncompensatory 
option and the fair market value of any property (other than the 
option) contributed to the partnership on the exercise of the 
noncompensatory option. The proposed regulations then require the 
partnership to revalue its property immediately following the exercise 
of the noncompensatory option, when the holder has become a partner. 
Under the proposed regulations, the partnership must allocate the 
unrealized income, gain, loss, and deduction from this revaluation, 
first, to the noncompensatory option holder, to the extent necessary to 
reflect the holder's right to share in partnership capital under the 
partnership agreement, and, then, to the historic partners, to reflect 
the manner in which the unrealized income, gain, loss, or deduction in 
partnership property would be allocated among those partners if there 
were a taxable disposition of such property for its fair market value 
on that date. To the extent that unrealized appreciation or 
depreciation in the partnership's assets has been allocated to the 
capital account of the noncompensatory option holder, the holder will, 
under section 704(c)

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principles, recognize any income or loss attributable to that 
appreciation or depreciation as the underlying assets are sold, 
depreciated, or amortized.
    In some cases, the built-in gain or loss in the option will exceed 
the unrealized appreciation or depreciation in the partnership's assets 
(that has not been reflected in the partners' capital accounts 
previously). In those cases, even after all of the unrealized 
appreciation or depreciation in the partnership's assets has been 
allocated to the option holder, a disparity may remain between the 
noncompensatory option holder's right to share in partnership capital 
and the value of money and other property contributed by the partner. 
Most commentators have recommended and Treasury and the IRS agree that 
the partnership nevertheless should be allowed to shift capital between 
the historic partners an the noncompensatory option holder on the 
exercise of the noncompensatory option.
    Some commentators also have suggested that the historic partners 
and the noncompensatory option holder should be allocated notional tax 
items over the recovery period for partnership assets similar to the 
remedial allocations that are permitted, but not required, under the 
regulations issued under section 704(c)(1)(A). Although the use of 
section 704(c) notional tax items would ensure that the noncompensatory 
option holder and the historic partners receive the proper amount of 
income and loss over time, Treasury and the IRS believe that 
implementing such a system would be unduly complex where the built-in 
gain or loss to be allocated to the noncompensatory option holder 
exceeds the built-in gain or loss in the partnership's assets.
    Instead, the proposed regulations require that the partnership make 
corrective allocations of gross income or loss to the partners in the 
year in which the option is exercised so as to take into account any 
shift in the partners' capital accounts that occurs as a result of the 
exercise of a noncompensatory option. These corrective allocations are 
allocations of tax items that differ from the partnership's allocations 
of book items. If there are not sufficient actual partnership items in 
the year of exercise to conform the partnership's tax allocations to 
the capital shift, additional corrective allocations are required in 
succeeding taxable years until the capital shift has been fully taken 
into account.
    The proposed regulations also provide rules for revaluing the 
partners' capital accounts while a noncompensatory option is 
outstanding. Section 1.704-1(b)(2)(iv) contains rules for maintaining a 
partnership's capital accounts. Section 1.704-1(b)(2)(iv)(f) provides 
that a partnership may, upon the occurrence of certain events 
(including the contribution of money to the partnership by a new or 
existing partner), increase or decrease the partners' capital accounts 
to reflect a revaluation of partnership property. If one or more 
options are outstanding when a revaluation occurs, and the revaluation 
does not account for the value associated with the outstanding options, 
the partners' capital accounts will not reflect the true economic value 
of their interests. For example, in partnerships with appreciated 
property, the historic partners' capital accounts often would overstate 
the distributions that would be made to the partners if the partnership 
were liquidated, because a portion of the partnership's assets may 
ultimately be paid to the option holder. Therefore, the proposed 
regulations modify Sec.  1.704-1(b)(2)(iv)(f) and (h) to provide that 
any revaluation during the period in which there are outstanding 
noncompensatory options generally must take into account the fair 
market value, if any, of outstanding options.

4. Characterization Rule

    Under section 704(b), a partner's distributive share of income, 
gain, loss, deduction, or credit (or item thereof) is determined under 
the partnership agreement if the allocation under the agreement has 
substantial economic effect. If the allocation does not have 
substantial economic effect, or the partnership agreement does not 
provide for the allocation, then the allocation must be made in 
accordance with the partner's interest in the partnership (determined 
by taking into account all facts and circumstances). Section 1.704-
1(b)(2)(ii)(h) provides in part that, for this purpose, the partnership 
agreement includes all agreements among the partners, or between one or 
more partners and the partnership, concerning affairs of the 
partnership and responsibilities of partners, whether oral or written, 
and whether or not embodied in a document referred to by the partners 
as the partnership agreement, including puts, options, and buy-sell 
agreements. Currently, there is some uncertainty about the extent to 
which these rules require a partnership to take into account a 
noncompensatory option to acquire an interest in a partnership when 
making its annual allocations.
    Treasury and the IRS believe that it is appropriate to clarify 
these rules with respect to noncompensatory options addressed in this 
project. As these proposed regulations are limited to noncompensatory 
options, nothing in these proposed regulations provides any inference 
as to the operation of this rule for compensatory options or other 
types of agreements.
    Given the uncertainty of the exercise of most noncompensatory 
options, Treasury and the IRS believe that noncompensatory options 
generally should not be treated as entitling the holder to a fixed 
right to share in partnership income until the option is exercised. 
However, if a noncompensatory option provides the holder with rights 
that are substantially similar to the rights afforded to a partner, 
then the holder should be treated as a partner and the option should be 
taken into account in allocating partnership income. At the same time, 
Treasury and the IRS recognize that treating a noncompensatory option 
holder as a partner may, in some circumstances, frustrate the intent of 
the parties without substantially altering their aggregate tax 
liabilities.
    For these reasons, the proposed regulations generally respect 
noncompensatory options as such and do not characterize them as 
partnership equity. However, the proposed regulations contain a rule 
that characterizes the holder of a noncompensatory option as a partner 
if the option holder's rights are substantially similar to the rights 
afforded to a partner. This rule applies only if, as of the date that 
the noncompensatory option is issued, transferred, or modified, there 
is a strong likelihood that the failure to treat the option holder as a 
partner would result in a substantial reduction in the present value of 
the partners' and the option holder's aggregate tax liabilities.
    The proposed regulations use a facts and circumstances test to 
determine whether a noncompensatory option holder's rights are 
substantially similar to the rights afforded to a partner, including 
whether the option is reasonably certain to be exercised and whether 
the option holder has partner attributes. The proposed regulations list 
a number of factors that are used to determine whether a 
noncompensatory option is reasonably certain to be exercised, including 
the premium paid for the option, the exercise price of the option, the 
term of the option, the predictability and stability of the value of 
the underlying partnership interest, and whether the partnership is 
expected to make distributions during the term of the option. If a 
noncompensatory option is reasonably certain to be exercised, then the 
holder of the option ordinarily

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has rights that are substantially similar to the rights afforded to a 
partner. Partner attributes include the extent to which the option 
holder shares in the economic benefit and detriment of partnership 
income and loss and the extent to which the option holder has the right 
to participate in the management of the partnership.
    If the holder of a noncompensatory option is treated as a partner 
under the proposed regulations, then the holder's distributive share of 
the partnership's income, gain, loss, deduction, or credit (or items 
thereof) generally must be determined in accordance with such partner's 
interest in the partnership (taking into account all facts and 
circumstances) as determined under Sec.  1.704-1(b)(3). For this 
purpose, the partner's interest in the partnership generally must 
reflect the economic differences between holding an option to acquire a 
partnership interest and holding the partnership interest itself. For 
example, unlike a partner, a noncompensatory option holder is not 
required initially to contribute to the partnership the full amount of 
the purchase price for the partnership interest. Instead, the 
noncompensatory option holder generally pays an option premium that is 
considerably smaller than the purchase price and may wait until the 
option is about to expire to decide whether to exercise the option and 
pay the exercise price. The computation of the noncompensatory option 
holder's share of partnership items should reflect this lesser amount 
of capital investment to the extent appropriate in a particular case. 
In addition, a noncompensatory option holder's cumulative distributive 
share of partnership losses and deductions may be limited under 
sections 704(b) and (d) to the amount paid by the holder to the 
partnership for the option.

