[Federal Register Volume 78, Number 24 (Tuesday, February 5, 2013)]
[Proposed Rules]
[Pages 8060-8062]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2013-02260]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-106918-08]
RIN 1545-BH89


Treatment of Grantor of an Option on a Partnership Interest

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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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. Specifically, the proposed regulations expand 
the characterization rule measurement events to include certain 
transfers of interests in the issuing partnership and other look-
through entities, and provide additional guidance in determining the 
character of the grantor's gain or loss as a result of a closing 
transaction with respect to, or a lapse of, an option on a partnership 
interest. The proposed regulations will affect partnerships that issue 
noncompensatory options, the partners of such partnerships, and the 
holders of such options.

DATES: Written or electronic comments and requests for a public hearing 
must be received by May 6, 2013.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-106918-08), room 
5203, Internal Revenue Service, PO Box 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:PA:LPD:PR (REG-
106918-08), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue NW., Washington, DC, or sent electronically via the Federal 
eRulemaking Portal at www.regulations.gov (IRS REG-106918-08).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations 
under Sec.  1.761-3, Benjamin Weaver at (202) 622-3050; concerning the 
proposed regulations under Sec.  1.1234-3, Shawn Tetelman at (202) 622-
3930; concerning submissions of comments and requests for a public 
hearing, Oluwafunmilayo (Funmi) Taylor, (202) 622-7180 (not toll free 
numbers).

SUPPLEMENTARY INFORMATION: 

Background

    This document contains proposed amendments to 26 CFR part 1 under 
sections 761 and 1234 of the Internal Revenue Code (Code). On January 
22,

[[Page 8061]]

2003, proposed regulations (REG-103580-02) relating to the tax 
treatment of noncompensatory options and convertible instruments issued 
by a partnership (noncompensatory partnership option regulations) were 
published in the Federal Register (68 FR 2930). Final regulations in 
the Rules and Regulations section of this issue of the Federal Register 
contain amendments to the Income Tax Regulations (26 CFR Part 1), which 
finalize the proposed regulations. However, the Treasury Department and 
the IRS have decided to propose amendments to the regulations expanding 
the characterization rule measurement events to include certain 
transfers of interests in the issuing partnership and other look-
through entities.
    Additionally, the Treasury Department and the IRS received comments 
on the proposed regulations expressing uncertainty as to whether 
section 1234(b) applies to the grantor of an option on a partnership 
interest on the lapse or repurchase of the option. The comments 
indicated that it was unclear whether the term ``securities,'' as used 
in section 1234(b)(2)(B), includes partnership interests. After 
consideration of all comments received, the IRS and Treasury Department 
believe that it is appropriate to propose an amendment to the 
regulations under section 1234(b) to expressly treat partnership 
interests as securities for purposes of section 1234(b).

Explanation of Provisions

1. Proposed Additions to the Noncompensatory Partnership Option 
Characterization Rule Measurement Events

    The final regulations being published elsewhere in this issue of 
the Federal Register, relating to the tax treatment of noncompensatory 
partnership options, contain a characterization rule providing that the 
holder of a noncompensatory option is treated as a partner under 
certain circumstances. Under the characterization rule, a 
noncompensatory option is treated as a partnership interest if, on the 
date of a measurement event (1) the noncompensatory option provides the 
option holder with rights that are substantially similar to the rights 
afforded a partner, and (2) there is a strong likelihood that 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 noncompensatory option holder's aggregate Federal tax 
liabilities. The final regulations define a measurement event as: (1) 
Issuance of the noncompensatory option; (2) an adjustment of the terms 
(modification) of the noncompensatory option or of the underlying 
partnership interest (including an adjustment pursuant to the terms of 
the noncompensatory option or the underlying partnership interest); or 
(3) transfer of the noncompensatory option if either (A) the option may 
be exercised (or settled) more than 12 months after its issuance, or 
(B) the transfer is pursuant to a plan in existence at the time of the 
issuance or modification of the noncompensatory option that has as a 
principal purpose the substantial reduction of the present value of the 
aggregate Federal tax liabilities of the partners and the 
noncompensatory option holder.
    The Treasury Department and the IRS believe it is appropriate to 
expand the list of measurement events to include certain transfers of 
interests in the issuing partnership and look-through entities. The 
proposed regulations add three measurement events to the list above, 
but apply only if those measurement events are pursuant to a plan in 
existence at the time of the issuance or modification of the 
noncompensatory option that has as a principal purpose the substantial 
reduction of the present value of the aggregate Federal tax liabilities 
of the partners and the noncompensatory option holder. The three 
additional measurement events are: (1) Issuance, transfer, or 
modification of an interest in, or liquidation of, the issuing 
partnership; (2) issuance, transfer, or modification of an interest in 
any look-through entity that directly, or indirectly through one or 
more look-through entities, owns the noncompensatory option; and (3) 
issuance, transfer, or modification of an interest in any look-through 
entity that directly, or indirectly through one or more look-through 
entities, owns an interest in the issuing partnership. The Treasury 
Department and the IRS believe that the first of these measurement 
events is necessary because it is inconsistent to test a 
noncompensatory option under the characterization rule upon transfer of 
the noncompensatory option, but not upon transfer of an interest in the 
issuing partnership, because either type of transfer may change the 
analysis of whether 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 option holder's 
aggregate tax liabilities. The Treasury Department and the IRS believe 
that the second and third measurement events are necessary to prevent 
avoidance of the characterization rule through the use of look-through 
entities.
    Like the measurement events in the final regulations, the three 
measurement events in the proposed regulations are subject to 
exceptions in Sec.  1.761-3(c)(2). The Treasury Department and the IRS 
believe that the limitations on these measurement events will reduce 
the administrative burden associated with testing under the 
characterization rule upon these events.
    The Treasury Department and the IRS request comments on the 
appropriate procedures for notifying the partners and the partnership 
upon the occurrence of a measurement event.

