Corporate Tax | Just Tax
Investment Company Exception (§ 351(e))
This checklist guides the analysis of whether § 351(a) nonrecognition treatment is denied under the § 351(e) investment company exception when property is transferred to a corporation that constitutes an investment company. Use this checklist when multiple transferors contribute assets to a corporation and any transferor is contributing stocks, securities, or other investment-type assets.
"This section shall not apply to a transfer of property to an investment company." (IRC § 351(e)(1))
- The statutory denial operates through a two-prong regulatory test.
- Treas. Reg. § 1.351-1(c)(1) provides that a transfer of property will be considered a transfer to an investment company only if (i) the transfer results directly or indirectly in diversification of the transferors' interests AND (ii) the transferee is a regulated investment company, a real estate investment trust, or a corporation meeting the 80-percent test.
- Both prongs must be satisfied for § 351(e) to deny nonrecognition treatment. If either prong fails, the transfer may qualify for § 351(a) nonrecognition assuming all other requirements are met.
- The analysis proceeds in sequence. First determine whether the transferee is an investment company. Then determine whether the transfer results in diversification.
- The provision was enacted in 1966 to combat "exchange funds" or "swap funds."
- The Foreign Investors Tax Act of 1966 (Pub. L. 89-809, § 203, 80 Stat. 1539) added the investment company exception to prevent investors from transferring appreciated marketable stocks and securities to newly formed corporations on a tax-free basis to achieve diversification without recognizing capital gain.
- Prior to 1966, a professional investment manager would bring together investors who each held appreciated stock of a single but different issuer. The investors contributed their respective holdings to a newly formed corporation in exchange for shares under § 351, enabling diversification without gain recognition (S. Rep. No. 1707, 89th Cong., 2d Sess. 61 (1966). H.R. Rep. No. 2327, 89th Cong., 2d Sess. 9 (1966)).
- The legislative history makes clear that Congress targeted arrangements where the economic substance was portfolio diversification while the formal structure was a tax-free incorporation.
- The 1976 expansion extended the rules to partnerships and trusts.
- The Tax Reform Act of 1976 (Pub. L. 94-455, § 2131) added § 721(b), which denies § 721(a) nonrecognition for transfers to partnerships that would be treated as investment companies if incorporated.
- The same Act added § 683(a), which requires gain recognition on transfers to trusts that would be investment companies if they were corporations. The 1976 legislation also added § 368(a)(2)(F), which addresses reorganizations of investment companies (S. Rep. No. 938, 94th Cong., 2d Sess., pt. 2, at 43-44 (1976)).
- Congress acted after the IRS issued a favorable private ruling (PLR 7504280550A, April 28, 1975) allowing tax-free exchange of securities for partnership interests, prompting concern that swap funds would migrate to partnership form.
- The 1997 amendments expanded the listed investment assets.
- The Taxpayer Relief Act of 1997 (Pub. L. 105-34, § 1002, 111 Stat. 909) significantly broadened the types of assets treated as "stock and securities" for purposes of the 80-percent investment company determination by adding clauses (i) through (viii) to § 351(e)(1)(B).
- The amendments added money, foreign currency, derivatives, precious metals, REIT and RIC interests, and entity look-through rules. Congress was concerned with swap funds holding more than 80% of assets in "high-quality investment assets such as non-convertible debt instruments, notional principal contracts, foreign currency and interests in metals" (1997 Blue Book, JCS-23-97, at p. 183, Dec. 17, 1997).
- The 1997 amendments apply to transfers after June 8, 1997, in taxable years ending after such date.
- The 1997 amendments did not override the diversification requirement.
- The 1997 Blue Book at page 183 confirms that the amendments were intended to expand the types of assets considered in making the investment company determination but not to alter the requirement that a transfer will be considered a transfer to an investment company only if the transfer results directly or indirectly in diversification of the transferors' interests.
- PLR 199901028 (Oct. 13, 1998) confirms this interpretation, applying the 1997 amendments only to the asset list while preserving the two-prong framework.
- The § 368(c) control requirement must still be satisfied as a threshold matter.
- § 351(a) requires that the transferor or transferors be in "control" (as defined in § 368(c), meaning ownership of stock possessing at least 80% of the total combined voting power and at least 80% of the total number of shares of all other classes) immediately after the exchange.
- If control is not satisfied, the transaction is fully taxable under § 1001 regardless of § 351(e). Only if control is met does § 351(e) operate as an override to deny nonrecognition when the transferee is an investment company and diversification occurs.
- The analysis framework proceeds in sequence. First determine whether the transferee is an investment company (Steps 2 through 4 below). Then determine whether the transfer results in diversification (Steps 5 through 7 below).
"The transferee is (a) a regulated investment company, (b) a real estate investment trust, or (c) a corporation more than 80 percent of the value of whose assets (excluding cash and nonconvertible debt obligations from consideration) are held for investment and are readily marketable stocks or securities, or interests in regulated investment companies or real estate investment trusts." (Treas. Reg. § 1.351-1(c)(1)(ii))
Treas. Reg. § 1.351-1(c)(1)(ii) establishes three categories of investment company. If the transferee falls within any category, the investment company prong is satisfied.
- A regulated investment company under § 851 is a per se investment company.
- No 80-percent test is required. If the transferee qualifies as a RIC under § 851, it is automatically an investment company for purposes of § 351(e).
- The transferor must then analyze whether the diversification prong is satisfied. The RIC status alone does not trigger gain recognition. Both prongs of the § 351(e) test must be met.
- A real estate investment trust under § 856 is a per se investment company.
- No 80-percent test is required. If the transferee qualifies as a REIT under § 856, it is automatically an investment company for purposes of § 351(e).
- The transferor must then analyze whether the diversification prong is satisfied. REIT status alone does not trigger gain recognition without diversification.
- Rev. Rul. 87-9, 1987-1 C.B. 133, illustrates the per se rule.
- In that ruling, certain shareholders transferred marketable stock of Y corporation (89% of total value) to a newly organized corporation X that intended to qualify as a RIC under § 851. Other persons transferred cash (11% of total value).
- The IRS held that the transfers constituted transfers to an investment company because X was a RIC, and the transfer resulted in diversification because the stock and cash were nonidentical assets. The cash contribution of 11% was held not to be an insignificant portion. Gain was determined under § 1001.
- This ruling establishes that cash combined with stock contributions to a RIC can trigger both the investment company prong (via RIC status) and the diversification prong (via nonidentical assets).
- The test requires that MORE than 80% of asset value be held for investment and consist of listed assets.
- Treas. Reg. § 1.351-1(c)(1)(ii)(c) defines the third category of investment company as "a corporation more than 80 percent of the value of whose assets (excluding cash and nonconvertible debt obligations from consideration) are held for investment and are readily marketable stocks or securities, or interests in regulated investment companies or real estate investment trusts."
- The phrase "more than 80 percent" means strictly greater than 80%. An 80.1% ratio satisfies the test. An 80.0% ratio does not.
- The exclusion of "cash and nonconvertible debt obligations from consideration" means these assets are removed from BOTH the numerator and the denominator of the fraction.
- The post-1997 statutory expansion broadens the assets counted toward the 80% test.
- While the regulatory text still refers to "readily marketable stocks or securities," the 1997 amendments to § 351(e)(1)(B) statutorily expanded the types of assets that count toward the 80-percent determination to include the full list of listed investment assets (money, equity interests, debt, options, derivatives, foreign currency, REIT/RIC/PTP interests, precious metals, and entity interests under the look-through rules).
- PLR 199901028 (Oct. 13, 1998) confirms that the 1997 amendments expanded the types of assets considered in determining whether a transfer is to a transferee described in § 1.351-1(c)(1)(ii)(c).
- Practitioners must apply the post-1997 statutory asset list even though the regulatory text has not been formally updated to reflect all amendments.
