Internal Revenue Code Section 751

Internal Revenue Code Section 751 Disproportionate Distributions

By any measure, the Internal Revenue Code is complex and frequently abstruse in its explanation of the myriad tax laws that control revenue collection activities in the United States, and this is certainly the case with Section 751 which addresses disproportionate distributions of so-called "hot" assets among members of partnerships or limited liability companies. Indeed, even many tax experts cite this section as being particularly challenging to understand. To gain some further insights into what is involved with respect to disproportionate distributions pursuant to Internal Revenue Code Section 751, this paper provides a review of the relevant peer-reviewed, scholarly and governmental literature, followed by a summary of the research and important findings in the conclusion.

Review and Discussion

Background and Overview

Section 751(b) of the Internal Revenue Code (IRC) is described by Burke as being "reputedly one of the most widely ignored provisions of Subchapter K [that] reserves its most daunting complexity for non-pro rata current distributions of property other than cash."

The rationale in support of the enactment of Section 751 was to prevent the conversion of ordinary income into capital gain and the transfer of ordinary income between partners.

The controlling Section 751(b) regulations set forth the identification of two distinct classes of assets:

1. So-called "hot" assets (defined by Section 751(c) as being unrealized receivables) as well as substantially appreciated inventory (as defined by Section 751(b)(3) and (d)); and,

2. So-called "cold" assets (defined by Section 751 as being assets other than unrealized receivables and substantially appreciated inventory).

Distributions are considered to be disproportionate by the IRS in those cases where partners receive more or less than their pro rata share of IRC section 751(b) "hot" assets.

According to the Internal Revenue Services (IRS), "Disproportionate distributions can occur during both current and liquidating distributions. The primary tax impact of a disproportionate distribution is that it is treated, in part, as a taxable sale or exchange. This prevents the partners from converting ordinary income into capital gain."

As opposed to income shifting, though, IRC Section 751 is concerned with income characterization.

In this regard, Section 751(b)(1) stipulates that:

(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 provisions of IRC Section 751 assets for the distribution of hot assets carry significant implications for a number of typical types of transactions that take place in modern partnerships, including the exchange or sale of an individual partnership interest as well as retirement payments that are conveyed to a partner pursuant to IRC Section 736(b) as well as disproportionate distributions. The framework established by IRC Section 751 concerning so-called "hot" assets (typically assets that would provide ordinary income if they were simply sold by the partnership) can be grouped into the following two categories:

1. Unrealized receivables; and,

2. Inventory.

These seemingly straightforward terms mask a significant amount of complexity, though. In this regard, the IRS notes that, "Unrealized receivables, as defined in IRC section 751, is a broad term that encompass much more than the accounts receivable of a cash basis taxpayer."

For instance, pursuant to Treas. Reg. section 1.460-4(k)(2)(iv)(E)( 1), contracts that are accounted for using the long-term contract method of accounting are regarded as being unrealized receivables for the purposes of IRC Section 751(c); however, the ordinary income component in these types of long-term accounted contracts is equal to the amount of income or loss that the partnership would receive had the contract been completed.

Likewise, the term "unrealized receivables" contains provisions that set forth the right to be paid for services or goods that are not capital assets. Some precedential case law in this regard includes the following examples.

In Logan v. Commissioner, 51 T.C. 482-1968, it was held by the Tax Court that unbilled fees for a law firm's work product were covered by the definition contained in IRC Section 751(c). In support of their decision, the Tax Court emphasized that since there was no express agreement between the partnership and its clientele, the plaintiff's argument was not valid and there was no corresponding entitlement to payment. Indicating that in the event the plaintiff had remained in the partnership, he would have received ordinary income, the court determined that, "[t]he fruit petitioner left on the partnership tree may not have been ripe, but it was nonetheless fruit."

Therefore, as defined by IRC Section 751, the term "unrealized receivables" may include far more than the receivables of a cash basis taxpayer and can potentially include any right to be paid for services or goods that are not specifically capital assets.

In the case, Roth v. Commissioner, 321 F.2d 607 (9th Cir. 1963), aff'g. 38 T.C. 171 (1962), a partnership competing in the entertainment industry was responsible for the production of a motion picture that assigned Paramount Pictures Corp. A 10-year distribution right in a quid pro quo arrangement wherein the partnership would receive a percentage of the production's gross receipts. The Tax Court held that the partnership's rights to payments under the contract represented an unrealized receivable.

