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IRS Proposed Partnership Regs Embrace "Hypothetical Sale" Approach for Hot Asset Distributions. (Parker Tax Publishing November 12, 2014)

On November 3, the IRS issued proposed regulations embracing the "hypothetical sale" approach for measuring whether a distribution reduces a partner's interest in the partnership's Section 751 property, and allowing greater flexibility in determining tax consequences when a reduction occurs. The proposed regulations also provide new rules under Code Sec. 704(c) to help partnerships compute partner gain in Section 751 property more precisely, and describe how basis adjustments under Code Secs. 734(b) and 743(b) affect the computation of partners' interests in Section 751 property.

The proposed regulations affect partners in partnerships that own unrealized receivables and inventory items and that make a distribution to one or more partners. Issued in REG-151416-06 (11/03/14), the regulations are generally proposed to apply to distributions occurring in taxable periods ending on or after the date they are finalized.

Background to Code Section 751

In 1954, Congress enacted Code Sec. 751 to prevent the conversion of potential ordinary income into capital gain by way of partnership distributions. Code. Sec. 751(a) provides that amounts a transferor partner receives in exchange for all or part of that partner's interest in the partnership's unrealized receivables and inventory items (Section 751 property) is considered as an amount realized from the sale or exchange of property other than a capital asset. Further, Code Sec. 751(b) overrides the nonrecognition provisions of Code Sec. 731 to the extent a partner receives a distribution from the partnership that causes a shift between the partner's interest in the partnership's Section 751 property and the partner's interest in the partnership's other property. Whether Code Sec. 751(b) applies depends on the partner's interest in the partnership's Section 751 property before and after a distribution.

The regulations under Code Sec. 751(a) provide that a partner's interest in the Section 751 property is the amount of income or loss from such property that would be allocated to the partner if the partnership had sold all of its property in a fully taxable transaction for cash in an amount equal to the fair market value of such property. However, the current regulations under Code Sec. 751(b) determine a partner's interest in Section 751 property by reference to the partner's share of the gross value of the partnership's assets (the "gross value" approach). Because the gross value approach focuses on a partner's share of the asset's value rather than the partner's share of the unrealized gain, the gross value approach may allow a distribution that reduces a partner's share of the unrealized gain in the partnership's Section 751 property without triggering Code Sec. 751(b), and, conversely, may trigger Code Sec. 751(b) even if the partner's share of the unrealized gain in the partnership's Section 751 property is not reduced.

If the distribution results in a shift between the partner's interest in the partnership's Section 751 property and the partnership's other property, the current regulations require a deemed asset exchange of both Section 751 property and other property between the partner and the partnership to determine the tax consequences of the distribution (the "asset exchange" approach). The asset exchange approach is complex, requiring the partnership and partner to determine the tax consequences of both a deemed distribution of relinquished property and a deemed taxable exchange of that property back to the partnership. The asset exchange approach also often accelerates capital gain unnecessarily by requiring certain partners to recognize capital gain even when their shares of partnership capital gain have not been reduced.

Notice 2006-14 Introduces New Approaches

In 2006, the IRS published Notice 2006-14, which suggested two new approaches to Code Sec. 751(b) issues: (1) 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, and (2) replacing the asset exchange approach with a "hot asset sale" approach to determine the tax consequences when Code Sec. 751(b) applies.

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 fair market value immediately before the distribution.

The hot asset sale approach deems the partnership to distribute the relinquished Section 751 property to the partner whose interest in the partnership's Section 751 property is reduced, and then deems the partner to sell the relinquished Section 751 property back to the partnership immediately before the actual distribution.

Changes Made by the Proposed Regulations

The proposed regulations embrace the "hypothetical sale" approach for measuring whether a distribution reduces a partner's interest in the partnership's Section 751 property, and also allow greater flexibility in determining tax consequences when a reduction occurs. The proposed regulations also provide new rules under Code Sec. 704(c) to help partnerships compute partner gain in Section 751 property more precisely, and describe how basis adjustments under Code Secs. 734(b) and 743(b) affect the computation of partners' interests in Section 751 property.

Hypothetical Sale Approach

The hypothetical sale approach requires a partnership to compare: (1) the amount of ordinary income (or ordinary loss) that each partner would recognize if the partnership sold its property for fair market value immediately before the distribution with (2) the amount of ordinary income (or ordinary loss) each partner would recognize if the partnership sold its property, and the distributee partner 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 Code Sec. 751(b) and will be considered as a sale or exchange of the property between the partner and the partnership.

Because the hypothetical sale approach relies on the principles of Code Sec. 704(c) to preserve a partner's share of the unrealized gain and loss in the partnership's Section 751 property, the proposed regulations make several changes to the regulations relating to Code Sec. 704(c). Specifically, the proposed regulations revise Reg. Sec. 1.704-1(b)(2)(iv)(f), regarding revaluations of partnership property, to make its provisions mandatory if a partnership distributes money or other property to a partner as consideration for an interest in the partnership and the partnership owns Section 751 property immediately after the distribution.

OBSERVATION: Code Sec. 704 deals with partners' distributive shares of income, gain, loss, deduction, or credit, determined with respect to the partnership agreement. Regulations under Code Sec. 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 Code Sec. 704(c), which generally preserve each partner's share of the unrealized gain and loss in the partnership's assets.

In addition, the proposed regulations contain a special revaluation rule for distributing partnerships that own an interest in a lower-tier partnership.