- The determination is made immediately after the transfer unless a plan exists.
- Treas. Reg. § 1.351-1(c)(2) provides that the determination is ordinarily made by reference to circumstances immediately after the transfer.
- Where circumstances change thereafter pursuant to a plan in existence at the time of the transfer, the determination is made by reference to the later circumstances when that plan is executed.
- This plan exception is discussed in detail in Step 9 below.
- Assets are held for investment unless they fall within two exceptions.
- Treas. Reg. § 1.351-1(c)(3) provides that "stocks and securities will be considered to be held for investment unless they are (i) held primarily for sale to customers in the ordinary course of business, or (ii) used in the trade or business of banking, insurance, brokerage, or a similar trade or business."
- This is a negative definition. The default presumption is that stocks and securities are held for investment. Only if one of the two specified exceptions applies are they not held for investment.
- Assets used in an active trade or business are NOT held for investment and do not count toward the 80% test.
- Inventory, manufacturing equipment, real estate used in a trade or business, goodwill used in an active business, and similar operating assets are not "held for investment." These assets are excluded from the numerator of the 80-percent test.
- TRAP. Such assets ARE included in the denominator of the 80-percent test (unless they also fall within the cash or nonconvertible debt exclusions), which can actually help the corporation avoid investment company status by increasing the denominator.
- Securities held by a dealer for sale to customers are not held for investment.
- A broker-dealer that holds securities primarily for sale to customers in the ordinary course of business does not hold those securities for investment under § 1.351-1(c)(3)(i). Such securities are excluded from the numerator of the 80-percent test.
- However, securities held for appreciation or for investment purposes by a dealer may still qualify as held for investment.
- The banking, insurance, and brokerage exception in § 1.351-1(c)(3)(ii) similarly removes those assets from the numerator.
"For purposes of the preceding sentence, the determination of whether a company is an investment company shall be made (A) by taking into account all stock and securities held by the company, and (B) by treating as stock and securities (i) money, (ii) stocks and other equity interests in a corporation, evidences of indebtedness, options, forward or futures contracts, notional principal contracts and derivatives, (iii) any foreign currency, (iv) any interest in a real estate investment trust, a common trust fund, a regulated investment company, a publicly-traded partnership (as defined in section 7704(b)) or any other equity interest (other than in a corporation) which pursuant to its terms or any other arrangement is readily convertible into, or exchangeable for, any asset described in any preceding clause, this clause or clause (v) or (viii), (v) except to the extent provided in regulations prescribed by the Secretary, any interest in a precious metal, unless such metal is used or held in the active conduct of a trade or business after the contribution, (vi) except as otherwise provided in regulations prescribed by the Secretary, interests in any entity if substantially all of the assets of such entity consist (directly or indirectly) of any assets described in any preceding clause or clause (viii), (vii) to the extent provided in regulations prescribed by the Secretary, any interest in any entity not described in clause (vi), but only to the extent of the value of such interest that is attributable to assets listed in clauses (i) through (v) or clause (viii), and (viii) any other asset specified in regulations prescribed by the Secretary." (IRC § 351(e)(1)(B))
- Clause (i). Money.
- All money regardless of its source or intended use is treated as stock and securities for purposes of the 80-percent test. This was a significant 1997 expansion.
- Pre-1997, cash was excluded from the denominator entirely. Post-1997, money counts toward the numerator as a listed asset.
- This means that a corporation holding cash plus marketable securities may have a higher percentage of listed assets than pre-1997 law would have produced.
- Clause (ii). Stocks, equity interests, debt, options, forward and futures contracts, notional principal contracts, and derivatives.
- This clause broadly captures all equity interests in corporations, evidences of indebtedness, options, forward or futures contracts, notional principal contracts, and derivatives.
- Unlike the pre-1997 regulatory framework which required assets to be "readily marketable," this clause does not impose a ready marketability requirement for the assets it enumerates.
- Even private company stock with no ready market counts as a listed asset under this clause.
- Clause (iii). Any foreign currency.
- All foreign currency is treated as stock and securities. This includes currency held for investment, for hedging, or incidental to foreign operations.
- No trade or business exception applies to foreign currency under this clause.
- A corporation that holds substantial foreign currency reserves may exceed the 80-percent threshold even if the currency is held for operating purposes.
- Clause (iv). Interests in REITs, common trust funds, RICs, publicly traded partnerships, and readily convertible equity interests.
- This clause captures any interest in a REIT, common trust fund, RIC, publicly traded partnership (as defined in § 7704(b)), or any other equity interest in a non-corporate entity.
- The catch-all within this clause covers equity interests that are "readily convertible into, or exchangeable for, any asset described in any preceding clause, this clause or clause (v) or (viii)."
- The "readily convertible" catch-all ensures that equity interests structured to be economically equivalent to listed assets cannot avoid treatment.
- Clause (v). Interests in precious metals (with an active business exception).
- Any interest in a precious metal is treated as stock and securities EXCEPT to the extent provided in regulations, and EXCEPT if the metal is used or held in the active conduct of a trade or business after the contribution.
- To date, the Secretary has not prescribed regulations under this clause. Therefore, the statutory exception for precious metals "used or held in the active conduct of a trade or business" operates as the sole limitation.
- Gold bullion held for investment is a listed asset. Gold held by a jeweler for use in manufacturing jewelry is not a listed asset by reason of the trade or business exception.
- Clause (vi). Full look-through for entities where substantially all assets are listed assets.
- An interest in any entity is treated as stock and securities if substantially all of the entity's assets (directly or indirectly) consist of assets described in clauses (i) through (v) or clause (viii).
- "Substantially all" is generally construed to mean 90% or more. If an entity has 90% or more listed assets, the ENTIRE interest in that entity is treated as a listed asset.
- This applies unless otherwise provided in regulations, and no such regulations have been issued.
- Clause (vii). Partial look-through for other entities.
- To the extent provided in regulations, an interest in any entity not described in clause (vi) is treated as stock and securities only to the extent of the value attributable to listed assets.
- The regulations have not fully operationalized this clause. Legislative history suggests that if fewer than 20% of an entity's assets are listed assets, no portion of the interest is treated as a listed asset.
- This clause creates a proportional attribution regime for entities that hold a mix of listed and non-listed assets.
- Clause (viii). Regulatory catch-all.
- The Secretary may specify additional assets to be treated as stock and securities. To date, no assets have been specified under this clause.
- The Secretary also has authority to delist assets. The final sentence of § 351(e)(1)(B) provides that the Secretary may prescribe regulations that under appropriate circumstances treat any asset described in clauses (i) through (v) as not so listed. No such regulations have been issued.
- The 1997 Blue Book at page 183 confirms that this authority was included to provide flexibility but has not been exercised.
- The 1997 amendments expanded the 80% test without overriding the diversification requirement.
- The 1997 Blue Book (JCS-23-97) at page 183 confirms that the amendments were intended to expand the types of assets considered in making the investment company determination under the regulations to include assets in addition to readily marketable stocks and securities and interests in RICs and REITs.
- The Blue Book expressly states that the Act was not intended to alter the requirement that a transfer be considered a transfer to an investment company only if the transfer results in diversification of the transferors' interests.
- Both prongs of the Treas. Reg. § 1.351-1(c)(1) test remain fully operative after the 1997 amendments.
- Cash is excluded from BOTH the numerator and the denominator.
- Treas. Reg. § 1.351-1(c)(1)(ii)(c) explicitly excludes "cash" from consideration in the 80-percent test. Cash does not count toward the 80% threshold. Cash also does not increase the denominator.
- A corporation holding $70 million of marketable securities and $30 million of cash would compute the 80-percent test as $70M / $70M = 100%, which exceeds 80%.
- This means that adding cash to a corporation already holding listed assets does not help avoid investment company status.
