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Partnership - Audit Technique Guide - Chapter 4 - Distribution (Revised 12/2007)

LMSB-04-1107-076
Revised 12/2007

NOTE: This guide is current through the publication date.  Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.

Each chapter in this Audit Techniques Guide (ATG) can be printed individually. Please follow the links at the beginning or end of this chapter to return to either the previous chapter or the Table of Contents or to proceed to the next chapter.

Chapter 3 | Table of Contents | Chapter 5

Chapter 4 - Table of Contents

Note:  The names used in the examples are hypothetical.  The names for corporations were chosen at random from a list of names of American colleges and universities as shown in Webster’s Dictionary.

INTRODUCTION

As a general rule, when a partner transfers property to a partnership, gain or loss is not recognized.  Additionally, a partner does not generally recognize gain or loss upon receiving distributions from a partnership unless the distribution is a cash distribution in excess of the partner’s basis in his/her partnership interest (outside basis).

Although the general rule aims to treat partnership distributions as nontaxable events, the exceptions can quickly overshadow the general rule.  The possibility of moving property in and out of partnerships unimpeded by possible negative tax considerations to the partners creates the potential for abuse.  Transactions, which are essentially sales, can masquerade as tax-free distributions. To prevent income or basis shifting among partners, several provisions track property movements.  For example, partners generally can’t use their partnership as a device to “swap” appreciated or depreciated property.

This Chapter will describe:

  • The basics of current and liquidating distributions
  • Disguised sales of property to partnerships
  • Disguised sales of partnership interests
  • Distributions of built-in gain or loss property to a non-contributing partner
  • Distributions of other property to partners who contribute built in gain property
  • Disproportionate distributions

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BASICS –- CURRENT AND LIQUIDATING DISTRIBUTIONS

Distributions fall into two categories under IRC section 731(a)(1):

  1. Current distributions (Nonliquidating distributions)
  2. Liquidating distributions

Current Distributions

In a current distribution, the partnership is simply distributing money or property to a continuing partner.  On the other hand, a liquidating distribution completely terminates the partner’s interest in the partnership.  A single distribution or a series of distributions can liquidate the interest. 

A partner must report his/her distributive share of partnership income in his/her taxable year in which (or with which) the partnership’s taxable year ends.  That may or may not be the same year in which he/she receives a distribution of cash or property.  In other words, a partner must report his/her distributive share of partnership income regardless of whether the income is actually distributed.

As with sales of partnership interests, distributions can be complicated by the distribution of IRC section 751 assets (unrealized receivables and inventory) which have ordinary income potential.  This depends on whether the partner receives a proportionate or disproportionate share of IRC section 751 assets.  If the distribution retains the partners’ original share of the partnership’s ordinary income assets, it is a proportionate distribution and the regular distribution rules apply.  If, on the other hand, a partner receives more or less than his/her share of IRC section 751 assets, the transaction will be treated as a sale or exchange (note that if the property is inventory, this special rule applies only if the inventory items have “appreciated substantially” in value, as that phrase is defined in IRC section 751(b)(3)).  IRC section 751 must be considered for both current and liquidating distributions. 

The determination of whether a partner is distributed a proportionate share of IRC section 751 assets is determined based on the fair market value of the assets distributed instead of the bases of the assets.  See the discussion later in this chapter regarding disproportionate distributions.

Proportionate (pro rata) distributions are distributions in which the partner’s share of the value of IRC section 751 and non-IRC section 751 assets remains unchanged after the distribution.  The regular distribution rules apply in these instances.

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Proportionate Current Distributions

A current distribution is one in which the partner’s interest in the partnership continues.  In a current proportionate distrubution:

  • The partnership will not recognize a gain or loss.IRC section 731(b).
  • The distributee partner will generally not recognize gain, unless money distributed exceeds the partner’s outside basis in his partnership interest.IRC section 731(a).
  • The distributee partner will never recognize a loss.IRC sections 731(a) and 732(a).
  • The distributee partner’s basis in property received will generally be equal to the partnership’s basis in the property (i.e. the partner takes a “carryover” basis).IRC section 732(a)(1).
  • If an IRC section 754 election is in effect, the distribution may impact the basis of undistributed property left in the partnership.See IRC section 734(a).

Example 4-1

Mike and Larry are partners in an investment partnership.  They each have a basis in their partnership interest of $2,000.  The partnership distributes $1,500 to each partner.  Mike and Larry each have a tax-free distribution of $1,500 and their respective outside bases are reduced to $500.  The partnership does not recognize a gain on the distribution. See IRC sections 731(a)(1) and 731(b).

As noted above, a partner recognizes gain only to the extent that money is distributed in excess of the partner’s outside basis in his/her partnership interest.  IRC section 731(a)(1).  For purposes of the distribution rules, “money” includes cash, a decrease in a partner’s share of partnership liabilities (IRC section 752(b)), and the fair market value of marketable securities (IRC section 731(c)(1)(B)). 

There is a close relationship between a partner’s outside basis in his/her partnership interest and the basis assigned to distributed assets.  Distributions of cash and property reduce outside basis.  The total amount of basis that can be assigned to property distributed is limited to the partner’s outside basis in the partnership interest immediately prior to the distribution.

Basis of Distributed Property in Current Distributions

As noted, the basis of distributed property to the partner is usually the adjusted basis of the property to the partnership immediately before the distribution.  Assuming that the partner has enough outside basis, property distributed will have a straight carryover basis.  IRC sections 732(a)(1) and (2).

The exception to this general rule occurs when the partnership’s adjusted basis in the property (the “inside basis”) exceeds the distributee partner’s outside basis.  When this happens, the distributee partner’s basis in the distributed property is limited to the partner’s outside basis reduced by any money received in the same transaction.  The distributee partner’s outside basis is allocated among the distributed items in the following order:

  1. Cash, including relief of liabilities, and the fair market value of marketable securities.
  2. IRC section 751 assets (“hot assets”), and
  3. Other non-IRC section 751 property.

If the sum of cash, the relief of liabilities, and the fair market value of marketable securities exceeds the partner’s outside basis, no basis will be left to allocate to either IRC section 751 assets or other property.  Depending on the fair market value of the distributed assets, it is possible for a partner to have a continuing interest in a partnership with a zero outside basis.  A liquidating distribution will always result in a zero outside basis (because after a liquidating distribution the partner is gone), while a current distribution may or may not.

Effect of an IRC section 754 Election – Optional Basis Adjustment

A partnership does not ordinarily adjust the basis of the non-distributed property. However, if an IRC section 754 election is in effect, the basis of the partnership’s undistributed properties is increased by the gain recognized by the distributee partner under IRC section 731(a) (i.e. in those situations involving the distribution of money, relief of liabilities, and fair market value of marketable securities in excess of partner’s partnership basis).  This is known as an IRC section 734(b) adjustment.                                                                                         

Additionally, the IRC section 734(b) adjustment will increase the bases of the partnership’s remaining properties to the extent the adjusted basis in the property distributed exceeds the adjusted basis of the partner’s outside basis in his/her  partnership interest as described in IRC section 732(a)(2). 

Character and Holding Period of Distributed Property

When the distributed property is disposed of at a later date, the character of the gain or loss on disposition is governed by IRC section 735.

  • The gain or loss on the disposition of unrealized receivables will be ordinary regardless of the distributee partner’s holding period.
  • In general, a distributee partner’s holding period for property received in a distribution includes the partnership’s holding period.In other words, the distributee “tacks” or adds the partnership’s holding period on to his/her own.
  • The gain or loss on the disposition of property which was inventory to the partnership is ordinary if the inventory is disposed of within 5 years of the distribution date.If the disposition takes place 5 years after the date of the distribution, then the character of the gain or loss depends on the inventory’s character in the hands of the distributee partner at the date of sale (that is, inventory, capital asset, trade or business asset).Treas. Reg. section 1.735-1(a)(2).If an inventory item appreciates in the distributee partner’s hands, the post-distribution appreciation will also be subject to the 5-year ordinary income taint period.See Treas. Reg. section 1.735-1(b) and IRC section 1223(2).

Example 4-2

B is a partner in ABC partnership.  B receives a current distribution of $90,000 cash and land with an adjusted basis to the partnership of $60,000.  B’s outside basis in his partnership interest is $100,000.  The distribution is pro rata.

B’s Outside Basis in ABC

$100,000

  

    Cash Received 

(90,000)

IRC section 732(c)(1)

    Balance

10,000

 No Gain $ < A/B

Land Received 

(10,000)

IRC section 732(c)(2)
& (a)(2) 

B's Remaining Outside Basis
   in ABC   

0

IRC section 733 


 

 

   
   
                                   

 

B does not recognize gain in this example because the amount of money distributed does not exceed his outside basis in ABC partnership.  IRC section 731(a)(1).

Determining a distributee partner’s basis in property received. 

Under IRC sections 732(a)(1) and (a)(2), a distributee partner takes a carryover basis in property received from the partnership.

Exception:  the distributee’s basis in the property received cannot exceed the lesser of:

  • The partnership adjusted basis in the property (i.e. its ”carryover basis”), or
  • The partner’s adjusted basis in his/her partnership interest less cash distributed in the same transaction.

Applying the facts of Example 4-2, the land has a basis to the distributee partner of $10,000.  The partner adds the partnership’s holding period to his own (i.e. the holding period “tacks”).  If, however, the land had been inventory to the partnership, the partner would not include the partnership’s holding period in computing the 5-year ordinary income taint under Section 735(a)(2).  Treas. Reg. section1.735-1(b) and IRC section 1223(2).

Distributions of Corporate Stock – IRC Section 732(f)

The Tax Relief Extension Act of 1999 amended IRC section 732(f) to address a perceived abuse whereby a corporate partner would achieve an unintended tax-free increase in the basis of assets received in distributions from a partnership. 

If a partnership distributes corporate stock to a corporate partner whose outside basis is lower than the partnership's inside basis in the stock, the basis of the stock to the distributee is stepped down to an amount that does not exceed the distributee’s partner's outside basis immediately before the distribution.   This is consistent with the normal rules under IRC section 732.  However, the basis underlying corporate assets would not change.  In order to effectively avoid the basis step down, the partnership could, in the absence of IRC section 732(f), contribute the property to a new corporation under IRC section 351 and distribute the stock in the new corporation to its distributee partner. Because in such situations the distributee corporate partner usually controlled the new corporation within the meaning of IRC section 332(b), the distributee could receive the property in a liquidating distribution under IRC section 332.  Under Section 334(b), the distributee corporate partner would take a basis in the assets equal to the basis the partnership had in the assets when it made the IRC section 351 contribution.  Thus, using these interrelated steps, the distributee could frustrate the intent of IRC section 732. 

IRC section 732(f) closes this loophole by requiring a basis reduction in the distributed property equal to the excess of (1) the partnership's basis in the distributed corporation's stock immediately before the distribution, over (2) the corporate partner's basis in the distributed corporation's stock immediately after the distribution.

Distribution of Property Subject to (or Relieved of) Debt.

  • IRC section 752(a) provides that an increase in a partner's share of partnership liabilities, or an increase in a partner's individual liabilities because of his/her assumption of partnership liabilities, is treated as if he/she contributed money to the partnership.Therefore, when a partner takes on liabilities of or on half of the partnership, he/she increases his/her outside basis.
  • Likewise, IRC section 752(b) provides that a decrease in a partner's share of the liabilities of a partnership or a decrease in a partner's individual liabilities because of the assumption by the partnership of such individual liabilities is treated as if he/she had received a cash distribution from the partnership.This reduces from the partner’s outside basis.

