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Understanding IRC 731
IRC 731 refers to Section 731 of the US Internal Revenue Code relating to the rule applicable to distributions made by partnerships to partners.
The general rule behind Section 731 is that distributions made to partners should generally be tax-free to the partner as partners are required to pay taxes on their distributive share of the partnership every year regardless of whether any distributions are made or not.
In other words, under Section 731 IRC, the partnership or a partner will not have to recognize a gain or a loss on cash or property distributions made.
However, there are two exceptions to this rule.
The first exception is the partner gain recognition.
When the partnership distributes cash to a partner, the partner will need to recognize a Section 731 gain if the money received exceeds the partner’s basis in his or her interest in the partnership.
The second exception is the partner loss recognition.
A partner cannot recognize a loss unless the distribution to the partner is made in the context of the liquidation of the partner’s entire interest in the partnership.
Section 731 Internal Revenue Code Provision
Section 731 of the Internal Revenue Code has several paragraphs and subparagraphs defining the general rule and exceptions relating to partnership distributions.
26 U.S. Code § 731 is entitled “Extent of recognition of gain or loss on distribution”.
Here is a summary of the different paragraphs of Code 731:
- 731(a) Partners
- 731(b) Partnerships
- 731(c) Treatment of marketable securities
- 731(d) Exceptions
Section 731(a)(1) sets out the general rule that gains should not be recognized by partners to the extent the money distributed exceeds the partner’s adjusted basis in the partnership at the moment of the distribution.
For the purpose of 731(a)(1), distributions of marketable securities are deemed to be cash distributions.
Section 731(a)(2) sets out the general rule that a loss should not be recognized by a partner except in the case of a liquidation distribution.
For the purpose of 731(a)(2), distributions of marketable securities are not considered to be cash distributions.
Types of Distributions By Partnerships
Partnerships can make three types of distributions to partners where each type of distribution will result in different tax treatment for the partnership and the partners.
The three types of distributions a partnership can make are:
- Nonliquidating distributions
- Liquidating distributions
- Disproportionate distributions
Nonliquidating distributions are cash or property distributions made to the partners by the partnership that will not result in the liquidation of the partner’s interests.
On the other hand, liquidating distributions are cash or property distributions that will put an end to the partners’ interest in the partnership.
Disproportionate distributions are distributions that affect the partner’s share of ordinary income property of the partnership.
Section 731 IRC Examples
Let’s look at a few examples to see how the IRC rule 731 works.
731 Gain Example
Imagine that a partner has an outside basis of $50,000 in the partnership and receives $40,000 in cash and property having a fair market value of $15,000 (totaling $55,000 in distributions).
In this case, the partner will not have to report any capital gain.
In essence, distributee partners will not have any gains to recognize with respect to the distribution of property unless the property is actually sold (with some exceptions).
However, if the partner received $55,000 in cash, then a $5,000 gain should be recognized by the partner.
731 Loss Example
Now imagine that a partner is looking to completely get out of the partnership.
The partner has a $50,000 adjusted basis in the partnership.
The partner receives his retiring share of the partnership in cash and inventory having a basis of $15,000 to the partner.
In this case, the partner has a $10,000 loss that he can recognize under Section 731(a)(2).
Section 731 Exceptions
There are different types of exceptions that can apply to rule 731 IRC.
One exception is the contributing partner exception.
Under Section 731(c)(3), a partner will not recognize a gain if securities are distributed to a partner who had contributed the securities to the partnership.
You have the Hedge Fund exemption where the partnership is an “investment partnership” and does not engage in “trade” or “business” and most of its assets were held in cash, securities, or derivatives.
Then you have the IPO exception where the securities that were acquired by the partnership were not marketable securities when acquired where:
- The issuer did not have any marketable securities when the securities were acquired by the partnership
- The partnership held the securities for at least six months before the securities become marketable
- The partnership distributes the securities within five years following the moment the securities become marketable
Another exception is the reorganization exception where securities are purchased by the partnership in a nonrecognition transaction.
Section 731 IRC Takeaways
So there you have it folks!
What is Section 731 IRC?
How does Section 731 apply to partnerships?
Section 731 of the US Internal Revenue Code states that where money is distributed by a partnership to a partner, there should be no gain recognized to the partner unless the money exceeds the partner’s adjusted basis in the partnership.
This general rule applies to both current distributions made to partners and when the partnership is liquidating a partner’s interest in the entire partnership.
There are different exceptions that can apply to this general rule, such as:
- The contributing partner’s exception
- The hedge fund exception
- The IPO exception
- The reorganization exception
I hope that I was able to provide you with further insights into Code Section 731 so you have a better understanding of how it applies to partners and partnerships, its general rule, and exceptions.
This article is general in nature, if you need specific advice with regards to a particular situation you are dealing with, you should consult a tax attorney or tax accountant for proper tax advice.
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IRC Section 731 Overview
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