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

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1 FOR LIVE PROGRAM ONLY IRC 751 "Hot Assets": Calculating and Reporting Ordinary Income in Disposition of Partnership or LLC Interests WEDNESDAY, JULY 26, 2017, 1:00-2:50 pm Eastern IMPORTANT INFORMATION FOR THE LIVE PROGRAM 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 DURING THE LIVE EVENT For Additional Registrations: -Call Strafford Customer Service x10 (or x10) For Assistance During the Live 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 Tips for Optimal Quality FOR LIVE PROGRAM ONLY Sound Quality When listening via your computer speakers, please note that the quality of your sound will vary depending on the speed and quality of your internet connection. If the sound quality is not satisfactory, please immediately so we can address the problem.

3 IRC 751 "Hot Assets" July 26, 2017 Yoram Keinan, Partner Smith Gambrell & Russell, New York James Lynch, Esq., CPA, Tax Director Sobel & Co., Livingston, N.J. Brian Keida, CPA, Tax Senior Manager Crowe Horwath, Atlanta

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) Asset Rules Brian Keida Crowe Horwath, LLP

6 Aggregate versus Entity The taxation of partnerships and partners under subchapter K of the Internal Revenue Code (the Code ) blends entity and aggregate principles. Under a pure entity view, partnerships would be treated as entities separate from their partners. Sales of partnership interests would be taxed as sales of separate assets, without regard to the character of partnership assets. Under a pure aggregate view of partnerships, the partners of a partnership would be treated as the direct co-owners of partnership property.

7 Aggregate v. Entity Approach: Aggregate - An interest in each Partnership Asset Partner holds a share of each partnership asset Example: A contributes $80,000 and B contributes $120,000 to Partnership AB for a 40%/60% interest in Partnership AB. Partnership AB acquires land for $200,000 and generates $12,000 in a receivable (rent). In a pure aggregate view, if A sells the 40% interest, A is selling a 40% interest in the land plus a 40% 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 A B AB assets A B Real Estate Receivable Real Estate Receivable 8

9 Background History Prior to 1954, the entity view prevailed. Partnership interests were treated as capital assets that were distinguishable from the assets held by the partnership. Taxpayers could sell interests in partnership with right to future payment that would generate ordinary income and characterize resulting gain as capital gain. Section 751 was enacted to address taxpayers converting ordinary income to capital gain.

10 Section 751 Enacted 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. Section 751(a) provides an exception by recharacterizing any amount realized on a sale or exchange of a partnership interest attributable to the assets below as an amount realized from the sale or exchange of an asset other than a capital asset. These are commonly referred to as hot assets. Unrealized receivables Inventory Items 10

11 Reg (a)(1) To the extent that money or property received by a partner in exchange for all or part of his partnership interest is attributable to his share of the value of partnership unrealized receivables or substantially appreciated inventory items, the money or fair market value of the property received shall be considered as an amount realized from the sale or exchange of property other than a capital asset. The remainder of the total amount realized on the sale or exchange of the partnership interest is realized from the sale or exchange of a capital asset under section

12 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 12

13 Unrealized Receivables Evolving definition Other Items Reg (c)(4) Gain from mining property Section 617(f)(2) Gain from Section 1245 Property Gain from Section 1250 Property Farm Land Gain Section 1252(a)(2) Gain from stock in a DISC Section 992(a) Gain from PFIC Stock Section 1248 Gain from Farm Recapture Property 1251(c) Gain from Franchises, Trademarks, and Trade Names Section 1253(a) Natural resource recapture Section 1254(a) 13

14 Inventory Items Reg (d)(2) Property of the partnership of the kind described in section 1221(a)(1). Any other property which, on sale or exchange, would be considered property other than a capital asset under section 1221 and other than property described in section Accounts receivable acquired in the ordinary course of business for services Any other property retained by partnership which, if held by the selling partner would be considered property described above. 14

15 Property of the Kind Described in Section 1221(a)(1) 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. (Freeland Est. v Comr., Morse v. U.S. and Ginsburg v. U.S.). 15

16 Sale of Partnership Interest A hypothetical sale approach is used to determine the amount of ordinary income or loss recognized by the selling partner. Reg. Section (a)(2). There are look-through rules that apply to collectibles and Section 1250 capital gain (IRC Section 1(h)). Section 1250 is not a hot asset. Section 751(a) re-characterizes gain from capital to ordinary, which can result in significant ordinary income offset by a large capital loss. Mechanics of look-through approach: First determine overall gain or loss under entity approach. Second, determine amount of ordinary income that would be allocated to the selling partner taking into account and section 704(c) allocations upon a hypothetical sale of all of the partnership s assets for FMV immediately before the transfer. Finally determine the residual amount of capital gain or loss on the sale. 16

