We ran across an article by Hilary Bricken, Esq. entitled Welcome to the Jungle: Changes in Ownership, Financial Interests, and Entities for California Cannabis Businesses. The article is a valiant attempt to capture a very real and complex problem. However, our view is that the article falls far short of addressing the totality of the problem, if for no other reason, there are myriad sets of rules that have not been reconciled with each other, which leaves use with a situation where all we have is confusion rather than clear path to follow to reach answers, let alone safe harbors that can be utilized in setting up transactions.
Ms. Bracken’s article seeks to address:
- Changes in Cannabis Business Entity Ownership
- Changes in Financial Interest Holders
- Changes to Entity
The first two topics involve the definitions of Ownership and Financial Interest within the BCC regulations, without consideration of the broader transaction guidelines issued by BCC, let alone the comprehensive sets of entity and owner attribution guidelines provided for Federal Income Tax purposes for corporations and partnerships. These topics are further complicated by the existence of rules for participating and convertible debt.
The first two topics involve the definitions of Ownership
(al) “Owner” means any of the following:
- A person with an aggregate ownership interest of 20 percent or more in the person applying for a license or a licensee, unless the interest is solely a security, lien, or encumbrance.
- The chief executive officer of a nonprofit or other entity.
- A member of the board of directors of a nonprofit.
- An individual who will be participating in the direction, control, or management of the person applying for a license
The “Changes to Entity” topic in California where not for profit entities are involved is an entirely complex and unique subject in itself that we are going to reserve on for a future post. We now proceed to share with you the detail to the rules that Ms. Bricken glossed over.
Bureau of Cannabis Control Definitions
The Bureau of Cannabis Control [“BCC”] has promulgated very detailed definitions of Owner[1] and Financial Interest[2]. BCC has stated in an information release titled GUIDANCE ON COMMERCIAL CANNABIS ACTIVITY that:
Under the Medicinal and Adult-Use Cannabis Regulation and Safety Act (MAUCRSA), all commercial cannabis activity shall be conducted between licensees. The employees of a licensee may engage in commercial cannabis activity on behalf of the licensee.
Commercial cannabis activity includes activities that are plant touching such as cultivating, manufacturing, and transporting cannabis, as well as activities that are not plant touching such as procuring and selling cannabis.
“However, whether or not an activity is compliant with statute and regulation requires a case-by-case analysis and is determined by the specific facts and circumstances of the unique situation”.
BCC provided examples of allowable cannabis activities subject to the caveat above[3].
Attribution Rules – Federal Income Tax
The Federal Income Tax law contains numerous detailed sets of provisions which relate to the constructive ownership of interests is entities, the corporate and partnership provisions are discussed in detail in the sections that follow, as are the definitions related to a partner’s interest in a partnership “PIP”
Corporate Attribution Rules When a corporate entity is involved, the attribution rules that apply for determining ownership are contained in IRC Sec. 318[4] with further elaboration contained in the Regulations which we are not going to entirely reproduce in the footnotes[5].
Whether a redemption qualifies as an exchange under §§ 302(b)(1) through 302(b)(3) depends on the magnitude of reduction in the shareholder’s stock ownership. The constructive stock ownership rules of § 318(a) must be taken into account for this purpose. Applicable only to those Code provisions that expressly incorporate them, they attribute stock owned by one person to another on the basis of various relationships Section 302(c)(1) makes § 318 applicable to all of § 302, and the regulations remove any doubt that that includes § 302(b)(1). Because § 318 is important to the operation of § 302, it is convenient to discuss it first.
A few preliminary words on terminology are in order. Section 318 creates “constructive” ownership, sometimes referred to as ownership by attribution, and treats it as actual ownership. Real ownership is referred to in various places in § 318 as stock owned “directly or indirectly”—stock titled in the name of the owner (direct ownership) or, for example, held by an agent (indirect ownership). Indirect ownership is distinct from constructive ownership. Hence, direct and indirect ownership plus constructive ownership under § 318 are combined to determine total stock ownership for purposes of § 302.
