By: Robert Traester, MST – WithumSmith+Brown, PC
Transferring assets to a company or partnership that constitutes an “investment company” for tax purposes creates a unique set of complications. In certain situations you may have to recognize gain under Internal Revenue Code Section 351(e) or 721(b) when contributing appreciated assets to an investment company in exchange for an equity interest.
What is an Investment Company?
An investment company is defined under IRC Section 351(e)(1) as a company holding at least 80% of its assets in stocks, securities, cash, notes, options, foreign currency, certain financial instruments, interests in REITs, and ownership in entities holding such assets. Section 721(b) extends the same asset test to partnerships. Assets such as real estate and certain mineral interests are not included in the numerator towards reaching the 80% asset threshold. This is important to understand as gain on appreciated assets is only recognized when these assets are contributed to an investment company in exchange for equity. Contributing assets to a company that does not fit the “investment company” definition will likely not trigger a gain to be recognized as a result of IRC Sections 721(a) and 351.
I’ve Contributed to an Investment Company, Now What?
The next step is to determine if your contribution has resulted in a diversification of your investments. Internal Revenue Code Section 721(b) was created to disallow taxpayers from creating a tax-free diversification of an investment portfolio. Put simply, if you’re putting a share of Apple into a company and receiving an interest in a portfolio as diverse as the S&P 500 you should consider it a deemed sale. Please also note that only gains are recognized. If you’re considering contributing assets that are at a loss you would be better served to sell the assets, immediately recognize the loss, and contribute the cash proceeds.
How Do I Know if my Contribution Creates a Diversified Investment?
The idea of diversification is defined under IRC Section 368(a)(2)(F)(ii) which states that a taxpayer is diversified, “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 the value of its total assets is invested in the stock and securities of 5 or fewer issuers” . This includes a look-through rule for investments in mutual funds or other pass-through entities. Furthermore, under Section 368(a)(2)(F)(iv) government securities are included in the total assets for purposes of the denominator 25%/50% computation but are excluded from the numerator. If you’re contributing an already diversified portfolio as defined under IRC Section 368(a)(2)(F)(ii) then you will not have to recognize gain upon the contribution.
What if my Contribution is Not Diversified?
Treasury Reg. 1.351-1(c)(5) provides an exception to gain recognition for situations in which certain nonidentical assets are insignificant to other assets transferred. A more clear depiction of this concept can be found under Example 1 of Treasury Reg 1.351-1(c)(7). The example shows a situation in which three investors are contributing to a corporation with 101 shares of common stock. Investors A and B each contribute $10,000 worth of one marketable security in exchange for 50 shares each. Investor C then contributes $200 worth of a different marketable security in exchange for 1 share of common stock. Under this example the $200 worth of marketable securities contributed by Investor C is insignificant, does not create diversification, and therefore will not cause gain recognition for the investors.
How Does Cash Create a Diversified Portfolio?
When investors are contributing a mixture of cash and securities to an investment company additional examination will have to be done. For example, if investors A and B each contribute to a partnership, with A contributing $10,000 worth of one security and B contributing $10,000 worth of cash it would appear that the investors have not obtained a diversified portfolio at the time of the contribution. However, if investor B’s contributed cash is part of a plan to purchase assets and create a diversified portfolio, then this later action would be viewed as creating a diversified portfolio under General Counsel Memorandum 39253. As a result investor A would recognize any gain embedded in its contributed security.
As it quickly becomes evident, the pitfalls of IRC Sections 351(e) and 721(b) create some unique circumstances that can complicate tax planning when forming an investment company. In summary, gain recognition occurs if contributions are made to an investment company in exchange for equity and the contributions create a diversified portfolio for the investor. Nevertheless, proper tax planning can allow you to avoid recognition of gain at the time of contribution.
If you have any questions regarding contributions to an investment company or other tax issues, please contact your WithumSmith+Brown representative.