Content area
Full text
In Notice 2006-14,1 the IRS requested comments on a proposed wholesale revision of the regulations promulgated under §751(b). Such a revision will be welcomed by most practitioners in the area: §751(b) is not only frighteningly complex but also fails to accomplish the goal underlying the provision.2 Section 751(b) was enacted in 1954, and regulations were finalized in 1956. As a result, neither the statute nor the regulations reflect the current approach of Subchapter K, such as allocations must satisfy the "substantial economic effect" test of §704(b), mandatory allocation of pre-contribution gain and loss to the contributing partner under §704(c)(1)(A), and proper maintenance of capital accounts under Regs. §1.7040 1(b)(2)(iv).
INTRODUCTION
Section 751(b) speaks to partnership distributions that rearrange the partners' shares of the partnership's ordinary income.3 That is, it is not an anti-conversion provision, but rather an anti-misallocation provision. As a result, the issue to which it speaks is a problem for the Treasury only if distributions have the effect of rearranging ordinary income and the partners are in different tax brackets. In many cases, the partners will be in the same brackets, so there is no need for the application of §751(b) to such partnerships. Unfortunately, §751(b) is mechanical in application and is blind to the tax brackets of the partners.
Worse, §751(b) does not preserve the partners' shares of ordinary income, but rather accelerates it. Further, it can accelerate the recognition of capital gain as well. For example, suppose a partnership owns inventory and a capital asset, with an adjusted basis of $100 and fair market value of $500 in the inventory and an adjusted basis of $300 and a fair market value of $500 in the capital asset. If this partnership has two equal partners, each having an outside basis of $200, then a liquidating distribution of the inventory to one, and of the capital asset to the other, will be recharacterized as an exchange of half of the inventory for half of the capital asset. Thus, there will be immediate recognition of $200 of ordinary income and $100 of capital gain. Absent §751(b), neither distribution would be taxable, and all of the unrealized appreciation in the assets would be deferred until eventual disposition by the distributees.
Even conceding that acceleration...