Question

Discuss the partnership taxation topic of hot assets.

Answer 1

The Partnership Taxation topic of Hot Assets.

Hot assets are business assets that have the potential of built-in ordinary income. In other words, these are assets that would generate ordinary income if sold. The main two examples are inventory and accounts receivable. 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.

The two types of "hot assets" are not subject to the same rules. For example, Unrealized receivables represent ordinary income which will always be accorded "hot asset" treatment. On the other hand, depending on a mechanical test under section 751, inventory items may or may not be substantially appreciated inventory. Because inventory items can potentially avoid "hot asset" treatment, they will be discussed separately.

UNREALIZED RECEIVABLES

Unrealized receivables represent the portion of unrealized apprecia­tion in the receivables consisting of ordinary income. For example, as­sume that an unrealized receivable has a tax basis of $100 and a fair market value of $500. Furthermore, assume that ordinary income of $300 and capital gain of $100 would be recognized if the asset was sold. In this situation only $300 of the asset is an unrealized receivable.

SUBSTANTIALLY APPRECIATED

Inventory There are two primary differences in treatment afforded to inventory assets as compared with unrealized receivables under section 751. First, the entire fair market value of inventory may be deemed a hot asset. Second, the determination of whether inventory assets are substantially ap­preciated depends upon the results of a mechanical test. If the fair market value of the inventory items is greater than 10% of the fair market value of the aggregate partnership assets other than cash and greater than 120% of the tax basis of the inventory items, the assets are considered to be substantially appreciated.

The preferable capital gains tax treatment could reduce the partner’s personal income taxes dramatically, so the IRS made a rule about it. They decided that if the partnership has any hot assets, the leaving partner must recognize ordinary income to the extent of his percentage ownership in the hot assets. The rest of the partnership interest can still be treated as capital gains.

This prevents the partner from receiving favorable tax treatment from liquidating his or her interest. The amount of the exiting partner’s ordinary gain or loss is the difference between the amount realized from his portion of hot assets and the partnership basis in these assets.