Section 318 is one of several sets of constructive ownership rules in the Code, which differ in such details as the degree of family relationship warranting attribution, whether one partner’s holdings should be attributed to another partner, and other minutiae. Although in theory each set could be uniquely crafted to suit the particular issue it addresses, divergences are often trivial and usually inexplicable.33 There is no common law of attribution, so close attention to the details of the applicable regime is important.
There are four types of constructive ownership in § 318. One, family attribution under § 318(a)(1) treats stock owned by one family member as constructively owned by certain others. Two, § 318(a)(2) attributes stock owned by an entity (partnership, estate, trust, corporation) up to, loosely speaking, its owners (partners, beneficiaries, shareholders). Three, moving in the opposite direction, § 318(a)(3) attributes stock ownership from owners down to the entity they own. Four, § 318(a)(4) treats the owner of an option to acquire stock as constructively owning the underlying stock. This seems straightforward enough, but, as the following pages show, § 318 can be tricky, never quite taking the last curtain call.
Subject to two exceptions, § 318(a)(5)(A) treats constructive ownership as actual ownership, enabling an endless path of attribution. The first exception, § 318(a)(5)(B), prohibits double family attribution—from one family member to another and then again to another, for example, from daughter to father and then to son. The second, § 318(a)(5)(C), prohibits what is sometimes referred to as sideways attribution, a moniker that invites overbreadth. Specifically, it prohibits attributing ownership from an owner down to an entity and then from the entity up to another owner, for example, from one partner down to a partnership and then up to another partner.37 It does not prohibit attribution from an entity up to an owner and then down to another entity, for example, attribution from one commonly owned corporation to another.
Before examining the various types of attribution in detail, two other groundskeeping rules should be pointed out. First, despite downward attribution from a shareholder to a corporation under § 318(a)(3)(C), a corporation cannot own its own stock under this provision—a corporation cannot own itself by attribution from its shareholders.3 For example, Ajax Corp. does not own the Ajax stock actually owned by its sole shareholder. Second, and easily misconstrued in light of the zero-sum point made just below, stock is not counted twice. That is, despite that a particular share can be owned by two or more persons (one actually and one or more constructively), a single share cannot be owned more than once by the same person. However, in calculating constructive ownership, the attribution path that maximizes ownership is the one that applies. Thus, if a 50 percent trust beneficiary has an option on all the stock of corporation X owned by the trust, the beneficiary is charged with all, rather than only 50 percent, of the stock, since option attribution results in greater constructive ownership than trust-to-beneficiary attribution.
Section 318 is not a zero-sum game. Stock actually owned by A that is constructively owned by B is nonetheless still actually owned by A. In other words, § 318 increases one person’s ownership without decreasing another’s.
Although the attribution rules are ordinarily disadvantageous, they occasionally assist qualifying for sale treatment.
Under § 318(a)(1), an individual is deemed to own stock owned by his spouse, children, grandchildren, and parents. Unlike some other attribution rules,42 § 318(a)(1) does not attribute stock from one sibling to another—family affinity is lineal only (two generations down and one up). As mentioned earlier, stock attributed from one family member to another is not reattributed to yet another.
The family attribution rules deliver rough, objective justice based on normal expectations of family affinity, applying despite actual hostility between family members according to the IRS and most courts. However, as discussed below, they can be waived in a redemption that completely terminates a shareholder’s interest under § 302(b)(3).