Under IRC section 731(b), a partner’s assumption or relief of partnership liabilities (or the individual liabilities he/she incurred on behalf of the partnership) has no effect on the partnership.

Example 4-3

Assume the same facts as Example 4-2, except that B receives a $101,000 cash distribution.  Because B received a distribution of cash in excess of his outside basis in ABC, he recognizes a gain of $1,000 under IRC section 731(a)(1).  Under IRC section 731(a)(2) the gain is considered from the sale or exchange of B’s interest in ABC partnership.

The sale of a partnership interest is governed by IRC section 741. IRC section 741 treats the sale of a partnership interest as the sale of a capital asset.  Therefore, the sale or exchange of a partnership interest generally gives rise to capital gain except in the case of partnership interests involving "hot assets” under IRC section 751.

Example 4-4

On January 1, 2001, ABC partnership distributed $5 cash and $30 of inventory pro rata to each partner.   Just prior to the distribution, the balance sheet appeared as follows:

         

Adjusted
Basis     

Value

Cash 

60

60

Accounts Receivable

0

39

Inventory

60

90

Land

30

90

    

 

 

 

 

The distributions had the following impact on the partners’ outside bases in ABC partnership:


      

Outside Bases
in the Partnership

      

Balance

40

30

20

Cash Distributed

5

5

5

Balance 

35

25

5

Inventory 

20

20

15

Ending balance 

15

5

0

 

 

 

 

 

 

No partner received cash (or a relief of liabilities or marketable securities treated as cash) in excess of his outside basis.  Therefore, no partner recognized gain on distribution.  Partners A and B take a $20 carryover basis in the inventory.  This is equal to ABC’s basis in the inventory immediately before the distribution.  Partner C’s basis in the inventory is limited to $15, his outside basis in ABC immediately before the inventory distribution. 

 

On January 1, 2002, Partner C sold the inventory for $40.  His gain was computed as follows:

Amount Realized

$40 

Adjusted Basis 

15 

Gain  

25 IRC section 735(a)(2)
There was less than 5 years
between the distribution and
the subsequent  sale so it
would be an ordinary gain.

  

 

 


       

Because less than 5 years had passed between the distribution and the subsequent sale, Partner C had to recognize an ordinary gain under IRC section 735(a)(2).  Partner C’s holding period begins on January 1, 2001, the date ABC made the distribution.  Under IRC section 735(b), Partner C does not count the time ABC partnership held the inventory in determining his holding period.

If Partner C sells the inventory for $40 on January 1, 2008, the ordinary income taint from the partnership will expire, because more than 5 years will have passed since the original distribution.  At that point, the character of the gain will depend on the character of the asset in former Partner C’s hands. If he holds the asset as inventory, then the gain will be ordinary income. 

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Liquidating Distributions

Proportionate Liquidating Distributions

The treatment of proportionate (pro rata) liquidating distributions is similar to that of current distributions.  Gain is only recognized if the amount of money distributed (including relief of liabilities and the fair market value of marketable securities) exceeds the partner’s basis in his/her partnership interest just prior to the distribution.  Additionally, the liquidating partner’s outside basis is allocated among the distributed items in the same order:

  1. First to money received,
  2. then to IIRC section 751 (hot) assets, and finally to
  3. other assets

In a liquidating distribution, a partner’s interest in the partnership is terminated in exchange for his/her share of the partnership’s value. When the liquidation process concludes, the partner has an outside basis of zero. 

Recognition of Loss

Unlike current distributions, losses can be recognized in a liquidating distribution.  However, this can happen only if the partner receives assets consisting only of one or more of the following: (1) cash, (2) unrealized receivables as described (IRC section 751(c)), or inventory (as defined in IRC section 751(d)).  See IRC section 731(a)(2).  In other words, the receipt of a capital asset will prevent the recognition of any loss by the distributee.  The amount of loss recognized is the difference between the partner’s outside basis in the partnership immediately before the distribution and the sum of money and the partnership’s adjusted basis in distributed unrealized receivables and inventory.

Example 4-5

Lee’s interest in the XYZ partnership is terminated when her outside basis is equal to $100,000.  She receives a liquidating distribution of $20,000 cash and inventory with a basis to the partnership of $70,000.  She recognizes a loss of $10,000 ($100,000 partnership basis less $90,000 basis in assets received).

A loss is permitted in this situation because the basis of an IRC section 751 asset is never increased beyond the basis it had inside the partnership.  Since the Code preserves the ordinary income character of IRC section 751 assets, Lee’s unrecovered partnership basis ($10,000) does not get assigned to the inventory she receives.  Therefore, she recognizes a capital loss under IRC section 741 of $10,000 upon the termination of her partnership interest under IRC section 741.

 Allocation of Basis Among Distributed Assets

Determining a departing partner’s basis in property received in a liquidating distribution is somewhat different than in a current distribution. As in the case of a current distribution, the distributee partner’s outside basis is allocated first to cash, then to “hot assets” (ordinary income assets under IRC section 751) and then to other assets.   In a current distribution, if various items of property are distributed with bases to the partnership that are less than the distributee partner’s outside basis, the difference simply remains in the partner’s outside basis.  Unlike a current distribution, however, the partner’s outside basis is reduced to zero in a liquidating distribution, signifying the closing out of his/her investment in the partnership.

 

If, however, the partnership’s “inside” basis in distributed assets does not equal the distributee partner’s outside basis (which is often the case) the difference must be allocated  to the properties based on appreciation (or depreciation) in the fair market value of the property. See IRC section 732(c). 

 

A decrease in the basis of distributed assets can occur in either a current or liquidating distribution.  The method for allocating a decrease in basis, defined in IRC section 732(c)(3), is the same for both current and liquidating distributions of property.

An increase in the basis of other non-IRC section 751 property will occur only when there is a liquidating distribution.  The remaining outside basis is first allocated to properties with unrealized appreciation.  Any remaining outside basis is then allocated among all properties in proportion to their fair market values (not basis).

The following two examples illustrate the allocation of basis in distributed assets in a liquidating distribution.

Example 4-6

AB Partnership has two partners, A and B, who share capital and profits equally.  A and B decide to go their separate ways.  A is distributed all of the land, one-half of the unrealized receivables, and one‑half the inventory in complete liquidation of his partnership interest. . B receives the cash, one-half of the unrealized receivables, and one-half the inventory.  These are proportionate distributions because both A and B both receive their pro rata shares of the value of IRC section 751 “hot assets.” The balance sheet and steps in the liquidation are as follows:

                                       

Basis

FMV

Cash 

$40

$40

Unrealized Receivables

$0

$20

Inventory 

$20

$20

Land 

$80

$40


   

 

 

Partners' Outside Bases

    

Outside Basis

     

A

Balance       

$70

$40

Cash 

$0

(40)

Remaining Basis   

$70

$0

Unrealized Receivables

$0

(0)

Inventory 

(10)

(0)

Remaining Basis 

$60

$0

Land 

(60)

$0

Basis must be $0 

$0

$0

 

    

                                                 


     

          

                                           
 

Since the AB partnership is completely liquidated, the post-distribution outside bases for both A and B is $0.

If only one partner was liquidating his/her interest, the rules of IRC section 736 relating to the retirement of a partner would be applied.  These rules are discussed in Chapter 7.

Tax Consequences of the Liquidating Distribution

Because the partners’ outside bases are less than the partnership’s inside basis in the distributed assets, the likelihood is that one or more of the distributee partners will take the assets with a stepped down basis.  Under IRC section 732(c) and Treas. Reg. section 1.732-1(c), the following steps are taken to make the necessary adjustments:

Partner A:

  1. A receives no cash (or items considered cash for these purposes, such as liability relief under IRC section 752(b)). Therefore, pursuant to IRC section 731(a)(2), A recognizes no gain.  In addition, because A receives a capital asset (land), he can’t recognize a loss. The only time a loss is allowed on a liquidating distribution is when the assets distributed consist solely cash, or IRC section 751 “hot assets (unrealized receivables, depreciation recapture, or inventory).
  2. A receives unrealized receivables and inventory.  Because these are ordinary income “hot” assets, A’s outside basis is allocated to these items in an amount equal to their adjusted bases to the partnership immediately before the distribution.   See Treas. Reg. section 1.732-1(c)(1)(i). 
  3. A’s remaining outside basis, after subtracting cash and the basis in ordinary income assets, is $60.  The partnership’s pre-distribution inside basis in the land is $80.  This results in $20 step down in basis of the land in A’s hands.  Upon a later disposition of the land, A will compute his gain or loss on the asset using the new substituted basis amount of $60.

Partner B:

  1. B receives cash of $40. Because the cash distribution is not greater than B’s outside basis, B recognizes no gain.  B also receives unrealized receivables and inventory, but no capital assets.  Therefore, B has a potential loss.  However, one other requirement must be met to take a loss:  The amount of B’s outside basis must be greater than the bases in the assets received.   But in this case, the $40 cash distribution brings B’s outside basis to zero.  Therefore, B does not receive a loss because he has recovered his outside basis.
  2. Assets distributed to B also include unrealized receivables and inventory; these assets are distributed using the adjusted bases in the assets.  B has insufficient outside basis after receiving the cash distribution to assign basis to any other assets or to take a loss with respect to IRC section 751 assets.  Therefore, B must take a substituted basis of $0 in the unrealized receivables and inventory.

If either A or B sells the assets at a later date, IRC section 735 will apply to determine the character of any gain or loss in the same way as in Example 4-4, pertaining to current distributions.  That is, the ordinary income character will be preserved indefinitely with respect to the unrealized receivables and for five years in the case of the inventory items.

The regular distribution rules described in this section are the only rules applied unless there is a disproportionate distribution of IRC section 751 assets (unrealized receivables, depreciation recapture, and inventory).  When this occurs, the treatment of the distribution is split into a sale and exchange portion and a regular distribution portion. 

The following example reflects an increase to the basis of assets received in a distribution where the assets have unrealized appreciation (or built-in gain), and the distributee partner’s outside basis is larger than the inside basis of the partnership assets distributed in the liquidating distribution.

Example 4-7

Sam, Rod, and Mike are equal 1/3 partners in a real estate partnership, The Partnership distributes the following to Sam in complete liquidation of his interest: 1) a parcel of land (held by the partnership as inventory) with a basis of $1,000, 2) a sculpture that was in the lobby of one of the partnership’s buildings, 3) and shares of XYZ, Inc. a publicly traded company. In addition, Sam’s $1,000 share of partnership liabilities is reduced to zero. The sculpture, which was purchased as an investment, has a fair market value of $9,000 and a basis of $3,000 (unrealized appreciation of $6,000).  The XYZ, Inc. corporate stock has a basis to the partnership of $1,000 and a fair market value of $3,000 (unrealized appreciation of $2,000).  Assume that the distribution is proportionate. Sam has an outside basis of $16,000 immediately before the liquidating distributions.

Allocation of Basis

Pre-distribution Outside Basis    $  16,000
Less:
  Cash (liability relief under
   IRC section 752(b)                         (1,000)
   Basis in inventory                           (1,000)
   Basis in sculpture                           (3,000)
   Basis in stock                                 (1,000)      
Remaining Basis                            $ 10,000

Sam’s outside basis of $16,000 exceeds the partnership’s pre-distribution inside basis in these assets. Under IRC section 732(c) and Treas. Reg. section 1.732-1(c), Sam’s remaining basis of $10,000 is allocated as follows:

  1. First the basis is allocated to reduced unrealized appreciation.  The sculpture has unrealized appreciation of $6,000, Therefore, $6,000 of Sam’s remaining outside basis is allocated to increase the basis of the sculpture by $6,000.  Likewise, $2,000 of his basis is allocated to the unrealized appreciation stock.  This leaves $2,000 of excess basis to be allocated. 
  2. This remaining basis of $2,000 is allocated in proportion to the fair market value of the “other properties” received (i.e. those other than cash and hot assets) received.  The only “other properties” are the sculpture and the stock.  Recall that their fair market values were $9,000 in the case of the sculpture and $3,000 in the case of the stock, for a total of $12,000. 

