Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
ORIGINS AND EVOLUTION OF SECTION 751(b)
Karen C. Burke*
* Warren Distinguished Professor, University of San Diego School of Law; Smith College, B.A., 1972; Harvard University, M.A., 1975; Ph.D., 1979; Stanford University, J.D., 1982; Boston University, LL.M., 1985
Section 751(b), reputedly one of the most widely ignored provisions of Subchapter K, reserves its most daunting complexity for non-pro rata current distributions of property other than cash. While partnership tax has been revolutionized by increasingly sophisticated capital accounting rules, the 1956 regulations implementing section 751(b) have never been updated to reflect the modern concept of revaluations and section 704(c) special allocations. Recently, the Treasury Department requested comments concerning alternative approaches that would simplify and rationalize accounting for shifts of ordinary income and capital gain among partners. Although section 751(b) is concerned mainly with the character of income, it also has a significant impact on the timing of recognition. Thus, updating section 751(b) furnishes a starting point for considering broader reform of the partnership distribution rules.
Section 751(b) emerged in substantially its present form as part of the 1954 codification of Subchapter K, which represented the culmination of intensive study by the ABA and American Law Institute (ALI). The provision owes its origin to the ABA-ALI drafters’ proposed solution to the “collapsible partnership” problem, which threatened to “open up the widest loophole in the field of taxation which would exist.” The approach proposed by the ABA-ALI drafters was startlingly different from section 751(b) as enacted. The ABA-ALI drafters sought to address disproportionate distributions in liquidation (or partial liquidation) of a partner’s interest by reallocating inside basis among distributed and retained assets to preserve shares of unrealized appreciation (or depreciation). When Congress rejected key aspects of the ABA-ALI proposal—partial liquidation treatment and mandatory inside basis adjustments—as excessively complex, it turned to the flawed approach of current section 751(b). By comparison to the current section 751(b) or section 704(c) extended special allocations, however, the ABA-ALI approach may now seem appealing.
Part I of this Article considers proposals to replace the imputed exchange mechanism under the current section 751(b) regulations with a simple hot asset sale approach, coupled with a revaluation of partnership property and reverse section 704(c) allocations. Part II examines the evolution of the collapsible partnership rules as part of the larger process of enacting the 1954 Code, and traces the flaws of the current provision to the Senate drafters’ failure to focus on disproportionate current distributions. Part III assesses the ABA-ALI basis reallocation approach, which drew a fundamental distinction between current distributions (with no change in the partners’ percentage interests in the partnership) and distributions in liquidation (or partial liquidation) of a partner’s interest. Finally, Part IV considers extending the hot asset sale approach to all non-pro rata distributions that reduce a partner’s interest, thereby remedying section 734(b) adjustments which no longer function well.Viewed broadly, reform of section 751(b) presents the challenge of integrating a longstanding statutory provision with more recent developments that may call into question its continued viability. Some commentators view section 751(b) as an anachronism that deserves repeal, particularly given its distressing complexity and limited utility. If the operation of section 751(b) appears incongruous, however, it may be well to ask how the provision came to be in the first place. Reexamining the origin and statutory evolution of section 751(b) offers fresh insight: namely, that the architects of the original provision envisaged that it would play a fundamental nonrecognition role by preserving unrealized gain whenever a partner’s interest was fully or partially liquidated. Far from being antiquated, the notion of inside basis adjustments to align properly the partners’ post distribution percentage interests may offer a simpler alternative than section 704(c) to prevent shifting of built-in gain in connection with non-pro rata current distributions. Some 50 years later, Subchapter K has yet to achieve coherent treatment of disproportionate distributions as envisaged by the ABA-ALI drafters.