Under § 318(a)(2), stock owned, directly or indirectly, by partnerships, estates, trusts, and corporations is attributed to beneficial owners in proportion to ownership interests. (S corporations are treated as partnerships for purposes of this rule. For partnerships with uniform (“straight-up”) allocations, proportionate interests are based on partnership percentage interests. For partnerships with special allocations, presumably attribution would be based on the partner’s particular interest in the stock owned by the partnership, which would depend on his distributive share of dividends and gain or loss on disposition of the stock. Attribution from an estateis based on the beneficiary’s proportionate interest in the estate, but stock is attributed only to those beneficiaries who have a “direct present interest” (as opposed to a remainder interest). Strangely, and contrary to the approach just suggested for partnerships with special allocations, this appears to attribute stock to a beneficiary who cannot inherit the stock.
Stock owned by a trust (other than a § 401(a) employee trust) is constructively owned by beneficiaries in proportion to their actuarial interests (regardless of how small, remote, or contingent). In the case of a grantor trust described in §§ 671 through 679, the person taxable on trust income is the constructive owner of stock owned by the trust. Stock owned by a corporation is attributed only to shareholders who own (actually or by attribution) 50 percent or more in value of the corporation’s stock, in proportion to the value of the stock they own.
Under § 318(a)(3), stock owned, directly or indirectly, by partners, beneficiaries, and shareholders is attributed in full to the partnership, estate, trust, or corporation. (As in the case of upward attribution, S corporations are treated as partnerships for this purpose. ) Unlike proportionate entity-to-owner attribution, downward attribution from owner to entity is full. Accordingly, stock owned by partners and estate beneficiaries is attributed to the partnership or estate. Stock owned by a beneficiary of a trust (other than a § 401(a) employee trust) is attributed to the trust unless the beneficiary has only a remote contingent interest. Stock owned by a person taxable on income of a grantor trust under §§ 671 through 679 is attributed to the trust. Stock owned by a shareholder owning (actually or by attribution) 50 percent or more of the value of the stock of a corporation is attributed to the corporation.
Section 318(a)(4) attributes to an option holder ownership of the shares attainable through exercise of the option. If A gives B an option to purchase outstanding Ajax stock owned by A, B constructively owns the optioned shares. Recall the two types of prohibited reattribution discussed above: double family attribution and sideways (down and up) attribution, barred, respectively, by §§ 318(a)(5)(B) and 318(a)(5)(C). If the first leg of prohibited reattribution is duplicated by option attribution, the prohibition falls away. For example, if father has an option to purchase son’s stock, father’s constructively owned stock is reattributed to daughter notwithstanding § 318(a)(5)(B). Similarly, if a partnership has an option to acquire stock owned by a partner, the partnership’s constructively owned stock is reattributed to other partners notwithstanding § 318(a)(5)(C). The same is true of sideways attribution involving estates, trusts, and corporations.
Whether § 318(a)(4) applies to contingent options and options on unissued (or treasury) stock is somewhat murky. To begin, it is clear that warrants, convertible debentures, and other noncontingent rights to obtain stock at the holder’s election are options within the meaning of § 318(a)(4). However, options contingent on events outside the holder’s control (e.g., merger or death) generally are not. But if the only contingency is that the option may not be exercised until a period of time has elapsed, § 318(a)(4) applies.
Authority on whether options on unissued stock are taken into account under § 318(a)(4) is mixed. The regulations state, almost surely without option attribution in mind, that only actually issued and outstanding stock is counted under § 302(b)(2). The IRS and courts, however, have applied § 318(a)(4) to options on unissued stock on several occasions. The real issue is how it applies. There is no dispute that, in computing a reduction in ownership under § 302, options held by the redeemed shareholder (and by those whose holdings are attributed to the redeemed shareholder under § 318) are taken into account. In other words, both the numerator and denominator employed to determine before-and-after percentage ownership includes unissued stock that the redeemed shareholder (or person of § 318 affinity) would obtain through exercise.
The dispute is whether options on unissued stock held by unrelated parties inflate the denominator. The IRS and some courts say no, while other courts say yes. Whether dilution caused by including stock attributable to options held by unrelated parties strengthens or weakens the case for exchange treatment depends on whether the options existed before the redemption (as opposed to being issued in the redemption) and the relative size of the option’s purchasing power.
