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

• Author: McCreary, D. Lee

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...