IRC 751 "Hot Assets": Calculating and Reporting Ordinary Income in Disposition of Partnership or LLC Interests

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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 This program is approved for 2 CPE credit hours. To earn credit you must: IMPORTANT INFORMATION 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.

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3 IRC 751 "Hot Assets" July 9, 2015 Thomas I. Hausman Law Office of Thomas I. Hausman Yoram Keinan Carter Ledyard & Milburn Christopher McLoon Verrill Dana

4 Notice ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY THE SPEAKERS FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN. You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

5 Section 751(a) Current Law Christopher McLoon Verrill Dana, LLP

6 A Little Background

7 Aggregate v. Entity: Competing Constructs for Tax Purposes Aggregate - An interest in each Partnership Asset Partner holds a share of each partnership asset Example: A and B each contribute $100,000 each to Partnership AB for a 50% interest in Partnership AB. Partnership AB acquires land for $200,000 and generates $10,000 in a receivable (rent). In a pure aggregate view, if A sells the 50% interest, A is selling a 50% interest in the land plus a 50% interest in the receivable. Entity - An interest in the Partnership Per Se Partner holds an interest in AB as an entity. A sale of the interest is a sale of the interest in the entity - a capital asset. 7

8 Aggregate v. Entity Aggregate Entity A's Interest is in AB assets, not AB as A A's Interest in AB, and AB A an entity holds interest in AB AB assets AB Real Estate Receivable Real Estate Receivable 8

9 Section 751 Compromise In 1954, Congress enacted Section 751 to prevent taxpayers from using the entity theory to convert into capital gain the value derived from assets producing ordinary income. In other words, Congress adopted the entity theory as to partnership interests, except as to certain assets that generate ordinary income. As to those assets, Congress adopted an aggregate approach. Those assets are: Unrealized receivables Appreciated Inventory 9

10 Unrealized Receivables Evolving definition Has always included rights to payment for: Goods delivered or to be delivered Services rendered or to be rendered Amounts not previously included in income under partnership s method of accounting Applies only to rights arising from contracts/agreements that exist at time of sale (or distribution) Basis includes costs or expenses paid or accrued but not previously taken into account under the partnership s method of accounting 10

11 Unrealized Receivables Evolving definition Other Items Gain from mining property Section 617(f)(2) Gain from stock in a DISC Section 992(a) Gain from Section 1245 Property Gain from PFIC Stock Section 1248 Gain from Section 1250 Property Farm Land Gain Section 1252(a)(2) Gain from Farm Recapture Property 1251(c) Gain from Franchises, Trademarks, and Trade Names Section 1253(a) 11

12 Inventory Items Stock in trade of the partnership Other property properly included in inventory if on hand at the close of the taxable year Property primarily held for sale to customers in the ordinary course of the partnership s trade or business 12

13 Inventory Items Any other property of the partnership which, on sale or exchange, would be considered property other than a capital asset and other than Section 1231 property Any property retained by the partnership that, if held by the partner selling his interest or receiving a distribution would be considered property within the definition of inventory items above 13

14 Example 1 Basic 751(a) Calculation A and B are equal partners in personal service partnership PRS. B transfers its interest in PRS to T for $15,000 when PRS s balance sheet is as follows: Note: PRS has no 704(c) property and the capital assets are non-depreciable 14

15 Assets Basis Value Cash $3,000 $3,000 Loans Receivable $10,000 $10,000 Capital Assets $7,000 $5,000 Unrealized Receivables $0 $14,000 Totals $20,000 $32,000 Liabilities & Capital Liabilities $2,000 $2,000 Capital A $9,000 $15,000 B $9,000 $15,000 Totals $20,000 $32,000 15

16 Example 1 Basic 751(a) Calculation Amount Realized Adjusted Basis B s Gain without Section 751(a) Item Value Comments Gain $6,000 $16,000 Includes $15,000 of cash plus $1,000 of Section 752 reduced share of liabilities $10,000 Includes $9,000 regular basis plus $1,000 share of liabilities 16

17 Example 1 - Section 751 Gain Calculation Amount Realized Item Value Comment Adjusted Basis $0 Income on Sale of Unrealized Receivable B s 50% share of Income from sale of Unrealized Receivable $14,000 Value of Unrealized Receivables $14,000 $7,000 The amount of Section 751(a) gain on the sale of B s interest 17