Partnership Interest Attribution
The attribution rules for partnerships and limited liability companies [“LLC’s] which are taxed as partnerships are a bit more straightforward. In determining a person’s ownership of capital and profits for purposes of § 707(b), the constructive ownership rules of § 267(c), other than § 267(c)(3), are applied. Thus,
Capital or profits interests owned, directly or indirectly, by or for a corporation, partnership, estate, or trust are considered to be owned proportionately by or for its shareholders, partners, or beneficiaries; and
An individual is considered to own partnership capital or profits interests owned, directly or indirectly, by or for any member of his family.
For this purpose, a person’s “family” includes his brothers and sisters, spouse, ancestors, and lineal descendants. However, in applying the constructive ownership rules, the family attribution rules may not be applied twice in succession.
Partners Acting Outside Capacity as Partners
Section 707(a), by its terms, applies to every “transaction” between a partnership and a partner who is not acting in his capacity as a member of the partnership. Subject to various statutory limitations, transactions subject to § 707(a) are treated as “occurring between the partnership and one who is not a partner.” Transactions falling within the purview of § 707(a) include the following:
[l]owns of money or property by the partnership to the partner or by the partner to the partnership, the sale of property by the partner to the partnership, the purchase of property by the partner from the partnership, and the rendering of services by the partnership to the partner or by the partner to the partnership. In addition, leases of property between partners and partnerships are § 707(a) transactions. In defining the scope of § 707(a), the Regulations distinguish contributions by partners and distributions by partnerships from § 707(a) transactions, and provide that the substance rather than the form of a transaction determines whether it is subject to § 707(a).[6]
Hybrid Debt Structures
While it may be viewed as beyond the scope of this discussion, we believe that a basic discussion of both shared appreciation or “kicker debt”[7] and convertible debt[8] is necessary due to the gaping loophole that might be exploited by non-California, or even non-US residents seeking to structure a cannabis investment.
[1] § 5003. Designation of Owner.
(a) All applicants for a commercial cannabis license shall have at a minimum one individual who meets the definition of “owner” under Business and Professions Code section 26001(al) and who will submit the information required of owners under section 5002 of this division.
(b) “Owner” means any of the following:
(1) A person with an aggregate ownership interest of 20 percent or more in the person applying for a license or a licensee, unless the interest is solely a security, lien, or encumbrance.
(2) The chief executive officer of a nonprofit or other entity.
(3) A member of the board of directors of a nonprofit.
(4) The trustee(s) and all persons who have control of the trust and/or the commercial cannabis business that is held in trust.
(5) An individual entitled to a share of at least 20 percent of the profits of the commercial cannabis business.
(6) An individual who will be participating in the direction, control, or management of the person applying for a license. Such an individual includes any of the following:
- A general partner of a commercial cannabis business that is organized as a partnership.
(B) A non-member manager or managing member of a commercial cannabis business that is organized as a limited liability company.
(C) An officer or director of a commercial cannabis business that is organized as a corporation.
(c) When an entity is an owner in a commercial cannabis business, all entities and individuals with a financial interest in the entity shall be disclosed to the Bureau and may be considered owners of the commercial cannabis business. For example, this includes all entities in a multilayer business structure, as well as the chief executive officer, members of the board of directors, partners, trustees and all persons who have control of a trust, and managing members or nonmember managers of the entity. Each entity disclosed as having a financial interest must disclose the identities of persons holding financial interests until only individuals remain. Authority: Section 26013, Business and Professions Code. Reference: Sections 26001 and, 26012, Business and Professions Code.
[2] § 5004. Financial Interest in a Commercial Cannabis Business.
(a) A financial interest means an agreement to receive a portion of the profits of a commercial cannabis business, an investment into a commercial cannabis business, a loan provided to a commercial cannabis business, or any other equity interest in a commercial cannabis business except as provided in subsection (d). For the purpose of this division, an agreement to receive a portion of the profits includes, but is not limited to, the following individuals:
(1) An employee who has entered into a profit share plan with the commercial cannabis business.