5. Original Issue Discount Provisions

    The final regulations under the original issue discount (OID) 
provisions provide special rules for debt instruments convertible into 
the stock of the issuer. See Sec. Sec.  1.1272-1(e), 1.1273-2(j), and 
1.1275-4(a)(4). In response to Notice 2000-29, commentators requested 
that these special rules be extended to apply to debt instruments 
convertible into partnership interests. Treasury and the IRS agree with 
the commentators. Treating convertible debt issued by partnerships and 
corporations differently for purposes of these special rules could 
create unjustified distinctions between the taxation of instruments 
that are economically equivalent. Accordingly, the proposed regulations 
amend the OID provisions to treat partnership interests as stock for 
purposes of the special rules for convertible debt instruments.

Proposed Effective Date

    These regulations are proposed to apply to noncompensatory options 
that are issued on or after the date final regulations are published in 
the Federal Register.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It also has 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations, and because 
the regulations do not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Internal Revenue Code, this 
notice of proposed rulemaking will be submitted to the Chief Counsel 
for Advocacy of the Small Business Administration for comment on its 
impact on small businesses.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight copies) that are submitted timely to the IRS. Alternatively, 
taxpayers may submit comments electronically directly to the IRS 
Internet site at www.irs.gov/regs. The IRS and Treasury Department 
request comments on the clarity of the proposed rules and how they can 
be made easier to understand. All comments will be available for public 
inspection and copying.
    A public hearing has been scheduled for May 20, 2003, beginning at 
10 a.m. in room 4718, Internal Revenue Building, 1111 Constitution 
Avenue, NW., Washington, DC. Due to building security procedures, 
visitors must enter at the Constitution Avenue entrance. In addition, 
all visitors must present photo identification to enter the building. 
Because of access restrictions, visitors will not be admitted beyond 
the immediate entrance area more than 30 minutes before the hearing 
starts. For information about having your name placed on the building 
access list to attend the hearing, see the FOR FURTHER INFORMATION 
CONTACT portion of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments must submit written comments and an 
outline of the topics to be discussed and the time to be devoted to 
each topic (a signed original and eight (8) copies) by April 29, 2003. 
A period of 10 minutes will be allotted to each person for making 
comments. An agenda showing the scheduling of the speakers will be 
prepared after the deadline for reviewing outlines has passed. Copies 
of the agenda will be available free of charge at the hearing.

Drafting Information

    The principal author of these proposed regulations is Audrey W. 
Ellis of the Office of the Associate Chief Counsel (Passthroughs and 
Special Industries). However, other personnel from the IRS and Treasury 
participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    1. The authority citation for part 1 continues to read in part as 
follows:

    Authority: 26 U.S.C. 7805 * * *

    2. Section 1.704-1 is amended as follows:
    1. Paragraph (b)(0) is amended by adding entries for 1.704-
1(b)(2)(iv)(d)(4), 1.704-1(b)(2)(iv)(h)(1), 1.704-1(b)(2)(iv)(h)(2), 
1.704-1(b)(2)(iv)(s), 1.704-1(b)(4)(ix), and 1.704-1(b)(4)(x).
    2. Paragraph (b)(1)(ii) is amended by adding a sentence at the end 
of the paragraph.
    3. Paragraph (b)(2)(iv)(d)(4) is added.
    4. Paragraph (b)(2)(iv)(f)(1) is revised.
    5. Paragraphs (b)(2)(iv)(h)(1), and (2) are redesignated as 
paragraphs (b)(2)(iv)(h)(1)(i) and (ii), respectively; the text of 
paragraph (b)(2)(iv)(h) is redesignated paragraph (b)(2)(iv)(h)(1); a 
heading is added to new paragraph (b)(2)(iv)(h)(1); and paragraph 
(b)(2)(iv)(h)(2) is added.
    6. Paragraph (b)(2)(iv)(s) is added immediately after the 
undesignated paragraph that follows paragraph (b)(2)(iv)(r)(2).
    7. Paragraphs (b)(r)(ix) and (b)(4)(x) are added.
    8. Paragraph (b)(5) is amended by adding Example 20, Example 21, 
Example 22, Example 23, and Example 24.
    The additions and revisions read as follows:

[[Page 2934]]

Sec.  1.704-1  Partner's distributive share.

* * * * *
    (b) (0) * * *

Exercise of noncompensatory     1.704-1(b)(2)(iv)(d)(4)
 options.
 
                              * * * * * * *
In general....................  1.704-1(b)(2)(iv)(h)(1)
Adjustments for                 1.704-(b)(2)(iv)(h)(2)
 noncompensatory options.
 
                              * * * * * * *
Adjustments on the exercise of  1.704-1(b)(2)(iv)(s)
 a noncompensatory option.
 
                              * * * * * * *
Allocations with respect to     1.704-1(b)(4)(ix)
 noncompensatory options.
Corrective allocations........  1.704-1(b)(4)(x)
 
                              * * * * * * *
 

    (1) * * *
    (ii) * * * In addition, paragraph (b)(2)(iv)(d)(4), paragraph 
(b)(2)(iv)(h)(2), paragraph (b)(2)(iv)(s), paragraph (b)(4)(ix), 
paragraph (b)(4)(x), and Examples 20 through 24 in paragraph (b)(5) of 
this section apply to noncompensatory options (as defined in Sec.  
1.721-2(d)) that are issued on or after the date final regulations are 
published in the Federal Register.
* * * * *
    (2) * * *
    (iv) * * *
    (d) * * *
    (4) Exercise of noncompensatory options. For purposes of paragraph 
(b)(2)(iv)(b)(2) of this section, the fair market value of the property 
contributed on the exercise of a noncompensatory option (as defined in 
Sec.  1.721-2(d)) does not include the fair market value of the option 
privilege, but does include the consideration paid to the partnership 
to acquire the option and the fair market value of any property (other 
than the option) contributed to the partnership on the exercise of the 
option. With respect to convertible equity, the fair market value of 
the property contributed to the partnership on the exercise of the 
option includes the converting partner's capital account immediately 
before the conversion. See Examples 20 through 24 of paragraph (b)(5) 
of this section.
* * * * *
    (f) * * *
    (1) The adjustments are based on the fair market value of 
partnership property (taking section 7701(g) into account) on the date 
of adjustment, as determined under paragraph (b)(2)(iv)(h) of this 
section, reduced by the consideration paid to the partnership acquire 
any outstanding noncompensatory options (as defined in Sec.  1.721-
2(d)) that are issued on or after the date final regulations are 
published in the Federal Register. See Example 22 of paragraph (b)(5) 
of this section.
* * * * *
    (h) Determinations of fair market value--(1) In general. * * *
    (2) Adjustments for noncompensatory options. The fair market value 
partnership property must be adjusted to account for any outstanding 
noncompensatory options (as defined in Sec.  1.721-2(d)) at the time of 
a revaluation of partnership property under paragraph (b)(2)(iv(f) or 
(s) of this section. If the fair market value of outstanding 
noncompensatory options (as defined in Sec.  1.721-2(d)) as of the date 
of the adjustment exceeds the consideration paid by the option holders 
to acquire the options, then the fair market value of partnership 
property must be reduced by that excess to the extent of the unrealized 
income or gain in partnership property (that has not been reflected in 
the capital accounts previously). This reduction is allocated only to 
properties with unrealized appreciation in proportion to their 
respective amounts of unrealized appreciation. If the price paid by the 
option holders to acquire the outstanding noncompensatory options (as 
defined in Sec.  1.721-2(d)) exceeds the fair market value of such 
options as of the date of the adjustment, then the value of partnership 
property must be increased by that excess to the extent of the 
unrealized deductions or loss in partnership property (that has not 
been reflected in the capital accounts previously). This increase is 
allocated only to properties with unrealized depreciation in proportion 
to their respective amounts of unrealized depreciation.
* * * * *
    (s) Adjustments on the exercise of a noncompensatory option. A 
partnership agreement may grant a partner, on the exercise of a 
noncompensatory option (as defined in Sec.  1.721-2(d)), a right to 
share in partnership capital that exceeds (or is less than) the sum of 
the consideration paid by the partner to acquire and exercise such 
option. Where such an agreement exists, capital accounts will not be 
considered to be determined and maintained in accordance with the rules 
of this paragraph (b)(2)(iv) unless--
    (1) In lieu of revaluing partnership property under paragraph 
(b)(2)(iv)(f) of this section immediately before the exercise of the 
option, the partnership revalues partnership property in accordance 
with the provisions of paragraphs (b)(2)(iv)(f)(1) through (4) of this 
section immediately after the exercise of the option;
    (2) In determining the capital accounts of the partners (including 
the exercising partner) under paragraph (b)(2)(iv)(s)(1) of this 
section, the partnership first allocates any unrealized income, gain, 
loss, or deduction in partnership assets (that has not been reflected 
in the capital accounts previously) to the exercising partner to the 
extent necessary to reflect that partner's right to share in 
partnership capital under the partnership agreement, and then allocates 
any remaining unrealized income gain, loss, or deduction (that has not 
been reflected in the capital accounts previously) to the existing 
partners, to reflect the manner in which the unrealized income, gain, 
loss, or deduction in partnership property would be allocated among 
those partners if there were a taxable disposition of such property for 
its fair market value on that date;

