Congress enacted section 751 of the Internal Revenue Code to prevent both the transformation of ordinary income into capital gain and the shifting of ordinary income among partners of a partnership. The section applies when a distribution alters partners’ share of unrealized receivables and substantially appreciated inventory (“hot assets”).
In determining whether a distribution alters a partner’s share of hot assets, the regulations focus on the gross value of the partnership’s assets. Specifically, the regulations compare the distributee partner’s share of hot and cold assets before and after the distribution and if the partner’s share in such assets changes, the typical non-recognition rules of section 731 are ignored and the distribution is taxed. To determine the tax consequences of the distribution, the regulations require a deemed distribution of the assets in which the distributee partner’s interest decreases followed by a deemed sale of such assets from the partner to the partnership in exchange for the assets in which the partner’s interest increases.
Critics identified two principal flaws with the above methodology. First of all, Congress enacted section 751 to prevent the shifting of ordinary income among partners. However, the regulations trigger section 751’s application based on a change in each partner’s share of the gross value of partnership assets as opposed to unrealized gain in the assets. Second, the method for calculating the section 751 tax is at best confusing and at times incredibly complex.
In response to these concerns, Treasury issued Notice 2006-14 (“Notice”) in 2006. The Notice addressed the above critiques. First, the Notice proposed a hypothetical sale approach to determine whether section 751 applies. The hypothetical sale approach compares each partner’s share of hot asset income upon a sale of all partnership assets before and after the distribution. If the partners’ share of hot asset income changes as a result of the distribution then section 751 applies. The Notice adopted section 704(c) built in gain / loss principles in applying the hypothetical sales approach.
In the event section 751 applies, the Notice prescribed a hot asset sale approach for determining the tax consequences of the distribution. The approach deemed the partnership to distribute the property in which the distributee partner’s interest decreases and then the distributee partner sells the property back to the partnership immediately before the distribution.
The IRS recently issued proposed regulations which largely adopt Notice 2006-14. Specifically, the regulations adopt the hypothetical sale approach to determine whether section 751 applies to a partnership distribution. The proposed regulations do not mandate a specific method to determine the tax consequences of a section 751 distribution. Instead, the regulations require the partnership to “use a reasonable approach that is consistent with the purpose of section 751(b) to determine the tax consequences” of the distribution.
The regulations discuss two approaches that are reasonable in most circumstances. The first approach is the hot asset sale approach recommended in Notice 2006-14. The second approach is the deemed gain approach, under which the partnership recognizes ordinary income in the aggregate amount of each partner’s reduction in hot assets, allocates the ordinary income to the partner(s) whose interest in hot assets is reduced by the distribution, and then adjusts the basis of its assets to account for the ordinary income recognition. Generally speaking, once the partnership applies one approach to determine the tax consequences of a section 751 distribution it must continue to use that approach.
The proposed regulations also include an anti-abuse rule, which allows the Commissioner to recast transactions that do not otherwise trigger section 751 to reflect section 751 principles. The targeted distributions generally defer a partner’s recognition of ordinary income without actually reducing the partner’s interest in hot asset gain.
The proposed regulations are effective for distributions occurring on or after the date the regulations are published as final regulations in the Federal Register. However, taxpayers may apply the hypothetical sales approach for distributions made on or after November 3, 2014 as long as the partnership and partners consistently apply the other regulatory changes.