Divider
Divider

Stephen Ehrenberg
Stephen Ehrenberg

Taxing certain partnership distributions

Proposed regulations would affect the tax treatment of distributions of unrealized receivables and appreciated inventory.

December 18, 2014
by Stephen J. Ehrenberg, CPA

Taxpayers have long sought mechanisms to “cash out” their corporate and partnership interests while paying as little tax as possible. While corporate distributions are frequently subject to the dreaded double taxation of earnings at both the corporate and shareholder level, partnerships maintain the distinct advantage of a single level of taxation, as partnership items of income, expense, gain, and loss are passed through to the partners to determine their tax treatment. Additionally, whereas corporate distributions of appreciated property give rise to tax under Sec. 311(b), similar distributions of appreciated property from partnership entities are generally not subject to tax until the asset is sold or disposed of by the distributee partner.

However, while partnership distributions are not subject to the provisions of Sec. 311(b), partnership distributions must be analyzed under Sec. 751 to determine whether they are treated in whole or in part as sales or exchanges that give rise to ordinary income. Sec. 751, which was enacted to prevent taxpayers from converting ordinary income to capital gains in sales or exchanges of partnership interests and certain partnership distributions, requires ordinary income treatment for distributions associated with so-called hot assets (i.e., unrealized receivables and appreciated inventory).

Straightforward in concept, the provisions of Sec. 751 have long been an area of concern for partners and partnerships, as applying these provisions has proved quite difficult in certain situations. In response to this concern, the IRS and Treasury issued proposed regulations (REG-151416-06) in October 2014 in an attempt to provide clarity to this complex area.

History and current law

The provisions of Sec. 731 provide the general rules governing the recognition of gain or loss on distributions from partnerships to their partners. Sec. 751, however, supersedes the general stipulations of Sec. 731 for the distribution of hot assets.

Under the current regulations, the application of Sec. 751(b) hinges on the gross value of the partnership’s assets, focusing on a given partner’s share in all partnership assets, as opposed to the partner’s allocable share of the unrealized gain or loss in the property. If the partnership has no unrealized receivables and/or inventory, the provisions of Sec. 751(b) have no bearing. However, if the partnership owns hot assets, as well as other assets, calculating gain or loss on the sale or exchange of a partner’s interest in the partnership can become quite complex, as a deemed-sale analysis of the relinquished asset is required.

In response to the complexities imposed by Sec. 751(b), the IRS issued Notice 2006-14 asking for comments on the following alternative approaches:

  • Hypothetical-sale approach. Rather than using the gross value of the assets to determine if  Sec. 751(b) applies, the notice suggests a hypothetical-sale approach, which compares the amount of ordinary income that would be allocated to a given partner had the partnership sold its assets at fair market value (FMV) immediately before and immediately after the distribution occurs.
  • Hot-asset-sale approach. Provided Sec. 751 applies, the gain on the transaction must be determined. Whereas the current regulations provide for a complex “deemed-sale” approach, the notice suggests an alternative approach. Under the alternative approach, the partnership is deemed to have distributed the hot assets to the distributee partner, followed immediately by a deemed sale of these assets from the distributee partner back to the distributing partnership. The distributee partner recognizes ordinary income upon the deemed sale of the assets to the partnership, while the partnership gets basis in the assets to the extent of the “sale proceeds.”

While the suggested alternatives have drawbacks as well, the general consensus from practitioners was that these proposed rules would simplify the Sec. 751(b) complexities by focusing the analysis on the FMV of the assets in question, as opposed to all of the partnership assets. However, practitioners did differ on which of the suggested approaches (or a combination of the two) would be most effective.

Proposed regulations (REG-151416-06)

Notice 2006-14 was the initial attempt at revamping the complex rules governing sales or exchanges of partnership interests when the partnership held unrealized receivables and/or substantially appreciated inventory. Since the notice was issued nearly 10 years ago, both tax practitioners and the IRS have continued to want a more practical method to determine how to treat these types of transactions.

In response to the need for a more practical method, the proposed regulations issued in October 2014 cover the following parts:

  • Determining a partner’s interest in Sec. 751 property. Establishes an approach for measuring a partner’s interest in Sec. 751 property using the hypothetical-sale approach. Additionally, the proposed regulations provide allocation rules incorporating the income recognition and allocation provisions of Sec. 704(c) and describe the effect of Sec. 734(b) and Sec. 743(b) basis adjustments on Sec. 751 property.
  • Determining the application of Sec. 751(b) to a partnership distribution. Establishes the threshold for application of Sec. 751(b), stipulating that Sec. 751(b) applies if either of the following situations exist:
    • Increase in a partner’s share of net Sec. 751 gain; or
    • Decrease in a partner’s share of Sec. 751 loss.
  • Tax consequences of a Sec. 751(b) distribution. Instead of mandating a specific method to determine the tax consequences of a Sec. 751(b) transaction, the proposed regulations require taxpayers to use a reasonable approach that is consistent with the purpose of section 751(b), including either the deemed-sale approach, the hot-asset-sale approach, or any other reasonable method.

Taxpayers and practitioners should also make themselves familiar with the other areas that are addressed in the proposed regulations, which include, but are not limited to, merger-and-acquisition activity, revaluation of partnership interests, and anti-abuse rules.

Conclusion

The tax consequences and implications of liquidating distributions, both in the corporate and partnership area, provide a number of unique challenges. From a partnership perspective, income characterization issues associated with distributions received in exchange for an interest in a partnership can be particularly complex when the partnership’s asset base includes Sec. 751 unrealized receivables and/or inventory. While the proposed regulations issued in REG-151416-06 are not effective until they are adopted, taxpayers should pay careful attention to ongoing developments. In the preamble to the proposed rules, the IRS and Treasury are requesting comments on how distributions associated with Sec. 751 hot assets are taxed that could lead to changes being made to the rules in the final regulations.

 Rate this article 5 (excellent) to 1 (poor). Send your responses here.

Stephen J. Ehrenberg, CPA, MBT, is a tax principal in the Los Angeles office of Holthouse Carlin & Van Trigt LLP.