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Partnership Transactions — Section 751 Property (Portfolio 720)

Product Code: TPOR41
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Partnership Transactions—Section 751 Property, written by Todd Y. McArthur, Esq., Principal, KPMG LLP, analyzes the federal income tax consequences of both a sale or exchange of a partnership interest where the partnership owns a §751(a) property (i.e., unrealized receivables and inventory items) and a distribution from a partnership owning §751(b) property (i.e., unrealized receivables and inventory items which have appreciated substantially in value) where such distribution has the effect of changing the proportionate interests of the partners in the §751(b) property.  

Sale of a partnership interest generally gives the selling partner capital gain. Section 751, however, recharacterizes a portion of the amount realized as ordinary income to the partner, at times even in the absence of realized gain. The amount so recharacterized roughly corresponds to the amount of ordinary income the partnership would have if it sold the §751(a) property, thus preventing a partner from converting into a capital gain the ordinary income that would pass through if the partnership sold the property. 

This Portfolio discusses the computation of §751(a) ordinary gain when a partner sells or exchanges a partnership interest and examines how distributions from a partnership are (or potentially are) to be analyzed under §751(b), particularly in light of the possible application of the principles under §704(c) concerning built-in gain and built-in loss properties.  A complete analysis of the definition of §751(a) and §751(b) property is included.  

Partnership Transactions—Section 751 Property recognizes that much of the analysis under §751(b) for complex situations has become more uncertain over time because guidance under §751(b), primarily in the form of regulations published in 1956, has lagged behind legislative and regulatory developments in related areas.  Thus, this Portfolio explains different approaches for analyzing the application of §751(b) in situations where other provisions, such as §704(c), are involved. It also describes approaches currently under consideration by the IRS. 

Partnership Transactions—Section 751 Property allows you to benefit from:

  • Hundreds of hours of original research on specific tax planning topics from leading practitioners in this area
  • Invaluable practice documents including tables, charts and lists
  • Plain-English guidance from world-class experts
  • Real-world and in-depth analysis that lets you explore various options
  • Time-saving access to relevant sections of tax laws, regulations, court cases, IRS documents and more
  • Alternative approaches to both common and unique tax scenarios 

This Portfolio is part of the U.S. Income Portfolios Library, a comprehensive series that includes more than 200 Portfolios, which cover every federal tax topic with expert, in-depth analysis, and offer commentary on a wide range of federal taxation topics, including Compensation Planning, Deductions and Credits, Partnerships and Corporations, Special Pass-Through Entities, Corporate Reorganizations, Real Estate, Procedure and Administration, and more.

Detailed Analysis

I. Introduction to Section 751

A. Overview

B. Case Law Before the Enactment of Section 751

C. Legislative History

1. Overview

2. 1954 Enactment

a. House of Representatives Proposal

b. Senate Proposal

c. Conference Committee Revisions

3. 1993 Revisions to Substantially Appreciated Inventory

4. 1997 Repeal of Substantially Appreciated Inventory Requirement of § 751(a)

5. Proposed Repeal of § 751(b)

6. Requests for Comments on the Application of § 751(b)

D. Lingering Effects of Pre-1954 Law

E. Other Developments

II. Section 751(a) - Sales or Exchanges of Interests in Partnerships Owning Section 751(a) Property

A. Introduction

B. Scope of Section 751(a)

1. In General

2. Section 351 Exchanges Involving Partnership Interests

3. Partnership Incorporations

4. Section 721(a) Exchanges Involving Partnership Interests

5. Partnership Distributions of Partnership Interests

6. Partnership Mergers, Consolidations, Divisions, and Conversions

a. Overview

b. Partnership Mergers and Consolidations

c. Partnership Divisions

d. Partnership Conversions

7. Distributions of Partnership Interests by Corporations

8. Partnership Terminations

9. Abandonments and Worthlessness of Partnership Interests

10. Gifts

11. Sales of Partnership Interests Distinguished from Distributions

C. Application of Section 751(a)

1. Overview

2. Sales or Exchanges On or After December 15, 1999 - The Hypothetical Sale Approach

a. Overview of Transferor Partner Consequences

b. Overview of Transferee Partner Consequences

c. Five-Step Application of § 751(a) Using the Hypothetical Sale Approach

d. Example of Five-Step Application of § 751(a)

