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When to report ordinary income if a partnership with hot assets redeems a partnership interest and the liquidating distributions are made over several tax years.

When a partner in a business partnership retires with a buyout agreement in place, the buyout agreement typically requires either a sale of the retiring partner's interest to the remaining partners (a cross purchase agreement) or a redemption of the retiring partner's interest by the partnership. If the partnership does not have unrealized receivables or substantially appreciated inventory, the choice to the retiring partner between a cross purchase (a sale by the retiring partner) or a liquidating distribution is generally income tax neutral. If the partnership's assets consist of unrealized receivables, substantially appreciated inventory, or both, the timing for the reporting of the retiring partner's ordinary income can be drastically different in a sale of a partnership interest as opposed to a redemption of a partnership interest. If the partnership or the remaining partners are strapped for cash, an installment sale and the liquidating distribution may be spread over subsequent tax years.

If the partnership's assets consist of unrealized receivables, appreciated inventory items, or both (commonly referred to as "hot assets" (1)), the retiring partner should be aware of the uncertainty under Subchapter K and the regulations of a looming ordinary income tax trap when receiving liquidating distributions spread over multiple tax years.

Deferred Payment Sale of a Partnership Interest (2)

Upon the sale (3) or liquidation of a partnership interest, [section][section] 751(a) and (b) are designed to prevent an assignment of one partner's share of ordinary income to another partner. The mechanism that prevents this assignment of ordinary income creates a fiction under [section] 751(a) for a sale and a fiction under [section] 751(b) for a redemption of a partnership interest. A disproportionate distribution can occur when: 1) the partner receives more than his or her share of hot asset (4) items in a partnership distribution; or 2) the partner receives less than his or her share of hot asset items in a partnership distribution; or 3) the distributee partner's redistribution allocation of hot assets changes.

In an all cash redemption, a portion of the partnership distribution is recharacterized as a taxable sale or exchange between the partner and the partnership. Section 751(b) divides the partnership distribution into two steps: 1) The retiring partner receives a distribution equal to his or her proportionate share of hot assets; and 2) the retiring partner then exchanges the hot assets that were deemed distributed to the retiring partner for an increased portion of cold assets (i.e., cash) that the retiring partner actually received. (5)

The examples in the regulations determine a partner's interest in [section] 751 and other property by reference to the partner's interest in partnership capital. (6) If the partnership has [section] 751 assets, then the partner's interest in those assets is determined to be that fraction of their value equal to the partner's fractional interest in all partnership capital. For example, if the partner's capital account is 40 percent of the sum of all partners' capital accounts, the partner has a 40 percent share of the partnership's [section] 751 assets. (7)

Character of Gain Recognized from Sale of Hot Assets with Lump Sum Payment (8)

At the time a retiring partner relinquishes an interest in [section] 751(b) property, the distributee partner realizes ordinary income (9) measured by the difference between his or her adjusted basis for the hot assets relinquished and the fair market value of other property received in exchange for the hot assets. (10) On the other hand, the character of the gain or loss to the partnership is determined by reference to the character of the assets it exchanges for the relinquished [section] 751(b) property, which is generally capital in character. (11)

Recognition of Income When a Partnership Without Hot Assets Makes a [section] 736(b) Liquidating Distribution in Installments

Treasury Regulation [section] 1.736-1(b)(6) states that except to the extent [section] 751(b) applies (i.e., hot assets), the amount of any gain or loss with respect to payments under [section] 736(b) for a retiring or deceased partner's interest in property for each year of payment shall be determined under [section] 731. Section 736(a)(1) recognizes gain in a liquidating payment only when the money distributed exceeds the adjusted basis of the partner's interest in the partnership immediately before the distribution. Section 731(a)(2) defers a recognized loss to the retired partner until after the last distribution has been made so that any unrecovered outside basis is deducted as a capital loss at that time.

Example--A retires from the ABC partnership and is to receive $12,000 in two annual installments of $6,000 each in liquidation of his interest in [section] 736(b) property, none o f which is [section] 751 property. The partner's basis in his partnership interest is $9,000. Under the general cost-recovery rule, the retired partner would recover his entire basis during the second $6,000 installment payment, and the remaining $3,000 of the second installment would constitute taxable gain in its entirety.

