New Regulations Can Treat Convertible Debt or Penny Warrants as Partnership Equity
Tax regulations finalized in March 2013 can have serious consequences for options (including warrants or convertible debt) to purchase equity in a partnership or an LLC treated as a partnership for tax purposes. These regulations affect both the partnership and the lender, especially where the lender itself is a partnership.
In certain situations, the new regulations treat unexercised options as an equity interest in the partnership. For example, any partnership (or LLC treated as a partnership) that issues an equity kicker to a lender may cause the lender to be treated as a partner for tax purposes, which will change the expected tax allocations and reporting. Furthermore, where a mezzanine fund makes a loan to a portfolio company treated as a partnership for federal tax purposes, and receives penny warrants in connection with the loan, these regulations may treat the mezzanine fund as a partner in the portfolio company, with potentially serious consequences for the fund's investors.
These regulations are effective for options issued on or after February 5, 2013.
Consequences for partnership borrower
The recharacterization rule will have a significant impact on partnerships or LLCs that provide an equity kicker (such as penny warrants or convertible debt with a favorable conversion price) in connection with a borrowing. If the lender is treated as a partner, the lender must be allocated its share of partnership income and loss. Failure to treat the lender as a partner where required by these new regulations will cause the partnership to make incorrect allocations to all of its partners. If the IRS reallocates the partnership's income or loss on audit, every partner would then be required to file an amended federal income tax return and may owe interest and penalties.
Consequences for lender
The new rule can also have severe consequences where the lender is itself a partnership, such as a mezzanine fund. Specifically, it can cause the mezzanine fund's partners to have unrelated business taxable income (UBTI) or effectively connected income (ECI). Investment funds with tax-exempt and foreign investors should consider the impact of these new regulations to equity kickers they receive in connection with loans.
General discussion of recharacterization rule
Generally, a noncompensatory option with respect to a partnership interest is treated as a partnership interest (that is, the option is treated as exercised) for tax purposes if two conditions are met:
- the option provides the option holder with rights that are "substantially similar" to the rights afforded a partner, and
- there is a "strong likelihood" that failure to treat the option holder as a partner would result in a "substantial reduction" in the present value of the partners' and option holder's aggregate federal tax liabilities.
The first condition is met if either the option is reasonably certain to be exercised or the option holder possesses partner attributes (such as the right to vote or participate in management). An option with an exercise price substantially lower than its fair market value (such as a "penny warrant") would likely satisfy the first condition and thus would be treated as equity in the partnership if it also meets the second condition.
The "strong likelihood" condition depends on the timing and amount of partnership income and loss allocations that would be made to the partners of the borrower both with and without treating the option holder as a partner, and depends on the federal tax attributes of each partner and the option holder. In the case of a mezzanine fund that is itself a partnership for tax purposes, the tax attributes of its partners must be taken into account for this purpose. In general, in evaluating a loan to be made to a partnership, the question is whether net income of the partnership would likely be subject to more tax if allocated to the lender (and through the lender to the lender's partners) rather than to the actual partners in the borrower.
This "strong likelihood" test is likely to be immensely complicated to apply in practice and will depend on whether the borrower partnership is expected to generate income or losses, the character (capital or ordinary) of the income or losses, and the tax attributes of the actual partners in the borrower partnership and of the option holder's own partners. The analysis will depend on a number of factors:
- Whether the borrower is expected to generate income or loss;
- Whether the income or loss will be capital or ordinary;
- The rights that the option holder would have in partnership income or loss upon exercise of the option;
- The identity of the borrower's actual partners (for example, individuals, corporations, or tax-exempt entities) and their tax attributes (for example, the marginal tax rate applicable to an individual, whether the passive activity rules apply, or whether a corporation has significant NOLs); and
- The identity of the lender's partners and their tax attributes.
Even if the lender's option is not recharacterized as equity under these rules, if the lender does exercise the option, the new regulations require special allocations to be made to the lender (and in some cases, the borrower's other partners).
A partnership issuing an equity kicker in connection with a loan to a partnership, or a mezzanine fund receiving such an equity kicker, should consult with its tax advisors to determine the impact of these new regulations.
IRS Circular 230 Disclosure: To comply with certain U.S. Treasury regulations, we inform you that, unless expressly stated otherwise, any U.S. federal tax advice contained in this communication was not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding any penalties that may be imposed on such taxpayer by the Internal Revenue Service. In addition, if any such tax advice is used or referred to by other parties in promoting, marketing, or recommending any partnership or other entity, investment plan, or arrangement, then (i) the advice should be construed as written in connection with the promotion or marketing by others of the transaction(s) or matter(s) addressed in this communication and (ii) the taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor.
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