There is a potential income tax trap involved with setting up a partnership holding stocks and other portfolio investments. Under a partnership tax rule (IRC § 721(b)), gain is recognized on the transfer of appreciated property to a partnership if the partnership constitutes an investment company. An investment company is generally a partnership where more than 80% of the value of the assets (excluding cash and nonconvertible debt obligations) are held for investment and are readily marketable stock or securities or other interests. The reason for this rule is to avoid a perceived abuse where two or more individuals would combine their portfolios as an indirect method of diversifying the portfolios rather than selling stock and reinvesting to diversify.
3.1.1 There will be no deemed diversification if the portfolios being combined meet certain highly technical tests. Under a corporate rule ( § 368(a)(2)(F)(ii)) which is held to apply in the partnership setting, if not more than 25% of the value of the total assets are invested in stocks and securities of any one issuer and not more than 50% of the value of the total assets is invested in stocks or securities of five or fewer issuers, then the investment company will be considered not to have tripped the diversification rule. There are at least two letter rulings supporting this rule (Private Letter 9328035 and Private Letter 9310019). In these letter rulings, the contribution of property into a partnership was held not to create diversification for the transferors if they fell within the guidelines outlined above. Obviously, we will have to examine carefully the nature and value of the assets as we combine the portfolios in this partnership.