2014-Issue 47—On October 31, 2014, the IRS released proposed regulations that contain further guidance on the application of Code Section 751(b). The proposed regulations for the most part follow the methodology originally outlined in Notice 2006-14 and provide an anti-abuse rule. They repudiate the primary methodology adopted by the original regulations for Section 751(b), which the IRS believed provided an opportunity for taxpayers to defer or convert ordinary income into capital gain in situations it believed to be inappropriate.
Generally, because distributions from partnerships are tax free under Section 731, unless there is insufficient tax basis under Section 704(d), distributions in excess of tax basis are typically treated as long-term capital gain. However, when a partnership has a significant amount of ordinary income producing assets, the rules under Section 751 can cause a distribution to be taxable even when on the surface it appears not to be, and the gain that a taxpayer may have expected to be taxed at capital gain rates can be treated as ordinary income and taxed accordingly.
Taxpayers who desire more certainty on the proper application of these rules to a transaction may choose to apply the proposed regulations for purposes of determining a partner’s interest in 751 property on or after November 3, 2014. But if a partnership chooses to apply the proposed regulations, it must continue to do so for all future partnership distributions, sales and exchanges. Therefore, it is important for taxpayers to carefully consider the impact of these rules on a variety of common partnership transactions.
Purpose of Section 751
Enacted in 1954, the primary purpose of Section 751 is to prevent taxpayers from converting ordinary income to capital gain through the sale of partnership interests, when the value of the partnership interest consists of appreciated ordinary income assets, also called “hot assets,” such as inventory and unrealized receivables. Like many partnership tax concepts, on the surface Section 751 seems like reasonable, simple, logical approach, but as the world of partnership tax became more complex with the application of allocations under 704(b) and the required application of 704(c), more guidance was needed. The proposed regulations do provide needed guidance, but computing the impact of Section 751(b) is trickier than ever with the complex tiered structures of private equity and hedge funds of today.
A Little History — Gross Asset Value Method
The current regulations for Section 751(b), which were adopted in 1956, require a Gross Asset Value method approach to determining ordinary income from 751 assets. The Gross Asset Value method measures “hot assets” and “cold assets” (non-751 assets) before and after the distribution. If there was a shift in the gross value between partner and partnership, the non-recognition provisions of Section 731 would be ignored and tax liability for the partner could be generated. From the IRS’s perspective, the significant flaw of this approach is that it failed to consider the gain attributable to the “hot assets,” thereby causing a potentially unwanted surprise of a taxable transaction.
New Approach — Hypothetical Sale Approach
The proposed regulations adopt the Hypothetical Sale Approach that was originally proposed in Notice 2006-14. Under this approach, the first step in determining whether 751(b) comes into play is to determine the partners’ interest in 751(b) property via a hypothetical sale by comparing:
- The amount of ordinary income that each partner would recognize if the partnership sold its property for fair market value immediately before the distribution with
- The amount of ordinary income each partner would recognize if the partnership sold its property and the distributee partner sold the distributed assets for fair market value immediately after the distribution.
The hypothetical gain would take into consideration Section 704(c), as well as any Section 743(b) basis adjustments that could affect the overall gain or loss. If the distribution reduces the distributee partner’s share of Section 751 property, via a reduction in ordinary income or an increase in ordinary loss, Section 751(b) will be deemed to apply.
Mandatory Application of 704(c) Upon Disproportionate Distribution
The proposed regulations require mandatory “book-ups” of partnership property if 751(b) is applicable to a distribution in order to maintain consistency with principles of Section 704(c). Furthermore, if an upper-tier partnership has a controlling interest (50 percent or greater) in a lower-tier partnership, the book-up must be applied to the lower-tier partnership’s assets if the lower-tier partnership holds ordinary income property after the distribution. If the upper-tier partnership does not have a controlling interest, the lower-tier partnership must allocate income as if the book-up was done at the lower-tier level.
We Have a 751(b) Distribution — Now What?
The proposed regulations allow any reasonable approach to determine the tax consequences of a Section 751(b) distribution. Two approaches the IRS deems to be reasonable in the majority of cases are (1) a hot asset sale approach and (2) a deemed gain approach.
Under the hot asset sale approach, as described originally in Notice 2006-14, (1) the partnership is deemed to distribute the relinquished property to the partner whose interest in the partnership’s Section 751 property is reduced, and (2) the partner is deemed to sell the relinquished Section 751 property back to the partnership immediately before the actual distribution.
Under the deemed gain approach, the partnership (1) recognizes ordinary income in the aggregate amount of each partner’s reduction in the partner’s interest in Section 751 property, (2) allocates the ordinary income to the partner or partners whose interest in Section 751(b) property was reduced by the distribution, and (3) makes appropriate basis adjustments to its assets to reflect its ordinary income recognition.
The proposed regulations also include anti-abuse provisions that attempt to prevent the application of Section 751(b) by using Section 704(c). If the distribution would otherwise be subject to 751(b) absent the application of Section 704(c), then the IRS believes that Section 751(b) should apply. In layperson’s terms, the IRS wants to prevent sophisticated tax accountants and lawyers from engineering a situation in which distribution would comply with 704(c) and prevent the application of Section 751(b). The regulations list five examples of transactions to which 751(b) would apply:
- A partner’s interest in net Section 751 unrealized gain is at least four times greater than the partner’s capital account immediately after distribution;
- A distribution reduces a partner’s interest to such an extent that the partner has little or no exposure to partnership losses and does not meaningfully participate in partnership profits aside from a preferred return for use of capital;
- The net value of the partner (or its successor) becomes less than its potential tax liability from Section 751 property as a result of a transaction;
- A partner transfers a portion of its partnership interest within five years after the distribution to a tax-indifferent party in a manner that would not trigger ordinary income recognition in the absence of the anti-abuse rule; or
- A partnership transfers to a corporation in a non-recognition transaction Section 751 property other than pursuant to a transfer of all property used in a trade or business excluding assets not material to a continuation of a trade or business.
Alvarez & Marsal Taxand Says:
While the proposed regulations have updated rules under Section 751(b) to work in conjunction with Section 704(b) and Section 704(c), the calculations necessary to determine whether Section 751 applies to your distribution are still extremely complicated and can produce unexpected results. Also, we believe more guidance is needed to properly apply the mandatory revaluations within tiered partnership structures. However, regardless of whether the proposed regulations are finalized as proposed or with modifications, it is clear that taxpayers should carefully consider these proposed rules since they are one more example of the IRS’s increased attention to what it believes are abuses of Subchapter K. We are seeing increased audit scrutiny of pass-through entities by the IRS in general, and Section 751 is yet another potential weapon in the IRS’s arsenal and a potential trap for the unwary.
Tyler Horton, Managing Director, contributed to this issue.
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