18 Example 1 Capital Gain/Loss Calculation Gain from Sale without Section 751 Item Value Comment $6,000 From slide 12 Section 751 Gain from Sale $7,000 From slide 13 Capital Gain/(Loss) from Sale ($1,000) Gain from Sale without Section 751 minus the amount of Section 751 Gain 18

19 Section 743 Adjustment Assuming that PRS has a Section 754 election in place, T is entitled to a Section 743 adjustment to the inside basis of assets Adjust for the difference between transferee s outside basis (sections 742 and 752, reduced by share of liabilities) Transferee s share of inside basis proceeds of hypothetical liquidation adjusted for gain/loss Allocated under Section 755 & Treas. Reg (b)(2). 19

20 Post Section 743 Adjustment Balance Sheet Assets Basis 743 Basis Adj. Value Cash $3,000 $3,000 Loans Receivable $10,000 $10,000 Capital Assets $7,000 $5,000 Unrealized Receivables $0 $6,000 $14,000 Totals $20,000 $6,000 $32,000 Liabilities & Capital Liabilities $2,000 $2,000 Capital A $9,000 $15,000 T $15,000 $15,000 Totals $26,000 $32,000 20

21 Example 1a Sale at a Discount A and B are equal partners in personal service partnership PRS. B its interest in PRS to T for $12,000 when PRS s balance sheet is as follows: Note: PRS has no section 704(c) property and the capital assets are non-depreciable 21

22 Assets Basis Value Cash $3,000 $3,000 Loans Receivable $10,000 $10,000 Capital Assets $7,000 $5,000 Unrealized Receivables $0 $14,000 Totals $20,000 $32,000 Liabilities & Capital Liabilities $2,000 $2,000 Capital A $14,000 $15,000 B $4,000 $15,000 Totals $20,000 $32,000 22

23 Example 1a Gain Calculation Amount Realized Adjusted Basis B s Gain without Section 751(a) Item Value Comments Gain $3,000 $13,000 Includes $12,000 of cash plus $1,000 of Section 752 reduced share of liabilities $10,000 Includes $9,000 regular basis plus $1,000 share of liabilities 23

24 Example 1a - Section 751 Gain Calculation Amount Realized Item Value Comment Adjusted Basis $0 Income on Sale of Unrealized Receivable B s 50% share of Income from sale of Unrealized Receivable $14,000 Value of Unrealized Receivables $14,000 $7,000 The amount of Section 751(a) gain on the sale of B s interest 24

25 Example 1a Capital Gain/Loss Calculation Gain from Sale without Section 751 Item Value Comment $3,000 From slide 18 Section 751 Gain from Sale $7,000 From slide 19 Capital Gain/(Loss) from Sale ($4,000) Gain from Sale without Section 751 minus the amount of Section 751 Gain 25

26 Example 1b Section 704(c) A and B are equal partners in personal service partnership PRS. B contributed the Unrealized Receivable when it had a FMV of $10,000 and an adjusted basis of $0. B transfers its interest in PRS to T for $15,000 when PRS s balance sheet is as follows: Note: The capital assets are non-depreciable 26

27 Example 1b Gain Calculation Amount Realized Adjusted Basis B s Gain without Section 751(a) Item Value Comments Gain $10,000 $15,000 Includes $12,000 of cash plus $1,000 of Section 752 reduced share of liabilities $5,000 Includes $4,000 regular basis plus $1,000 share of liabilities 27

28 Example 1b - Section 751 Gain Calculation Amount Realized Item Value Comment Adjusted Basis $0 Section 704(c) Income on Sale of Unrealized Receivable $14,000 Value of Unrealized Receivables $10,000 FMV at contribution less AB at contribution Remaining Income from Sale of Unrealized Receivable $4,000 B s 50% share of Income from sale of Unrealized Receivable $2,000 Total Section 751 Gain to B $12, (c) share of Section 751 Gain, plus remaining (704(b) share) of Section 751 Gain 28

29 Example 1b Capital Gain/Loss Calculation Gain from Sale without Section 751 Item Value Comment $10,000 From slide 22 Section 751 Gain from Sale $12,000 From slide 23 Capital Gain/(Loss) from Sale ($2,000) Gain from Sale without Section 751 minus the amount of Section 751 Gain 29

