How To Sell A Partnership Property

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1 IRC 751 "Hot Assets": Calculating and Reporting Ordinary Income in Disposition of Partnership or LLC Interests THURSDAY, JULY 9, 2015, 1:00-2:50 pm Eastern IMPORTANT INFORMATION This program is approved for 2 CPE credit hours. To earn credit you must: Participate in the program on your own computer connection (no sharing) if you need to register additional people, please call customer service at x10 (or x10). Strafford accepts American Express, Visa, MasterCard, Discover. Listen on-line via your computer speakers. Respond to five prompts during the program plus a single verification code. You will have to write down only the final verification code on the attestation form, which will be ed to registered attendees. To earn full credit, you must remain connected for the entire program. WHO TO CONTACT For Additional Registrations: -Call Strafford Customer Service x10 (or x10) For Assistance During the Program: -On the web, use the chat box at the bottom left of the screen If you get disconnected during the program, you can simply log in using your original instructions and PIN.

2 SECTION 751(b) Thomas I. Hausman The Law Office of Thomas I. Hausman, LLC Cleveland, Ohio The disproportionate distribution of hot or cold assets under section 751(b). The hot asset rule of section 751(b) is very complicated. Section 751(b) provides that in certain circumstances, a distribution of property or money can result in the recognition of gain or loss to the recipient partner and/or the partnership. The gain or loss may be ordinary or capital, and the gain or loss may be recognized even if it would not otherwise be recognized under the normal distribution rules of section 731(a). In general, the section applies where a partner receives in a distribution more or less than his share of certain classes of partnership property. For this purpose, there are only two classes of partnership property: capital assets and ordinary income property, further described in the next paragraph. If a partner receives more than his share of one class of partnership property, he is deemed to exchange the excess over his share for property in the other class of partnership property, and this is characterized as a sale, which could generate ordinary income or loss, or capital gain or loss, to both the distributee partner and the partnership. Under section 751(b), the partnership s property is divided into two classes: one is capital and section 1231 assets (including cash for this purpose) (referred to as capital gain property or cold assets ) and the other is unrealized receivables and substantially appreciated inventory (referred to collectively as 751 property or hot assets ). Under section 751, if a partner receives property (including cash) in a distribution that consists of more than his pro rata share of one class of property, and in exchange he relinquishes his interest in the other class of property, he must take account of (recognize) gain or loss with respect to the property relinquished. Example 1 is a concise illustration of this principle. Example 1. Assume that in the ABC partnership, A has an adjusted basis of $1,000 for his partnership interest, and a value of $10,000. A, B, and C share profits and losses one-third each. The partnership s only assets are cash of $20,000, and inventory having an adjusted basis of $1,000 and a fair market value of $10,000. The partnership has no liabilities. In liquidation of A s interest, the partnership distributes cash of $10,000 to him (one-third of the $30,000 total value of assets). Without the application of section 751(b), A would recognize $9,000 of long-term capital gain under section 731(a)(1). However, under section 751(b), A s gain must be bifurcated between capital gain and ordinary income. A would be required to recognize ordinary income of $3,000 (his share of the ordinary income he would have recognized if the partnership had sold all the inventory for its fair market value and allocated one-third of it to A), and the balance would be taxed as capital gain. More specifically, prior to the liquidation of A s interest, his one-third share of the inventory had a value of $3,333 and his share of the cash was 1

3 $6,666. When the cash of $10,000 was distributed to him, he received $3,333 more than his share of the cash, and he is deemed to have relinquished his interest in the inventory. Section 751(b) operates (in a convoluted manner) to force A to recognize $3,000 of ordinary income, which would be A s share of the ordinary income that would be generated from the sale of the inventory at its fair market value. This example is overly simple. The regulations provide that in order for section 751(b) to apply, there must be: (1) a so-called disproportionate distribution of one type of property to a partner, (2) in exchange for the relinquishment of that partner s interest in the other type of property. Under this scenario, the partnership s properties are divided into two categories: capital gain properties and ordinary income properties. The capital gain properties consist of cash, capital assets and 1231 assets (to the extent in excess of depreciation recapture), and generally, any assets the sale of which produce capital gains or losses. The ordinary income assets consist of unrealized receivables and inventory items that have appreciated substantially in value. 1 An explanation of these assets follows. 1. Unrealized receivables. Unrealized receivables consist generally of rights to payment for goods delivered or to be delivered, or services rendered or to be rendered, but only to the extent not previously included in income under the accounting method used by the partnership. Thus, this category means accounts receivable of a cash method taxpayer. It also includes various other items that produce ordinary income upon sale, such as depreciation recapture. Unrealized receivables would also include a management contract. The regulations provide that in determining the amount of any unrealized receivables, the taxpayer may take into account the expenses anticipated to recognize the income, and may take into account the time value of money. 2. Substantially Appreciated Inventory Items. Inventory items consist of: (a) stock in trade, or any other property of a kind which would properly be included in the inventory of the partnership if on hand at the close of the taxable year, or property held by the partnership primarily for sale to customers in the ordinary course if its trade or business; (b) any other property which on sale or exchange by the partnership would be considered property other than a capital asset and 1231 assets, including accounts receivable; and (c) any other property owned by the partnership which, if held by a partner receiving a distribution governed by section 751(b), would be considered inventory under clauses (a) or (b) above. 2 It is important to understand how extensive the definition of inventory items is. It includes unrealized receivables because upon their sale they would produce ordinary income. 1 Section 751(b). Unrealized receivables consist generally of rights to payment for goods delivered or to be delivered, or services rendered or to be rendered, but only to the extent not previously included in income under the accounting method used by the partnership. Thus, accounts receivable of a cash method taxpayer are included. It also includes various other items that produce ordinary income upon sale, such as depreciation recapture. Inventory consists, in part, of unrealized receivables. 2 Reg (d)(2). 2