[[Page 2935]]

    (3) If, after making the allocations described in paragraph 
(b)(2)(iv)(s)(2) of this section, the exercising partner's capital 
account still does not reflect that partner's right to share in 
partnership capital under the partnership agreement, then the 
partnership reallocates partnership capital between the existing 
partners and the exercising partner so that the exercising partner's 
capital account does reflect the exercising partner's right to share in 
partnership capital under the partnership agreement (a capital account 
reallocation). Any increase or reduction in the capital accounts of 
existing partners that occurs as a result of a capital account 
reallocation under this paragraph (b)(2)(iv)(s)(3) must be allocated 
among the existing partners in accordance with the principles of this 
section; and
    (4) The partnership agreement requires corrective allocations so as 
to take into account all capital account reallocations made under 
paragraph (b)(2)(iv)(s)(3) of this section (see paragraph (b)(4)(x) of 
this section). See Examples 20 through 24 of paragraph (b)(5) of this 
section.
* * * * *
    (4) * * *
    (ix) Allocations with respect to noncompensatory options. A 
partnership agreement may grant to a partner that exercises a 
noncompensatory option a right to share in partnership capital that 
exceeds (or is less than) the sum of the amounts paid by the partner to 
acquire and exercise such option. In such a case, allocations of 
income, gain, loss, and deduction to the partners while the 
noncompensatory option is outstanding cannot have economic effect, 
because, if the noncompensatory option is exercised, the exercising 
partner, rather than the existing partners, may receive the economic 
benefit or bear the economic detriment associated with that income, 
gain, loss, or deduction. Allocations of partnership income, gain, 
loss, and deduction to the partners while the noncompensatory option is 
outstanding will be deemed to be in accordance with the partners' 
interests in the partnership only if--
    (a) The holder of the noncompensatory option is not treated as a 
partner under Sec.  1.761-3;
    (b) The partnership agreement requires that, on the exercise of the 
noncompensatory option, the partnership comply with the rules of 
paragraph (b)(2)(iv)(s) of this section; and
    (c) All material allocations and capital account adjustments under 
the partnership agreement not pertaining to noncompensatory options are 
recognized under section 704(b). See Examples 20 through 24 of 
paragraph (b)(5) of this section.
    (x) Corrective allocations. If partnership capital is reallocated 
between existing partners and a partner exercising a noncompensatory 
option under paragraph (b)(2)(iv)(s)(3) of this section (a capital 
account reallocation), the partnership must, beginning with the taxable 
year of the exercise and in all succeeding taxable years until the 
allocations required are fully taken into account, make corrective 
allocations so as to take into account the capital account 
reallocation. A corrective allocation is an allocation (consisting of a 
pro rata portion of each item) for tax purposes of gross income and 
gain, or gross loss and deduction, that differs from the partnership's 
allocation of the corresponding book item. See Example 21 of paragraph 
(b)(5) of this section.
* * * * *
    (5) * * *

    Example 20. (i) In Year 1, TM and PK each contribute cash of 
$10,000 to LLC, a newly formed limited liability company, classified 
as a partnership for Federal tax purposes, in exchange for 100 units 
in LLC. Under the LLC agreement, each unit is entitled to 
participate equally in the profits and losses of LLC. LLC uses the 
cash contributions to purchase a non-depreciable property, Property 
A, for $20,000. Also in Year 1, at a time when Property A is still 
valued at $20,000, LLC issues an option to DH. The option allows DH 
to buy 100 units in LLC for an exercise price of $15,000 in Year 2. 
DH pays $1,000 to the LLC for the issuance of the option. Assume 
that the LLC agreement requires that, on the exercise of a 
noncompensatory option, LLC comply with the rules of paragraph 
(b)(2)(iv)(s) of this section, and that all material allocations and 
capital account adjustments under the LLC agreement not pertaining 
to noncompensatory options are recognized under section 704(b). Also 
assume that DH's option is a noncompensatory option under Sec.  
1.721-2(d), and that DH is not treated as a partner with respect to 
the option. In Year 2, DH exercises the option, contributing the 
$15,000 exercise price to the partnership. At the time the option is 
exercised, the value of Property A is $35,000.

------------------------------------------------------------------------
                                                        Basis     Value
------------------------------------------------------------------------
Assets:
  Property A........................................   $20,000   $35,000
  Cash Premium......................................     1,000     1,000
  Exercise Price....................................    15,000    15,000
                                                     -----------
        Total.......................................    36,000    51,000
 
  TM................................................    10,000    17,000
  PK................................................    10,000    17,000
  DH................................................    16,000    17,000
                                                     -----------
        Total.......................................    36,000    51,000
------------------------------------------------------------------------

    (ii) Under paragraphs (b)(2)(iv)(b)(2) and (b)(2)(iv)(d)(4) of 
this section, DH's capital account is credited with the amount paid 
for the option ($1,000) and the exercise price of the option 
($15,000). Under the LLC agreement, however, DH is entitled to LLC 
capital corresponding to 100 units of LLC (\1/3\ of LLC's capital). 
Immediately after the exercise of the option, LLC's assets are cash 
of $16,000 ($1,000 premium and $15,000 exercise price contributed by 
DH) and Property A, which has a value of $35,000. Thus, the total 
value of LLC's assets is $51,000. DH is entitled to LLC capital 
equal to \1/3\ of this value, or $17,000. As DH is entitled to 
$1,000 more LLC capital than DH's capital contributions to LLC, the 
provisions of paragraph (b)(2)(iv)(s) of this section apply.
    (iii) Under paragraph (b)(2)(iv)(s) of this section, LLC must 
increase DH's capital account from $16,000 to $17,000 by, first, 
revaluing LLC property in accordance with the principles of 
paragraph (b)(2)(iv)(f) of this section and allocating the first 
$1,000 of book gain to DH. The net gain in LLC's assets (Property A) 
is $15,000 ($35,000 value less $20,000 basis). The first $1,000 of 
this gain must be allocated to DH, and the remaining $14,000 of this 
gain is allocated equally to TM and PK in accordance with the LLC 
agreement. Because the revaluation of LLC assets under paragraph 
(b)(2)(iv)(s)(2) of this section increases DH's capital account to 
the amount agreed on by the members, LLC is not required to make a 
capital account reallocation under paragraph (b)(2)(iv)(s)(3) of 
this section. Under paragraph (b)(2)(iv)(f)(4) of this section, the 
tax items from the revalued property must be allocated in accordance 
with section 704(c) principles.

