Section 3. DISCUSSION

(a) Determining the partners’ shares of partnership property

The current regulations under § 751(b) provide little guidance on how each partner’s share of partnership property is determined. Two economic rights are inherent in most partnership interests: a right to partnership capital, and a right to partnership profits and losses. A partner may have a different interest in each of these rights, and those interests may vary over time. Moreover, a partner’s share of unrealized partnership items may be affected by both the economic arrangement of the partners and certain requirements of subchapter K, such as § 704(c).

The legislative history of § 751(b) emphasizes “income rights” of the partners and suggests that these rights may be treated as severable and subject to the same tax consequences as those of an individual entrepreneur. S. Rep. No. 1622, at 99. Consistent with this legislative history, in order to determine whether a distribution may be subject to § 751(b), commentators have suggested that new regulations could require partnerships and their partners to compare the amounts of ordinary income that would be recognized by the partners if the partnership’s hot assets (including distributed assets) were sold or exchanged for fair market value in a taxable transaction both before and after the distribution (hypothetical sale approach). If the amount of ordinary income that would be allocated to any partner (including the distributee)

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cold asset, each with a basis of $0 and a fair market value of $150. A, B, and C each have an adjusted basis in the partnership interest of $0, and a $50 share of hot asset appreciation. A is fully redeemed by a distribution of 2/3 of the cold asset ($100). Immediately before the distribution, the partnership’s assets are revalued and the partners’ capital accounts are increased to $100 to reflect each partner’s share of the unrealized appreciation in the partnership’s assets. Because the entire $150 of hot asset appreciation remains in the partnership after the distribution, A ’s share of that appreciation has been reduced by $50. Under the hot asset sale approach, PRS would be treated as distributing the relinquished share of the hot asset ($50) to A and then purchasing that share for $50. A would recognize income of $50 and would be treated as contributing the $50 to PRS . A ’s basis in the partnership interest would increase to $50 and A ’s capital account would be restored to $100. The portion of the hot asset deemed sold would take a cost basis, increasing the partnership’s basis in the hot asset to $50.

In this example, because A ’s basis in its partnership interest is $50, the basis of the distributed cold asset would be increased under § 732(b) to $50 in A ’s hands. The cold asset remaining in the partnership has a $0 basis and would not be subject to a basis reduction under § 734(b) even if the partnership had a § 754 election in effect. In these circumstances, $50 of capital gain is potentially eliminated from the system, however.

The hot asset sale approach also raises certain complications where the distributee partner has insufficient basis in its partnership interest to absorb the partnership’s adjusted basis in the distributed hot assets. This can lead to results inconsistent with the intent of § 751(b).

Example 3 . Assume the same facts as Example 2, except that instead of distributing 2/3 of the cold asset to A, the partnership fully redeems A by a distribution of 2/3 of the hot asset ($100). Because only $50 of hot asset appreciation remains in the partnership after the distribution, B ’s and C ’s shares of that appreciation have been reduced by $25 each. Under the hot asset sale approach, PRS would be deemed to distribute the relinquished share of the hot asset ($50) equally to B and C and each would be treating as selling $25 worth of the hot asset to the partnership. B and C would each recognize $25 of ordinary income and would be treated as contributing $25 to the partnership. The portion of the hot asset deemed sold would take a cost basis, increasing the partnership’s basis in the distributed portion of the distributed hot asset to $50. Because A ’s basis in its partnership interest is $0, however, the basis of the distributed hot asset would be reduced under § 732(b) to $0 in A ’s hands. If the partnership had a § 754 election in effect, the partnership would increase the basis of the retained hot asset under § 734(b) by $50. After the distribution, A ’s share of unrealized income in hot assets would still be $100, and B and C, who each recognized $25 of ordinary income, would recognize no additional ordinary income.

If § 704(c) principles were applicable for purposes of § 751(b), the distribution to C would not trigger § 751(b), as C ’s predistribution share of the unrealized income in the receivables ($30) is fully preserved in its capital account after the distribution. Section 704(c) principles would require the partnership to allocate that share of appreciation to C when it is recognized.

Special rules may be necessary to address distributions of hot assets to a partner where the adjusted basis of the distributed assets (and the unrealized appreciation in those assets) is different in the hands of the distributee partner than it was in the hands of the partnership. Under §§ 732(a)(2) and (b), the adjusted basis of distributed hot assets is reduced (and the unrealized appreciation in those hot assets is increased) if the distributee partner’s basis in its partnership interest is insufficient to absorb the partnership’s adjusted basis in the distributed hot asset. If the partnership has a § 754 election in effect at the time of the distribution, § 734(b)(1)(B) permits the partnership to increase the adjusted basis of the partnership’s retained hot assets to the extent of the reduction in the basis of the distributed hot assets under § 732(a)(2) or (b). Under these circumstances, the hot asset appreciation remaining in the partnership is reduced. As such, one of the issues raised by use of a hypothetical sale to measure changes in a partner’s interest in hot asset appreciation is the extent to which basis adjustments under §§ 732 and 734(b) should be taken into account.