- Nonconvertible debt obligations are excluded from BOTH the numerator and the denominator.
- Treas. Reg. § 1.351-1(c)(1)(ii)(c) also excludes "nonconvertible debt obligations from consideration." A nonconvertible debt obligation is a debt instrument that cannot be converted into equity of the issuer.
- Nonconvertible bonds held by the corporation are excluded entirely from both numerator and denominator.
- Convertible debt obligations are NOT excluded and count as listed assets under § 351(e)(1)(B)(ii).
- CAUTION. Cash CAN cause diversification even though it does not count toward the 80% test.
- Rev. Rul. 87-9, 1987-1 C.B. 133, demonstrates this critical distinction. In that ruling, transferors contributed stock (89%) and cash (11%) to a newly organized RIC.
- While the cash did not count toward the 80-percent investment company test, the cash was a "nonidentical asset" relative to the stock, which caused the transfer to result in diversification. The investment company prong was satisfied through RIC status.
- The diversification prong was satisfied because stock and cash are nonidentical assets and the cash (11%) was not an insignificant portion. Thus, the cash contribution triggered gain recognition on the stock contributions even though cash itself was excluded from the 80-percent calculation.
- Real estate used in an active trade or business is not a listed asset.
- Real property used in a trade or business (such as a factory, office building, or retail space used by the corporation or its subsidiaries) is not treated as stock and securities under § 351(e)(1)(B).
- Such real estate is excluded from the numerator of the 80-percent test. However, the real estate DOES count toward the denominator (increasing the total asset base), which helps reduce the percentage of listed assets.
- TRAP. Real estate held for investment (rental property, land speculation) IS treated as a listed asset because it is held for investment, not used in a trade or business.
- Active business assets are not listed assets.
- Inventory, raw materials, work in process, finished goods held for sale, manufacturing equipment, machinery, vehicles, and goodwill used in an active trade or business are not treated as stock and securities under § 351(e)(1)(B).
- These assets are excluded from the numerator. They count toward the denominator.
- The distinction between investment assets and active business assets is critical for the 80-percent determination.
- Precious metals used or held in an active trade or business are excluded by § 351(e)(1)(B)(v).
- The statute itself provides that any interest in a precious metal is treated as stock and securities UNLESS such metal is used or held in the active conduct of a trade or business after the contribution.
- Gold held as an investment is a listed asset. Platinum held by an automobile catalytic converter manufacturer for use in production is not a listed asset by reason of this statutory exception.
- No regulations have been issued under this clause to date.
- Non-readily-marketable stock in non-subsidiary corporations presents a nuanced question.
- Pre-1997, only "readily marketable" stocks and securities counted toward the 80-percent test under § 1.351-1(c)(3). Post-1997, § 351(e)(1)(B)(ii) treats "stocks and other equity interests in a corporation" as stock and securities without a ready marketability limitation.
- Therefore, even non-readily-marketable stock in a private corporation counts toward the 80-percent test. However, if the corporation owns 50% or more of the subsidiary, the look-through rule of § 1.351-1(c)(4) applies instead.
- TRAP. Stock in a non-subsidiary (less than 50% owned) private corporation IS treated as a listed asset under § 351(e)(1)(B)(ii) even if it has no ready market.
- TRAP. Assets not on the § 351(e)(1)(B) list are excluded from the numerator but count toward the denominator.
- This is one of the most important structural features of the 80-percent test. An asset that is not a listed investment asset (such as real estate used in business, inventory, or equipment) does not count toward the 80% threshold in the numerator.
- But it DOES increase the total asset base in the denominator. This means that adding non-listed assets to the corporation can help the corporation avoid investment company status by diluting the percentage of listed assets below the 80% threshold.
- This structural feature creates a legitimate planning opportunity. A corporation can be structured with sufficient operating assets to keep the listed asset percentage below 80%.
- EXAMPLE. Corporation holds marketable securities and business real estate. Corporation X has $70 million of marketable securities (held for investment) and $30 million of real estate used in its trade or business. Cash and nonconvertible debt are excluded from consideration. The 80-percent test is computed as $70M (listed assets) / $70M (total assets after excluding cash and nonconvertible debt) = 100%. The $30 million of business real estate is excluded from the denominator entirely because it is neither a listed asset nor cash nor nonconvertible debt. The result (100%) exceeds 80%. Corporation X is an investment company.
- EXAMPLE. Corporation holds marketable securities and active business assets. Corporation Y has $70 million of marketable securities and $40 million of active business assets (inventory, equipment, goodwill). Cash and nonconvertible debt are zero. The 80-percent test is computed as $70M (listed assets) / $70M (total assets after excluding non-listed business assets) = 100%. The $40 million of business assets is excluded from the denominator entirely. The result exceeds 80%. Corporation Y is an investment company. The presence of substantial business assets does not prevent investment company status because those assets are excluded from the denominator.
- EXAMPLE. Corporation holds marketable securities and cash. Corporation Z has $70 million of marketable securities and $20 million of cash. Nonconvertible debt is zero. The 80-percent test is computed as $70M (listed assets) / $70M (total after excluding cash) = 100%. The cash is excluded from both numerator and denominator. The result exceeds 80%. Corporation Z is an investment company. This example illustrates that cash does not help dilute the 80-percent ratio because it is excluded from the denominator.
"A transfer ordinarily results in the diversification of the transferors' interests if two or more persons transfer nonidentical assets to a corporation in the exchange." (Treas. Reg. § 1.351-1(c)(5))
- The default rule is that two or more persons transferring nonidentical assets results in diversification.
- Treas. Reg. § 1.351-1(c)(5) establishes the baseline rule. When two or more persons transfer nonidentical assets to a corporation in the exchange, the transfer "ordinarily" results in diversification.
- The word "ordinarily" signals that exceptions exist (discussed below). When diversification occurs and the transferee is an investment company, § 351(e) denies nonrecognition treatment and transferors must recognize gain or loss under § 1001.
- This is the most common fact pattern that triggers § 351(e). Multiple transferors contributing different types of assets to a corporation that is (or becomes) an investment company will ordinarily result in denied nonrecognition.
- A single transferor to a newly organized corporation generally does NOT result in diversification.
- Treas. Reg. § 1.351-1(c)(5) provides that if there is only one transferor to a newly organized corporation, the transfer "will generally be treated as not resulting in diversification."
- A single transferor contributing a portfolio of different stocks to a new corporation has not achieved diversification through the transfer because the transferor already held those diverse positions directly. The corporation merely holds the same assets the transferor previously held.
- This rule reflects the principle that § 351(e) targets transfers that achieve diversification, not transfers that merely change the form of already-diversified holdings.
- Two or more transferors of identical assets generally do NOT result in diversification.
- Treas. Reg. § 1.351-1(c)(5) also provides that if two or more transferors transfer identical assets to a newly organized corporation, the transfer "will generally be treated as not resulting in diversification."
- If ten shareholders each contribute Y corporation stock to a new corporation X, they have not diversified their interests. Each transferor's economic position is the same before and after the transfer (direct ownership of Y stock versus indirect ownership of Y stock through X).
- This exception preserves § 351(a) nonrecognition for incorporations where all transferors contribute the same type of asset.
- The de minimis exception disregards nonidentical assets that constitute an "insignificant portion" of total value.
- Treas. Reg. § 1.351-1(c)(5) provides that if any transaction involves one or more transfers of nonidentical assets which taken in the aggregate constitute an insignificant portion of the total value of assets transferred, such transfers shall be disregarded in determining whether diversification has occurred.
- Treas. Reg. § 1.351-1(c)(7), Example 1, illustrates this principle. Individuals A and B each transferred $10,000 of X corporation stock. C transferred $200 of Y corporation securities. C's $200 contribution was approximately 0.99% of the $20,200 total. The example holds that C's participation is disregarded, no diversification occurs, and gain or loss is not recognized.