----------------------------------------------------------------------------------------------------------------
                                                         TM                    PK                    DH
                                               -----------------------------------------------------------------
                                                   Tax        Book       Tax        Book       Tax        Book
----------------------------------------------------------------------------------------------------------------
Capital account after exercise................    $10,000    $10,000    $10,000    $10,000    $16,000    $16,000
Revaluation amount............................  .........      7,000  .........      7,000  .........      1,000
                                               ------------
    Capital account after revaluation.........     10,000     17,000     10,000     17,000     16,000     17,000
----------------------------------------------------------------------------------------------------------------


[[Page 2936]]

    Example 21. (i) Assume the same facts as in Example 20, except 
that, in Year 1, LLC sells Property A for $40,000, recognizing gain 
of $20,000. LLC does not distribute the sale proceeds to its 
partners and it has no other earnings in Year 1. With the proceeds 
($40,000), LLC purchases Property B, a nondepreciable property. Also 
assume that DH exercises the noncompensatory option at the beginning 
of Year 2 and that, at the time DH exercises the option, the value 
of Property B is $41,000. In Year 2, LLC has gross income of $3,000 
and deductions of $1,500.

------------------------------------------------------------------------
                                                        Basis     Value
------------------------------------------------------------------------
Assets:
  Property B........................................   $40,000   $41,000
  Cash..............................................    16,000    16,000
                                                     -----------
        Total.......................................    56,000    57,000
 
  TM................................................    20,000    19,000
  PK................................................    20,000    19,000
  DH................................................    16,000    19,000
                                                     -----------
        Total.......................................    56,000    57,000
------------------------------------------------------------------------

    (ii) Under paragraphs (b)(2)(iv)(b)(2) and (b)(2)(iv)(d)(4) of 
this section, DH's capital account is credited with the amount paid 
for the option ($1,000) and the exercise price of the option 
($15,000). Under the LLC agreement, however, DH is entitled to LLC 
capital corresponding to 100 units of LLC (\1/3\ of LLC's capital). 
Immediately after the exercise of the option, LLC's assets are 
$16,000 cash ($1,000 option premium and $15,000 exercise price 
contributed by DH) and Property B, which has a value of $41,000. 
Thus, the total value of LLC's assets is $57,000. DH is entitled to 
LLC capital equal to \1/3\ of this amount, or $19,000. As DH is 
entitled to $3,000 more LLC capital than DH's capital contributions 
to LLC, the provisions of paragraph (b)(2)(iv)(s) of this section 
apply.
    (iii) Under paragraph (b)(2)(iv)(s) of this section, LLC must 
increase DH's capital account from $16,000 to $19,000 by, first, 
revaluing LLC property in accordance with the principles of 
paragraph (b)(2)(iv)(f) of this section, and allocating the $1,000 
of book gain from the revaluation to DH. This brings DH's capital 
account to $17,000. Second, under paragraph (b)(2)(iv)(s)(3) of this 
section, LLC must reallocate $2,000 of capital from the existing 
partners (TM and PK) to DH to bring DH's capital account to $19,000 
(the capital account reallocation). As TM and PK share equally in 
all items of income, gain, loss, and deduction of LLC, each member's 
capital account is reduced by \1/2\ of the $2,000 reduction 
($1,000).
    (iv) Under paragraph (b)(2)(iv)(s)(4) of this section, beginning 
in the year in which the option is exercised, LLC must make 
corrective allocations so as to take into account the capital 
account reallocation. In Year 2, LLC has gross income of $3,000 and 
deductions of $1,500. The book gross income of $3,000 is shared 
equally by TM, PK, and DH. For tax purposes, however, LLC must 
allocate all of its gross income ($3,000) to DH. LLC's deductions 
($1,500) must be allocated equally among TM, PK, and DH. Under 
paragraph (b)(2)(iv)(f)(4) of this section, the tax items from 
Property B must be allocated in accordance with section 704(c) 
principles.

----------------------------------------------------------------------------------------------------------------
                                                         TM                    PK                    DH
                                               -----------------------------------------------------------------
                                                   Tax        Book       Tax        Book       Tax        Book
----------------------------------------------------------------------------------------------------------------
Capital account after exercise................   $20,000    $20,000    $20,000    $20,000    $16,000    $16,000
Revaluation...................................  .........  .........  .........  .........  .........     1,000
                                               ------------
    Capital account after revaluation.........    20,000     20,000     20,000     20,000     16,000     17,000
Capital account reallocation..................  .........    (1,000)  .........    (1,000)  .........     2,000
                                               ------------
    Capital account after capital account         20,000     19,000     20,000     19,000     16,000     19,000
     reallocation.............................
Income allocation (Yr. 2).....................  .........     1,000   .........     1,000      3,000      1,000
Deduction allocation (Yr. 2)..................      (500)      (500)      (500)      (500)      (500)      (500)
                                               ------------
    Capital account at end of year 2..........    19,500     19,500     19,500     19,500     18,500     19,500
----------------------------------------------------------------------------------------------------------------

    Example 22. (i) In Year 1, AC and NE each contribute cash of 
$10,000 to LLC, a newly formed limited liability company classified 
as a partnership for Federal tax purposes, in exchange for 100 units 
in LLC. Under the LLC agreement, each unit is entitled to 
participate equally in the profits and losses of LLC. LLC uses the 
cash contributions to purchase two non-depreciable properties, 
Property A and Property B, for $10,000 each. Also in Year 1, at a 
time when Property A and Property B are still valued at $10,000 
each, LLC issues an option to DR. The option allows DR to buy 100 
units in LLC for an exercise price of $15,000 in Year 2. DR pays 
$1,000 to LLC for the issuance of the option. Assume that the LLC 
agreement requires that, on the exercise of a noncompensatory 
option, LLC comply with the rules of paragraph (b)(2)(iv)(s) of this 
section, and that all material allocations and capital account 
adjustments under the LLC agreement not pertaining to 
noncompensatory options are recognized under section 704(b). Also 
assume that DR's option is a noncompensatory option under Sec.  
1.721-2(d), and that DR is not treated as a partner with respect to 
the option.
    (ii) Prior to the exercise of DR's option, ML contributes 
$17,000 to LLC for 100 units in LLC. At the time of ML's 
contribution, Property A has a value of $30,000 and a basis of 
$10,000, Property B has a value of $5,000 and a basis of $10,000, 
and the fair market value of DR's option is $2,000.
    (iii) Upon ML's admission to the partnership, the capital 
accounts of AC and NE (which were $10,000 each prior to ML's 
admission) are, in accordance with paragraph (b)(2)(iv)(f) of this 
section, adjusted upward to reflect their shares of the unrealized 
appreciation in the partnership's assets. Under paragraph 
(b)(2)(iv)(f)(1) of this section, those adjustments must be based on 
the fair market value of LLC property (taking section 7701(g) into 
account) on the date of the adjustment. The fair market value of 
partnership property ($36,000) must be reduced by the consideration 
paid by DR to the partnership to acquire the option ($1,000) (under 
paragraph (b)(2)(iv)(f)(1) of this section), and the excess of the 
fair market value of the option as of the date of the adjustment 
over the consideration paid by DR to acquire the option ($1,000) 
(under paragraph (b)(2)(iv)(h)(2) of this section), but only to the 
extent of the unrealized appreciation in LLC property ($15,000). 
Therefore, the revaluation adjustments must be based on a value of 
$34,000. Accordingly, AC and NE's capital accounts must be increased 
to $17,000. This $1,000 reduction is allocated entirely to Property 
A, the only asset having unrealized appreciation. Therefore, the 
book value of Property A is $29,000. The $19,000 of built-in gain in 
Property A and the $5,000 of built-in loss in Property B must be 
allocated equally between AC and NE in accordance with section 
704(c) principles.

