6.3 Nonliquidating & Liquidating Distributions & Section 751 Hot Assets

Current (Nonliquidating) Distributions: Nonrecognition & Cash Triggers

A partnership distribution occurs when the entity transfers cash or property to a partner with respect to their equity interest. Distributions are categorized into two statutory types:

1. Current (Nonliquidating) Distributions: Operating distributions made to an ongoing partner that do not completely terminate the partner's interest.
2. Liquidating Distributions: One or a series of distributions that completely extinguish and terminate the partner's entire partnership interest.

The General Nonrecognition Rule: IRC §731

Under IRC §731(a) and §731(b), the general rule of partnership distributions is complete nonrecognition of gain or loss for both the partnership and the partner. Neither the entity nor the distributee recognizes taxable income on a distribution of property.

Partnership Distributes Cash / Property  ──►  IRC §731(a) General Rule
(No Gain or Loss to Partnership §731(b))        No Gain or Loss Recognized to Partner

The Gain Recognition Exception (Cash Exceeding Outside Basis)

Under IRC §731(a)(1), a partner must recognize taxable gain on a current distribution if and only if the amount of money distributed exceeds the partner's adjusted outside basis immediately before the distribution:

$\text{Recognized Gain} = \text{Money Distributed} - \text{Partner's Adjusted Outside Basis}$

• Character of Recognized Gain: Any gain recognized under §731(a)(1) is treated as capital gain from the sale or exchange of a partnership interest (short-term or long-term, depending on the partner's holding period in the partnership interest under §1223).
• Statutory Inclusions in "Money": For purposes of §731, "money" includes:
  1. Actual cash and currency;
  2. Marketable securities at fair market value under IRC §731(c) (subject to exceptions for investment partnerships and certain non-recognition transfers);
  3. Deemed cash distributions from liability relief under IRC §752(b) (e.g., when the partnership pays off entity debt or another partner assumes partnership debt).

The Absolute Loss Prohibition for Current Distributions

Under IRC §731(a)(2), a partner can NEVER recognize a loss on a current distribution. Even if a partner receives property with a fair market value or inside basis substantially lower than their outside basis, loss recognition is strictly prohibited. The remaining outside basis simply continues to attach to the partner's retained partnership interest.

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Basis of Distributed Property in Current Distributions (IRC §732(a))

When a partnership distributes non-cash property in a current distribution, the partner's basis in that property is governed by IRC §732(a):

1. General Carryover Basis Rule (§732(a)(1))

The partner takes a carryover basis in the distributed property equal to the partnership's adjusted inside basis immediately prior to the distribution.

2. Basis Limitation (§732(a)(2))

The basis of distributed property in the hands of the partner cannot exceed the partner's adjusted outside basis, reduced by any money distributed in the same transaction.

$\text{Basis in Distributed Property} = \min(\text{Partnership's Inside Basis}, \text{Outside Basis after Money})$

3. Outside Basis Reduction (§733)

Under IRC §733, the partner's outside basis is reduced (but never below zero) in the following mandatory statutory sequence:

• Step 1: Reduced dollar-for-dollar by money distributed (including marketable securities and §752(b) debt relief).
• Step 2: Reduced by the tax basis allocated to distributed property under §732.

Worked Example: Current Property Distribution with Basis Limitation

Facts: Marcus has an outside basis of $35,000 in the Apex Partnership. Apex distributes $10,000 cash and a parcel of investment land with an inside basis of $30,000 and an FMV of $50,000 to Marcus in a current distribution.

• Step 1: Money Distributed: Marcus receives $10,000 cash. Outside basis is reduced from $35,000 to $25,000 ($35,000 - $10,000). Because cash ($10,000) does not exceed initial basis ($35,000), $0 gain is recognized.
• Step 2: Basis in Land (§732(a)(2)): Apex's inside basis in the land is $30,000, but Marcus has only $25,000 of remaining outside basis. Marcus's basis in the land is limited to $25,000.
• Step 3: Remaining Outside Basis (§733): Marcus's outside basis is reduced by the $25,000 basis assigned to the land, reducing his outside basis to $0 ($25,000 - $25,000).
• Tax Consequences: $0 gain recognized; land basis = $25,000; outside basis = $0.

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Liquidating Distributions: Substituted Basis Mechanics (IRC §732(b))

In a liquidating distribution, the partnership completely liquidates the partner's equity interest. Because the partner will have no remaining partnership interest after the distribution, the partner's outside basis must be fully absorbed.