- This example suggests that approximately 1% or less may be treated as insignificant.
- Rev. Rul. 87-9, 1987-1 C.B. 133, establishes that 11% is NOT insignificant.
- In that ruling, cash constituted 11% of total assets transferred. The IRS held that the cash transfer was NOT an insignificant portion and therefore could not be disregarded under the de minimis exception.
- Combined with the stock transfers (the nonidentical assets), diversification occurred. This ruling establishes the outer boundary. Contributions exceeding 11% are clearly not de minimis.
- The de minimis threshold between 1% and 11% remains an area of some uncertainty.
- PLR 200006008 treated less than 5% as insignificant.
- This private letter ruling applied a methodology under which nonidentical assets constituting less than 5% of aggregate value were treated as insignificant and disregarded for diversification purposes.
- TRAP. Private letter rulings may not be cited as precedent under § 6110(k)(3). The de minimis threshold between 1% and 11% remains an area of uncertainty. Practitioners should exercise caution when relying on PLR methodology.
"For purposes of paragraph (c)(5) of this section, a transfer of stocks and securities will not be treated as resulting in a diversification of the transferors' interests if each transferor transfers a diversified portfolio of stocks and securities." (Treas. Reg. § 1.351-1(c)(6)(i))
- The safe harbor applies only if EACH transferor transfers a diversified portfolio.
- Treas. Reg. § 1.351-1(c)(6)(i) provides that a transfer of stocks and securities will NOT be treated as resulting in diversification if each transferor transfers a diversified portfolio.
- The requirement is all or nothing. If even one transferor contributes a non-diversified portfolio, the safe harbor is unavailable for the entire transaction.
- The analysis then falls back to the general diversification rule of § 1.351-1(c)(5).
- A portfolio is diversified if it satisfies the 25% and 50% tests of § 368(a)(2)(F)(ii).
- The safe harbor incorporates by cross-reference the diversification tests from § 368(a)(2)(F)(ii). A portfolio satisfies the 25% test if not more than 25% of the value of its total assets is invested in the stock and securities of any one issuer.
- A portfolio satisfies the 50% test if not more than 50% of the value of its total assets is invested in the stock and securities of five or fewer issuers. Both tests must be satisfied.
- Controlled groups under § 1563(a) are treated as a single issuer for these tests. Holdings in RICs and REITs are looked through to the underlying assets.
- Government securities receive favorable treatment in the 25/50 tests.
- Treas. Reg. § 1.351-1(c)(6)(i) provides that government securities are included in total assets for purposes of the denominator of the 25 and 50-percent tests (unless the government securities are acquired to meet the 25 and 50-percent tests), but are not treated as securities of an issuer for purposes of the numerator.
- This treatment is more favorable than under § 368(a)(2)(F) itself, which excludes government securities entirely from total assets.
- The regulatory modification was designed to address the problem of money market funds and similar portfolios that hold primarily government securities. If 95% of a portfolio is invested in government securities and 5% in X corporation stock, the government securities rule ensures the portfolio passes the 25% test (X stock = 5% of total assets) rather than failing (X stock = 100% of non-government assets).
- The safe harbor is effective for transfers completed on or after May 2, 1996.
- T.D. 8663 (1996-1 C.B. 34) added the diversified portfolio safe harbor. For transfers completed before May 2, 1996, the regulation provides a transitional rule.
- Transfers of diversified but nonidentical portfolios completed before that date may be treated either (A) consistent with the safe harbor (no diversification) or (B) as resulting in diversification.
- This transitional rule reflects the fact that prior to 1996, the IRS had not expressly recognized a safe harbor for diversified portfolio transfers.
- EXAMPLE. Three transferors each contribute diversified portfolios.
- Transferor A contributes a portfolio with no more than 20% in any single issuer and 40% in the top five issuers. Transferor B contributes a different portfolio with no more than 22% in any single issuer and 45% in the top five. Transferor C contributes a third portfolio with no more than 18% in any single issuer and 35% in the top five.
- Each portfolio independently satisfies the 25% and 50% tests. Even though A, B, and C contribute different (nonidentical) portfolios, the safe harbor applies and the transfer is NOT treated as resulting in diversification.
- § 351(a) nonrecognition treatment is preserved (assuming all other requirements are met). The key point is that the safe harbor looks at each transferor's portfolio individually, not at the aggregate mix of all contributed assets.
"If a transfer is part of a plan to achieve diversification without recognition of gain, such as a plan which contemplates a subsequent transfer, however delayed, of the corporate assets (or of the stock or securities received in the earlier exchange) to an investment company in a transaction purporting to qualify for nonrecognition treatment, the original transfer will be treated as resulting in diversification." (Treas. Reg. § 1.351-1(c)(5))
- The anti-plan rule treats a transfer as diversification if it is part of a plan to achieve tax-free diversification.
- Treas. Reg. § 1.351-1(c)(5) provides that even if a transfer would not independently result in diversification (for example, because there is only one transferor, or because identical assets are transferred), the transfer IS treated as resulting in diversification if it is part of a plan to achieve diversification without recognition of gain.
- The regulation explicitly states that the subsequent transfer may be "however delayed," meaning the IRS can integrate temporally separated transactions that are part of a single plan.
- The key element is the PLAN. A mere possibility or contingent future event is not sufficient to trigger the rule.
- Rev. Rul. 88-32, 1988-1 C.B. 113, distinguishes taxable diversification from tax-free diversification.
- In that ruling, shareholders of Y corporation transferred their Y stock to a newly formed corporation X. Pursuant to a pre-existing plan, X sold significant amounts of Y stock (recognizing taxable gain) and purchased other marketable investments.
- The IRS held that the initial transfer did NOT result in a transfer to an investment company. The rationale was that the initial transfer of identical Y stock to a new corporation did not result in diversification because the transferors contributed identical assets.
- The subsequent diversification occurred through taxable sales by X (in which X recognized gain) and taxable purchases of new investments, NOT through a nonrecognition transaction. Because the plan did NOT contemplate achieving diversification "without recognition of gain," the anti-plan rule did not apply.
- The step-transaction doctrine can integrate related transfers.
- Rev. Rul. 70-140 (1970) illustrates the application of the step-transaction doctrine in the corporate reorganization context. Commissioner v. Gordon, 391 U.S. 83 (1968), addresses the step-transaction doctrine in corporate distributions.
- American Bantam Car Co. v. Commissioner, 11 T.C. 397 (1948), applies the step-transaction doctrine to integrate a series of formally separate transfers.
- Under these authorities, if a taxpayer structures a transfer of identical assets followed by a pre-arranged nonrecognition exchange into diversified assets, the step-transaction doctrine may cause the integrated transaction to be treated as a single transfer resulting in diversification.
- Substance-over-form analysis applies to transactions lacking business purpose.
- Gregory v. Helvering, 293 U.S. 465 (1935), is the foundational case holding that a transaction that complies literally with statutory requirements but lacks business purpose and is undertaken solely for tax avoidance may be recharacterized according to its substance.
- In the § 351(e) context, a transaction structured to avoid the form of diversification (such as using a single transferor with a pre-arranged subsequent transfer) may be recharacterized if it lacks substance apart from tax savings.
- Courts look for a genuine business purpose beyond tax savings to respect the transactional form.
- The economic substance doctrine is codified at § 7701(o).
- § 7701(o) provides that a transaction satisfies the economic substance doctrine only if (1) the transaction changes in a meaningful way the taxpayer's economic position apart from federal income tax effects, and (2) the taxpayer has a substantial purpose apart from federal income tax effects for entering into the transaction.
- A transaction that is structured solely to avoid § 351(e) recognition without meaningful economic change may fail this test.
- The conjunctive test (both prongs required) creates a high bar for transactions that lack independent economic substance.