Thus, 75 percent of the remaining $2,000 of outside basis is allocated to the sculpture ($9,000/$12,000 x $2000 = $1,500) and 25 percent is allocated to the stock ($3,000/$12,000 x $2,000 = $500).  The basis of the sculpture in Sam’s hands is $10,500 ($9,000 + $1,500) and the basis of the stock is $3,500 ($3,000 + $500).

Note that the remaining basis is allocated solely to non IRC section 751 assets.  Even if the inventory (the land lot in this example) had an extremely high fair market value, its basis would not have been increased so that any ordinary gain that existed prior to the liquidating distribution is preserved in the hands of the distributee partner. 

Thus, the distributed parcel of land, which was inventory to the partnership, will carry an ordinary income taint in Sam’s hands for 5 years following the year of distribution. See IRC section 735.

Disproportionate Distributions will be discussed in the last section of this chapter. 

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Examination Techniques for Proportionate Distributions

  1. Review Schedules K-1 and M-2 for distributions.If Schedule K-1 reflects a cash distribution, request a computation of outside basis to determine whether the cash received exceeds the partner’s basis in his/her partnership interest. A receipt of money in excess of a partner’s outside basis results in a taxable gain under IRC section 731(a).
  2. Compare the beginning and ending balance sheets (Schedule L of Form 1065).Be alert to the types of assets distributed.If there is an indication of a disproportionate distribution of IRC section 751 assets, gain recognition may be required. This is true whether there is a current distribution or a complete liquidation.
  3. Review the Schedules K-1 for ownership changes.This may indicate a partial or complete liquidation.Losses are allowed only in complete liquidations and only in limited circumstances involving hot assets.
  4. Be alert to losses claimed in a liquidating distribution where the partner continues to hold a partnership interest. A partner must completely liquidate his/her interest before a loss on liquidation is allowable.Review Schedules K-1 to ascertain if the same partner is both a limited and a general partner or if the same partner holds separate preferred and common interests. Liquidating one type of interest while retaining the other would not be a complete liquidation.
  5. Verify that any net decrease in the partner’s share of partnership liabilities is treated as a distribution of money under IRC section 752(b).
  6. Determine if marketable securities were distributed. Marketable securities are generally treated as money for purposes of the distributions rules. This could also result in a taxable gain.
  7. Review the ending capital accounts on the Schedules K-1.If an ending capital account is reduced to zero, then a partnership interest may have been completely liquidated.
  8. Request a calculation of the partner’s outside basis to determine the consequences of the distribution.

Documents to Request

  1. Partnership Agreement and any amendments.
  2. Prior and subsequent year partnership returns.
  3. Calculation of the partner’s outside basis.
  4. Calculation of depreciation recapture, if applicable.
  5. Copy of the partner’s tax return for the year of distribution.

Interview Questions

  1. Is the distribution in liquidation of a partner’s interest under IRC section 731(a)(2) or payments to a retiring partner or a deceased partner’s successor in interest under IRC section 736?(Refer to Chapter 7 for guidance on the latter situation).
  2. What type of property was distributed to the partner or partners?
  3. Was the liquidating distribution pro rata or was there a disproportionate distribution regarding the IRC section 751 assets?
  4. Was there relief of liabilities?

Supporting Law

 IRC, Subchapter K: 
    section 731
    section 732
    section 733
    section 734
    section 735
    section 741
    section 751
    section 752
    IRC section 1223
Regulations supporting the above code Sections.

Other Sources of Information

Bischoff, William R. 1065 Deskbook, 16th Edition.   Chapter 33, “Distributions and Basis Adjustments.”  Practitioners Publishing Company (September, 2005).

McKee, William S., Nelson, William F., and Whitmire, Robert L., Federal Taxation of Partnership and Partners,   Chapter 19, "Distributions That Do Not Alter the Partners' Interests in Section 751 Property.” (2007).

Cunningham, Laura E. and Cunningham, Noel B. The Logic of Subchapter K, A Conceptual Guide to the Taxation of Partnership, (3rd Ed.) “Chapter Eleven, Distributions--The Basics.” West Publishing Company (2006).

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ISSUE:  DISGUISED SALES

Definition

When reviewing distributions from partnerships, examiners should be alert to the possibility that an outflow of cash or property labeled as a “distribution” could in substance be part of a taxable disguised sale.

Example 4-8

John contributes land with a fair market value of $150,000 and a basis of $100,000 to his partnership.  In the same year, the partnership distributes $100,000 of cash and marketable securities worth $50,000 to John.  John would not have contributed the land in the absence of the expected distribution.  In substance, this transaction is a sale and not a tax-free contribution and distribution of property.

The disguised sales rules apply when property – not just cash – is distributed to a partner in connection with a contribution of property or money to the partnership.

IRC section 707(a)(2)(B) was enacted as part of the Tax Reform Act of 1984 to address transactions that are the economic equivalent of sales rather than nontaxable contributions and distributions under IRC sections 721 and 731.

IRC section 707(a)(2)(B) provides that:

  1. If a partner transfers (directly or indirectly) money or property to a partnership and the partner (or another person) receives (directly or indirectly) money or property in return, and
  2. When viewed together, both transfers are properly characterized as a sale or exchange of property,
  3. Then the transfers are treated as a sale of the property to the partnership or as a sale between two or more partners not acting as partners in the partnership.

IRC section 707(a)(2)(B) and the regulations thereunder govern the circumstances under which contribution/distribution transactions will be viewed as substantive sales.

Identifying a Disguised Sale

Obviously not all contributions followed by distributions are disguised sales.  All the facts and circumstances must be considered in determining whether a transaction is a disguised sale rather than a legitimate contribution and distribution. 

The applicable regulations, Treas. Reg. section 1.707-3, provide a two-part test for determining when a transaction should be recharacterized as a sale.

Two-Part Test:

  1. “But for Test” ─ The partnership would not have transferred money or property to the partner BUT FOR the transfer of the property by the partner to the partnership Treas. Reg. section1.707-3(b)(1)(i); and
  2. “Facts and Circumstances Test” -- When the transfers are not simultaneous, the subsequent transfer is not dependent on the entrepreneurial risks of the partnership’s operations. Treas. Reg. section 1.707-3(b)(1)(ii).

For simultaneous transfers, the only relevant factor is whether the money or property transferred to the partner from the partnership would have been transferred regardless of the partner’s contribution to the partnership.  In analyzing non-simultaneous transfers, as a general matter, a determination must be made as to whether, under all the facts and circumstances, the partner’s contribution was insulated from the risks of the partnership’s venture.

In some circumstances, a transaction should be recharacterized as a partial sale and a partial contribution.

Example 4-9

Kevin, a scientist, contributes a patent he developed to XYZ Pharmaceutical Partnership in exchange for a partnership interest.  At the time of the contribution, Kevin could have sold the patent to XYZ for $5 million.  Kevin has a $1 million adjusted basis in the patent.  On the date of the contribution, XYZ distributes $2 million to Kevin.  The distribution was agreed to in advance.

Result:

Because the cash Kevin received was less than the fair market value of the patent, the transaction is in substance a partial sale and a partial contribution.  The portion of the property sold is equal to the ratio of the cash received over the fair market value of the property transferred.  In this case, 40 percent of the patent was sold and 60 percent was contributed.

Consequences to the Partner:

  1. Basis in property sold = $400,000 (40 percent of original basis).
  2. Gain on sale = $1,600,000 ($2,000,000 - $400,000).
  3. Basis in contributed property = $600,000.
  4. Basis in partnership interest (outside basis) = $600,000.

Consequences to the Partnership:

The patent’s inside basis is $2,600,000 ($2,000,000 sales price plus $600,000 basis in contributed property).

In this example, the gain could not be properly calculated without knowing the fair market value of the patent.  In such situations, the examiner may need to make a referral to an engineer or valuation specialist.

The Regulations

The regulations list ten primary but non-exclusive factors that should be considered in determining if there was a sale:

  1. The certainty of the timing and amount of the second transfer;
  2. Whether or not the second transfer is legally enforceable;
  3. Whether or not the second transfer is secured in any way;
  4. Whether a third party is obligated to make a contribution to the partnership to enable it to make the second transfer;
  5. Whether a third party is obligated to make a loan to the partnership to enable it to make the second transfer;
  6. Whether the partnership has incurred, or is obligated to incur, debt to enable it to make the second transfer;
  7. Whether the partnership has excess liquid assets that are expected to be available for the second transfer;
  8. Whether the partnership distributions, allocations, or control of operations are designed to effect an exchange of the benefits and burdens of the ownership of the contributed property;
  9. Whether the amount of the distribution to a partner is disproportionately large in relation to his/her general and continuing interest in partnership profits;
  10. Whether the partner has no or minimal obligation to return distributions to the partnership.

Treas. Reg. sections 1.707-3(b)(2)(i) through (x).

Two Year Presumption

The timing of the contribution and distribution is important.  The regulations contain two rebutable presumptions.

  1. Transfers that occur within 2 years of each other are presumed to be sales unless the facts and circumstances clearly establish that the transfers do not constitute a sale.  Treas. Reg. section 1.707-3(c)(1).
  2. Transfers that are made more than 2 years apart are presumed not to be a sale unless the facts and circumstances clearly establish that a sale took place. Treas. Reg. section 1.707-3(d).

It must be determined whether the partner’s contribution was subject to the business or investment risks of the venture; if not, the contributing partner may have simply “cashed out” his/her interest in the property. In some cases, the partnership is actually the seller of the property rather than the buyer. In this situation, the partnership may disguise the sale as a nontaxable distribution under IRC section 731(a) in exchange for a payment disguised as a contribution under IRC section 721(a).

Exceptions to the Two-Year Presumption:  “Normal Distributions”

Certain types of distributions or payments are presumed not to be part of a disguised sale even if they occur within 2 years of a contribution unless the facts and circumstances clearly establish that the transfer is part of a sale. To protect “normal” periodic partnership distributions from falling within the scope of IRC section 707(a)(2)(B), the following types of payments do not trigger the two-year presumption:

  1. Distributions from normal operating cash flow.  For these purposes, see Treas. Reg. section 1.707-4(b)(2) which discusses the calculation of operating cash flow.
  2. Reasonable guaranteed payments. A guaranteed payment is a payment that is determined without regard to partnership income.  For purposes of the disguised sale rules, a guaranteed payment is considered reasonable if it does not exceed the partner's unreturned capital for the year times 150% of the highest applicable federal rate. See Treas. Reg. section 1.707-4(a)(1) through (3).
  3. Reasonable preferred returns. A preferred return is a priority distribution of partnership cash flow to a partner in order to compensate the partner for the use of contributed property.  Preferred returns are matched, to the extent available, by an allocation of income or gain.  Treas. Reg. section 1.707-4(a)(2).
  4. Reimbursements of preformation expenditures.  Under Treas. Reg. section 1.707-4(d), a partnership may reimburse a partner for certain capital expenditures made within two years preceding the transfer of property to the partnership without having the reimbursement subject to the disguised sale rules.  Such expenditures include, for example, capitalized partnership organization and syndication costs, and capital costs incurred with respect to property contributed to the partnership by the partner.  In the case of costs incurred with respect to contributed property, the reimbursements generally can not exceed 20% of the fair market value of the contributed property.  However, this 20% limit does not apply if the fair market value of the contributed property does not exceed 120% of the partner's adjusted basis in the contributed property at the time of contribution.