2. Character of Gain or Loss on Lapse, Sale, or Exchange of Partnership 
Options

A. Character of Gain or Loss to the Grantor of the Option
    In response to comments, the proposed regulations address the 
application of section 1234(b) to the grantor of an option on a 
partnership interest on the lapse or repurchase of the option. Section 
1234(b) provides that, in the case of the grantor of an option, gain or 
loss from any closing transaction with respect to, and gain on lapse 
of, an option in property shall be treated as gain or loss from the 
sale or exchange of a capital asset held not more than one year. 
Section 1234(b)(2)(B) defines the term property to mean stock and 
securities (including stocks and securities dealt with on a when issued 
basis), commodities, and commodity futures. Accordingly, for section 
1234(b) to apply to a closing transaction with respect to, or lapse of, 
an option on a partnership interest, a partnership interest would have 
to be a security and, thus, property within the meaning of section 
1234(b)(2)(B). The proposed regulations provide that the term 
``securities'' as used in section 1234(b)(2)(B) includes partnership 
interests. As a result, in the case of the grantor of an option on a 
partnership interest, gain or loss from any closing transaction with 
respect to, and gain on lapse of, the option is generally treated under 
the proposed regulations as gain or loss from the sale or exchange of a 
capital asset held not more than 1 year.
B. Character of Gain Or Loss to the Option Holder
    With respect to an option holder, under section 1234(a), gain or 
loss on the sale or exchange of, or loss on failure to exercise, an 
option is

[[Page 8062]]

considered gain or loss from the sale or exchange of property that has 
the same character as the property to which the option relates would 
have in the hands of the taxpayer. Although a partnership interest is 
generally considered a capital asset, section 751(a) may apply to 
recharacterize a portion of a partner's gain on the sale or exchange of 
a partnership interest as ordinary. A number of commenters on the 
noncompensatory partnership option proposed regulations questioned 
whether section 751 applies to the lapse, repurchase, sale, exchange, 
or other termination of a noncompensatory option.
    The Treasury Department and the IRS continue to study this issue 
and request comments on (1) if section 751(a) applies to the lapse, 
repurchase, sale, or exchange of a noncompensatory option, (a) how the 
option holder's share of income or loss from section 751 property would 
be determined under Sec.  1.751-1(a)(2), and (b) how a partner in the 
issuing partnership that transfers its partnership interest while the 
option is outstanding would determine its share of income or loss from 
section 751 property under Sec.  1.751-1(a)(2) (that is, should it be 
reduced by the amount of income or loss from section 751 property 
attributable to the option holder); and (2) if section 751(a) does not 
apply to the lapse, repurchase, sale, or exchange of a noncompensatory 
option, what measures, if any, should be taken to ensure that ordinary 
income is not permanently eliminated.

Effective/Applicability Date

    To coordinate the proposed regulations with the final 
noncompensatory partnership option regulations, the proposed 
regulations are proposed to have the same effective date as the final 
noncompensatory partnership option regulations. Therefore, the proposed 
regulations are proposed to apply to options issued on or after 
February 5, 2013.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866, as supplemented by Executive Order 13563. 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 this regulation, and because the regulation does not 
impose a collection of information requirement on small entities, the 
Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. 
Pursuant to section 7805(f) of the Code, this regulation has been 
submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business.

Comments and Requests for Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written (a signed original and eight 
(8) copies) or electronic comments that are submitted timely to the 
IRS. The Treasury Department and the IRS request comments on all 
aspects of the proposed rules. All comments are available at 
www.regulations.gov or upon request. A public hearing may be scheduled 
if requested in writing by any person that timely submits written 
comments. If a public hearing is scheduled, notice of the date, time, 
and place for the public hearing will be published in the Federal 
Register.

Drafting Information

    The principal authors of these proposed regulations are Benjamin 
Weaver of the Office of Associate Chief Counsel (Passthroughs and 
Special Industries) and Shawn Tetelman of the Office of Associate Chief 
Counsel (Financial Institutions and Products). However, other personnel 
from the IRS and Treasury Department 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

0
Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

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

0
Par. 2. Section 1.761-3 is amended by adding paragraph (c)(1)(iv) to 
read as follows:


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

* * * * *
    (c) * * *
    (1) * * *
    (iv) An event described in paragraphs (c)(1)(iv)(A), (B), or (C) of 
this section, provided the event is pursuant to a plan in existence at 
the time of the issuance or modification of the noncompensatory option 
that has as a principal purpose the substantial reduction of the 
present value of the aggregate Federal tax liabilities of the partners 
and the noncompensatory option holder (under paragraph (a)(1)(ii) of 
this section):
    (A) Issuance, transfer, or modification of an interest in, or 
liquidation of, the issuing partnership;
    (B) Issuance, transfer, or modification of an interest in any look-
through entity (as defined in paragraph (b)(1) of this section) that 
directly, or indirectly through one or more look-through entities, owns 
the noncompensatory option;
    (C) Issuance, transfer, or modification of an interest in any look-
through entity that directly, or indirectly through one or more look-
through entities, owns an interest in the issuing partnership.
* * * * *
0
Par. 3. Section 1.1234-3 is amended by adding a sentence at the end of 
paragraph (b)(2) to read as follows:


Sec.  1.1234-3  Special rules for the treatment of grantors of certain 
options granted after September 1, 1976.

* * * * *
    (b) * * *
    (2) * * * For purposes of the preceding sentence, for options 
granted on or after February 5, 2013, the term securities includes 
partnership interests.
* * * * *

Steven T. Miller,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 2013-02260 Filed 2-4-13; 8:45 am]
BILLING CODE 4830-01-P