Therefore, partnership contracts that contain provisions for the right to be paid for future services provided or goods delivered may fall under the purview of Section 751(c).

Finally, in the case, Hale v. Commissioner, T.C. Memo 1965-274, in exchange for his partnership interest, a withdrawing partner received real property as well as a promissory note. Among the partnership's remaining assets was the right to share in future profits of a real estate development company conditioned on the commitment by the partnership to provide services in the future. The Tax Court determined that the right to future income was an unrealized receivable since it was founded on an obligation to render future services.

For the purposes of Section 751, the term "unrealized receivables" can also apply to the recapture of potential depreciation.

In the past, inventories of partnership as a class had to be "substantially appreciated" in order to fall within the purview of the definition of an IRC Section 751 asset before the enactment of the Taxpayer Relief Act of 1997 (the "Act"); however, the Act disposed of this requirement for sales of partnership interests but the Act did not eliminate the requirement for disproportionate distributions.

According to Partnership - Audit Technique Guide - Chapter 4 -- Distribution, "For purposes of selling a partnership interest, all inventory is considered to be within the scope of IRC Section 751. For disproportionate distributions, however, inventory must still be 'substantially appreciated.'"

For the purposes of IRC Section 751 determinations, inventory items are regarded as having appreciated substantially in those cases where their combined fair market value is shown to be in excess of 120% of the partnership's adjusted tax basis in the inventory assets.

The basis of the determination is total inventory; therefore, the potential exists for partners to avoid the Section 751 provisions by purchased any additional inventory that remained unappreciated. To avoid this potential avoidance, IRC section 751(b)(3)(B) provides a rule that prevents the manipulation of the inventory fair market value calculation. Pursuant to the provisions of this rule, any inventory that is purchased for "a principal purpose" of overcoming the 120% requirement is prevented from being included in the calculation of the total inventory's fair market value.

With respect to determining whether inventory is substantially appreciated for the purposes of the calculation of inventory, the IRC stipulates that all "hot assets" that could be converted into ordinary income pursuant to IRC Section 751(c) had they been sold must be included in the calculation to determine whether partnership inventory items (as defined by IRC Section 751(d)) satisfy the 120% substantial appreciation test. According to the IRS, "This means that ordinary income items, including unrealized receivables and unrealized cost recovery recapture, must be aggregated with inventory in determining whether inventory is substantially appreciated."

Pursuant to IRC Section 731(a)(1), partners are considered to have received gain on their partnership distributions to the degree that any "money" that was distributed exceeds the adjusted basis of the individual partner's interest in the partnership.

Likewise, pursuant to Section 731(a)(1) and IRC Section 737, marketable security are not considered to be "money" for the purposes of disproportionate distribution calculations. In this regard, Weitzner and Sayre report that, "As a result, partners generally recognize gain to the extent the value of securities distributed from a partnership exceeds their basis in that partnership; however, the new rules allow partners to receive marketable securities attributable to their share of a partnership's marketable securities without recognizing gain."

The determination for marketable security with respect to disproportionate distribution is accomplished by reducing the amount of marketable securities that is treated as money using the following steps:

1. The excess of the partner's share of net gain that would be recognized if all securities of the type distributed held by the partnership immediately before the transaction were sold at fair market value over

2. The partner's share of gain that would be taken into account if the securities held by the partnership immediately after the transaction were sold.

While the term "marketable securities" includes interests in actively traded precious metals and other financial instruments that are set forth in the applicable IRC code and regulations, there are some exceptions to this provision, though, and it does not apply in three specific situations as noted below:

1. Contributed by partner. If the security itself was contributed to the partnership by the distributee-partner, the provision generally does not apply.

2. Not a security when acquired. The property distributed to the partner was not a marketable security when the partnership acquired it -- to the extent provided in the regulations.

3. Investment partnership. The partnership is an investment partnership [defined in section 731(c)(3)(C)(i)] and the partner is an eligible partner [defined in section 731(c)(3)(C)(iii)]. Look-through rules are provided for tiered partnerships.

By and large, the same techniques that are used with inventory are applied to marketable securities for the purposes of determining partnership distributions, with Section 751(b) being relevant in some cases as follows.

