James H. Boyd, Contributing Author
A Deeper Dive into Hot Assets
Subchapter K is complicated because of one aspect of partnership taxation: the idea of ordinary income treatment. This means that the income earned must be preserved and given to the partner. This ordinary income preservation concept is applicable to the distribution of assets from a partner, liquidation under SS 736 of a partnership interests, and sale of a partner interest.
Hot assets. Hot assets, or ordinary-income-producing assets, are the mechanism that this ordinary income preservation takes place. A transaction that would alter a partner’s interest is required to be accounted for and the associated ordinary income must be recognized by the affected party. Hot assets are “unrealized receivables”, and “inventory,” as described in SSSS 751 (c) and d, and discussed later. These two types of hot assets have different definitions depending on whether the triggering transaction was a sale or distribution.
Sales of a partnership interests (SS 741). Because they are conceptually easier to understand, sales of partnership interests are first covered. SS 751(a) states that the proceeds of a selling partner from the sale of a partnership interests that relate to unrealized receivables and inventory “shall not be considered an amount realized from sale or exchange of property other capital assets.” The selling partner’s sale price is divided between the fair market value (1) of the partnership’s hot assets, and (2) other assets. Similar allocations are made for the selling partner’s share in the basis in the partnership assets. It’s as simple as that. The partner’s share of the gain from the sale of hot assets and the partner’s loss or gain on the remainder of the sale are calculated. The selling partner recognizes the normal income from the hot asset sale and the (short-term or long-term), gain or loss on any remaining sales.
Distributions (including SS736). Distributions (including SS 736).
The so-called “disproportionate Distribution” refers to (1) a proportionate distribution (hot assets) followed by (2) a sale (deemed sale) of these assets from the partner who did not receive them. The non-recipient partner pays taxes and is relieved from future tax liability on these assets. The recipient partner then owns the assets with an increase in basis equal to the income recognized and paid by the other partner. For more information, see the discussion on disproportionate distributions in this text.
The rules of SS736 follow the same logic, but a different analysis applies. A SS736 transaction is a distribution of assets of the partnership in liquidation of a partner’s interest in that partnership. If the liquidating distribution was paid in cash, the liquidated partnership recognizes the appropriate portion of the potential partnership ordinary income. If the payment triggering ordinary income is a SS736(a) payment, the partnership can claim a deduction. Or it can have basis in ordinary-income producing assets if the portion of payment triggering ordinary income recognition is a SS736(b)payment. If the partnership distributes any other assets (e.g. inventory), it could end up being the party that recognizes ordinary income. The calculations can become much more complicated.
Unrealized receivables. Unrealized receivables are defined in Section 751(c). It is any amount that the partnership has not reported as income under its normal accounting methods to the extent it would come from (1) “goods delivered, or to be delivered [to what extent the amount would be treated] as received from the sale or exchanging of property other than a principal asset” or (2) “services rendered, or to be rendered.”
A long paragraph (the flush language in SS751(c)), describes specific income sources that are considered ordinary income potential for distributions and sales of a partnership interests. However, this paragraph excludes transactions under SS736. For example, potential depreciation recapture revenue under SSSS1245 and 1250 can be treated as a hot asset to distribute or sell a partnership interest but not for liquidations under SS736.
James H. Boyd, Contributing Author