----------------------------------------------------------------------------------------------------------------
                                                                 Assets                    Option      1704(c)
                                                                 basis        Value      adjustment      book
----------------------------------------------------------------------------------------------------------------
Property A..................................................      $10,000      $30,000     ($1,000)      $29,000
Property B..................................................       10,000        5,000           0         5,000

[[Page 2937]]

 
Cash........................................................        1,000        1,000           0         1,000
                                                             --------------
    Subtotal................................................       21,000       36,000      (1,000)       35,000
                                                             ==============
Cash contributed by ML......................................       17,000       17,000           0        17,000
                                                             --------------
    Total...................................................       38,000       53,000      (1,000)       52,000
----------------------------------------------------------------------------------------------------------------


------------------------------------------------------------------------
                                                       Liabilities and
                                                           Capital
                                                   ---------------------
                                                       Tax       Value
------------------------------------------------------------------------
AC................................................    $10,000    $17,000
NE................................................     10,000     17,000
ML................................................     17,000     17,000
Option............................................      1,000      2,000
                                                   ------------
    Total.........................................     38,000     53,000
------------------------------------------------------------------------

    (iv) After the admission of ML, when Property A still has a 
value of $30,000 and a basis of $10,000 and Property B still has a 
value of $5,000 and a basis of $10,000, DR exercises the option. On 
the exercise of the option, DR's capital account is credited with 
the amount paid for the option ($1,000) and the exercise price of 
the option ($15,000). Under the LLC agreement, however, DR is 
entitled to LLC capital corresponding to 100 units of LLC (\1/4\ of 
LLC's capital). Immediately after the exercise of the option, LLC's 
assets are worth $68,000 ($15,000 contributed by DR, plus the value 
of LLC assets prior to the exercise of the option, $53,000). DR is 
entitled to LLC capital equal to \1/4\ of this value, or $17,000. As 
DR is entitled to $1,000 more LLC capital than DR's capital 
contributions to LLC, the provisions of paragraph (b)(2)(iv)(s) of 
this section apply.
    (v) Under paragraph (b)(2)(iv)(s) of this section, the LLC must 
increase DR's capital account from $16,000 to $17,000 by, first, 
revaluing LLC property in accordance with the principles of 
paragraph (b)(2)(iv)(f) of this section and allocating the first 
$1,000 of book gain to DR. The net increase in the value of LLC 
properties since the previous revaluation is $1,000 (the difference 
between the actual value of Property A, $30,000, and the book value 
of Property A, $29,000). The entire $1,000 of book gain is allocated 
to DR. Because the revaluation of LLC assets under paragraph 
(b)(2)(iv)(s)(2) of this section increases DR's capital account to 
the amount agreed on by the members, the LLC is not required to make 
a capital account reallocation under paragraph (b)(2)(iv)(s)(3) of 
this section. Under paragraph (b)(2)(iv)(f)(4) of this section, the 
tax items from Properties A and B must be allocated in accordance 
with section 704(c) principles.

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                           AC                    NE                    ML                    DR
                                                                 ---------------------------------------------------------------------------------------
                                                                     Book       Tax        Tax        Book       Tax        Book       Tax        Book
--------------------------------------------------------------------------------------------------------------------------------------------------------
Capital account after admission of ML...........................    $10,000    $17,000    $10,000    $17,000    $17,000    $17,000  .........  .........
Capital account after exercise of DH's option...................     10,000     17,000     10,000     17,000     17,000     17,000    $16,000    $16,000
Revaluation.....................................................  .........  .........  .........  .........  .........  .........  .........      1,000
                                                                 ------------
    Capital account after revaluation...........................     10,000     17,000     10,000     17,000     17,000     17,000     16,000     17,000
--------------------------------------------------------------------------------------------------------------------------------------------------------

    Example 23. (i) On the first day of Year 1, MS, VH, and SR form 
LLC, a limited liability company classified as a partnership for 
Federal tax purposes. MS and VH each contribute $10,000 cash to LLC 
for 100 units of common interest in LLC. SR contributes $10,000 cash 
for a convertible preferred interest in LLC. SR's convertible 
preferred interest entitles SR to receive an annual allocation and 
distribution of cumulative LLC net profits in an amount equal to 10 
percent of SR's unreturned capital. SR's convertible preferred 
interest also entitles SR to convert, in year 3, SR's preferred 
interest into 100 units of common interest. If SR converts, SR has 
the right to the same share of LLC capital as SR would have had if 
SR had held the 100 units of common interest since the formation of 
LLC. Under the LLC agreement, each unit of common interest has an 
equal right to share in any LLC net profits that remains after 
payment of the preferred return. Assume that the LLC agreement 
requires that, on the exercise of a noncompensatory option, LLC 
comply with the rules of paragraph (b)(2)(iv)(s) of this section, 
and that all material allocations and capital account adjustments 
under the LLC agreement not pertaining to noncompensatory options 
are recognized under section 704(b). Also assume that SR's right to 
convert the preferred interest into a common interest qualifies as a 
noncompensatory option under Sec.  1.721-2(d), and that, prior to 
the exercise of the conversion right, SR is not treated as a partner 
with respect to the conversion right.
    (ii) LLC uses the $30,000 to purchase Property Z, a property 
that is depreciable on a straight-line basis over 15 years. In each 
of Years 1 and 2, LLC has net income of $2,500, comprised of $4,500 
of gross receipts and $2,000 of depreciation. It allocates and 
distributes $1,000 of this net income to SR in each year. LLC 
allocates, but does not distribute, the remaining $1,500 of net 
income equally to MS and VH in each year.

----------------------------------------------------------------------------------------------------------------
                                                         MS                    VH                    SR
                                               -----------------------------------------------------------------
                                                   Tax        Book       Tax        Book       Tax        Book
----------------------------------------------------------------------------------------------------------------
Capital account upon formation................    $10,000    $10,000    $10,000    $10,000   $10,000    $10,000
Allocation of income Years 1 and 2............      1,500      1,500      1,500      1,500     2,000      2,000
Distributions Years 1 and 2...................  .........  .........  .........  .........    (2,000)    (2,000)
                                               ------------
    Capital account end of Year 2.............     11,500     11,500     11,500     11,500    10,000     10,000
----------------------------------------------------------------------------------------------------------------

    (iii) At the beginning of Year 3, when Property Z has a value of 
$38,000 and a basis of $26,000 ($30,000 original basis less $4,000 
of depreciation) and LLC has accumulated undistributed cash of 
$7,000 ($9,000 gross receipts less $2,000 distributions), SR 
converts SR's preferred interest into a common interest. Under 
paragraphs (b)(2)(iv)(b)(2) and (b)(2)(iv)(d)(4) of this section, 
SR's capital account after the conversion equals SR's capital 
account before the conversion, $10,000. On the conversion of the 
preferred interest, however, SR is entitled to LLC capital 
corresponding to 100 units of common interest in LLC (\1/3\ of LLC's 
capital). At the time of the conversion, the total value of LLC 
assets is $45,000. SR is entitled to LLC capital equal to \1/3\ of 
this

[[Page 2938]]

value, or $15,000. As SR is entitled to $5,000 more LLC capital than 
SR's capital account immediately after the conversion, the 
provisions of paragraph (b)(2)(iv)(s) of this section apply.