1. IRC section 704(c)(1)(B) may simultaneously apply if another partner contributed the marketable securities.

2. The code and the legislative history are silent on the provision's application to a termination under IRC section 708(b)(1)(B).

3. The disguised sale rules of IRC section 707(a)(2)(B) appear to take precedence.

4. To the extent marketable securities are treated as money, the same amount also is money for purposes of applying Internal Revenue Code section 737. This reduces the amount of gain recognized. In addition, the portion of the marketable securities not treated as money is treated as property for section 737 purposes.

5. IRC section 751(b) (disproportionate distributions) takes precedence.

The same regulatory guidance that covers disproportionate distributions in partnerships is applicable to limited liability companies as well. For instance, according to Magina, Plummer and Streer, disproportionate distributions in limited liability companies (LLC) take place when a distribution is made to a member that represents more or less than the member's share of ordinary income-producing property (as defined in IRC Section 751(a) as unrealized receivables or substantially appreciated inventory). These authorities add that, "When either a current or liquidating disproportionate distribution is made, IRC Section 751 applies to prevent the shifting of ordinary income among the LLC's members."

With respect to LLCs and as with partnerships, any excess of the unrealized receivables and substantially appreciated inventory distributed to members of the LLC that are above their respective proportionate share of these items is regarded to have been purchased from the LLC in return for the members' respective allocation of any cash and capital assets that were not actually received. Conversely, in those cases where LLC members receive an excess of cash or capital assets, such excess is considered to have been purchased from the LLC in return for their respective portion of ordinary income property that was not received.

Consequently, both the LLC members who receive the distribution as well as the LLC itself stand to experience gain or loss, but the gain or loss is recognized by the LLC flows-through and affects all members of the LLC even if they do not receive any distribution of property.

Beyond the foregoing considerations with respect to inventory, Weitzner and Sayre emphasize that the rules regarding distributions of marketable securities from partnerships also require careful application and administration. According to these authorities, "To prevent partners from exchanging their share of a partnership's appreciated assets for a disproportionate share of the partnership's marketable securities and thus deferring gain, the Uruguay Round Agreements Act -- related to the General Agreement on Tariffs and Trade -- added section 731(c) to the Internal Revenue Code."

These provisions are generally applicable for distributions from partnerships that were completed after December 8, 1994.

Identifying a Disproportionate Distribution

In order to determine if the distribution of partnership property was a pro rata or disproportionate share, the fair market value of the all partnership assets is taken into account instead of the bases in these corresponding assets. According to the IRS, "In order to fall within the regular pro-rata distribution rules described in the above Sections on current and liquidating distributions, each partner's share of IRC Section 751 assets and other property (including cash) must remain unchanged after the distribution."

Internal Revenue Code Section 751(b) provisions become applicable in those cases where partners' respective share of IRC Section 751 and non-IRC Section 751 assets is altered; for example, in those cases where partners are provided with debt relief from the partnership but nothing beyond this relief, they are considered to have received a cash distribution. In those cases where there are IRC Section 751 assets involved (including the recapture of depreciation), there are disproportionate distributions involved.

The IRS sets forth a number of examination techniques that can be used to answer the following questions with the implications indicated in Table 1 below.

Table 1

Examination Techniques and Issue Identification for Disproportionate Distribution of Assets

Question No.

Content

Implications (if applicable)

1

Do the Schedules K-1 indicate distributions?

If so, the Schedule M-2 should show those distributions. This will alert the examiner that there was either a current or liquidating distribution.

2

Do any of the Schedules K-1 reflect cash distributions?

If so, cash received in excess of the partner's basis in his/her partnership interest is taxable under IRC section 731(a).

3

What type of property was distributed?

A review of the balance sheet (Schedule L) for changes in asset and liability balances should help in this identification.

4

If there was a disproportionate distribution of IRC section 751 property, gain recognition may be required.

This is true if there is a partial liquidation or a complete liquidation. The examiner must be able to document the type and fair market value of each partner's share of the partnership's assets and the type and fair market value of the assets distributed.

5

Was there a change in ownership on the Schedules K-1?

If so, this may indicate a partial liquidation, complete liquidation, or sale of partnership interest.

6

Does it appear that a disproportionate amount of Section 751 assets were distributed? Were all IRC section 751 assets taken into account?

This will impact the recognition of ordinary income or capital gain to the partner or the partnership.

7

Was an IRC section 754 election in effect?