The Application of the Investment Company Rules to Limited Partnerships

 

What is the Investment Company Exception to the Non-recognition Rule?

There is an “investment company” exception to this rule.[1] This rule was broadened by the Taxpayer Relief Act of 1997, by amending IRC §351(e)(1).[2] Under IRC §721(b) the contributor of property to the FLP will recognize gain if the partnership would have been treated as an investment company under §351 if it were a corporation:

 

(a) General rule. No gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership.

(b) Special rule. Subsection (a) shall not apply to gain realized on a transfer of property to a partnership which would be treated as an investment company (within the meaning of section 351 ) if the partnership were incorporated.[3]

 

As a general rule, a corporation will be treated as an investment company if, after the transfer, more than 80% in value of the assets (with some exceptions) are stock or securities, interests in Regulated Investment Companies, Real Estate Investment Trusts, money, foreign currency, precious metals, or other assets described in 351(a)(1)(B) or the regulations. Treas. Reg. §1.351-1(c)(3) defines stock or securities as readily marketable only if they are traded on a securities exchange or traded or quoted regularly in the over-the-counter market.

What Happens If the Partnership is Classified as an Investment Company Under the Rules, But There is No Diversification?

The fact that the partnership would technically be classified as an investment company is only one of two conditions that must be met before gain will be recognized on transfer. In addition to In order for gain to be recognized on transfer to a partnership, the transfer must also result in diversification. The regulations provide:

(1)        . . . A transfer of property after June 30, 1967, will be considered to be a transfer to an investment company if —

(i)         The transfer results, directly or indirectly, in diversification of the transferors' interests, and . . . .[4]

Can Diversification Be Avoided by Transferring Identical Assets?

Under Reg. §1.351-1(c)(5), diversification exists if two or more persons transfer nonidentical assets to the partnership, unless they constitute an insignificant portion of the total assets transferred. “If there is only one transferor (or two or more transferors of identical assets) to a newly organized corporation, the transfer will generally be treated as not resulting in diversification.”[5] Accordingly, diversification should never result (and §721(b) should not apply) when the sole partners are a husband and wife and the contributed property is community property or identical separate property created by partition.

Is There a De Minimus Exception to the Diversification Test?

[I]f any transaction involves one or more transfers of nonidentical assets which, taken in the aggregate, constitute an insignificant portion of the total value of assets transferred, such transfers shall be disregarded in determining whether diversification has occurred.[6]

Unfortunately, the regulations do not tell us what an insignificant portion is, but the private letter rulings suggest that it is 1% or less.

A What Point in Time Are the Investment Company Rules Applied?

The determination of whether a corporation is an investment company shall ordinarily be made by reference to the circumstances in existence immediately after the transfer in question. However, where circumstances change thereafter pursuant to a plan in existence at the time of the transfer, this determination shall be made by reference to the later circumstances.[7]

*          *          *

If a transfer is part of a plan to achieve diversification without recognition of gain, such as a plan which contemplates a subsequent transfer, however delayed, of the corporate assets (or of the stock or securities received in the earlier exchange) to an investment company in a transaction purporting to qualify for nonrecognition treatment, the original transfer will be treated as resulting in diversification.[8]

Can the Timing Regulation Be Used As a Shield?

The regulations just quoted were probably meant to be used as a sword by the IRS to disqualify a transfer by aggregating it with later transfers. Can the partners adopt a “plan” that can be used as a shield, such that additional contributions are required if the initial contribution(s) would fail the test?

Treas. Reg. §1.351-1(c)(2), the first of the last two regulations quoted above, is not made specifically applicable only to cases where diversification results. The second regulation quoted (Treas. Reg. §1.351-1(c)(5), last sentence)arguably ought to be applicable even if it causes the original transfer to be treated as not resulting in diversification.

Is There a Mathematical Safe Harbor?

Under private letter rulings, and relatively recent amendments to the regulations,[9] the IRS has liberalized the diversification requirements, holding that “investment company” exception will not result in gain recognition if (a) each transfer transfers a portfolio of which (a) not more than 25% of its assets are the securities of one company, and (b) no more than half of the assets are held in securities of five (or fewer) issuers.

Apparently, the composition of the partnership assets is irrelevant, unless IRC §368(a)(2)(F) is somehow also directly applicable, instead of being merely the test to be applied to the partners individually, and this does not appear to be the case.[10]

As an example of how this rule might operate, if a portfolio consisted of stocks in 11 different companies, and each group of stock all had the same value, both the 25% and the 50% tests would be satisfied.

 

Stated another way, no one stock constitutes more than 25% of the portfolio, and there is no group of 5 stocks making up 50% of the portfolio.

 

Specifically, Treas. Reg. §1.351-1(c)(6)(i) provides:

(i) For purposes of paragraph (c)(5) of this section, a transfer of stocks and securities will not be treated as resulting in a diversification of the transferors' interests if each transferor transfers a diversified portfolio of stocks and securities. For purposes of this paragraph (c)(6), a portfolio of stocks and securities is diversified if it satisfies the 25 and 50-percent tests of section 368(a)(2)(F)(ii), applying the relevant provisions of section 368(a)(2)(F). However, Government securities are included in total assets for purposes of the denominator of the 25 and 50-percent tests (unless the Government securities are acquired to meet the 25 and 50-percent tests), but are not treated as securities of an issuer for purposes of the numerator of the 25 and 50-percent tests.[11]

 

And IRC §368(a)(2)(F) provides:

