Swap_Funds

Research Paper: “Swap Funds” Section 351(e) Introduction: Presently the law states that a contribution of property to a corporation does not result in gain or loss to the contributing shareholder if the contributor is part of a group of contributors who own eighty percent of the voting stock of each class of stock entitled to vote. Certain Internal Revenue Code sections provide exceptions to this general rule for deferral of gain and loss. One such exception requires that gains or losses be recognized upon a contribution by a shareholder to a corporation that is an investment company under §351(e). Many wealthy investors may have a large amount of stock of one company that may have appreciated in value, and for them to diversify their portfolio may cause serious tax consequences. The investors can sell the stock and incur capital gains on the amount that exceeds their basis in the stock and then use the proceeds to buy a variety of stocks to diversify their portfolio. Investors look for some way to diversify without incurring the capital gains, and for years there was a way to do just that. If there are a number of individuals each with large holdings in different types of stock, they could form a mutual fund or a regulated investment company, which is treated like a corporation for tax purposes. This is essentially like a §351 exchange; the mutual fund receives all the various stocks of the individuals, which is considered property, then issues the individuals the new fund’s stock. With this transaction the investors have essentially diversified their portfolios while maintaining some interest in the original shares, and they have escaped capital gains because of §351. These funds were known as “swap funds,” and until 1976 they escaped taxation. In 1976, Congress added §351(e) to the Internal Revenue Code, which excludes under §351 transfers to investment companies. History: For years people were creating “swap funds” to diversify their portfolios, and there were no tax consequences for those involved. As is noted above, these “swap funds” were designed for stockholders with a large interest in a single stock and had a desire to avoid capital gains taxes. In the 1950’s and early 1960’s, when they were especially popular, capital gains rates were around twenty-five percent, which lead to a fast rise in popularity in these funds, especially compared to other mutual funds. The first one was created by Denver Banker William M.B. Berger, who had a bright idea about §351(a). He initially created the Centennial Fund, which had 191 investors, whose securities were worth $25,800,000. After people noticed the potential in Berger’s idea, a number of different “swap funds” emerged. It is estimated that in the early 1960’s some 24,000 people had nearly $1 billion worth of deposits in such funds. The shareholders ranged from business moguls to Sears employees who retired with large blocks of Sears’ stock. During the 1950’s and early 1960’s, the IRS issued responses to hundreds of private letter rulings regarding these funds. In all of the responses the IRS stated that the transactions were good under §351, but things did not remain like this for long. In 1962, the IRS announced in Revenue Procedure 62-32 that it would no longer issue rulings involving “swap funds.” This did not stop the creation of “swap funds.” At that time every tax professional was recommending this transactions to his clients that wanted to diversify. In 1966, Treasury took steps to eliminate the tax-free treatment of “swap funds” when it issued a proposed regulation that disallowed the non-recognition of taxes on future “swap funds”. This proposed regulation was confirmed the same year, and it affected all “Swap funds” that were created after June 30, 1967, by excluding investment companies from the definition of corporations under §351. This regulation in effect did away with the tax-free nature of “swap funds.” Brokers at the time insisted that the Government was making a mistake by ending the “swaps” based on the idea that they were depriving the United States of capital gains revenue. The brokers also believed that the stockholders were not likely going to sell the stocks they held and pay the tax. Therefore the Government collects taxes when fund managers sell off some shares to pay costs or make portfolio changes. These financial advisors did not only have their client’s interest in mind; at that time their commissions averaged $2,975 on “swap funds” and only $80 for a typical NYSE transaction. The subsequent enactment of §351(e) in 1976 basically stated that the “swap funds” would not be allowed, and was simply a more authoritative restatement of what the Treasury regulation already stated. Minor changes were made to the wording of the statute, but in 1997 more drastic changes were made due to the Taxpayer Relief Act. The scope of investment companies and diversification were widened to prevent investor’s transactions from escaping taxation. Internal Revenue Code and Regulations: Section 351(e) is written to provide an exception to what will be considered tax-free according to the general §351 rules. The first part of §351(e), which deals with investment companies and what is considered a stock or security, reads: (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 stocks 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… This is not an exhaustive list of what Congress will consider stocks