The Substituted Basis Rule (IRC §732(b))

Under IRC §732(b), the basis of property (other than money) distributed in a complete liquidation is an amount equal to the partner's adjusted outside basis, reduced by any money distributed in the same transaction.

$\text{Basis in Liquidated Property} = \text{Outside Basis immediately before Liquidation} - \text{Money Distributed}$

Unlike a current distribution (which carries over inside basis up to outside basis), a liquidating distribution substitutes the partner's remaining outside basis into the distributed property. Consequently, the basis of distributed property in the partner's hands can be stepped up or stepped down relative to the partnership's prior inside basis!

Worked Example: Liquidating Basis Step-Up

Facts: Sarah has an adjusted outside basis of $70,000 in the Horizon Partnership. In complete liquidation of her partnership interest, Horizon distributes $20,000 cash and a parcel of commercial real estate having an inside basis of $35,000 and an FMV of $60,000.

• Step 1: Money Distributed: Sarah receives $20,000 cash. Outside basis is reduced to $50,000 ($70,000 - $20,000). Because cash is less than basis, $0 gain is recognized.
• Step 2: Substituted Basis in Real Estate (§732(b)): Sarah's remaining outside basis of $50,000 is substituted into the real estate. Even though Horizon's inside basis was $35,000, Sarah's tax basis in the real estate becomes $50,000 (a $15,000 step-up).
• Sarah's Remaining Outside Basis: $0 (interest terminated).

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Loss Recognition Rules in Liquidations (IRC §731(a)(2))

While losses are strictly barred in current distributions, IRC §731(a)(2) allows a partner to recognize a loss in a complete liquidation under very narrow, specific statutory conditions.

The Two Strict Prerequisites for Loss Recognition

A partner recognizes a loss on a liquidating distribution if and only if:

1. The distribution consists EXCLUSIVELY of money, unrealized receivables, and inventory (no capital assets, §1231 assets, land, or equipment are distributed); AND
2. The partner's adjusted outside basis exceeds the sum of the money distributed plus the inside basis of the unrealized receivables and inventory distributed.

$\text{Recognized Capital Loss} = \text{Outside Basis} - (\text{Money Distributed} + \text{Inside Basis of Receivables and Inventory})$

[!CRITICAL] If the partnership distributes ANY other property—even a completely worthless piece of old furniture or a minor investment parcel—NO loss can be recognized. The excess outside basis must instead be allocated to that other property, increasing its basis!

Worked Example: Permissible Liquidating Loss

Facts: Trevor has an outside basis of $60,000 in the Delta LLC (taxed as a partnership). In complete liquidation of his interest, Trevor receives $25,000 cash and inventory with an inside basis of $15,000 (FMV $22,000). No other assets are distributed.

• Test 1: Qualifying Assets Only? Yes. Distribution consists solely of money ($25,000) and inventory (inside basis $15,000).
• Test 2: Basis Exceeds Distributed Inside Basis? Yes. Basis ($60,000) exceeds $40,000 ($25,000 cash + $15,000 inventory basis).
• Recognized Loss (§731(a)(2)): $60,000 - $40,000 = $20,000 Capital Loss.
• Basis in Inventory (§732(c)(1)): Trevor takes a carryover basis of $15,000 in the inventory (basis in inventory can never be stepped up above inside basis in a liquidation).

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Multi-Property Basis Allocation Rules (IRC §732(c))

When a distribution includes multiple non-cash assets and the partner's remaining outside basis does not equal the aggregate inside basis of the distributed assets, IRC §732(c) governs the allocation:

Partner's Outside Basis
  ├── Step 1: Reduce dollar-for-dollar by Money received
  ├── Step 2: Allocate to Unrealized Receivables & Inventory up to Inside Basis
  └── Step 3: Allocate Remaining Outside Basis to Other Distributed Properties
                ├── If remaining basis > inside bases: Step-Up Rules (§732(c)(2))
                └── If remaining basis < inside bases: Step-Down Rules (§732(c)(3))

Allocation of Basis Increases (§732(c)(2))

If the remaining outside basis exceeds the aggregate inside bases of the Tier 3 properties:

1. First, allocate basis to each asset with unrealized appreciation up to its fair market value;
2. Any remaining excess basis is allocated among the properties in proportion to their relative fair market values.