(1) Step 1 - Classify Each Partnership Asset as Either an Item of § 751(a) Property or an Item of Other Property

(2) Step 2 - Determine the Gross Fair Market Value, § 704(b) Basis, and Tax Basis of Each Item of § 751(a) Property and, If Necessary, Items of Other Property of the Partnership

(3) Step 3 - Determine and Allocate the Total Amount of § 704(b) Gain or Loss Attributable to § 751(a) Property that Would Be Recognized from a Hypothetical Sale of All Partnership Assets for Their Fair Market Value

(4) Step 4 - Determine the Amount of Taxable Ordinary Income or Loss that the Transferor Partner Recognizes Under § 751(a) with Respect to the Transferred Interest

(5) Step 5 - Determine the Transferor Partner's Residual Capital Gain or Loss Recognized

3. Sales or Exchanges Before December 15, 1999 – the Current Distribution Approach

a. Overview of Transferor Partner Consequences

b. Overview of Transferee Partner Consequences

c. Relevance of Gross Fair Market Value and the Interaction of § § 751(a) and 752

d. Interaction of § 704(c) Principles and § 751(a) as Applied Under the Former § 751(a) Regulations

e. Five-Step Application of the Current Distribution Approach Under the Former § 751(a) Regulations

f. Example of Current Distribution Approach

(1) Step 1 - Identify the § 751(a) Property of the Partnership

(2) Step 2 - Determine the Portion of the Amount Realized by the Transferor Partner Attributable to § 751(a) Property

(3) Step 3 - Allocate a Portion of the Transferor Partner's Adjusted Tax Basis in the Transferred Partnership Interest to § 751(a) Property

(4) Step 4 - Calculate the Transferor Partner's § 751(a) Ordinary Gain or Loss

(5) Step 5 - Calculate the Transferor Partner's Capital Gain or Loss

D. Sales and Exchanges of Partial Interests

E. Other Fragmentation of Partnership Interests

1. Capital Gain Rate Differences - Holding Periods and § 1(h)

a. Overview

b. Multiple Holding Periods for Partnership Interests

c. Look-through Treatment for Collectibles Gain and § 1250 Capital Gain

2. Installment Sales

3. Entity v. Aggregate Analysis and the Abuse-of-Entity Rule

F. Tax Reporting Obligations

1. Reporting Obligations of the Transferor Partner

a. Sales or Exchanges On or After December 15, 1999

b. Sales or Exchanges Before December 15, 1999

2. Reporting Obligations Imposed Under § 6050K

III. Section 751(b) - Distributions to Partners Treated as Sales or Exchanges of Section 751(b) Property or Other Property

A. Introduction

B. Section 751(b) Policy and Limitations

C. Scope of Section 751(b)

1. Overview

2. The Distribution Requirement of § 751(b)

a. In General

b. Cash Deemed Distributed Under § 752(b)

c. Types of Distributions - Nonliquidating and Liquidating

d. Partnership Incorporations

e. Distributions of Partnership Interests, Aggregate Principles, and the Effects of § 751(f)

f. Partnership Mergers, Consolidations, Divisions, and Conversions

(1) Overview

(2) Partnership Mergers and Consolidations

(3) Partnership Divisions

(4) Partnership Conversions

g. Abandonments and Worthlessness of Partnership Interests

3. The Exchange Requirement of § 751(b)

a. In General

b. Current Drawings and Advances

4. Transactions Exempted from § 751(b)

a. Distributions of Property Contributed by the Distributee Partner

b. Section 736(a) Payments

c. Gifts, Payments for Services or for the Use of Capital, and Guaranteed Payments

D. Threshold Issues in the Application of Section 751(b)

1. Overview

2. Relevance of Gross Fair Market Value and Partnership Liabilities

3. Allocating Unrealized Appreciation and Depreciation in Partnership Property

4. Amount and Allocation of Zero-basis Unrealized Receivables

5. Interaction of § § 751(b) and 704(c) on the Tax Basis of a Partner's Interests in § 751(b) Property and Other Property

a. Overview

b. Tax Basis of Property Relinquished by a Distributee Partner in a § 751(b) Exchange

