Proposed Regulations Would Change Treatment of Sec. 751 Property

By Sally P. Schreiber, J.D.

Regulations

The IRS issued proposed regulations under Sec. 751 that would amend the rules governing how a partner measures its interest in a partnership's unrealized receivables and inventory items and the tax consequences of a distribution to a partner reducing that interest (REG-151416-06).

Sec. 751 was enacted to prevent taxpayers from using a partnership to convert what should be ordinary income into capital gain. Sec. 751(a) provides that the amount of any money, or the fair market value (FMV) of any property, a transferor partner receives in exchange for all or part of that partner's interest in the partnership's unrealized receivables and inventory items is deemed to be an amount realized from the sale or exchange of property other than a capital asset.

Sec. 751(b) overrides the Sec. 731 nonrecognition provisions when a partner receives a distribution from the partnership that shifts the partner's interest in the partnership's unrealized receivables or substantially appreciated inventory items (the partnership's Sec. 751 property) and the partner's interest in the partnership's other property. The partner's interest in Sec. 751 property equals the partner's rights to income from that property.

The current regulations under Sec. 751 involve using a gross-value approach to determine a partner's interest in Sec. 751 property, which looks at a partner's share of the gross value of the partnership's assets, not the partner's share of the unrealized gain or loss in the property. The proposed rules would replace the gross-value approach with a "hypothetical sale" approach, which involves determining a partner's interest in Sec. 751 property by reference to the amount of ordinary income that would be allocated to the partner if the partnership disposed of all of its property at FMV immediately before the distribution.

In addition, the current regulations apply a deemed-asset-exchange approach if the distribution results in a shift between the partner's interest in the partnership's Sec. 751 property and its other property. This method is complex because it requires the partnership and partner to determine the tax consequences of both a deemed distribution of relinquished property and a deemed taxable exchange of that property back to the partnership. The proposed rules would replace that approach with a "hot asset sale" method, which treats the partnership as having distributed the relinquished Sec. 751 property to the partner whose interest in the partnership's Sec. 751 property is reduced, and then treats the partner as having sold the relinquished property back to the partnership immediately before the actual distribution.

The IRS issued similar rules in Notice 2006-14 and received mostly favorable comments on the rules proposed then. The proposed regulations generally will apply to distributions that occur in any tax period ending on or after the date the regulations are finalized.

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