30 Installment Sales The timing of Section 751 income is not affected by installment sale rules Mingo v. Commissioner, Tax Notes Doc (5 th Cir. 2014) 30

31 Thomas I. Hausman Attorney at Law The Law Office of Thomas I. Hausman

32 Where a partnership owns section 751 property, gain or loss can be recognized upon the distribution of partnership property, and the character of the gain may be ordinary or capital, depending on circumstances. The recognition of gain or loss would not otherwise be taxable. Section 751(b) applies to disproportionate distributions, that is, where a partner receives more of a particular class of property in a distribution in exchange for the release of his share of property of the other class. 32

33 For this purpose, the PS property is divided into two groups: capital gain property and ordinary income property. Capital gain property means capital assets, and section 1231 assets those that would generate capital gain on sale. Ordinary income assets means assets that would generate ordinary income on sale. These assets are unrealized receivables and inventory items. 33

34 Unrealized receivables: basically, accounts receivable of a cash method taxpayer. 751(c). For purposes of section 751(b), substantially appreciated inventory means inventory whose FMV exceeds 120 percent of its adjusted basis. 751(d). For this purpose, any asset, including accounts receivable, that would generate ordinary income upon sale, is included as inventory. Depreciation recapture is included, and for this purpose, depreciation recapture is deemed to have an adjusted basis of zero. 34

35 The idea is to identify the property in which the distributee partner has relinquished his interest. This property is then deemed to be distributed to the distributee partner in a current distribution before the actual distribution, and the distributee partner is deemed to then sell the property back to the partnership for its fair market value for a portion of the actual consideration received. 35

36 Assume the DEF Partnership, where D is a 50% partner, E is a 25% partner, and F is a 25% partner. The Partnership has a liability of $27,000, of which E s share is $6,750. E s adjusted basis for his interest is $11,750. E, on withdrawal from the partnership, receives $13,250 in cash (Item No. 4 on the balance sheet is cash), in full satisfaction of his interest and the assumption of his share of the liabilities by the remaining partners; that there are no unrealized receivables under 751(c); and that assets No. 5, 6 and 7 meet the definition of inventory items under 751(d)(2). Ignore section 736 for this problem. 36

37 Item Basis Value Liabilities 1 Cap gain $10 $10 Mortgage $27 2 Cap gain Cap gain 4 5 Cap Accounts 4 cash D 10 5 inventory 2 11 E 5 6 inventory 4 4 F 5 7 inventory Cap gain 3 20 Total $47 $80 Total 47 37

38 Divide partnership property into asset classes: Non-751 Asset # E s share FMV E s share AB Total: FMV: 15,000; AB:10, Asset # E s share FMV E s share AB Total: FMV: 5,000; AB:

39 The chart shows that if E received a proportionate distribution, he would have received $15,000 worth of non-751 property and $5,000 worth of 751 property. Instead, E received no 751 property he relinquished his interest in that property. The inventory in this situation is substantially appreciated ($20,000 > 120% of $7,000). Since there is a disproportionate distribution and the inventory is substantially appreciated, section 751(b) would apply. E is treated as receiving his share of the inventory in a current distribution and then selling this inventory back to the partnership for $5,000, its FMV. 39

40 As a result, E would be deemed to receive his share of the inventory having an adjusted basis to him of $1,750 ( 732(a)(1)), and he would sell it back to the PS for $5,000, the actual cash received. E would recognize an ordinary gain of $3,250. The $5,000 distribution is deemed to be a selling price it is not part of the $13,250 in cash received on the liquidation of his interest. 40

41 The partnership s adjusted basis for these assets before the distribution was $7,000. Upon the hypothetical distribution, the partnership s adjusted basis will be reduced by the adjusted basis of the inventory distributed ($1,750) = $5,250. The partnership is then deemed to purchase the inventory for $5,000, so the adjusted basis for the inventory is now $10,250. Note that if the partnership purchased the inventory with appreciated assets, and not cash, the partnership could recognize gain or loss. 41

42 The regulations permit the partners to agree on which properties are exchanged, it being understood that for this purpose, only non- 751 properties and 751 properties are exchanged. See, Reg (g), Examples 3 and 4. However, a partner cannot exchange more than his pro-rata share of any property. If the partners do not agree on which properties are exchanged, then a portion of each property is exchanged. 42