(ii) A corporation meets the requirements of this clause if not more than 25 percent of the value of its total assets is invested in the stock and securities of any one issuer and not more than 50 percent of the value of its total assets is invested in the stock and securities of 5 or fewer issuers. For purposes of this clause, all members of a controlled group of corporations (within the meaning of section 1563(a)) shall be treated as one issuer. For purposes of this clause, a person holding stock in a regulated investment company, a real estate investment trust, or an investment company which meets the requirements of this clause shall, except as provided in regulations, be treated as holding its proportionate share of the assets held by such company or trust.[12]

 

The regulations give these examples:

(7)        The application of subparagraph (5) of this paragraph may be illustrated as follows:

Example (1). Individuals A, B, and C organize a corporation with 101 shares of common stock. A and B each transfers to it $10,000 worth of the only class of stock of corporation X, listed on the New York Stock Exchange, in exchange for 50 shares of stock. C transfers $200 worth of readily marketable securities in corporation Y for one share of stock. In determining whether or not diversification has occurred, C's participation in the transaction will be disregarded. There is, therefore, no diversification, and gain or loss will not be recognized.

 

Example (2). A, together with 50 other transferors, organizes a corporation with 100 shares of stock. A transfers $10,000 worth of stock in corporation X, listed on the New York Stock Exchange, in exchange for 50 shares of stock. Each of the other 50 transferors transfers $200 worth of readily marketable securities in corporations other than X in exchange for one share of stock. In determining whether or not diversification has occurred, all transfers will be taken into account. Therefore, diversification is present, and gain or loss will be recognized.[13]

 

The preamble to the proposed version of the regulations indicates the rationale of the IRS:

The Service wants to clarify that §1.351-1(c)(5) does not prevent tax-free combinations of already diversified portfolios, and that combinations of already diversified portfolios are not inconsistent with the purposes of section 351(e) (i.e., preventing the tax-free transfer of one or a few stocks or securities to swap funds).[14]

Do All Partners Recognize Gain if One Partner Recognizes Gain Under 721(b)?

I have not been able to find a clear and concise answer to this question in any of the secondary sources that I have reviewed, and until I do, it would be best to proceed on the assumption that the failure of one partner to meet the test could cause the rule to apply to all. But it may be that this is only the case if the mathematical safe harbor is the sole means for avoiding the rule.

 

The regulations discussed above[15], suggest that each partner must pass the 25%/50% test in order to rely upon the safe harbor rules. However, §721(b) clearly only applies to the contributing partner, and not to the partnership. I suppose that if the mathematical safe-harbor test, found in Treas. Reg. §1.351-1(c)(7) and described above, is failed, then 721(b) could apply to each partner who otherwise becomes diversified as a result of the transfer, but that if the partner could show that diversity was not achieved (based on another test), then 721(b) would not apply to that partner.

All in all, this looks like somewhat of a gray area to me, and I advise proceeding on the assumption that all partners must each pass the 25%/50% test in order to rely upon that safe harbor.

If the Partnership Owns a Holding Company, Does a “Look-Through” Rule Apply?

(4) In making the determination required under subparagraph (1)(ii)(c) of this paragraph, stock and securities in subsidiary corporations shall be disregarded and the parent corporation shall be deemed to own its ratable share of its subsidiaries' assets. A corporation shall be considered a subsidiary if the parent owns 50 percent or more of (i) the combined voting power of all classes of stock entitled to vote, or (ii) the total value of shares of all classes of stock outstanding.[16]

In addition to the rule just described in the regulations, the 1997 change to 351 now provides that an entity will be treated as owning the assets of any other entity “if substantially all of the assets of such entity consist (directly or indirectly) of any assets described in any preceding clause or clause [i.e., investment assets on the list].” This last provision is limited by an ” except as otherwise provided in regulations” clause.

Can the Partnership Agreement Be Drafted to Automatically Avoid Diversification?

It may be that a partnership agreement can be drafted to preclude the possibility of diversification in operation.[17] For example, diversification would appear to be precluded if (1) each partner is allocated all of the income, gains and losses from the property that partner contributed[18] and (2) that if the partner withdraws the partner will receive the property back (if it is still owned by the partnership).

 

 

 


[1] As succinctly as IRC §721(a) provided for general nonrecognition, §721(b) provides and exception, “:Subsection (a) shall not apply to gain realized on a transfer of property to a partnership which would be treated as an investment company (within the meaning of section 351 ) if the partnership were incorporated.”

[2] §1002(a) of P.L. 105-34., effective for transfers after June 8, 1997.

[3] IRC §721(a) & (b).

[4] Treas. Reg. §1.351-1(c)(1)(i).

[5] Treas. Reg. §1.351-1(c)(5), next to last sentence.

[6] Treas. Reg. §1.351-1(c)(5).

[7] Treas. Reg. §1.351-1(c)(2).

[8] Treas. Reg. §1.351-1(c)(5), last sentence.

[9]Treas. Reg. §1.351(c)(6)(i). IRC §368(a)(2)(F).

[10] PLR 9538023. 

[11]Treas. Reg. §1.351(c)(6)(i).

[12]IRC §368(a)(2)(F)(ii).

[13]Treas. Reg. §1.351-1(c)(7).

[14] Prop. Treas. Reg. §1.351-1, 60 Fed. Reg. 40795 (1995).

[15]Treas. Reg. §1.351-1(c)(7) Ex. 1.

[16] Treas. Reg. §1.351-1(c)(4).

[17] Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1976, 658 (1976); S. Rep. No. 938, 94th Cong., 2d Sess. 44 (1976). Cf. McKee, Nelson & Whitmire, Federal Taxation of Partnerships and Partners, Ch. 4.

[18] Section 704(c) sometimes requires that all the precontribution built‑in gain or loss be specially allocated, but not income or postcontribution gains and losses.