(1) The “Traditional” Method

(2) Ceiling Rule Limitations and Alternative § 704(c) Approaches

6. Economic and Tax Effects of a § 704(b) Revaluation on the Application of § 751(b)

7. Conclusion

E. Application of Section 751(b) Using the Complex Proportionate-Interest Approach

1. Selecting a Method to Identify the § 751(b) Exchange

2. Seven-Step Application

3. Step 1: Identify Any Exceptions to the Application of § 751(b)

4. Step 2: Classify Each Partnership Asset Subject to § 751(b) as an Item of § 751(b) Property or an Item of Other Property

5. Step 3: Determine the Distributee Partner's Interests in the Gross Fair Market Value of Each Item of § 751(b) Property and Other Property Before and After the Distribution

6. Step 4: Identify the § 751(b) Exchange

7. Step 5: Determine the Tax Basis of Interests in the § 751 Class Relinquished by the Distributee Partner

a. Hypothetical Current Distribution of Relinquished Interests

b. Collateral Effects of a Hypothetical Current Distribution

c. Effect of a § 743(b) Basis Adjustment

d. Effect of a § 732(d) Basis Adjustment

e. Effect of § 704(c) Principles

8. Step 6: Determine the Federal Income Tax Consequences of the § 751(b) Exchange to the Distributee Partner and the Partnership

a. Overview

b. Sale and Purchase by the Distributee Partner

(1) Gain or Loss Recognized by the Distributee Partner

(2) Character of Gain or Loss

(3) Tax Basis of Property Deemed Purchased

(4) Holding Period of Purchased Property

c. Sale and Purchase by the Partnership

(1) Gain or Loss Recognized

(2) Character of Gain or Loss

(3) Tax Basis of Partnership Property

(4) Holding Period of the Purchased Property

9. Step 7: Determine the Federal Income Tax Consequences of the Portion of the Partnership Distribution that Is Not a § 751(b) Exchange

a. Residual Tax Consequences to the Distributee Partner

b. Residual Tax Consequences to the Remaining Partnership

10. Review of Overall Results of the Application of § 751(b)

F. Nonliquidating Distributions

1. In General

2. Step 1: Identify Any Exceptions to the Application of § 751(b)

3. Step 2: Classify Each Partnership Asset Subject to § 751(b) as an Item of § 751(b) Property or an Item of Other Property

4. Step 3: Determine the Distributee Partner's Interests in the Gross Fair Market Value of Each Item of § 751(b) Property and Other Property Before and After the Distribution

5. Step 4: Identify the Section 751(b) Exchange

6. Step 5: Determine the Tax Basis of Interests in the § 751 Class Relinquished by the Distributee

7. Step 6: Determine the Federal Income Tax Consequences of the § 751(b) Exchange to the Distributee Partner and the Partnership

8. Step 7: Determine the Federal Income Tax Consequences of the Portion of the Partnership Distribution That Is Not a § 751(b) Exchange

9. Review of Overall Results of the Application of § 751(b)

G. Partnership Liquidations

H. Tax Reporting Obligations - Statements Required to Be Filed by Partnership and Distributee Partners

I. Examples of the Seven-Step Application of Section 751(b)

1. Example 23: Distribution of Excess Other Property Resulting in the Recognition of Ordinary Income and Capital Gain to the Distributee Partner

2. Example 24: Distribution of Excess Other Property Resulting in the Recognition of Ordinary Income to the Distributee Partner and Capital Gain to the Partnership

3. Example 25: Distribution of Excess § 751(b) Property Resulting in the Recognition of Capital Loss to the Distributee Partner and Ordinary Income to the Partnership

