Due to the increasing incidence of fund investors who want to transfer their investment fund interests, private investment funds face a risk of being classified as publicly traded partnerships. That would mean the fund would become taxable as a corporation.
A bad result.
Under Internal Revenue Code § 7704, a partnership will be classified as a publicly traded partnership if (1) the fund interests are traded on an established securities market or (2) the fund interests are readily tradable on a secondary market or its substantial equivalent.
The big problem is determining when you have a “substantial equivalent” of a secondary market. Under the regulations, the IRS uses a facts and circumstances test to determine if “partners are readily able to buy, sell, or exchange their partnership interests in a manner that is comparable, economically, to trading on an established securities market.” You hate to get into a facts and circumstances discussion with the IRS.
Fortunately there are some safeguards in the implementing regulations at 26 C.F.R. § 1.7704-1.
Involvement of the Partnership
For purposes of section 7704(b), interests in a partnership are not readily tradable on a secondary market or the substantial equivalent unless (1) The partnership participates in the establishment of the market or (2) The partnership recognizes any transfers made on the market by (i) redeeming the transferor partner or (ii) admitting the transferee as a partner.
Since most fund partnerships require the general partner to approve the the transferee and then admit the transferee, they are unlikely to be able to take advantage of this safe harbor.
De Minimis Trading Safeharbor
The focus of a fund should be on the 2% de minimis safe harbor. 26 C.F.R. § 1.7704-1(j) provides for interests in a partnership to be deemed not readily tradable on a secondary market or the substantial equivalent thereof if the sum of the percentage interests in partnership capital or profits transferred during the taxable year of the partnership does not exceed 2 percent of the total interests in partnership capital or profits.
You want avoid having more than 2 percent of the partnership interests changing hands each tax year.
If you get close to that number there are several transfers that are disregarded transfers for this safeharbor, including:
- block transfers by a single partner of more than 2% of the total interests
- intrafamily transfers
- transfers at death
- distributions from a qualified retirement plan
- Transfers by one or more partners of interests representing 50 percent or more of the total interests in partnership
Private Placement Safeharbor
The regulations deem a transfer to not be a trade if it was a private placement. But the regulations have their own definition of a private placement: (1) the issuance of the partnership interests had to be exempt from registration under the Securities Act of 1933, and (2) the partnership does not have more than 100 partners at any time during the tax year of the partnership. 26 C.F.R. § 1.7704-1(h)
The first prong should be straight-forward for most private funds. The trickier part is the second prong. In some circumstances the IRS can look through the holder of a partnership interest to its beneficial owners and expand the number of partners to include the beneficial holders of that interest.
Passive Income Safeharbor
If a fund is determined to be a Publicly Traded Partnership, it will nonetheless not be taxed as a corporation if 90% or more of the fund’s gross income is passive-type income. [26 U.S.C. § 7704(c)] Passive-type income generally includes dividends, real property rents, gains from the sale of real property, income from mining and oil and gas properties, gains from the sale of capital assets held to produce income, and gains from commodities (not held primarily for sale in the ordinary course of business), futures, forwards, or options with respect to commodities. The income test is on a taxable year basis and must be have been met each prior year.