[Federal Register Volume 59, Number 92 (Friday, May 13, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-11612]
[[Page Unknown]]
[Federal Register: May 13, 1994]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[TD 8539]
RIN 1545-A078
Application of Section 514(c)(9)(E) of the Internal Revenue Code
to Partnerships in Which One or More (but not all) of the Partners Are
Qualified Organizations Within the Meaning of Section 514(c)(9)(C)
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations.
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SUMMARY: This document contains final regulations relating to the
application of section 514(c)(9)(E) of the Internal Revenue Code to
partnerships in which one or more (but not all) of the partners are
qualified tax-exempt organizations within the meaning of section
514(c)(9)(C). These organizations include educational organizations
described in section 170(b)(1)(A)(ii) and their affiliated support
organizations, and qualified trusts described in section 401. The final
regulations provide rules governing the application of section
514(c)(9)(E) of the Internal Revenue Code (Code). Section 514(c)(9)(E)
was added to the Code by the Omnibus Budget Reconciliation Act of 1987,
and was amended by the Technical and Miscellaneous Revenue Act of 1988.
The final regulations are necessary to provide affected partnerships
and their partners with the guidance they need to comply with the
applicable tax law.
EFFECTIVE DATE: May 13, 1994.
For dates of applicability of these regulations, see ``Effective
dates'' under SUPPLEMENTARY INFORMATION in the preamble.
FOR FURTHER INFORMATION CONTACT: Deane M. Burke at (202) 622-3080 (not
a toll-free number).
SUPPLEMENTARY INFORMATION:
Background
This document amends 26 CFR part 1, which provides rules governing
the application of section 514(c)(9)(E) of the Internal Revenue Code of
1986 (Code), as amended. Section 514(c)(9)(E) was added to the Code by
section 10214 of the Omnibus Budget Reconciliation Act of 1987, Pub. L.
100-203, and was amended by section 2004(h) of the Technical and
Miscellaneous Revenue Act of 1988, Pub. L. 100-647.
On June 25, 1990, Notice 90-41, 1990-1 C.B. 350, was published in
the Internal Revenue Bulletin to provide interim guidance regarding the
application of section 514(c)(9)(E) of the Code and to request
comments. On December 30, 1992, the IRS published a notice of proposed
rulemaking in the Federal Register (57 FR 62266) (the proposed
regulations) regarding section 514(c)(9)(E). The preamble to that
notice contains an explanation to the proposed rules.
The IRS received written comments on the proposed regulations, but
cancelled a public hearing scheduled for March 31, 1993, because no one
requested to testify. After consideration of all the public comments on
the proposed regulations, the regulations are adopted as revised by
this Treasury decision.
Explanation of Provisions
I. Statutory Provisions
Section 511 of the Code provides that tax-exempt organizations are
generally taxable on their unrelated business taxable income. Section
514(a) provides that unrelated business taxable income includes a
specified percentage of the gross income derived from debt-financed
property described in section 514(b). Section 514(c)(9) provides an
exception for income derived from certain debt-financed investments in
real property by qualified organizations. Under section 514(c)(9)(C),
qualified organizations include educational organizations described in
section 170(b)(1)(A)(ii) and their affiliated support organizations,
and qualified trusts described in section 401.
If a qualified organization (QO) invests in debt-financed real
property through a partnership in which one or more (but not all) of
the partners are qualified organizations, the QO is eligible for the
exception provided in section 514(c)(9) only if the partnership
satisfies an additional requirement. Either each allocation to a
partner that is a qualified organization must be a qualified allocation
within the meaning of section 168(h)(6), or the partnership must
satisfy the requirements of section 514(c)(9)(E). These regulations
provide rules governing the application of section 514(c)(9)(E).
II. Overview of the Regulations
To satisfy the requirements of section 514(c)(9)(E), a partnership
must establish that the allocation of items to any partner that is a QO
cannot result in that partner having a percentage share of overall
partnership income for any taxable year greater than that partner's
percentage share of overall partnership loss for the taxable year for
which that partner's percentage loss share will be the smallest (that
partner's fractions rule percentage). This requirement, commonly
referred to as the fractions rule, must be satisfied both on a
prospective basis and on an actual basis for each taxable year of the
partnership.
