When Contributions to a Partnership Are Not Tax-Free

By: Tyler B. Korn, Esq.

Contributions of property or money to a partnership are usually non-recognition events if the contributions are in exchange for a partnership interest – meaning that the contributions are tax-free both to the contributing partner and to the partnership.

This non-recognition rule, which is contained in Section 721(a) of the Internal Revenue Code, generally applies regardless of whether the contribution is made on formation of the partnership or after it has been in existence and operating for some time. This non-recognition rule does not apply to transactions between the partnership and a partner acting outside his capacity as a partner or when the purported contribution is actually a disguised sale.

“Due to the breadth of asset classes included under Section 721(b), it is relatively easy for a contributing partner to inadvertently trigger gain recognition upon making a contribution to a partnership.”

In the course of representing clients, however, many tax practitioners often overlook another important exception to the Section 721. Under Section 721(b), the general non-recognition rule of 721(a) also does not apply to gain realized upon a contribution of property to a partnership “investment company” where the contribution results in the diversification of the transferor’s assets. Although Section 721(b) is intended principally to prevent tax-free diversification of securities portfolios, its actual effect is for two reasons much broader that it appears.

First, while the legislative history to Section 721(b) clearly stated that no gain will be recognized under Section 721(b) unless a contribution results, directly or indirectly, in the diversification of the transferors’ interests, the actual statutory language of Section 721(b) imposes no diversification requirement whatsoever. The test that is generally applied to determine whether diversification exists is contained in the Treasury Regulations under Section 351 of the Internal Revenue Code, but that test is senselessly broad. According to Section 1.351-1(c)(1)(i) of the Treasury Regulations, a transfer ordinarily results in the diversification of interests if two or more persons transfer non-identical assets to the entity, with nominal disparities in contributed assets being disregarded. Under this standard, nearly any transfers of assets by different persons will meet the diversification test. Accordingly, it is not just “swap funds” and “exchange funds” in partnership form that are affected by Section 721(b).

Second, Section 721(b) requires recognition of gain (though not losses) upon the contribution of many types of property — not just securities — to a partnership investment company. Whether or not a partnership will be treated as an investment company is determined under Section 351(e)(1) of the Internal Revenue Code. A partnership will be treated as an investment company if, after the exchange, over 80% of the value of its assets are held for investment and are “stock and securities” (or interests in real estate investment trusts or in regulated investment companies).

Property covered by this gain recognition rule is actually not limited to stock and securities but rather includes eight separate categories of assets:

  • Money intended for the purchase of stock or securities;
  • Stocks and other equity interests in a corporation, evidences of indebtedness, options, forward or futures contracts, notional principal contracts and derivatives;
  • Foreign currency;
  • Any interest in a REIT, common trust fund, registered investment company, publicly traded partnership, etc.;
  • Any interest in a precious metal, unless used or held in the active conduct of a trade or business post-contribution;
  • Interests in any entity if substantially all of the assets of the entity consist (directly or indirectly) of any assets listed in (i) through (v) or (viii);
  • An interest in an entity not described in (vi), to the extent of the value of the interest that is attributable to assets listed in (i) through (v) or (viii); and
  • Any other asset specified in the Treasury Regulations.

Due to the breadth of asset classes included under Section 721(b), it is relatively easy for a contributing partner to inadvertently trigger gain recognition upon making a contribution to a partnership. For instance, while a contribution of real estate will not be counted as “stock and securities,” stocks and other interests in corporations are taken into account – regardless of whether they are publicly traded or convertible into interests that are publicly traded. Section 721(b) can also be highly problematic for indirect investments in pooled, Tenancy in Common (“TIC”) investments.

If you have questions regarding your partnership contributions, please feel free to call us.

Comments are closed.

THIS ARTICLE IS INTENDED SOLELY FOR INFORMATIONAL PURPOSES AND SHOULD NOT BE CONSTRUED AS, OR USED AS, A SUBSTITUTE FOR LEGAL ADVICE FOR SPECIFIC TRANSACTIONS OR IN SPECIFIC CIRCUMSTANCES.

THIS ARTICLE MAY NOT HAVE BEEN UPDATED BY THE TIME OF YOUR READING, AND MAY BE TIME-SENSITIVE IN NATURE.

THIS ARTICLE MAY NOT BE REPRODUCED, IN WHOLE OR PART, WITHOUT THE PRIOR WRITTEN APPROVAL OF THE KORN LAW FIRM, P.L.