4 Inventory is deemed to be substantially appreciated if their fair market values exceed 120 percent of their adjusted bases. 3 When calculating whether inventory is substantially appreciated, unrealized receivables are included in the formula. Depreciation recapture for this purpose has an adjusted basis of zero 4 and a fair market value equal to the amount of the depreciation recapture that would be recognized if the partnership sold the property subject to such recapture for its fair market value. 5 In calculating whether inventory is substantially appreciated, all inventory items are combined; substantial appreciation is not calculated on an item-by-item basis. At one time, in order to be substantially appreciated inventory, the fair market value of the inventory items had to exceed 10% of the fair market value of all partnership property other than money. This requirement was eliminated in 1993, but the regulations have not been amended to reflect this change. If inventory is acquired by the partnership with a principal purpose of avoiding section 751(b), then that property is excluded from consideration as inventory. For example, if a partnership owns inventory having a fair market value of $130 and an adjusted basis of $100, the inventory would be substantially appreciated. If the partners contribute high basis inventory so that the total fair market value and adjusted basis is $150, the inventory would not be substantially appreciated, and if the inventory so contributed was done in order to avoid the recognition of ordinary income under section 751, the recently contributed inventory would be excluded from the computations. Partners must therefore be careful if they contribute such inventory or the partnership purchases such inventory. 3. Methodology for calculating gain or loss. The methodology employed by the regulations to determine the amount of ordinary income and capital gain is complicated. Several examples follow these rules, so if you cannot initially follow them (and most people cannot), please refer to the examples. Here are the steps: 1. Divide the partnership s property into the two classes: hot and cold assets. In Example 1 above, there are only two assets, inventory and cash. The inventory is a hot asset, and the cash is a cold asset. In many partnerships, there is more than one kind of 751 assets, such as accounts receivable, inventory, and depreciation recapture. 2. Determine if a disproportionate distribution has occurred. This is done by determining whether the distributee partner has received in the distribution to him, more or less than his share of one class of property in relinquishment of his share of the other class of property. To the extent that a partner has received more than his pro-rata share, it is referred to in this book as the excess 751 property or capital gain property, as the case may be. In Example 1, A received more than his one-third share of capital gain property (cash) in relinquishment of his share of the section 751 assets. In fact, he received no section 751 assets at all. It was assumed that because A was an equal one-third partner, he shared one-third of the partnership s assets. This is often correct, but there could be some situations where that might 3 Section 751(b)(3). 4 Reg (c)(5). 5 Reg (c)(4)(iii). 3

5 not apply. Usually, the determination is made of how much property of each class a partner would receive upon liquidation if all the assets were distributed in-kind to the partners and each partner received his proportionate share. The method of segregating the assets into classes is not well-defined in the regulations or elsewhere, and this makes it particularly difficult. The IRS recognizes that substantial unfairness may result from the failure to provide guidance. In Notice , the IRS stated that the section 751(b) regulations should probably be revised to provide guidance on how to separate the hot and cold assets. This topic is discussed further below. As of the date of this book, the IRS has not provided any further guidance on this issue. In addition, it is often helpful to identify the distributee partner s interest in partnership property, as follows: Non- 751 Property FMV AB Cash $20,000 20,000 A s 1/3 share 6,666 6, Property Inventory 10,000 1,000 A s 1/3 share 3, This chart shows that A s total share of the non- 751 property is $6,666, and his share of the 751 property is $3,333. If all of A s interests in partnership property were distributed proportionally, A would receive $6,666 worth of non- 751 property (cash), and $3,333 worth of 751 property (inventory). If the partnership sold all of its property, A would recognize $3,000 of ordinary income. In our example, A withdrew from the partnership and he received a cash distribution of $13,250 plus the relief of his share of partnership liabilities in the amount of $6,750. His interest was worth $20,000 (gross values), and he received only non- 751 assets (cash) of $20,000. Under 751(b), A received a disproportionate distribution he received $5,000 more of non- 751 assets in relinquishment for his interest in the 751 assets. 3. If it is determined that there has been a disproportionate distribution to a partner (which could be a current distribution or a liquidating distribution), then determine which assets are exchanged. In Example 1 above, this process was easy because only cash was distributed to A in the liquidation of his interest, and the partnership had only two assets. In that example, A received his share of the capital gain assets ($6,666 of cash), plus an extra $3,333 of cash. This extra cash was received in relinquishment of A s interest in the inventory. The regulations permit the partners to agree on the assets that are exchanged. 6 However, if the partners do not so agree, then the distributee is deemed to have sold a proportionate amount of each property in which he has relinquished an interest (other than property of the same class 6 Reg (g), Examples 3 and 4, which indicate that the partners can agree on the specific properties deemed exchanged. 4