43 Asset Gross Value of Distributee s Post-Distribution Interest Gross Value of Assets Distributed Gross Value of Distributee s Predistribution Interest Increase (Decrease) in Distributee s Interest Other Property Cash = , ,500 1,250 1,250 5,000 5,000 (2,500) (1,250) (1,250) 15,000 (5,000) Total Other Property 0 20,000 15,000 5,000 Section 751 Property ,750 1,000 1,250 (2,750) (1,000) (1,250) Total Section 751 Property 0 0 5,000 (5,000) 43

44 E would recognize a gain of $3,250 ordinary income. Section 735(a)(2) provides that a partner s gain on the sale of inventory distributed to him will constitute ordinary income if sold within 5 years. Thus, of the $20,000 E is deemed to receive, $5,000 of it is deemed to be sale proceeds. 44

45 E started out with an AB = $11,750. Upon the distribution of the inventory to him, his AB is reduced by $1,750 to $10,000. The balance of the distribution, in the amount of $15,000, will generate a capital gain of $5,000 (the excess of a cash distribution of $5,000 over E s adjusted basis of $10,000). 736; 731(a)(1). 45

46 Section 736 applies to distributions received by a partner in liquidation of his interest upon his death or retirement. Retirement means he is no longer a partner under local law. A retirement agreement should specify that a person is no longer a partner and has no further right to vote after a certain date. 46

47 Must allocate payments to a deceased or retiring partner between section 736(a) and (b) payments. 736(a) payments are for a partner s distributive share of partnership income, or are guaranteed payments. 47

48 Section 736(b) payments are for a partner s share or interest in partnership property. However, for this purpose, and subject to the conditions below, property does not include unrealized receivables or unstated goodwill (unless the agreement provides for goodwill payments). 736(b)(2). The above rule only applies if (i) capital is not a material income producing factor for the partnership (non-capital factor), and (ii) the retiring or deceased partner was a general partner in the partnership (general partner factor). 736(b)(3). 48

49 This means that any payments for a partner s share of unrealized receivables will be treated as a section 736(a) payment (and if a specific amount, then ordinary income to the recipient and deductible by the partnership under 707). If capital is not a material income producing factor, then unrealized receivables are property, and so is goodwill. Payments under section 736(b) may be subject to section 751(b), so for example, if cash is paid to a partner under 736(b) and is a disproportionate distribution, 751(b) applies. 49

50 Of the $20,000 that E receives, none of the distribution will be governed by section 736(a) because the partnership has no unrealized receivables or unstated goodwill. Instead, the entire distribution will be governed by section 736(b) a distribution in exchange for partnership property. Section 751(b) also applies here to the extent of the disproportionate distribution. The balance of the distribution, in the amount of $15,000, is governed by section 736(b)(1) and 731(a). 50

51 The simple case is a liquidation of a partner s interest. However, section 751(b) can apply to a reduction of a partner s interest as well. Example 5, Reg (g): a partner s interest is reduced from 1/3 to 1/5 in exchange for a distribution or cash and accounts receivable. In this case, the establishment of a partnership exchange table is critical to determine if there is a disproportionate distribution. 51

52 Partners have discretion to determine what property is exchanged for other property. Example 5, Reg (g). It will often make a difference if property is exchanged for a partner s share of one type of property as opposed to another type of property. 52

53 Proposed Regulations under Section 751(b) (REG , Nov. 03, 2014) Yoram Keinan, Chair of Tax Department, Carter Ledyard & Milburn LLP

54 Overview

55 Section 751 in General Congress enacted section 751 to prevent the use of a partnership to convert ordinary income into capital gain. Section 751(a) provides that the amount of any money, or FMV of any property, received by a transferor partner in exchange for all or part of that partner s interest in the partnership s unrealized receivables and inventory items is considered as an amount realized from the sale or exchange of property other than a capital asset. Section 751(b) overrides the section 731 nonrecognition provisions that apply in cases where a partner receives a distribution from the partnership that shifts the partner's interest in the partnership's unrealized receivables or substantially appreciated inventory items (the Section 751 Property ) and the partner's interest in the partnership's other property. Section 751(b) applies to a partnership distribution to the extent the distribution reduces a partner s interest in section 751 property. 55