The fractions rule is applied on an overall partnership basis.
Therefore, if partnership allocations to one QO partner fail to satisfy
the requirements of the fractions rule, that partner, and other QO
partners in the partnership, are subject to the debt-financed property
rules, even if the allocations to those other QO partners would
otherwise have complied with the requirements of the fractions rule.
A second requirement under section 514(c)(9)(E) is that each
partnership allocation must either have substantial economic effect or
(in the case of certain allocations that cannot have economic effect)
otherwise appropriately comply with the requirements of the regulations
under section 704(b).
For purposes of the fractions rule, overall partnership income is
the amount by which the aggregate items of partnership income and gain
for the taxable year exceed the aggregate items of partnership loss and
deduction for the year. Overall partnership loss is the amount by which
the aggregate items of partnership loss and deduction for the taxable
year exceed the aggregate items of partnership income and gain for the
year. In general, all items of partnership income, gain, loss, and
deduction that increase or decrease the partners' capital accounts
under Sec. 1.704-1(b)(2)(iv) are taken into account in computing
overall partnership income or loss.
The proposed regulations exclude allocations of certain items--
generally by disregarding those items in computing overall partnership
income or loss and the partners' allocable shares of overall
partnership income or loss. In some situations, however, items are
disregarded only until an allocation is actually made. The purpose of
the exclusions is to allow ordinary economic business allocations (such
as preferred returns), to avoid technical violations arising due to the
requirements of section 704(b), and to avoid foot-faults.
III. Public Comments and Clarifying Changes
A. Manner in Which the Fractions Rule Is Applied
One commentator requested clarification regarding the prospective
application of the fractions rule, especially with respect to
allocations that are taken into account only when an allocation is
made. The final regulations clarify that a partnership generally does
not qualify for the fractions rule exception for any taxable year of
its existence unless it satisfies the fractions rule--both on a
prospective and actual basis--for every year. The regulations also
clarify that if the partnership violates the fractions rule by reason
of an allocation that the regulations provide is ``disregarded'' or
``not taken into account'' until an actual allocation is made, the
partnership is treated (subject to the anti-abuse rule) as violating
the fractions rule only for the taxable year of that actual allocation
and subsequent taxable years. The final regulations also add an example
illustrating this wait-and-see approach.
B. Section 704(c) Allocations
The proposed regulations provide that tax items allocable under
section 704(c) (or Sec. 1.704-1(b)(2)(iv)(f)(4)), are not included in
computing overall partnership income or loss. The final regulations
clarify that those types of tax allocations may nonetheless be relevant
in determining if the partnership violates the anti-abuse rule.
C. Exclusion of Reasonable Preferred Returns and Guaranteed Payments
Under the exception for reasonable preferred returns, items of
income and gain allocated with respect to a reasonable preferred return
for capital are disregarded in computing overall partnership income or
loss for purposes of the fractions rule. Reasonable guaranteed payments
for capital or services also are disregarded. However, to qualify for
the exception, the income allocation (or the deduction of the
guaranteed payment) generally must not precede the making of the
related cash payment.
The final regulations adopt a commentator's recommendation that the
exception for reasonable preferred returns should apply not only to
allocations effected with items of income or gain, but also to
allocations effected with overall partnership income. In implementing
this change, the regulations refer to ``an allocation of what would
otherwise be overall partnership income.'' (This technical refinement
also was made to several parts of the regulation that previously
referred to allocations of overall partnership income.) This is
necessary because the exclusion of an allocated item from the
computation of overall partnership income or loss for purposes of the
fractions rule means that the item is not overall partnership income or
overall partnership loss.
