As discussed in my January 12, 2022, blog post, Section 731(c) generally treats marketable securities as money in determining gain or loss on a distribution to a partner. Section 731(c)(3)(A)(iii) provides an exception in the case of marketable securities held by an investment partnership that are distributed to an eligible partner. But what is an investment partnership, and what is an eligible partner?

An investment partnership is defined by Section 731(c)(3)(C)(i) to mean “any partnership which has never been engaged in a trade or business and substantially all of the assets (by value) of which have always consisted of (i) money, (ii) stock in a corporation, (iii) notes, bonds, debentures, or other evidences of indebtedness, (iv) interest rate, currency, or equity notional principal contracts, (v) foreign currencies, (vi) interest in or derivative financial instruments (including options, forward or future contracts, short positions, and similar financial instruments) in any asset described in any other subclause of this clause or in any commodity traded on or subject to the rules of a board of trade or commodity exchange, (vii) other assets specified in regulations prescribed by the Secretary, or (viii) any combination of the foregoing.”

Notably, the list of investments includes some that are not marketable securities. Although the exception applies on the distribution of marketable securities, the investment partnership test does not require a partnership substantially all the assets of which are marketable securities. “Substantially all” is not defined in the Code or the Treasury Regulations as to investment partnerships. However, in the context of another subsection of Section 731, it is defined in Reg. § 1.731-2(c)(3) as “90% or more of the assets of the entity (by value).” That definition likely provides guidance as to the meaning of “substantially all” for purposes of Section 731(c)(3)(A)(iii).

Another requirement for an investment partnership is the partnership has never engaged in a trade or business. Section 731(c)(3)(C)(ii) explains “a partnership shall not be treated as engaged in a trade or business by reason of (i) any activity undertaken as an investor, trader, or dealer in any asset described in clause (i), or (ii) any other activity specified in regulations prescribed by the Secretary.” Reg. § 1.731-2(e)(3)(ii) and (iii) provide a partnership is not treated as being engaged in a trade or business by reason of (i) reasonable and customary management services provided to a lower-tier investment partnership but not management services provided to lower-tier partnerships other than investment partnerships, and (ii) reasonable customary services provided in assisting the formation, capitalization, expansion, or offering of interests in an entity in which the partnership holds or acquires a significant equity interest provided anticipated receipt of compensation for the services does not represent a significant purpose for the partnership’s investment in the entity.

The next question is who is an eligible partner. That is defined in Section 731(c)(3)(C)(iii)(I) as “any partner who, before the date of the distribution, did not contribute to the partnership any property other than the assets” listed in Section 731(c)(3)(C)(i). Subclause (II) states that the term “shall not include the transferor or transferee in a nonrecognition transaction involving a transfer of any portion of any interest in a partnership with respect to which the transferor was not an eligible partner.” This second clause prevents someone who is not an eligible partner as to a partnership interest from simply contributing the interest to another partnership to eliminate non-eligible partner treatment. The rule also prevents a partner who contributes to the partnership non-qualifying assets that are more than 10% by value of the contributed assets from being an eligible partner. The intent is for only the partners who contributed the qualifying assets to be eligible for favorable treatment.

John G. Hodnette is an attorney with Johnston, Allison & Hord in Charlotte.

July 27, 2022/by TAX