Liabilities

As explained in Chapter 3, a net decrease in a partner’s individual or entity level  liabilities or a net decrease in a partner’s share of partnership liabilities is considered to be a deemed distribution of money.  A partner who contributes property subject to a mortgage will have such a distribution because the other partners are deemed to take on a share of the liability. 

Any liabilities that are not considered qualified liabilities may constitute the proceeds of a disguised sale.  A qualified liability is one that is not incurred “in anticipation of the transfer.”  On the other hand, a nonqualified liability is one which was incurred in anticipation of transferring the property to the partnership and is a device used by the partner to “cash out” his/her investment in the contributed property.  The portion of the nonqualified liability shifted from the contributing partner to the other partners constitutes payment for a disguised sale.

Qualified Liabilities

Treas. Reg. section 1.707-5 provides that a liability is qualified if it was incurred more than 2 years prior to the transfer of the property to the partnership.  These liabilities are thought to be “old and cold” and outside the scope of the disguised sales rules.  The rational is that these types of liabilities were probably not incurred in anticipation of the transfer of the property to a partnership.

If a liability was incurred within 2 years of the transfer, it still can be considered a qualified liability, depending on how the proceeds of the debt were used. First, if the proceeds were used to acquire or improve the contributed property, the liability is qualified.  This is because the contributing partner has used the loan proceeds to increase his/her investment in the property rather than decreasing the investment, as is the case in a sale.  Second, if the liability is incurred in the ordinary course of the business and substantially all of the business assets are contributed to the partnership, the liability is still qualified.  This rule addresses trade payable and other liabilities whose purpose is not to cash out the contributing partner’s interest in the property.

Nonqualified Liabilities

A nonqualified liability is fully subject to the disguised sales rules.  If a liability was incurred less than 2 years before transferring the property, it is presumed to be nonqualified unless the facts and circumstances clearly indicate that it was not incurred in anticipation of the transfer.

Under the disguised sale rules, the contributing partner is treated as having an amount realized equal to the amount that was shifted to other partners under IRC section 752(b).  This is the excess of the total liability contributed over the contributing partner’s remaining share of the liability post-contribution.  Thus, to determine the amount realized, it is necessary to apply the rules under IRC section 752 to determine the post-contribution debt share of each partner.

In the case of recourse liabilities, the normal debt allocation rules under IRC section 752 apply.  That is, a partner's share of a partnership recourse liability, the portion for which the partner or related person bears the economic risk of loss.  See Treas. Reg. section 1.752-2(a).  For non-recourse liabilities, the first two tiers listed in Treas. Reg. section 1.752-3 are ignored and only the third tier, excess non-recourse liabilities are taken into consideration.  Excess non-recourse liabilities are generally shared based on the partner’s share of profits.  Thus, for determining the amount realized under IRC section 707(a)(2)(B), a partner’s share of non-recourse debt is computed in the same manner as “excess non-recourse liabilities.”

Debt-financed Distributions

The amount of money or other consideration distributed to a partner in connection with a transaction that would otherwise be regarded as a disguised sale is reduced by the partner's share of partnership liabilities incurred to finance the distribution.  Treas. Reg. section 1.707-5(b)(1) provides that for purposes of the disguised sale rules, if: 1) a partner transfers property to a partnership, and 2) the partnership incurs a liability, and 3) all or a portion of the proceeds of that liability are allocable under Treas. Reg. section 1.163-8T to a transfer of money or other consideration to the partner made within 90 days of incurring the liability, the transfer of money or other consideration to the partner is taken into account only to the extent that the amount of money or the fair market value of the other consideration transferred exceeds that partner's allocable share of the partnership liabilities.  In other words, if the partnership borrows to make a distribution to the contributing partner, and can legitimately allocate that liability to the contributing partner, the distribution will not be considered part of a disguised sale. 

The rationale for this exception is that to the extent a partner is properly allocated debt borrowed by a partnership, the receipt of funds attributable to such debt produces no net economic benefit and thus is not treated as a taxable event. This exception treats the partner as though the partner had “borrowed through the partnership.”

This exception is sometimes aggressively interpreted.  In some cases, the determination of the distributee partner's share of partnership liabilities for these purposes is improper.  For example, in the case of a recourse liability, Treas. Reg. section 1.752-2(j)(1) provides that the Service may disregard an obligation of a partner or related person if the facts and circumstances indicate that a principal purpose of the arrangement was to create the appearance of a partner or related person bearing the economic risk of loss, when the substance of the arrangement is otherwise.

Similarly, in the case of nonrecourse debt, the concept of “excess non-recourse liabilities” under Treas. Reg. section 1.752-3(a)(3) is sometimes used by taxpayers in a manner not intended by the regulations.  As noted earlier, excess non-recourse liabilities are usually shared among the partners based on the individual partner’s share of profits.  However, the third tier allocation regulations also allow allocations specified in the partnership agreement if the allocations are reasonably consistent with allocations (assuming they have substantial economic effect under the Section 704(b) regulations) of some “other significant item” of partnership income or gain. 

Example 4-10

Jim and Bob are partners in a partnership and generally share capital and profits in a ratio of 50 % each.  The partnership agreement provides that Jim is entitled to a preferred return equal to 100% of the first $10,000 of net proceeds with respect to the sale of capital assets during the year.  Any amount in excess of this preferred return will be allocated to Bob.  Assume further that the partnership agreement provides that for purposes of Treas. Reg. section 1.752-3(a)(3), third-tier nonrecourse debt allocations will be made in the same manner in which the partners share this first $10,000 of net capital proceeds.  Jim takes the position that this sharing arrangement entitles him to 100% of the nonrecourse debt for purposes of the disguised sale rules.

While all facts and circumstances would have to be considered, this allocation probably does not reflect the underlying economic relationship of the partners. Suppose, for example, the total amount of net capital proceeds the partnership expects to earn in that same year is $50,000.  Jim is only being allocated 20% of the total net capital proceeds, yet Jim is being allocated 100% of the third tier allocations.  When relying on an allocation based upon the “other significant item” language found in Treas. Reg. section 1.752-3(a)(3), examiners should take care to make certain that the arrangement reflects the underlying economic relationship of the parties.  Otherwise, the allocation should be reallocated in accordance with the partners’ share of partnership profits.   In this example, 50% of the nonrecourse debt would be allocated to Jim rather than the 100% he claimed.

In some cases, partners will allocate liabilities in a manner designed to avoid the disguised sale rules with the intention of reducing the distributee partner’s share of liabilities soon after the distribution.  In order to prevent this abuse, the regulations provide for a reduction in a partner's share of a liability where it is anticipated that the partner's share of the liability will be immediately reduced after the transfer and such reduction is part of a plan to avoid the disguised sale rules. Treas. Reg section 1.707-5(b)(2)(iii).

Disguised Sales of Partnership Interests

Although the previous discussion has focused on disguised sales of property, a contribution and related distribution may also involve a disguised sale of a partnership interest.

On November 26, 2004, the Service issued proposed regulations relating to the disguised sales of partnership interests (see Proposed Reg. section 1.707-7).  The proposed regulations follow the form of the existing property regulations and include rules similar to many of the rules in the existing regulations, with appropriate modifications.  As of the date this audit technique guide was revised, final regulations were still pending.

Disclosure Requirements

For certain transfers that are presumed to be sales, the partnership and the partners must comply with the disclosure requirements found in Treas. Reg. section 1.707‑8.  Generally, disclosure is required when:

  1. Certain transfers to a partner are made within two years of a transfer of property by the partner to the partnership; and
  2. When debt is incurred within two years of the earlier of a written agreement to transfer or of a transfer of the property that secures the debt, if the debt, nevertheless, is treated as a qualified liability.

The disclosure must be made on the partner’s return using Form 8275 or a statement providing the same information.  When more than one partner transfers property to a partnership pursuant to a plan, the disclosure may be made by the partnership rather than by each partner on their individual returns.

Meeting the disclosure requirements does not necessarily satisfy the disclosure requirements for purposes of penalties under IRC section 6662.  However, a failure to provide the disclosure when required may increase the likelihood of a penalty assessment. 

Similar disclosure rules are contained in the proposed regulations for disguised sales of partnership interests. 

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Examination Techniques

  1. Review any material distributions of cash or property from the partnership.Attempt to ascertain whether the distributions meet the “normal distribution” safe harbors.For example, if a distribution to a partner is equal to the partner’s allocable share of operating income, a disguised sale would not be indicated.
  2. Inspect prior and subsequent years’ tax returns and Schedules K-1 for evidence of a contribution from the same partner who received a distribution. Note that under the disguised sale rules, a related contribution and distribution can occur in any order.For example, a partner may receive a distribution in Year 1 and make the contribution to the partnership in Year 2.
  3. Review the partnership agreement, amendments, and any internal or external correspondence pertaining to the contribution and the distribution.
  4. Determine and document the timing of the contribution and distribution.
  5. If available, review financial statement issued by the partner and the partnership.Ascertain how the transaction was reported for financial accounting purposes and note any differences between the financial accounting reports and how the transaction was reported for tax return purposes at both the partnership and partner levels.Schedules M-1 or M-3 may be useful for this analysis.
  6. If the taxpayer is relying on the debt financed distribution exception provided under Treas. Reg. section 1.707-5(b)(1), determine if the debt has been properly allocated to the taxpayer for purposes of the disguised sale rules.

Issue Identification

  1. Does the Schedule K-1 or the Schedule M-2 reflect a contribution or a distribution?If so, identify the property contributed or distributed.Ascertain the facts and circumstances of the contribution and distribution.Note that both schedules divide contributions and distributions into cash and non-cash components.
  2. If there was a contribution or a distribution, were liabilities involved?Determine if the contributing partner was relieved of nonqualified liabilities that would result in a disguised sale.

Documents to Request

  1. Partnership Agreement and any amendments.
  2. Correspondence, memoranda and other internal or external communications relating to the contribution or distribution.
  3. Documents relating to the dates of contribution and distribution.  Such documents might include, for example, dates the property was entered into the partnership’s books and records, evidence of ownership transfer, or property tax documents indicating the date of transfer.
  4. Schedule of book and tax capital accounts to determine if there is a history of normal distributions to partners or is this an unusual transaction.
  5. Loan documents pertaining to partnership debt associated with a contribution or distribution to determine if the liabilities are qualified or nonqualified. 
  6. Side agreements among the partners regarding the guarantee or repayment of partnership liabilities.
  7. Financial statements issued to third parties to determine how the transactions were reported for financial accounting purposes.

Interview Questions

Interview question should consider the following factors:

  1. How was the amount of the distribution(s) to the partner determined? Is there a relationship to the success or failure of the business or investment venture, or was the distribution a quid pro quo based on the value of the property contributed?
  2. Are there factors indicating that the contribution and distribution were related? For example, if the financial statements characterize the transaction as a sale, obtain an explanation of the different reporting for tax purposes.
  3. After the distribution, who bore the benefits and burdens of the contributed property?
  4. What was the business purpose for the contribution and distribution?Is there an indication that the property transferred was held for sale prior to the contribution/distribution transaction with the partnership?

