Question

Can you discuss Section 751 as related to partnerships? Assets include property, unrealized receivables and inventory, like are likely to generate revenue when sold. Can you discuss Section 751 and why it is important to understand when discussing partnerships?

Answer 1

• Generally, when a partner sells his or her partnership interest, the transaction is considered as the disposition of a capital asset, and any gain from the sale is taxed at lower capital gains rates. A notable exception to this treatment occurs when the partnership holds “hot assets” detailed in IRC Section 751.
• In those cases, the sale of the partnership interest converts a portion of that long-term capital gain to ordinary income, and the sale may require the seller to report ordinary income in a transaction that generates a capital loss.
• Section 751 was implemented to prevent partners from claiming favorable capital gain treatment on income that would be taxed as ordinary income if realized by the partnership, and lists two basic classes of properties requiring reclassification: “inventory” and “unrealized receivables.”
• Taxpayers holding interests in partnerships with significant levels of either inventory or unrealized receivables must be aware, prior to sale of the interest, of the different tax treatment of these assets to avoid negative tax consequences. Section 751 applies when there is a shift in “hot assets,”whether a partner has capital gains or not.
• Because the regulations seem to provide some difference in treatment depending on whether the transaction is structured as a sale of interest or a redemption, tax advisers should calculate the impact of Section 751 assets in each scenario to achieve the best possible tax result.

Congress enacted Sec. 751 to prevent the conversion of potential ordinary income into capital gain upon the sale or redemption of a partnership interest. Given the federal rate differential between ordinary income rates (35%) and long-term capital gain rates (15%), a partner should consider the tax cost and purchase price allocation prior to finalizing an agreement to dispose of the partnership interest. As noted in Example 3, it is also important to consider the tax differences that may result between structuring a disposition as a sale or a redemption.

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