(2) A landlord who has entered into a lease agreement with the commercial cannabis business for a share of the profits.
(3) A consultant who is providing services to the commercial cannabis business for a share of the profits.
(4) A person acting as an agent, such as an accountant or attorney, for the commercial cannabis business for a share of the profits.
(5) A broker who is engaging in activities for the commercial cannabis business for a share of the profits.
(6) A salesperson who earns a commission.
(b) The license application shall include the name, birthdate, and government-issued identification type and number for all individuals who have a financial interest in a commercial cannabis business but are not owners as defined in section 5003(b) of this division. These individuals shall not be required to submit the information required of owners under section 5002(c)(20) of this division.
(c) When an entity has a financial interest in a commercial cannabis business, then all individuals who are owners of that entity shall be considered financial interest holders of the commercial cannabis business. For example, this includes all entities in a multi-layer business Bureau of Cannabis Control Order of Adoption – 9 of 138 structure, as well as the chief executive officer, members of the board of directors, partners, trustees and all persons who have control of a trust, and managing members or non-member managers of the entity. Each entity disclosed as having a financial interest must disclose the identities of persons holding financial interests until only individuals remain.
(d) Notwithstanding subsection (b), the following persons are not required to be listed on an application for licensure under section 5002(c)(19) of this division:
(1) A bank or financial institution whose interest constitutes a loan;
(2) Persons whose only financial interest in the commercial cannabis business is through an interest in a diversified mutual fund, blind trust, or similar instrument;
(3) Persons whose only financial interest is a security interest, lien, or encumbrance on property that will be used by the commercial cannabis business; and
(4) Persons who hold a share of stock that is less than 5 percent of the total shares in a publicly traded company.
Authority: Section 26013, Business and Professions Code. Reference: Sections 26012 and 26051.5, Business and Professions Code.
[3] See
Licensees may enter into intellectual property licensing agreements with unlicensed entities. However, the intellectual property holder cannot exert control over the licensee’s commercial cannabis operations. If the intellectual property holder is exerting control over the licensee’s commercial cannabis operation, then the intellectual property holder must be disclosed as an owner on the license.
Licensees may use the services of unlicensed entities such as consultants and brokers to conduct non-commercial cannabis activity such as renting property, purchasing packaging, or leasing equipment for use by the commercial cannabis business. Consultants or brokers that are engaged in commercial cannabis activity for a licensee, such as procuring or purchasing cannabis for a licensee, must be included as either an owner or financial interest holder on the license.
Licensees may package and label cannabis with another licensee’s brand. For example, a licensed distributor may package and label cannabis with a licensed retailer’s brand on behalf of the licensed retailer.
Licensees may use a referral service or agency to find a licensed distributor to distribute cannabis goods. The referral service or agency is not permitted to share in any profits or revenue from the agreement or have any direction or control over a license, unless the referral service or agency is disclosed as an owner or financial interest holder of the license.
Licensees may procure or purchase cannabis on behalf of or at the request of another licensee, such as a licensed distributor procuring cannabis for a licensed manufacturer. Licensees may not procure or purchase cannabis on behalf of any person that is not licensed under MAUCRSA.
Licensees may enter into rental agreements where the landlord takes a percentage of a licensee’s profits if the landlord is disclosed as an owner or financial interest holder of the license.
Licensed retailers and licensed microbusinesses may contract with a service that provides a technology platform to facilitate delivery of cannabis goods to customers if the service does not share in the licensee’s profits.
Licensees may hire an advertising agency or marketing firm to build and/or promote the licensee’s brand. The advertising agency is not permitted to share in any royalties or a percentage of profits or revenue of the licensee unless disclosed as an owner or financial interest holder of the license.