56 Section 751(b) Whether section 751(b) applies to a distribution depends on the partner s interest in the partnership s Section 751 Property before and after a distribution. The statute does not define a partner s interest in a partnership s Section 751 Property, but the legislative history indicates that a partner s interest in a partnership s Section 751 Property should equal the partner s rights to income from the partnership s Section 751 Property. A distribution of partnership property (including money) is a section 751(b) distribution if the distribution reduces any partner s share of net section 751 unrealized gain or increases any partner s share of net section 751 unrealized loss. 56

57 Current Regulations In computing the distributee partner s income under section 751(b), the current regulations apply a gross value approach and compare the distributee partner s share of the partnership s hot assets and its other assets ( cold assets ) before and after the distribution. For this purpose, under current rules, each partner s share of the partnership s hot and cold assets is determined by reference to the gross value of the assets. In addition, the current regulations apply a deemed-asset-exchange approach if the distribution results in a shift between the partner's interest in the partnership's Section 751 Property and its other property. 57

58 2014 Proposed Regulations On November 03, 2014, the IRS issued proposed regulations under section 751(b) to amend the rules governing how a partner measures its interest in a partnership's unrealized receivables and inventory items and the tax consequences of a distribution to a partner reducing that interest. 58

59 The Proposed Hypothetical Sale Approach The proposed rules would replace the gross value approach with a "hypothetical sale" approach, which involves determining a partner's interest in Section 751 Property by reference to the amount of ordinary income that would be allocated to the partner if the partnership disposed of all of its property at FMV immediately before the distribution. 59

60 The Hot Asset Sale Approach The proposed rules would apply a "hot asset sale" method, which treats the partnership as having distributed the relinquished Section 751 Property to the partner whose interest in the partnership's Section 751 Property is reduced, and then treats the partner as having sold the relinquished property back to the partnership immediately before the actual distribution. The proposed regulations generally will apply to distributions that occur in any tax period ending on or after the date the regulations are finalized. 60

61 Notice

62 Overview The IRS issued Notice to consider and request comments concerning alternative approaches to section 751(b) so as to achieve the purpose of the statute and also to provide greater simplicity. Notice requested comments on: Replacing the gross value approach with a hypothetical sale approach for purposes of determining a partner s interest in the partnership s section 751 property Replacing the asset exchange approach with a hot asset sale approach to determine the tax consequences when section 751(b) applies Notice also requested comments on other possible approaches to simplifying compliance with section 751(b). 62

63 Notice (Hypothetical Sale) As described in Notice , the hypothetical sale approach for section 751(b) is similar to the approach taken in the 1999 regulations issued under section 751(a), shifting the focus to tax gain and away from gross value. Under the hypothetical sale approach, a partner s interest in Section 751 Property is determined by reference to the amount of ordinary income that would be allocated to the partner if the partnership disposed of all of its property for FMV immediately before the distribution. 63

64 Hypothetical Sale (Cont.) Notice indicated that changes to the framework of subchapter K since the promulgation of the existing regulations would work in tandem with the hypothetical sale approach to achieve the statute s objective of ensuring that a partner recognizes its proper share of the partnership s income from section 751 property without unnecessarily accelerating the recognition of that income. For example, regulations under section 704(b) allow a partnership to revalue its assets upon a distribution in consideration of a partnership interest. Any revaluation gain or loss is subject to the rules of section 704(c), which generally preserve each partner s share of the unrealized gain and loss in the partnership s assets. The hypothetical sale approach applies section 704(c) principles in comparing: (1) the amount of ordinary income that each partner would recognize if the partnership sold all of its property for fair market value immediately before the distribution; with (2) the amount of ordinary income each partner would recognize if the partnership sold all of its property (and the distributee partners sold the distributed assets) for fair market value immediately after the distribution. If the distribution reduces the amount of ordinary income (or increases the amount of ordinary loss) from section 751 property that would be allocated to, or recognized by, a partner thus reducing that partner s interest in the partnership s section 751 property the distribution triggers section 751(b). 64

65 Notice (Hot Assets Method) Notice also requested comments on using the hot asset sale approach, rather than the asset exchange approach, to determine the tax consequences of the distribution that is subject to section 751(b). Once it is determined that section 751(b) is triggered, the hot asset sale approach would deem the partnership to distribute the relinquished property to the partner whose interest in the partnership s section 751 property is reduced, and then would deem the partner to sell the relinquished section 751 property back to the partnership immediately before the actual distribution. 65

