What Is a Diversification Test for Tax Purposes?

A diversification test is a set of standards applied to certain investment funds to ensure their assets are not overly concentrated. These rules are a condition for receiving special tax treatment, allowing investment income and gains to pass directly to shareholders without being taxed at the fund level. The regulations verify that a fund is genuinely diversified, preventing it from being used to hold a few securities while still receiving tax advantages.

Asset Diversification Requirements

The specific asset diversification rules are measured at the close of each quarter of a fund’s taxable year. These regulations are most commonly associated with Regulated Investment Companies (RICs) and are broken down into two components: the “50% test” and the “25% test.” Meeting these quarterly tests is required to maintain tax-favored status.

The 50% test requires that at least half of a fund’s total assets consist of cash, cash items, U.S. government securities, securities of other RICs, and other securities. Within this portion of the portfolio, a fund’s investment in any single issuer cannot exceed 5% of the fund’s total asset value. The fund also cannot own more than 10% of that issuer’s outstanding voting securities.

For a fund with $100 million in total assets, the 50% test requires at least $50 million to be held in qualifying assets. If the fund invests in corporate stocks as part of this $50 million, its holding in any single corporation cannot be valued at more than $5 million. Additionally, the fund cannot own more than 10% of that company’s total voting shares.

The 25% test limits concentration for the entire portfolio. This rule states that no more than 25% of the value of the fund’s total assets may be invested in the securities of a single issuer. This limitation also applies to investments in two or more issuers that are controlled by the fund and engaged in the same or similar lines of business.

Using the same $100 million fund, the 25% test means the fund cannot invest more than $25 million in the securities of any one company. For example, an investment of $30 million into a single company would cause the fund to fail this test for the quarter.

Investment Vehicles Subject to Testing

Several investment products must comply with asset diversification rules to maintain their tax advantages. The most common are Regulated Investment Companies (RICs), which include mutual funds and exchange-traded funds (ETFs). Meeting the requirements in Section 851 of the tax code is necessary for these entities to achieve pass-through tax status.

The insurance industry also applies these tests to the segregated asset accounts that fund variable annuity and variable life insurance contracts. Under Internal Revenue Code Section 817, these accounts must meet diversification standards similar to the RIC rules. This ensures the policyholder does not have excessive control over investment decisions, which preserves the tax-deferral benefits of the insurance contract.

Real Estate Investment Trusts (REITs) are subject to their own asset diversification tests tailored for real estate holdings under IRC Section 856. These rules require REITs to hold a high percentage of their assets in real estate, cash, and government securities. The rules also limit the concentration of non-real estate securities, with one test restricting a REIT from having more than 5% of its asset value in any single issuer’s securities. Compliance allows the REIT to function as a pass-through entity.

Consequences of a Test Failure

If an investment fund fails to meet asset diversification requirements at a quarter’s end, it risks losing its tax-favored status for that year. A Regulated Investment Company (RIC), for example, would be taxed as a standard C corporation. This results in double taxation, where the fund’s income is taxed at the corporate rate, and shareholders are taxed again on dividends.

The Internal Revenue Code provides “cure provisions” that allow a fund to fix a failure and avoid disqualification, provided the failure was due to “reasonable cause.” One remedy is a 30-day cure period. If a failure results from acquiring a security, the fund has 30 days after the quarter’s end to eliminate the discrepancy and restore compliance.

For failures not fixed within the initial 30-day window, another cure is available. The fund must dispose of the non-compliant assets within six months of the end of the quarter in which the failure was identified. This provision is available for both minor and significant failures, though penalties may differ.

Using the six-month cure provision often requires the fund to pay a penalty tax. For failures that are not de minimis, this tax is the greater of $50,000 or an amount based on the net income from the non-compliant assets. A de minimis failure, which is a discrepancy of less than $10 million or 1% of the fund’s total assets, can be cured within six months without a monetary penalty.