Supporting Law

IRC, Subchapter K:  Section 707(a)(2)(B)

Supporting regulation and specific regulations cited above including the following:   

General Rules                           Treas. Reg. section 1.707-3
“Normal” Distributions              Treas. Reg. section 1.707-4
Special Rules for Liabilities        Treas. Reg. section 1.707-5
Sales by Partnership to Partner  Treas. Reg. section 1.707-6

In Goudas v. Commissioner, T.C. Memo 1996-555, aff’d, 137 F.3d 368 (6th Cir. 1998 the taxpayer attempted to recharacterize a transaction structured as a straight sale into a transaction that in substance was part sale and part capital contribution.   The tax court found that the taxpayer’s treatment was not supported by the facts and refused to recharacterize the taxpayer’s share of the gain as a nontaxable distribution.

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ISSUE:  Contributions and Distributions of Built-In Gain or Loss Property

As explained in Chapter 3, IRC section 704(c) property is property that had a built-in gain or loss at the time it was contributed to the partnership.  In certain situations, distributions of IRC Section 704(c) property to a noncontributing partner will cause the partner who contributed the property to recognize gain.  As explained in Chapter 3, IRC section 704(c) property is property that had a built-in gain or loss at the time of its contribution to the partnership.

Under IRC section 704(c), a built-in gain or loss must be allocated back to the contributing partner when the property is sold, or over time as depreciation or amortization deductions are allocated away from the contributing partner.  Prior to October 3, 1989, IRC section 704(c) could be circumvented simply by distributing the IRC section 704(c) property rather than selling it.  IRC section 704(c)(1)(B) eliminates the inconsistent treatment between sales and distributions of IRC section 704(c) property.

Distribution Treated as a Sale

If IRC section 704(c) property is distributed within a 7 year period to any partner other than the contributing partner, IRC section 704(c)(1)(B) treats the distribution as if it were a sale taking place on the date of the distribution. This “sale” is deemed to occur at the property’s fair market value.  The deemed sale requires the contributing partner to recognize any built-in gain that was inherent in the property at the time of its contribution to the partnership.  In addition, recognition of gain (or loss) by the partner triggers an adjustment to both the inside basis of the property and to the partner’s outside basis immediately before the distribution.  Treas. Reg. section 1.704-4(e). Others partners are not affected by the deemed sale.

Example 4-11

Brown Corporation and Pace Pharmaceuticals Inc. form a partnership on January 1, 1999.  Brown contributes a patent for Drug X that has a basis of $2 million and a fair market value of $10 million.  Pace Pharmaceuticals Inc. contributes its own stock, valued at $20 million.  On January 15, 1999, the patent is distributed to Pace Pharmaceuticals.

Brown has in substance exchanged its patent for an undivided 50 percent interest in a partnership.  However, the disguised sales rules under IRC section 707 are inapplicable because Brown did not receive a distribution in return.

IRC section 704(c)(1)(B) prevents partners from engaging in property swaps through a partnership that would not qualify for IRC section 1031 like-kind treatment outside the partnership.  In this case, the distribution of the patent would be treated as a sale and Brown would realize gain of $8 million.  Brown’s capital account would be increased by $8 million and the partnership would also increase its basis in the patent by that amount.  Thus, Pace Pharmaceutical’s basis in the distributed patent would be $10 million under IRC section 732 and not $2 million.

By triggering gain recognition to Brown, IRC section 704(c)(1)(B) has not only prevented income shifting from Brown to Pace (the gain that had accrued on the patent in Brown’s hands), but has also prevented the deferral of gain.  If IRC section 704(c)(1)(B) were not in effect, Brown could have essentially sold the patent to Pace and the $8 million gain might never be taxed, despite the fact that Brown closed out its economic position in the patent.

Seven Year Period

IRC section 704(c)(1)(B) only applies to distributions made within the 7 year period following the contribution of the built-in gain or loss property.  Therefore, in developing this issue, it is important to ascertain how the partnership obtained the distributed property.  An analysis of the partnership’s capital accounts going back 7 years and a review of the original partnership agreement and its amendments may yield important information in determining the source of contributed property.  Note that as a balance sheet item, records supporting the calculation of partner capital accounts should be maintained indefinitely.

Calculation of Gain or Loss

The gain or loss allocated to the contributing partner is the amount that would have been allocated to the contributing partner under IRC section 704(c)(1)(A) and Treas. Reg. section 1.704-3 had the partnership sold the property to the distributee partner for its fair market value on the date the property was distributed.  Thus, the contributing partner will recognize the lesser of:

  • The built-in gain or loss inherent in the property at time of contribution, or
  • The gain or loss that would be allocated to the contributing partner if the partnership sold the property to the distributee for its fair market value.

Example 4-11

Chris contributes north land lot and south land lot to an equal partnership formed with Diane.  Both land lots have a basis of $40 and a fair market value of $100.  Diane contributes $200 cash.  Both land lots are IRC section 704(c) property because they each have a built-in gain of $60.  The partnership uses the cash to subdivide the lots.

After 3 years, when it is worth $150, the north land lot is distributed to Diane.  Chris, the contributing partner must recognize the lesser of:

$60,The property’s built-in gain or loss at time of contribution, OR

$85, the amount that the contributing partner would recognize had the partnership sold the property for its fair market value (built-in gain of $60 plus half of the $50 gain that accrued in the hands of the partnership

Thus, Chris would recognize a $60 gain upon the distribution.  The gain would increase both her outside basis and the inside basis of the north land lot just prior to its distribution.  Thus, Diane's basis in the land would be $100.

Example 4-12

Chris contributes north land lot and south land lot to an equal partnership formed with Mary.  Both land lots have a basis of $40 and a fair market value of $100.  Mary contributes $200 cash.  Both land lots are IRC section 704(c) property because they each have a built-in gain of $60.  The partnership uses the cash to subdivide the lots.

After 3 years, when it is worth $150, the north land lot is distributed to Mary.  Chris, the contributing partner must recognize the lesser of:

  • $60, the property’s built-in gain or loss at time of contribution, or
  • $85, the amount that the contributing partner would recognize had the partnership sold the property for its fair market value (built-in gain of $60 plus half of the $50 gain that accrued in the hands of the partnership).

Thus, Chris would recognize a $60 gain upon the distribution.  The gain would increase both her outside basis and the inside basis of the north land lot just prior to its distribution.  Thus, Mary's basis in the land would be $100.

Example 4-13

Assume the same facts as Example 4-13, except that on the date of distribution the north land lot has a fair market value of $60.  The hypothetical sale would therefore produce a tax gain of $20 (sales price of $60 less adjusted tax basis of $40) and a book loss of $40 (sales price of $60 less book basis of $100).                   

Under the methods described Chapter 3, the following would result:

  • Under the traditional method, Chris would be allocated a $20 gain.
  • Under the remedial method, a tax loss of $40 would be allocated to Mary to match her book loss.As a result, $40 of gain would be allocated to Chris as an offsetting remedial allocation.Therefore, Chris would recognize a $60 gain, consisting of $20 of IRC 704(c) gain and $40 of remedial gain.

Exception Transactions Equivalent to Like-Kind Exchanges

Since the aim of the provision is to prevent a partner from closing out an economic position in contributed property without recognizing gain, it makes sense that an exception should apply for situations that would qualify for the like-kind exchange rules.  If, within a certain time period of distributing the IRC section 704(c) property, the partnership also distributes like-kind property to the contributing partner, the contributing partner will be treated as having engaged in an IRC section  1031 exchange and not a sale.  The amount of gain or loss that the contributing partner would normally recognize under IRC section 704(c)(1)(B) is reduced by the amount of built-in gain or loss in the distributed like-kind property.

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De Minimis Rule

Under Treas. Reg. section 1.704-3(e)(1)(ii), a partnership may disregard the application of IRC section 704(c) if two conditions are met.  First, the fair market value of the contributed property cannot differ from the tax basis by more than 15 percent of the adjusted tax basis.  Second, the total gross disparity between the fair market value and tax basis does not exceed $20,000. 

Anti-Abuse Rule

Treas. Reg. section 1.704-4(f)(1) provides an anti-abuse rule applicable to IRC section 704(c)(1)(B) transactions.  If a principal purpose of a transaction is to achieve a tax result that is inconsistent with the purpose of IRC section 704(c)(1)(B), the Commissioner can recast the transaction for federal income tax purposes.  This prevents the contributing partner from closing out his/her economic position in the distributed property prior to the end of the 7 year period, but before the distribution actually takes place.

For example, A, B, and C are partners in a partnership, and want to distribute a certain piece of property to B in order to completely liquidate B’s partnership interest.  The property was contributed to the partnership 4 yeas ago by A, and has a built-in gain.  The partners learn that if they distribute the property before 7 years have elapsed since its contribution to the partnership, A will have to recognize gain under IRC section 704(c)(1)(B).  Wishing to avoid this result, the partners amend their partnership agreement and take other steps to provide that substantially all of the economic risks and benefits of the contributed property are borne by B as of Date X.  The partnership then waits until the 7 year period has passed before distributing the property to B.  In this case, the Commissioner may apply Treas. Reg. section 1.704-4(f)(1) and recast the transaction in order to achieve tax results consistent with IRC section 704(c)(1)(B).  Thus, A will be required to recognize gain on Date 1, the date that the economic risks and benefits of the contributed property were transferred B.  See Treas. Reg. section 1.704-4(f)(2), Example 1.

To ensure consistent application of the anti-abuse rule, it is recommended that examiners consult with one of the Partnership Technical Advisors before proposing an adjustment based on the anti-abuse rule in Treas. Reg. section 1.704-4(f). 

Examination Techniques

Determine if there was a distribution of property to a partner.  Request a schedule of contributions that have been made by the partners in the last 7 years.  If the distributed property is IRC section 704(c) built-in gain property then ensure that the contributing partner has recognized the built-in gain in the property.  Remember that this rule applies only if the property was distributed to a partner other than the original contributing partner.  If the property was distributed back to the contributing partner then this rule does not apply.

Issue Identification

  1. Review Schedule M-2 and the partners’ Schedules K-1 for any contributions and distributions during the current, prior and subsequent years.
  2. Review prior year’s partnership returns and Schedules K-1.If IRC section 704(c) depreciable property is present, then the Schedules K-1 should reflect a special allocation of the depreciation using one of the methods described in Chapter 3 relating to IRC section 704(c) principles.This will alert the examiner to the fact that IRC section 704(c) property exists within the partnership.

Documents to Request

  1. Partnership Agreement and any amendments.
  2. Correspondence relating to distributions.
  3. Documents relating to the dates of contributions and distributions.
  4. Prior and subsequent year returns for the partnership including the Schedules K-1.
  5. Workpapers used to calculate the partners’ capital accounts for the current year and preceding 6 years if there is reason to suspect that built in gain or loss property was contributed to the partnership.
  6. An outside basis calculation and a capital account calculation for all of the partners.  An analysis of the capital accounts should identify the partner who contributed the built in gain or loss property and the partner who received the property in a distribution.  If the partnership keeps book capital accounts under IRC 704(b), a comparison of the fair market value of the property on the date of contribution and its basis will provide the amount of the built in gain or loss.
  7. The contributing partner’s Form 1040 to make sure there has been a taxable gain reported if there is an IRC section 704(c)(1)(B) transaction present.
  8. A calculation of the gain that should be recognized by the contributing partner.
Interview Questions
  1. Did the partnership distribute property to or for the benefit of any of the partners during the year? 
  2. What property was distributed?  Was the property previously purchased or contributed by another partner?  If it was contributed by another partner then IRC section 704(c) principles rules may need to be applied, if the property was built-in gain or loss property.
  3. Was there an appraisal of the property at the time of the contribution and at the time of the distribution?  If not, how was the value of the distribution determined?
  4. When was the property contributed?  When was the property distributed?