Although the exception for reasonable preferred returns contained
in the proposed regulations applies only to those allocations made to a
QO, the final regulations apply the exception to all partners. Without
this change, a partnership that paid a reasonable preferred return to
both its QO and taxable partners arguably could disregard the
allocations to its QO partners in computing overall partnership income
or loss, but at the same time, take the corresponding allocations to
its taxable partners into account in computing overall partnership
income or loss. Although the anti-abuse rule of the proposed
regulations does not permit the excessive allocation of income or gain
to the QO partners that would result if this argument were accepted,
the final regulations clarify this issue. A similar change was not
called for with respect to guaranteed payments because guaranteed
payments to taxable partners automatically are excluded from overall
partnership income or loss.
The proposed regulations generally provide that a material
distribution is a return of capital if it is not attributable to the
partnership's cash flow from its business operations. Concern was
expressed that under this rule certain returns on capital might
inappropriately be characterized as a return of capital. There also was
a separate concern that this rule inappropriately implied that
distributions of operating cash flow would generally not be respected
as a return of capital.
To address these concerns and to reflect that capital may be
returned from a number of different sources, the final regulations
provide that a designation of distributions in a written partnership
agreement generally will be respected in determining a partner's
unreturned capital so long as the designation is economically
reasonable. Although the regulations do not specify when the
designation must be made, timing may be relevant in determining whether
the designation is reasonable.
Some commentators characterized the cash payment requirement as a
significant limitation on the exception for preferred returns and
guaranteed payments. The principal objection voiced on this point is
that requiring a cash payment may prevent partners from achieving their
economic deal. Since real estate partnerships often lack free cash in
their early years, the money partners are forced to rely on the
partnership having sufficient income in subsequent years to ultimately
provide them with their preferred return.
The IRS and Treasury Department are concerned that if the
requirement were eliminated, partnerships might attempt to optimize
their overall economics by allocating significant amounts of
partnership income and gain to QOs in the form of preferred returns and
guaranteed payments. It is believed that in many instances this would
be a departure from the normal commercial practice followed by
partnerships in which the money partners are generally subject to
income tax. Taxable partners generally are not willing to bear the tax
burden attributable to income allocations that precede the
corresponding distribution of cash by many years. A suggestion that
partnerships be required to compound allocated but unpaid amounts could
exacerbate the problem. Compounding would increase the amount of
undistributed income or gain allocated to the tax-exempt partners.
The final regulations retain the cash payment requirement. However,
the regulations also provide more explicitly that the normal rules of
accrual accounting are overridden with respect to the deduction of
reasonable guaranteed payments. The deduction is delayed until the
partnership taxable year in which the payment is made in cash.
(Similarly, the inclusion of the guaranteed payment in the QO's income
is delayed because the regulation does not change the existing rule
under Sec. 1.707-1(c) that a guaranteed payment is included in income
in the same taxable year it is deducted by the partnership.) For
partnerships that are concerned about the availability of sufficient
future income to ensure the payment of a preferred return, this
clarification may help them use guaranteed payments to achieve greater
assurance that the partnership ultimately will pay a return on capital.
D. Chargebacks and Offsets
The final regulations continue to provide exceptions for four types
of chargebacks and offsets: (1) Allocations that charge back prior
disproportionately large allocations (i.e., in excess of a qualified
organization's fractions rule percentage) of overall partnership loss
to a qualified organization, or prior disproportionately small
allocations of overall partnership income to a qualified organization;
(2) minimum gain chargebacks of nonrecourse deductions; (3) chargebacks
of partner nonrecourse deductions (and of compensating allocations of
recourse deductions to another partner); and (4) qualified income
offsets. The final regulations also continue to provide that
allocations of minimum gain that may be made with respect to
distributions of proceeds of nonrecourse liabilities are taken into
account only to the extent an allocation is actually made (to avoid
technical violations of the fractions rule that would otherwise arise
from including a minimum gain chargeback provision in a partnership
agreement). In addition, a limited new chargeback exception (described
in greater detail below) applies to allocations of minimum gain
attributable to certain distributions of proceeds of nonrecourse
liabilities.
