Investment Partnerships and Distributions Under IRC Section 731: A Confusing, Often-Mislabeled Concept

Dealing with tax partnerships holding investment securities

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Table of Contents

1. The Issue

2. General Tax Outcomes

3. Exception One:  Return of Contributed Securities

   1. Return of Contributed Securities in General

   2. Nonrecognition Transactions

   3. Anti-Stuffing Rule

   4. Precontribution Gain

   5. Planning Challenges

4. Exception Two: Distributed Security Becomes Marketable

5. Exception Three: Investment Partnership

   1. Asset Holding Requirements

   2. No Trade or Business

   3. Eligible Partner

6. Conclusion

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The Issue

In estate planning and wealth transfer, it is common to use entities such as partnerships and LLCs to hold investments and securities.  These structures allow for the aggregation of investments for various family members, creating leverage for investment opportunities and diversification.  While some cases have attacked these entities from an estate tax perspective, valuation discounts may be available for lifetime transfers. 

These structures, however, are often taxed as partnerships.  This can lead to interesting income tax issues.  Previously, I discussed the possible gain recognition on contribution of marketable securities to a tax partnership under IRC Section 721(b) and the investment company rules.  A partnership subject to this outcome is sometimes colloquially known as an “investment partnership.”  But, this definition does not reflect the actual tax code definition of an investment partnership – which is instead found in IRC Section 731(c). 

This definition, however, leads us to a related income tax outcome estate planners should be aware of.  This outcome has to do with the tax treatment of distributions of securities from a partnership. 

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General Tax Outcomes

With respect to C and S corporations, I have been outlining some of the issues that arise when making distributions of cash or property.  For C corporations, distributions are often treated as dividends – leading to a shareholder-level tax.  And, distributions of appreciated property are often treated as sales of property by the C corporation – leading to corporate tax on the recognized gain. 

For tax partnerships, however, we do not have these same outcomes.  IRC Section 731(a)(1) generally provides that no gain is recognized on distributions, except to the extent money distributed exceeds a partner’s adjusted basis in their partnership interest.  Under IRC Section 741, this gain will generally be capital gain, except with respect to the receipt of certain “hot” ordinary income assets under IRC Section 751 (a subject for another time). 

When we consider securities, we would usually assume that these are treated as property and not money.  Property that is distributed, according to 731(a)(1) and other rules, should not generate gain.  Indeed, a partner’s basis is reduced, but not below zero, by the basis (to the partnership) of distributed property under IRC Section 733 unless the distribution is in complete liquidation of a partner’s interest, in which case the basis of distributed property (after reducing the partner’s basis by distributions of money – including deemed cash distributions from decreases of a partner’s share of partnership liabilities under IRC Section 752) is substituted for the distributee partner’s adjusted basis in their liquidated partnership interest under IRC Section 732. 

So, why are we so concerned?  Outside of some Code Sections to be mentioned below dealing with a partner’s precontribution gain, we have this odd rule under IRC Section 731(c)(1) that as a default treats marketable securities as “money.”  Under IRC Section 731(c)(2), in distributing such securities, we reduce a partner’s basis by the FMV (and not basis) of the distributed securities – an exception to IRC Sections 732 and 733.

What does this mean?  It means that a distribution of securities with an FMV in excess of a partner’s basis in their partnership interest can generate gain.  Unlike IRC Section 311, which generates corporate-level or pass-through gain on the distributed assets, this gain is instead recognized solely by the partner with respect to their partnership interest and not the distributed assets themselves. 

Many tax advisors, analysts, and strategists stop with this general rule and assumption.  But, there are exceptions to this treatment.