Using LLCs to Hold Paper Assets

LLC-Protect-Paper-Assets

Many of our clients hold their stocks, bonds and other paper assets in the name of an LLC. If sued personally they will benefit from the charging order protections in strong states like Wyoming. Conversely, if they hold brokerage account(s) in their individual name a creditor can reach such accounts without a problem. Using an LLC to hold paper assets is good planning.

When transferring the brokerage account from your name to the LLC name there is no taxable event. You haven’t really “sold” your stock. You’ve just changed how the assets are held – from 100% you to 100% of a new LLC owned by you. This is done thousands of times all of the time without a problem or a whiff of taxation.

One Person is Fine – Joining Forces May be Taxing

But what if you and another person want to use the same LLC to hold your respective brokerage accounts? Wouldn’t it be cheaper to use one LLC instead of two?

You must be careful here. The savings of a few hundred dollars may be far outweighed by the taxation and complications of now being considered an investment company or investment partnership.

What follows is a fairly technical discussion of the applicable law. The short answer here is to only use one LLC for one person’s holdings. Joining together with two or more people can be taxing.

Husband and wife holding paper assets as jointly held or community property assets will be treated as one owner. But a husband and wife bringing separate property into one LLC can be counted as two persons and subject to the strict rules ahead.

APPLICABLE LAW

Under federal law, 26 U.S.C. § 721, pertaining to “[n]onrecognition of gain or loss on contribution,” provides in relevant portion:

“(a) GENERAL RULE

“No gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership.

“(b) SPECIAL RULE

Subsection (a) 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.”

In turn, 26 U.S.C. § 351, pertaining to “[t]ransfer to corporation controlled by transferor,” provides in relevant portion:

“(a) GENERAL RULE

“No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control (as defined in section 368(c)) of the corporation.

“(b) RECEIPT OF PROPERTY

“If subsection (a) would apply to an exchange but for the fact that there is received, in addition to the stock permitted to be received under subsection (a), other property or money, then–

“(1) gain (if any) to such recipient shall be recognized, but not in excess of–

“(A) the amount of money received, plus

“(B) the fair market value of such other property received; and

“(2) no loss to such recipient shall be recognized.

“…

“(e) EXCEPTIONS

“This section shall not apply to–

“(1) TRANSFER OF PROPERTY TO AN INVESTMENT COMPANY

“A transfer of property to an investment company. 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), or

“(viii) any other asset specified in regulations prescribed by the Secretary.
The Secretary may prescribe regulations that, under appropriate circumstances, treat any asset described in clauses (i) through (v) as not so listed.”

26 U.S.C. § 368(a)(2)(F)(ii) provides in relevant portion:

“(ii) A corporation meets the requirements of this clause if not more than 25 percent of the value of its total assets is invested in the stock and securities of any one issuer, and not more than 50 percent of the value of its total assets is invested in the stock and securities of 5 or fewer issuers. For purposes of this clause, all members of a controlled group of corporations (within the meaning of section 1563(a)) shall be treated as one issuer….”

BRIEF DISCUSSION

Generally speaking, neither realized gain nor realized loss is recognized when property is contributed to a partnership in exchange for a partnership interest. See, 26 U.S.C. § 721(a). However, the general non-recognition rule contained in above-quoted 26 U.S.C. § 721(a) does not apply where gain is realized upon a contribution of property to an “investment partnership” and the contribution results, either directly or indirectly, in the diversification of the transferor’s interest. See, 26 U.S.C. § 721(b).

In turn, an “investment partnership” is defined by reference to the definition of an “investment company,” contained in 26 U.S.C. § 351(b). See, 26 U.S.C. § 721(b). The determination of whether a partnership is an “investment partnership” ordinarily is made by reference to the circumstances in existence immediately after the transfer; however, 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. See, 26 C.F.R. 1.351-1(c)(2).

An “investment partnership” is a partnership in which more than 80 percent of the value of the assets of the partnership is from “stock and securities” that are “held for investment.” See, 26 U.S.C. § 721(b); 26 U.S.C. § 351(e)(1).

There is one significant difference between “investment partnerships” under 26 U.S.C. § 721(b) and “investment companies” under 26 U.S.C. § 351(e)(1): with “investment partnerships under 26 U.S.C. § 721(b), realized losses are not recognized. Thus, if a contributing partner contributes a portfolio of stock and securities, the amount of realized gain to be recognized is determined on an asset-by-asset basis, which may result in realized gains being recognized, even though there is a net loss on the portfolio of stock and securities when taken together. On the other hand, both realized gains and realized losses are recognized for transfers to “investment companies” under 26 U.S.C. § 351(e)(1).