or securities; it also allows for the Secretary of the Treasury to create regulations that further expand the scope. The details of how to deal with these transactions are not elaborate upon in the Code section, but Treasury regulations §1.351-1 provides more clarifications to taxpayers and preparers. According to the textbook, Treasury Regulation §1.351-1 describes what outcomes will qualify the transferee as an “investment company.” If directly or indirectly, the transferor’s investments are diversified because of a transaction with the transferee, who is “a regulated investment company, a real estate investment trust, or a corporation more than eighty percent of the value of the asset of which is held in readily marketable stocks or securities or similar transferable interest” then it is an “investment company.” Also the regulation defines what Treasury considers diversification, which is when “two or more persons transfer nonidentical assets to a corporation in the exchange.” This definition is so broad though that it seems not only “swap funds” will be affected by the diversification issue. Taxpayers should be extremely careful of any §351 transactions they participate in that involve an “investment company.” Taxpayer Relief Act of 1997: In the Senate Committee Report entitled “Limitation on Exception for Investment Companies under Section 351” of the Taxpayer Relief Act of 1997, the authors elaborated on the reasons for the law and certain changes to better ensure these transactions do not escape taxation. They were most concerned with certain “swap funds” that fall outside of the definition of investment companies and may go without being taxed. Under the law and regulations in 1997, a corporation was not treated as an investment company even though more than eighty percent of its assets were a combination of readily marketable stock and securities and other liquid investment assets, such as foreign currency and interests in metals. Therefore a shareholder could contribute such assets to a corporation and, without current taxation, receive an interest in an entity that was essentially a portfolio of investment assets. Where, as a result of such a transaction, the shareholder has diversified or otherwise changed the nature of the financial assets in which it has an interest, the transaction has the effect of a taxable exchange. Certain “swap funds” at the time were being structured to fall outside the definition of an investment company and contributors were not being taxed. The Taxpayer Relief Act of 1997 modified the definition of an investment company for purposes of determining whether a transfer of property to a corporation results in gain recognition by requiring that certain assets be taken into account for purposes of the definition, in addition to readily marketable stock and securities as under the law at the time. Now an investment company includes any corporation “if more than eighty percent of its assets by value consist of money, stocks and other equity interests in a corporation, evidences of indebtedness, options, forward or futures contracts, notional principal contracts or derivatives, foreign currency, certain interests in precious metals, interests in REITs, RICs, common trust funds and publicly- traded partnerships or other interests in non-corporate entities that are convertible into or exchangeable for any of the assets listed.” Other assets that count toward the eighty-percent test are an interest in an entity substantially all of the assets of which are assets listed, and to the extent provided in Treasury regulations, interests in other entities, but only to the extent of the value of the interest that is attributable to assets listed. Finally, the bill granted authority to the Treasury to add other assets to the list set out in the provision, or, under certain circumstances, to remove items from the list. IRS Publications on the Issue: The IRS was released two important Revenue Rulings regarding §351(e). In Revenue Ruling 87-27 the IRS takes the position that the requirement that two or more persons transfer nonidentical assets to the corporation will be satisfied even if one group transfers stock of a single corporation and the other group only transfers cash. According to this, taxpayers must be very careful regarding the type of property that they transfer into the investment company. Also in Revenue Ruling 88-32, if a taxpayer “transfers stock of one corporation to a newly created corporation by the transferors followed by the sale of the transferred stock and purchase of other stocks and securities by the transferee corporation do not constitute transfers to an investment company within the meaning of section 351(e) of the Code.” This type of transaction qualifies for nonrecognition under §351(a). This means that if persons transfer all one type of stock to a new corporation, and because an already established plan the new corporation sells the stock received and purchases new stock and securities to diversify, then no gain or loss will be recognized on the original transaction. This is tax-free under §351(a) since Treasury Regulation §1.351-1(c)(2) provides that the determination of whether a corporation is an investment company is ordinarily made by reference to the circumstances in existence immediately after the transfer in question. Immediately after the initial transaction, the new corporation will not be an investment company. While