Supporting Law

IRC, Subchapter K:  Section 704(c)(1)(B)

Supporting regulations and specific regulations cited above including Treas. Reg. section 1.704-4.

Resources

Cunningham, Laura E. and Cunningham, Noel B., The Logic of Subchapter K, A Conceptual Guide to the Taxation of Partnership, (3rd Ed.)  “Chapter Fifteen, Disguised Sales and Exchanges.” West Publishing Company (2006).

ISSUE:  DISTRIBUTION OF PROPERTY TO CONTRIBUTING PARTNER

A contributing partner will sometimes attempt to accomplish a tax-free sale of appreciated property by having the partnership distribute other property to him/her thereby liquidating his/her interest in the contributed property.

Example 4-14

Carmen, a real estate developer, contributes a parcel of land to ABC Partnership.  The land has a fair market value of $250,000 and a basis of $100,000.  Three years later, when the land is still worth $250,000, the partnership distributes heavy equipment worth $250,000 to Carmen.  Assume the distribution is a pro rata distribution.  Even though Carmen has closed out her economic interest in the land, she does not report any gain.

IRC section 737 was enacted to prevent this type of transaction.

Under IRC section 737, if a partner receives a distribution of other property within a 7-year period of contributing appreciated property, gain, but not loss, may be recognized by the partner.  IRC section 737 presumes that the distributee partner is effectively “selling” any appreciated property that was contributed during the previous seven years.

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Effect of IRC section 751 and IRC section 731

Gain recognized under IRC section 737 is in addition to any gain recognized under IRC section 731.  Thus, a distribution could result in gain recognized under both IRC sections 731 and 737.

IRC section 737 does not apply to a distribution to the extent that IRC section 751(b) applies.  Thus, it is important to determine if the distribution results in a change in the partner’s share of IRC section 751 (“hot assets”) and non-IRC section 751 assets.  Under Treas. Reg. section 1.737-1(a)(2), if the distribution is disproportionate, then IRC section 751(b) applies before IRC section 737.  Treas. Reg. section 1.737-1(a)(2).  Additionally, IRC section 737 does not apply to deemed distributions of property caused by technical terminations under IRC section 708(b)(1)(B). 

Amount of Gain

The gain recognized will equal the lesser of:

  • The “excess distribution” – this is the amount by which the fair market value of the property received (other than money) exceeds the distributee partner’s outside basis reduced by any money received, or
  • The distributee partner’s “net precontribution” gain.

The net precontribution gain is the total amount of built-in gain in all property contributed by the distributee partner during the 7 years prior to the distribution that is still held by the partnership at the time of the distribution.

Notice that the IRC section 737 rules are similar to those under IRC section 704(c)(1)(B) and have the similar objective of preventing the contributing partner from escaping taxation on the unrealized gain on the contributed property.  Thus, in the case of depreciable or amortizable property, the partnership must follow IRC section 704(c) principles to reduce the disparity between the property’s book value and tax basis.  Therefore, the amount of the net precontribution gain declines over time as cost recovery deduction as shifted away from the contributing partner.

Example 4-15

On January 1, 2003, John contributes land that is dealer property with a $50,000 basis and a fair market value of $100,000 to the ABC Partnership.  On January 1, 2005, he contributes dealer property, with a $80,000 basis and a fair market value of $120,000.  On January 1, 2007, he receives a distribution of a warehouse with a fair market value is $300,000.  Because partnership operating income exactly matched partnership distributions for the year, John’s outside basis is remains at $130,000 ($50,000 and $80,000).

John’s precontribution gain on January 1, 2007, is $90,000 ($50,000 from the first land contribution and $40,000 from the second land contribution).  The value of the warehouse exceeds his outside basis by $170,000 ($300,000 fair market value less outside basis of $130,000).  Since his precontribution gain is less than the excess distribution of $170,000, he will recognize a $90,000 gain upon receiving the warehouse.

As shown in the following example, gain recognized under IRC section 737 is in addition to any gain recognized under IRC section 731(a) because gain recognized on distributions of money and marketable securities come under IRC section 731(a) rather than IRC section 737.  Treas. Reg. section 1.737-1(a)(1).

Example 4-16

Assume the same facts as presented in the previous example, except that partnership losses have reduced John’s basis to $10,000.  On January 1, 2007, John receives $15,000 in cash and the warehouse from the partnership.  John’s basis is reduced to zero and he recognizes $5,000 of IRC section 731 gain (cash distribution in excess of basis).  Additionally, he recognizes $90,000 of IRC section 737 gain, because the amount of his precontribution gain is less than the fair market value of the property distributed ($300,000) less his outside basis ($0 after the cash distribution).

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Basis Adjustments

The outside basis of the partner subject to IRC section 737 is increased by the amount of gain recognized.  The increase is not taken into account for determining the amount of any gain recognized under IRC section 731.  See Treas. Reg. section 1.737-3(a).  It is, however, taken into account for determining the basis in the property received.  The basis of the distributed property is determined under the normal rules of IRC section 732(a) or IRC section 732(b).  Additionally, the partnership increases its basis in eligible property by the amount of gain recognized by the partner subject to IRC section 737.

Example 4-17

Assume the same facts as in Example 4-16.  John’s basis in his partnership interest is increased by $90,000, the amount of gain recognized under IRC section 737.  His total outside basis is therefore $220,000 ($130,000 plus $90,000).  If the partnership’s basis in the warehouse was $200,000, John would take a carryover basis of $200,000 and his outside basis in his partnership interest would be reduced to $20,000.

Additionally, as shown in the next example, the partnership increases its basis in eligible property by the amount of gain recognized by the partner subject to IRC section 737.  Eligible property is defined in Treas. Reg. section 1.737‑3(c)(2) and includes the property that entered into the calculation of the distributee partner’s net precontribution gain.  The required basis increase is allocated among the eligible properties in the same order that the partner originally contributed the property to the partnership.  Starting with the property contributed first (i.e., the earliest contributed property), basis is allocated in an amount equal to the difference between the property’s fair market value and adjusted basis at the time of the distribution.

Example 4-18

Assume the same facts as in Example 4-16.  The values of the two properties contributed by John in 2003 and 2005 have remained the same.  The partnership must increase the basis of the first property by $50,000 and increase the basis of the second property by $40,000.

Distribution of Previously Contributed Property

To the extent the distributee partner receives back property he/she previously contributed to the partnership, the precontribution gain associated with that property is not taken into account when calculating the partner’s net precontribution gain.  IRC section 737(d)(1).  However, an interest in an entity previously contributed to the partnership is not treated as previously contributed property to the extent that the value of the interest is attributable to property contributed to the entity after the interest was contributed to the partnership.  In other words, this rule cannot be used to avoid IRC section 737 by increasing the value of an entity that is then distributed back to the contributing partner.  Treas. Reg. section 1.737-2(d)(2).

Example 4-19

Assume the same facts as in Example 4-14, except that in addition to contributing land, Carmen also contributes all of the stock of her closely held real estate development corporation.  The partnership contributes the heavy equipment to the corporation in a nontaxable IRC section 351 exchange.  Three years later, the partnership distributes all of the stock to Carmen.  Assume that it is a pro rata distribution.  In this situation, IRC section 737 would apply and Carmen would recognize gain of $150,000.

Character of the Gain

Under Treas. Reg. section 1.737-1(d), the character of the gain recognized depends on the character of the net precontribution gain.  Precontribution gains and losses are netted according to their character.  The character of a net negative amount is disregarded.

Example 4-20

Carmen, a real estate developer, contributes Parcel A, Parcel B, and $5,000 of Emory, Inc. stock to an investment partnership.  Parcel A has a tax basis of $10,000 and a fair market value of $20,000.  Parcel B has a tax basis of $10,000 and a fair market value of $5,000.  Emory Inc. stock has a tax basis of $50,000.

Parcel A and Parcel B were inventory in Carmen’s hands.  Parcel A had a built in gain of $10,000 and Parcel B had a built-in loss of $5,000.  Therefore, Carmen has $5,000 of net ordinary precontribution gain.  The $45,000 built-in capital loss from the Emory, Inc. stock is disregarded since it is a net negative amount.  Therefore, the character of any distribution to Carmen to which Section 737 would apply would be ordinary.

Anti-Abuse Rule

An anti-abuse rule is found in Treas. Reg. section 1.737-4.  It states that if a principal purpose of a transaction is to achieve a tax result that is inconsistent with the purpose of IRC section 737, the Commissioner can recast the transaction for federal tax purposes.

To illustrate, Treas. Reg. section 1.737-4(b), Example 1, addresses a situation in which a partner contributes to a partnership additional property (Property A2) in order to increase his/her adjusted tax basis in the partnership interest. The partner’s goal is to create a situation, for purposes of calculating the excess distribution, where the adjusted basis of the partnership interest is greater than the fair market value of the property distributed.  A “straight” application of IRC Section 737 in this case would result in no gain, since there would be no excess distribution. 

However, in the example, A, the contributing partner, retained all of the benefits and burdens of ownership of the property.  The key words in the example are: “steps are taken so that substantially all of the economic risks and benefits of Property A2 are retained by A.”  Because there was no bona fide contribution, the Commissioner can apply Treas. Reg. section 1.737-4 and recast the transaction for federal income tax purposes, and A would be required to recognize the gain.

Treas. Reg. section 1.737-4(b), Example 2, illustrates when a transaction entered into to avoid IRC section 737 gain will be respected by the Commissioner.  In the example, the distributee partner (A) increases A’s outside basis by assuming the partnership’s recourse liability.  As a result of the liability shift, A’s adjusted tax basis in the partnership interest is greater than the fair market value of the property distributed.  In this case, there is no excess distribution; thus, no IRC section 737 gain is recognized by A.

The key sentence in this example is: “[t]he $10,000 recourse liability is a bona fide liability of the partnership that was undertaken for a substantial business purpose and A’s and B’s agreement that A will assume responsibility for repayment of that debt has substance.”

These two examples involve the application of substance over form principles.  In the first example, the contribution that increased the basis in the partnership interest was without substance.  In contrast, the increase in the partner’s outside basis in the partnership, presented in second example, was respected because the contributing partner assumed the risk of repayment of bona fide partnership debt.

To ensure consistent application of the Treas. Reg. section 1.737-4 anti-abuse rule, it is recommended that examiners involve one of the Partnership Technical Advisors before proposing an adjustment based on this rule.

Issue: Installment Obligations and Contributed Contracts

Prior to changes in the regulations (see Treas. Reg. section 1.704-3(a)(8)), which became effective in 2003, installment notes were sometimes used by partners to circumvent the anti-mixing bowl rules under IRC sections 704(c)(1)(b) and 737.  

Example 4-21

Sam has property worth $11,000 which he wants to sell.  His adjusted basis in the property is $1,000.  Bob would like to purchase the property.  Sam and Bob form a limited partnership, S&B Partnership.  Sam contributes the property for a 49.5 % interest.  Bob contributes $11,000 cash for a 49.5 % interest.  A corporate entity controlled by Sam, Regis, Inc., contributes $22 in cash for a 1% interest. After formation, the balance sheet of the partnership is as follows:

Cash         $11,000
Property      $1,000

                                       Tax         Book     704(c) Gain
Capital - Sam                 $1,000   $11,000         $10,000
Capital - Bob                 11,000     11,000  
Regis, Inc.                             22            22

Two years and one month later, the Partnership sells the property to Bob (or his agent) in exchange for an installment note.  Depending upon the terms of the installment note, there might be very little (if any) immediate recognition of gain. 

