Who Appreciates This Tax Complexity?

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By James Edward Maule, Esq.
Villanova University School of Law, Villanova, PA

Last week, in Partnership Taxation class, I alerted students to the trap that exists in §751 and the need for them to be very careful when dealing with the identification of partnership assets subject to §751. There is a wrinkle that seems to serve no purpose other than to confuse taxpayers, tax practitioners, and tax students. Some background is helpful.

When a partner “sells” a partnership interest for tax purposes, the tax law (§751(a), to be specific) treats the gain or loss recognized on the sale as capital gain or loss, except to the extent it is attributable to the partner's share of §751 assets in the partnership. The purpose of this provision is to prevent the partner from “converting” ordinary income into capital gain. Accordingly, even though the partner is treated as having sold a thing called a partnership interest, which reflects an “entity” approach similar to a shareholder selling stock in a corporation, an “aggregate approach” is used with respect to §751 assets. In effect, the analysis “looks through” the partnership interest to the underlying asset.

A similar provision (§751(b), to be specific) applies to distributions to a partner that changes the partner's interest in §751 assets. The purpose of the provision is the same, to prevent the partner from obtaining capital gain treatment with respect to assets that would generate ordinary income.

So what's the catch?

The catch is that the definition of §751 assets differs for purposes of §751(a) and (b). The definitions are identical except with respect to inventory items. For purposes of §751(a), which applies to sales of partnership interests, all inventory items are treated as §751 assets. But for purposes of §751(b), which applies to distributions, inventory items are treated as §751 assets only if they are “substantially appreciated.” To be substantially appreciated, the inventory items must have a fair market value that exceeds 120% of their adjusted basis, with a rule disregarding inventory items acquired to manipulate these numbers.

Why the difference? The short answer is that I don't know. Once upon a time, the definition of §751 assets was the same for purposes of both §751(a) and (b). Inventory items were included only if they were substantially appreciated. Why not include all inventory items? I cannot think of a legitimate, reasonable, worthwhile, defensible reason. If the goal is to prevent the conversion of ordinary income into capital gain, it ought not matter whether the inventory is 104% appreciated or 123% appreciated. It's not a de minimis rule, because inventory can flunk the substantial appreciation test while having tens or hundreds of millions of dollars of ordinary income inherent in the inventory. Putting aside the fact that this entire discussion would be irrelevant if capital gains and ordinary income were not treated differently, it makes no sense to treat some ordinary income as ordinary income and other ordinary not as ordinary income, but that is how things stood until Congress amended §751.

When news broke that §751 was going to be amended, I rejoiced. Well, I didn't really rejoice, but I was glad, because it meant I could free up some class time because the definition and computation of substantial appreciation would be tossed out of the course. Unfortunately, when the amending legislation worked its way through Congress on its route to enactment, the amendment was tweaked so that we ended up with the “dual definition” of §751 assets. Why? Again, I don't know. Why should the ordinary income in inventory that is 104% appreciated be ordinary income when dealing with a selling partner but not ordinary income when dealing with a distributee partner? It's tough to visualize the special interest group behind this one, because partners rarely know ahead of time whether they'll end up as a selling partner or distributee partner.

The effect of this difference is to confuse people. True, it creates exam material for tax law professors. That provides the opportunity to identify students who are careful and precise and those who are not, but I prefer to do that using Code provisions that require care and precision for explicable reasons. Nonetheless, I've been known to include §751 asset definition questions on exams and in semester exercises.

Not only is there confusion in terms of the dual definition, there's also a variety of circumstances where the substantial appreciation rule generates surprise results. For example, assume a partnership has actual inventory with an adjusted basis of 100 and a fair market value of 110, and assume it also has unrealized receivables of 30. Standing alone, the inventory is not substantially appreciated, but when the inventory items, which include the receivables, are aggregated, the inventory items are substantially appreciated. Considering that §751 assets are often referred to as “hot assets,” (don't ask), one can refer to this situation as “receivables heating up the inventory.” Consider a partnership that owns inventory with an adjusted basis of 100 and a fair market value of 130. Standing alone, the inventory is substantially appreciated. But assume the partnership also has realized receivables of 60. When aggregated, the inventory items (adjusted basis 160, fair market value 190) are not substantially appreciated. The receivables have “cooled down the hot inventory.” Why should the ordinary income treatment, or not, of a distributee partner turn on theses sorts of “computational games”?

Something else I do not know is how much revenue would be raised if all inventory were treated as §751 assets for purposes of both sales of partnership interests and distributions to partners. Surely it is some positive number, but whether it is in the tens of millions, hundreds of millions, or even low billions is a question I cannot answer. Perhaps someone else, perhaps a revenue estimator, could crank out the numbers. What I do know is that the tax law would be simplified, by a smidgen, if the definition of §751 assets for the purposes of sales of partnership interests were extended to distributions. So I return to the question, why not do so? Whatever may have been the reason for not doing so when §751 was amended, assuming there was a reason, it surely wasn't and isn't one that justifies this sort of complexity.

So here's a proposal that brings simplification and revenue increases, and that can be justified on the grounds that the income in inventory that is not substantially appreciated ought not be taxed at capital gains rates even if one accepts the idea of special low tax rates for capital gains. This sounds like a “shelf project” for Calvin Johnson. Yes, when this is posted, I'm passing on to him the URL for the post. I wouldn't be surprised to learn he's “already on it.” Even if it's a small revenue increase, he keeps telling us we're going to need every dollar to deal with a looming budget deficit crisis that will severely threaten the nation. He's right. So I guess I'm going to become a lobbyist, arguing for this change to §751. But I'd like to think that I'm lobbying for the nation's economic and budgetary welfare. Of course, I'd rather be lobbying for repeal of the special low tax rates, but it's worth having a backup plan in the unfortunately likely event Congress cannot be persuaded to ditch a disproven rate giveaway.

Hopefully, someone will appreciate this effort. Perhaps even substantially.

For more information, in the Tax Management Portfolios, see McArthur, 720 T.M., Partnership Transactions -- Section 751 Property, and in Tax Practice Series, see ¶4050, Partnership Distributions.