A Deeper Dive into Hot Assets

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Contributing Author: James H. Boyd 

A Deeper Dive into Hot Assets 

One aspect of partnership taxation creates much of the complexity of Subchapter K:  the idea that ordinary income treatment must be preserved and allocated to the partner to whom that income accrued. This ordinary income preservation concept applies to distribution of assets from a partnership, liquidation of a partnership interest under § 736, and sale of a partnership interest. 

Hot assets. “Hot assets” – or ordinary-income producing assets  are the mechanism by which this ordinary income preservation occurs. If a transaction would change a partner’s interest in these assets, an accounting must be made, and the related ordinary income is recognized by the affected partner. Hot assets include “unrealized receivables” and “inventory, as defined in §§ 751(c) and (d) and discussed later. The definitions of these two types of hot assets differs, depending on whether the triggering transaction is a sale or a distribution. 

Sales of a partnership interest (§ 741)Sales of a partnership interest are covered first because they are probably easier, conceptually, to understand. Under § 751(a), the portion of a selling partner’s proceeds from sale of a partnership interest that relates to unrealized receivables or inventory “shall be considered as an amount realized from the sale or exchange of property other than a capital asset.” Here’s how it works:  the selling partner’s sales price is apportioned between his/her/its share of the fair market value of (1) the partnership’s hot assets and (2) other assets. The selling partner’s share of the basis in the partnership assets is similarly allocated. Then, it’s simple math. The partner’s share of gain on sale of hot assets is calculated, as well as the partner’s gain or loss on the rest of the sale. The selling partner recognizes ordinary income related to the deemed hot asset sale, and (short- or long-term) gain or loss on the rest of the sale. 

Distributions (including § 736)Under § 751(b), a distribution that changes a partner’s share of partnership unrealized receivables or substantially appreciated inventory, is “considered a sale or exchange of such property between the distributee and the partnership (as constituted after the distribution). (Note the “appreciation” requirement – we’ll discuss that later.) 

For distributions, the so-called “disproportionate distribution” is recast as (1) a proportionate distribution of hot assets followed by (2) a deemed sale of these assets from the partner(s) who did not receive them to the partner(s) who did receive them. Therefore, the non-recipient partner pays tax and is relieved of future responsibility for tax on those assets, and the recipient partner owns the assets with a basis increase equal to the income recognized by the other partner(s). See the discussion of disproportionate distributions in the text for more information. 

The rules of §736 follow this same logic, although a different analysis applies. A §736 transaction involves a distribution of partnership assets in liquidation of a partner’s interest in the partnership. If the liquidating distribution is paid in cashthe liquidated partner recognizes the appropriate share of potential partnership ordinary incomeThe partnership either claims a deduction (if the portion of the payment triggering the ordinary income is considered a §736(a) payment) or it has basis in the ordinary-income producing assets (if the portion of the payment triggering the ordinary income recognition is considered a §736(b) payment)Note that if the partnership distributes other assets (e.g., inventory), the partnership could end up being the party that recognizes the ordinary income and the calculations become significantly more difficult. 

Unrealized receivablesSection 751(c) defines unrealized receivables as any amount not previously reported as income by the partnership under its normal methods of accounting to the extent it would arise from (1) “goods delivered or to be delivered [to the extent the amount would be treated as] received from the sale or exchange of property other than a capital asset,” or (2)“services rendered or to be rendered.” So, for either sales or distributions, hot assets include ordinary income potential from cash basis accounts receivable and other sales or services that would result in ordinary income, if recognized (e.g., an installment sale of ordinary income producing property). 

A long paragraph (the flush language of § 751(c)) describes specific sources of income treated as having ordinary income potential for purposes of distributions and sales of a partnership interest – but this paragraph specifically excludes transactions under § 736. So, for example, potential depreciation recapture income under §§1245 or 1250 is treated as a hot asset for distributions and sales of a partnership interest, but not for purposes of liquidations under § 736. 

Inventory. Section 751(d) defines inventory so broadly that it basically includes any asset that would yield ordinary income if the asset was sold either by the partner or by the partnership. Specifically, § 751(d) defines inventory as (1) property described in § 1221(a)(1), or (2) property that, if sold by the partnership, “would be considered property other than a capital asset and other than property described in section 1231. Section 751(d)(3) expands the definition to include any additional partnership property that, “if held by the selling or distribute partner,” would meet one of the definitions in the last sentence. So, essentially, “inventory” is any asset other than a capital asset or a §1231 asset. 

As you might have noticed in the discussion above, for distributions (including distributions under §736), the inventory must be substantially appreciated, meaning its fair market value must be more than 120% of its basis. However, for sales, any inventory (whether or not appreciated) is treated as a hot asset. 

Concluding notes. For any transactions in which a partner’s share of hot assets changes, the partner must recognize a corresponding share of ordinary income. However, the types of assets subject to these rules differs, depending on the type of transaction. 

  • For a distribution, inventory must be substantially appreciated and “unrealized receivables” includes depreciation recapture as well as the items outlined in the flush language of § 751(c). 
  • For a § 736 payment, inventory must (again) be substantially appreciated, but “unrealized receivables” does not include the items outlined in the flush language of § 751(c). 
  • For sale of a partnership interest, any ordinary income on the partner’s share of “inventory” (as broadly defined, and whether or not substantially appreciated) must be recognized as ordinary income; further, “unrealized receivables” includes the potential ordinary income items described in the flush language of § 751(c). 

Classroom Activities and Assignments 

  1. Discuss why the hot asset rules are relevant for partnerships. Why are these rules not relevant for corporations (including S corporations)? [Instructor note: The aggregate theory applies to partnerships but not to C or S corporations.] 
  2. Discuss how partnership taxation would be simplified if the hot asset rules did not apply. [Instructor note: Absent the hot asset rules, the “entity” theory would apply to each of the three types of transactions discussed. There would be no ordinary income recognition related to disproportionate distributions (including under § 736) or sales of a partnership interest. 
  3. Have the students research whether any current or pending legislation might change the treatment of hot assets. [Instructor note: In Checkpoint, the students can look at § 751 and click either the “New Law Analysis” or “Bill Tracker” buttons. In CCH IntelliConnect, the students can look at § 751 and click “Current Developments.”] 
  4. Have the students prepare a 3-column chart summarizing the treatment of the following items for purposes of (1) distribution rules, (2) § 736 payments to retiring partners and deceased partners successors in interest, and (3) sales of partnership interests. The students can enter a “Y” for “Yes, included” and an “N” for “not a hot asset for this purpose.” 
  • Cash. [Instructor note: N” in all three columns] 
  • Cash basis accounts receivable. [Instructor note: “Y” in all three columns] 
  • Accrual method accounts receivable. [Instructor note: “N” in all three columns] 
  • Inventory that is 120% appreciated. [Instructor note: “Y” in all three columns] 
  • Inventory that is 102% appreciated. [Instructor note: “Y” in the “sale” column; “N” in the other two columns] 
  • Depreciation recapture. [Instructor note: “N” in the § 736 column; “Y” in the “sale” and “distribution” columns.] 
  • Land held for investment. [Instructor note: “N” in all three columns] 
  • Land held for sale as inventory if the land value is 120% of its basis. [Instructor note: “Y” in all three columns] 

 

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