It is somewhat common for private equity and venture capital firms to distribute investments in stock to their owners. However, an array of complex tax rules may impact the presumption of tax-free treatment when such distributions are made from a pass-through entity (PTE). A general understanding of these tax rules for distributions of stock by a PTE can help partners in private equity (PE) and venture capital (VC) funds manage their tax profile. PE and VC funds, together with their partners, should also be mindful of special tax rules surrounding distributions of marketable securities that could catch some by surprise.

General Rules

Internal Revenue Code (IRC) Section 732 outlines the tax treatment for distributions of property from a PTE, including stock distributions. When property such as stock is distributed to a partner, whether in the form of a liquidating or non-liquidating distribution, the distribution generally is a non-taxable event for both the PTE and the partner. In that case, all of the tax attributes of the property, including basis and holding period, are passed from the PTE to the partner.

If the distribution is a non-liquidating distribution, the PTE’s tax basis in the stock (inside basis) generally carries over to the distributee partner (carryover basis). The partner’s basis in the PTE (outside basis) is then reduced by this same amount. Note, however, that the partner’s carryover basis in the distributed stock cannot exceed the partner’s outside basis immediately prior to the distribution; the partner’s basis in the stock received is therefore limited to the partner’s outside basis in the PTE immediately prior to distribution. In other words, the basis that the partner has in the distributed stock is the lesser of the PTE’s inside basis in the stock (determined immediately prior to the distribution) or the partner’s outside basis in the PTE (determined immediately prior to the distribution).

If the distribution is in liquidation of the partner’s interest in the PTE, the basis the partner takes in the distributed stock is equal to the partner’s outside basis in the PTE immediately prior to the distribution (substituted basis). This is the result regardless of whether the PTE’s inside basis in the stock (determined immediately prior to the distribution) is greater than or less than the partner’s outside basis in the PTE.

Despite these general rules, special treatment applies when the distributed stock constitutes marketable securities.

Distributions of Marketable Securities by a PTE – Exception to Tax-Free Treatment

Section 731(c) treats the distribution of marketable securities as money, not property, in an amount equal to the fair market value of the distributed securities. As a result, the partner may need to recognize taxable gain if the fair market value (FMV) of the marketable securities exceeds the partner’s outside basis in the PTE (determined immediately before the distribution of such marketable securities). Note that this rule, unfortunately, is “one-sided.” A partner cannot recognize a loss if the partner receives a distribution of marketable securities, even if the partner would have recognized a loss had the partner received cash in liquidation of the PTE interest. This alternative would otherwise result when the partner has outside basis immediately before the distribution that exceeds the liquidating cash distribution received. Again, that does not apply to the distribution of marketable securities.

When the distributee partner recognizes gain on the distribution of marketable securities, the basis of the distributed marketable securities is the normal amount of basis determined under Section 732 (outlined above), increased by the amount of gain recognized in the distribution. The basis of distributed marketable securities with respect to which no gain is recognized is the same basis determination under Section 732, without any adjustment.

For purposes of Section 731(c), the term “marketable securities” generally means financial instruments and foreign currencies that are actively traded as of the date of distribution. The term “financial instruments” generally includes stocks and other equity interests, evidences of indebtedness, options, forward or future contracts, notional principal contracts, and derivatives. The regulations covering the definition of marketable securities are extensive.

Not all distributions of marketable securities are subject to the gain recognition exception, however.

Exception for Marketable Securities Distributed by Investment Partnerships

There are certain exceptions to the marketable securities rules outlined above. Section 731(c)(3) provides one such exception to this rule for distributions from an “investment partnership.” This exception effectively leads to marketable securities being treated as property, instead of money, for investment partnerships (i.e., a return to the general rules, above). An investment partnership generally is a PTE: 1) whose assets have always consisted of “specified investment-type assets” (not necessarily marketable securities), and (2) that has never been engaged in a trade or business.

Generally, “specified investment-type assets” include:

• Money,
• Stock in a corporation,
• Notes, bonds, debentures, or other evidences of indebtedness,
• Foreign currencies,
• Derivative financial instruments (i.e. options, forwards, future contracts, etc.) in any aforementioned assets or in any commodity traded on or subject to the rules of a board or exchange,
• Other assets specified in the regulations, and
• Any combination of the aforementioned assets.

PE/VC firms going down this path will also need to consider whether a partnership is engaged in a trade or business. Partnership activity that is coterminous with an investor, trader, or dealer in specified investment-type assets does not result in trade or business status for the partnership. Further, a “look-through” rule is applicable for this purpose, whereby the PTE is treated as holding a proportionate share of the assets of any lower-tier PTE and as engaging in any trade or business conducted by a lower-tier PTE. The regulations provide that this look-through rule does not apply if the upper-tier PTE does not participate in the management of the lower-tier PTE, and if the interest held by the upper-tier PTE is less than 20% of the total profits and capital interests in the lower-tier PTE. If the look-through rule does not apply to a lower-tier PTE, then it is treated as if it were a specified investment-type asset.

Anti-Abuse Rules

Section 731(c)(7) and the related regulations provide anti-abuse rules that address avoidance of the marketable securities rules. The regulations provide that if a principal purpose of a transaction is to achieve a tax result that is inconsistent with the purpose of Section 731(c) and related regulations, the transaction can be re-casted so that the tax results are consistent with the purpose of Section 731(c) and related regulations. Whether a tax result is inconsistent with these rules is based on all facts and circumstances, however, the regulations give three examples of the application of the anti-abuse rule:

• A change in partnership allocations or distribution rights with respect to marketable securities may be treated as a distribution of marketable securities subject to Section 731(c) if the change in allocations or distribution rights is, in substance, a distribution of the securities;
• A distribution of substantially all of the assets of the partnership other than marketable securities and money to some partners may also be treated as a distribution of marketable securities to the remaining partners if the distribution of the other property and the withdrawal of the other partners is, in substance, equivalent to a distribution of the securities to the remaining partners; and
• The distribution of multiple properties to one or more partners at different times may also be treated as part of a single distribution if the distributions are part of a single plan of distribution.

Thus, careful consideration should be given to the anti-abuse rules before distributing shares of marketable securities disproportionately to partners.

Next Steps

As highlighted above, generally when a PTE distributes stock or other property to its partners, the transaction will be a nontaxable event. However, there are transaction criteria that could lead to gain recognition, such as when the distribution consists of or includes marketable securities, and a detailed analysis of the facts and circumstances may be needed. Investment partnerships may have an opportunity to distribute marketable securities tax-free, but these rules are complex and have “traps for the unwary.” To learn more please contact a member of our team.