The IRS published taxpayer-favorable proposed regulations to help minimize unnecessary tax under the Section 751(b) “hot asset” rules when a partnership makes a disproportionate distribution.  The hot asset rules are designed to prevent a shifting of higher-tax ordinary income gain assets between partners.  Thus if a partnership has a mix of capital gain and ordinary income assets, the rules prevent the partnership from distributing tax-free all of the ordinary income assets to one partner and capital gain assets to another.  However, these rules had an intrinsic flaw in that they tracked the hot assets based on the gross value of the assets and not the net gain inherent in the assets.  This disconnect resulted in the potential application of a deemed taxable hot asset exchange in many instances where it was not warranted.

The proposed regulations follow the general construct the IRS suggested in Notice 2006-14,  Specifically, the proposed regulations adopt the hypothetical sale approach as the method by which the partners must measure their respective interests in Section 751 property for the purpose of determining whether a distribution reduces a partner’s interest in the partnership’s Section 751 property.  Because this approach relies on Section 704(c) locking in a partner’s share of hot asset gain, the proposed regulations make so-called “bookups” mandatory under Reg. §1.704-1(b)(2)(iv)(f) in a distribution that would implicate the Section 751(b) hot asset rules.  The proposed regulations also contain a special revaluation rule for distributing partnerships that own an interest in a lower-tier partnership and describe how basis adjustments under Sections 734(b) and 743(b) affect the computation of partners’ interests in Section 751 property.

The regulations are proposed to apply to distributions occurring in any taxable period ending on or after the date of publication of the regulations as final.