The installment note is then distributed to Bob in liquidation of his partnership interest.  Under IRC section 732(b), Bob takes a basis in the installment note equal to his outside basis in his partnership interest, $11,000 (assume there was no other activity of the partnership during this period).  He also has a basis in the property equal to what he paid for it, $11,000.  

The partnership is now left with Sam and Regis, Inc. and the cash contributed by Bob.  Sam will recognize gain only when he is distributed the cash, and then only to the extent it exceeds his outside basis.  Economically, Sam has exchanged his property for cash, but has deferred the gain.

Treas. Reg. section 1.704-3(a)(8), effective for sales of property on or after November 24, 2003, prevents this type of abuse by providing that the IRC section 704(c) taint carries over to the installment obligation.  Therefore, the distribution of the installment obligation to the non-contributing partner, Bob, will be treated as if Sam had distributed the property to Bob and will therefore trigger the recognition of built-in gain to the contributing partner, Sam.

Note that these rules function similarly when the transaction is subject to IRC section 737 gain rules.

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Examination Techniques

When examining issues under IRC sections 704(c) and 737, it is important to determine if contributions and distributions of property occurred within a 7-year period.  If an IRC section 704(c) or IRC section 737 issue is suspected during an examination, the following techniques can be helpful.

Issue Identification

  1. Scrutinize the partnership’s Schedule M-2 and the Schedules K-1 for any distributions during the partnership year.
  2. Request a schedule of contributions that have been made by the partners during the last 7 years.  In many cases, the partnership will maintain both IRC section 704(b) “book” and tax basis capital accounts.  If so, a line by line comparison of these parallel capital accounts will readily indicate whether the distributed property is IRC section 704(c) built-in gain property.
  3. Analyze the capital accounts for the last 7 years.  Review property contributions and distributions.
  4. Review amendments to the partnership agreement, and any memoranda regarding contributions of property and agreed upon value of such property during this period.  The partnership should have records showing the contributing partner’s basis in order to calculate cost recovery or basis for purposes of gain, loss, or other tax purposes.   However, if there is a difference between the value and basis at the date of distribution, the partners will generally track this difference because they want to allow the contributing partner a share of partnership book capital in an amount equal to the value the property contributed. 
  5. Review prior years’ partnership returns and Schedules K-1.  If there was IRC section 704(c) depreciable property present, then the Schedule K-1 and the Schedule M-1 should reflect a special allocation of the depreciation using one of the methods described in Chapter 3 (relating to IRC section 704(c) principles).  This will alert the examiner that IRC section 704(c) property exists within the partnership.

Documents to Request

  1. Partnership Agreement and any amendments.
  2. Internal memoranda or correspondence relating to a distribution.
  3. An analysis of book and tax partnership capital accounts going back 7 years, including schedules of property contributed.
  4. Carryover basis calculations with respect to contributed property that was distributed in suspected IRC section 704(c) or IRC section 737 transactions.
  5. Prior and subsequent year partnership returns, including Schedules K-1.  Schedule K-1 will indicate whether there were cash vs. property contributions and distributions.
  6. If an IRC section 737 transaction is found, request the contributing partner’s return to verify that the gain was reported.
  7. Inquire as to how the partners arrived at the fair market value of the IRC section 704(c) property, and determine if the valuation is reasonable and determined at arm’s length.

Interview Questions

  1. If Schedule M-2 shows property distributions during the year, ask about the property distributed.  Did the partner receiving the property contribute other property to the partnership?  When was it contributed?
  2. How did the partnership determine the value of the contributed property?  Was an appraisal of the property made at the time of the contribution?
  3. When was the property contributed?  When was the property distributed?  Determine if it was within 7 years.

Supporting Law

IRC, Subchapter K:   Section 737.
Supporting Regulations and specific regulations cited below:
Recognition of precontribution gain  Treas. Reg. section 1.737-1
Exceptions and special rules            Treas. Reg. section 1.737-2
Basis adjustments                            Treas. Reg. section 1.737-3
Anti-Abuse rule                               Treas. Reg. section 1.737-4

Resources

Laura E. Cunningham and Noel B. Cunningham, The Logic of Subchapter K:   A Conceptual Guide to the Taxation of Partnerships. (3rd Ed.) “Chapter Fifteen Disguised Sales and Exchanges.” West Publishing Company (2006).

Terence Floyd Cuff, The Anti-Abuse Rule and the Basis Rules of the Final Section 737 Regulations,” The Journal of Partnership Taxation, Spring 1997.

Stephen J. White, et al, “Avoiding the Application of Section 737,” The Journal of Partnership Taxation, Fall 1993.

ISSUE:  DISPROPORTIONATE DISTRIBUTIONS

A distribution is disproportionate if a partner receives more or less than his/her pro rata share of IRC section 751(b) “hot” assets.   Disproportionate distributions can occur during both current and liquidating distributions.  The primary tax impact of a disproportionate distribution is that it is treated, in part, as a taxable sale or exchange.   This prevents the partners from converting ordinary income into capital gain.   IRC section 751 addresses income characterization, rather than income shifting.

This Section discusses disproportionate distributions as they relate to complete liquidations.   For an example of how these rules apply to partial liquidations, see Treas. Reg. section 1.751-1(g), Example 5.

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Identifying Section 751 “Hot” Assets

The presence of IRC section 751 assets has important implications for several common partnership transactions, including the sale or exchange of a partnership interest; retirement payments made to a partner under IRC section 736(b); and disproportionate distributions.   Under the IRC section 751 regime, so-called “hot” assets (generally assets that would give rise to ordinary income if sold by the partnership) fall into two categories:

  1. Unrealized receivables; and
  2. Inventory.

As will become apparent, a degree of complexity lurks behind these simple terms.

Unrealized Receivables

Unrealized receivables, as defined in IRC section 751, is a broad term that encompass much more than the accounts receivable of a cash basis taxpayer.  

For example, under Treas. Reg. section 1.460-4(k)(2)(iv)(E)( 1), contracts accounted for under the long-term contract method of accounting are unrealized receivables within the meaning of IRC section 751(c). The ordinary income component in such contracts is equal to the amount of income or loss that the partnership would take into account if the contract were completed.

The term “unrealized receivables” includes any right to be paid for goods or services which are not capital assets.   In Logan v. Commissioner, 51 T.C. 482 1968, the Tax Court determined that unbilled fees for a law firm’s work in progress fell within the definition of IRC section 751(c).   The court rejected the taxpayer’s argument that because there were no express agreements between the partnership and its clients there was no right to payment.   Noting that had Logan stayed in the partnership, he would have received ordinary income, the court concluded that, “[t]he fruit petitioner left on the partnership tree may not have been ripe, but it was nonetheless fruit.”

In Roth v. Commissioner, 321 F.2d 607 (9th Cir. 1963), aff’g. 38 T.C. 171 (1962), a partnership which produced a movie gave Paramount Pictures Corp. 10-year distribution rights in exchange for a percentage of gross receipts.   The court determined that the partnership’s rights to payments under the contract constituted an unrealized receivable.

In Hale v. Commissioner, T.C. Memo 1965-274, a withdrawing partner received real property and a promissory note in exchange for his partnership interest.   One of the partnership’s remaining assets was the right to share in future profits of a real estate development company, conditioned on the partnership’s promise to render future services.   The court held that the right to future income was an unrealized receivable because it was based on an obligation to render future services.

The term unrealized receivables also covers potential depreciation recapture.  See Treas. Reg. section 1.751-1(c)(4).

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Inventory

Prior to the Taxpayer Relief Act of 1997, the inventory of the partnership as a class had to be “substantially appreciated” to come within the definition of an IRC section 751 asset.   The 1997 Act eliminated this requirement for sales of partnership interests but not for disproportionate distributions.   For purposes of selling a partnership interest, all inventory is considered to be within the scope of
IRC section 751.   For disproportionate distributions, however, inventory must still be “substantially appreciated.”

Inventory items are considered to have appreciated substantially if their combined fair market value exceeds 120 percent of the partnership’s adjusted tax basis in the inventory assets.  Since the determination is made based on total inventory, partners could obviously circumvent this rule by simply purchasing additional (unappreciated) inventory.   In order to prevent manipulation of the inventory fair market value calculation, IRC section 751(b)(3)(B) contains an anti-abuse rule. Under this rule, any inventory acquired for “a principal purpose” of avoiding the 120 percent requirement will be excluded from the calculation of the total inventory’s fair market value.

Solely for purposes of calculating whether inventory is substantially appreciated, all “hot assets” that would give rise to ordinary income under IRC section 751(c) if sold must be taken into account in determining whether partnership inventory items (as defined by IRC section 751(d)) meet the 120 percent substantial appreciation test.  This means that ordinary income items, including unrealized receivables and unrealized cost recovery recapture, must be aggregated with inventory in determining whether inventory is substantially appreciated.  See Treas. Reg. section 1.751-1(d)(2)(ii).

Identifying a Disproportionate Distribution

To determine if a pro rata share of partnership property was distributed, the fair market value of the all partnership assets is considered, rather than the bases in these assets.   In order to fall within the regular pro-rata distribution rules described in the above Sections on current and liquidating distributions, each partner’s share of IRC section 751 assets and other property (including cash) must remain unchanged after the distribution.   When the partner’s share of the partnership’s IRC section 751 and non-IRC section 751 assets is altered, IRC section 751(b) rules come into play.

Note:   When a partner receives relief of debt (and nothing else) from the partnership in a liquidating distribution, he/she is considered to have received a cash distribution.   If there are any IRC section 751 assets, including depreciation recapture, then there would be a disproportionate distribution.

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Conceptual Overview

Treas. Reg. section 1.751-1 divides the distribution into two parts:

  1. The non-pro rata portion of the distribution is carved out and treated as a taxable sale. This is referred to as a “deemed distribution” or a “deemed exchange.”   Both the deemed distribution and the deemed exchange have all of the tax consequences of a true distribution and sale.   The regular sale and exchange Code sections apply to this portion of the transaction, including IRC sections 1231, 1001(b) and (c), and 1011.
  2. The remaining pro rata portion of the distribution follows the regular distribution rules.

The purpose of treating a portion of the distribution as a sale or exchange is to prevent the partners from converting ordinary income into capital gain. It ensures that after a distribution, each partner eventually reports his/her share of ordinary income from the IRC section 751 property that was held in the partnership immediately before the distribution.

The IRC section 751(b) regulations provide the mechanism for handling the portion of the distribution subject to the sale or exchange treatment.   Under these regulations, the following is deemed to occur:

  1. If the distributee partner receives more than his/her share of IRC section 751 property, he/she is deemed to have swapped his/her share of non-IRC section 751 property for IRC section 751 property in a fully taxable exchange.
  2. If the distributee partner receives less than his/her share of the IRC section 751 property then he/she is deemed to have swapped his/her share of IRC section 751 property for non- IRC section 751 property in a fully taxable exchange

Note that unrealized receivables are always considered IRC section 751 property, but in a disproportionate distribution, inventory must meet the “substantially appreciated” test in IRC section 751(b)(3) to be considered IRC section 751 property.

Consequences When the Distributee Partner Receives More Than His/Her Share of IRC Section 751 Property

Partner Consequences

The distributee partner is “deemed” to have sold or exchanged his/her share of non-IRC section 751 property, including cash as follows:

  1. The distributee recognizes gain or loss equal to the difference between the adjusted basis in the non-IRC section 751 property surrendered and the fair market value of the IRC section 751 property deemed to have been purchased.
  2. The distributee partner’s adjusted basis in the non-IRC section 751 property surrendered is the basis that the property would have had if he had received it in a current distribution under the regular distribution rules under IRC sections 731 through 735.
  3. The character of the gain or loss recognized by the distributee partner is determined by the non-IRC section 751 property given up.  This will generally result in a taxable capital gain or loss to the distributee partner.

