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Beware the new "investment company" rules.

Recent years have seen a resurgence in transactions involving "corporate joint ventures," "strategic partnerships," and the like. The Taxpayer Relief Act of 1997 (the "1997 Act") has created a significant risk that the formation of such joint ventures could be taxable as a result of changes to the definition of an investment company. Indeed, these changes could result in taxation of such commonplace transactions as the formation of a nonconsolidated subsidiary or the transfer of appreciated property to a partnership with an unrelated person. This potential trap for the unwary should be on the checklist of every tax professional.

Background

Sections 351 and 721 of the Internal Revenue Code(1) have long provided that transfers of property to a corporation or partnership, respectively, are not a taxable event if the transferor receives either sufficient stock or a partnership interest in exchange. Specifically, under section 351(a), no gain or loss is recognized if property is transferred to a corporation by one of more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control (as defined in section 368(c))(2) of the corporation. Likewise, under section 721(a), gain or loss is not recognized if property is transferred to a partnership in exchange for an interest in the partnership.

This general rule of nonrecognition has long been subject to an exception in the case of transfers to entities that were treated as "investment companies." Specifically, section 351(e) has provided since 1967 that gain or loss would be recognized upon the transfer of property to an investment company. Similarly, section 721(b) provided hat gain, but not loss, is recognized upon a contribution of property by a partner to a partnership that would be treated as an investment company if the partnership were a corporation. This provision was added to the Code to prevent "swaps" of stock through formation of an investment company.

Section 351(e) did not itself specify a definition of an "investment company," but a definition was provided by the Internal Revenue Service in regulations issued in 1967. Under Treas. Reg. [sections] 1.351-1(c)(1), a transfer of property after June 30, 1967, was considered to be a transfer to an investment company if W the transfer results, directly or indirectly, in diversification of the transferors' interests, and (ii) the transferee is (a) a regulated investment company (RIC), (b) a real estate investment trust (REIT), or (c) a corporation more than 80 percent of the value of whose assets (excluding cash and non-convertible debt obligations from consideration) are held for investment and are readily marketable stocks or securities, or interests in RICs or REITs. The determination whether a corporation was an investment company was made by reference to the circumstances in existence immediately after the transfer in question, although where circumstances change thereafter pursuant to a plan in existence at the time of the transfer, such plan could also be taken into account.(3)

Under the regulations, except in the case of transfers to RICs or REITs (which were self-evident), the threshold questions in applying the investment company rules were whether more than 80 percent of the value of the assets of the transferee corporation were (i) readily marketable stock or securities that (ii) were held for investment. For purposes of this test, stock and securities were considered to be readily marketable only if they were part of a class of stock or securities which was traded on a securities exchange or traded or quoted regularly in the over-the-counter market. Readily marketable stock or securities also included convertible debentures, convertible preferred stock, warrants, and other stock rights if the stock for which they may be converted or exchanged is readily marketable.(4) Stock and securities in subsidiary corporations were disregarded and the parent corporation was deemed to own its ratable share of the subsidiary's assets; a corporation was considered a subsidiary if the parent owns 50 percent or more of (i) the combined voting power of all classes of stock entitled to vote, or (ii) the total value of all classes of stock outstanding.(5)

Although the definition of readily marketable stock or securities was relatively limited under the regulations, the "held for investment" test in the regulations was relatively broad. Specifically, under the regulations, all stock and securities were considered to be held for investment unless such stock and securities were (i) held primarily for sale to customers in the ordinary course of a business, or (ii) used in the trade or business of banking, insurance, brokerage, or a similar trade or business.(6)

Even if these two requirements were satisfied, a transfer to a corporation of readily marketable stock or securities that were held for investment (or a transfer to a RIC or a REIT) was not taxable under section 351(e) unless the transfer resulted in "diversification." Under the regulations, a transfer ordinarily results in diversification of the transferors' interests if two or more persons transfer nonidentical assets to a corporation in the exchange. For this purpose, if any transaction involves one or more transfers of nonidentical assets that, taken in the aggregate, constitute an insignificant portion of the total value of assets transferred, such transfers were disregarded in determining whether diversification had occurred. Likewise, if there is only one transferor (or two or more transferors of identical assets) to a newly-organized corporation, diversification does not exist. On the other hand, if a transfer is a part of a plan to achieve diversification without the recognition of gain, such as a plan involving a subsequent transfer, however delayed, in a transaction purporting to qualify for nonrecognition under section 351(a), the original transfer will be treated as resulting in diVerSification.(7)