6 as the property distributed). 7 In Example 1 of Reg (g), the IRS establishes a so-called property exchange table, which shows the properties exchanged. This property exchange table is further described below. When drafting an agreement for the distribution of property to a partner where section 751(b) may apply, the partners may wish to specify which properties are exchanged. This could make the tax consequences much simpler to determine. The following is an example of a property exchange table referred to above. It is a very simple one in this case, as the partnership has only two assets = 4 Asset Other Property: Cash Gross Value of Distributee s Post-Distribution Interest Gross Value of Assets Distributed Gross Value of Distributee s Predistribution Interest Increase (Decrease) Distributee s Interest 0 10,000 6,666 3,333 Total Other Property 0 10,000 6,666 3,333 Section 751 Property 0 0 3,333 (3,333) in Total Section 751 Property 0 0 3,333 (3,333) The above chart shows that A relinquished his interest in $3,333 worth of the section 751 property for $3,333 worth of other property (cash). This is the exchange that was made and that is subject to section 751(b). This transaction was relatively simple to diagram. However, assume the following modification of Example 1. Assume that ABC s properties are as follows: Other property: AB FMV Cash 10,000 10,000 Land 1,000 3,000 Stock 1,000 5,000 Totals 12,000 18,000 Section 751 property: Accounts receivable: 0 6,000 7 Id. 5

7 Inventory: 3,000 6,000 Totals 3,000 12,000 Liabilities 0 0 Capital: A 5,000 10,000 B 5,000 10,000 C 5,000 10,000 Total 15,000 30,000 If A s entire interest is liquidated in exchange for the distribution of $10,000 cash, then the partnership exchange table would reflect the following: = 4 Asset Other Property: Cash: Land Stock Gross Value of Distributee s Post-Distribution Interest Gross Value of Assets Distributed Gross Value of Distributee s Predistribution Interest 10,000 3,333 1,000 1,250 Increase (Decrease) Distributee s Interest 6,666 (1,000) (1,666) Total Other Property 0 10,000 5,583 4,000 Section 751 Property Acct. Rec.: Inventory ,000 2,000 (2,000) (2,000) in Total Section 751 Property 0 0 4,000 (4,000) The above chart shows that A relinquished his interest in $1,000 worth of the land and $1,666 worth of the stock in exchange for $2,666 of cash, and that A also relinquished his interest in $2,000 of the unrealized receivables and $2,000 of the inventory, in exchange for $4,000 of cash. The only exchange that is subject to section 751(b) is the exchange of the interest in accounts receivable and inventory in exchange for the cash. The exchange of cash for other property is not governed by section 751(b). 4. Once it is determined what assets are exchanged, the following is deemed to occur: (a) Hypothetical distribution of shortfall in one class of property. To the extent the distributee partner fails to receive his full pro rata share of one type of property, any shortfall in his share of that property is distributed to the partner in a 6