A suggestion that all chargebacks be permitted without regard to
whether the initial allocation was ``disproportionate'' was carefully
considered and rejected. A principal consideration in rejecting the
proposal was that it would represent a significant departure from the
mechanical approach contained in the proposed regulations, which,
overall, is relatively simple for taxpayers to apply and for the IRS to
administer and enforce. Accordingly, the final regulations retain the
basic approach of the proposed regulations, but add a number of
technical and clarifying changes. In addition, two examples have been
added to further clarify the operation of these provisions.
The final regulations clarify that disproportionate allocations
need not be reversed in full, but may also be reversed in part. In
addition, the provision requiring that an initial allocation of less
than the entire overall partnership income or loss consist of a pro
rata portion of each item of partnership income, gain, loss, or
deduction now excepts from the pro rata requirement nonrecourse
deductions and certain other allocations relating to nonrecourse debt.
Absent this change, the disproportionate chargeback provisions might
have overly limited applicability, because real estate partnerships
typically have borrowed on a nonrecourse basis.
One commentator accurately noted that the exception for allocations
of overall partnership loss (or, more precisely, what would otherwise
be overall partnership loss) that charge back disproportionately small
allocations of overall partnership income to a QO partner is somewhat
confusing and counterintuitive. Part of the confusion arises because
the Code refers to chargebacks of disproportionately large income
allocations to taxable partners. However, the equivalent approach taken
in the regulations is desirable because it avoids the need to determine
the analog of a fractions rule percentage for taxable partners and
because it is simpler to apply to partnerships with more than one QO
partner. Accordingly, an example has been added to the final
regulations, as requested by the commentator, to illustrate a
qualifying allocation of overall partnership loss that charges back a
disproportionately small allocation of overall partnership income to a
QO partner.
The final regulations revise the formula approach in the proposed
regulations for determining the extent to which a minimum gain
chargeback is attributable to nonrecourse deductions (or partner
nonrecourse deductions) to properly interact with the Sec. 1.704-2
regulations governing partnership minimum gain and partner nonrecourse
debt minimum gain. The Sec. 1.704-2 regulations effect minimum gain
chargebacks on the basis of the partners' percentage shares of minimum
gain. Accordingly, the final regulations require partnerships to
determine--in a reasonable and consistent manner--the extent to which a
partner's percentage share of the partnership minimum gain is
attributable to nonrecourse deductions. The final regulations also
provide, by way of example, a formula for determining in certain
circumstances the extent to which a partner's percentage share of
minimum gain is attributable to nonrecourse deductions. Although the
final regulations do not explicitly so provide, a partnership that
computes the extent to which minimum gain is attributable to
nonrecourse deductions, also computes, by default, the extent to which
minimum gain is attributable to prior distributions of proceeds of
nonrecourse liabilities.
There is a limited new chargeback exception that applies if QO
partners initially contribute capital used to purchase depreciable real
property and are allocated the resulting depreciation deductions. If
the partnership later borrows money on a nonrecourse basis (using that
depreciable real property as security) and distributes the proceeds to
the QO partners as a return of capital, the resulting minimum gain
chargeback is permanently disregarded in computing overall partnership
income or loss for purposes of the fractions rule. Without a special
rule, the distribution of nonrecourse proceeds and the resulting
minimum gain chargeback might cause a violation of the fractions rule
in the year the minimum gain is triggered. In effect, the new exception
allows the partnership to apply the general chargeback rule for
nonrecourse deductions (rather than the general chargeback rule for
nonrecourse distributions) even though the initial depreciation
deductions allocated to the QO partners were not nonrecourse.
This new rule is narrow. It provides complete relief to
partnerships only to the extent the amount of the partnership
depreciation deduction for the property for the year does not exceed
the overall partnership loss for the year. The reason for making this
rule narrow is that chargebacks attributable to distributions of
proceeds of nonrecourse liabilities may provide greater potential for
manipulation than other chargebacks. Nonetheless, the new provision
should provide significant relief from a problem that may be fairly
common.