The regulations provided two examples that shed some light on these tests. In one example, individuals A, B, and C organized a corporation with 101 shares of common stock. A and B each transferred to the corporation $10,000 worth of the readily marketable stock of Y, whereas C transferred $200 worth of the stock of Y. The regulations conclude that C's participation would be disregarded, so that no diversification occurred.(8) On the other hand, in the other example, A, together with 50 other transferors, organized a corporation with 100 shares of stock. A transferred $10,000 worth of readily-marketable shares of X in exchange for 50 shares of stock, while each of the other 50 i transferors transferred $200 worth of readily marketable stock in other corporations in exchange for one share of stock each. This transaction was held to result in diversification.(9)

Subsequent rulings have clarified that a much lower level of diversification than the 50 percent illustrated in the regulations will be viewed by the IRS as significant. In Rev. Rul. 87-9, 1987-1 C.B. 133, some of the shareholders of Y corporation transferred their Y stock to Y, a newly-organized corporation which is a RIC, in exchange for 89 percent of the stock of X; other persons transferred cash to X in exchange for 11 percent of its stock. The IRS concluded that 11 percent of the value of X was not "insignificant," so that the diversification requirement of section 351(e) was satisfied.

Approximately 30 years after the regulations were originally promulgated, the IRS addressed the treatment of transfers of diversified portfolios. Under Treas. Reg. [sections] 1.351-1(c)(6), a transfer of stocks and securities will not be treated as resulting in diversification if each transferor transfers a diversified portfolio of stocks and securities. For purposes of this test, a portfolio of stocks and securities is diversified if it satisfies the 25- and 50percent tests of section 368(a)(2)(F)(ii), but including government securities in the denominator but not in the numerator for purposes of these tests.(10) The test under section 368(a)(2)(F)(ii) is satisfied by a corporation if not more than 25 percent of the value of its total assets is invested in the stock and securities of any one issuer and not more than 50 percent of its total assets is invested in the stock and securities of 5 or fewer issuers.

The 1997 Act

In considering changes to the investment company rules, Congress was concerned that under prior law, a partnership or a corporation was not treated as an investment company even though more than 80 percent of its assets were a combination of readily-marketable stock and securities and other high-quality investment assets of determinable values, such as non-convertible debt instruments, notional principal contracts, foreign currency, and interests in metals. Thus, a partner could contribute stock, securities, or other assets to an investment partnership and, without current taxation, receive an interest in an entity that was essentially a pool of high-quality investment assets. Where, as a result of such a transaction, the partner or shareholder has diversified or otherwise changed the nature of the financial assets in which it has an interest, the transaction has the effect of a taxable exchange. Of particular concern to Congress was the reappearance of so-called swap funds, which are partnerships or RICs that are structured to fall outside the definition of an investment company, thereby allowing contributors to make tax-free contributions of stock and securities in exchange for an interest in an entity that holds similar assets.

To address this perceived "loophole," section 35 1(e)(1) was amended in the 1997 Act to require that all stock and securities, whether or not readily marketable, held after the transfer should be taken into account to determine if more than 80 percent of its assets by value consist of readily marketable stock and securities.(11) For this purpose, stock and securities are defined in section 351(a)(1)(B) to include the following types of assets ("Listed Assets"):

* Money

* Stocks and any other equity interest in a corporation

* Evidences of indebtedness

* Options

* Forward or future contracts

* National principal contracts

* Derivatives

* Any foreign currency

* Any interest in a REIT

* Any interest in a common trust fund

* Any interest in a RIC

* Any interest in a publicly-traded partnership

* Except as may be provided by regulations, any interest in a precious metal, unless used in the active conduct of a trade or business

* Any other assets specified in regulations

* Any other equity interest (other than in a corporation) that pursuant to its terms or any other arrangement is readily convertible into, or exchangeable for, any of the 14 preceding types of assets

* Except as otherwise provided in regulations, an interest in any entity if substantially all of the assets of such entity consist (directly or indirectly) of any of the preceding assets(12)

* To the extent provided in regulations, any interest in any entity not described in the foregoing item but only to the extent the value of such interest is attributable to assets described in the previous items.

The legislative history of the 1997 Act emphasizes that the foregoing Listed Assets are to be taken into account in addition to readily marketable stock and securities, in determining whether a corporation or a partnership is an investment company. The committee reports also emphasize, however, that the 1997 Act only changes the types of assets considered in defining an investment company and does not override the other provisions in the regulations under section 351. Thus, the 1997 Act does not alter the provisions in the regulations that (i) only assets held for investment are considered, (ii) the assets of a subsidiary are treated as owned proportionally by a parent owning 50 percent or more of its stock, (iii) the determination that a corporation is an investment company must take into account any plan with regard to an entity's assets in existence at the time of the transfer; and (iv) a contribution of property to an investment company must result in diversification in order for gain to be recognized. A footnote in the legislative history indicates that although money is counted toward the 80-percent test, if contributed money is used pursuant to a plan to purchase assets not treated as stock or securities, then the investment company determination would be made only on the basis of the entity's assets after such purchase.

