Some Additional Random Thoughts On Proposed 751(b) Regulations

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Following up on my initial post here on the proposed section 751(b) regulations, I wanted to offer up some additional, although admittedly random, thoughts on the proposed regulations.

1. Prop. reg. 1.704-1(b)(2)(iv)(f) states: “A partnership agreement may, upon the occurrence of certain events, and must in the circumstances described in § 1.751-1(b)(2)(iv), increase or decrease the capital accounts of the partners to reflect a revaluation of partnership property (including intangible assets such as goodwill) on the partnership’s books. If a partnership that revalues its property pursuant to this paragraph owns an interest in another partnership, that partnership in which it owns an interest may also revalue its property in accordance with this section. Similarly, if an interest in a partnership that revalues its property pursuant to this paragraph is owned by another partnership, the partnership owning that interest may also revalue its property in accordance with this section.”

2. Prop. reg. 1.751-1(b)(2)(iv) states: “For a partnership that distributes money or property (other than a de minimis amount) to a partner as consideration for an interest in the partnership, and that owns section 751 property immediately after the distribution, if the partnership maintains capital accounts in accordance with § 1.704-1(b)(2)(iv), the partnership must revalue its assets immediately prior to the distribution in accordance with § 1.704-1(b)(2)(iv)(f). …. In addition, if the partnership (upper-tier partnership) owns another partnership directly or indirectly through one or more partnerships (lower-tier partnership), and the same persons own, directly or indirectly (through one or more entities), more than 50 percent of the capital and profits interests in both the upper-tier partnership and the lower-tier partnership, the lower-tier partnership must also revalue its assets immediately prior to the distribution in accordance with § 1.704-1(b)(2)(iv)(f) if the lower-tier partnership owns section 751 property. If the same persons do not own, directly or indirectly, more than 50 percent of the capital and profits interests in both the upper-tier partnership and the lower-tier partnership, the upper-tier partnership must allocate its distributive share of the lower-tier partnership’s items among its partners in a manner that reflects the allocations that would have been made had the lower-tier partnership revalued its property.”

3. Finally, prop. reg. 1.704-3(a)(9) states: “If a partnership (the upper-tier partnership) owns an interest in another partnership (the lower-tier partnership), and both the upper-tier partnership and the lower-tier partnership simultaneously revalue partnership property pursuant to § 1.704-1(b)(2)(iv)(f), the principles of this paragraph (a)(9) shall apply to any reverse section 704(c) allocations created upon the revaluation.”

And so, the proposed regulations do in fact require the lower tier partnership to hold hot assets to force a revaluation if the more than 50 percent test is met. However, if upper tier partnership owns a more than 50 percent interest in middle tier partnership and middle tier partnership holds more than a 50 percent interest in lower tier partnership, and if middle tier holds only cold assets but there are hot assets in lower tier partnership, the proposed regs seem to require looking through middle tier to lower tier to force a revaluation at lower tier but those same proposed regs do not force a revaluation of middle tier because it does not own hot assets. That is what is written. I have no idea of what was intended.

Some additional points.

1. Suppose UTP distributes an interest in LTP to one of its partners and UTP holds only cold assets and LTP holds only hot assets. The proposed regulations do not address whether the LTP interest is a hot asset although under aggregate-entity principles we would think that the LTP interest is a hot asset. But it seems necessary for the proposed regs to have addressed this point. Note that in this fact pattern, other partners in LTP would seem to be unaffected by the distribution because their shares of hot assets will not have changed when UTP distributes its interest in LTP. But also note that if LTP only holds hot assets, the other partners of LTP will not be subject to section 751(b) as a partner has to have a share of hot and cold assets (by applying 751(f) or not) for section 751(b) to apply.

2. Suppose in the fact pattern in paragraph 1 immediately above that instead of UTP distributing an interest in LTP that LTP distributes a hot asset up to UTP. Stopping at that point, partners in LTP other than UTP itself will have a decrease in their shares of hot assets. But section 751(b) cannot apply to those other partners of LTP unless LTP holds some cold assets as well.

3. Suppose that UTP holds only cold assets and that LTP holds both hot and cold assets and that UTP distributes an interest in LTP to one of its partners. How do you apply section 751(b) in that case? It would seem that comparing the result under section 751(f) both before and after the distribution would have given you the answer but don’t you also need to know what the tax basis and value is of the distributed hot asset to apply the special 734(b) rules in these proposed regs? I think the answer is yes. That seems to require a bifurcation of the LTP interest that is distributed into hot and cold components so you can test whether section 734(b) will apply to the hot assets inside LTP. That should have been addressed in the proposed regs but was not.

4. Suppose that UTP holds only hot assets and LTP holds only cold assets and UTP distributes an interest in LTP. Here, unless a partner is completely redeemed it would seem that section 751(b) will not apply because the shares of hot assets is not changing. The same answer would appear to occur if UTP holds both hot and cold assets.

5. I think that if the upper tier partnership only holds cold assets and the lower tier partnership holds only hot assets that no revaluation at upper tier is needed to apply section 751(b) because you can apply section 751(f) to the lower tier partnership and you can revalue at the lower tier to catch the right amount of hot asset gain at lower tier. Technically,  section 751(f) can apply without doing any revaluations at either tier but you will get the wrong amounts of section 704(c) gain by failing to revalue. If you screw up the section 704(c) shares of hot gain, you screw up section 751(b) as well. If you screw up section 704(c) shares of cold assets, you do not screw up section 751(b) because the reg drafters have not told us whether the share of cold assets swapped for hot assets need to be at correct values or not. Since the reciprocal gain model is to be removed, it seems that you do not need to revalue partnerships with cold assets to apply section 751(b). I think you should be required to do so to avoid either a section 482 problem or creating other book-tax disparities that could create problems throughout subchapter K. In short, it was a mistake for the government not to address section 751(f) in the guidance.


6. The optional revaluation among non-controlled tiers under proposed regulation sections 1.751-1(b)(2)(iv) and 1.704-1(b)(2)(iv)(f) has a technical authority problem when you incorporate the proposed changes at 1.704-3(a)(9). These rules say that if there is no revaluation at the lower tier that the upper tier must allocate the lower tier items as if there had been a revaluation. The problem is that absent remedial allocations, you cannot allocate items that do not exist under either section 702(a) or current reg. section 1.704-1(b)(1)(vii).

These rules are way way too complex for the average tax practitioner and rules should not be written where only a selected few can understand and apply them. The same goes for the ability of the IRS to apply and audit these rules.

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