Licensees may purchase the right to use a patent for cannabis extraction. The patentholder is not permitted to share in any royalties or a percentage of profits of the licensee unless the patent-holder is disclosed as an owner or financial interest holder on the license.
Licensees may purchase non-cannabis materials such as empty cartridges, batteries, packaging, extraction equipment, grow lights, and transportation and delivery vehicles, from unlicensed businesses.
Licensed cannabis event organizers may only coordinate cannabis events. Licensed cannabis event organizers are not authorized or licensed to engage in commercial cannabis activity governed by manufacturing licenses, cultivation licenses, distribution licenses, or retail licenses.
[4] (a)General rule For purposes of those provisions of this subchapter to which the rules contained in this section are expressly made applicable—
(1)Members of family
(A)In general An individual shall be considered as owning the stock owned, directly or indirectly, by or for—
(I)his spouse (other than a spouse who is legally separated from the individual under a decree of divorce or separate maintenance), and
(ii)his children, grandchildren, and parents.
(B)Effect of adoption for purposes of subparagraph (A)(ii), a legally adopted child of an individual shall be treated as a child of such individual by blood.
(2)Attribution from partnerships, estates, trusts, and corporations
(A)From partnerships and estates Stock owned, directly or indirectly, by or for a partnership or estate shall be considered as owned proportionately by its partners or beneficiaries.
(B)From trusts
(i)Stock owned, directly or indirectly, by or for a trust (other than an employees’ trust described in section 401(a) which is exempt from tax under section 501(a)) shall be considered as owned by its beneficiaries in proportion to the actuarial interest of such beneficiaries in such trust.
(ii) Stock owned, directly or indirectly, by or for any portion of a trust of which a person is considered the owner under subpart E of part I of subchapter J (relating to grantors and others treated as substantial owners)shall be considered as owned by such person.
(C)From corporations If 50 percent or more in value of the stock in a corporation is owned, directly or indirectly, by or for any person, such person shall be considered as owning the stock owned, directly or indirectly, by or for such corporation, in that proportion which the value of the stock which such person so owns bears to the value of all the stock in such corporation.
(3)Attribution to partnerships, estates, trusts, and corporations
(A)To partnerships and estates – Stock owned, directly or indirectly, by or for a partner or a beneficiary of an estate shall be considered as owned by the partnership or estate.
(B)To trusts
(i)Stock owned, directly or indirectly, by or for a beneficiary of a trust (other than an employee’s ‘trust described in section 401(a) which is exempt from tax under section 501(a)) shall be considered as owned by the trust, unless such beneficiary’s interest in the trust is a remote contingent interest. For purposes of this clause, a contingent interest of a beneficiary in a trust shall be considered remote if, under the maximum exercise of discretion by the trustee in favor of such beneficiary, the value of such interest, computed actuarially, is 5 percent or less of the value of the trust property.
(ii) Stock owned, directly or indirectly, by or for a person who is considered the owner of any portion of a trust under subpart E of part I of subchapter J (relating to grantors and others treated as substantial owners) shall be considered as owned by the trust.
(C)To corporations – If 50 percent or more in value of the stock in a corporation is owned, directly or indirectly, by or for any person, such corporation shall be considered as owning the stock owned, directly or indirectly, by or for such person.
(4)Options If any person has an option to acquire stock, such stock shall be considered as owned by such person. For purposes of this paragraph, an option to acquire such an option, and each one of a series of such options, shall be considered as an option to acquire such stock.
(5)Operating rules
(A)In general – Except as provided in subparagraphs (B) and (C), stock constructively owned by a person by reason of the application of paragraph (1), (2), (3), or (4), shall, for purposes of applying paragraphs (1), (2), (3), and (4), be considered as actually owned by such person.
(B)Members of family – Stock constructively owned by an individual by reason of the application of paragraph (1) shall not be considered as owned by him for purposes of again applying paragraph (1) in order to make another the constructive owner of such stock.
