IRC 751 "Hot Assets": Calculating and Reporting Ordinary Income on Disposition of Partnership or LLC Interests

Description

Generally, when a partner sells his or her partnership interest, the transaction is treated as the disposition of a capital asset, and any gain from the sale is taxed at lower capital gains rates. A notable exception to this treatment occurs when the partnership holds “hot assets” detailed in IRC Section 751.

In those cases, the sale of the partnership interest converts a portion of what would be a long-term capital gain to ordinary income, and the sale may require the seller to report ordinary income in a transaction that generates a capital loss. Section 751 was implemented to prevent partners from claiming favorable capital gain treatment on income that would be taxed as ordinary income if realized by the partnership, and lists two basic classes of properties requiring reclassification: “inventory” and “unrealized receivables.”

Taxpayers holding interests in partnerships with significant levels Section 751 assets must be aware, before the sale of the interest, of the different tax treatment of these assets to avoid adverse tax consequences. Section 751 applies when there is a shift in “hot assets,” whether a partner has capital gains or not.

Because the regulations seem to provide some difference in treatment depending on whether the transaction is structured as a sale of interest or a redemption, tax advisers should calculate the impact of Section 751 assets in each scenario to achieve the best possible tax result.

Listen as our expert panel provides an in-depth exploration into the Section 751 requirements, offering practical guidance and best practices for avoiding unforeseen tax traps in partnership interest dispositions.