8 hypothetical current distribution. This hypothetical distribution is a current distribution, which means that the distributee partner s adjusted basis for that property will normally equal the property s adjusted basis in the hands of the partnership under section 732(a)(1). There would normally be no gain recognized by the distributee partner upon the distribution of his pro-rata share of assets under section 731(a). Furthermore, upon the hypothetical distribution to the distributee partner, the adjusted basis for his partnership interest will be reduced by the adjusted basis of the property hypothetically distributed. In Example 1 above, A s shortfall in his share of the 751 assets (one-third of the inventory) will be deemed to be distributed to him in a current distribution. When one-third of the inventory is distributed to him, A will acquire an adjusted basis in that inventory of one-third of the adjusted basis in the hands of the partnership (ie, $333) under section 732(a), and A s adjusted basis for his partnership interest is reduced by the same amount to $667 under sections 705 and 733. (b) Sale to the partnership of property hypothetically distributed. The property hypothetically distributed is then deemed to be sold back to the partnership for its fair market value and the consideration received from the partnership for that property consists of a portion of the property and/or cash actually distributed to the distributee partner (and the distributee partner s relief of liabilities under section 752(b) constitutes cash for this purpose). Thus, a portion of the proceeds actually received by the distributee partner (a portion of the $10,000 actually received in Example 1) is deemed to be received not as a distribution, but as sale proceeds for his share of the class of assets that were hypothetically distributed to him, and the balance of the distribution is treated as a distribution under the normal rules of sections 731 and 732. Upon the deemed sale of the property back to the partnership, the distributee partner will recognize gain or loss equal to the difference between the fair market value of the property and cash actually received by the distributee partner over the adjusted basis of the property hypothetically distributed and deemed sold back to the partnership. 8 It also means that the partnership will be deemed to have purchased that property, and will be entitled to increase its adjusted basis by the amount of the purchase price paid. As if this were not confusing enough, the partnership will recognize gain or loss on its purchase of the relinquished property if the purchase price is paid in property other than cash. However, this will not occur if only cash is distributed to the distributee partner. If capital gain property (other than cash) is distributed, the partnership will recognize either capital or section 1231 gain or loss, measured by the difference between the adjusted basis to the partnership of the excess capital gain property distributed over the adjusted basis of the 8 The regulations provide that where non- 751 property is distributed (such as cash), the distributee partner recognizes ordinary income or loss in the amount of the difference between his adjusted basis for the section 751 property relinquished in the exchange (including any special basis adjustments), and the fair market value of other property (including cash) received by him in exchange for his interest in the 751 property he exchanged. Reg (b)(3). Where excess 751 property is received in the distribution, the distributee partner will recognize gain or loss measured by the difference between the adjusted basis of the property relinquished in the exchange (including any special basis adjustment he may have under section 743(b) or 734(b)) and the fair market value of the 751 property received by him in exchange for his interest in the capital gain property which he has relinquished. The character of the gain or loss is determined by the character of the property in which he relinquished his interest. This would normally be capital or section 1231 gain. Reg (b)(2)(iii). 7

9 751 property in which an interest was relinquished (that is, the property deemed distributed). 9 If excess 751 property is distributed by the partnership, then the partnership will recognize ordinary income to the extent of the difference between the adjusted basis of the excess 751 property distributed, and the fair market value of the capital gain property in which he relinquished his interest. 10 All gain or loss recognized by the partnership must be allocated to the partners other than the distributee partner. In Example 1 above, A hypothetically received $3,333 worth of inventory in a current distribution, which is the property he relinquished. A is then deemed to sell the inventory hypothetically distributed to him for its fair market value of $3,333, and the partnership is deemed to pay this amount with the cash distributed to A in excess of A s share of the partnership s cash. This would result in a gain of $3,000 to A, and the partnership is deemed to purchase this inventory for $3,333. If instead of paying cash for the property the partnership actually distributed to A some IBM stock having a fair market value of $3,333 and an adjusted basis of $1,000, then the partnership would be deemed to have sold the stock in exchange for the inventory hypothetically distributed to A, and the partnership would recognize a capital gain of $2,333. (c) Remainder of distribution treated under sections 736 and 731. The excess of the distribution is treated under the rules of sections 736 and 731. Section 736 applies to a distribution in liquidation of a retired or deceased partner s interest. Under section 736, property must be divided between section 736(a) and 736(b) properties, and part of this determination may depend on whether capital is a material income producing factor of the partnership. Assuming that under section 736 all property is determined to be section 736(b) property (assuming further that capital is a material income producing factor, and that the distributee partner was a general partner see section 736(b)(2) and (b)(3)), if the consideration received is limited to cash, gain will not be recognized except to the extent that the amount of the cash exceeds the adjusted basis of the distributee partner s interest (after the application of section 751(b)). If property is distributed, gain or loss will normally not be recognized except perhaps to the extent the distribution is subject to the mixing bowl rules or the distribution of marketable securities. In Example 1 above, the amount of the cash distributed to A after subtracting the $3,333 that was deemed paid for the inventory, equals $6,667. A s adjusted basis for his partnership interest immediately before the distribution, but after the hypothetical distribution and sale back to the partnership under section 751(b), was $667 ($1,000 beginning basis, less $333 adjusted basis of the inventory hypothetically distributed currently). This means that A would recognize a gain of $6,000 on the distribution under sections 736 and 731(a)(1), the difference between the cash distributed to him and his adjusted basis. In these circumstances, the partnership can make a section 754/732(b) election to increase the basis of its remaining capital gain property by the amount of the gain recognized, unless it does not own any capital gain property, in which case, the adjustment stands in suspense, and the adjustment is made when the partnership subsequently acquires capital gain property. 11 See, Chapter 11 on special basis adjustments. In Example 1, 9 Reg (b)(3)(ii). 10 Reg (b)(2)(ii). 11 Reg (c)(4). 8