(C)Partnerships, estates, trusts, and corporations – Stock constructively owned by a partnership, estate, trust, or corporation by reason of the application of paragraph (3) shall not be considered as owned by it for purposes of applying paragraph (2) in order to make another the constructive owner of such stock.
(D)Option rule in lieu of family rule – For purposes of this paragraph, if stock may be considered as owned by an individual under paragraph (1) or (4), it shall be considered as owned by him under paragraph (4).
(E)S corporation treated as partnership for purposes of this subsection
(i)an S corporation shall be treated as a partnership, and
(ii) any shareholder of the S corporation shall be treated as a partner of such partnership.
The preceding sentence shall not apply for purposes of determining whether stock in the S corporation is constructively owned by any person.
(b)Cross references For provisions to which the rules contained in subsection (a) apply, see—
- section 302 (relating to redemption of stock);
- section 304 (relating to redemption by related corporations);
- section 306(b)(1)(A) (relating to dispositionof section 306 stock);
- section 338(h)(3)(defining purchase);
- section 382(l)(3) (relating to special limitations on net operating losscarryovers);
- section 856(d) (relating to definition of rents from real propertyin the case of real estate investment trusts);
- section 958(b) (relating to constructive ownership rules with respect to controlled foreign corporations); and
(8) section 6038(e)(2) (relating to information with respect to certain foreign corporations).
[5] See Reg. Sec. 1.318-1
[6] See Federal Taxation of Partnerships & Partners [“FTP”], McKee, Nelson & Whitmire at Para. 14.02
[7] See
It is important to distinguish between an equity participation and a convertible mortgage. An “additional interest” type equity participation provides an interest “kicker” to the lender, keyed in some manner to the economic performance of the mortgaged property.
It involves the payment of contingent additional interest, not the acquisition of an ownership interest in the property. In a convertible mortgage, on the other hand, the lender obtains an option to acquire an interest in the property. In exchange for providing a lower interest rate and a larger mortgage loan than could be obtained through conventional financing, the convertible mortgage lender obtains the right to convert all or part of the mortgage loan to an equity interest at a future date.
The shared appreciation mortgage is an interest enhancement device that has a significant equity flavor. In a typical format it provides for a fixed interest rate, plus a contingent amount measured by a specified percent of any appreciation in the mortgaged property between the date of purchase and a specified future date. The future date may be either a fixed date or the date when the underlying property is sold.
The contingent interest payable under a shared appreciation mortgage that is. debt for tax purposes should be taxable to the lender and deductible by the borrower as interest when paid or accrued, depending upon the lender’s and borrower’s method of accounting.
[8] See
The convertible mortgage is a hybrid mortgage that can provide attractive economic and tax benefits to both the borrower and the lender. It normally affords the borrower both larger loan proceeds and lower debt service than a conventional mortgage and provides the lender with the right to acquire a potentially valuable equity interest.
The convertible mortgage is essentially a conventional mortgage linked with an option given to the lender to purchase a portion of the mortgaged property. If the borrower is a partnership or limited liability company (LLC) treated as a partnership, as is usually the case, the option will be to purchase a partnership or membership interest.
The option price for the interest is paid for by the lender by the transfer of part or all of the mortgage note to the partnership or LLC, thus making the mortgage “convertible” into an equity interest.
The convertible mortgage differs fundamentally from what is generally referred to as a mortgage “equity participation.”
An equity participation provides an interest “kicker” to the lender that is keyed in some manner to the economic performance of the mortgaged property. It involves the payment of contingent additional interest, not the acquisition of an ownership interest in the property.
In a convertible mortgage, on the other hand, the lender obtains an option to acquire an interest in the property. In exchange for providing a lower interest rate and a larger mortgage loan than could be obtained through conventional financing, the convertible mortgage lender obtains the right to convert part or all of the mortgage loan to an equity interest at a future date.
The convertible mortgage presents several unusual federal income tax issues as a result of its combination of a mortgage debt with an option.