Moreover, a hypothetical sale at any one point in time does not take into account future allocations that are planned or expected. For example, a partner’s allocations with respect to a particular asset may vary over time. Measuring income or loss on a hypothetical sale of that asset at a particular time may not accurately reflect that partner’s income rights with respect to that asset over the life of the partnership.

Once it is determined that a partner’s share of the income rights in the partnership’s hot assets has been reduced by a distribution, the tax consequences of the distribution under § 751(b) must be determined.

(b) Determining the tax consequences of disproportionate distributions

The current § 751(b) regulations impose a complex deemed distribution/exchange approach for determining the tax

consequences of a disproportionate distribution. One possible way to simplify this determination would be to treat a disproportionate distribution as triggering a taxable sale of the partners’ shares of relinquished hot assets to the partnership immediately before the distribution (hot asset sale approach). The hot asset sale approach would apply § 751(b) in a fully aggregate manner that is arguably consistent with its legislative history (under which each partner’s tax treatment should be that of an individual entrepreneur).

This approach could be combined with the hypothetical sale approach. Thus, new regulations could provide that § 751(b) applies if any partner’s share of the net unrealized appreciation in hot assets of the partnership is reduced as a result of a distribution from the partnership. Under the hot asset sale approach, for any partner whose share of hot assets is reduced (selling partner), whether or not the selling partner is the distributee, the selling partner would be treated as receiving the relinquished hot assets in a deemed distribution and selling to the partnership the relinquished share of the hot assets immediately before the actual distribution. The selling partner would recognize ordinary income from the deemed sale, and the partner’s basis in the partnership interest and the partner’s capital account would be adjusted to reflect the consideration treated as contributed to the partnership. The assets deemed sold to the partnership would have a cost basis under § 1012. Under the hot asset sale approach there would be no deemed exchange for cold assets, thereby eliminating the need to identify cold assets to be exchanged and to construct a deemed distribution of those assets.

The hot asset sale approach can be straightforward if the distributee partner’s share of hot asset appreciation is reduced by the distribution. In this situation, the partnership would be treated as distributing the relinquished share of hot assets to the distributee who sells the hot assets back to the partnership, recognizing ordinary income, with appropriate adjustments to the distributee partner’s basis in the partnership interest and capital account. The asset deemed sold would take a cost basis, and the distribution would be governed by §§ 731 through 736.

Example 2 . Assume A, B and C are each 1/3 partners in a partnership that holds one hot asset and one

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so, the appropriate parameters and availability of such a safe harbor. 2. Whether the current § 751(b) regulations should be generally retained or retained in combination with a safe harbor, or whether the current § 751(b) regulations should be completely revised to adopt a new paradigm such as the hot asset sale approach. 3. Whether mandatory or elective capital gain recognition should be included in the hot asset sale approach. Comments should be submitted in writing on or before August 2, 2006, and should include a reference to Notice 2006–14. In addition to the topics on which comments are specifically requested above, comments are requested on any other matters that should be addressed in future guidance under § 751(b). Comments may be submitted to CC:PA:LPD:PR (Notice 2006–14), Room 5226, Internal Revenue Service, PO Box 7604, Ben Franklin Station, Washington, DC 20044. Alternatively, comments may be submitted electronically via the following e-mail address: Notice.Comments@irscounsel.treas.gov . Please include “Notice 2006–14” in the subject line of any electronic communications. Submissions may be hand delivered Monday through Friday between the hours of 8 a.m. and 5 p.m. to CC:PA:LPD:PR (Notice 2006–14), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC 20224.

DRAFTING INFORMATION

The principal author of this notice is Charlotte Chyr of the Office of Associate Chief Counsel (Passthroughs & Special Industries). For further information regarding this notice, contact Charlotte Chyr at (202) 622–3070 (not a toll-free call).

Extension of June 28, 2005, Safe Harbor Date

Notice 2006–15

The purpose of this notice is to extend the June 28, 2005, grandfather date in Rev. Proc. 2005–24, 2005–16, I.R.B. 909, until further guidance is issued by the Internal Revenue Service.

Commentators have suggested that, in these situations, it may be appropriate to permit or require the distributee partner to recognize capital gain to the extent the adjusted basis of the distributed hot assets exceeds that partner’s basis in the partnership interest. In Example 3, A could elect, or be required, to recognize capital gain equal to the amount by which the adjusted basis of the distributed hot assets exceeds that partner’s basis in the partnership interest ($50), thereby increasing A ’s basis to $50. The distributed hot asset would take a $50 basis in A ’s hands under § 732(b), and no § 734(b) adjustment would be made to the retained hot asset. If A recognizes capital gain on the distribution, future regulations could permit an equivalent increase to the basis of the partnership’s retained cold assets.