10 the partnership does not own any remaining capital gain property, so any special basis adjustment it might make will not become effective until capital gain property is acquired. The foregoing rules are impossible to grasp without an example, so it is hoped that the following example will explain these concepts. 4. Example - Cash Distributions. Where cash is the only asset distributed in a section 751(b) transaction, here are the tax consequences. Example 2 Cash Distribution. Assume the ABC Partnership, where A is an equal one-third partner. His adjusted basis is $2,900, and the fair market value of his interest is $6,000. The partnership has no liabilities. The partnership s balance sheet is as follows: Assets FMV AB Gain/Loss Cash 6,000 6,000 0 Land 2, ,800 Building 2,000 1,000 1,000 Machine 1, Inventory 6, ,700 Accounts rec. 1,000 1,000 0 Total 18,000 8,700 9,300 Liabilities and capital Liabilities: 0 0 Capital accounts: A: 6,000 2,900 B: 6,000 2,900 C: 6,000 2,900 Totals 18,000 8,700 The machinery is subject to $800 of depreciation recapture. The inventory is substantially appreciated because the inventory items, consisting of inventory, accounts receivable, and depreciation recapture on the machine, have an aggregate fair market value of $7,800, and their adjusted bases total $1,300 (the adjusted basis of the depreciation recapture is zero). A s onethird share of these items has a value of $2,600 and a basis of $433. In liquidation of A s interest, the partnership distributes cash of $6,000 to him. 12 No part of this distribution constitutes a part of A s distributive share of the partnership s income or a guaranteed payment for the year. The distribution to A would be disproportionate because A s share of the ordinary income assets in the amount of $2,600 was not distributed to him. Instead, total cash of $6,000 was distributed to him. This is a disproportionate distribution because A received $2,600 in cash in exchange for his relinquishment of $2,600 worth of 751 property. 12 The tax consequences of this transaction would in part be governed by section 736, pertaining to payments to a retiring or deceased partner. This topic is covered in detail in Chapter 9. 9

11 In this case, assume that the partners do not agree on the specific assets deemed to be exchanged. As a result, the partnership is treated as if it distributed A s share of the ordinary income assets to A in a current distribution. In that current distribution, A would receive property valued at $2,600, and having an adjusted basis in his hands of $433, under section 732(a). The property A is deemed to receive is his share of the inventory, accounts receivable, and depreciation recapture, 13 having a FVM of $2,600 and an adjusted basis of $433. Under section 733, A s adjusted basis for his partnership interest is reduced by $433, bringing his adjusted basis down to $2,467. A is then deemed to sell the ordinary income assets back to the partnership for $2,600 in cash, resulting in a $2,167 gain of ordinary income. Section 735(a) clarifies that even if the inventory would not otherwise be inventory in A s hands after the distribution, A s gain on the sale of that property will nevertheless result in ordinary income. The cash distributed to A of $6,000 is treated as if $2,600 were really sale proceeds, and not distribution proceeds. Thus, A will be deemed to have received in the distribution cash equal to $3,400 ($6,000 total, less $2,600 deemed to be sales proceeds). This would result in gain to A equal to $933, which is the excess of the $3,400 over A s adjusted basis for his partnership interest of $2,467. Consequently, A s total gain from the sale would be $3,100, which is equal to the $6,000 cash received by A from the partnership over his adjusted basis of $2,900. This also makes sense in this Example 2 because if the partnership sold all its assets for their respective fair market values and allocated the gain and loss among the partners, A would be allocated $2,167 of ordinary income, and capital gain of $933. The partnership would re-compute the adjusted basis of the inventory and machine. In the hypothetical current distribution of A s share of the inventory and unrealized receivables, the partnership would have reduced the adjusted basis of the machine by zero because the adjusted basis of the depreciation recapture is zero. The partnership is deemed to have purchased the depreciation recapture for the amount of $267 (one-third of the $800 depreciation recapture), and the partnership would increase its adjusted basis in the machine by $266. With respect to the inventory, the partnership would be deemed to have distributed one-third of it to A, and the partnership would reduce its basis for the inventory by $100. When the partnership repurchased the inventory for $2,000, it would increase its adjusted basis by that amount. When the partnership is deemed to hypothetically distribute one-third of the accounts receivable, it would reduce its adjusted basis in the accounts receivable by $333, and would be deemed to repurchase them for the same $333. Consequently, after the liquidation, the adjusted basis of these items would be calculated as follows: Asset (A) (B) (C) New adjusted Beginning Reduction for Increase for basis (A-B+C) basis distribution repurchase Machine Inventory ,000 2,200 Accounts 1, ,000 receivable Totals 1, ,600 3, The depreciation recapture is deemed to have a fair market value of $800 and an adjusted basis of zero. The machine is a capital gain property to the extent of its basis. 10

