The Department of the Treasury and the Internal Revenue Service issued final regulations, effective February 5, 2013, concerning the tax consequences of noncompensatory options and convertible instruments issued by a partnership or limited liability company, such as warrants. Among the various provisions covered, the final regulations include a characterization rule to determine whether a noncompensatory option is treated as a direct interest in the issuing partnership. These new regulations have very significant importance to, among others, private investment funds that either are prohibited from receiving Unrelated Business Taxable Income ("UBTI") or have a strong investor mandate or desire to limit exposure to any UBTI. These regulations will cause funds with foreign and tax-exempt investors to revisit their procedures for determining whether and how to acquire warrants in connection with loans to portfolio companies that are treated as partnerships for tax purposes.
A key provision of the regulations implements a new test to determine whether a noncompensatory warrant issued by a partnership or limited liability company taxed as a partnership would be considered a partnership interest upon grant or other “measurement event.” If two conditions are satisfied, a noncompensatory warrant will be considered a direct interest for tax purposes. The first condition requires that “the noncompensatory option (and any agreement associated with it) provides the option holder with rights that are substantially similar to the rights afforded a partner.” A “penny” warrant, which is most commonly utilized as the typical “equity-kicker” received by a lender in a financing transaction, appears to satisfy the first condition, so the status of a penny warrant as a partnership interest is likely to depend on the application of the second condition, which requires that: “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.” This article focuses on the application of the second condition, referred to in this article as “the present value test.”
The new regulations state that the determination of whether the present value test is satisfied “is based on all of the facts and circumstances, including—
- “(i) The interaction of the allocations of the issuing partnership and the partners’ and noncompensatory option holder’s Federal tax attributes (taking into account tax consequences that result from the interaction of the allocations with the partners’ and noncompensatory option holder’s Federal tax attributes that are unrelated to the partnership);
- “(ii) the absolute amount of the Federal tax reduction;
- “(iii) the amount of the reduction relative to overall tax liability; and
- “(iv) the timing of items of income and deductions.”
The regulations require that the analysis look through pass-through entities such as partnerships, trusts, limited liability companies and S corporations that may be partners. In many cases, the present value test will be difficult to apply because the results depend on tax characteristics of partners of which the potential warrant holder may not be aware, assumptions about the taxable income and losses, including amount and type of income, of the partnership, and assumptions about the exit strategy of the warrant holder and of the partnership. Nevertheless, we are providing some general guidance below that may be helpful in trying to apply the test.
Determine whether the partnership is likely to generate tax losses for a period of time and whether the losses will be significant. The analysis of the use of losses can be distinctly different than the analysis of the use of income.
Determine what type of income the partnership is likely to generate such as ordinary income, capital gains, and passive income that is not included in unrelated business taxable income of tax-exempt investors (such as interest, dividends and royalties).
Assess the tax positions of the warrant holder or the partners/members of the warrant holder. Are they individuals, corporations, pension funds, governmental entities or tax-exempt entities? If the warrant holder is a corporation, does it have NOL carryovers that can absorb income without any current tax consequences (or relatively de minimis tax consequences resulting from the alternative minimum tax)?
Assess the tax positions of the partners/members of the partnership.
The following table points to factors that would lead to a favorable result (not satisfying the present value test) or an unfavorable result (satisfying the present value test) for a penny warrant issued to a partnership by a partnership that is expected to have taxable income each year and for which there is no exit strategy or expectation of a sale of the partnership or its assets in the short run.
Income Producing Partnership
Issuing Partnership or LLC
None of, or only a small portion of, equity interests in the issuing partnership or LLC held by entities described in the box to the right.
A substantial percentage of partnership interests held by:
- Corporations in full-tax position (no NOL carryovers and taxed at a 34 percent percent or 35 percent percent federal rate)
- Individuals who are taxed at the margin at the highest individual marginal tax rates (unless partnership expected to generate substantial dividend or long-term capital gains income).
- Foreign investors with effectively connected income.
- Partnerships with partners (or LLCs with members) described in the preceding bullets.
