Taxing Hot Asset Shifts

Abstract

Notice 2006-14 invites comments concerning proposals to simplify and rationalize the treatment of disproportionate distributions that rearrange the partners\u27 shares of unrealized appreciation in ordinary income and capital gain assets ( hot asset distributions ). Specifically, the Notice requests comments concerning whether to adopt the hot asset sale approach in lieu of the imputed exchange mechanism under the current section 751(b) regulations. Upon a current nonprorata distribution, the hot asset sale approach would be coupled with a revaluation of partnership property and special allocations to preserve shares of built-in hot asset gain to the extent possible. Although enacted in 1954, section 751(b) has remained largely unchanged. Indeed, the regulations issued in 1956 have never been updated to reflect the modem concept of revaluations and section 704(c) allocations. While section 751(b) is sometimes viewed mainly as concerned with the character of income, it also has a significant impact on the timing of gain recognition. Section 751(b) is only one of several provisions that are intended to prevent a distribution or sale of partnership interests from shifting built-in ordinary income or capital gain among partners. The collapsible partnership rules of sections 751(a) and 751(b) and the inside basis adjustment rules of sections 743(b) and 734(b) represented the culmination of intensive study by the American Bar Association (ABA) and American Law Institute (ALI) leading to the 1954 codification of Subchapter K. While sections 743(b) and 751(a) dealing with sales of partnership interests generally function relatively well, sections 734(b) and 751(b) are subject to important defects that impair their ability to prevent shifting of built-in gain. These defects stem mainly from Congress\u27 failure to follow through on the 1954 ALI proposals for treating a nonprorata current distribution as a partial liquidation of the distributee\u27s interest, coupled with mandatory inside basis adjustments. To avoid inadvertently undermining the purpose of section 751 (b), the hot asset sale approach needs to be coordinated with section 734(b) adjustments. Part II of this Commentary considers the general operation of the hot asset sale approach when partnership property is revalued. Part III considers the relationship between sections 734(b) and 751 (b), focusing on the 1954 ALI proposals and Professor Andrews\u27 more recent proposals to reform the treatment of hot asset distributions and inside basis adjustments. Part IV explores the hot asset sale approach in the context of liquidating distributions that trigger section 734(b) because of insufficient shares of outside (or inside) basis. Part V addresses nonprorata current distributions that reduce the distributee\u27s interest in the partnership, leaving the distributee with a retained interest that may be insufficient (by value) to support booked-up hot asset gain. Part VI suggests the need to restore conformity between sections 751(a) and 751(b) by extending the hot asset sale approach to shifts of tepid asset gain. While the hot asset sale approach represents a significant improvement, this Commentary concludes that section 75 1(b) should continue to play an essential gain-recognition function