Hedge Fund In-Kind Contributions
Fund managers may allow investors to make “in-kind” contributions to the fund. This means that instead of, or in addition to, a cash subscription, the manager may allow the investor to transfer securities or other assets to the fund in exchange for fund interests. Both managers and investors should be
aware of the tax consequences that arise from such transfers. This post will provide an overview of the general rule and other issues which managers should be aware of with respect to future transactions after an in-kind contribution. We always recommend that managers discuss the tax consequences of any in-kind contribution with tax counsel prior to the contribution and then with respect to any future disposition of the assets which were contributed.
Please note that tax issues are often complex and depend on the facts of a situation. This post is intentionally general and you should not rely on this post with respect to any tax issue. Please see our disclaimer and note we are not providing tax advice.
General Rule
For hedge fund investors, the general rule with respect to in-kind contributions is:
a gain will be recognized on the transfer of stocks or securities to an “investment company” that results in “diversification” of that investor’s interests
Please note that this is a two part test: the transfer must be
- to an “investment company” and
- result in “diversification“
If both parts of the test are not met then there will be no gain on the transfer.
What is an “Investment Company”?
The term “investment company” means an entity with more than 80% of the value of its assets consisting of certain properties including money, readily-marketable stocks or other equity interest, options, futures contracts, derivative financial instruments, and foreign currency. The determination of whether an entity qualifies as an “investment company” is generally made immediately after the transfer of property.
Most hedge funds will qualify as an “investment company” using the 80% test.
What is “Diversification”?
The crucial test for investors is whether or not there is diversification with respect to a transfer. Diversification happens if, at the time of the transfer (i.e. subscription to the fund), two or more investors transfer non-identical assets. In most cases, the determination of whether diversification resulted is made immediately after the transfer of property.
In the following situations, there is generally no diversification:
1. No diversification if identical assets
Example: Individuals A and B organize New Co with 100 shares of common stock. A and B each contribute $500 worth of the only class of corporation X stock, listed on the NYSE, in exchange for 50 shares of New Co stock each.
2. No diversification if “insignificant amount of assets” transferred are non-identical. According to the IRS (in Treasury Regulations and various private letter rulings*), 1% and 5% of non-identical assets were insignificant, but 11% of non-identical assets was significant and resulted in diversification.
Example: Individuals A and B organize New Co with 100 shares of common stock. A contributes $990 worth of the only class of corporation X stock, listed on the NYSE, in exchange for 99 shares of stock. B contributes $10 of readily-marketable securities in corporation Y in exchange for 1 share of New Co stock.
3. No diversification if all investors transfer a diversified portfolio of assets. The term “diversified portfolio of assets” means a portfolio in which not more than 25% of transferred assets are invested in the stock or securities of one issuer and not more than 50% is invested in the stock or securities of five or fewer issuers. Cash transfers are not included in these calculations. There are also restrictions on the inclusion of government securities in these calculations. Each investor to the transaction must transfer diverse portfolios. If one transfers a non-diverse portfolio, all will be taxed on the gains.
Example: Individuals A and B organize New Co with 100 shares of common stock. A and B each contribute $120 worth of the only class of corporation X stock, listed on the NYSE, in exchange for 12 shares of stock; $240 worth of the readily-marketable securities in corporations Y and Z in exchange for 24 shares of stock; and $140 worth of options in exchange for 14 shares of stock.
Issues after an In-Kind Contribution
Both the manager and investor should be aware of the potential tax consequences which follow from an in-kind contribution. The following is a non-exclusive list of tax issues which the manager and investor should consider.
Allocation of Gains and Losses When the Fund Disposes of In-Kind Contributions
If the person making an in-kind contribution does not recognize taxable gains at the time of transfer, then what happens to the gains or losses once there is a disposition of the assets at the fund level? In general, the fund will be required to first allocate the recognized gains and losses to the contributing investor and then pro rata to the other investors. This allocation is required to account for the variation between the fund’s adjusted tax basis resulting from the in-kind contribution and the fair market value of those securities when they were contributed. In essence, the contributing investor will pay the tax, but gets the benefit of the deferral.
Distributing the In-Kind Contributions
If the fund distributes a contributed security (which was not taxed at the time of contribution) to an investor other than the person who made the in-kind contribution anytime within 7 years of the contribution, such person will generally recognize the unrealized gain or loss at the time of the distribution.
Two Year Rule
If the fund makes a distribution of cash to a person who made an in-kind contribution simultaneously with or after the contribution, the contribution may be treated as if such person sold the securities to the fund for fair market value–resulting in recognized gain. In fact the Treasury Regulations has established a rebuttable presumption about such a situation–if an person who made an in-kind contribution receives a distribution within 2 years after contributing securities, the distribution will be deemed to have been part of a disguised sale. Such person can rebut the presumption by demonstrating that when it made the contribution, it did not intend to receive a distribution of cash in exchange or that the investment is subject to the appreciation or depreciation of the fund’s assets while invested.
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Cole-Frieman & Mallon LLP provides comprehensive hedge fund formation and other legal services. Bart Mallon can be reached directly at 415-868-5345.