Discussion of Contingent Allocations for SAFEs and LLCs. Further discussions of federal income tax treatments and implications.

1. SAFEs and LLCs issue re:
Contingent Allocations
Silicon Valley, San Francisco, Los Angeles
rroyse@rroyselaw.com
www.rroyselaw.com

2. Roger Royse is the founder of the Royse Law Firm. He is a
frequent speaker and active in several leadership roles in the
American Bar Association.
He serves as Chair of the Taxation Committee for the
Business Law Section, as well as Vice Chair for the Tax
Section’s Tax Policy and Simplification Committee and Tax
Practice Management Committee.
He is also Chair of the Tax Policy, Practice and Legislation
Committee of the State Bar of California Taxation Section.
Roger wrote “Dead On Arrival,” a practical guide for entrepreneurs and new
lawyers to avoid the legal mistakes that can kill otherwise successful startups.
Roger regularly advises domestic and international startup and emerging growth
companies on formation, financing, and exit planning. He currently serves as an
adjunct professor for the Master of Laws (LL.M.) in Taxation Program at Golden
Gate University.

3. Federal Income Tax Treatments
• The IRS issued final regulations (T.D. 9612) in 2013, which is relating
to federal income tax treatments for non-compensatory options,
warrants and convertible instruments (“NCPO”) issued by a
partnership
• Options issued in connection with the performance of services and
options issued by disregarded entities are not covered
• The final regulations modify the regulations under IRC Section 704(b)
regarding the maintenance of partners’ capital accounts and
allocations of p/ship’s items
• The final regulations clarify when the option holder is treated as a
partner for tax purposes
• The final regulations are effective for NCPO issued on or after
February 5, 2013

4. To the Option Holder
• On issuance:
– Governed by the “open transaction” principle, not a taxable event
– The option holder is not a partner of the partnership until he/she
exercise the option
– The holder only need to recognize gain or loss on a transfer of
appreciated/depreciated property to the partnership in exchange
of the NCPO

5. To the Option Holder
• On issuance (cont.):
– Exception: a NCPO would be deemed to be exercised at the
“measurement event” (and the option holder become a partner
of the partnership), if:
1. “Reasonably certain to be exercised” or “partner attributes”;
AND
2. A “strong likelihood”

6. To the Option Holder
• On issuance (cont.):
– Reasonably certain to be exercised: a facts and circumstances test
– Two safe harbors:
• A NCPO is not considered reasonably certain to be exercised if it may be
exercised no more than 24 months after the date of the applicable
measurement event and it has a strike price equal to or greater than 110
percent of the fair market value of the underlying partnership interest on
the date of the measurement event
• A NCPO is not considered reasonably certain to be exercised if the terms of
the option provide that the strike price of the option is equal to or greater
than the fair market value of the underlying partnership interest on the
exercise date

7. To the Option Holder
• On exercise:
– Contributing property (option premium + exercise price) for a
partnership interest; not taxable
– Exception: the option holder is required to recognize interest, rent
or royalty income in two situations:
• Transfer of a p/ship interest to an option holder in satisfaction of the
p/ship’s debt that accrued on or after the beginning of the convertible debt
holder’s holding period for the debt
• Exercise price is satisfied with the p/ship’s obligation to the option holder
for unpaid rent, royalties, or interest that accrued on or after the beginning
of the option holder’s holding period for the obligation

8. To the Option Holder
• On exercise (cont.):
– Initial Capital Account = consideration paid to acquire the option+
cash/FMV of property contributed on exercise
– Capital Account Entitlement= Initial Capital Account + allocation of
the unrealized gain/loss in the p/ship’s assets (maybe, depending
on the terms of the option)
– Become a partner of the partnership

9. To the Partnership
• On issuance:
– Governed by the “open transaction” principle, not a taxable event

10. To the Partnership
• On exercise: revaluing its property and booking unrealized gain/loss
– First to the option holder to the extent necessary to reflect the
holder capital account entitlement
– Then to the historic partners to reflect the remaining unrealized
gain/loss in the p/ship property that would be allocated if there
was a taxable disposition of such property for its FMV on the date
of exercise
– Corrective allocations: In the event that the difference between
the option holder’s initial capital account and its capital account
entitlement exceeds the unrealized gain/loss in the p/ship’s
assets, reallocate capital form historic partners to the option
holder
– The revaluations take into account outstanding NCPOs

11. To the Partnership
• On lapse:
– Recognizing income in an amount equal to the option premium
paid by the holder

12. Concluding Thoughts
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