The formation of a partnership is generally a nonrecognition transaction for both the contributing partner and the newly-created partnership. Thus, as a general rule, no gain is recognized by a partnership or its partners on the contribution of property to the partnership in exchange for an interest in the partnership. There are, however, potential exceptions to this general rule.
Most notably, an exception applies with respect to property transferred to a partnership that would be treated as an “investment company” (within the meaning of I.R.C. § 351) if the partnership were incorporated.
Section 351 addresses the concept of an “investment company.” The Treasury Regulations define an investment company. A transfer of property to an investment company occurs when:
(i) the transfer results, directly or indirectly, in diversification of the transferor’s interest (the “diversification” test); and
(ii) the transferee is (a) a regulated investment company, (b) a real estate investment trust, or (c) a corporation more than 80 percent of the value of whose assets (excluding cash and nonconvertible debt obligations from consideration) are held for investment and are readily marketable stocks or securities, or interests in regulated investment companies or real estate investment trusts (the “investment” test).
Under this definition, an investment company exists if, but only if, both the diversification test and the investment test are satisfied. A transfer to an investment company generally requires that the transferors recognize the built-in gain or loss under I.R.C. § 1001 on the transfer of property.
The Investment Test.
As set forth above, the so-called “investment” test is satisfied if more than 80 percent of the value of the assets of the transferee entity (excluding cash and nonconvertible debt obligations from consideration) are held for investment and are readily marketable stocks or securities. The 80% test, thus, turns on whether 80% or more of the assets are (i) held for investment and (ii) readily marketable stocks or securities. See Treas. Reg. § 1.351-1(c)(1)(ii).
Readily Marketable Stock or Securities
For these purposes, the following assets are treated as stocks and securities:
(i) money, (ii) stocks and other equity interests in a corporation, evidences of indebtedness, options, forward or futures contracts, notional principal contracts and derivatives, . . .(vii) to the extent provided in regulations prescribed by the Secretary, any interest in any entity not described in clause (vi), but only to the extent of the value of such interest that is attributable to assets listed in clauses (i) through (v) or clause (viii), or (viii) any other asset specified in regulations prescribed by the Secretary.
Stocks and securities are considered readily marketable if “they are part of a class of stock or securities which is traded on a securities exchange or traded or quoted regularly in the over-the-counter market.” Readily marketable stocks or securities include “convertible debentures, convertible preferred stock, warrants, and other stock rights if the stock for which they may be converted or exchanged is readily marketable.” Further, stocks and securities are considered held for investment unless they are “(i) held primarily for sale to customers in the ordinary course of business, or (ii) used in the trade or business of banking, insurance, brokerage, or a similar trade or business.” Investment company status is generally determined immediately after the transfer(s) at issue.
If, upon a contribution to a partnership, more than 80 percent of the value of the assets in the partnership are held for investment and are readily marketable stocks or securities, the partnership will fall under the definition of an investment company under Section 721 if the diversification test is also met.
The Diversification Test.
As set forth in this section, the contribution to the partnerships will not result in diversification. Diversification exists where two or more persons transfer nonidentical assets in the formation of the partnership. As a corollary, if two or more persons transfer identical assets to a newly organized partnership, the transfer does not result in diversification.
The Regulations provide for a de minimis rule that, where it applies, disregards certain transfers for purposes of diversification. Under the de minimis rule, the IRS will disregard transfers of nonidentical assets that, taken in the aggregate, are an insignificant portion of the total value of assets transferred. Although the regulations do not precisely define the phrase, “an insignificant portion,” IRS guidance provides helpful insight regarding the scope of the phrase.
In Revenue Ruling 87–9, the IRS considered whether transfers of stock and cash by different transferors to a newly organized corporation were transfers to an investment company. There, the transferors of the stock received 89% of the stock in the new corporation, and the transferors of cash received 11% of the stock. The IRS held that the cash was a significant portion of the value of the property transferred, and thus the exchange resulted in diversification of the transferors’ interests.
Example 1 under Treas. Reg. § 1.351-1(c)(6) provides additional guidance. There, two individuals each transfer $10,000 of publicly traded X corporation stock to Z, a newly organized corporation, for 50 shares of Z stock, and a third individual transfers $200 in Y corporation marketable securities to Z for one share of Z stock. The third transferor’s contribution, which amounts to less than one percent of the total assets contributed, is ignored, and no diversification occurs. The regulation thus indicates that a transfer of less than one percent is treated as an insignificant portion.
In IRS Private Letter Ruling 9608026, the IRS considered whether transfers of stock and cash by different transferors to a limited partnership were transfers to an investment company. There, transferor A contributed securities and cash and transferors B, C, and M transferred cash. Since B, C, and M’s cash contributions were not identical to A’s securities contributions, the issue was whether the transfers resulted in diversification. The IRS found that B, C, and M’s transfers were insignificant because the cash was less than 1% of the total assets transferred to the partnership, and thus those cash transfers were ignored for diversification purposes.