------------------------------------------------------------------------
                                                        Basis     Value
------------------------------------------------------------------------
Assets:
  Property Z Undistributed Income...................   $26,000   $38,000
                                                         7,000     7,000
                                                     -----------
        Total.......................................    33,000    45,000
                                                     ===========
Liabilities and Capital:
  MS................................................    11,500    15,000
  VH................................................    11,500    15,000
  SR................................................    10,000    15,000
                                                     -----------
        Total.......................................    33,000    45,000
------------------------------------------------------------------------

    (iv) Under paragraph (b)(2)(iv)(s) of this section, LLC must 
increase SR's capital account from $10,000 to $15,000 by, first, 
revaluing LLC property in accordance with the principles of 
paragraph (b)(2)(iv)(f ) of this section, and allocating the first 
$5,000 of book gain from that revaluation to SR. The net unrealized 
gain in LLC's assets (Property Z) is $12,000 ($38,000 value less 
$26,000 basis). The first $5,000 of this gain must be allocated to 
SR. The remaining $7,000 of that gain must be allocated equally to 
MS and VH in accordance with the LLC agreement. Because the 
revaluation of LLC assets under paragraph (b)(2)(iv)(s)(2) of this 
section increases SR's capital account to the amount agreed on by 
the members, LLC is not required to make a capital account 
reallocation under paragraph (b)(2)(iv)(s)(3) of this section. Under 
paragraph (b)(2)(iv)(f)(4) of this section, the tax items from the 
revalued property must be allocated in accordance with section 
704(c) principles.

----------------------------------------------------------------------------------------------------------------
                                                         MS                    VH                    SR
                                               -----------------------------------------------------------------
                                                   Tax        Book       Tax        Book       Tax        Book
----------------------------------------------------------------------------------------------------------------
Capital account prior to conversion...........    $11,500    $11,500    $11,500    $11,500    $10,000    $10,000
Revaluation on conversion.....................  .........      3,500  .........      3,500  .........      5,000
                                               ------------
    Capital account after conversion..........     11,500     15,000     11,500     15,000     10,000     15,000
----------------------------------------------------------------------------------------------------------------

     Example 24. (i) On the first day of Year 1, AK and JP each 
contribute cash of $10,000 to LLC, a newly formed limited liability 
company classified as a partnership for Federal tax purposes, in 
exchange for 100 units in LLC. Immediately after its formation, LLC 
borrows $10,000 from JS. Under the terms of the debt instrument, 
interest of $1,000 is payable annually and principal is repayable in 
five years. Throughout the term of the indebtedness, JS has the 
right to convert the debt instrument into 100 units in LLC. If JS 
converts, JS has the right to the same share of LLC capital as JS 
would have had if JS had held 100 units in LLC since the formation 
of LLC. Under the LLC agreement, each unit participates equally in 
the profits and losses of LLC and has an equal right to share in LLC 
capital. Assume that the LLC agreement requires that, on the 
exercise of a noncompensatory option, LLC comply with the rules of 
paragraph (b)(2)(iv)(s) of this section, and that all material 
allocations and capital account adjustments not pertaining to 
noncompensatory options are recognized under section 704(b). Also 
assume that JS's right to convert the debt into an interest in LLC 
qualifies as a noncompensatory option under Sec.  1.721-2(d), and 
that, prior to the exercise of the conversion right, JS is not 
treated as a partner with respect to the convertible debt.
    (ii) LLC uses the $30,000 to purchase Property D, property that 
is depreciable on a straight-line basis over 15 years. In each of 
Years 1, 2, and 3, LLC has net income of $2,000, comprised of $5,000 
of gross receipts, $2,000 of depreciation, and interest expense 
(representing payments of interest on the loan from JS) of $1,000. 
LLC allocates, but does not distribute, this income equally to AK 
and JP.

----------------------------------------------------------------------------------------------------------------
                                                         AK                    JP                    JS
                                               -----------------------------------------------------------------
                                                   Tax        Book       Tax        Book       Tax        Book
----------------------------------------------------------------------------------------------------------------
Initial capital account.......................    $10,000     10,000    $10,000     10,000  .........  .........
Year 1 net income.............................     $1,000      1,000     $1,000      1,000  .........  .........
Years 2 net income............................     $1,000      1,000     $1,000      1,000  .........  .........
Years 3 net income............................     $1,000      1,000     $1,000      1,000  .........  .........
                                               ------------
    Year 4 initial capital account............    $13,000     13,000    $13,000     13,000          0          0
----------------------------------------------------------------------------------------------------------------

    (iii) At the beginning of year 4, at a time when Property D, the 
LLC's only asset, has a value of $33,000 and basis of $24,000 
($30,000 original basis less $6,000 depreciation in Years 1 through 
3), and LLC has accumulated undistributed cash of $12,000 ($15,000 
gross receipts less $3,000 of interest payments) in LLC, JS converts 
the debt into a 1/3 interest in LLC. Under paragraphs 
(b)(2)(iv)(b)(2) and (b)(2)(iv)(d)(4) of this section, JS's capital 
account after the conversion is the adjusted basis of the debt 
immediately before JS's conversion of the debt, $10,000, plus any 
accrued but unpaid qualified stated interest on the debt, $0. On the 
conversion of the debt, however, JS is entitled to receive LLC 
capital corresponding to 100 units of LLC (1/3 of LLC's capital). At 
the time of the conversion, the total value of LLC's assets is 
$45,000. JS is entitled to LLC capital equal to 1/3 of this value, 
or $15,000. As JS is entitled to $5,000 more LLC capital than JS's 
capital contribution to LLC ($10,000), the provisions of paragraph 
(b)(2)(iv)(s) of this section apply.

------------------------------------------------------------------------
                                                        Basis     Value
------------------------------------------------------------------------
Assets:
  Property D........................................   $24,000   $33,000
  Cash..............................................    12,000    12,000
                                                     -----------
        Total.......................................    36,000    45,000
                                                     ===========
Liabilities and Capital:
  AK................................................    13,000    15,000
  JP................................................    13,000    15,000
  JS................................................    10,000    15,000
                                                     -----------
        Total.......................................    36,000    45,000
------------------------------------------------------------------------

    (iv) Under paragraph (b)(2)(iv)(s) of this section, LLC must 
increase JS's capital account from $10,000 to $15,000 by, first, 
revaluing LLC property in accordance with the principles of 
paragraph (b)(2)(iv)(f) of this section, and allocating the first 
$5,000 of book gain from that revaluation to JS. The net unrealized 
gain in LLC's assets (Property D) is $9,000 ($33,000 value less 
$24,000 basis). The first $5,000 of this gain must be allocated to 
JS, and the remaining $4,000 of that gain must be allocated equally 
to AK and JP in accordance with the LLC agreement. Because the 
revaluation of LLC assets under paragraph (b)(2)(iv)(s)(2) of this 
section increases JS's capital account to the amount agreed upon by 
the members, LLC is not required to make a capital account 
reallocation under paragraph (b)(2)(iv)(s)(3) of this section. Under 
paragraph (b)(2)(iv)(f)(4) of this section, the tax items from the 
revalued property must be allocated in accordance with section 
704(c) principles.

[[Page 2939]]



----------------------------------------------------------------------------------------------------------------
                                                         AK                    JP                    JS
                                               -----------------------------------------------------------------
                                                   Tax        Book       Tax        Book       Tax        Book
----------------------------------------------------------------------------------------------------------------
Year 4 capital account prior to exercise......    $13,000    $13,000    $13,000    $13,000          0          0
Capital account after exercise................     13,000     13,000     13,000     13,000     10,000     10,000
Revaluation...................................  .........      2,000  .........      2,000  .........      5,000
                                               ------------
    Capital account after revaluation.........     13,000     15,000     13,000     15,000     10,000     15,000
----------------------------------------------------------------------------------------------------------------

    3. Section 1.704-3 is amended by revising the first sentence of 
paragraph (a)(6)(i) to read as follows:


Sec.  1.704-3  Contributed property.

    (a) * * *
    (6) Other applications of section 704(c) principles--(i) 
Revaluations under section 704(b). The principles of this section apply 
to allocations with respect to property for which differences between 
book value and adjusted tax basis are created when a partnership 
revalues partnership property pursuant to Sec.  1.704-1(b)(2)(iv)(f) or 
1.704-1(b)(2)(iv)(s) (reverse section 704(c) allocations). * * *
* * * * *
    4. Section 1.721-2 is added to read as follows:


Sec.  1.721-2  Noncompensatory options.

