If a fund has frequent transfers by its limited partners, it risks being classified as a publicly traded partnership. That’s a bad result because the fund then becomes taxable as a corporation, subject to a qualifying income test. You might be surprised how low the threshold is for being treated as a publicly traded partnership.
A partnership is treated as a PTP if (i) interests in the partnership are traded on an established securities market, or (ii) interests in the partnership are readily tradable on a secondary market or the substantial equivalent thereof. 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.
One safeguard in the implementing regulations at 26 C.F.R. § 1.7704-1 is a de minimis trading exception. 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.
Two percent is a very low threshold.
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
Another option is the use of a Qualified Matching Service (QMS).
If transfers are made through a “qualified matching service,” up to 10% of the interests in a partnership can be transferred during the partnership’s taxable year without resulting in the partnership being a PTP.
Under Section 1.7704.1(g) a a qualified matching service has to meet the following standards:
(i) The matching service consists of a computerized or printed listing system that lists customers’ bid and/or ask quotes in order to match partners who want to sell their interests in a partnership (the selling partner) with persons who want to buy those interests;
(ii) Matching occurs either by matching the list of interested buyers with the list of interested sellers or through a bid and ask process that allows interested buyers to bid on the listed interest;
(iii) The selling partner cannot enter into a binding agreement to sell the interest until the 15th calendar day after the date information regarding the offering of the interest for sale is made available to potential buyers and such time period is evidenced by contemporaneous records ordinarily maintained by the operator at a central location;
(iv) The closing of the sale effected by virtue of the matching service does not occur prior to the 45th calendar day after the date information regarding the offering of the interest for sale is made available to potential buyers and such time period is evidenced by contemporaneous records ordinarily maintained by the operator at a central location;
(v) The matching service displays only quotes that do not commit any person to buy or sell a partnership interest at the quoted price (nonfirm price quotes) or quotes that express interest in a partnership interest without an accompanying price (nonbinding indications of interest) and does not display quotes at which any person is committed to buy or sell a partnership interest at the quoted price (firm quotes);
(vi) The selling partner’s information is removed from the matching service within 120 calendar days after the date information regarding the offering of the interest for sale is made available to potential buyers and, following any removal (other than removal by reason of a sale of any part of such interest) of the selling partner’s information from the matching service, no offer to sell an interest in the partnership is entered into the matching service by the selling partner for at least 60 calendar days; and
(vii) The sum of the percentage interests in partnership capital or profits transferred during the taxable year of the partnership (other than in private transfers described in paragraph (e) of this section) does not exceed 10 percent of the total interests in partnership capital or profits.
A fund sponsor can theoretically set up its own QMS to allowing greater liquidity in interests in its partnerships than permitted by the 2% safe harbor.
- Frequent Fund Transfers and Redemptions Creating PTP Status Concerns by Julia Corelli of Pepper Hamilton
- Avoiding “Publicly Traded Partnership” Status for U.S. Federal Income Tax Purposes (.pdf)