Taxing Compensatory Partnership Options
12 Pages Posted: 19 Sep 2003 Last revised: 12 Sep 2015
In this article, Burke considers the tax treatment of partnership options issued in connection with performance of services (compensatory option). In particular, Burke discusses whether compensatory options should be taxed by analogy to a vesting partnership profits interest or a transfer of property under section 83. Recently issued proposed regulations treat exercise of a noncompensatory option as generally tax-free to both the option holder and the partnership and provide rules for adjusting the partners' capital accounts to reflect a noncompensatory capital shift. In light of the proposed regulations, Burke discusses the contentious issue of whether exercise of a compensatory option should be treated, under section 721, as a taxable capital shift, triggering recognition of gain to the historic partners. By contrast, the circle-of-cash theory would permit the historic partners to avoid gain recognition, by analogy to the treatment of corporate options under section 1032. Although the circle-of-cash theory has numerous adherents, Burke suggests that a recognition rule may be warranted to prevent the historic partners from investing in services with unrealized appreciation and suggests a deemed-sale approach based on section 704(c) principles. Ultimately, the proper treatment of compensatory options cannot be divorced from the overarching problem of service-related transfers of partnership interests.
Keywords: partnership, options, services, capital shift, compensatory, noncompensatory
JEL Classification: K34
Suggested Citation: Suggested Citation