17 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 nondepreciable 17

18 Assets Basis Fair Market 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 18

19 Example 1 Basic 751(a) Calculation Amount Realized Adjusted Basis Step 1 - B s Overall 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 19

20 Example 1 - Section 751 Gain Calculation Step 2 Determine amount of ordinary income to allocate to seller 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 20

21 Example 1 Capital Gain/Loss Calculation Step 3 Determine the residual amount of capital gain or loss on the sale Gain from Sale without Section 751 Item Value Comment $6,000 From slide 19 Section 751 Gain from Sale $7,000 From slide 20 Capital Gain/(Loss) from Sale ($1,000) Gain from Sale without Section 751 minus the amount of Section 751 Gain 21

22 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). 22

23 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 ($1,000) $5,000 Unrealized Receivables $0 $7,000 $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 23

24 Example 2 Sale of Interest A and B are equal partners in personal service partnership PRS. B sells their 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 24

25 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 25

26 Example 2 Gain Calculation Amount Realized Adjusted Basis B s Gain without Section 751(a) Item Value Comments Gain $8,000 $13,000 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 26

27 Example 2 - 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 27

28 Example 2 Capital Gain/Loss Calculation Gain from Sale without Section 751 Item Value Comment $8,000 From slide 26 Section 751 Gain from Sale $7,000 From slide 27 Capital Gain/(Loss) from Sale $1,000 Gain from Sale without Section 751 minus the amount of Section 751 Gain 28

29 Example 3 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 29

30 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 30

31 Example 3 Gain Calculation Amount Realized Adjusted Basis B s Gain without Section 751(a) Item Value Comments Gain $11,000 $16,000 Includes $15,000 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 31

32 Amount Realized Example 3 - Section 751 Gain Calculation 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 32

33 Example 3 Capital Gain/Loss Calculation Item Value Comment Gain from Sale without Section 751 Section 751 Gain from Sale Capital Gain/(Loss) from Sale $11,000 From slide 31 $12,000 From slide 32 ($1,000) Loss from Sale without Section 751 minus the amount of Section 751 Gain 33

34 Reg (c)(5) Only amount or recapture potential is considered to be an unrealized receivable. Section 1245 property includes all depreciable property other than buildings or structural components. Section 1250 is any real property other than section Basis of any potential gain is zero. The recapture must be computed separately for each asset, assuming the asset has a zero basis. This may result in partner recognizing ordinary income on disposition of interest even though the aggregate FMV of all of the assets would produce an overall loss. 34

35 Example 4 Unrealized Receivables A and B are equal partners in personal service partnership PRS. B sells their interest in PRS to T for $45,000 when PRS s balance sheet is as follows: 35

36 Assets Basis Value Cash $3,000 $3,000 Accounts Receivable $10,000 $10,000 Machine A ($8,000 A/D) $19,000 $27,000 Machine B ($12,000 A/D) $88,000 $70,000 Totals $120,000 $110,000 Liabilities & Capital Liabilities $20,000 $20,000 Capital A $50,000 $45,000 B $50,000 $45,000 Totals $120,000 $110,000 36

37 Example 4 Unrealized Receivables Amount Realized Adjusted Basis B s Loss without Section 751(a) Item Value Comments Gain / (Loss) ($5,000) $55,000 Includes $45,000 of cash plus $10,000 of Section 752 reduced share of liabilities $60,000 Includes $50,000 regular basis plus $10,000 share of liabilities 37

38 Example 4 - Section 751 Gain Calculation Item Value Comment Potential Recapture Machine A Adjusted Basis $0 Total Section 751 Gain to B $4,000 $4,000 Value of Unrealized Receivables (Section 1245) Potential Recapture Machine B $0 Value of Unrealized Receivables (Section 1245) Adjusted Basis $0 Amount Realized Machine B $0 38

39 Example 4 Capital Gain/Loss Calculation Loss from Sale without Section 751 Item Value Comment ($5,000) From slide 37 Section 751 Gain from Sale $4,000 From slide 38 Capital Gain/(Loss) from Sale ($9,000) Loss from Sale without Section 751 minus the amount of Section 751 Gain 39

40 Tax Reporting Obligations Each partnership must file a separate Form 8308 with respect to each section 751(a) sale or exchange of an interest. Within 30 days of the Section 751(a) exchange, each transferor partner must provide the partnership with the information needed to complete Form Also file a Section 751(a) statement providing the following information: The date of the sale or exchange; The amount of any gain or loss attributable to Section 751(a) property; and The amount of any gain or loss attributable to capital gain or loss on sale of interest. 40