    (a) Exercise of a noncompensatory option. Notwithstanding Sec.  
1.721-1(b)(1), section 721 applies to the exercise (as defined in 
paragraph (e)(4) of this section) of a noncompensatory option (as 
defined in paragraph (d) of this section). However, if the exercise 
price (as defined in paragraph (e)(5) of this section) of a 
noncompensatory option exceeds the capital account received by the 
option holder on the exercise of the noncompensatory option, the 
transaction will be given tax effect in accordance with its true 
nature.
    (b) Transfer of property in exchange for a noncompensatory option. 
Section 721 does not apply to a transfer of property to a partnership 
in exchange for a noncompensatory option. For example, if a person 
purchases a noncompensatory option with appreciated property, the 
person recognizes income or gain to the extent that the fair market 
value of the noncompensatory option exceeds the person's basis in the 
surrendered property.
    (c) Lapse of a noncompensatory option. Section 721 does not apply 
to the lapse of a noncompensatory option.
    (d) Scope. The provisions of this section apply only to 
noncompensatory options and do not apply to any interest on convertible 
debt that has been accrued by the partnership (including accrued 
original issue discount). For purposes of this section, the term 
noncompensatory option means an option (as defined in paragraph (e)(1) 
of this section) issued by a partnership (the issuing partnership), 
other than an option issued in connection with the performance of 
services.
    (e) Definitions. The following definitions apply for the purposes 
of this section.
    (1) Option means a call option or warrant to acquire an interest in 
the issuing partnership, the conversion feature of convertible debt (as 
defined in paragraph (e)(2) of this section), or the conversion feature 
of convertible equity (as defined in paragraph (e)(3) of this section). 
A contract that otherwise constitutes an option shall not fail to be 
treated as such for purposes of this section merely because it may or 
must be settled in cash or property other than a partnership interest.
    (2) Convertible debt is any indebtedness of a partnership that is 
convertible into an interest in that partnership.
    (3) Convertible equity is preferred equity in a partnership that is 
convertible into common equity in that partnership. For this purpose, 
preferred equity is any interest in the issuing partnership that 
entitles the partner to a preferential return on capital and common 
equity is any interest in the issuing partnership that is not preferred 
equity.
    (4) Exercise means the exercise of an option or warrant or the 
conversion of convertible debt or convertible equity.
    (5) Exercise price means, in the case of a call option or warrant, 
the exercise price of the call option or warrant; in the case of 
convertible equity, the converting partner's capital account with 
respect to that convertible equity, increased by the fair market value 
of cash or other property contributed to the partnership in connection 
with the conversion; and, in the case of convertible debt, the adjusted 
issue price (within the meaning of Sec.  1.1275-1(b)) of the debt 
converted, increased by accrued but unpaid qualified stated interest 
and by the fair market value of cash or other property contributed to 
the partnership in connection with the conversion.
    (f) Example. The following example illustrates the provisions of 
this section:

    Example. In Year 1, L and M form general partnership LM with 
cash contributions of $5,000 each, which are used to purchase land, 
Property D, for $10,000. In that same year, the partnership issues 
an option to N to buy a one-third interest in the partnership at any 
time before the end of Year 3. The exercise price of the option is 
$5,000, payable in either cash or property. N transfers Property E 
with a basis of $600 and a value of $1,000 to the partnership in 
exchange for the option. N provides no other consideration for the 
option. Assume that N's option is a noncompensatory option under 
paragraph (d) of this section and that N is not treated as a partner 
with respect to the option. Under paragraph (b) of this section, 
section 721(a) does not apply to N's transfer of Property E to LM in 
exchange for the option. In accordance with Sec.  1.1001-2, upon N's 
transfer of Property E to the partnership in exchange for the 
option, N recognizes $400 of gain. Under open transaction principles 
applicable to noncompensatory options, the partnership does not 
recognize any gain upon receipt of appreciated property in exchange 
for the option. The partnership has a basis of $1,000 in Property E. 
In Year 3, when the partnership property is valued at $16,000, N 
exercises the option, contributing Property F with a basis of $3,000 
and a fair market value of $5,000 to the partnership. Under 
paragraph (a) of this section, neither the partnership nor N 
recognizes gain upon N's contribution of property to the partnership 
upon the exercise of the option. Under section 723, the partnership 
has a basis of $3,000 in Property F. See Sec.  1.704-
1(b)(2)(iv)(d)(4) and (s) for special rules applicable to capital 
account adjustments on the exercise of a noncompensatory option.

    (g) Effective Date. This section applies to noncompensatory options 
that are issued on or after the date final regulations are published in 
the Federal Register.
    5. Section 1.761-3 is added to read as follows.


Sec.  1.761-3  Certain option holders treated as partners.

    (a) In general. A noncompensatory option (as defined in paragraph 
(b) of this section) is treated as a partnership interest if the option 
(and any rights associated with it) provides the holder with rights 
that are substantially similar to the rights afforded to a partner. 
This paragraph applies only if, as of the date that the noncompensatory 
option is

[[Page 2940]]

issued, transferred, or modified, there is a strong likelihood that the 
failure to treat the holder of the noncompensatory option as a partner 
would result in a substantial reduction in the present value of the 
partners' and the holder's aggregate tax liabilities. If the holder of 
a noncompensatory option is treated as a partner under this section, 
such partner's distributive share of the partnership's income, gain, 
loss, deduction or credit (or items thereof) is determined in 
accordance with that partner's interest in the partnership (taking into 
account all facts and circumstances) in accordance with Sec.  1.704-
1(b)(3).
    (b) Definitions--(1) Noncompensatory option. For purposes of this 
section, a noncompensatory option means an option (as defined in 
paragraph (b)(2) of this section) issued by a partnership, other than 
an option issued in connection with the performance of services. A 
noncompensatory option issued by an eligible entity (as defined in 
Sec.  301.7701-3(a)) that would become a partnership under Sec.  
301.7701-3(f)(2) of this chapter if the option holder were treated as a 
partner under this section is also a noncompensatory option for 
purposes of this section. If a noncompensatory option is issued by such 
an eligible entity, then the eligible entity is treated as a 
partnership for purposes of applying this section.
    (2) Option. For purposes of this section, a call option or warrant 
to acquire an interest in the issuing partnership is an option. In 
addition, convertible debt (as defined in Sec.  1.721-2(e)(2)) and 
convertible equity (as defined in Sec.  1.721-2(e)(3)) are options for 
purposes of this section. A contract that otherwise constitutes an 
option shall not fail to be treated as such for purposes of this 
section merely because it may or must be settled in cash or property 
other than a partnership interest.
    (c) Rights taken into account. (1) In determining whether a 
noncompensatory option provides the holder with rights that are 
substantially similar to the rights afforded to a partner, all facts 
and circumstances are considered, including whether the option is 
reasonably certain to be exercised (as of the time that the option is 
issued, transferred or modified) and whether the option holder 
possesses partner attributes. For purposes of this section, if a 
noncompensatory option is reasonably certain to be exercised, then the 
holder of the option ordinarily has rights that are substantially 
similar to the rights afforded to a partner.
    (2) Reasonable certainty of exercise. The following factors are 
relevant in determining whether a noncompensatory option is reasonably 
certain to be exercised (as of the time that the noncompensatory option 
is issued, transferred, or modified)--
    (i) The fair market value of the partnership interest that is the 
subject of the option;
    (ii) The exercise price of the option;
    (iii) The term of the option;
    (iv) The volatility, or riskiness, of the partnership interest that 
is the subject of the option;
    (v) The fact that the option premium and, if the option is 
exercised, the option exercise price, will become assets of the 
partnership;
    (vi) Anticipated distributions by the partnership during the term 
of the option;
    (vii) Any other special option features, such as an exercise price 
that declines over time or declines contingent on the happening of 
specific events;
    (viii) The existence of related options, including reciprocal 
options; and
    (ix) Any other arrangements (express or implied) affecting the 
likelihood that the option will be exercised.
    (3) Partner attributes. Partner attributes include the extent to 
which the holder of the option will share in the economic benefit of 
partnership profits (including distributed profits) and in the economic 
detriment associated with partnership losses. Partner attributes also 
include the existence of any arrangement (either within the option 
agreement or in a related agreement) that, directly or indirectly, 
allows the holder of a noncompensatory option to control or restrict 
the activities of the partnership. For this purpose, rights in the 
partnership possessed by the option holder solely by virtue of owning a 
partnership interest and not by virtue of holding a noncompensatory 
option are not taken into account, provided that those rights are no 
greater than rights granted to other partners owning similar interests 
in the partnership.
    (d) Examples. The following examples illustrate the provisions of 
this section. For the following examples, assume that:
    (1) Each option agreement provides that the partnership cannot make 
distributions to its partners while the option remains outstanding; and
    (2) The option holders do not have any significant rights to 
control or restrict the activities of the partnership (other than 
restricting distributions and dilutive issuances of partnership 
equity).