Allocation of Basis Decreases (§732(c)(3))

If the remaining outside basis is less than the aggregate inside bases of the properties:

1. First, reduce the basis of assets with unrealized depreciation down to their fair market value;
2. Any remaining required basis decrease is allocated among the properties in proportion to their adjusted tax bases.

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Section 751(b) Disproportionate Distributions & Hot Assets

In general, distributions do not trigger ordinary income. However, Congress enacted IRC §751(b) to prevent partners from shifting ordinary income into capital gain, or shifting ordinary income between high-bracket and low-bracket partners, through strategic non-pro-rata property distributions.

What Are Section 751 "Hot Assets"?

Under Section 751, partnership assets are divided into Hot Assets (ordinary income property) and Cold Assets (capital assets, §1231 assets, and cash):

1. Unrealized Receivables (IRC §751(c)):
   • Rights to payment for goods delivered or services rendered not yet included in income under the partnership's accounting method (e.g., cash-basis trade accounts receivable with a $0 basis);
   • Depreciation Recapture: Potential recapture income under IRC §1245 (depreciation on personal property) and IRC §1250 (accelerated depreciation on real estate) is treated as an unrealized receivable with a zero basis!
2. Inventory Items (IRC §751(d)):
   • Stock in trade, merchandise, and goods held primarily for sale to customers;
   • Any other property that would produce ordinary income if sold by the partnership (including accounts receivable).
   • The Substantial Appreciation Requirement for §751(b): For distribution purposes under §751(b), inventory items trigger hot asset treatment only if they are substantially appreciated—meaning their aggregate fair market value exceeds 120% of their adjusted tax basis.

The Deemed Sale/Exchange Mechanism of Section 751(b)

Under IRC §751(b), if a distribution alters a partner's proportionate share of hot assets relative to cold assets, the transaction is treated as a fictitious, deemed sale or exchange between the distributee partner and the partnership:

• Case 1: Distributee Receives Excess Cold Assets (Cash/Property) & Gives Up Hot Assets: The partner is treated as having sold their relinquished share of hot assets back to the partnership. The partner must recognize immediate ordinary income equal to the difference between the fair market value of the cold assets received in exchange and the basis of the hot assets given up!
• Case 2: Distributee Receives Excess Hot Assets & Gives Up Cold Assets: The partnership is treated as having sold the excess hot assets to the partner, triggering immediate gain to the non-distributee partners.

Worked Example: Section 751(b) Ordinary Income Trigger

Facts: Partner Brian owns a one-third (33.33%) interest in the ABC General Partnership. ABC holds the following assets:

• Cash: $90,000 (Basis $90,000; FMV $90,000)
• Unrealized Accounts Receivable: $0 Basis; FMV $90,000
• Total: Basis $90,000; FMV $180,000

Prior to any distribution, Brian's 1/3 share of the hot assets (receivables) is $30,000 FMV ($0 basis), representing $30,000 of potential ordinary income.

ABC distributes $60,000 cash to Brian in partial redemption of his partnership interest, leaving Brian with a 0% interest in the remaining $90,000 of receivables.

• The Shift: Brian received $60,000 of cold assets (cash) and gave up his entire $30,000 share of hot assets (receivables).
• Deemed Sale under §751(b): Brian is treated as having received his $30,000 share of receivables (carryover basis $0) and immediately selling them back to ABC for $30,000 cash.
• Tax Result: Brian recognizes $30,000 of ordinary income under Section 751(b). The remaining $30,000 cash distribution is evaluated under standard §731 rules against Brian's outside basis.

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Comparison: Current vs. Liquidating Distributions

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Common Exam Traps & Pitfalls

1. The Current Distribution Loss Trap: Exam questions often present a partner with $80,000 basis receiving $30,000 cash in a current distribution, offering "$50,000 capital loss" as a choice. A loss is never deductible on a current distribution.
2. Disqualifying Liquidating Losses: If a partner receives $10,000 cash, $5,000 inventory, and a piece of equipment worth $100, the presence of the equipment completely eliminates loss recognition. The remaining outside basis is forced into the equipment's basis.
3. Depreciation Recapture as a Hot Asset: Candidates forget that potential Section 1245 depreciation recapture on machinery is an unrealized receivable under Section 751(c). Even if a partnership owns no accounts receivable, depreciated machinery can trigger Section 751 ordinary income.
4. Ordering Rules for Basis Reduction: Cash reduces outside basis first. Only remaining basis is available to absorb distributed property. If cash equals or exceeds basis, all distributed property takes a $0 tax basis.