E. Exclusion of Partner-Specific Items of Deduction
The final regulations continue to exclude from the computation of
overall partnership income or loss, certain expenditures allocated to
the partners to whom they are attributable. Furthermore, in partial
response to a commentator's request that certain other exceptions be
added, the final regulations expand the exception for expenditures
incurred in computing section 743(b) basis adjustments to generally
encompass additional record-keeping and accounting expenditures
incurred in connection with transfers of partnership interests. To
allow proper consideration of other items that might be excepted, the
final regulations also permit the list of qualifying expenditures to be
expanded in the future by revenue ruling, revenue procedure, or private
letter ruling.
F. Unlikely Losses and Deductions
The requirement that a loss or expenditure not be reasonably
foreseeable to qualify as unlikely has been revised in response to
concerns that were voiced. To qualify as ``unlikely'' under the final
regulations, a loss or deduction must have a low likelihood of
occurring, taking into account the relevant facts and circumstances.
In addition, the final regulations clarify that the types of events
described in the regulations are not per se unlikely. They merely
illustrate possible situations giving rise to allocations to which the
exception for unlikely losses and deductions applies (if they have a
low likelihood of occurring taking into account the relevant facts and
circumstances). In response to a comment, the discovery of
environmental conditions that require remediation has been added to the
illustrative list of potential relevant events.
Contrary to a commentator's request, the final regulations do not
sanction pre-funding of a loss or deduction. Generally, pre-funding is
incompatible with a conclusion that a loss or deduction is unlikely.
G. Changes in Partnership Allocations
The final regulations retain the rule that changes in partnership
allocations resulting from transfers or shifts in partnership interests
will be closely scrutinized, but generally will be relevant only on a
prospective basis. However, the final regulations provide taxpayers
with more specific guidance. The scope of the scrutiny relates to the
determination of whether the transfers or shifts stem from a prior
agreement, understanding, or plan, or could otherwise be expected given
the structure of the transaction (e.g., a situation where the structure
and economics is such that it could well be anticipated that a sale of
an interest would occur at some particular phase of the partnership's
(or transaction's) life). This approach bears some similarity to the
approach of Sec. 1.704-1(b)(4)(vi) (relating to the scrutiny given to
amendments to partnership agreements).
H. De Minimis Exceptions
In response to comments, changes were also made to the two de
minimis rules. One commentator asked for clarification on the exception
for de minimis interests. In response, the rule has been slightly
clarified and an example has been added to illustrate the rule's
application.
The nature of the comments received with respect to the de minimis
allocation exception indicated that the exception was viewed
differently than had been intended. The intent of this exception was to
provide relief for what would otherwise be minor inadvertent violations
of the fractions rule. One example would be a plumber's bill that is
paid directly by a taxable partner, or that is paid by the partnership
but is overlooked until after the partnership's allocations have been
computed and then is allocated entirely to the taxable partner. It was
not intended that this provision be used routinely by partnerships to
allocate some of the partnership's losses and deductions. Consistent
with the intent underlying this provision, the final regulations limit
the total amount (rather than the amount allocated to the QO partner)
to which the exception applies to the lesser of $50,000 and one percent
of the partnership's total losses and deductions.
I. Anti-Abuse Rule
At least one commentator suggested that the anti-abuse rule in the
proposed regulations was vague. To address this concern, the final
regulations provide a more complete statement of the purpose of the
fractions rule, which largely tracks the wording of the Conference
Committee Report accompanying the enactment of the Revenue Act of 1987.
See H.R. Conf. Rep. No. 495, 100th Cong., 1st Sess. 957 (1987).
J. Tiered Partnerships
The rules regarding tiered partnerships were well received and
remain largely the same as in the proposed regulations. However, some
changes were made. First, the final regulations clarify that the
relevant partnerships (as opposed to individual QOs) must demonstrate
that the relevant chains satisfy the requirements of the regulations
under any reasonable method. Also, although the same three basic
examples contained in the proposed regulations continue to illustrate
the application of this rule, a number of changes were made to those
examples. Most of the changes to the examples are stylistic or
clarifying.
One clarification is that tiered partnerships may not simply be
used to achieve results that could not be achieved in the absence of a
tiered-partnership structure. For example, the facts in the second
tiered-partnership example (relating to the entity-by-entity approach)
now state that each of the upper-tier partnerships has been established
for the purpose of investing in numerous real estate properties
independently of the other upper-tier partnership and its partners.