    Example 1. Active trade or business. PRS is a partnership 
engaged in a telecommunications business. In exchange for a premium 
of $8x, PRS issues a noncompensatory option to A to acquire a 10 
percent interest in PRS for $17x at any time during a 7-year period 
commencing on the date on which the option is issued. At the time of 
the issuance of the option, a 10 percent interest in PRS has a fair 
market value of $16x. Due to the riskiness of PRS's business, the 
value of a 10 percent PRS interest in 7 years is not reasonably 
predictable as of the time the option is issued. Therefore, it is 
not reasonably certain that A's option will be exercised. 
Furthermore, although the option provides A with substantially the 
same economic benefit of partnership profits as would a direct 
investment in PRS, A does not share in substantially the same 
economic detriment of partnership losses as would a partner in PRS. 
Given these facts, the option to acquire a PRS interest does not 
provide A with rights that are substantially similar to the rights 
afforded to a partner. Therefore, A is not treated as a partner 
under this section.

    Example 2. Option issued by partnership with reasonably 
predictable earnings. PRS owns rental real property. The property is 
95 percent rented to corporate tenants with a mid-investment grade 
bond rating or better and is expected to remain so for the next 20 
years. The tenants of the building are responsible for paying all 
real estate taxes, insurance, and maintenance expenses relating to 
the property. Occupancy rates in properties of a similar character 
are high in the geographic area in which the property is located, 
and it is reasonably predictable that properties in that area will 
retain their value during the next 10 years. In exchange for a 
premium of $6.5x, PRS issues a noncompensatory option to B to 
acquire a 10 percent interest in PRS for $17x at the end of a 7-year 
period commencing on the date of the issuance of the option. At the 
time the option is issued, a 10 percent interest in PRS has a fair 
market value of $16.5x. Given the stability of PRS's rental 
property, PRS can reasonably predict that its net cash flow for each 
of the 7 years during which the option is outstanding will be $10x 
($70x over the 7 years), and that there will be no decline in the 
value of the property during that time. In light of the reasonably 
predictable earnings of PRS and the fact that PRS will make no 
distributions to its partners during the 7 years that the option is 
outstanding, it is reasonably certain that the value of a 10 percent 
interest in PRS at the end of the option's 7-year term will 
significantly exceed the exercise price of the option. Therefore, 
the option is reasonably certain to be exercised. Because the option 
is reasonably certain to be exercised, under these facts, B has 
rights that are substantially similar to the rights afforded to a 
partner. Therefore, if there is a strong likelihood that failure to 
treat B as a partner would result in a substantial reduction in the 
partners' and B's aggregate tax liabilities, B will be treated as a 
partner. In such a case, B's distributive share of PRS's income, 
gain, loss, deduction, or credit (or items thereof) is determined in 
accordance with B's interest in the partnership (taking into account 
all facts and circumstances) in accordance with Sec.  1.704-1(b)(3).

[[Page 2941]]

    Example 3. Deep in the money options. (i) LP is a limited 
partnership engaged in an internet start-up venture. In exchange for 
a premium of $14x, LP issues a noncompensatory option to C to 
acquire a 5 percent interest in LP for $6x at any time during a 10-
year period commencing on the date on which the option is issued. At 
the time of the issuance of the option, a 5 percent interest in LP 
has a fair market value of $15x. Because of the riskiness of LP's 
business, the option is not reasonably certain to be exercised. 
Nevertheless, because C has paid a $14x premium for a partnership 
interest that has a fair market value of $15x, C has substantially 
the same economic benefits and detriments as a result of purchasing 
the option as C would have had if C had purchased a partnership 
interest. Therefore, the option provides C with rights that are 
substantially similar to the rights afforded to a partner (partner 
attributes). See paragraph (c)(3) of this section. If there is a 
strong likelihood that failure to treat C as a partner would result 
in a substantial reduction in the partners' and C's aggregate tax 
liabilities, C will be treated as a partner. In such a case, C's 
distributive share of LP's income, gain, loss, deduction, or credit 
(or items thereof) is determined in accordance with C's interest in 
the partnership (taking into account all facts and circumstances) in 
accordance with Sec.  1.704-1(b)(3).
    (ii) The facts are the same as in paragraph (i) of this Example 
3, except that C transfers $150x to LP in exchange for a note from 
LP that matures 10 years from the date of issuance and a warrant to 
acquire a 5 percent interest in LP for an exercise price of $6x. The 
warrant issued with the debt is exercisable at any time during the 
10-year term of the debt. The debt instrument and the warrant 
comprise an investment unit with the meaning of section 1273(c)(2). 
Under Sec.  1.1273-2(h), the issue price of the investment unit, 
$150x, is allocated $136x to the debt instrument and $14x to the 
warrant. As in paragraph (i), C has substantially the same economic 
benefits and detriments as a result of purchasing the warrant as C 
would have had if C had purchased a partnership interest. Therefore, 
the warrant provides C with rights that are substantially similar to 
the rights afforded to a partner. If there is a strong likelihood 
that failure to treat C as a partner would result in a substantial 
reduction in the partners' and C's aggregate tax liabilities, then C 
will be treated as a partner. In such a case, C's distributive share 
of LP's income, gain, loss, deduction, or credit (or items thereof) 
is determined in accordance with C's interest in the partnership 
(taking into account all facts and circumstances) in accordance with 
Sec.  1.704-1(b)(3).

    (e) Effective Date. This section applies to noncompensatory options 
that are issued on or after the date final regulations are published in 
the Federal Register.
    6. Section 1.1272-1 is amended by adding a sentence at the end of 
paragraph (e) to read as follows:


Sec.  1.1272-1  Current inclusion of OID in income.

* * * * *
    (e) * * * For debt instruments issued on or after the date final 
regulations are published in the Federal Register, the term stock in 
the preceding sentence means an equity interest in any entity that is 
classified, for Federal tax purposes, as either a partnership or a 
corporation.
* * * * *
    7. Section 1.1273-2 is amended by adding a sentence at the end of 
paragraph (j) to read as follows:


Sec.  1.1273-2  Determination of issue price and issue date.

* * * * *
    (j) * * * For debt instruments issued on or after the date final 
regulations are published in the Federal Register, the term stock in 
the preceding sentence means an equity interest in any entity that is 
classified, for Federal tax purposes, as either a partnership or a 
corporation.
* * * * *
    8. Section 1.1275-4 is amended by adding a sentence at the end of 
paragraph (a)(4) to read as follows:


Sec.  1.1275-4  Contingent payment debt instruments.

    (a) * * *
    (4) * * * For debt instruments issued on or after the date final 
regulations are published in the Federal Register, the term stock in 
the preceding sentence means an equity interest in any entity that is 
classified, for Federal tax purposes, as either a partnership or a 
corporation.
* * * * *

David A. Mader,
Assistant Deputy Commissioner of Internal Revenue.
[FR Doc. 03-872 Filed 1-21-03; 8:45 am]
BILLING CODE 4830-01-U