FLP’s and the Investment Company Rule

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Partnerships and LLCs are popular entity forms for a wide variety of shared ventures, whether for operating businesses or investments. Typically, they are created when two or more parties contribute assets to the partnership or LLC in exchange for an interest in the entity (a unit). Units can then be transferred in sale or gift transactions. When all the unit holders are related, this is often called a Family Limited Partnership (FLP), whether it is a partnership or an LLC that has elected to be taxed as a partnership.

General Rule: No Recognition of Gain on FLP Formation

One of the key features of partnership taxation is the application of section 721 of the Internal Revenue Code which provides that, in general, the individual partners do not recognize gain when they contribute assets to the partnership in exchange for units. This is true even if the partner’s basis is lower than the fair market value of the asset on the date the partnership is formed. If Alice contributes an apartment building and Betty contributes cash, it is not treated as though Alice sold her building to the partnership upon formation.

When this occurs, the partner’s basis in their units is equal to their basis in the assets contributed (their “outside” basis), and the partnership’s basis in the asset (the “inside” basis) is the same as the partner’s basis in the asset at the time of contribution. There are additional rules for how income gain and loss are allocated among partners that are beyond the scope of this article.

Investment Company Exception: Gain Is Recognized on FLP Formation

A common reason for forming an FLP is to create an aggregate portfolio with centralized management to achieve economies of scale. This is where one of the exceptions to the “non-recognition of gain” rule can come into play. Section 721 provides that if 80% or more of the assets of the partnership are readily marketable securities, making the partnership an investment company, then recognition of gain occurs upon contribution if there is diversification. This is due to the investment company rule. 

One of the ways this can happen is when multiple parties contribute marketable securities in exchange for units and the value of the marketable securities is 80% or more of the value of all assets owned by the partnership. When that occurs, each partner contributing appreciated securities will recognize capital gain on formation of the entity.

EXAMPLE 1
Cara, Diane and Eve form a partnership. Cara contributes $10,000 worth of Apple stock with basis of $5,000, Diane contributes $10,000 worth of Microsoft stock with basis of $1,000, and Eve contributes $10,000 worth of SpaceX stock with basis of $9,000. Upon contribution of these assets in exchange for units, Cara, Diane and Eve will each recognize capital gain based on their individual basis in the contributed asset.

Alternatively, this can happen when a new addition is made to a partnership qualifying as an investment company. For example, if Felicity contributes one or more marketable securities to an FLP that only holds marketable securities, she will recognize gain on the contribution. This is true even if Felicity is already a partner, as long as she is not the sole partner of the entity, and even if she did not recognize gain upon her original contribution to the partnership.

Structuring FLPs to Avoid the Investment Company Rule

There are generally four ways to avoid the application of the investment company rule when forming an FLP.

Option 1: Single contributor. The first is for one individual or a married couple (treated as a single individual for these purposes) to create the FLP with marketable securities, and for other individuals or trusts to become partners only by receiving gifts of units or purchasing units from the original owner. Because the contributions to the FLP in exchange for units do not cause a diversification for the contributor, no gain is recognized.

EXAMPLE 2
Greg and Hannah are married. They create the GH Partnership and contribute $1 million dollars in marketable securities with basis of $300,000 in exchange for all the units. They make gifts of the units to each of their three children and to trusts for each of their four grandchildren. No gain is recognized upon the formation of the FLP, or upon the transfer of those units.

Option 2: Contributing identical securities. The second option is for each partner to contribute the same basket of securities to the partnership. When this happens, there is also no diversification occurring by contributing the assets to the partnership for units. In this event, there is no gain recognized.

EXAMPLE 3
Irene, Jackie and Karen wish to create an investment partnership. Each of them contributes a portfolio of marketable securities with exactly the same composition:

• 100 shares of Exxon Mobil
• 100 shares of Alphabet
• 100 shares of Pfizer
• 100 shares of Home Depot
• 100 shares of Caterpillar

Because each of them contributed the same stocks in the same proportion, the units owned by each of the partners represent identical performance, risk and value as the partner owned before contributing to the partnership. No diversification occurs so no gain is recognized on formation.

Option 3: Contributing a diversified portfolio. The third option for structuring an FLP is for each partner to contribute an already diversified portfolio. The test is whether the value of the largest issue contributed represents less than 25% of the entire partnership portfolio, and the top five issues by value represent less than 50% of the partnership portfolio. In that event, the contribution is not treated as causing diversification, and no gain is recognized.

EXAMPLE 4
Lena, Marie and Nancy create a partnership. Each one contributes a portfolio of 200 securities, none of which constitutes more than 2% of the portfolio.  Because each portfolio is already diversified, the formation of the partnership is not a diversification, and no gain is recognized on formation.

Option 4: 20% or More in Assets Other than Marketable Securities. The final option is for the partnership to consist of less than 80% readily marketable securities. If 20% or more of the value of the assets of the partnership consists of other asset classes, such as real estate, non-publicly traded businesses, oil and gas interests, or tangibles, then the partnership is not an investment company and there is no recognition of gain.

EXAMPLE 5
Olivia and Phyllis create a partnership. Olivia contributes her commercial real estate property worth $5 million, and Phyllis contributes marketable securities worth $5 million. No gain is recognized on formation because the partnership is not an investment company. To be an investment company, 80% or more of the partnership’s assets would need to be marketable securities.

These are the same rules that apply to exchange funds, which typically rely on this exception to avoid immediate recognition of gain on contribution.

Key Takeaways

Creating an FLP with marketable securities for centralized investment management, economies of scale and a way to make gifts of fractional interests in a whole portfolio rather than a single asset can be an effective strategy. But it is important to keep in mind that the benefits of section 721 (contributing assets in exchange for units without recognizing capital gain) are only available if the partnership is not an investment company (assets are not 80% or more marketable securities) or the formation does not result in diversification. Analysis of the transaction by legal and tax advisors prior to implementing it can avoid unanticipated and unwelcome tax surprises.