Transfers to Investment Companies: Pitfalls of Secs. 351 and 721

By Robert A. Velotta, CPA, Cohen & Company, Cleveland, OH

Editor: Anthony S. Bakale, CPA, M.Tax.

In many instances, property can be contributed to an entity by its owners in exchange for ownership interests, without gain or loss being recognized on the contribution. For corporations, the general rule under Sec. 351(a) is that “no gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control…of the corporation.” Similarly, the general rule under Sec. 721(a) states that “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.” Both sections, however, contain lesser-known exceptions to the general nonrecognition rules for investment companies. These rules may create unintended consequences for taxpayers who do not properly consider them when transferring appreciated property to an entity qualifying as an investment company.

Overview

The transfer-to-investment-company (TIC) provision of Sec. 721(b) refers to Sec. 351. Under Regs. Sec. 1.351-1(c)(1), a TIC is defined as:

  1. A transfer to a regulated investment company (RIC), real estate investment trust (REIT), or corporation more than 80% of the value of whose assets (excluding cash and nonconvertible debt obligations) are held for investment and are readily marketable stocks or securities, or interests in RICs or REITs; and

  2. The transfer results, directly or indirectly, in diversification of the transferor’s interests.

For the 80% test, Regs. Sec. 1.351-1(c)(3) states that 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.” The definition of readily marketable securities includes 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 under Regs. Sec. 1.351-1(c)(3), stocks and securities are considered held for investment unless held primarily for sale to customers in the ordinary course of business or used in the trade or business of banking, insurance, brokerage or a similar trade or business. As such, a corporation (or partnership) engaged in the active trade or business of securities trading (as opposed to investing activities) may also qualify as an investment company under Sec. 351.

A transaction ordinarily results in the diversification of the transferor’s assets if two or more persons transfer nonidentical assets to the entity in the exchange.

Example 1: A owns 100 shares of stock of publicly traded Y Corp., with a $2,000 basis and $10,000 fair market value (FMV). B owns 50 shares of publicly traded Z Corp., with a $12,000 basis and $10,000 FMV. A and B form partnership E, to which each contributes their securities. As both A and B achieve diversification in this transaction and E owns only marketable securities, these transfers fall under the TIC rules and must be treated accordingly.

Differences between Secs. 351 and 721

Secs. 351 and 721 have one significant difference. Transfers to investment partnerships under Sec. 721 will only cause recognition of gains; losses will be deferred until the partnership sells the property. Thus, in Example 1, A would be required to recognize $8,000 gain on the transfer to E. However, B would not recognize the built-in loss (BIL) on contribution to E. Instead, E would take B’s carryover basis and holding period in the Z stock. On disposition of that security, B should be allocated the BIL under Sec. 704(c).

Gains and losses may not be netted by contributing partners in determining the gain to be recognized. As such, if a contributing partner contributes a portfolio of securities, the amount of gain to be recognized is determined on an asset-by-asset basis. This may result in gains being triggered on a TIC, even if there is an overall loss on the portfolio being transferred.

Example 2: The facts are the same as in Example 1, except that B contributes two different securities to E:

Security Basis FMV Gain/(loss)
W $6,000 $8,000 $2,000
X 6,000 2,000 (4,000)
Total $12,000 $10,000 (2,000)

Even though the overall portfolio has a loss on contribution to E, B must recognize $2,000 gain on the contribution of W, but cannot recognize the $4,000 loss on the contribution of X.

Transfers to corporations qualifying as investment companies under Sec. 351 will cause the transferor to recognize both gains and losses on the contributed property.

Example 3: The facts are the same as in Example 1, except that E is taxed as a corporation. In this situation, A would be required to recognize $8,000 gain on the transfer to E, and B would recognize a $2,000 loss on the transfer, as if the securities were sold at their FMV on the transfer date.

Diversification and Planning

The transfer of identical assets generally will not cause the transferors to recognize gain and/or loss under the TIC provisions, unless the transfers are part of a larger plan of diversification. There is little guidance as to how this is defined; however, the determination of whether a contribution is taxable under the TIC rules is generally made by looking at the circumstances immediately after the transfer. When circumstances change under a diversification plan in existence at the time of the transfer, the determination may be made by reference to later circumstances. As such, tax advisers need to look at the facts and circumstances to determine whether a contribution was part of an overall plan of diversification and, thus, subject to the TIC exception to the Secs. 351 and 721 nonrecognition provisions.

In letter rulings, the IRS has ruled that the diversification must be meaningful for the TIC rules to apply. For example, in Letter Ruling 9608026, one partner contributed publicly traded securities; other related parties contributed less than 1% of the total value of contributions. The Service ruled that there was no diversification (and hence, no gain or loss recognition), because the partner contributing the appreciated securities was the only significant contributor.

Under Regs. Sec. 1.351-1(c)(6)(i), if each transferor transfers a diversified portfolio, diversification of the transferor’s interest does not occur. A portfolio of stocks and securities is considered diversified if it satisfies the 25% and 50% tests of Sec. 368(a)(2)(F)(ii) (not more than 25% of value of total assets is invested in the stock or securities of any one issuer, and not more than 50% of value of total assets is invested in the stock and securities of five or fewer issuers). Thus, the transfer of an already diversified portfolio into an investment company does not result in diversification, nor does it trigger gain/loss recognition under the TIC rules.

These rules are often encountered by investment advisers seeking to set up a hedge fund, other investment partnership or a RIC. For example, an adviser may provide investment advisory services to separately managed accounts. Each of these accounts may own substantially the same investments. In an effort to manage only one pool of investments, reduce commission fees, or for other business reasons, each of the adviser’s clients contribute their investments to a partnership. If each portfolio meets the tests under Sec. 368(a)(2)(F)(ii), these transactions will not cause the transferors to recognize immediate gain on the transfer.

A partnership otherwise qualifying as an investment company may potentially avoid this designation and its negative tax consequences by drafting an operating agreement to allocate all income, gains, and losses from the contributed property to the partner that contributed it. This agreement should also contain provisions that the partner would receive the contributed property in distribution should it withdraw from the partnership. However, this approach may create other operational or tax issues.

Another option to avoid the potentially negative tax consequences of the TIC rules is to avoid meeting the 80%-of-marketable-securities test, by holding real estate or other nonmarketable securities that constitute more than 20% of the value of the entity at the time of the transfer.

Conclusion

The TIC rules often come into play when investment advisers are thinking about funding hedge funds, other investment partnerships and RICs through contributions of appreciated securities. However, tax practitioners who practice outside of the financial services industry should also be aware of these rules, as they contain many pitfalls and potentially unintended consequences that may result in gain recognition on the contribution of securities and other appreciated property to entities that may qualify as an investment company, such as family limited partnerships, investment clubs and other entities holding marketable securities.

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