A substantial portion of the equity interests in the issuing partnership or LLC held by:
- Tax-exempt partners (unless (i) partnership is engaged in a trade or business, (ii) partnership does not generate significant passive income that is exempt from the unrelated business income tax, and (iii) tax-exempt partner does not have losses from other unrelated business activity).
- Governmental entities (including government pension funds).
- Individual partners who are not taxed at the margin at the highest individual marginal tax rates.
- Corporations with NOL carryovers or that are minimum-tax taxpayers.
- Individual partners if partnership is expected to have significant capital gain and/or dividend income.
- Partnerships with partners (or LLCs with members) described in the preceding bullets.
Note that the present value test requires a strong likelihood of a substantial reduction in taxes if the warrant holder is not treated as a partner. Therefore, if as a whole the partners of the warrant holder would bear about the same tax liability with respect to an allocable portion of the income of the issuing partnership as the partners of the issuing partnership would bear if the income was allocated to them rather than the warrant holder, the present value test is not likely to be satisfied and the warrant holder would not have to be treated as a partner.
If the issuing partnership is expected to generate tax losses for an extended period of time and the losses may have a greater present value than the income generated by the issuing partnership before the expected disposition of the business, the expected redemption of the warrant, or another expected “exit,” many of the factors in the table above would flip, and the following additional considerations would need to be taken into account:
- Individuals, trusts and closely held corporations are subject to the passive loss rules. Those rules may restrict or limit the ability of individuals, trusts and closely held corporations to use losses from a trade or business conducted by the partnership unless they have income from other sources or are actively involved in the partnership’s trade or business. Therefore, it would be helpful to have partners whose use of losses is blocked by the passive loss rules in the issuing partnership and unhelpful to have them in the warrant-holder partnership.
- Application of at-risk rules, basis rules, and partnership allocation rules, which may operate to limit the losses allocable to or usable by particular partners of the issuing partnership and the warrant-holder partnership.
When undertaking an analysis of the present value test, one must also look at the rights that the warrant holder would have if it exercised the warrants. For example, if the warrant is for a class of partnership interest that only participates in distributions resulting from the sale of substantially all of the assets of the issuing partnership, one should not assume that if the warrant holder were treated as a partner it would have a pro rata share of the all of the income of the issuing partnership. Instead, it is more likely that it would only have a pro rata share of the undistributed income of the partnership. This may be material in determining whether the failure to treat the warrant holder as a partner results in a substantial reduction in tax liability.
This article provides only a flavor of factors that may be taken into account when assessing whether a warrant is likely to pass or fail the present value test. Other factors may also play a role in determining whether a particular warrant will pass or fail the test. For example, it may be necessary to compare the tax consequences of a potential exit strategy. Each penny warrant must be examined separately, but an overall evaluation of the composition of a warrant holder-partnership may provide a good indicator of whether its warrants can generally be expected to pass or fail the test. The factors provided in the table above are intended to provide general guidance but should not be strictly relied upon when making a determination as to whether a warrant would be classified as a partnership interest for federal income tax purposes. Rather, we recommend that persons making this determination consult with their tax and legal advisors to ensure that all the facts and circumstances relating to the warrant ownership and the issuing partnership can be fully considered. The tax and finance team at Patton Boggs is available to assist warrant holders and potential warrant holders in undertaking an analysis of whether a warrant will be considered a partnership interest.
To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication (including attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.
 The regulations state that a noncompensatory option provides the holder with rights substantially similar to a partner if (i) the option is reasonably certain to be exercised or (ii) the option holder possesses partner attributes. The regulations provide guidance for determining whether an option is reasonably certain to be exercised. Under that guidance, it appears that an option with a very low exercise price will be considered reasonably certain to be exercised. A holder of a “penny” warrant might be able to argue in certain cases that, despite the apparent economics of the warrant, it is not reasonably certain to be exercised because the holder is precluded by its own organizational documents from holding an interest in a partnership or LLC operating a business and the only likely exit strategy is redemption or sale of the warrant. An analysis of that possible argument is beyond the scope of this article.
 It is possible that if the warrant holder and partnership expect a sale of the partnership or its assets in the short term, the tax consequences of a potential sale need to be taken into account in the analysis. The table below focuses primarily on tax consequences from the operation of the partnership or LLC.