Colorado Real Estate Journal - December 17, 2014
On Oct. 31, 2014, the Treasury Department issued proposed regulations that would amend existing regulations and the manner in which ordinary income is potentially recognized upon distributions of cash or property to a partner. While the proposed regulations currently are not mandatory, they may be relied on beginning Dec. 3, 2014, offering another option for the treatment of affected distributions. The proposed regulation principally relates to Internal Revenue Code Section 751; this section originally was enacted in 1954 and was intended to prevent conversion of ordinary income into capital gain and shifting of ordinary income among partners in a partnership. The rules apply to both the sale of a partnership interest from one partner to a new or existing partner and to distributions from a partnership to a partner, whether or not in liquidation of the partner’s interest. In general, a partnership interest is a capital asset, similar to a share of corporate stock, and upon its sale or upon certain distributions, gain would be considered as a favorable capital gain. To the extent the partnership owns unrealized receivables or appreciated inventory (Section 751 assets), however, the gain potentially is recast as ordinary income to any partner who has a reduction in his or her share of Section 751 assets. The proposed regulations simplify how this potential ordinary income piece is measured and determined for distributions by a partnership. The rules would not materially change the determination of the ordinary income element upon the sale of a partnership interest by a partner. The proposed rules generally will affect a disproportionate distribution to one partner. That could be disproportionate in amount or in composition of the distribution between cash and property. In order for the rules to apply, a partnership must own Section 751 assets. As noted above, a Section 751 asset for this purpose is either of the following: Unrealized receivable – the simplest example is an account receivable for services provided by a cash-basis taxpayer, although there are a number of other items statutorily defined as an unrealized receivable for this purpose. Appreciated inventory – inventory is deemed appreciated if its value is more than 120 percent of its adjusted basis. The approach adopted in the proposal assumes each partner owns a share of the Section 751 assets. Under that assumption, if any partner has a reduction in his or her share of the partnership’s Section 751 assets from immediately before a distribution to immediately after the distribution, that partner will have ordinary income to the extent of the reduction. One of the most important changes contained in the proposed regulations: Immediately before the distribution, the assets of the partnership are revalued under existing 704(b) regulations. The effect of the revaluation and the interrelationship of Section 704(c) is to lock each partner’s share of the Section 751 assets to his predistribution allocation, regardless of ownership or sharing percentages after the distribution. The following example illustrates the concepts of a partner’s share of Section 751 assets and the revaluation rule: In ABC Partnership, Example 1, Partner C wants a $50 cash distribution. Each partner’s share of the Section 751 asset is $30 – one-third of its $90 value. Upon receipt of the $50 cash distribution, C becomes a 25 percent partner and the balance sheet of ABC Partnership is depicted in Example 2. To determine if the distribution caused ordinary income to any of the partners, compare each partner’s share of Section 751 assets before and after the $50 distribution to Partner C. Due to the mandatory revaluation, each partner has a $30 share both before and after; therefore, none of the $50 distribution to C is taxable. If the revaluation did not occur, C would have recognized $7.50 of ordinary income on the distribution – the decrease in C’s $30 share of the 751 asset before distribution and his $22.50 (25 percent) share post-distribution. The $30 ordinary income allocation to C is preserved by the reverse 704(c) rules and will be recognized by C when the unrealized receivable is recognized for tax purposes. While these proposed rules would require additional compliance time and capital account tracking, they provide the opportunity to defer ordinary income recognition by one or more partners in the case of disproportionate distributions by a partnership, subject to certain anti-abuse rules. While seemingly complex in some regards, the proposal is generally a welcome relief in its simplicity and practicality compared to the existing rules. The proposal is not without quirks and unwieldy provisions, but as they are only proposed, Treasury has requested comments on ways to make the proposed rules more workable in their application. Contact your financial adviser for more information on how these changes could affect you. This article is for general information purposes only and is not to be considered as legal advice.