If, on the other hand, A elected to Apportion (12) the gain among the installments, $4,500 of each liquidating installment would be treated as basis recovery, computed as follows: $9,000 the adjusted basis in his partnership interest divided by the number of payments, i.e., two. The $1,500 balance of each installment would be taxable gain, computed as follows: $6,000 (the amount of each installment) less $4,500 allocable portion to his basis. Over two years, there is $3,000 of taxable income and a $9,000 return of basis.

Thus, the general rule, as evidenced by the example, is that the [section] 736(b) liquidating payments are reported according to the cash-basis, cost-recovery method. (13)

When to Recognize Income When a Partnership with Hot Assets Makes Its [section] 736(b) Liquidating Distribution in Installments

A plausible option (14) is to subject the deferred payment redemption of a partnership interest with hot assets to the installment reporting provisions of [section] 453. Section 453(b) provides that an installment sale is any disposition of property where at least one payment is to be received after the close of the taxable year in which the disposition occurs, or is deemed to occur. If the partnership is treated under the general entity approach of [section] 741, a partnership interest would be a capital asset that would qualify for [section] 453 treatment.

Revenue Ruling 89-108 held that income from the sale of a partnership interest may not be reported under the installment method to the extent it represents income attributable to the substantially appreciated inventory. Furthermore, it has been suggested (15) that although this ruling deals with substantially appreciated inventory items, its logic encompasses unrealized receivables (16) as well. (17) This revenue ruling can be read more broadly to suggest that when a partner in a partnership with unrealized receivables assets sells his or her partnership interest, all of the ordinary income is not eligible for the installment method.

Professor Manning's Approach

While scholars differ as to the correct tax treatment, surprisingly, there is no direct administrative guidance on this issue by the IRS or case law. Professor Elliot Manning notes that although [section] 751(b) may apply to a portion of the [section] 736(b) payments, the regulations do not address the allocation of the [section] 736(b) payments between [section] 751 property [hot assets] and other property [cold assets]. He feels that since the ratable inclusion election is denied (18) to [section] 736(b) payments attributable to [section] 751 property, and the general approach of [section] 751(b) is to create the fictional [section] 751 exchange even before the actual [section] 736(b) payment is made, then the first [section] 736(b) payments are allocable to the [section] 751 fictional exchange. Let's explain with a variation of Professor Manning's examples:

Kosar, Irvin, and Winslow are equal (one-third) partners in the Canes partnership. If Canes' assets are cash and fixed assets with a basis and value of $30,000, and substantially appreciated inventory with a basis of $18,000 and a value of $180,000; and each partner's outside basis is $36,000, the [section] 751(b) exchange apparently comes first out of the [section] 736(b) payments. If this is so, the first $60,000 of the fixed payments (the first eight years and part of the ninth year with $8,000 fixed payments, and, presumably all fixed payments with $6,000 fixed payments) are part of the [section] 751(b) exchange. Thus, in effect, 10 percent ($18,000 inventory basis/$180,000 value) of each payment is a recovery of Kosar's outside basis and the rest is ordinary income. This means $6,300 of ordinary income under [section][section] 751(b) in each of the first eight years and $3,600 in the ninth year (total $55,000) when the fixed payments are $8,000, and $5,500 each year when the fixed payments are $6,000. The parties can, apparently, agree to alter these amounts by putting the [section] 736(a) payments first or last, as described in Figure 1.

Payments to a retiring partner under [section] 736 must first be divided between payments under [section] 736(a) and [section] 736(b). (21) While the general default approach is to treat [section] 751 first, there are no constraints on the parties' agreeing to accelerate [section] 736(a) payments (22) before [section] 736(b) payments. Section 751(b) does not apply to payments made to a retiring partner to the extent that, under [section] 736(a), such payments constitute a distributive share of partnership income or guaranteed payments. (23) Thus, Professor Manning suggests that the parties should agree to accelerate [section] 736(a) payments before [section] 736(b) payments, thus, not taking the hot assets (i.e., no ordinary income taxation upfront) into account right away while the partnership distributes [section] 736(b) payments to the retiring partner in later tax years. (24)

The redemption payment will be $10,000 a year for the next seven years, plus a [section] 735(a) payment equal to five percent interest on the unpaid balance. The chart in Figure 2 illustrates Professor Manning's approach.