12 In this example, it is easy to see that A s share of the ordinary income was $500, and that is exactly the amount of his ordinary income if the partnership had simply sold the ordinary income assets. It is an easy way to see if the methodology required by the regulations generates the correct results. This example was also easy for two other reasons. One was that cash was used to buy the ordinary income assets hypothetically distributed. If other property, say for example, the building and $1,000 worth of the land had been used to buy the ordinary assets, the partnership itself would have recognized gain because it used capital assets to buy ordinary assets. Thus, the partnership would have recognized a $3,000 section 1231 gain from the building (FMV $4,000, AB $1,000) and a $900 capital gain from the sale of one-half of the land (FMV $1,000, AB $100). It is a well-established concept in federal income tax law that if a taxpayer buys property with appreciated property, he will recognize gain or loss on the sale. There is another reason this was simple is that the distribution was a liquidating distribution. Technically, section 751(b) applies to any distribution. These situations usually occur where a partner receives property in exchange for relinquishing a part of his interest. For example, in exchange for cash, A s interest is reduced from one-third to one-sixth. These computations can become very complicated, and they become even more complicated when the partnership has liabilities from which the distributee partner is relieved under section 752(b). 5. Property distributed. When the partnership distributes property to a partner in a section 751(b) transaction, the tax consequences become much more complicated, not to mention the complexity involved upon a distribution of cash and property in the same transaction. The example below shows what happens if inventory is distributed to a partner where section 751(b) applies. You will note that in this case, not only will the distributee partner, A, recognize gain, but the remaining partners, will also recognize gain even though they did not receive anything in a distribution. Example 3 Distribution of Inventory. Assume that in example 2 above A s interest is liquidated by the distribution to him of all the inventory and no cash. To refresh your memory, the partnership s balance sheet is as follows, and A s beginning adjusted basis for his partnership interest is $2,900: Assets FMV AB Inherent Gain/Loss Cash 6,000 6,000 0 Land 2, ,800 Building 2,000 1,000 1,000 Machine 1, Inventory 6, ,700 Accounts rec. 1,000 1,000 0 Total 18,000 8,700 9,300 Liabilities and capital 11

13 Liabilities: 0 0 Capital accounts: A: 6,000 2,900 B: 6,000 2,900 C: 6,000 2,900 Totals 18,000 8,700 When the partnership distributes $6,000 worth of inventory to A, he will have received a disproportionate distribution. His share of the value of the 751 assets is $2,600, having an adjusted basis of $433. (The 751 assets are the inventory, the accounts receivable, and depreciation recapture of $800. The depreciation recapture has an adjusted basis of zero. Thus, the value of the total 751 assets is $7800, one-third of which is $2,600.) His share of the capital gain assets is $3,400, having an adjusted basis of $2,466 (one-third of the capital gain assets and their adjusted bases; included in this figure is $200 of the FMV of the machine and the $200 adjusted basis of the machine). A has received $3,400 more than his share of the 751 assets, so there has been a disproportionate distribution of the inventory in exchange for the relinquishment of A s share of the capital gain assets. Assuming that the partners do not agree on the specific assets deemed to be exchanged, A will be deemed to receive a proportionate part of each capital gain property. As a result, $3,400 worth of the capital gain assets is deemed to be currently distributed to him (one-third of each capital gain asset, counting the machine only to the extent of $200). A is deemed to receive $2,000 cash in a current distribution; $667 worth of the land having an adjusted basis of $67; $667 worth of the building having an adjusted basis of $333, and $67 worth of the machine having an adjusted basis of $67. The capital gain assets are then deemed to be sold back to the partnership in exchange for $3,400 worth of the excess inventory that was actually distributed to him. If the capital gain assets were hypothetically distributed to A in a current distribution, they would have an aggregate adjusted basis of $2,467 under sections 732(a) and 705. (The cash distributed would not result in any gain or loss to A because the cash distributed does not exceed A s adjusted basis for his interest under section 731(a).) When they are sold to the partnership for inventory worth $3,400, A would recognize a capital or 1231 gain of $933 ($3,400 - $2,467). (The partnership would be deemed to buy the cash for $2,000, the land for $667, the building for $667, and the machine for $67.) A recognizes this gain even though under section 731(a), A would normally not recognize any gain upon the distribution of property. In addition, when the partnership buys the capital gain assets from A for the $3,400 worth of the inventory actually distributed to him, the partnership will recognize a gain because it is using appreciated property to pay the purchase price of the capital gain property. The partnership s gain will be $3,230, computed as follows. Inventory having a fair market value of $3,400 will have an adjusted basis of $170 ($3,400 divided by the total inventory of $6,000, multiplied by the adjusted basis of $300). $3, = $3,230 ordinary income. The gain will be allocated to B and C as the remaining partners of the partnership. 12