The changes in the 1997 Act apply to all transfers after June 8, 1997, in taxable years ending after such date, unless the transfer was made pursuant to a binding written contract in effect on such date.

Effect of the 1997 Act

The change to the definition of an investment company in the 1997 Act was intended to prevent the growth of "swap fund" transactions, in which a taxpayer transferred appreciated (but non-marketable) stock or securities to a partnership that held cash or other liquid assets. Under prior law, the partnership was not treated as an investment company because less than 80 percent of its assets were readily marketable stock or securities. Such transactions allowed the transferors to diversify their holdings, but the transfers were not taxable unless one of the specific anti-abuse provisions in the Code was triggered.(13)

As often is the case, Congress attacked this gnat of a problem with a sledgehammer. Congress widened the definition of "readily marketable stock and securities" to include any type of financial asset, whether or not publicly traded, including an stock, securities, debt instruments, notional principal contracts, and even cash. The result of this broad definition is that many "normal," non-abusive transactions will now be swept within the investment company rule.

For example, assume that a corporation owns all of the stock of a subsidiary, and the corporation wants to engage in a corporate joint venture with another entity ("Third Party"). Instead of transferring assets to a partnership, the corporation transfers the stock of its subsidiary to a partnership, and the Third Party transfers the stock of its subsidiary or cash. Even though the assets held by the partnership are not readily marketable under the common interpretation of such words, the partnership will be classified as an investment company because more than 80 percent of its assets will be Listed Assets.

Moreover, the problem goes far beyond transfers of subsidiary stock. Assume that the corporation was aware of the potential investment company problem, so that it transfers the assets of its subsidiary. These assets could include, however, stock of second-tier subsidiaries. Such stock would also be treated as lasted Assets. If more than 80 percent of the assets of the transferee were Listed Assets, the transfers would be taxable.

In addition, the other assets that are transferred may not provide protection against investment company treatment if such assets do not have a substantial fair market value or are encumbered. The application of the 80-per,!cent requirement in section 351(e) is based on the fair market value of the transferred assets, taking into account any indebtedness which encumbers such assets.

For example, assume that a corporation owns a subsidiary which has two assets, a building with a tax basis of $0 and a fair market value of $1 million, and stock of a second-tier subsidiary with a tax basis and a fair market value of $400,000. The building is also subject to a $900,000 mortgage. If the subsidiary's assets am transferred to a partnership to which a Third Party transfers cash of $500,000, the resulting partnership 11 will be treated as an investment company because more than 80 percent of the fair market value of its assets am Listed Assets,(14) notwithstanding that the unencumbered value of the building exceeds 20 percent of the total assets of the partnership. As a result, the corporation would be required to recognize its gain inherent in the building.

Taking this example even further, assume that a corporation owns undeveloped land with a tax basis of $0 and a fair market value of $1 million. The corporation wants to construct its headquarters on the land, but the cost will exceed $10 million and the corporation does not have that amount of cash and is not certain when the construction will occur. The corporation transfers the land to a partnership to which a Third Party transfers $20 million to be used eventually to construct a building to be used as the corporate headquarters and as rental property by the Third Party, but there is no binding plan for utilizing the money to construct the building. The corporation would be required to recognize its gain inherent in the land because more than 80 percent of the assets of the partnership would be Listed Assets, and the footnote in the legislative history under which planned uses of money could be taken into account would not apply.(15)

The risks are even greater if the assets transferred to a corporation or a partnership include an interest in a partnership or a limited liability company (LLC). In that case, the "look through" rules in the regulations under section 731(c) apply, so that all of the assets of the partnership or LLC must be taken into account if more than 20 percent of such assets are Listed Assets, and the partnership interest itself will be treated as a Listed Asset if more than 90 percent of the partnership's assets are Listed Assets.

For example, assume that a partnership owns cash of $1 million, mortgaged property with a fair market value of $10 million subject to debt of $9 million, corporate stock with a value of $2 million, and tangible personal property worth $4 million but subject to purchase money debt of $3 million. In that case, the total fair market value of the partnership's assets is $5 million, of which 60 percent are Listed Assets. Thus, if an interest in the partnership were transferred to a corporation or partnership, the "look through" rule would apply, so that the transferee would be deemed to hold $3 million of Listed Assets and $2 million of other assets. If the Third Party transferred $5 million of Listed Assets to the transferee, the transfer would be taxable.

The result would get even worse if the facts were changed slightly, so that the fair market value of the Listed Assets exceeds 90 percent of the value of the partnership or LLC interest. In that case, the entire interest in the partnership or LLC would be treated as a Listed Asset. If the Third Party transferred other Listed Assets sufficient to result in diversification, the entire transfer would be taxable.

