Section 751(b): Taxing Disproportionate Distributions

When a partner receives cash or property from their partnership, the event is often treated as a non-taxable return of their investment, assuming the partner is withdrawing from their capital account. The tax is deferred until the partner sells their interest in the partnership, which allows for flexibility in managing cash flow without immediate tax consequences.

However, Section 751(b) of the Internal Revenue Code creates an exception. This rule prevents partners from converting potential ordinary income into capital gains by recharacterizing certain distributions. It applies when a distribution changes a partner’s share of specific partnership assets that would produce ordinary income if sold. When a distribution is “disproportionate,” the rule recharacterizes a portion of it as a taxable sale, looking through the form of the transaction to its substance to preserve income character.

Identifying a Triggering Distribution

A disproportionate distribution occurs when a distribution of cash or property alters a partner’s interest in Section 751 property relative to their interest in all other partnership property. To determine if a distribution is disproportionate, one must establish a “before and after” snapshot of the partner’s interest in the partnership’s assets. Immediately before the distribution, the partner has a quantifiable interest in the partnership’s Section 751 property and its other assets, and after the distribution, their interest will have changed.

The rule is triggered if the distribution results in the partner receiving more than their share of non-Section 751 property in exchange for giving up a portion of their interest in Section 751 property. The focus is not on the total value received but on the change in the composition of the assets underlying the partner’s interest.

Consider a partnership with two equal partners that holds cash (a non-Section 751 asset) and accounts receivable (Section 751 property). If one partner receives a distribution consisting entirely of cash that reduces their partnership interest, their share of the partnership’s accounts receivable is indirectly reduced. They have effectively exchanged their interest in the receivables for an excess distribution of cash, creating a disproportionate distribution.

Defining Section 751 Property

At the heart of any Section 751(b) analysis is the specific class of assets it governs, collectively known as “Section 751 property.” These assets are often referred to as “hot assets” because they carry the potential for generating ordinary income rather than capital gain upon sale. The two categories of hot assets are unrealized receivables and inventory items.

Unrealized receivables represent rights to payment that the partnership has earned but has not yet reported as income under its method of accounting. This includes rights to payment for goods delivered or services rendered. The term also encompasses recapture income, such as the ordinary income portion of gain that would be recognized if the partnership sold certain depreciable property under Section 1245.

Inventory items are defined more broadly than just stock-in-trade. The category includes any property held by the partnership primarily for sale to customers in the ordinary course of its trade or business. This category also includes any asset that, if sold by the partnership, would not be considered a capital asset or a Section 1231 asset. This definition can capture a wide range of assets, including raw materials and work-in-process.

For the rule to apply to inventory, the inventory must be “substantially appreciated.” This requirement is met if the fair market value of all inventory items in the aggregate exceeds 120% of their adjusted basis to the partnership. This test prevents the rule from applying to inventory that has not increased significantly in value. The combination of unrealized receivables and substantially appreciated inventory forms the complete pool of hot assets.

The Deemed Sale and Exchange Calculation

Once a disproportionate distribution has been identified, Section 751(b) recasts the transaction from a simple distribution into a deemed sale or exchange. This hypothetical transaction is the mechanism for ensuring that any ordinary income shifted between partners is immediately recognized. The calculation requires a step-by-step analysis of the assets deemed to have been exchanged between the partner and the partnership.

The first step is to identify which assets the distributee partner received in excess of their proportionate share and which assets they relinquished. For example, if a partner receives an all-cash distribution that reduces their interest, they have received an excess share of cash (a “cold asset”) and relinquished their share of the partnership’s Section 751 property. The value of the relinquished hot assets is treated as having been sold to the partnership.

This deemed transaction is a taxable event for both the partner and the partnership. The partner is treated as receiving a distribution of the hot assets they relinquished and then selling them back to the partnership at fair market value. The partner will recognize ordinary income or loss on this deemed sale, calculated as the difference between the fair market value of the assets and the partner’s tax basis in them.

Simultaneously, the partnership is treated as having sold the excess cold assets to the partner. The partnership may recognize a gain or loss on this deemed sale, the character of which depends on the type of cold asset involved. Following this exchange, the partnership obtains a cost basis in the hot assets it is deemed to have purchased from the partner.

To illustrate, assume Partner A has a one-third interest in a partnership with cash of $60,000 and unrealized receivables of $90,000. Partner A’s share is $20,000 of cash and $30,000 of receivables. The partnership distributes $50,000 in cash to Partner A in complete liquidation of her interest.

Partner A received $30,000 more than her share of cash and relinquished her entire $30,000 interest in the receivables. Section 751(b) treats this as if Partner A sold her $30,000 share of receivables to the partnership for $30,000 of the cash she received. If the partnership’s basis in those receivables was zero, Partner A recognizes $30,000 of ordinary income.

Exceptions to the Rule

The Internal Revenue Code provides specific exceptions where the deemed sale rules do not apply, even if a distribution is disproportionate.

One exception applies to a distribution of property to a partner who had previously contributed that same property to the partnership. In this scenario, the distribution is viewed as a return of the partner’s own property because it does not involve an exchange of their share of the partnership’s income-producing assets.

Another exception involves payments made to a retiring partner or to the successor in interest of a deceased partner. If these payments are classified as income payments under Section 736, they are not subject to the Section 751(b) rules. Section 736 already treats these payments as either a distributive share of partnership income or as guaranteed payments, which result in ordinary income to the recipient. Applying Section 751(b) would be redundant since the income character is already preserved.