41 Installment Sales Section 453 The timing of Section 751 income is not affected by installment sale rules. Mingo v. Commissioner, Tax Notes Doc (5 th Cir. 2014) Gain recognized subject to Section 1245 and 1250 recapture is recaptured as ordinary income in the year of recognition (Section 453 recapture). Rev. Rul , IRS ruled substantially appreciated inventory would also be subject to income recognition at time of sale. 41

42

43 Definition of Hot Assets James Lynch Sobel & Co.

44 Agenda Definitions Unrealized receivables Substantially appreciated receivables 44

45 Definition Sec 751 includes as hot assets Unrealized receivables Substantially appreciated Inventory 45

46 Definition These categories are not simple They include many items that most practitioners would not think are included 46

47 Unrealized Receivables This category is extremely broad We will first list the subcategories We will then discuss those subcategories in more detail 47

48 Unrealized Receivables Includes any amount not recognized before as income Received for the sale of goods delivered or to be delivered Received for the sale of services provided or to be provided Which are not capital gain 48

49 Unrealized Receivables Ordinary income that could be recognized from the sale of assets under Sec Ordinary income that could be recognized from the sale of assets under Sec Ordinary income that could arise from the sale of partnership assets under Sec. 467, 617, 1248, 1252, 1253, 1254, 1278, and

50 Unrealized Receivables The first category is part of the general understanding of unrealized receivables Unpaid amounts from the sale of goods Not recognized in income 50

51 Unrealized Receivables Does not include receivables from an accrual taxpayer Those receivables have already been recognized in income 51

52 Unrealized Receivables Receivables from the sale of goods will generally not be unrealized Most sellers of goods have to be on the accrual basis 52

53 Unrealized Receivables A receivable from the sale of depreciable or real property that was held for one year or less is included in this category Property held for a year or less does not fall under Sec Therefore, the receivable is included under Sec

54 Unrealized Receivables Unrealized receivables does include proceeds from the sale of capital assets Deferred gain on the sale of Sec property is not included as an unrealized receivable 54

55 Unrealized Receivables Unrealized receivables can include unpaid amounts for services More common occurrence than unrealized receivables on the sale of goods More service providers use cash method 55

56 Unrealized Receivables Unrealized receivables for services has its complications What about partially completed services? 56

57 Unrealized Receivables A service provider begins a project for a client The service provider uses the cash method of accounting The project is only partially completed, and not billed, when a partner is bought out Is there an unrealized receivable? 57

58 Unrealized Receivables In Logan v. Commissioner 51 TC 4852 (1968) the court said yes The service provider has the right to receive payment for incomplete work 58

59 Unrealized Receivables There can be a fine line between future payments for goodwill and payments for services. Payments for goodwill are payments for a capital asset and are not subject to Sec

60 Unrealized Receivables A right to share of a firm s future profits can be considered to be in part from goodwill However, the Tax Court has considered the right to receive profits in return for services to be an unrealized receivables 60

61 Unrealized Receivables Revenue Ruling provides another example of this type of problem In , a partnership had a management contract with a life insurance company Partnership interests were sold to other individuals This was done with the knowledge and permission of the life insurance company 61

62 Unrealized Receivables The IRS concluded that the management contract was an unassignable personal service contract The acceptance of the sale of partnerships interests by the insurance company was the same as if the old contract had been cancelled 62

63 Unrealized Receivables At the same time, a new contract was agreed to by the insurance company and the new partnership, including all the new partners. The selling partners were given, as part of the sales price, payment in consideration of the relinquishment of their rights in the contract 63

64 Unrealized Receivables The amounts received by the selling partners for their interests in the management contract were for payment rights for services to be rendered Those amounts were taxed as ordinary income 64

65 Unrealized Receivables Some additional findings of unrealized receivables occurred in Roth v Commissioner 321 F2d 607 (9 th Dir. 1963) in which monies to be received under a film distribution contract were considered to be an unrealized receivable This was so even though the payments were termed rent 65

66 Unrealized Receivables In Revenue Ruling CB 225 the completed contract method of accounting was used. A long term uncompleted contract was considered to be an unrealized receivable 66

67 Unrealized Receivables Ledoux v. Commissioner 77 TC 293 (1981) aff d per curiam 695 F2d 1320 (11 th Cir. 1983) involved a contract similar to a management employment contract This contract was the major asset of the partnership 67

68 Unrealized Receivables The Tax Court found that under the contract the partners had the right to provide services and receive income in the future The right to receive income constituted an unrealized receivable Despite the fact that the agreement did not require services to be performed 68

69 Unrealized Receivables Practitioners should exercise caution when they attempt to determine what is an unrealized receivable 69

70 Unrealized Receivables Various types of recapture income are included in unrealized receivables This is to prevent the conversion of ordinary income into capital gain income by putting assets into a partnership 70

71 Unrealized Receivables Recapture provisions included in unrealized receivables include IRC 1245 and 1250 dealing with depreciation 71