Open Transaction Approach

A second scholar (26) feels that when a withdrawing partner receives a cash liquidating distribution from a partnership with hot assets, the partner is treated as if he or she received a distribution of his or her proportionate share of hot assets and then sold it back to the partnership for cash (i.e., fictional [section] 751(b) exchange). The withdrawing partner must determine the portion of each separate distribution that is treated as a sale under [section] 751(b) and report the amount of ordinary income or loss he or she recognizes. Unlike Professor Manning's default approach that divided each payment between hot and cold assets (and suggested accelerating the cold assets first), Professor Friedland suggests that the withdrawing partner would recognize gain or loss under [section] 751(b) only when the amount of money withdrawing partner receives exceeds his or her basis in the hot assets. This approach is the default approach under [section] 736 and is the equivalent of the "open transaction" reporting approved in Burnett v. Logan, 283 U.S. 404 (1931). (27) Thus, until basis in the hot assets is surpassed, [section] 736(b) payments with hot assets will not create immediate ordinary income taxation. The policy rationale is that the [section] 736(b) timing treatment should trump the fictional distribution and sale back to the partnership of hot assets under [section] 751(b) and, thus, delay the recognition of any gain/loss because, quite likely, no actual distribution is made in that year. If the taxpayer did not receive the benefit of the income, he or she should not be currently taxed on it. The chart in Figure 3 illustrates the open transaction approach.

A third group of scholars (28) suggests that when liquidating payments are spread over many years, it makes a difference whether the payments are fixed or nonfixed. If the payments are fixed, they would be tested for [section] 751(b) disproportionality at the onset of the payments. Since a taxable exchange occurred (even though it was fictional), with the partnership deemed to distribute the property to the retiring partner and the retiring partner then selling the property back to the partnership for cash, gain or loss would be reported immediately even though payments are in installments that occur in a future taxable year. This approach is consistent with the prohibition for using the installment method for inventory. But since [section] 453 does not apply to [section] 736 because there is no cash in the year of redemption, this approach is highly impractical. (29) (See Figure 4.)

This result is debated by scholars (30) who feel that the parties would calculate the [section] 751(b) impact assuming a single payment and then allocate the ordinary income or loss over all of the payments that are made over multiple years. Such result is similar to the apportioning method in Treasury Regulation [section] 1.736-1(b)(6).

If the distribution is nonfixed, then each transfer would be tested for [section] 751(b) disproportionality in the year of the transfer, making it necessary to reapply [section] 751 each year. While this approach might follow the technical fiction created by [section] 751(b), it would not be sound tax policy to have a retiring partner currently recognize a gain for installment payments he or she will be receiving two years from now.

Bifurcated Approach

Finally, the author advocates that the IRS adopt the position that each payment is bifurcated between the partner's distributive share of hot and cold assets. This approach demonstrates sound tax policy as it does not tax all the ordinary income gain upfront nor does it penalize innocent taxpayers who did not plan around such a trap by characterizing all their initial gain as [section] 736(a) gain. The chart in Figure 5 illustrates our approach.


While the IRS's position is that use of the installment method is improper when a partnership with hot assets makes liquidating distributions over the course of multiple years, the author feels that it is not sound tax policy to recognize all [section] 751(b) ordinary income upfront when, in all likelihood, liquidating payments will be made in subsequent years. A bifurcated default approach that divides each payment between hot and cold assets is best suited to reflect the economic reality of the liquidating payments as well as to ensure that taxpayers do not entirely postpone the recognition of ordinary income. Of course, well advised taxpayers, who follow Professor Manning's planning advice, could simply dance around this unsettled area of the law and postpone the recognition of ordinary income by ensuring that their partnership agreements stipulate for the acceleration of [section] 736(a) payments before [section] 736(b) payments.

(1) Commonly referred to as unrealized receivables and appreciated inventory items. Section 751(a) applies to a sale of a partnership interest with inventory items that have even a de minimis amount of appreciation. Section 751(b) applies only if the inventory items are substantially appreciated. Section 751(b) applies if a partner receives a distribution that represents a disproportionate share of the value of the partnership's "hot assets" or "cold assets." Whereas unrealized receivables (an item is an unrealized receivable if its value exceeds the partnership's basis in the asset) are hot assets for both [section][section] 751(a) and 751(b), inventory items are hot assets for distribution purposes only if they are substantially appreciated. All other assets are commonly referred to as "cold assets."

(2) Note that under [section] 736, all unrealized receivables are [section] 736(a) payments and its impact in a deferred redemption will be considered later.

(3) Since this is a sale, [section] 751(a) applies instead of [section] 751(b).

