Publicly Traded Partnership Rules Under Reg. 1.7704-1

A Publicly Traded Partnership (PTP) is a business structure that combines the tax benefits of a partnership with the liquidity of a publicly traded security. Partnerships are treated as “pass-through” entities, meaning income is passed directly to partners for tax purposes. This structure avoids the double taxation that corporations face, where income is taxed at the corporate level and again when distributed to shareholders.

The PTP classification is significant because Internal Revenue Code Section 7704 dictates that a PTP will be taxed as a corporation unless it meets specific exceptions. This reclassification subjects the partnership’s income to corporate tax and treats distributions as dividends. The detailed rules for determining if interests are publicly traded are in Treasury Regulation 1.7704-1, which provides a framework for analyzing trading and offers safe harbors to avoid the PTP designation.

Determining if Partnership Interests are Traded

The determination of whether a partnership is a PTP hinges on how its interests are traded. Treasury Regulation 1.7704-1 establishes two primary tests for this assessment. The first test is whether the partnership interests are traded on an “established securities market.” This includes national securities exchanges registered with the SEC, such as the New York Stock Exchange or NASDAQ, and is also met if interests are quoted on an interdealer system that regularly provides firm buy or sell prices.

The second test is whether the interests are “readily tradable on a secondary market or the substantial equivalent thereof.” This is a facts-and-circumstances analysis that captures arrangements providing liquidity comparable to an established market. A secondary market or its equivalent exists if partners have a readily available, regular, and ongoing opportunity to buy, sell, or exchange their interests, such as when a broker regularly quotes prices.

A secondary market equivalent can also be created if prospective buyers and sellers can transact in a timeframe and with a regularity comparable to a formal market. If the partnership or another party facilitates frequent and regular opportunities for transfers, the interests may be deemed readily tradable. This broad definition requires partnerships not listed on major exchanges to carefully manage how interests are transferred.

Disregarded Transfers in PTP Analysis

In the analysis of whether partnership interests are readily tradable, Treasury Regulation 1.7704-1 specifies several types of “disregarded transfers.” These transfers are excluded from the trading volume calculations used in key safe harbors, allowing partnerships to facilitate certain ownership changes without risking PTP classification. Major categories of disregarded transfers include:

• Private transfers, such as those at death, from an estate, between family members, or as gifts.
• Transfers where the recipient’s tax basis in the interest is determined by the transferor’s basis.
• Issuances of new interests by the partnership in exchange for cash, property, or services.
• Distributions from a qualified retirement plan.

A “block transfer” is also a disregarded transfer. This is a transfer by a partner and any related persons in a 30-day period of interests representing more than 2% of the total interests in the partnership’s capital or profits. This rule allows significant investors to sell large stakes without the transaction being counted as trading for the de minimis safe harbor.

Key Safe Harbors from PTP Classification

Treasury Regulation 1.7704-1 provides several safe harbors that allow a partnership to avoid being classified as a PTP, even if some trading of interests occurs. These safe harbors are practical tools for managing liquidity within tax rules. While failure to meet a safe harbor does not automatically result in PTP status, satisfying one provides certainty.

Private Placement Safe Harbor

To qualify for the private placement safe harbor, a partnership must meet two conditions. First, all interests in the partnership must have been issued in transactions that were not required to be registered under the Securities Act of 1933. Second, the partnership must not have more than 100 partners at any time during its taxable year.

De Minimis Trading Safe Harbor

Under the de minimis trading safe harbor, interests are not considered readily tradable if the sum of the percentage interests in partnership capital or profits transferred during the taxable year does not exceed 2% of the total interests. This 2% threshold provides a clear limit on trading. The calculation of the 2% limit excludes the “disregarded transfers” discussed previously, such as private transfers and block transfers. The partnership must carefully track all transfers to ensure it remains within the 2% limit.

Qualified Matching Service Safe Harbor

A partnership can use a qualified matching service (QMS) to facilitate transfers. A QMS is a system that lists bid and ask quotes to connect buyers and sellers. To be “qualified,” the service must meet several requirements. These include a 15-day waiting period between when an interest is listed and when a binding agreement can be made.

The closing of the sale cannot occur for at least 30 days after the interest is made available. The service cannot display firm price quotes, and total interests transferred through the QMS and other means (excluding private transfers) cannot exceed 10% of total partnership interests for the year.

Redemption and Repurchase Agreement Safe Harbor

Partnerships can also provide liquidity through redemption or repurchase agreements under a specific safe harbor. To qualify for this safe harbor for “closed-end” redemption plans, partners must provide at least 60 days’ notice of their intent to have their interests redeemed. Additionally, the total interests redeemed or repurchased under the agreement during the taxable year cannot exceed 10% of the total interests in partnership capital or profits.

The Qualifying Income Exception

Even if a partnership is classified as a PTP, it can still avoid being taxed as a corporation by meeting the “qualifying income exception.” This exception is found in Section 7704 of the Internal Revenue Code. To meet this exception, the partnership must satisfy a gross income test.

The test requires that for the current taxable year, and all preceding years in which the entity was a PTP, at least 90% of the partnership’s gross income must be “qualifying income.” This 90% test is an ongoing requirement. Failure to meet the test in any given year can result in corporate taxation for that year and all subsequent years.

Qualifying income is generally passive-type income. The primary categories of qualifying income defined under Section 7704 include:

• Interest and dividends.
• Real property rents.
• Gain from the sale or disposition of real property and capital assets held for the production of passive income.
• Income and gains from the exploration, development, mining, production, processing, refining, transportation, or marketing of any mineral or natural resource.