- CAUTION. A plan to contribute identical assets followed by a pre-arranged nonrecognition exchange into diversified assets will trigger the anti-plan rule.
- The critical distinction from Rev. Rul. 88-32 is whether the subsequent diversification occurs in a taxable transaction or in a purported nonrecognition transaction.
- If transferors contribute identical Y stock to a new corporation X, and X then exchanges the Y stock for diversified assets in a transaction purporting to qualify for nonrecognition (such as a claimed § 351 or § 368 exchange), the IRS will apply the anti-plan rule to treat the original transfer as resulting in diversification.
- The transferors will be required to recognize gain on their initial contributions. To avoid this result, any post-transfer rebalancing should occur through taxable transactions in which the corporation recognizes gain or loss.
A corporation cannot avoid the investment company taint by holding its investment portfolio through subsidiary entities. Both the regulations and the statute provide look-through mechanisms that attribute subsidiary assets to the parent corporation. The regulatory rule applies to corporate subsidiaries. The statutory rules extend look-through treatment to partnership and other entity interests.
- Treas. Reg. § 1.351-1(c)(4) requires that stock and securities in subsidiary corporations be DISREGARDED. The parent corporation is deemed to own its ratable share of the subsidiary corporation's assets for purposes of the 80% investment company test. This prevents the transparent end-run of parking listed investment assets in a 50%+ owned subsidiary.
- A corporation qualifies as a subsidiary if its parent owns 50% or more of (i) the combined voting power of all classes of stock entitled to vote, or (ii) the total value of shares of all classes of stock outstanding. Treas. Reg. § 1.351-1(c)(4).
- Example. If Parent Corp owns 60% of Subsidiary Corp's stock, and Subsidiary Corp holds $1,000,000 of marketable securities, then Parent Corp is deemed to hold $600,000 of marketable securities through Subsidiary Corp. The stock of Subsidiary Corp itself is disregarded entirely.
- The look-through applies regardless of whether the subsidiary is a newly formed or pre-existing corporation.
- If the subsidiary's assets are operating assets (factory equipment, inventory, real property used in a trade or business), those operating assets are attributed to the parent and may help the parent avoid investment company status.
- If the subsidiary's assets consist primarily of listed investment assets, those assets are attributed to the parent and may cause the parent to fail the 80% test.
- CAUTION. The regulatory look-through rule in Treas. Reg. § 1.351-1(c)(4) applies ONLY to stock in subsidiary CORPORATIONS.
- There is no regulatory look-through for partnership interests, LLC interests taxed as partnerships, or other non-corporate entities.
- If a corporation holds a 90%+ interest in a partnership, the corporation cannot look through to the partnership's operating assets. The partnership interest itself must be characterized under the statutory rules of § 351(e)(1)(B).
- TRAP. A client may structure around the corporate look-through by holding assets through a partnership rather than a corporate subsidiary. This strategy shifts the analysis to the statutory rules, which may produce a different result.
- Clause (vi) provides a full look-through for interests in entities where "substantially all" of the entity's assets consist of listed investment assets. § 351(e)(1)(B)(vi).
- "Substantially all" is generally interpreted to mean 90% or more of the entity's assets. When this threshold is met, the parent's entire interest in the entity is treated as a listed investment asset.
- This applies to interests in partnerships, LLCs, trusts, and other entities that are not corporate subsidiaries covered by Treas. Reg. § 1.351-1(c)(4).
- Clause (vii) provides a partial (proportional) look-through to the extent of value attributable to listed assets. § 351(e)(1)(B)(vii).
- If less than "substantially all" of the entity's assets consist of listed investment assets, only the portion of the interest's value attributable to listed assets is treated as a listed investment asset.
- Example. If a partnership is 60% invested in marketable securities and 40% in operating real estate, then 60% of the corporate owner's partnership interest value counts toward the 80% test.
- PLR 201547003 (November 20, 2015) applied the look-through concept to publicly traded partnership interests.
- The IRS ruled that if a transferee corporation owned 50% or more of the total value of a publicly traded partnership's equity interests, the partnership interests would be disregarded and the corporation would be deemed to own its ratable share of the partnership's assets for purposes of the investment company determination under § 351(e).
- This ruling extended the look-through concept from corporate subsidiaries (under the regulations) to partnership interests on analogous facts.
- PLR 202016013 (January 8, 2020) addressed whether a transfer to a partnership would be treated as a transfer to an investment company.
- The ruling analyzed the partnership's assets under § 721(b), which cross-references the § 351(e) investment company definition.
- The IRS applied the look-through rules of § 351(e)(1)(B)(vi)-(vii) in evaluating the partnership interests held by the entity.
- A corporation cannot avoid investment company status by holding listed assets through a 50%+ subsidiary.
- The regulatory look-through in Treas. Reg. § 1.351-1(c)(4) is comprehensive and covers both the vote and value tests for subsidiary status.
- Even if the subsidiary itself engages in an active trade or business, only the parent's ratable share of the subsidiary's actual assets is taken into account.
- Partnership interests require a separate analysis under the statutory look-through rules.
- First determine whether the partnership interest falls under clause (vi) (substantially all assets are listed = full look-through) or clause (vii) (partial look-through).
- If the partnership operates an active business with primarily non-listed assets, the partnership interest may contribute little or nothing to the 80% numerator.
- TRAP. A client may inadvertently create investment company status through subsidiary structures that appear to hold operating assets.
- Example. A parent corporation owns 55% of a subsidiary that holds a portfolio of marketable securities. The parent believes it is safe because the subsidiary is an "operating company." In fact, the subsidiary's securities are fully attributed to the parent, and the subsidiary stock is disregarded. The parent may now be an investment company.
- Always apply the look-through rules BEFORE concluding that the 80% test is satisfied.
The investment company determination is ordinarily made as a snapshot immediately after the transfer. But the plan exception allows the IRS to look to later circumstances if a plan was in existence at the time of the transfer. This creates both a trap for the unwary and a legitimate planning boundary.
- Treas. Reg. § 1.351-1(c)(2) provides that the determination is ordinarily made immediately after the transfer.
- The snapshot approach evaluates the corporation's assets at the moment the transfer is complete. Assets contributed in the transfer, plus any pre-existing assets, are valued and classified at that moment.
- This timing rule gives practitioners a clear point of reference for the 80% test and the diversification analysis.
- The 1997 Blue Book at page 184 confirms this general timing rule.
- The Joint Committee on Taxation's General Explanation of Tax Legislation Enacted in 1997 states that "the determination of whether a corporation is an investment company is ordinarily made immediately after the transfer."
- The Blue Book further explains that this rule provides certainty because transferors can evaluate the corporation's asset composition at a discrete point in time.
- Treas. Reg. § 1.351-1(c)(2) creates an important exception. If circumstances change thereafter pursuant to a plan in existence at the time of the transfer, the determination is made by reference to the later circumstances.
- The exception applies only where a PLAN was in existence at the time of the transfer. A mere possibility, hope, or contingency is not sufficient.
- The plan must contemplate a change in the corporation's assets or operations that would alter the investment company determination.
- EXAMPLE. Transferor A contributes appreciated stock of X Corp to Newco. Transferor B contributes cash. At the moment of transfer, Newco holds only X Corp stock and cash, and no diversification has occurred. However, B's cash contribution was made pursuant to a pre-existing plan under which Newco will use the cash to purchase additional marketable securities within 30 days.
- Under the plan exception, the determination is made by reference to the post-plan asset mix (X Corp stock plus the newly purchased securities).
- The post-purchase portfolio constitutes an investment company under the 80% test, and the transfer results in diversification because A and B contributed nonidentical assets.
- Therefore, § 351(e) applies and both transferors must recognize gain.
- CAUTION. The plan rule requires a PLAN, not just a possibility.
- A plan may be evidenced by written documents (board resolutions, contribution agreements, offering materials), oral understandings, or a course of conduct showing a prearranged design.