14 This example is very important because it illustrates that even though B and C never received a distribution from the partnership, they will recognize gain on this transaction. It will usually occur that where appreciated property is used in a section 751(b) transaction, the remaining partners will recognize gain or loss in addition to the distributee partner. The only time this will not happen is where cash is used to buy the withdrawing partner s interest. B and C will each increase the adjusted basis of their respective partnership interests by their share of the gain. The partnership will adjust the basis of its capital gain assets because of its deemed repurchase of the capital gain property. To summarize the transaction: A s gain: $933 capital or section 1231 gain. B and C s gain: $1,615 ordinary income each. Partnership s adjusted basis for its assets: Asset (A) (B) (C) New adjusted Beginning Reduction for Increase for basis (A-B+C) basis distribution repurchase Cash Land Building 1, ,334 Machine Totals 7,400 2,467 3,400 3,667 You should also note that the adjusted basis of the assets is increased even though there may not be a section 754 election in effect. The basis increase is caused by the deemed sale of property to the partnership and would result regardless of whether there is a section 754 election in effect. 6. Combination of property distributed. It sometimes occurs that a combination of property is distributed in a transaction governed by section 751(b). This makes the calculations even more complicated, but the regulations have several examples of how section 751(b) operates in this situation. Here is an example, using Example 2 above. Assume that in Example 3, A received $3,000 of cash and $3,000 worth of inventory. There would be a $400 excess distribution of the 751 property, and a $400 shortfall in the distribution of the capital gain property. Assuming the partners do not agree on the specific property to be exchanged, A would be deemed to receive in a hypothetical current distribution $400 worth of the capital gain property, and he would be considered to receive a pro rata share of each capital gain property, except for the cash because he has received more than his pro rata share of the cash. The amount received with respect to each capital gain property is as follows: Land: $2000 (FMV of the Land) / 4200 (FMV of Land, Building and $200 of Machine) x 400 (shortfall in capital gain property distributed) = $190. Building = $190. Machine = $20. These properties will be deemed to have an adjusted basis as follows: land: 190/2000 x 200 = 19; building 190/2000 x 1000 = 95; machine: 20/200 x 200 = 20. Therefore, the gain recognized to A would be equal to the following: Land: $ = $171; Building: $ = $95; machine: = 0. 13

15 The partnership would be deemed to recognize ordinary income of $380. The partnership is deemed to have paid for the $400 worth of the capital gain property distributed in the hypothetical distribution with $400 worth of inventory actually distributed. If $400 of the inventory was sold, it would result in ordinary income of $380. The basis of $400 worth of inventory is calculated as follows: $400 worth of inventory, divided by $6,000 worth of total inventory, multiplied by $300 adjusted basis of all inventory = $20. $400 capital gain property deemed received, less $20 adjusted basis of $400 worth of inventory, = $380. The $380 gain would be required to be allocated equally to B and C. 7. Non-liquidating distributions. Up to this point, all of the examples involve the liquidation of A s interest in the partnership. However, section 751(b) can apply even if there is only a current distribution. Of course, section 751(b) does not apply if a distribution is not in relinquishment of a partner s share of the other class of property. Thus, the regulations state that section 751 is not applicable to current drawings or to advances against the partner s distributive share, or to a distribution, which is, in fact, a gift or payment for services or for the use of capital. 14 Section 751(b) does not apply to the distribution of a partner s distributive share of 751 or capital gain property. However, in determining whether a partner has received his share, he must take account of his interest in the partnership s remaining property. The regulations provide the following example. 15 The 751 property in the ABC partnership has a fair market value of $100,000, and A has a 30% interest in the partnership. He therefore has a $30,000 in the 751 property. If A receives $20,000 of 751 property in a current distribution, and after the distribution, he continues to have a 30% interest in the partnership s remaining $80,000 of 751 property, his share will be deemed to be only $6,000 ($30,000 minus $24,000). Thus, of the $20,000 distributed to him, $6,000 will be considered to be his share, and $14,000 will be in excess of his share and section 751(b) will apply. Assume that in Example 2, A receives $3000 in cash and his interest in the partnership is reduced thereafter from a one-third partner, to a 20% partner. A reduction to 20% makes sense because the value of the capital accounts after the distribution would total $15,000, and the value of A s capital account would be $3,000. Thus, A would have a value of 20% of the partnership. In order to determine if section 751(b) would apply in this instance, the regulations establish a so-called property exchange table 16 as follows: Asset A s interest A received A FMV relinquished One-third 20% Distributive In Excess of Before After Share Share Cash Land Reg (b)(1)(ii). 15 Reg (b)(1)(ii). 16 This example is adapted from Example 1 of Reg (g). That regulation does not use the term property exchange table, but that is the effect of the table. 14

