By: John S. Morlu II, CPA
Partnerships are highly flexible business structures, allowing partners to share profits, losses, and assets in ways that suit their mutual goals. However, when distributions of partnership property are disproportionate—meaning they alter a partner’s share of specific partnership assets such as unrealized receivables or inventory—tax complications can arise. These situations are governed by Section 751(b) of the Internal Revenue Code and can result in the recognition of ordinary income or gain for the partner or the partnership.
What Are Disproportionate Distributions?
A disproportionate distribution occurs when a distribution to a partner changes that partner’s share of the partnership’s unrealized receivables or substantially appreciated inventory. These assets are treated differently because of their potential to generate taxable ordinary income.
Under Section 751(b)(1), disproportionate distributions are described as situations where:
1. A partner receives:
- Unrealized receivables, which include items like accounts receivable or property subject to depreciation recapture under Section 1245, or
- Substantially appreciated inventory, defined as inventory with a fair market value (FMV) exceeding 120% of its adjusted basis,
in exchange for their interest in other types of partnership property.
2. A partner receives property other than unrealized receivables or substantially appreciated inventory in exchange for their interest in these specific assets.
In these scenarios, the transaction is treated as a sale or exchange between the partner and the partnership. The result can be taxable ordinary income or gain, depending on the nature and value of the assets involved.
Why Are Unrealized Receivables and Substantially Appreciated Inventory Treated Differently?
These two types of assets have unique tax implications because they often contain built-in gains that have not yet been taxed:
- Unrealized Receivables: These include items like accounts receivable and certain depreciable property (e.g., equipment subject to depreciation recapture under Section 1245). Since these items represent income that has not yet been recognized, they are taxed as ordinary income when distributed disproportionately.
- Substantially Appreciated Inventory: Inventory gains are also taxed as ordinary income rather than being deferred or converted to capital gains. Substantial appreciation is defined as a fair market value exceeding the adjusted basis by 120% or more.
These rules ensure that built-in gains in these assets are taxed appropriately, even if the partnership reallocates ownership through disproportionate distributions.
Tax Implications of Disproportionate Distributions
For the Partnership
If a disproportionate distribution occurs, the partnership may need to recognize ordinary income or loss. This is determined by the difference between:
- The adjusted basis of the distributed property (e.g., unrealized receivables or inventory), and
- The fair market value of the property relinquished by the partner.
The resulting ordinary income or loss is allocated among the remaining partners, excluding the distributee partner.
For the Distributee Partner
The distributee partner also recognizes gain or loss. This is calculated as the difference between:
- The adjusted basis of the property the partner relinquished, and
- The fair market value of the property they received.
The character of the gain or loss (ordinary income vs. capital gain) depends on the nature of the property relinquished.
Example of a Disproportionate Distribution
Consider a partnership with three partners: Partner A, Partner B, and Partner C. The partnership owns $150,000 worth of inventory and other partnership assets.
- Partner A receives $50,000 worth of unrealized receivables in a disproportionate distribution.
- The adjusted basis of the receivables is $30,000.
Tax Implications:
- The partnership recognizes $20,000 in ordinary income ($50,000 FMV – $30,000 basis).
- Partner A recognizes a $20,000 ordinary income gain on the distribution because they received unrealized receivables in excess of their adjusted basis.
Exceptions to Disproportionate Distribution Rules
Certain types of distributions are not considered disproportionate and are therefore exempt from the rules under Section 751(b):
1. Pro Rata Distributions: If distributions are made equally among all partners, with no changes to their respective ownership percentages, they are not disproportionate.
2. Draws, Advances, Loans, or Guaranteed Payments: Regular payments to partners unrelated to specific partnership property are excluded.
3. Liquidating Payments: Payments made to retiring partners or the estate of a deceased partner, unlessthey involve their share of unrealized receivables or inventory.
4. Distributions of Contributed Property: If a partner receives property they initially contributed to the partnership, the rules do not apply.
Calculating the Taxable Gain or Loss
For a disproportionate distribution, the following steps help determine the taxable gain or loss for both the partnership and the distributee partner:
1. For the Partnership:
- Calculate the adjusted basis of the property distributed.
- Subtract this basis from the fair market value of the property relinquished by the partner.
- The result is the partnership’s ordinary income or loss, which is allocated to the remaining partners.
2. For the Partner Receiving the Distribution:
- Determine the adjusted basis of the property relinquished by the partner.
- Subtract this from the fair market value of the property received.
- The result is the distributee partner’s gain or loss, which may be ordinary income or capital gain depending on the type of property relinquished.
Provisions for the Sale of a Partnership Interest
It’s important to note that the provisions of Section 751(b) also apply when a partner sells their partnership interest. This is because the sale of a partnership interest can also reallocate the partner’s share of unrealized receivables or substantially appreciated inventory. These situations will be addressed separately when discussing the decline stage of partnership operations.
Conclusion
Disproportionate distributions can complicate the tax landscape for both the partnership and the partners involved. By changing ownership shares of unrealized receivables or substantially appreciated inventory, these transactions trigger taxable events, ensuring built-in gains are recognized and taxed appropriately.
Understanding these rules—and the exceptions—can help partnerships avoid unexpected tax consequences. Partners and partnerships are encouraged to consult tax professionals to navigate these complex situations and maintain compliance with Section 751(b).
Author: John S. Morlu II, CPA
John S. Morlu II, CPA, is the CEO and Chief Strategist of JS Morlu, a globally acclaimed public accounting and management consulting powerhouse. With his visionary leadership, JS Morlu has redefined industries, pioneering cutting-edge technologies across B2B, B2C, P2P, and B2G landscapes.
The firm’s groundbreaking innovations include:
• ReckSoft (www.ReckSoft.com): AI-driven reconciliation software revolutionizing financial accuracy and efficiency.
• FinovatePro (www.FinovatePro.com): Advanced cloud accounting solutions empowering businesses to thrive in the digital age.
• Fixaars (www.fixaars.com): A global handyman platform reshaping service delivery and setting new benchmarks in convenience and reliability.
Under his strategic vision, JS Morlu continues to set the gold standard for technological excellence, efficiency, and transformative solutions.
