When launching a new fund or raising capital for an existing one, there’s a good chance you’ve asked this question: how do I accept in-kind contributions instead of cash? If these contributions are going into a partnership, you’re looking at some important tax considerations: Are they built-in gains? What about holding periods? And the big question – will they trigger taxes?
Here’s the good news: Under IRC 721(a), partnerships can typically accept contributions tax-free. But (and this is important), there are exceptions under IRC 721(b) and IRC 351(e) that can trigger taxable gains. These “diversified portfolio” rules can sneak up on you in various ways.
Let’s break down the three key rules you need to know to accept in-kind contributions that pass the test:
The 25:1 and 50:5 Rule: Clear Objective, Unclear Territory
The diversified portfolio rule has one clear goal: Make sure neither the fund nor investor appears to have a plan to become diversified when accepting in-kind contributions. Sounds straightforward, right? Well, the definition of “plan to become diversified” is where things get murky between the IRS and taxpayers.
Let’s look at the “bright line test” with two key guidelines:
- One issuer can’t contribute more than 25% of the portfolio’s fair market value
- Five or fewer issuers can’t contribute more than 50% of its fair market value
Pro tip: When running your diversification test calculations, remember:
- Cash and cash equivalents are excluded
- Assets acquired to meet diversification requirements are out
- U.S. government securities count in total assets but aren’t treated as securities
- The definition of stocks and securities includes money, corporate stock, notes, bonds, debentures, and derivative financial instruments
The 11% Rule: Watching Your Cash Position
Next up is the 11% rule – think of it as a “substance over form” test that pops up in memorandums, revenue rulings, and case law. The key? Contributed assets can’t be treated like cash or take cash form. The IRS and courts are watching to see if these assets are being used for expenses, liabilities, or new acquisitions.
Bottom line: Keep cash below 11% of the total contribution. While this percentage might seem arbitrary (and yes, it appears in case law), it’s not worth testing the IRS on this one. (Rev Rule 87-9, 1987-1 C.B, 133)
The 5% Rule: The Small-Scale Solution
Finally, there’s the 5% rule – your “de minimis” rule. If the contribution is less than 5% of total value, it’s considered minimal and won’t trigger taxable gain. For larger funds with multiple partners, this can be a handy exception. (Ltr. Rul. 200006008)
Best Practice: Don’t Accept In-Kind Contributions without Guidance
These diversification rules aren’t exactly light reading, and without clear bright lines, you’re best off analyzing each contribution individually. If you’re questioning whether these rules apply to your situation, reach out to the experts at Richey May before accepting those in-kind contributions.
Got questions about alternative investments? Contact our Business Development Partner, Steve Vlasak.