the end result is diversification to the transferor, the IRS does not feel this type of diversification falls under the rules established by the Treasury regulations. Stock and Securities: Section 351(e) provides a list of items that will be considered stocks and securities, and then leaves Treasury the right to come up with even more items that qualify. This means that investors need to be aware of what can cause their transactions to meet the requirements of §351(e) and what qualifies a corporation as an investment company. For the purpose of the eighty percent test regarding investment companies, money is included in calculating the percentage. This was added in 1997 with the Tax Relief Act so that Congress could expand what transactions fall under §351(e). Still in regards to money, Congress noted how they wanted it to be dealt with, “under this provision in the regulations should have the effect that where money is contributed and, pursuant to a plan, assets not treated as stock or securities under the bill are either purchased or contributed by other parties, the investment company determination would be made only on the basis of the entity's assets after such events.” Other assets that count as stocks and securities for the eighty percent rule are evidences of indebtedness, options, forward or futures contracts, notional principal contracts or derivatives, foreign currency, certain interests in precious metals, interests in REITs, RICs, common trust funds and publicly-traded partnerships or other interests in non-corporate entities that are convertible into or exchangeable for any of the assets listed. An example of one of the above items is if a corporation has a 5% interest in a partnership, which is not an asset included in the list. The corporation currently has the right to exchange its interest for the partnership's interest in a REIT that comprises less than 10% of the partnership's assets. The corporation’s interest in partnership is the type of exchangeable equity interest covered and the corporations must take its value into account. Effects of §351(e): As is mentioned above, if §351(e) applies to a transaction, the transferors must recognized gain or loss on the property transferred to the corporation. One of the drawbacks of this law is that it operates as a cliff. If several taxpayers transfer property and just one of the taxpayer’s transfers qualify under §351(e), they are all subject to tax on the transfer. With this as the rule, taxpayers and their advisors need to be aware of all the rules so they can discern whether or not §351(e) will apply. In Revenue Ruling 87-9, the IRS has established that (1) there has to be more than one transferor and (2) nonidentical asset have to be transferred. If the first transferor transfers one type of stock and the second transfers only cash, then it will treat it as a §351(e) transaction. It is clear that the IRS will treat cash as an investment asset. In situation where a new corporation is being formed, it is easier to handle then transfers to existing corporations because the new one has no assets of its own to consider. Only the assets being transferred in need to be considered when a new corporation is being created. Also based on Letter Ruling 200931042, tax professionals must look into whether or not the transferee entity already owns a diversified portfolio as well as the transferors. The regulations, allows tax-free status to those who are already diversified but only if all transferors are already diversified. Richard W. Bailine, a partner a KPMG’s Washington National Tax Corporate Tax practice, discusses that fact that there is not a lot of information to be found on §351(e) in revenue rulings and treasury regulations. There are a number of letter rulings that provide information to taxpayers and professionals on this issue, but they may not be relied on. Bailine feels that the IRS needs to invest more time in explaining the effects of these transactions so that there is less ambiguity. Special Rule Regarding “Swap Funds” The latest changes in Treasury Regulation 1.351-1(c)(5) provide that a transfer of stocks and securities is not considered to result in diversification of the transferor’s interest if each transfers a diversified portfolio or stocks and securities. Also a transferor whose interest is already diversified may transfer interest to an investment company and still qualify for nonrecognition treatment under §351(a). Prior to the changes, the regulation provided that 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 and it would not be tax-free. Now the basic rule for whether or not an interest is diversified is if it meets the twenty-five percent and fifty percent tests under §368(a)(2)(F)(ii). Those tests are met if not more than twenty-five percent of the total assets transferred by each transferor consists of stock and securities of a single issuer, and not more than fifty percent of the value of the total assets transferred by each transferor consists of stock and securities of five or fewer issuers. Additionally the Treasury regulations modify the test of §368(a)(2)(F)(ii) by including government securities in total assets. The final regulations make it clear that government securities are included for purposes of the denominator of the tests unless they are acquired to meet the tests, but are not treated as securities of an issuer for purposes of the numerator of the tests. Including