According to the Secretary, a transfer ordinarily results in the diversification of the transferors’ interests if two or more persons transfer non-identical assets to a corporation in the exchange. However, if any transaction involves one or more transfers of non-identical assets which, taken in the aggregate, constitute an insignificant portion of the total value of assets transferred, such transfers are disregarded in determining whether diversification has occurred. See, 26 C.F.R. 1-351(c)(5). Similarly, if two or more persons transfer identical assets to a partnership, the transfer generally will not be treated as resulting in diversification.

Significantly, a transfer of stock and securities will not be treated as resulting in a diversification of the transferors’ interests if each transferor transfers a diversified portfolio of stock and securities. A portfolio of stock and securities is considered to be diversified if it satisfies the 25- and 50-percent tests of 26 U.S.C. § 368(a)(2)(F)(ii). See, 26 C.F.R. 1-351(c)(6).

In turn, 26 U.S.C. § 368(a)(2)(F)(ii) provides that a portfolio of stock and securities is considered to be diversified if not more than 25 percent of the value of its total assets is invested in the stock and securities of any one issuer, and not more than 50 percent of the value of its total assets is invested in the stock and securities of 5 or fewer issuers.

In Internal Revenue Service (IRS) Letter Ruling Number 200931042, released July 31, 2009, the IRS concluded that contributions of cash and/or a diversified portfolio of stocks in exchange for a partnership interest did not trigger the gain recognition rules applicable to “investment companies.”

CONCLUSION

Initially, it would appear that, if the LLC in question is being set up for the benefit of only one person, in order to hold only one person’s solitary brokerage account, then there would be no possibility of diversification whatsoever, and accordingly, there would be no possibility of only one person incurring adverse tax consequences as a result of the LLC in question being construed as an “investment partnership” under the provisions of 26 U.S.C. § 721(b) and 26 U.S.C. § 351(b).

On the other hand, if the LLC in question is being set up for the benefit of two or more persons, in order to hold two or more persons’ combined brokerage accounts, then it is entirely possible that, if these two or more persons contribute non-diversified portfolios, consisting of high concentrations of non-identical stock and securities, and/or assets from the other eight (8) proscribed asset classes set forth in 26 U.S.C. § 351(e)(1), then these two or more persons might well experience unexpected and highly undesirable tax consequences. For example, this situation easily might occur if more than 25 percent of the value of the LLC’s total assets were invested in the stock and securities of any one issuer, or if more than 50 percent of the value of the LLC’s total assets were invested in the stock and securities of five (5) or fewer issuers. Clearly, the latter scenario should be avoided at all costs.

On the other hand, if these two or more persons each contribute a diversified portfolio of “stock and securities” that satisfies the 25- and 50-percent tests of 26 U.S.C. § 368(a)(2)(F)(ii), then these two or more persons most likely will not experience any negative tax consequences. See, 26 C.F.R. 1-351(c)(6).

All things considered, it would be best if the LLC in question were being set up for the benefit of only one person, in order to hold only one person’s solitary brokerage account. That way, there would be no possibility whatsoever of diversification, and accordingly, no negative tax consequences as a result of the LLC in question being construed as an “investment partnership” under the provisions of 26 U.S.C. § 721(b) and 26 U.S.C. § 351(b).

That being said, with two or more persons, perhaps the safest and easiest way to avoid any negative tax consequences as a result of the LLC in question being construed as an “investment partnership” under the provisions of 26 U.S.C. § 721(b) and 26 U.S.C. § 351(b), is to avoid meeting the 80% test altogether, by having the LLC own real estate and/or other non-marketable securities that constitute more than 20% of the value (say 33% of the value) of the LLC at the time of the transfer.

26 U.S.C. § 721(b) and 26 U.S.C. § 351(b), together with their accompanying rules and regulations, are quite complex statutes, and they contain many counter-intuitive perils, pitfalls, and unintended consequences for the unwary. Thus, without careful tax planning, the contribution to an LLC by two or more persons of “stock and securities,” and/or assets from the other eight (8) proscribed asset classes set forth in 26 U.S.C. § 351(e)(1), might easily result in unexpected and highly undesirable gain recognition, if the LLC were to be construed as an “investment partnership.” If you want to go this route be certain to work with an experienced CPA or tax attorney.

Otherwise, don’t be penny wise and pound foolish. The safest course is to use one LLC to hold the paper assets of just one individual.

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