Partnership Consequences

  1. The partnership recognizes a gain or loss determined by the difference between the partnership’s adjusted basis in the IRC section 751 property surrendered in the deemed exchange and the fair market value of the non‑IRC section 751 property deemed purchased.
  2. The fair market value of the non‑IRC section 751 property deemed to be purchased is the distributee partner’s fair market value interest in the IRC section 751 property given up.
  3. Because the character of the gain or loss by the partnership is determined with respect to the IRC section 751 property surrendered, the character of the gain or loss will be ordinary.  Under IRC section 702(a)(7), this ordinary income recognized by the partnership is reported as a separately stated item to all partners other than the distributee partner.

Consequences When a Partner Receives Less Than His/Her Share of IRC Section 751 Property

In this situation, the distributee partner is “deemed” to have sold his/her share of IRC section 751 property.

Partner Consequences

  1. The distributee partner recognizes gain or loss equal to the difference between the adjusted basis in the IRC section 751 property surrendered in the deemed exchange and the fair market value of the non‑IRC section 751 property deemed received.
  2. The distributee partner’s adjusted basis in the IRC section 751 property surrendered is the basis that the property would have had in a current distribution under the regular distribution rules of IRC sections 731 through 735.  
  3. The fair market value of the non‑IRC section 751 property received is the distributee partner’s fair market value interest in the IRC section 751 property surrendered.  
  4. The character of the distributee partner’s gain or loss is determined by the IRC section 751 property given up, which means that there will always be taxable ordinary income to the distributee partner.

Partnership Consequences

  • The partnership recognizes a gain or loss determined by the difference between the partnership’s adjusted basis in the non‑IRC section 751 property surrendered in the deemed exchange and the fair market value of the IRC section 751 property deemed purchased.
  • The fair market value of the IRC section 751 property deemed purchased is the distributee partner’s fair market value interest in the non‑IRC section 751 property surrendered.
  • The character of the gain or loss by the partnership is determined by the non‑IRC section 751 property given up. Generally, this is capital gain.Under IRC section 702(a)(7),the capital gain the partnership recognizes is reported as a separately stated item to all of the partners, other than the distributee partner.

The following example illustrates the mechanics of a disproportionate distribution.   

Example 4-22

X has a one-third interest in the capital, profits, and losses of the XYZ Partnership.   XYZ distributes $25,000 cash to X in complete liquidation of his partnership interest.   The partnership balance sheet immediately before the distribution to X appears as follows:

    

Basis

Value

Cash 

$25,000

$25,000

Inventory

15,000

25,000

Land  

8,000

25,000

TOTAL 

$48,000

$75,000

       

Capital Accounts

Partner X

$16,000

$25,000

Partner Y

16,000

25,000

Partner Z

16,000

25,000

TOTAL

$48,000

$75,000

   

 

 

 

 

 

 

 

Step 1:  Divide assets on the balance sheet into Section 751 "hot assets" and Non-IRC 751 Assets.

IRC section 751 Property

$15,000

$25,000

Non IRC section 751

        

     Property: 

       

        Land 

8,000

25,000

        Cash 

25,000

25,000

TOTAL 

$48,000

$75,000

 

 

 

 

 

          Step 2:  Determine the actual presence of IRC section 751 property.

Are there unrealized receivables?  No

Is the inventory substantially appreciated in value?  Yes
The inventory’s fair market value of $25,000 is 120 percent of the adjusted basis of all Section 751(d) items.   Generally, these items include the following:

1) Inventory – Stock-in-trade
2) Unrealized Receivables
3) Accounts Receivable
4) Notes Receivable
5) Depreciation recapture

Step 3  Determine the value of the property received by the distributee partner.

Note:   The partnership agreement may specify what was exchanged for the IRC section 751 property and what falls under the regular distribution rules (IRC sections 731 through 735).   If the partnership agreement does not specify, then assume a proportionate share.

In this case, X received $25,000 cash in liquidation of the partnership interest.  

Step 4:  Determine the “deemed” distribution.

A. Determine the fair market value of the IRC section 751 property actually received by the distributee partner.

Answer:  $0

B. Determine the partner’s proportionate share of the IRC section 751 property or the proportionate share of the non IRC section 751 property at fair market value.

Answer:  the parner's proportionate share of IRC section 751 property is $8,333.

C. Compare the IRC section 751 property actually received with the partner’s proportionate share of the IRC section 751 property and determine the deemed distribution amount.

Result:   Negative Amount - ($8,333).  That is, he received less that his pro-rata share.

Deemed Distribution Amount:

In determining the deemed distribution amount, there are three possible outcomes: (1) zero; (2) a positive amount; or (3) a negative amount.  This is determined by the following calculation:

The deemed distribution equals:

  1. The fair market value of IRC section 751 property actually received

Minus

  1. The distributee’s proportionate share of IRC section 751 assets.

If there is a zero IRC section 751 amount - STOP!   The distributee partner has received his/her proportionate share of the IRC section 751 property – regular distribution rules apply.  

If there is a positive IRC section 751 amount, the distributee partner has received more than his/her share of IRC section 751 property.

  1. To the extent of the positive IRC section 751 amount the partner is considered to have sold (given up) his/her interest in non‑IRC section 751 partnership property for IRC section 751 property.

    Amount Realized = Fair Market Value of IRC section 751 Property
    Adjusted Basis = Non‑IRC section 751 Property Given up
  2. The distributee partner recognizes a capital gain or loss or an IRC section 1231 gain or loss on the sale of non‑IRC section 751 property given up.        
  3. The distribution has the opposite effect on the partnership because the partnership treats the IRC section 751 (ordinary income) property as having been sold to the distributee partner in exchange for non‑IRC section 751 (capital gain) property, resulting in ordinary income or loss to the partnership.

See Treas. Reg. section 1.751-1(b)(2).

If there is a negative IRC section 751 amount, the distributee partner has received less than his/her share of IRC section 751 property.

  1. The deficit represents the amount of IRC section 751 property the distributee partner is considered to have sold to the partnership in exchange for non‑IRC section 751 property.

    Amount Realized = fair market value of non‑IRC section 751 property received
    Adjusted Basis = IRC section 751 property given up
  2. The distributee partner recognizes ordinary income or loss on the deemed sale of the IRC section 751 property.
  3. The distribution has the opposite effect on the partnership because the partnership is considered to have sold non‑IRC section 751 property in exchange for the IRC section 751 property, resulting in capital gain or loss.

See Treas. Reg. section 1.751-1(b)(3).

Step 5:   Determine which property or properties are deemed to have been surrendered.

In Example 4-22, X received cash, which is non‑IRC section 751 property.   In exchange, X surrendered inventory, which is an IRC section 751 asset.

Step 6:  Determine the tax consequences to the distributee partner.

Deemed Exchange – Sale and Exchange Portion

Negative IRC section 751 amount                                        $8,333
Less:  adjusted basis in IRC section 751property
deemed distributed (inventory surrendered)                           (5,000)
Ordinary Gain                                                                       $3,333

Note:  The character of the gain depends on the property given up.

Regular Distribution Portion

X’s outside basis in his partnership interest
     immediately before the distribution                                 $16,000
Less:  adjusted basis in IRC section 751 property
     deemed distributed (inventory surrendered)                     (5,000)
Remaining outside basis in partnership
     after deemed distribution                                                $11,000
Less:  money and debt relief after deemed
      exchange ($25,000 less $8,333)                                   (16,667)
IRC section 731(a) Gain                                                  $ 5,667

Step 7:  Tax consequences to the Partnership.

Negative Section 751 amount                                                   $8,333
Less:  Adjusted Basis in Non‑Section 751
  property given up (cash – $ 25,000 x 1/3)                             (8,333)
Gain/Capital or IRC section 1231 Gain                                    $0

Note that no gain is recognized by the partnership if the partnership uses cash or debt relief to purchase an interest in IRC section 751 property because the adjusted basis and fair market value of this type of non‑IRC section 751 property is the same.

If the partnership had an IRC section 754 election in effect, the partnership would be entitled to increase the inside basis in the land by $5,667, the amount of regular distribution IRC section 731(a) gain recognized by the partner.

Examination Techniques and Issue Identification

The examination techniques used should serve, in the end, to answer the following questions:

  1. Do the Schedules K-1 indicate distributions?If so, the Schedule M-2 should show those distributions.This will alert the examiner that there was either a current or liquidating distribution.
  2. Do any of the Schedules K-1 reflect cash distributions?If so, cash received in excess of the partner’s basis in his/her partnership interest is taxable under IRC section 731(a).
  3. What type of property was distributed?A review of the balance sheet (Schedule L) for changes in asset and liability balances should help in this identification.
  4. If there was a disproportionate distribution of IRC section 751 property, gain recognition may be required.This is true if there is a partial liquidation or a complete liquidation.The examiner must be able to document the type and fair market value of each partner’s share of the partnership’s assets and the type and fair market value of the assets distributed.
  5. Was there a change in ownership on the Schedules K-1?If so, this may indicate a partial liquidation, complete liquidation, or sale of partnership interest.
  6. Does it appear that a disproportionate amount of Section 751 assets were distributed? Were all IRC section 751 assets taken into account?This will impact the recognition of ordinary income or capital gain to the partner or the partnership.
  7. Was an IRC section 754 election in effect? If so, make certain that the inside basis of the remaining assets was appropriately adjusted under IRC section 734(b).
  8. Were the partners consistent in how they treated IRC section 751 gains and losses on their own returns?

Interview Questions

  1. What types of assets were distributed? Which partners received particular assets?
  2. Did the distributions result in a liquidation?Was a series of distributions made?If so, under Treas. Reg. section 1.761-1(d), the partnership interest will not be considered as liquidated until the final distribution has been made.
  3. Does the distribution constitute the retirement of a partner? If so, refer to Chapter 7.
  4. Inquire as to whether an IRC section 754 election is in place.Does the return indicate an IRC section 734(b) adjustment to the basis of the nondistributed assets? If so, request the calculation.
  5. Was cash or marketable securities distributed? Did any of the partners receive debt relief? If so, request a basis calculation for the distributee partner to make sure the amount of any money distributed did not exceed the partner’s outside basis.

Supporting Law

IRC, Subchapter K: 
Section 731
Section 732
Section 734
Section 751
Section 752
Section 754
Supporting regulations and specific regulations cited above.

Resources

Bischoff, William R., et al. 1065 Deskbook, 16th Edition. “Chapter 37: The Hot Asset Rules - Collapsible Partnerships.“ Practitioners Publishing Company (September, 2005).

Cunningham, Laura E. and Cunningham, Noel B. The Logic of Subchapter K, A Conceptual Guide to the Taxation of Partnership, (3rd Ed.) “Chapter Thirteen. Disproportionate Distributions.” West Publishing Company (2006).

McKee, William S., Nelson, William F., and Whitmire, Robert L., Federal Taxation of Partnership and Partners. “Chapter 21 - Distributions That Alter the Partners' Interests in Section 751(b) Property.” (2007).

“Blissful Ignorance: Section 751(B) Uncharted Territory.” Jackel, Monte A. and Stok, Avery I.  Practicing Law Institute, 702 PLI/Tax 105 (June, 2006).

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Page Last Reviewed or Updated: 25-Nov-2013