Transfers to investment companies: pitfalls of secs. 351 and 721.

• Author: Velotta, Robert A.

In many instances, property can be contributed to an entity by its owners in exchange for ownership interests, without gain or loss being recognized on the contribution. For corporations, the general rule under Sec. 351(a) is that "no gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control ... of the corporation." Similarly, the general rule under Sec. 721(a) states that "no gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership" Both sections, however, contain lesser-known exceptions to the general nonrecognition rules for investment companies. These rules may create unintended consequences for taxpayers who do not properly consider them when transferring appreciated property to an entity qualifying as an investment company.

Overview

The transfer-to-investment-company (TIC) provision of Sec. 721(b) refers to Sec. 351. Under Regs. Sec. 1.351-1(c)(1), a TIC is defined as:

1. A transfer to a regulated investment company (RIC), real estate investment trust (REIT), or 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; and

2. The transfer results, directly or indirectly, in diversification of the transferor's interests.

For the 80% test, Regs. Sec. 1.351-1(c)(3) states that stocks and securities are considered readily marketable if "they are part of a class of stock or securities which is traded on a securities exchange or traded or quoted regularly in the over-the-counter market." The definition of readily marketable securities includes convertible debentures, convertible preferred stock, warrants, and other stock rights if the stock for which they may be converted or exchanged is readily marketable.

Further under Regs. Sec. 1.351-1(c)(3), stocks and securities are considered held for investment unless held primarily for sale to customers in the ordinary course of business or used in the trade or business of banking, insurance, brokerage or a similar trade or business. As such, a corporation (or partnership) engaged in the active trade or business of securities trading (as opposed to investing...