Indeed, were it not for the diversification requirement in the regulations under section 351(e), many more common transactions would be "caught" by the new definition of an investment company. For example, assume that more than 80 percent of the assets of a partnership are Listed Assets. If the partnership desired to convert into an LLC, the transaction would technically involve the transfer of its asses (or interests in the partnership) to the LLC in exchange for interests in the LLC. The LLC would be treated as an investment company because more than 80 percent of its assets are Listed Assets. There would be no diversification in this transaction, however, so that the investment company definition will not be triggered.

Another problem arises in the partnership context because of the possibility of transfers that are not in exchange for controlling interests. If more than 80 percent of the assets of a partnership are Listed Assets (as now broadly defined), the transfer of any other assets to the partnership would be taxable, section 721 notwithstanding This problem will not arise in the corporate context unless the transferors satisfy the control requirement of section 368(c).

For example, assume that a taxpayer owns an appreciated building that the taxpayer intends to transfer to a corporation or a partnership in exchange for a 10-percent ownership interest. In the case of a transfer to a corporation, the transaction would be taxable under section 351. The transfer to the partnership, on the other hand, would be nontaxable under section 721 if less than 80 percent of the partnership's assets are Listed Assets immediately after the transfer. Thus, the taxpayer will need to fully understand the assets of the transferee partnership in order to make certain that the transfer is not taxable.

The people most surprised by this new rule, however, may be corporate executives who engage in estate planning using family partnerships. It is exceedingly common for corporate executives to transfer stock or stock options A a corporation to a partnership including their spouse And children. Under prior law, many executives would have their spouse or children transfer some other assets, such as stock or money, to the partnership as well in order to ensure that their family members would be treated as "true" partners. As a result of the 1997 Act, if the assets transferred by the family members are not insignificant, the result could be the formation of an investment company, resulting in tax consequences to the executive. This problem does not arise if only the executive transfers stock or stock options to the partnership (thereby avoiding diversification); the executive can then transfer interests in the partnership to family members as gifts.

Conclusion

The practical result of this new rule is that a tax practitioner must look carefully at the nature of the assets that are transferred to every partnership and every corporation in order to make certain whether the assets are Listed Assets. In addition, the assets of every transferee must also be scrutinized to make certain that less than 80 percent of the assets of the transferee will be Listed Assets immediately after the transfer (or, if not, that some other exception, such as lack of diversification, applies). Furthermore, if any of the transferred assets consist of an interest in a partnership or LLC, the assets of that pass-through entity must be considered in order to determine whether all or a portion of its assets are Listed Assets. This will greatly increase the due diligence that must be undertaken whenever assets are transferred to a corporation or partnership.

(1) All statutory references are to the Internal Revenue Code of 1986, as amended.

(2) Under section 368(c), "control" is defined as ownership of 80 percent of all classes of stock entitled to vote and 80 percent of all other classes of stock.

(3) Treas. Reg. [sections] 1.351-1(c)(2).

(4) Treas. Reg. [sections] 1.351-1(c)(3).

(5) Treas. Reg. [sections] 1.351-1(c)(4).

(6) Tress. Reg. [sections] 1.351-1(c)(3).

(7) Tress. Reg. [sections] 1.351-1(c)(5).

(8) Tress. Reg. [sections] 1.351-1(c)(7), Example (1).

(9) Tress. Reg. [sections] 1.351-1(c), Example (2).

(10) This rule applies to transfers on or after May 2, 1996; transfers of a diversified, but nonidentical, portfolio of stock and securities before that date could be treated as resulting in diversification or not at the taxpayer's election.

(11) I.R.C. [sections] 351(e)(1)(A).

(12) Until such regulations are issued by the IRS, the regulations promulgated under similar provisions of section 731(c)(2) will apply. Thus, an entity will meet the "substantially all" requirement if 90 percent or more of its assets are Listed Assets. Similarly, with respect to partnerships and non-corporate entities, it is intended that, where 20 percent or more (but less than 90 percent) of the entity's assets consist of Listed Assets, a pro rata portion of the interest in the entity will be treated as a Listed Asset.

(13) For example, if the transferor received a distribution of other property within the period specified under section 737, gain could be recognized.

(14) The partnership would have cash of $500,000 and stock with a value of $400,000, while the building would have a value of only $100,000; thus, 90 percent of the partnership's assets would be Listed Assets.

(15) For this reason, it will be necessary to carefully document the planned utilization of cash that will be contributed to any corporation or partnership.

Richard M. Lipton is a partner in the Chicago law firm Sonneschein, Nath & Rosenthal. He is a frequent lecturer on corporate tax issues, and has published articles in other professional journals. This is his first article for The Tax Executive.
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Author:Lipton, Richard M.
Publication:Tax Executive
Date:Jan 1, 1998
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