72 Unrealized Receivables IRC 467 dealing with rental income IRC 617 dealing with mining and exploration expenses IRC 1248 dealing with gains on the sale of stock in foreign corporations 72

73 Unrealized Receivables IRC 1252 dealing with sales of farm land IRC 1253 dealing with transfers of franchises, trademarks, and trade names IRC 1254 dealing with gain from the disposition of interests in oil, gas, geothermal, or other mineral properties 73

74 Unrealized Receivables Sec 1278 dealing with market discount bonds Sec 1283 dealing with short term obligations 74

75 Unrealized Receivables The recapture provisions apply to both cash and accrual basis taxpayers These provisions are applied as if the partnership sold the affected assets for fair market value 75

76 Inventory Items Inventory items are defined as such by focusing on the assets as used both by the partnership and the receiving partner 76

77 Inventory Items Inventory includes Property held primarily for sale to customers in the ordinary course of business-per IRC 1221(a)(1) Any property of the partnership which, if sold, would not be considered a capital asset or an asset described in IRC

78 Inventory Items Any property held by the partnership which, if held by the receiving partner, would be considered inventory under the two points on the preceding slide 78

79 Inventory Items Real property can present interesting issues under this definition. Three cases, based on the same fact pattern, provide a classic case 79

80 Inventory Items The three cases are Morse v. United States 371 F2d 474 (Cl. Ct. 1967) Ginsberg v. United States 396 F2d 983 (Cl. Ct. 1968) Estate of Freeland v. Commissioner 393 F2d 573 (9 th Cir. 1968) 80

81 Inventory Items The three cases involved different limited partners in the same partnership The partnership owned undeveloped land which it planned to develop Due to economic troubles, the plan was never carried out 81

82 Inventory Items The issue before the court in each case was whether the land was inventory once the development plans had been abandoned In Morse and Ginsberg, the Court of Claims concluded that the original purpose of holding the land for development had been abandoned The Court concluded that the land was held for investment 82

83 Inventory Items In Freeland the Ninth Circuit upheld a Tax court decision the land was always held by the partnership for development Therefore, the partner had to recognize ordinary income on the sale of his interest 83

84 Inventory Items Second category includes assets which if sold would not be considered capital assets or assets under IRC 1231 This could include many assets considered unrealized receivable 84

85 Inventory Items IRC 1221(a)(4) excludes from capital assets receivables for Services rendered Inventory sold 85

86 Inventory Items Unrealized receivables are therefore considered inventory property This applies to both cash and accrual basis taxpayers The significance of this will be illustrated shortly 86

87 Inventory Items Inventory will also include amounts subject to recapture under the various provisions listed previously Those recapture sections treat the income as ordinary 87

88 Inventory Items IRC 64 provides that such recapture income is treated as coming from the sale of an asset which is not A capital asset An IRC 1231 asset 88

89 Inventory Items The final category of inventory is any property that would be inventory in the hands of the recipient partner 89

90 Inventory Items Assume for example that a partnership owned an apartment building which the partnership held for investment purposes Assume further that the partnership intended to distribute the apartment building to a partner Smith in complete liquidation of Smith s interest 90

91 Inventory Items Assume Smith is a real estate developer who plans to modernize the apartment building and sell each unit This apartment building would be inventory 91

92 Inventory Items IRC 751 applies to substantially appreciated inventory Inventory is considered to be substantially appreciated if its fair market exceeds 120 percent of its adjusted basis 92

93 Inventory Items Assume inventory with the following Adjusted basis $100,000 FMV $125,000 FMV is more than 120 percent ($120,000) of the adjusted basis of the inventory Therefore, the inventory has substantially appreciated in value. 93

94 Inventory Items Accounts receivable, even if not unrealized, are included in the definition of inventory This can effect whether the inventory is substantially appreciated or not 94

95 Inventory Items Assume the following Inventory-Basis $100,000 Inventory-FMV $150,000 Receivables-Basis $200,000 Receivables-FMV $200,000 95

96 Inventory Items To test if inventory has substantially appreciated Total-Basis $300,000 Total-FMV $350,000 FMV as percent of basis 117% This inventory is not substantially appreciated 96

97

98 Proposed Regulations under Section 751(b) (REG , Nov. 03, 2014) Yoram Keinan, Partner, Smith Gambrell & Russell LLP

99 Overview 99

100 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. 100

101 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. 101

102 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. 102

103 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. 103

104 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. 104

105 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. 105

106 Notice

107 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). 107

108 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. 108

109 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). 109

110 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. 110

111 The Proposed Regulations 111

112 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. 112

113 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. 113

114 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. 114

115 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. 115

116 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. 116

117 Anti Abuse Rule The proposed regulations include antiabuse 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. 117

118 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. 118

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