IRC Section 751 Treatment of Hot Assets

By Matthew Cavitch, The Cavitch Law Firm, Memphis, TN

The linchpin of taxing transfers of partnership interests is IRC Section 751. Under IRC Section 741, when a partner sells his interest, he is entitled to capital gain treatment, except as provided in IRC Section 751. Under IRC Section 731, when a partner receives a partnership distribution in liquidation of his interest, he is entitled to capital gain treatment, except as provided in IRC Section 751. Regarding sales of partnership interests to third parties, IRC Section 751 is pretty straightforward. But regarding sales of partnership interests back to the partnership, IRC Section 751 can get a little intricate.

Sale of Partnership Interest

When a partner sells his partnership interest to anyone other than the partnership, the partner is entitled to capital gain or loss treatment, except with respect to so-called "hot assets." "Hot assets" are "unrealized receivables" and "inventory items" as defined under IRC Section 751. These are basically ordinary income producing assets, such as accounts receivable not already recognized as income, LIFO reserves, appreciated inventory, and depreciation recapture. Thus, unlike the seller of corporate stock, a selling partner's tax treatment depends upon the underlying partnership assets.

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Redemption of Partnership Interest

When a partner sells all of his partnership interest to the partnership, this is referred to as a liquidation of the partner's interest, with the partner generally recognizing no gain, except to the extent he receives money (including relief from indebtedness) in excess of his basis in his interest...

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If a partner's interest is completely liquidated in exchange for a distribution of property only, without any distribution of money, then the partner recognizes no gain, but winds up with a basis in the distributed property equal to his prior basis in the partnership interest. The partnership would not recognize any gain or loss on the distribution....

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If a partnership distributes property to a partner, but not in liquidation of his interest, then the distribution is tax-free. The partner ends up with a basis in the distributed property equal to the lesser of the partnership's prior basis in that property, or the partner's basis in his interest. The partner's basis in his interest is reduced by the basis in the property, but not below zero...

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All of this becomes more complicated if the partnership owns hot assets and IRC Section 751 applies. If there are "unrealized receivables" or "substantially appreciated inventory items," and the partner does not receive his pro rata distribution of the hot assets, then the distribution will be treated as a sale or exchange by either the partner or the partnership. Whoever is treated as selling hot assets must recognize ordinary income. It is possible that both the partner and the partnership will recognize ordinary income.

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Sale of Partnership Business

... In a sale of partnership interests, the partners are entitled to capital gain or loss treatment, except with respect to so-called "hot assets," as described above. Thus, unlike the sale of corporate stock, a selling partner must look through to the underlying partnership assets...

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Liquidation of Partnership Business

When a partnership liquidates and distributes all assets proportionally to all partners, then the partnership does not recognize any gain or loss. does a partner recognize gain, except to the extent he receives money (including relief from indebtedness) that exceeds his basis...

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LEXIS users can access the complete commentary HERE. Additional fees may apply. (Approx. 7 pages)

RELATED LINKS: For more information on partnerships and "hot assets," see:

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