66 The Proposed Regulations

67 Hypothetical Sale Approach The proposed regulations adopt the Hypothetical Sale Approach that was originally proposed in Notice Under this approach, the partner s interest in Section 751(b) Property is assessed using a hypothetical sale by comparing (A) the amount of ordinary income that each partner would recognize if the partnership sold its property for FMV immediately before the distribution, with (B) the amount of ordinary income each partner would recognize if the partnership sold its property and the distributee partner sold the distributed assets for FMV immediately after the distribution. If the distribution reduces the distributee partner s share of Section 751 property, via a reduction in ordinary income or an increase in ordinary loss, Section 751(b) will be deemed to apply. 67

68 The Tax Consequences of a Section 751 Distribution If section 751(b) applies to a distribution, each partner must generally recognize or take into account currently ordinary income equal to its section 751(b) amount. If a partner has net section 751 unrealized gain both before and after the distribution, then the partner s section 751(b) amount equals the partner s net section 751 unrealized gain immediately before the distribution less the partner s net section 751 unrealized gain immediately after the distribution. If a partner has net section 751 unrealized loss both before and after the distribution, then the partner s section 751(b) amount equals the partner s net section 751 unrealized loss immediately after the distribution less the partner s net section 751 unrealized loss immediately before the distribution. If a partner has net section 751 unrealized gain before the distribution and net section 751 unrealized loss after the distribution, then the partner s section 751(b) amount equals the sum of the partner s net section 751 unrealized gain immediately before the distribution and the partner s net section 751 unrealized loss immediately after the distribution. 68

69 Hot Asset Sale/Deemed Gain Approaches The proposed regulations provide that if, under the hypothetical sale approach, a distribution reduces a partner s interest in the partnership s Section 751 Property, giving rise to a section 751(b) amount, then the partnership must use a reasonable approach that is consistent with the purpose of section 751(b) to determine the tax consequences of the reduction. The two proposed approaches are (1) the hot asset sale approach and (2) the deemed gain approach. The proposed regulations determined that a deemed gain approach produces an appropriate outcome in the greatest number of circumstances out of the approaches under consideration, and that the hot asset sale approach also produced an appropriate outcome in most circumstances. However, no one approach produced an appropriate outcome in all circumstances. Therefore, the proposed regulations would withdraw the asset exchange approach of the current regulations, but do not require the use of a particular approach for determining the tax consequences of a section 751(b) distribution. 69

70 Hot Assets Approach Under the hot asset sale approach, the partnership is deemed to distribute the relinquished property to the partner whose interest in the partnership s Section 751 Property is reduced, and the partner is deemed to sell the relinquished Section 751 Property back to the partnership immediately before the actual distribution. 70

71 Deemed Gain approach Under the deemed gain approach, the partnership recognizes ordinary income in the aggregate amount of each partner s reduction in the partner s interest in Section 751 property, allocates the ordinary income to the partner or partners whose interest in Section 751(b) Property was reduced by the distribution, and makes appropriate basis adjustments to its assets to reflect its ordinary income. 71

72 Anti Abuse Rule The proposed regulations include anti-abuse provisions that attempt to prevent the application of section 751(b) by using section 704(c). If the distribution would otherwise be subject to section 751(b) absent the application of section 704(c), then the IRS mandates that section 751(b) should apply. 72

73 Anti Abuse (Cont.) The proposed regulations provide a list of situations that are presumed inconsistent with the purpose of section 751. Under this list, a distribution is presumed inconsistent with the purpose of section 751 if section 751(b) would apply but for the application of section 704(c) principles, and one or more of the following conditions exists: A partner s interest in net section 751 unrealized gain is at least four times greater than the partner s capital account immediately after distribution. A distribution reduces a partner s interest to such an extent that the partner has little or no exposure to partnership losses and does not meaningfully participate in partnership profits aside from a preferred return for use of capital. The net value of the partner (or its successor) becomes less than its potential tax liability from section 751 property as a result of a transaction. A partner transfers a portion of its partnership interest within five years after the distribution to a tax-indifferent party in a manner that would not trigger ordinary income recognition in the absence of the anti-abuse rule. A partnership transfers to a corporation in a non-recognition transaction Section 751 property other than pursuant to a transfer of all property used in a trade or business excluding assets not material to a continuation of a trade or business. 73