Diversification Rules: How to Accept Contributions that Pass the Test
Articles by: Richey May, Nov 02, 2022
When launching a new fund or raising capital for an existing one, fund managers are often asked to take in-kind contributions in lieu of cash. If those contributions are issued to a partnership, you’ll have a host of tax considerations to keep in mind: Are they built-in gains? What are the holding periods? And most of all, will they be taxable?
Typically, under IRC 721(a), a partnership can accept contributions tax-free. But there are exceptions under IRC 721(b) and IRC 351(e) that can trigger a taxable gain. Often referred to as the “diversified portfolio” rules, they’re important rules of thumb that can be triggered in a variety of ways.
It pays to know the rules if you want your contributions to pass the diversification test. Here’s why and the three main rules to watch out for.
The 25:1 and 50:5 rule: Clear objective, unclear meaning
The diversified portfolio rule has a clear objective: Ensure that the fund or investor avoids being viewed as having a plan to become diversified when accepting contributions. The meaning of “plan to become diversified” is less clear and often creates ambiguity between the IRS and taxpayers.
Let’s start with the 25:1 and 50:5 rule, a sort of “bright line test” with two simple guidelines:
- One issuer cannot contribute more than 25% of the portfolio’s fair market value.
- Five or fewer issuers cannot contribute more than 50% of its fair market value.
When running calculations for the diversification test, you’ll want to note that this rule excludes cash and cash equivalents or assets acquired to meet the requirements for diversification. U.S. government securities are included in the total assets but are not treated as securities. Stocks and securities include money, stock in a corporation, notes, bonds, debentures or other debts, and derivative financial instruments.
The amount of the contribution is key. It needs to stay below these thresholds to pass the diversification test.
The 11% rule: Cash needs to stay below that line
Next up: The 11% rule, a substance over form test often looked to in memorandums, revenue rulings and case law. It states that contributed assets cannot be treated as or take the form of cash. In this case, the IRS and the courts look at whether the assets are used to pay for certain expenses, outstanding liabilities, or other assets the fund may have or want to acquire.
Essentially, they want to know if the assets are being used like a cash contribution. The bottom line: Cash needs to represent no more than 11% of the total contribution.
Note that the 11% is somewhat arbitrary and has been sighted in case law. But it’s not worth testing the 11% line, since cash contributions over 11% of the total could raise red flags. (Rev Rule 87-9, 1987-1 C.B, 133)
The 5% rule: Cash needs to stay below that line
Finally, there’s the 5% rule. Known as a “de minimis” rule, it states that if the contribution makes up less than 5% of the total value, it will be considered insignificant or “minimal” and will not trigger taxable gain.
For larger funds with many partners, this rule can serve as a powerful exception to help avoid triggering unnecessary taxable gain. (Ltr. Rul. 200006008)
Best practice: Ask the experts first
The diversification rules are complicated and can be difficult to navigate. Lacking a true bright line test, your best bet is to analyze contributions on a case-by-case basis.
If you find yourself questioning whether these rules apply, ask the experts at Richey May before accepting contributions in kind. Questions about how we can help with alternative investments? Reach out to our Business Development Partner, Steve Vlasak.