16 Building Machine Dep Recap Inventory Accts. Rec Total A received an excess distribution of his share of capital gain property. Under the regulations, for purposes of section 751(b), the fact that he relinquished his interest in $561 worth of other capital gain properties is ignored, or cancelled out. However, the remaining $1,039 was exchanged for interests in the partnership s 751 properties. The amount of each property that was hypothetically distributed is reflected in the column designated A relinquished. Thus, the partnership is deemed to have distributed $107 of depreciation recapture having an adjusted basis of zero, $800 worth of inventory having an adjusted basis of $40 ($800/6000 x 300), and $133 of accounts receivable having an adjusted basis of $133. When the partnership purchases these items from A after the hypothetical distribution, A will recognize ordinary income of $107 from the depreciation recapture, $760 ordinary income from the sale of the inventory, and zero ordinary income from the sale of the accounts receivable. There is some doubt whether the result in the above example is correct. Upon the distribution of cash to A, the partnership should revalue the assets and capital accounts, as is permitted by the regulations on substantial economic effect. When these assets are booked-up, the regulations require that section 704(c) principles must govern these assets. Thus, for example, when the assets are revalued, A will not be deemed to have relinquished his share of the depreciation recapture, inventory, or accounts receivable. If these assets are later sold, the inherent gain in them will still be allocated to A. This is a complicated concept, without doubt. However, the application of this principle is explained in Notice , which says that the above example would be incorrect if the partners revalued the partnership s assets and capital accounts. In fact, the Notice specifically states that the result in this situation should not trigger section 751(b), and the regulations should be revised to so provide. 8. Cash distributed includes the relief of liabilities. When determining the amount of a distribution to a partner, you must remember that the relief of a partner s share of liabilities constitutes a cash distribution to him. In many situations, a partner may receive several different types of property in a distribution. 9. The impact of deemed cash distributions. The fact that the relief of liabilities will be treated as cash distributions can lead to strange results, such as occurred in Rev. Rul In that ruling, A, B, and C were equal partners in partnership P. The value of each partner s interest was $25. D acquired a 25% interest in P by contributing $25 to P. Prior to D s contribution, the liabilities of P totaled $100, and each partner s share of the liabilities was $ In addition, P had unrealized receivables of $40, and each partner s share of these unrealized receivables was $ After the contribution by D, each partner s share of P s liabilities was $25; A, B, and C s shares of P s liabilities decreased by $8.33. Each partner s share of P s unrealized receivables was $10; and A, B, and C s share of the unrealized receivables decreased by $

17 The ruling holds that A, B, and C are treated as relinquishing an interest in $3.33 of their shares of the unrealized receivables in exchange for a deemed cash distribution under section 752(b) of $3.33, and there was a disproportionate distribution of their respective shares of cash in relinquishment of $3.33 of unrealized receivables, thereby triggering section 751(b). This is a harsh result because A, B, and C did not actually receive anything. If P had no liabilities, and D simply contributed $50 cash to P in exchange for a 25% partnership interest, there would certainly be no section 751(b) transaction. In addition, it is unclear whether the result is correct under present law. If the partners had booked-up (revalued) their respective capital accounts to fair market value, thus requiring the application of section 704(c) principles ( reverse section 704(c) allocations), then A, B, and C would not be deemed to have relinquished any interest in the unrealized receivables. They would still be allocated the taxable income from the unrealized receivables existing at the time of D s admission. The ruling concludes without explanation that D automatically succeeds to 25% of the unrealized receivables, but this is not so if section 704(c) applies. In Notice , the IRS recognized that the results of a deemed distribution that triggers section 751(b) is unfair in many situations. In the Notice, the IRS cites the legislative history of section 751(b), stating that Congress emphasized income rights of the partners, and suggests that these rights may be treated as severable and subject to the same tax consequences as those of an individual entrepreneur. In other words, if pursuant to an allocation the partner receiving a distribution does not relinquish any right he has to income from a certain class of property, there should be no section 751 problem. The IRS then states that in determining the impact of section 751(b), partners should be allowed to book-up the capital accounts and assets, and thereby trigger reverse section 704(c) allocations. If in Rev. Rul the partners had booked-up the assets and capital accounts as is permitted under the substantial economic effect regulations, A, B and C would continue to be taxed on the full amount of the gain from the unrealized receivables. As a result, A, B, and C never relinquished any interest in the unrealized receivables, and section 751(b) should not apply. The Notice also provides a simpler way of administering section 751(b). There would still be a deemed sale of assets, but not for the assets deemed distributed. Instead, there would be a deemed sale of the relinquished assets in exchange for cash only. This would simplify the section. 10. Further Exceptions to Section 751(b) and special rules. There are two exceptions to the application of section 751(b). One is that the section does not apply to property previously contributed by the distributee partner to the partnership. 17 Thus, if the distributee partner receives back the same property he contributed, section 751(b) will not be triggered. The second exception is that section 751(b) does not apply to section 736(a) (b)2)(A). 16

18 payments. 18 These are payments to a retiring or deceased partner that are treated either as a partner s distributive share of income, or as guaranteed payments. See, Chapter 9 for a detailed discussion of section 736. Under Code section 751(f), in determining whether a partnership owns unrealized receivables or an inventory item, a partnership is treated as owning its proportionate share of the property of any partnership in which it is a partner. Thus, if the ABC partnership is a 10% partner of the DEF partnership, in determining whether the ABC partnership owns unrealized receivables or inventory items, ABC is deemed to own 10% of DEF s property. This means that if a partnership distributes an interest in a second partnership to a distributee partner, he will be deemed to receive his proportionate share of property held by the second partnership (b)2)(B). 17