Section 2. BACKGROUND

Section 751 was enacted to prevent the conversion of ordinary income into capital gain and the shifting of ordinary income among partners. See H.R. Rep. No. 1337, at 70 (1954), reprinted in 1954 U.S.C.C.A.N. 4017, 4097. Section 751(a) provides for recharacterization of capital gain or loss when an interest in a partnership is sold or exchanged to the extent of the selling partner’s share of unrealized receivables and inventory items of the partnership. Section 751(b) overrides the nonrecognition scheme of § 731 for certain current and liquidating partnership

distributions that alter a partner’s share of unrealized receivables and substantially appreciated inventory items (disproportionate distributions). Section 751(b)(1) provides:

(1) GENERAL RULE.—To the extent a partner receives in a distribution—

(A) partnership property which is— (i) unrealized receivables, or (ii) inventory items which have appreciated substantially in value, in exchange for all or a part of his interest in other partnership property (including money), or (B) partnership property (including money) other than property described in subparagraph (A)(i) or (ii) in exchange for all or part of his interest in partnership property described in subparagraph (A)(i) or (ii), such transactions shall, under regulations prescribed by the Secretary, be considered as a sale or exchange of such property between the distributee and the partnership (as constituted after the distribution). The legislative history of § 751 demonstrates that Congress was primarily concerned with unrealized appreciation in unrealized receivables and inventory items of a partnership.

The provisions relating to unrealized receivables and appreciated inventory items are necessary to prevent the use of the partnership as a device for obtaining capital-gain treatment on fees or other rights to income and on appreciated inventory. Amounts attributable to such rights would be treated as ordinary income if realized in normal course by the partnership. The sale of a partnership interest or distributions to partners should not be permitted to change the character of this income. The statutory treatment proposed, in general, regards the income rights as severable from the partnership interest and as subject to the same tax consequences which would be accorded an individual entrepreneur. S. Rep. No. 1622, at 99 (1954), reprinted in 1954 U.S.C.C.A.N. 4621, 4732 (emphasis added).

The current regulations under § 751(b) require the identification of two classes of assets: (1) hot assets (unrealized receivables as defined in § 751(c) and substantially appreciated inventory as defined in § 751(b)(3) and (d)); and (2) cold assets (assets other than unrealized receivables and substantially appreciated inventory).

February 21, 2006 498 2006–8 I.R.B.

as a result of such a sale or exchange is reduced as a result of a distribution from the partnership, an analysis under § 751(b) would be required. The hypothetical sale approach, combined with the application of § 704(c) principles, could provide rules that achieve the objective of the statute in a less burdensome manner.

Under § 704(c), if partnership property is sold or exchanged, the built-in gain or loss in contributed or revalued partnership property must be allocated to the contributing or appropriate historic partner (§ 704(c) principles). See § 704(c)(1)(A) and §§ 1.704–1(b)(4)(i), 1.704–3(a)(2), and 1.704–3(a)(6). As a result of the application of § 704(c) principles, there can be layers of appreciation in partnership assets (due to successive revaluations), each of which may be allocable separately. Moreover, distributed § 704(c) property and § 704(c) property with a substantial built-in loss must be analyzed separately to determine each partner’s appropriate share of the unrealized gain or loss. See, e.g., § 704(c)(1)(B) and (C). As a result, § 704(c) generally operates to preserve each partner’s share of the built-in appreciation and depreciation in partnership assets. If the regulations under § 751(b) were amended to specify that § 704(c) principles are taken into account for purposes of determining whether a partner’s share of partnership hot assets has been altered by a distribution, significantly fewer distributions would trigger § 751(b).

Example 1 . Assume that A, B, and C each contribute $120 to partnership ABC . ABC purchases land for $210, which appreciates in value to $300. At a time when the partnership also has $90 of zero-basis unrealized receivables and cash of $150, ABC distributes $90 to C, reducing C ’s interest in ABC from 1/3 to 1/5. If, immediately before the distribution, the partnership’s assets are revalued and the partners’ capital accounts are increased to reflect each partner’s share of the unrealized appreciation in the partnership’s assets, C ’s entire pre-distribution share of the partnership’s unrealized income in the accounts receivable (1/3 of $90, or $30) is preserved in C ’s capital account after the distribution. ABC will have the following post-distribution balance sheet (before the application of section 751(b)):

In computing the distributee partner’s income under § 751(b), the current regulations provide that the distributee partner’s share of the partnership’s hot assets and cold assets before and after the distribution must be compared. For purposes of this comparison, each partner’s share of the partnership’s hot and cold assets is determined by reference to the gross value of the assets. If the distribution results in an exchange of all or a portion of the distributee partner’s share of one class of assets (relinquished assets) for assets in the other class (acquired assets), it is necessary to construct a deemed exchange by identifying which relinquished assets are treated as exchanged for which acquired assets.

For example, if a partner receives more than the partner’s share of the partnership’s hot assets in a distribution, that partner is treated as exchanging a portion of the partner’s interest in certain cold assets of the partnership for the other partners’ shares of the acquired hot assets. In order to accomplish the exchange, the distributee partner is treated as (1) receiving the relinquished assets (the cold assets) in a nonliquidating distribution and (2) engaging in a taxable exchange (with the partnership) of those assets for the acquired assets (the hot assets). Both the distributee partner and the other partners may recognize income or loss on the exchange. The distributee partner and the partnership then hold the exchanged assets (or portions thereof) with a cost basis under § 1012. The rest of the actual distribution (the part that is not subject to § 751(b)) is characterized under the general rules for partnership distributions prescribed in §§ 731 through 736.

The current regulations under § 751(b) were published in 1956 and have not been amended to reflect significant changes in subchapter K and in the operations of contemporary partnerships. Moreover, the current § 751(b) regulations have been widely criticized as being extraordinarily complex and burdensome and as not achieving the objectives of the statute. As a result, a distribution may reduce a

partner’s pro rata share of the unrealized appreciation in the partnership’s hot assets without triggering § 751(b), and a distribution can trigger § 751(b) even if the partner’s pro rata share of the unrealized appreciation is not reduced.

The Treasury Department and the Service are considering several possible methods, discussed below, for addressing the issues associated with the current § 751(b) regulations.