- Rev. Rul. 88-32 demonstrates that subsequent taxable transactions are NOT treated as part of a plan merely because they occur after the transfer. The critical distinction is whether the subsequent action was prearranged at the time of the initial transfer.
- Document whether a plan existed at the time of transfer. If no plan existed, the general timing rule (snapshot at transfer) should govern.
- Rev. Rul. 88-32, 1988-1 C.B. 113 is the foundational ruling on the boundary between the plan exception and legitimate post-transfer portfolio activity.
- Facts. Certain shareholders of Y corporation transferred their Y stock to X, a newly formed corporation. No assets other than Y stock were transferred to X. None of the transferors had acquired any of the Y stock transferred to X as part of the same plan to organize X. Pursuant to the plan to organize X, X subsequently sold significant amounts of Y stock in transactions in which X recognized gain or loss, and purchased other marketable investments.
- Holding. The initial transfer of Y stock to X did NOT result in diversification within the meaning of Treas. Reg. § 1.351-1(c)(1)(i).
- Rationale. The Y shareholders transferred identical assets (Y stock) to a newly organized corporation. Under Treas. Reg. § 1.351-1(c)(5), such a transfer is treated as not resulting in diversification unless it is part of a plan to achieve diversification in a series of nonrecognition transactions. The subsequent sale of Y stock and purchase of other investments occurred in taxable transactions in which X recognized gain or loss. Because the diversification occurred through taxable transactions, not nonrecognition transactions, the initial transfer was not tainted.
- The critical distinction from Rev. Rul. 88-32 is that diversification occurred through TAXABLE transactions (gain/loss recognized), not nonrecognition transactions.
- When a corporation sells contributed assets and reinvests the proceeds, the sale triggers corporate-level gain or loss recognition under § 1001.
- The IRS respects this taxable event as a genuine economic transaction that breaks the chain of nonrecognition.
- By contrast, if the corporation achieves diversification through a subsequent nonrecognition transaction (such as another § 351 transfer from a new shareholder), the plan exception may apply.
- Rev. Rul. 88-32 creates a legitimate planning path.
- Transferors may contribute identical assets (e.g., all shares of Y Corp) to a newly formed corporation under § 351 without triggering diversification.
- The corporation may then achieve economic diversification by selling the contributed assets in taxable transactions and reinvesting the proceeds in other securities.
- Because the sales are taxable, the initial § 351 transfer is not recast as a transfer to an investment company.
- CAUTION. The step-transaction doctrine remains a risk even within the Rev. Rul. 88-32 framework.
- If the post-transfer sales and purchases are prearranged as part of an integrated plan with no independent business purpose, the IRS may collapse the steps and treat the initial transfer as having achieved diversification.
- The key protective factors are (i) the taxable nature of the intermediate sale, and (ii) the absence of a binding prearranged plan at the time of the initial transfer.
Congress created a network of cross-referencing provisions that extend the investment company anti-deferral principle beyond § 351 to partnerships, trusts, and reorganizations. Understanding the differences across these provisions is essential because the gain/loss treatment and entity definitions vary materially.
- § 721(b) incorporates the § 351 investment company definition by reference and applies it to partnership contributions.
- § 721(b) provides that § 721(a) nonrecognition "shall not apply to gain realized on a transfer of property to a partnership which would be treated as an investment company (within the meaning of section 351) if the partnership were incorporated."
- The hypothetical incorporation framework requires analyzing the partnership as if it were a C corporation, then applying the same two-prong test (diversification + investment company status) under Treas. Reg. § 1.351-1(c).
- Critical asymmetry. § 721(b) only recognizes GAIN. Losses are deferred.
- § 351(e) recognizes BOTH gain and loss on transfers to corporate investment companies.
- § 721(b) recognizes only gain on transfers to partnership investment companies. A partner's built-in losses are deferred until the partnership sells the property.
- This distinction creates a meaningful planning preference for partnership structures when transferors have mixed built-in gains and losses.
- The same regulatory framework applies to both provisions.
- Treas. Reg. § 1.351-1(c)(1) governs the determination of whether a transferee is an investment company for purposes of both § 351(e) and § 721(b).
- The 80% test, the diversification test, the de minimis exception, and the diversified portfolio exception all apply to partnership contributions by cross-reference.
- PLRs 200931042 and 9826035 confirm that when each transferor contributes a diversified portfolio of securities and cash, no diversification occurs under § 721(b).
- § 368(a)(2)(F) was added by the Tax Reform Act of 1976 and prevents tax-free mergers of investment companies into diversified entities.
- § 368(a)(2)(F)(i) provides that if two or more parties to a reorganization were investment companies immediately before the transaction, the transaction shall not be treated as a reorganization unless the transferee meets the diversification requirements of clause (ii).
- The purpose is to prevent tax-free reorganization treatment for transactions that are economically equivalent to tax-free diversification of investment portfolios.
- The § 368(a)(2)(F) definition of "investment company" uses a different 50%/80% test.
- § 368(a)(2)(F)(iii) defines "investment company" as a RIC, a REIT, or a corporation 50% or more of whose total assets are stock and securities AND 80% or more of whose total assets are assets held for investment.
- This differs from the § 351(e) definition, which uses an 80% marketable securities test under Treas. Reg. § 1.351-1(c)(1)(ii)(c).
- A corporation may be an investment company under § 368(a)(2)(F) but not under § 351(e), and vice versa.
- The 25/50 diversification safe harbor from § 368(a)(2)(F)(ii) is incorporated by reference into Treas. Reg. § 1.351-1(c)(6).
- § 368(a)(2)(F)(ii) provides that a corporation meets the diversification requirements if (A) not more than 25% of the value of its total assets is invested in the stock and securities of any one issuer, and (B) not more than 50% of the value of its total assets is invested in the stock and securities of five or fewer issuers.
- Under Treas. Reg. § 1.351-1(c)(6), if each transferor transfers a diversified portfolio of stocks and securities meeting this 25/50 test, the transfer is NOT treated as resulting in diversification for § 351(e) purposes.
- The regulation modifies the 25/50 test by including government securities in the total assets denominator while not treating them as securities of an issuer for the numerator.
- § 683(a) extends the investment company anti-deferral principle to trust transfers.
- § 683(a) provides that "if property is transferred to a trust in exchange for an interest in other trust property and if the trust would be an investment company (within the meaning of section 351) if it were a corporation, then gain shall be recognized to the transferor."
- Enacted as part of the Tax Reform Act of 1976, § 683(a) directly cross-references § 351 for the investment company definition, ensuring consistency across entity types.
- Only gain is recognized under § 683(a).
- Like § 721(b), § 683(a) recognizes only gain on transfers to trust investment companies. Losses are not recognized.
- This creates the same asymmetry with § 351(e) that exists in the partnership context.
- § 683(b) provides an exception for transfers to pooled income funds.
- A pooled income fund (within the meaning of § 642(c)(5)) is a charitable giving vehicle that allows donors to retain an income interest while contributing remainder interests to charity.
- Because these transfers serve charitable purposes rather than tax-free diversification, Congress excluded them from the investment company rule.
When § 351(e) applies, the general nonrecognition rule of § 351(a) is overridden entirely. The transfer is treated as a taxable sale or exchange under § 1001. Both transferors and the transferee corporation must compute gain or loss, basis, and holding period as if no nonrecognition provision applied.
- § 351(e) overrides § 351(a). The general nonrecognition rule does NOT apply.
- § 351(e)(1) states that "this section shall not apply to a transfer of property to an investment company." The phrase "this section" refers to all of § 351, including the general nonrecognition rule in § 351(a).
- Because § 351(a) does not apply, the special basis rules in § 358 (transferor's basis in stock received) and § 362 (corporation's basis in transferred assets) also do not apply.
