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Abstract
Some of the issues a subdebt lender faces when a penny warrant is recharacterized as a partnership interest are explored. A penny warrant increases potential return on investment without raising the stated rate of interest, and it enables a lender to participate in the upside of the borrower. A partner has to deal with subchapter K equity oddities, such as tax and book capital accounts, mechanisms for correlating inside and outside basis, and passthrough of income. Prop. Reg. 1.761-3 contains a 2-part test to determine whether or not a noncompensatory option will be recharacterized as a partnership interest: 1. rights substantially similar to partner rights, and 2. substantial reduction in aggregate tax liabilities. If the company accountant decides a penny warrant holder is a partner, the warrant holder can expect a Schedule K-1. An important step is to ensure that the lender is entitled to company distributions to pay its tax liability for company income and gain allocated to it.