(4) See [section] 751(b)(3). For purposes of determining which assets are [section] 751 assets under [section] 751(b), inventory items are included only if they have appreciated in value. Generally, inventory items are considered to have appreciated in value if their fair market value exceeds their adjusted basis.

(5) Treas. Reg. [section] 1.751-1(b)(2), (3).

(6) For this purpose, value of capital accounts at the time of redemption is used. Therefore, future profit and loss allocations are irrelevant.

(7) Stephen G. Utz, Determining a Partner's Share of Unrealized Receivables at the Liquidation of the Partner's Interest, 78 Taxes: The Tax Magazine 37-42 (Oct. 2000).

(8) The retiring partner receives all of the sale proceeds or all of the liquidation distributions in the same tax year. There is an additional requirement for inventory items that requires the subsequent sale by the partner to occur within five years from the date the partnership distributed the inventory to the partner. Treasury Regulation [section] 1.735-1(a)(2) states that once the five-year time period has elapsed, the character of the distributed property is based on its character in the hands of the distributee at the time of the sale.

(9) Section 751(b) also prevents assignment of ordinary losses.

(10) Treas. Reg. [section] 1.751-1(b)(3)(iii).

(11) Treas. Reg. [section] 1.751-1(b)(3)(ii).

(12) Treas. Reg. [section] 1.736-1(b)(6). If the [section] 736(b) payments are a fixed sum, the retiring partner may elect to apportion a part of the total gain or loss among the installment payments. A statement shall be attached to the retiring partner's tax return in the first taxable year for which he or she receives such payments.

(13) McKee, Nelson, Whitmire, Federal Taxation of Partnerships and Partners, [paragraph] 22.02[4][a] (4th ed.).

(14) Id. at [paragraph] 16.04[1].

(15) Id. at [paragraph] 16.04[1][b].

(16) Many unrealized receivables relating to services rendered or to be rendered, fall within the judicial exclusion from [section] 453 of service-related property rights. A detailed analysis of these exclusions is beyond the scope of this article. See id. at [paragraph] 17.05[1] (4th ed.); CCA 2007-22-027.

(17) See CCA 2007-28-001 where the IRS assumed, without discussing the merits, that it was improper for the taxpayer to use the installment method to report that portion of the income of the sale that was attributable to the [section] 751(c)(2) unrealized receivables.

(18) Treas. Reg. [section] 1.736-1(b)(6).

(19) A partner's basis for a partnership interest is referred to as outside basis. Likewise, the partnership's basis in its assets is "inside basis."

(20) A deferred payment sale of inventory is not eligible for the installment method. [section] 453(b)(2)(B). See also Rev. Rul. 89-108.

(21) Treas. Reg. [section] 1.751-1(b)(4)(ii).

(22) Service 736(a) payments are considered a distributive share of partnership income or a guaranteed payment. An analysis of [section] 736(a) payments is beyond the scope of this article.

(23) Treas. Reg. [section] 1.751-1(b)(4)(ii).

(24) This approach is also supported by Karen Burke who feels that [section] 751(b) should only come into play once the [section] 736(b) payment is identified. Thus, if you accelerate the [section] 736(a) payment (and, thus, defer the [section] 736(b) payment), [section] 751(b) should only come into play as the actual payments are made.

(25) Professor Manning's planning solution is to allocate the first $14,000 to the [section] 736(a) payments.

(26) Jerold a. Friedland, Understanding Partnership and LLC taxation, [section] 10.02 (2d ed.).

(27) The open transaction doctrine was used by the taxpayer to claim that no gain should be realized on the sale of a portion of a property until the basis of the entire original purchase was recovered. See also Rev. Rul. 77-414 ("when it is impractical or impossible to determine the cost or other basis of the portion of the property sold, the amount realized on such sales should be applied to reduce the basis of the entire property and only the excess over the basis of the entire property is recognized as gain").

(28) Bishop, Brooks, Federal Partnership Taxation, [paragraph] 8.02 at 440 (1990); see also McKee, NelsoN, Whitmire, Federal Taxation of Partnerships and Partners, [paragraph] 22.02[4][a] (4th ed.).

(29) If a sale would be required to report all $54,000 of ordinary income in year one even though no cash is actually distributed and you cannot use [section] 453.

(30) Lipton, Carman, Fassler, Schwidetzky, Partnership Taxation, [section] 7.09 (2d ed.).

