Sec. 721(b): contributions to investment partnerships.

As most tax practitioners are aware, gain or loss is generally not recognized when property is contributed to a partnership in exchange for a partnership interest. However, many practitioners are unaware of the rules under Sec. 721(b) that require gain recognition in special circumstances. At a time when the family limited partnership is taking hold as a favored estate tax planning tool, a working knowledge of Sec. 721(b) is essential to avoid unintended tax consequences.

Sec. 721(b) was enacted to curb perceived abuses in the partnership arena. This section states that the general nonrecognition rules of Sec. 721 shall not apply to gain realized on a transfer of appreciated property to a partnership that would be treated as an investment company (within the meaning of Sec. 351) if the partnership were incorporated. Prior to its enactment, unrelated investors could pool their publicly traded stocks and other marketable securities in partnerships and, by doing so, diversify their individual holdings. In order to eliminate the use of partnerships in this manner, Sec. 721(b) provides that a taxpayer must recognize gain on any property contributed to a partnership treated as an investment company.

As the statute and regulations under Sec. 721 were intended to mirror the rules under Sec. 351(e), separate statutory and regulatory language was not provided under Sec. 721 to address this topic. Instead, one must look to Sec. 351 for guidance and convert its concepts to partnerships. (Note, however, that one significant difference exists between Sec. 721 and Sec. 351: under Sec. 721, losses are not recognized.) Under Sec. 351, a transfer of property will be considered as made to an investment company if:

* The transfer results, directly or indirectly, in diversification of the transferors' interests.

* The transferee is a regulated investment company (RIC), a real estate investment trust (REIT), or a 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.

Applied in the partnership context, an appreciated property contribution to a partnership will be a taxable event if more than 80% of the value of the partnership's assets (excluding cash and nonconvertible debt obligations) (1) are held for investment; (2) are readily marketable stocks or securities; and (3) when transferred, result in diversification of the transferors' interests in the contributed properties.

Each of these requirements is specifically defined by regulation. First, stocks and securities will be considered to be held for investment unless they are held primarily for sale to customers in the ordinary course of business, or are used in banking, insurance, brokerage or a similar trade or business. Next, stocks and securities will be considered readily marketable only if traded on a securities exchange or quoted regularly in the over-the-counter market. Note that "readily marketable stocks or securities" also includes convertible securities if the stock for which they may be converted or exchanged is readily marketable.

A transfer ordinarily results in the diversification of the transferors' interests if two or more persons transfer nonidentical assets to a partnership in the exchange. Likewise, if two or more persons transfer identical assets to a partnership, the transfer will generally not be treated as resulting in diversification. Diversification also does not appear to occur if the contributing partner retains the beneficial economic interest in the contributed asset. In Letter Ruling 9451035, the partners used the rules under Sec. 704(b) and their partnership agreement to allow contributing partners to retain certain economic rights and obligations with respect to the contributed assets and thereby avoid the diversification requirement. The regulations also allow for "step transaction" concepts to be applied when a plan exists to circumvent the intent of these rules.

Finally, the determination of whether a contribution is taxable will ordinarily be made by reference to the circumstances in existence immediately after the transfer in question. However, as noted, when circumstances change pursuant to a plan in existence at the time of the transfer, this determination shall be made by reference to the later circumstances.

As originally noted, contributions to a partnership are generally not taxable events. However, if the partnership meets certain asset value tests and the assetcontributing partner attains diversification as a result of the contribution, the contribution may be taxable. Even more importantly, only gains are recognized; losses are not. Thus, if a parent transfers a portfolio of securities to a family limited partnership and the transfer results in diversification, the gains will be triggered and a large tax may be due even when, on the whole, the portfolio's losses are large enough to offset the gains. In order to take advantage of the offset, the parent will have to sell the loss securities to third parties before the close of the year. All in all, taxpayers should take care when contributing assets to a partnership that owns publicly traded securities to see that unexpected tax results do not occur.