IV. Section 751 Property - Unrealized Receivables

A. Introduction

B. Rights to Payment for Services Rendered or to Be Rendered

1. In General

2. Services Rendered or to be Rendered

3. Rights (Contractual or Otherwise) to Payment

4. Method of Accounting (Including Long-term Contract Method)

5. Fair Market Value of Unrealized Receivables

6. Adjusted Tax Basis of Unrealized Receivables for Services

C. Rights to Payment for Goods Delivered or to Be Delivered

1. In General

2. Rights (Contractual or Otherwise) to Payment

3. Goods Other than “Capital Assets”

4. Method of Accounting

D. Potential Recapture and Other Ordinary Income

1. General Considerations and Comparison of Treatment Under Section 751(a) and (b)

2. Section 1245 Property

a. Depreciable Property Other Than Buildings and Their Structural Components

b. Partnership Property Subject to Basis Reduction Under § 1017

c. Other Property Subject to Recapture by Reference to § 1245

3. Property Subject to Other Ordinary Income Recapture or Characterization Listed in § 751(c)

a. Section 1250 Property

b. Mining Property

c. Oil, Gas, Geothermal, and Other Mineral Property

d. Farm Land

e. Stock of Domestic International Sales Corporations

f. Stock of Controlled Foreign Corporations

g. Franchises, Trademarks, and Trade Names

h. Market Discount Bonds

i. Short-Term Obligations

j. Leased Property Subject to § 467

V. Section 751 Property - Inventory Items

A. Overview and Background

B. Substantial-Appreciation Threshold

1. In General

2. The Anti-Stuffing Rule

C. Inventory Items

1. In General

2. Property of the Kind Described in § 1221(a)(1)

3. Property Described in § 751(d)(2)

a. Scope of § 751(d)(2)

b. Realized and Unrealized Receivables

c. Previously Expensed Property - “Property of a Character” and the Tax-Benefit Rule

(1) Self-Created Intangibles

(2) Prepaid Items of a Cash-Basis Partnership

d. Section 1221(a)(3) Property

4. Foreign Investment Company Stock (Before January 1, 2005)

5. Property Which, if Held by a Transferor or Distributee Partner, Would be Considered Inventory Items in § 751(d)(1) or (2)

VI. Interaction of Section 751 and Other Code Provisions

A. Section 707(a)(2)(B)

B. Section 704(c)(1)(B)

C. Section 737

D. Section 731(c)

E. Section 732(f)

VII. Other Rules that Preserve the Character of Ordinary Income Potential

A. Partnership Contributions - Sections 724, 704(c)

B. Partnership Distributions - Sections 735, 732(c)

C. Basis Adjustments Under Section 743(b) or Section 734(b)

Working Papers

Table of Worksheets

Worksheet 1 Table of Examples

Worksheet 2 Ways and Means Committee Report, Internal Revenue Code of 1954 H.R. Rep. No. 1337, 83rd Cong., 2d Sess. 70, A234 (1954) (Transfer of Partnership Interest)

Worksheet 3 Senate Finance Committee Report, Internal Revenue Code of 1954 S. Rep. No. 1622, 83rd Cong., 2d Sess. 98 (1954) (Collapsible Partnerships, Unrealized Receivables and Inventory Items)

Worksheet 4 Preamble to T.D. 8847, Adjustments Following Sales of Partnership Interests 64 Fed. Reg. 69903 (12/15/99)

Worksheet 5 Sample - Statement To Be Attached to the Transferor Partner's Tax Return Pursuant to Regs. § 1.751-1(a)(3)

Worksheet 6 Sample - Statement To Be Attached to the Tax Return of a Partnership Pursuant to Regs. § 1.751(b)(5)

Worksheet 7 Sample - Statement To Be Attached to the Tax Return of a Distributee Partner Pursuant to Regs. § 1.751-1(b)(5)

Worksheet 8 Sample - Notice Under § 6050K(c)(1) by the Transferor Partner to Partnership of § 751 Sale or Exchange

Bibliography

OFFICIAL

Statutes:

Internal Revenue Code of 1986, as amended:

Treasury Regulations:

Legislative History:

Treasury Rulings:

Cases:

UNOFFICIAL

Treatises

Periodicals:

1952

1954

1955

1960

1973

1978

1980

1981

1982

1983

1984

1985

1986

1987

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1990

1991

1997

1998

2000

2003

Todd Y. McArthur
Todd Y. McArthur, B.S., University of Virginia, McIntire School of Commerce (1985), Beta Alpha Psi; J.D., University of Virginia, School of Law (1990). Author, Selected Federal Income Tax Issues Arising in Technology Ventures and Business Transactions Involving Technology or Facilitated by the Internet — A Transactional Perspective; with Steven R. Lainoff, “The Final Functional Currency Regime for U.S. Taxpayers Operating in Hyperinflationary Environments: Mandatory DASTM”, 12 Tax Management Int'l J. 583 (1994). Member, Virginia State Bar, District of Columbia Bar, United States Tax Court, and American Bar Association.