- Transferors must recognize gain or loss under § 1001.
- The amount realized equals the fair market value of the stock received (plus the fair market value of any boot, such as cash or other property).
- The adjusted basis is the transferor's adjusted basis in the property contributed.
- Gain or loss equals amount realized minus adjusted basis.
- Unlike § 351(a), there is no limitation to gain recognition only. Built-in losses are recognized.
- The transferor's basis in the stock received equals its fair market value (not carryover basis).
- Because the transfer is taxable, the transferor takes a cost basis in the stock received under § 1012.
- The holding period in the stock begins on the date of transfer. § 1223(1) tacking does not apply because § 351(a) does not apply.
- The corporation's basis in the assets received equals their fair market value (not carryover basis).
- § 362(a) (carryover basis with gain step-up) does not apply because § 351(a) does not apply.
- The corporation takes a fair market value basis in each asset received under § 1012.
- The corporation's holding period in the assets begins on the date of transfer.
- Character of gain or loss depends on the nature of the assets transferred.
- If the transferred assets were capital assets in the transferor's hands, the gain or loss is capital gain or loss under § 1221.
- If the transferred assets were inventory or other property used in a trade or business, the gain or loss may be ordinary income or subject to § 1231.
- Each asset is analyzed separately to determine its character.
- If multiple transferors contribute and only some achieve diversification, an open question exists regarding which transferors are taxed.
- The statute states that "this section shall not apply to a transfer of property to an investment company." § 351(e)(1). This language suggests that ALL transferors to an investment company may be taxed, not just the transferors whose contributions caused the diversification.
- However, IRS practice through PLRs appears to tax only the diversifying transferors.
- The NYSBA Report (2011) recommends that only the transferors who actually achieve diversification should be subject to gain recognition, while transferors who contribute identical or already-diversified assets should retain nonrecognition treatment.
- TRAP. Until Treasury or the courts resolve this issue, practitioners should advise clients that ALL transferors to an investment company may face gain recognition.
- CAUTION. Advise clients on estimated tax payments if § 351(e) will apply.
- Because the transfer becomes fully taxable, transferors may owe substantial tax on built-in gains.
- Failure to make adequate estimated tax payments may result in penalties under § 6654 (individuals) or § 6655 (corporations).
- Coordinate the § 351(e) analysis with the client's overall tax planning to avoid underpayment surprises.
Even when a transaction technically satisfies the regulatory tests for § 351 nonrecognition, judicial anti-abuse doctrines may recharacterize the transaction or collapse multiple steps. These doctrines operate as an overlay on the statutory framework and must be considered in every § 351(e) analysis.
- Courts have developed three distinct tests for applying the step-transaction doctrine.
- (1) Binding commitment test. Commissioner v. Gordon, 391 U.S. 83 (1968). Steps will be collapsed only if there was a binding commitment to take later steps at the time the first step was undertaken. This is the narrowest test.
- (2) Mutual interdependence test. American Bantam Car Co. v. Commissioner, 11 T.C. 397 (1948), affirmed, 177 F.2d 513 (3d Cir. 1949). Steps will be collapsed if they are so interdependent that the legal relations created by one transaction would be fruitless without completion of the series.
- (3) End result test. Penrod v. Commissioner, 88 T.C. 1415 (1987). Steps will be collapsed if they appear to be "really arranged parts of a single transaction intended from the outset to reach the ultimate result." This is the most expansive test.
- Rev. Rul. 70-140, 1970-1 C.B. 73 is the foundational authority on step-transaction collapse in the § 351 context.
- Facts. A, the sole shareholder of X, transferred sole proprietorship assets to X in exchange for additional X stock. Then, pursuant to a prearranged plan, A transferred all X stock to unrelated Y corporation solely in exchange for Y voting stock.
- Holding. The two steps were collapsed. A was treated as transferring the sole proprietorship assets directly to Y in a taxable transaction, not as a § 351 exchange followed by a § 354 exchange.
- Rationale. The intermediate receipt of X stock was transitory and without substance. The steps were parts of a prearranged plan, and there was no alternative structure that would have achieved the desired result tax-free.
- Rev. Rul. 2003-51, 2003-1 C.B. 938 distinguishes Rev. Rul. 70-140 where an alternative structure exists.
- Facts. W formed Z by transferring business assets to Z for all Z stock. Immediately thereafter, W contributed all Z stock to Y in exchange for Y stock, while X simultaneously contributed cash to Y for Y stock. After all steps, W and X owned 40% and 60% of Y.
- Holding. The initial transfer to Z qualified under § 351 because the parties could have structured the transaction differently and still achieved nonrecognition treatment.
- Rationale. "In Rev. Rul. 70-140, there was no alternative form of transaction that would have qualified for nonrecognition treatment. In contrast, in this case, W's transfer of the business A assets to Z was not necessary for W and X to combine their business A assets in a manner that would have qualified for nonrecognition of gain or loss under § 351."
- Significance. Where an intermediate step is NOT necessary to achieve the desired tax result, the step-transaction doctrine may not apply even if the steps were prearranged.
- Gregory v. Helvering, 293 U.S. 465 (1935) is the foundational case for substance-over-form analysis.
- Facts. Mrs. Gregory owned all the stock of United Mortgage Corporation, which held 1,000 shares of Monitor Securities Corporation. For the sole purpose of transferring the Monitor shares to herself at reduced tax cost, she caused Monitor to transfer its assets to a newly formed Averill Corporation, then immediately liquidated Averill and distributed the Monitor shares to herself.
- Holding. The Supreme Court held that the transaction was not a true "reorganization" entitled to nonrecognition. The Court found the transaction had "no business or corporate purpose" and was "a mere device which put on the form of a corporate reorganization as a disguise for concealing its real character."
- Application to § 351(e). Analogous reasoning applies. If an incorporation serves no business purpose and is merely a device to achieve tax-free diversification, courts may recharacterize the transaction as a taxable exchange regardless of formal compliance with § 351.
- § 7701(o) codified the economic substance doctrine and applies to transactions where the doctrine is relevant.
- § 7701(o)(1) provides that a transaction shall be treated as having economic substance only if (A) the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer's economic position, AND (B) the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into the transaction.
- This conjunctive test (both prongs required) applies to all transactions "to which the economic substance doctrine is relevant." § 7701(o)(2)(A).
- Penalties. § 6662(b)(6) imposes a 20% penalty on underpayments attributable to transactions lacking economic substance, increasing to 40% if relevant facts are not adequately disclosed.
- TRAP. A transaction structured solely to avoid § 351(e) may be recharacterized under substance-over-form or economic substance principles.
- Example. A group of investors forms a corporation with 20% operating assets solely to avoid the 80% investment company threshold, with a prearranged plan to dispose of the operating assets shortly after formation. The IRS may collapse the transaction and apply § 351(e) on substance-over-form grounds.
- Ensure that any incorporation has a genuine non-tax business purpose (limiting liability, facilitating capital raising, centralized management) and produces a meaningful change in the taxpayer's economic position.
- Lucas v. Earl, 281 U.S. 111 (1930) established that income is taxed to the person who earns it.
- The Supreme Court held that "the fruits [of income] cannot be attributed to a different tree from that on which they grew."
- In the incorporation context, the assignment of income doctrine may apply where a transferor contributes income-producing property to a corporation but retains effective control over the income-generating activities.
- § 482 authorizes the IRS to allocate income among commonly controlled taxpayers to prevent tax evasion or clearly reflect income.
- § 482 applies where "two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests" engage in transactions that do not reflect arm's-length terms.
- In the § 351 context, § 482 may be used to reallocate income from a corporation to a controlling shareholder where the financial relations do not reflect arm's-length dealing.
- G.D. Searle & Co. v. Commissioner, 88 T.C. 252 (1987) is the leading case on the interplay between § 482 and § 351.
