TCP, Tax Compliance and Planning

Sources for Partnership Compliance: 704(c) Allocations, Hot Assets, and 754 Adjustments

Last reviewed 2026-10-06

The standards and authorities behind PocketCPA's TCP lessons on Partnership Compliance: 704(c) Allocations, Hot Assets, and 754 Adjustments. The topic rests on IRC Sec. 704(c) / 707 / 743(b) / 751 / 754.

About this topic

Two partners can own the same asset and owe completely different tax on it. Nothing is taxed when property goes into a partnership and nothing is taxed when it comes out until money exceeds basis, so precontribution appreciation does not disappear. It sits inside an entity that several people share. This Topic decides whose appreciation it was, and it settles that separately from the character the gain carries and separately again from whose basis absorbs it.

The examiner grades arithmetic that is built to cross-check itself. On a sale of a partnership interest the ordinary component is assembled asset by asset from the balance sheet, while the capital component is nothing but the residual. The two must therefore sum to the economic gain. The buyer's inside-basis adjustment then mirrors the seller's recognized gain asset by asset, which is a second independent route to the same figures. The error that costs most is reading the substantial-appreciation test for inventory as though it defined a hot asset generally. That test governs a disproportionate distribution and nothing else. On a sale of an interest, inventory is hot with no appreciation test at all, and the candidate who imports the test answers in the taxpayer's favor.

Key points

Sec. 704(c) allocations prevent shifting of pre-contribution gains or losses from the contributing partner to other partners.
Hot assets (unrealized receivables and substantially appreciated inventory) convert capital gain to ordinary income on sale of a partnership interest.
A Sec. 754 election adjusts the inside basis of partnership assets to reflect a purchasing partner's outside basis.
Guaranteed payments are ordinary income to the recipient and deductible by the partnership.

What the lessons cover

Built-in gain allocations under 704(c)
Hot assets under 751
Inside-basis adjustments under 754
Disguised sales
Outside basis, liabilities, and the loss limitation
Distributions: gain, loss, and the basis of what comes out
Guaranteed payments and payments to a retiring partner
Character carryover on contributed and distributed property
One partnership, end to end

Authoritative references

Contributions and allocations:

Sec. 721(a) and (b), nonrecognition on a contribution to a partnership, and the exception for an investment company.
Sec. 722 and Sec. 723, the partner's basis in the partnership interest and the partnership's basis in contributed property; Sec. 724, the character of gain or loss on contributed unrealized receivables, inventory, and capital loss property.
Sec. 704(a) and (b), the allocation of income and loss under the partnership agreement and the requirement of substantial economic effect.
Sec. 704(c)(1)(A), (c)(1)(B) and (c)(1)(C), the allocation of built-in gain or loss on contributed property to the contributing partner, the effect of a distribution of that property to another partner within seven years, and the limitation of built-in loss to the contributing partner.
Sec. 704(d) and Sec. 705(a), the basis limit on the deduction of partnership losses and the adjustments to outside basis; Sec. 704(e), family partnerships.

Hot assets and disguised sales:

Sec. 751(a) and (b), ordinary income on a sale or exchange of an interest to the extent of unrealized receivables and inventory items, and on a distribution that changes the partners' shares of those assets; Sec. 751(c) and (d), the definitions of unrealized receivables and substantially appreciated inventory.
Sec. 741 and Sec. 742, gain or loss on a sale of a partnership interest and the basis of an interest acquired other than by contribution.
Sec. 707(a)(2)(B), a disguised sale of property to a partnership, and Sec. 707(b)(1), (b)(2) and (b)(3), losses on sales between a partnership and a controlling partner and the character of gain.
Sec. 267(a), (b), (c) and (d), the related-party loss disallowance and attribution rules applied by Sec. 707(b)(1).

Inside-basis adjustments:

Sec. 743(a) and (b), the adjustment to the basis of partnership property on a transfer of an interest where a Sec. 754 election is in effect or the partnership has a substantial built-in loss, and Sec. 743(d) and (e), the substantial built-in loss and electing investment partnership rules.
Sec. 734(a) and (b), the corresponding adjustment on a distribution, increased by the gain recognized and reduced by the loss recognized by the distributee partner.
Sec. 754, the election to adjust basis under Sec. 734 and Sec. 743, and Sec. 755, the allocation of the adjustment among partnership assets.

Liabilities, distributions, and retirement payments:

Sec. 752(a) through (d), the treatment of an increase in a partner's share of liabilities as a contribution of money and a decrease as a distribution.
Sec. 731(a) and (b), the gain or loss recognized by the partner and by the partnership on a distribution; Sec. 731(c), the treatment of marketable securities as money.
Sec. 732(a) through (e), the basis of distributed property to the partner, and Sec. 733, the basis of the partner's interest after a distribution.
Sec. 735(a) and (b), the character of gain or loss on the disposition of distributed property and the holding period.
Sec. 737, the recognition of precontribution gain on a distribution to the contributing partner.
Sec. 707(a)(1) and (c), payments to a partner who is not acting as a partner, and guaranteed payments.
Sec. 736(a) and (b), payments to a retiring partner or a deceased partner's successor, split between distributive share or guaranteed payment and the exchange for the interest, including the payment for goodwill at (b)(3).

How PocketCPA uses these sources

Every lesson is written in original words and cites the paragraph each rule comes from. No standard's text is reproduced. How lessons and questions are written and checked is set out in our methodology.