government securities in the denominator (but not in the numerator) makes it easier to meet the twenty-five percent and fifty percent tests and thus to avoid gain recognition. Treasury Regulation § 1.351-1(c)(6) ), replacing old Regulation §1.351-1(c)(6), which was redesignated as Regulations § 1.351-1(c)(7). The test can also be applied to test if a corporation is a diversified investment company. If a corporation can meet the twenty-five percent and fifty percent rules, then it will qualify. Also all members of the same controlled group of corporations are treated as one issuer. This applies to transactions of this type occurring after May 1, 1996. Taxpayers have the option to treat the transaction either way if it occurred before the specified date so that they may chose the most favorable result for their overall tax situation. “Swap Funds” Today (Exchange funds: Time to Swap n Save) “Swap funds” are still available today. Many now refer to them as “exchange funds,” and they still promise to postpone your tax bill. It is basically the same type of transaction, but an investor cannot transfer all of their holdings of appreciated stock for a diversified portfolio. It is typically only twenty percent of the stock that investors can transfer and escape capital gains taxes until they subsequently sell the new stock. So how do these funds escape §351(e)' The Internal Revenue Service has set limits, and it says 20% of an exchange fund's holdings must be illiquid. To meet the requirement, most funds buy special securities called partnership preference units, or UPREITS, issued by real estate investment trusts. Shares in the diversified portfolio are locked up for seven years, unless you die or the company whose stock you contributed merges with another. You can get your original contribution back before seven years, but then you'd be back where you started. Also to participate in these funds, the investor needs to have at least $1 million in liquid assets aside from the shares he is swapping. At the end of the seven years, you can receive a diversified basket of stocks. You will pay capital gains taxes if you choose to sell some of those shares, assuming you have gains. This means that if an investor has 100 shares with a cost of $70,000 that are now worth $1 million, he can transfer them to a fund and get a diversified portfolio of various stocks. In seven year, the investor can withdraw this portfolio that still has a cost of $70,00 and pay capital gain taxes. Some investors may choice to avoid taxes completely though by never selling the shares of the fund and simply borrowing against it. The current types of “swap funds” are more restrictive on what stocks they accept and the value of the stocks and can have high fees for entry, which does not allow the typical investor to participate. Conclusion: The goal of §351(e) is to prevent people who have undiversified portfolios from diversifying under §351(a). Until the 1960’s people were diversifying in this way by investing in “swap funds.” When the Government realized that they were missing out on capital gains taxes, they put and end to such transactions. Above I have provided the history of “swap funds,” and how they went from being accepted by the IRS to almost completely disallowed some years later. The Code and Treasury regulations have established general guidelines for what transactions will meet §351(e) status, but there are still plenty of vague aspects of the law. Today certain investors can still engage in these “swap funds,” but they differ substantially from the original funds started in the 1950’s due to all the rules. With the broad scope of §351(e), it is essential that taxpayers and professionals are aware of what may cause §351(e) to apply because the tax consequences may be very costly. -------------------------------------------- [ 1 ]. RIA: History for Code Section 351 [ 2 ]. “Wall Street: A Stop to the Swap” [ 3 ]. “Wall Street: A Stop to the Swap” [ 4 ]. McDaniel,etc al., Federal Income Taxation of Business Organizations [ 5 ]. Rev Proc 62-32, 1962-2 CB 527 [ 6 ]. Treasury Regulation §1.351-1 [ 7 ]. “Wall Street: A Stop to the Swap” [ 8 ]. Treasury Regulation §1.351-1(c)(5) [ 9 ]. Treasury Regulation §1.351-1(c)(1) [ 10 ]. Committee Report: “Limitation on Exception for Investment Companies under Section 351” [ 11 ]. Committee Report: “Limitation on Exception for Investment Companies under Section 351” [ 12 ]. Committee Report: “Limitation on Exception for Investment Companies under Section 351” [ 13 ]. Revenue Ruling 87-27 [ 14 ]. Revenue Ruling 88-32 [ 15 ]. Treasury Regulation §1.351-1(c)(2) [ 16 ]. Committee Report: “Limitation on Exception for Investment Companies under Section 351” [ 17 ]. S Rept No. 105-33 (PL 105-34) p. 131 [ 18 ]. S Rept No. 105-33 (PL 105-34) p. 131 [ 19 ]. Bailine, Richard W., “Time for the IRS to Invest in Investment Companies.” [ 20 ]. Revenue Ruling 87-9 [ 21 ]. Bailine, Richard W., “Time for the IRS to Invest in Investment Companies.” [ 22 ]. Bailine, Richard W., “Time for the IRS to Invest in Investment Companies.” [ 23 ]. McDaniel,etc al., Federal Income Taxation of Business Organizations [ 24 ]. §368(a)(2)(F)(ii). [ 25 ]. Treasury Regulation § 1.368-3(c)(6) [ 26 ]. Treasury Regulation § 1.351-1(c)(6) ) [ 27 ]. Treasury Regulation § 1.351-1(c)(6) [ 28 ]. Businessweek:”Exchange Funds: Time to Swap and Save” [ 29 ]. 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