PARTNERSHIP TAXATION II
Tom Henning
Spring Semester 2006
March 2, 2006
PARTNERSHIP DISTRIBUTIONS – § 751 ASSETS
1.
Purpose of § 751(b).
(a)
§ 751 is the provision applicable to transactions that affect the ownership of
partnership ordinary income property, and is generally intended to ensure that
ordinary income inherent in these assets will be recognized by the partners.
While § 751(a) applies to sales and exchanges, § 751(b) applies to distributions.
(b)
Other provisions preserving characterization of income include:
(c)
(i)
§ 735(a) – preserves ordinary income character of § 751 property that is
distributed from a partnership to a partner.
(ii)
§ 732(c)(1) – prevents increase in basis of § 751 property upon its
distribution, thereby assuring that potential ordinary income is preserved.
The general purpose of § 751(b) is to prevent shifting of ordinary income inherent
in § 751 property from one partner to another. The statute does not fully prevent
such shifting, and also triggers both capital gain and ordinary income in
connection with disproportionate distributions even where there is no intention to
shift income. Many believe that the "cure" of § 751(b) is worse than the "disease"
for which it was enacted.
(i)
2.
Partner can receive its share of § 751(b) property in the form of high basis
§ 751(b) property without triggering a deemed exchange. Reg. § 1.7511(g) ex. 5. ("To the extent that inventory was exchanged for accounts
receivable, or to the extent cash was distributed for the release of C's
interest in the balance of the depreciable property and land, the transaction
does not fall within section 751(b). . . .")
§ 751(b) Property Described.
§ 751(b) property, also known as "hot assets," is comprised of the items of property or
income included in the definitions of "unrealized receivables" and "substantially appreciated
inventory."
© 2006 Thomas W. Henning
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3.
(a)
§ 751(c) – Unrealized Receivables. § 751(c) defines "unrealized receivables" to
include, to the extent not previously includible in income under the method of
accounting used by the partnership, any rights (contractual or otherwise) to
payment for (i) goods delivered, or to be delivered, to the extent the proceeds
therefrom would be treated as amounts received from the sale or exchange of
property other than a capital asset, or (ii) services rendered or to be rendered.
(b)
Depreciation Recapture. § 751(c) also provides that for purposes of §§ 731, 732
and 741 (but not § 736), the term unrealized receivables includes § 1245 property,
but only to the extent of the amount which would be treated as ordinary income
under § 1245(a) if such property were sold by the partnership at its fair market
value. § 1245(a)(3) defines § 1245 property to include all tangible and intangible
property which is or has been property of a character subject to the allowance for
depreciation provided in § 167 and which constitutes personal property.
(c)
§ 751(d) – Inventory Items. The other category of hot assets is "substantially
appreciated inventory items". In relevant part, § 751(d) defines inventory items
as (1) property of a partnership of the kind described in § 1221(a)(1), and (2) any
other property of the partnership which, on a sale or exchange by the partnership
or the distributee partner, would be considered property other than a capital asset
and § 1231 property.
(d)
Substantial Appreciation Requirement for Inventory. Unlike § 751(a) transfers, in
the case of a distribution, inventory items must be substantially appreciated to
constitute hot assets. Inventory items are considered to have appreciated
substantially in value and, therefore, to constitute hot assets for purposes of §
751(b), only if, in the aggregate, such inventory items have a fair market value
that exceeds 120% of their adjusted basis. The old requirement that the inventory
exceed 10% of the fair market value of all partnership assets has been eliminated.
Inventory items include accounts receivable. § 751(b)(2); Reg. § 1.751-1(g) ex.
2(c).
Events Triggering § 751(b).
(a)
Section 751(b) is triggered if a partner receives more or less than its share of
§ 751(b) property in exchange for all or part of its interest in "other property,"
which are also known as "cold assets." The converse also triggers § 751(b).
Thus, if a distribution results in a reduction in the distributee's share of one class
of property in exchange for an increase in the other class of property, then
§ 751(b) applies.
(i)
Pro rata distribution to all partners will not trigger § 751(b).
(ii)
Test is made based on the value of a distributee partner's interest in
partnership property, not tax basis, book value or built-in gain.
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4.
5.
(iii)
Shift in partner's share of partnership liabilities triggers a deemed cash
distribution and can trigger § 751(b) if distributee partner's share of
§ 751(b) property has gone down.
(iv)
Revenue Ruling 84-102: addition of a new partner to a partnership
holding both unrealized receivables and liabilities; newly admitted partner
becomes entitled to a share of the unrealized receivables and becomes
liable for a portion of partnership liabilities. Holding: admission of new
partner triggers § 751(b) because each existing partner's share of liabilities
is reduced, resulting in a deemed cash distribution to the existing partners,
and a reduction in each existing partner's share of the unrealized
receivables, resulting in a deemed exchange by the existing partners of a
portion of their interest in unrealized receivables for cash. Query whether
this distribution could arguably fall under the exception for the distribution
of property (cash in this case) previously contributed by the partner.