- Facts. G.D. Searle transferred intangible property to its wholly owned subsidiary SCO in a § 351 exchange. The IRS sought to reallocate income from SCO back to Searle under § 482.
- Holding. The Tax Court held that § 482 may be applied even in nonrecognition transactions governed by § 351. Treas. Reg. § 1.482-1(d)(5) specifically authorizes § 482 allocations in § 351 transactions where necessary to prevent tax avoidance or clearly reflect income.
- Significance. Even when § 351 nonrecognition technically applies, the IRS may use § 482 to reallocate income. This provides an alternative enforcement mechanism in cases where taxpayers structure around § 351(e).
- Eli Lilly & Co. v. Commissioner, 84 T.C. 996 (1985), affirmed in part and reversed in part, 856 F.2d 855 (7th Cir. 1988) reinforces the application of § 482 to nonrecognition transactions.
- The Seventh Circuit affirmed the Tax Court's application of the arm's-length principle under § 482 to reallocate income between a parent corporation and its subsidiary following a § 351 transfer.
- The court held that § 482 can override nonrecognition treatment where the transfer does not reflect arm's-length terms.
Thorough documentation and timely reporting are essential when § 351(e) applies or may apply. The principal reporting obligations are Form 926 for transfers to foreign corporations, Form 8865 for partnership contributions, and Form 5471 for ongoing foreign corporation ownership. Significant penalties attach to noncompliance.
- Maintain a schedule of all contributed assets with fair market value and adjusted basis for each asset.
- The schedule should identify the transferor, the asset description, the date acquired, the adjusted basis, the fair market value at contribution, and the resulting built-in gain or loss.
- This schedule is the foundation for the 80% test calculation, the diversification analysis, and the gain/loss computation if § 351(e) applies.
- Document whether each asset is a listed investment asset under § 351(e)(1)(B).
- For each asset, determine whether it falls within the statutory list (money, stocks, securities, evidences of indebtedness, options, derivatives, foreign currency, REIT/RIC interests, convertible instruments, precious metals, or interests in entities covered by clauses (vi) and (vii)).
- Assets not on the closed list do not count toward the 80% test, regardless of whether they are held for investment.
- Document whether the transferee meets the 80% test (with calculations).
- Prepare a workpaper showing the numerator (value of listed investment assets held for investment that are readily marketable) and the denominator (total asset value excluding cash and nonconvertible debt obligations).
- If subsidiary look-through applies, prepare a separate workpaper for each subsidiary showing the attributed assets.
- Document the diversification analysis (identical vs. nonidentical assets).
- Identify each transferor and the assets contributed by each transferor.
- Determine whether two or more transferors contributed nonidentical assets.
- If applicable, document the de minimis exception (showing that nonidentical assets constitute an insignificant portion of total value).
- If applicable, document the diversified portfolio exception (showing that each transferor's portfolio satisfies the 25/50 tests of § 368(a)(2)(F)(ii) as modified by Treas. Reg. § 1.351-1(c)(6)).
- Preserve evidence of any plan (or lack thereof) for post-transfer asset changes.
- If post-transfer asset sales or purchases are anticipated, document whether they were planned at the time of transfer.
- Written board resolutions, contribution agreements, and offering materials may be scrutinized by the IRS as evidence of a plan.
- If no plan exists, consider documenting the lack of a plan through contemporaneous memoranda or legal opinions.
- Retain opinion letters or ruling requests.
- A legal opinion from qualified tax counsel documenting the § 351(e) analysis may support a reasonable cause defense if the IRS challenges the transaction.
- A PLR from the IRS provides the highest level of certainty, though PLRs are binding only on the requesting taxpayer and may not be cited as precedent under § 6110(k)(3).
- Form 926 (Return by U.S. Transferor of Property to a Foreign Corporation) must be filed under § 6038B when property is transferred to a foreign corporation in a § 351 exchange.
- The form must be filed with the transferor's income tax return for the taxable year that includes the date of transfer. Treas. Reg. § 1.6038B-1(b)(1).
- When § 351(e) applies, the transferor must report the FULL gain recognized on the transfer (not zero gain as on a qualifying § 351 transfer).
- Required information includes the description of property transferred, fair market value, adjusted basis, gain recognized, and the transferor's ownership percentage before and after the transfer.
- Form 8865 (Return of U.S. Persons With Respect to Certain Foreign Partnerships) applies to partnership contributions subject to § 721(b).
- Schedule O of Form 8865 reports transfers of property to a foreign partnership.
- A U.S. person must file if the person owned directly or constructively at least a 10% interest in the foreign partnership immediately after the contribution, or if the value of property contributed exceeded $100,000. Treas. Reg. § 1.6038B-2(c).
- Form 5471 (Information Return of U.S. Persons With Respect to Certain Foreign Corporations) applies to 10%+ owners of foreign corporations.
- Form 5471 is not directly triggered by the § 351(e) analysis but by the ownership structure resulting from the transfer.
- Category 3 filers (U.S. persons who acquire 10% or more of a foreign corporation) must file in the year of the § 351 transfer.
- TRAP. The penalty for failure to file Form 926 is 10% of the fair market value of the property transferred, capped at $100,000. § 6038B(c)(1).
- The cap is removed if the failure was due to intentional disregard. § 6038B(c)(1).
- The penalty does not apply if the failure was due to reasonable cause and not willful neglect. § 6038B(c)(2).
- Reasonable cause requires filing an amended return with the delinquent form and a written statement explaining the reasons for the failure. Treas. Reg. § 1.6038B-1(f)(3).
- The statute of limitations on assessment remains open until three years after the IRS receives the required information. § 6501(c)(8).
- Form 5471 penalties are imposed under § 6038(b).
- The initial penalty is $10,000 per form per tax year.
- An additional $10,000 applies for each 30-day period after IRS notice, up to a maximum of $60,000 per form per year.
- Failure to file may also result in a 10% reduction in foreign tax credits, with additional 5% reductions per three-month period after notice. § 6038(c).
- States with rolling conformity automatically adopt federal § 351(e).
- Rolling conformity states (including New York, New Jersey, Colorado, Illinois, Pennsylvania, and Massachusetts) generally conform to the Internal Revenue Code as amended, including § 351(e).
- In these states, if § 351(e) applies for federal purposes, it will also apply for state purposes, and the transfer will be taxable at the state level.
- States with static (fixed-date) conformity may not conform to federal amendments.
- Static conformity states (including California, Texas, Florida, and Georgia) adopt the IRC as of a specific date.
- If a state's conformity date predates a relevant amendment to § 351(e) (such as the 1997 expansion of listed investment assets), the state may apply a different version of the statute.
- Check state-specific treatment of § 351 nonrecognition.
- Even in rolling conformity states, specific decoupling provisions or modifications may affect the application of § 351(e).
- Some states that generally conform to the IRC may have specific exceptions or modifications for investment company transfers.
- When a state does not conform to federal § 351 nonrecognition, the state may tax the transfer even if it is tax-free for federal purposes (or vice versa), and the state basis in the stock and assets may differ from the federal basis.
- EXAMPLE. California historically had partial nonconformity with federal § 351.
- California operates under a static conformity regime. For many years, California's IRC conformity date was January 1, 2015, meaning that federal amendments to § 351(e) enacted after that date would not automatically apply for California purposes.
- Senate Bill 711 (signed October 1, 2025) updated California's conformity date to January 1, 2025, effective for tax years beginning on or after January 1, 2025.
- Even with the updated conformity date, California maintains specific nonconformities with several federal provisions, and practitioners must verify whether California's version of § 351(e) at the relevant conformity date produces the same result as federal law.
- If a transfer is tax-free under federal § 351(a) but taxable under a state's non-conforming rules, the state basis in the stock received and the assets transferred may differ materially from the federal basis, creating ongoing tracking and reporting obligations.