Distributions Subject to Section 751(b)

• Pages: 233-248
• Author: James R. Repetti,William H. Lyons,Charlene D. Luke

233

Chapter Twelve

DISTRIBUTIONS SUBJECT

TO SECTION 751(b)

Section 751(b) seeks to prevent partners from shifting ordinary

income and capital gains among themselves by selecting assets for

distribution based on an asset’s tax characteristics.

1

Section 751,

however, is not limited to cases in which the partners care about the

character of their income. Section 751 (b) works by recharacterizing

distributions as transactions involving sales or exchanges. Eve n

partners indifferent to whether their gains and losses are capital

must pay care ful attentio n to § 751(b), because § 751(b) will cause

distributions that would have been tax free under § 731 to generate

gains, losses, and basis adjustments at both the partner and

partnership levels.

Section 751(b) is not easy to work with. Nevertheless, a thorough

understanding of how that section functions is necessary for anyone

who wants to be able to give accurate tax advice to partners and

partnerships. Nearly all partnerships hold assets subject to § 751.

When those p artnerships make distribut ions (and remember that a

distribution is deemed to occur whenever a partner’s share of

partnership liabilities decreases),

2

§ 751(b) will come into play unless

the distribution has been carefully structured. In real life, of course,

most partners are advised by lawyers and accountants who have not

mastered § 751(b) and who often, one suspects, have never even

heard of it. Keeping a provision in the Code when compliance with

that p rovision is questionable f or mos t taxpayers seems a dubious

policy choice.

Before examining § 751(b), let us look at a simple example of the

problem that section was intended to resolve.

1

Chapter 10 § A.2 discussed § 751(a), which, although it deals with similar

issues in the context of sales of partnership interests, is significantly less complex than

the hot asset rules applicable to distributions.

Gains and losses required to be recognized under § 731 are treated as capital gains

and losses from the sale of the distributee’s partnership interest. Chapter 11 §§ B.1

and B.2. Whether the gain is long term or short term will depend on the partner’s

holding period. Section 1061, which was adopted in 2017, will require non-corporate

service partners in certain capital-raising or investment partnerships (such as private

equity partnerships) to hold an interest for more than three years in order to obtain

long-term capital gain treatment under § 731(a). Reg. § 1.1061–4(a). For additional

discussion of § 1061, see Chapter 4 § B.3.

2

§ 752(b).

234

Distributions Subject to Section 751(b)

Ch. 12

Example 12-1: The RST equal partnership has these assets:

Basis

Fair Market Value

Cash

$1,200

$1,200

Inventory

600

1,200

Capital Asset

900

1,200

Total

$2,700

$3,600

Richard, who has an outside basis of $900, retires from

the partnership, receiving a liquidating distribution of all

the inventory (worth $1,200). Under the usual rules for

distributions, this would lead to Richard’s becoming the

only partner to report ordinary inco me attributable to the

inventory. To see why, consider that Richard would receive

the inventory with a basis of $600 (the partnership’s inside

basis) under § 732(c)(1).

3

For five years from the date of the

distribution, § 735 requires that the character of the

inventory remain ordinary. Thus, if he sold the inventory

for $1,200 within five years, he would report $600 of

ordinary income. The other partners, Sophia and Tess,

would report none of the ordinary income from the

inventory because their partnership (now the ST

partnership) would hold only capital assets and cash.

If Richard’s liquidating distribution co nsisted of t he

capital asset, only Sophia and Tess would report the

ordinary income represented by the inventory’s excess of

value ove r basis because they would be the only partners

when the partnership sold the inventory.

Section 751(b) was intended to prevent a distribution from

shifting ordinary income among the partners in the ways shown in

the example. As we shall see, it doesn’t always work, but it will

frustrate the simple attempts described in Example 12-1.

To determine whether § 751(b) applies to a distribution, one

must view partners as owning their proportionate shares of

partnership assets. Those assets are either “§ 751 p roperty” or other

property. “Section 751 property” consists of “unrealized receivables”

and “substantially appreciated inventory items”;

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everything else is

3

Richard would also recognize a capital loss of $300 under § 731(a)(2) because

the only asset he receives is inventory that has an inside basis of $600 while his outside

basis is $900.

4

“Unrealized receivables” and “inventory” are defined in § 751(c) and (d). See

Chapter 10 § A.2. Remember that, in the context of sales of partnership interests,

§ 751(a) applies to all inventory, in contrast to the “substantially appreciated” rule

discussed here, which apply to distributions.