Effect of Basis Adjustments on Code Section 751(b) Computations

While Code Sec. 704(c) revaluations generally preserve partners' interests in Section 751 property upon a partnership distribution, certain basis adjustments under Code Sec 732(c) or Code Sec. 734(b) may alter partners' interests in Section 751 property following the distribution. Accordingly, the proposed regulations provide rules on the computation of partners' interests in Section 751 property after taking such basis adjustments into account.

Under the proposed rules, a reduction in ordinary income would constitute a reduction in the partners' shares of unrealized gain in the partnership's Section 751 property, which could trigger Code Sec. 751(b) in situations in which Code Sec. 751(b) would not have otherwise applied. A similar reduction in Section 751 property could occur if the basis of the distributed property increases under Code Sec. 732.

To help avoid this possibly unwanted basis reduction, the proposed regulations provide that a basis adjustment under Code Sec. 732(c) or Code Sec. 734(b) (as adjusted for recovery of the basis adjustment) that is allocated to capital gain property and that reduces the ordinary income (attributable, for example, to recapture under Code Sec. 1245(a)(1)) that the partner or partnership would recognize on a taxable disposition of the property is not taken into account in determining: (1) the partnership's basis for purposes of Code Secs. 617(d)(1), 1245(a)(1), 1250(a)(1), 1252(a)(1), and 1254(a)(1); and (2) the partner or partnership's respective gain or loss for purposes of Code Secs. 995(c), 1231(a), and 1248(a).

In response to a commentator's concerns about the application of Code Sec. 751(b) upon the distribution to a partner of Section 751 property for which another partner has a basis adjustment under Code Sec. 743(b), the proposed regulations require that partners include the effect of carryover basis adjustments when determining their shares of Section 751 property as though those basis adjustments were immediately allocable to ordinary income property.

Code Section 751(b) Distributions

The purpose of Code Sec. 751 is to prevent a partner from converting its share of potential ordinary income into capital gain. A distribution of partnership property (including money) is a Code Sec. 751(b) distribution if the distribution reduces any partner's share of net Code Sec. 751 unrealized gain or increases any partner's share of net Code Sec. 751 unrealized loss, as determined under the hypothetical sale approach. For this purpose, a partner's net Code Sec. 751 unrealized gain or loss immediately before a distribution equals the amount of net gain or loss, as the case may be, from Section 751 property that would be allocated to the partner if the partnership disposed of all of the partnership's assets for cash in an amount equal to the fair market value of such property.

A partner's net Code Sec. 751 unrealized gain or loss also takes into account any Code Sec. 743 basis adjustment. For example, if A and B are partners in the AB partnership, which owns capital assets and a single ordinary income asset that is the subject of a Code Sec. 743(b) adjustment with respect to B, and that asset is distributed to partner A, B's basis adjustment is suspended because the partnership lacks other ordinary income property. However, the basis adjustment will eventually benefit B when the partnership acquires new ordinary income property. For this reason, the proposed regulations require B to take the suspended adjustment into account when determining whether Code Sec. 751(b) applies to B with respect to the distribution.

Code Section 751 Anti-Abuse Rule

The proposed regulations provide an anti-abuse rule that requires taxpayers to apply the proposed regulations in a manner consistent with the purpose of Code Sec. 751, and allows the IRS to recast transactions to achieve tax results consistent with Code Sec. 751. The proposed regulations provide a list of situations that are presumed inconsistent with the purpose of Code Sec. 751.

Tax Consequences of a Code Sec. 751(b) Distribution

If Code Sec. 751(b) applies to a distribution contemplated by the proposed regulations, partners must determine the consequences of its application to the partnership and its partners. Notice 2006-14 discussed replacing the asset exchange approach with a hot asset sale approach to determine these consequences. Commentators also proposed a "deemed gain" approach as an alternative to the hot asset sale approach.

The IRS determined that no one approach produced an appropriate outcome in all circumstances. Therefore, these proposed regulations 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 Code Sec. 751(b) distribution. Instead, 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 Code Sec. 751(b) amount, then the partnership must use a reasonable approach that is consistent with the purpose of Code Sec. 751(b) to determine the tax consequences of the reduction.

Additionally, the proposed regulations require a distributee partner to recognize capital gain to the extent necessary to prevent the distribution from triggering a basis adjustment under Code Sec. 734(b) that would reduce other partners' shares of net unrealized Code Sec. 751 gain or loss. The proposed regulations also allow distributee partners to elect to recognize capital gain in certain circumstances to avoid decreases to the basis of distributed Section 751 property.

Miscellaneous Issues Addressed

The proposed regulations also address a few ancillary issues raised by commentators.

As to Code Sec. 751(a), the proposed regulations provide that the amount of money or the fair market value of property received for purposes of Code Sec. 751(a) takes into account the transferor partner's share of income or gain from Section 751 property.

Additionally, the proposed regulations add successor rules to Code Sec. 751(b) similar to rules contained in other previously contributed property exceptions within subchapter K.

These proposed regulations also make a number of technical corrections to account for changes in the law since the issuance of existing regulations under Code Sec. 751.

Examples

The proposed regulations provide several in-depth examples of what the IRS considers to be a reasonable approach to determine the tax consequences in various hot asset distribution scenarios, and one example where the approach adopted was not deemed reasonable under the facts. In particular, Example 3 in Prop. Reg. Sec. 1.751-1 clearly illustrates the application of both the "deemed gain" and the "hot asset sale" to a liquidating distribution triggering Sec. 751(b).

Effective Date

The regulations proposed in REG-151416-06 are generally proposed to apply to distributions occurring in any taxable period ending on or after the date they are published as final regulations. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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