In partnerships, partners may receive property that changes their share of unrealized receivables or substantially appreciated inventory items, resulting in disproportionate distributions. The Internal Revenue Code treats these distributions as sales or exchanges under Section 751(b). This rule is designed to prevent ordinary income from being converted into capital gain and to make sure that income rights are taxed appropriately.

When partners receive property (such as money or assets), their share of certain income-generating items can be changed, resulting in a disproportionate distribution in a partnership. These items are comprised of:

• Unrealized receivables are money that is expected but not yet collected, like accounts receivable.
• Inventory that has greatly appreciated in value compared to its original cost.

In this instance, the distribution is viewed as if the partner sold or exchanged something with the other partner. This assures that the income (often taxed as ordinary income) related to these items is taxed correctly, not as capital gains, which usually have lower tax rates.

The objective is to prevent partners from evading ordinary income taxes by manipulating property distributions.

To enhance the significance of disproportionate distribution in partnership, here is an example.

Mac, a partner who owns 50% of the partnership, was distributed by the M and M Partnership. Land worth $6,000 and an adjusted basis of $4,000, and a building worth $100,000 and an adjusted basis of $40,000.

The distribution was equal in terms of unrealized receivables and substantially appreciated inventory. Section 1250 had a recapture potential of $55,000.

What is the tax consequence of this distribution for M and M?

There is no gain or loss because the distribution is equal and not disproportionate.