December 17, 2014-January 6, 2015 —
COLORADO REAL ESTATE JOURNAL
— Page 23
Law & Accounting
O
n Oct. 31, 2014, the
Treasury Department
issued proposed regu-
lations that would amend exist-
ing regulations and the manner
in which ordi-
nary income
is potentially
re c ogn i z ed
upon distribu-
tions of cash or
property to a
partner. While
the proposed
regul at ions
currently are
not manda-
tory, they may
be relied on
beginningDec.
3, 2014, offer-
ing another
option for the treatment of affected
distributions.
The proposed regulation prin-
cipally relates to Internal Revenue
Code Section 751; this sectionorigi-
nally was enacted in 1954 andwas
intended to prevent conversion of
ordinary income into capital gain
and shifting of ordinary income
among partners in a partnership.
The rules apply toboth the sale of a
partnership interest from one part-
ner to a new or existing partner
and to distributions from a part-
nership to a partner, whether or
not in liquidation of the partner’s
interest. In general, a partnership
interest is a capital asset, similar
to a share of corporate stock, and
upon its sale or upon certain dis-
tributions, gain would be consid-
ered as a favorable capital gain. To
the extent the partnership owns
unrealized receivables or appreci-
ated inventory (Section 751 assets),
however, the gain potentially is
recast as ordinary income to any
partner who has a reduction in his
or her share of Section 751 assets.
The proposed regulations simplify
howthispotential ordinary income
piece is measured and determined
for distributions by a partnership.
The rules would not materially
change the determination of the
ordinary income element upon the
sale of a partnership interest by a
partner.
The proposed rules generally
will affect adisproportionatedistri-
bution to one partner. That could
be disproportionate in amount
or in composition of the distribu-
tion between cash and property.
In order for the rules to apply, a
partnership must own Section 751
assets. As noted above, a Section
751 asset for this purpose is either
of the following:
n
Unrealized receivable –
the
simplest example is an account
receivable for services provided
by a cash-basis taxpayer, although
there are a number of other items
statutorily defined as an unreal-
ized receivable for this purpose.
n
Appreciated inventory –
inventory is deemed appreciated
if its value ismore than 120 percent
of its adjusted basis.
The approach adopted in the
proposal assumes each partner
owns a share of the Section 751
assets. Under that assumption, if
any partner has a reduction in his
or her share of the partnership’s
Section 751 assets from immedi-
atelybefore adistribution to imme-
diately after the distribution, that
partner will have ordinary income
to the extent of the reduction. One
of themost important changes con-
tained in the proposed regulations:
Immediately before the distribu-
tion, the assets of the partnership
are revalued under existing 704(b)
regulations. The effect of the reval-
uation and the interrelationship of
Section 704(c) is to lock each part-
ner’s share of the Section 751 assets
to his predistribution allocation,
regardless of ownership or sharing
percentages after the distribution.
The following example illustrates
the concepts of a partner’s share of
Section 751 assets and the revalua-
tion rule:
In ABC Partnership, Example 1,
Partner C wants a $50 cash distri-
bution. Each partner’s share of the
Section 751 asset is $30 – one-third
of its $90 value.
Upon receipt of the $50 cash dis-
tribution, C becomes a 25 percent
partner and the balance sheet of
ABC Partnership is depicted in
Example 2.
To determine if the distribution
caused ordinary income to any of
the partners, compare each part-
ner’s share of Section 751 assets
before and after the $50 distribu-
tion to Partner C. Due to the man-
datory revaluation, each partner
has a $30 share both before and
after; therefore, none of the $50
distribution to C is taxable. If the
revaluationdidnot occur, Cwould
have recognized $7.50 of ordinary
income on the distribution – the
decrease in C’s $30 share of the 751
asset before distribution and his
$22.50 (25 percent) share post-dis-
tribution. The $30 ordinary income
allocation to C is preserved by the
reverse 704(c) rules and will be
recognized by C when the unreal-
ized receivable is recognized for
tax purposes.
While these proposed rules
would require additional com-
pliance time and capital account
tracking, they provide the oppor-
tunity to defer ordinary income
recognition by one or more part-
ners in the case of disproportion-
ate distributions by a partnership,
subject to certain anti-abuse rules.
While seemingly complex in some
regards, the proposal is generally
a welcome relief in its simplic-
ity and practicality compared to
the existing rules. The proposal is
not without quirks and unwieldy
provisions, but as they are only
proposed, Treasury has requested
comments on ways to make the
proposed rules more workable in
their application.
Contact your financial adviser
for more information on how
these changes could affect you.
This article is for general informa-
tion purposes only and is not to be
considered as legal advice.
s
Tad A.
Goodenbour,
CPA
Partner, BKD LLP,
Colorado Springs
6400 S. Fiddler's Green Circle
Suite 1000
Greenwood Village, CO 80111
Phone (303) 796-2626
Fax (303) 796-2777
Deals. Litigation. Great Service.
Merc Pittinos
Matt Dillman
Abe Laydon
Attorneys at Law
Example 1
Example 2
