The IRS has issued proposed regulations (REG-151416-06) to revise regulations under Section 751(b) that have remained generally untouched since 1956.
The proposed regulations, which follow Notice 2006-14, address how a partner measures interest in a partnership's unrealized receivables and inventory items (hot assets) and also provide guidance that overrides the nonrecognition rules of Section 731 when a partner's interest in hot assets is decreased as a result of a disproportionate distribution from the partnership. Such application inhibits taxpayers from using partnerships to convert ordinary income to become capital gain.
A significant change in the proposed regulations is the adoption of the hypothetical sale approach to determine a partner's share in the partnership's hot assets. It replaces the use of the partner's share of the gross value in such property as illustrated in the examples in the current regulations.
In the hypothetical sale approach, a partnership compares the amount of ordinary income or loss that each partner would recognize (including Section 704(c) allocations) if the partnership sold all of its property for its fair market value immediately before the distribution with the amount of ordinary income or loss that each partner would recognize (including Section 704(c) allocations) if the partnership sold all of its property and the distributee partner sold the distributed property for its fair market value immediately after the distribution.
Since the hypothetical sale approach relies heavily on Section 704(c) principles, the proposed regulations also include changes to revaluations under Treas. Reg. Sec. 1.704-1(b)(2)(iv)(f). The proposed regulations would require a partnership to revalue its property (and to "book up" the partners' Section 704(b) capital accounts) if a partnership distributes cash or other property to a partner in exchange for at least a portion of such partner's interest in the partnership, and the partnership owns hot assets immediately after the distribution. Additionally, the proposed regulations include a special revaluation rule for distributing partnerships that own an interest in a lower-tier partnership.
The proposed regulations also address how certain basis adjustments under Section 732(c), Section 734(b) or Section 743(b) would affect the computation and determination of a partner's share of the partnership's hot assets and a potential reduction of such share.
An anti-abuse rule is included in the proposed regulations. It lists situations that are presumed inconsistent with the purpose of Section 751(b) and would require taxpayers to apply the rules set forth in the proposed regulations in a manner consistent with the purpose of Section 751(b). An example is the transfer of a partnership's hot assets (other than pursuant to a transfer of all property used in a trade or business) to a corporation in a nonrecognition transaction.
The regulations are proposed to apply to any distributions occurring in a taxable period ending on or after the date that such regulations are published as final. However, a partnership and its partners may be able to rely on Treas. Prop. Reg. 1.751-1(b)(2) for purposes of determining a partner's interest in the partnership's hot assets on or after Nov. 3, 2014.
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