Understanding IRS Regulation 1.7704 When Permitting Secondary Transfers

Secondary transfers of private partnership interests must not result in the private partnership becoming publicly-traded within the meaning of IRS Regulation 1.7704. If a private partnership is deemed to be a publicly-traded partnership, it can be taxed as a corporation by the IRS.
General partners should categorize each secondary transfer under one of the “safe harbors” below, plus meet the facts and circumstances” test of IRS 1.7704 for each secondary transfer to ensure that the private partnership is not viewed as having become a publicly-traded partnership. The safe harbor categories are:

a. Standard 2% Transfers. A private partnership can transfer up to 2% of its outstanding interests in a taxable year.
b. QMS Transfers. If transfers are handled by a Qualified Matching Service (QMS), such as the NYPPE, a private partnership can transfer up to 10% of its outstanding interests in a taxable year.
c. Exempt Transfers. If transfers qualify for an exemption, they are not counted in either calculation above. Some popular exempt transfer types are, i) transfers from any related persons in one or more transactions during any 30-calendar-day period representing in the aggregate more than 2% of the total interests in partnership capital or profits; ii) transfers at death, including transfers from an estate or testamentary trust; and iii) transfers between members of a family.
General partners should also be careful not to become actively involved in the transfer process in order to meet the “facts and circumstances test” of IRS 1.7704. Although an interest transfer can meet one of the safe harbors above, if the IRS believes that as a result of the prior actions of the General Partner (including their legal counsel’s actions), a private partnership’s interests have become “readily tradable, when taking into account all of the facts and circumstances”, the IRS can view the private partnership as having become a publicly-traded partnership, and tax the partnership as a corporation.
Many general partners are currently revising their secondary private transfer policies to permit the maximum dollar transfer amount in a taxable year while ensuring their private partnership tax status. In general, secondary transfers should be categorized under one of the safe harbors of IRS 1.7704 and in the following order priority each year: first, as an “exempt” transfer, up to an unlimited dollar amount; second, as a “QMS” transfer, up to an 8% limit; and third, as a standard transfer, up to a 2% limit. By following this basic strategy, general partners can efficiently utilize the safe harbors available under IRS 1.7704 and have maximum flexibility to permit transfers, and thereby, maintain valuable long-term relationships with limited partners.
The role of the QMS is increasingly important to the General Partner. When the QMS handles transfers, the private partnership can a) permit up to 10% of the partnership’s outstanding interests to be transferred versus the standard 2%, each year and b) reduce the risk of being viewed as actively involved in the transfer process under the facts and circumstances test by the IRS, thereby ensuring the tax exempt status of the private partnership.