The formation of a partnership is generally a nonrecognition transaction for both the contributing partner and the newly created firm.^[1]  Thus, no gain is recognized to a partnership or to any of its partners because of a contribution of property to the partnership in exchange for an interest in the partnership.^[2] While this nonrecognition rule is a useful instrument in the tax practitioner’s toolbox, the rule’s glamor often overshadows an important exception. Under I.R.C. § 721(b), the general nonrecognition rule will not apply to gain realized on a transfer of property to a partnership that would be treated as an investment company (within the meaning of I.R.C. § 351) if the partnership were incorporated.^[3]

This reference to I.R.C. § 351 shifts the analysis to the transfer rules for corporations to determine if the transferee partnership qualifies as an investment company (i.e., an investment partnership). Under the Treasury Regulations, a transfer of property to an investment partnership occurs when:

i. the transfer results, directly or indirectly, in diversification of the transferor’s interest; 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.^[4]

Thus, a transfer to an investment partnership only occurs when both the diversification test and investment test are satisfied. If such a transfer arises, then the exception to the nonrecognition rule applies and the transferors will recognize gain under I.R.C. § 1001 on the transfer of property in exchange for an interest in the newly organized partnership.^[5]

Investment test.

The 80% test requires a determination about whether the assets are (1) held for investment and (2) readily marketable stocks or securities.[6] 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, (iii) any foreign currency, (iv) any interest in a real estate investment trust, a common trust fund, a regulated investment company, a publicly-traded partnership (as defined in section 7704(b)) or any other equity interest (other than in a corporation) which pursuant to its terms or any other arrangement is readily convertible into, or exchangeable for, any asset described in any preceding clause, this clause or clause (v) or (viii), (v) except to the extent provided in regulations prescribed by the Secretary, any interest in a precious metal, unless such metal is used or held in the active conduct of a trade or business after the contribution, (vi) except as otherwise provided in regulations prescribed by the Secretary, interest in any entity if substantially all of the assets of such entity consist (directly or indirectly) of any assets described in any preceding clause or clause (viii), (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.^[7]

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.”^[8] 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.”^[9] 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.”^[10]

The timing of the determination of whether a partnership is an investment partnership is generally made by examining the circumstances in existence immediately after the transfer at issue.^[11] However, if a plan, which exists at the time of the transfer, changes circumstances after the transfer, then the determination should encompass the later circumstances.^[12]

Diversification test.

Interestingly, the actual statutory language of I.R.C. § 721(b) imposes no diversification requirement. However, the legislative history to I.R.C. § 721(b) clearly states that no gain will be recognized under I.R.C. § 721(b) unless a contribution results “directly or indirectly, in the diversification of the transferors’ interests.”[13] The IRS has followed this approach and considered diversification as a requirement to trigger I.R.C. § 721(b). Accordingly, any I.R.C. § 721(b) analysis must include a determination of whether the transfer results in diversification of the transferors’ interests.

Diversification occurs if two or more persons transfer nonidentical assets in the formation of the partnership.^[14]Thus, if two or more transferors to a newly organized partnership transfer identical assets, the transfer does not result in diversification.^[15]

Notwithstanding the above, a de minimis rule exists that, if applicable, disregards certain transfers when determining whether diversification occurs.^[16] Under this rule, if there are transfers of nonidentical assets that, taken in the aggregate, are an insignificant portion of the total value of assets transferred, the transfers are disregarded in the diversification determination.^[17] While the regulations do not define an insignificant portion, the IRS has provided guidance on the topic.

An example in the Treasury Regulations offers advice regarding what qualifies as an insignificant portion.^[18] 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.

In IRS Private Letter Ruling 9608026, the IRS considered whether transfers of stock and cash by different transferors to a limited partnership constituted transfers to an investment company.^[19] 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. Since A was the only relevant transferor, and diversification under Treasury Regulation § 1.351-1(c)(5) requires transfers by two or more persons, the IRS ruled that the partnership was not an investment company within the meaning of I.R.C. § 351(e)(1) and neither A nor the partnership would recognize gain or loss on A’s proposed contribution of the Securities under I.R.C. § 721(a).

Final Thoughts

Because of the range of assets included as stocks and securities under I.R.C. § 721(b), it is quite simple for a contributing partner to unintentionally trigger gain upon making a contribution to a partnership. Therefore, tax practitioners must properly consider I.R.C. § 721(b) when planning the transfer of appreciated property to a partnership that may qualify as an investment partnership.

[1] I.R.C. § 721(a).

[2] Id.

[3] I.R.C. § 721(b).

[4] Treas. Reg. § 1.351-1(c)(1).

[5] I.R.C. § 721(b). I.R.C. § 721(b) and I.R.C. § 351(e) have one significant difference. Transfers to investment partnerships under I.R.C. § 721(b) will only cause recognition of gains; losses will be deferred until the partnership sells the property. Transfers to investment companies under I.R.C. § 351(e) will cause recognition of gains and losses. Treas. Reg. § 1.351-1(c)(1).

[6] See Treas. Reg. § 1.351-1(c)(1)(ii).

[7] I.R.C. § 351(e)(1)(B). The Treasury Regulations do not reflect amendments that the Taxpayer Relief Act of 1997 made to I.R.C. § 351(e)(1)(B). Those amendments broadened the list of assets taken into account in determining whether a transferee is an investment company.

[8] Treas. Reg. § 1.351-1(c)(3).

[9] Id.

[10] Id.

[11] See Treas. Reg. § 1.351-1(c)(2).

[12] See id.

[13] S. Rep. No. 938, 94th Cong., 2d Sess., pt. 2, at 43, 44 (1976). See I.R.S. Priv. Ltr. Rul. 9608026 (Feb. 23, 1996) (holding that without diversification, the newly organized partnership was not an investment company); see also I.R.S. Priv. Ltr. Rul. 9550023 (Dec. 15, 1995) (concluding that I.R.C. § 721(b) did not apply to the proposed transfer of property to a partnership with more than 80% of its assets being held for investment and consisting of readily marketable stocks and securities because diversification was not found).

[14] See Treas. Reg. § 1.351-1(c)(5).

[15] See id.

[16] See id.

[17] See id.

[18] See Treas. Reg. § 1.351-1(c)(6) (example 1).

[19] See I.R.S. Priv. Ltr. Rul. 9608026 (Feb. 23, 1996).