Many taxpayers choose partnership structures (including LLCs taxed as partnerships) to operate their businesses. The tax consequences of setting up and contributing property to a partnership can be beneficial because contributing property in exchange for interest in the partnership generally does not result in recognition of gain or loss for the contributing partner or the partnership. However, when property is contributed to an “investment partnership”, that same contribution may be treated as a taxable exchange to the contributing partner. Under section Internal Revenue Code, an “investment partnership” is a partnership in which more than 80 percent of the value of the assets of the partnership is from “stock and securities” that are “held for investment” (the “80 Percent Test”). Under the 80 Percent Test, “stocks and securities” include a variety of liquid assets, such as cash, stock in corporations and interests in other entities that hold such liquid assets. The determination of whether a partnership is an investment partnership with respect to a contribution is made immediately after the contribution. However, if subsequent events occur pursuant to a plan in existence at the time of the contribution, the determination takes into account those subsequent events.
‘Stock or Securities’ Defined
While cash is generally included in the 80 Percent Test, it is not clear if cash that is working capital is included. Although cash is included in the list of liquid assets treated as stocks or securities, all of the liquid assets considered in the 80 Percent Test must be “held for investment”. Accordingly, since working capital presumably is not “held for investment,” it would not be considered cash that is within the definition of stock or securities for purposes of the 80 Percent Test.
Certain practitioners appear to agree that cash held for working capital should not be included in the 80 Percent Test, but, in the absence of formal authority, the most conservative approach would be to treat operating cash as stock or securities for purposes of the 80 Percent Test. If faced with a situation in which the treatment of working capital is critical to the status of the partnership under the 80 Percent Test, it may be difficult to determine the appropriate amount of cash to treat as working capital. A reasonable methodology might be to determine the typical cash balances carried by companies in a similar industry, with a similar capital structure and cash-flow needs, though this data may be less available than metrics based on all current assets (rather than just cash). However, no formal guidance has been issued.
The Look-Through Rules
When applying the 80 Percent Test to a partnership, two look-through rules apply:
A partnership is treated as owning directly its ratable share of the assets held by any corporation in which it owns a 50 percent (by vote or value) or greater interest.
The value of an interest in a lower-tier partnership is treated as being apportioned between “stocks and securities” and other assets based on the assets held by the partnership when the partnerships holdings of assets that are treated as “stock and securities” constitute 20 percent or more of its total assets and 90 percent or less of its total assets by value.
Corporate Subsidiary Look-Through Rule
There are few ambiguities associated with the corporate look-through rule, but two common issues can arise.
First, how does the look-through rule apply to tiered corporate subsidiaries? For example, if a partnership (P) owns 75 percent of the stock of a first-tier corporate subsidiary (S1), and S1 owns 65 percent of the stock of a second-tier corporate subsidiary (S2), it is unclear whether P may apply the look-through rule to S2. Although P owns less than 50 percent of the stock of S2 indirectly (49 percent), you could take the view that, because it owns more than 50 percent of S1, the assets of S2 are pushed up to P. Because S1 owns more than 50 percent of S2, P would be able to look through to the assets of S2 under this approach. However, the literal language of the regulation (Treas. Reg. 1.351-1(c)(4)), which focuses on the ownership of the “parent” (the tested partnership) with respect to the subsidiary, suggests that the assets of S2 are not taken into account by P.
Second, what ratable percentage of the underlying assets is treated as owned when the partnership owns a different percentage of voting interest in the corporation than it does in the value of the corporation (e.g., when the tested partnership holds both voting and nonvoting stock with equal economic rights)? From a practical standpoint, when testing a particular partnership, it may be sufficient to use the lesser ownership percentage if this does not have a material effect on the assets being treated as held by the tested partnership. However, at least one commentator has suggested that value (rather than vote) is the appropriate measure.
Partnership Look-Through Rules
The partnership look-through rules are based primarily on a reference in legislative history to rules similar to the regulations promulgated under Section 731(c)(2) of the Internal Revenue Code. These rules look to the value of assets that constitute stocks or securities owned by the partnership. A critical question in determining which assets are treated as owned by a lower-tier partnership is whether the lower-tier partnership is treated as owning assets of a corporation in which it owns more than 50 percent of the vote or value. Within Section 731(c)(2) and the associated corporate regulations, there is no corporate look-through rule. However, based on a private letter ruling, it appears that a lower-tier partnership may look through 50-percent-owned subsidiaries in determining the composition of its assets when applying the partnership look-through rules.
Thomas D. Phelan is an associate in the Tax Practice Group of Pepper Hamilton LLP, where his practice focuses on federal and international income tax. Tom graduated from the Temple University Beasley School of Law in 2011.