Daniel Bensimon is an associate at Guttenmacher & Bohatch, P.A., in Miami. He practices is the areas of international tax and estate planning and advises high net-worth individuals and closely held businesses. He is a graduate of Yeshiva University (B.A.), and earned his J.D. and LL.M. in taxation from the University of Miami School of Law.

The author thanks Jerry Hesch, Miami, for his tremendous insights and comments. In addition, the author thanks tax scholars Karen Burke, James Repetti, Noel Cunningham, James Maule, Charlene Luke, and William McKee.

This column is submitted on behalf of the Tax Section, Frances D. McCoid Sheehy, chair, and Michael D. Miller and Benjamin Jablow, editors.
Figure 1

Partner     Capital account   Outside basis (19)   Potential gain

Kosar       $70,000           $16,000              $54,000
Irvin       $70,000           $16,000              $54,000
Window      $70,000           $16,000              $54,000
Total       $210,000          $48,000              $162,000

Balance Sheet

Assets            Basis      Value

Cash              $10,000    $10,000
Inventory (20)    18,000     180,000
Capital Assets    20,000     20,000
Totals            $48,000    $210,000

Figure 2

Year   Payment     [section] 736(a)   [section] 736(b)
       Received    amount             amount

1      None        None               None
       $13,500     $3,500             $10,000
       $13,000     $3,000             $10,000
       $12,500     $2,500             $10,000
       $12,000     $2,000             $10,000
       $11,500     $1,500             $10,000
       $11,000     $1,000             $10,000
       $10,500     $500               $10,000

       Professor Manning's Approach (25)

Year   [section] 751(b)    [section] 751(b)   [section] 731
       Portion             Gain               Portion

1      None                None               None
2                                             None
       $10,000             $9,000
3                                             None
       $10,000             $9,000
4                                             None
       $10,000             $9,000
5                                             None
       $10,000             $9,000
6                                             None
       $10,000             $9,000
7                                             None
       $10,000             $9,000
8      None                None               $10,000

       $60,000             $54,000            $10,000

Figure 3

        Payment       [section] 736(a)   [section] 736(b)
Year    Received      amount             amount

1       None          None               None
2       $13,500       $3,500             $10,000
3       $13,000       $3,000             $10,000
4       $12,500       $2,500             $10,000
5       $12,000       $2,000             $10,000
6       $11,500       $1,500             $10,000
7       $11,000       $1,000             $10,000
8       $10,500       $500               $10,000

                      Open transaction

        [section] 751(b)   [section] 751(b)    [section] 731
Year    Portion            Gain                Portion

1       None               $4,000              None
2       $10,000            $10,000             None
3       $10,000            $10,000             None
4       $10,000            $10,000             None
5       $10,000            $10,000             None
6       $10,000            $10,000             None
7       $10,000            $10,000             None
8       $10,000            None                $10,000

Figure 4

        Payment      [section] 736(a)   [section] 736(b)
Year    Received     amount             amount

1       None         None               None

2       $13,500      $3,500             $10,000

3       $13,000      $3,000             $10,000

4       $12,500      $2,500             $10,000

5       $12,000      $2,000             $10,000

6       $11,500      $1,500             $10,000

7       $11,000      $1,000             $10,000

8       $10,500      $500               $10,000


                        Alternative #3 a

        [section] 751(b)   [section] 751(b)   [section] 731
Year    Portion            Gain               Portion

1       $60,000            $54,000            None

        None               None               None
        None               None               None
        None               None               None
        None               None               None
        None               None               None
        None               None               None
        None               None
8                                             $10,000

        $60,000            $54,000            $10,000

Figure 5

       Payment     [section]736(a)    [section]736(b)
Year   Received    amount             amount

1      None        None               None

2      $13,500     $3,500             $10,000

3      $13,000     $3,000             $10,000

4      $12,500     $2,500             $10,000

5      $12,000     $2,000             $10,000

6      $11,500     $1,500             $10,000

7      $11,000     $1,000             $10,000

8      $10,500     $500               $10,000

       Bifurcated Approach
       [section]751(b)   [section]751(b)    [section]731
Year   Portion           Gain               Portion

1      None              None               None

       $8,572            $7,714             $1,428
       $8,572            $7,714             $1,428

       $8,572            $7,714             $1,428

       $8,572            $7,714             $1,428

       $8,572            $7,714             $1,428

       $8,572            $7,714             $1,428

       $8,572            $7,714

8                                           $1,428
       $60,000           $54,000            $10,000
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Date:Oct 1, 2009
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