§ 751(b)(2)(A).
Exceptions.
(a)
Distribution of property which the distributee contributed to the partnership.
§ 751(b)(2)(A).
(b)
§ 736(a) payments in liquidation of a partner's interest, i.e., payments treated as
guaranteed payments or a distributive share of partnership income (which
includes a partner's share of unrealized receivables). § 751(b)(2)(B).
(c)
§ 751(b) does not apply to current drawings, advances against a partner's
distributive share, a payment for services or for the use of capital, or a distribution
which is a gift. Reg. § 1.751-1(b)(1)(ii). Drawings should be treated similarly to
§ 731, i.e., treated as distributions on the last day of the year, and if overall
distributions are disproportionate, then § 751(b) can be triggered.
Mechanics of § 751(b) Exchange.
(a)
A useful tool for analyzing disproportionate distributions is the "Partnership
Exchange Table." McKee, Nelson & Whitmire, "Federal Taxation of
Partnerships and Partners" (3d ed. 1997) 21.03[3]. In order to construct the table,
for each distribution the following amounts should be determined:
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Partnership Exchange Table
(1)
Value
Distributee's
Post-Distribution
Interest
(2)
+
Value
Distributee's Actual
Distribution
(incl. § 752(b))
(3)
-
Value
Distributee's
Pre-Distribution
Interest
(4)
=
Increase
(Decrease) in
Distributee's
Interest
Hot Assets
-- Inventory
-- Receivables
-- Depreciation
Recapture
TOTAL
Cold Assets
-- Capital assets
-- § 1231 property
TOTAL
(b)
(c)
If the total in column 4 is positive for one class of property and negative for
another, then a disproportionate distribution has occurred. A disproportionate
distribution is divided into:
(i)
First, a § 751(b) deemed distribution;
(ii)
Second, a § 751(b) deemed taxable exchange; and
(iii)
Third, the regular distribution.
To the extent that a distributee partner receives a larger share of one class of
property in exchange for the other class, there is a deemed distribution of the class
of property the distributee partner receives too little of. This is then followed by a
fictional exchange by the distributee of the property received in the fictional
distribution for the property that the distributee receives too much of.
(i)
The fictional exchange is taxable to both the distributee and the
partnership.
(ii)
The distributee partner's basis in her partnership interest is applied first to
the deemed distribution (treated as a current distribution).
(iii)
Note that if a partner assumes or takes subject to partnership liabilities, the
amount of the cash distribution is reduced or can even be negative.
(iv)
Where a partner receives an excess amount of one class of property, the
Regulations permit an agreement between the distributee and the
partnership identifying the non-§ 751(b) property that the distributee is
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considered to have exchanged for the excess § 751(b) property, or the
§ 751(b) property that the distributee is considered to have exchanged for
the excess non-§ 751(b) property, as the case may be. Reg. § 1.751-1(g)
ex. 3(c), ex. 5(c).
(v)
(d)
6.
Partnership gain or loss on the deemed exchange is allocated only to the
partners other than the distributee partner. § 751-1(b)(2)(ii).
Deemed distribution and exchange is then followed by the remaining actual
distribution, i.e., the portion which represents the distributee partner's
proportionate interest in the property distributed.
Future of § 751(b) .
(a)
IRS Notice. In Notice 2006-14, the IRS stated that the IRS and the Treasury
Department are considering developing a new approach to § 751(b). The Notice
indicates that the IRS and Treasury Department are conducting a study of the
current § 751(b) regulations and are considering alternative approaches which are
simpler and reduce administrative burdens while still serving the purpose of the
statute. The Notice indicates that the rules of § 751(b) may be substantially
revamped and requests comments.
(b)
Partners' Shares of Partnership Property. The Notice suggests that new rules
under § 751(b) may focus on whether a distribution shifts a partner's share of
partnership ordinary income. This would be determined by comparing the
amount of ordinary income that the partner would be allocated if the partnership's
assets were sold for their market value before and after the distribution. Under
this hypothetical sale approach, if the amount of ordinary income that would be
allocated to any partner is reduced as a result of the distribution, an analysis under
§ 751(b) would be required. The hypothetical sale approach, combined with the
application of reverse § 704(c) principles, could provide rules that achieve the
objective of the statute in a less burdensome manner.
(i)
(c)
§ 704(c) principles generally operate to preserve each partner's share of
the built-in appreciation and depreciation in partnership assets. If the
regulations under § 751(b) are amended to specify that § 704(c) principles
are taken into account for purposes of determining whether a partner's
share of partnership hot assets have been altered by a distribution,
significantly fewer distributions would trigger § 751(b).
Determining Tax Consequences of Disproportionate Distributions. The IRS
announcement also suggests that the current distribution/exchange approach for
determining the tax consequences of a disproportionate distribution could be
simplified, with a disproportionate distribution treated as only triggering a sale of
the partner's shares of hot assets. Under this approach, there would be no deemed
exchange of cold assets.
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