Thus, the tiered-partnership rules may not be used simply to apply the
fractions rule on a QO-by-QO basis instead of the regulation's
generally applicable overall partnership basis.
The facts in the second example also now contain a statement that
neither of the upper-tier partnerships have outstanding debt. The
reason for that statement is that in some cases, debt might be used to
attempt to achieve allocations that would not satisfy the fractions
rule if, for example, the lower-tier partnership had incurred the debt.
The inclusion of this added fact should not be viewed as flatly
precluding the existence of debt at any level other than the lower-tier
partnership. The absence of debt was added as a fact to obviate the
need to complicate the example by addressing the precise effect of
debt, in what likely would have been a fact pattern that would have
been of limited value in analyzing other debt arrangements.
Accordingly, the existence of debt at a level other than the lower-tier
partnership should be viewed as something to be taken into
consideration in determining whether a partnership can demonstrate that
the requirements of the regulations have been satisfied. It should also
be noted that the existence of debt at the partner level might also be
relevant in situations where tiered partnerships are not used.
One clarifying change and one technical change were made with
respect to the third example in the tiered-partnership rules (relating
to the independent chain approach). The clarifying change was to state
that the upper-tier partnership separately allocates to its upper-tier
partners the items allocated to the upper-tier partnership by the
lower-tier partnerships. This change emphasizes that, as a practical
matter, partnerships would not otherwise be able to demonstrate that
the requirements of the fractions rule are complied with.
The technical change, which is related, is to provide that for
purposes of applying Sec. 1.704-2(k) under the independent chain
approach, minimum gain chargebacks are taken into account on an if-and-
when basis. Absent this change, no tiered-partnership structure in
which a lower-tier partnership incurred nonrecourse debt would be able
to comply with the fractions rule. This is because Sec. 1.704-2(k)
would be treated on a prospective basis as giving rise to: (1) an
allocation of a decrease in minimum gain to the upper-tier partnership
(and, in turn, an upper-tier QO partner) from one lower-tier
partnership lacking sufficient income and gain to effect a minimum gain
chargeback; and (2) a corresponding minimum gain chargeback by the
upper-tier partnership using income and gain allocated to the upper-
tier partnership by the other lower-tier partnership.
K. Effective Date
The final regulations retain December 30, 1992, as their general
effective date, i.e., the date the proposed regulations were published
in the Federal Register. However, the final regulations also permit
reliance on the proposed regulations during the window period beginning
December 30, 1992, and ending on May 13, 1994. The regulations provide
transition rules for partnerships commencing after October 13, 1987,
property acquired by partnerships after October 13, 1987, and
partnership interests acquired by qualified organizations after October
13, 1987.
Special Analyses
It has been determined that this Treasury decision is not a
significant regulatory action as defined in EO 12866. Therefore, a
regulatory assessment is not required. It also has been determined that
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)
and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to
these regulations, and, therefore, a Regulatory Flexibility Analysis is
not required. Pursuant to section 7805(f) of the Internal Revenue Code,
the notice of proposed rulemaking preceding these regulations was
submitted to the Small Business Administration for comment on its
impact on small business.
Drafting Information
The principal author of these regulations is Deane M. Burke, Office
of Assistant Chief Counsel (Passthroughs and Special Industries),
Internal Revenue Service. However, other personnel from the IRS and
Treasury Department participated in their development.
List of Subjects in 26 CFR Part 1
Income Taxes, Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
Accordingly, 26 CFR part 1 is amended as follows:
Paragraph 1. The authority citation for part 1 is amended by adding
an entry in numerical order to read as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.514(c)-2 also issued under 26 U.S.C.
514(c)(9)(E)(iii). * * *
Par. 2. Section 1.514(c)-2 is added to read as follows:
Sec. 1.514(c)-2. Permitted allocations under section 514(c)(9)(E).
(a) Table of contents. This paragraph contains a listing of the
major headings of this Sec. 1.514(c)-2.
(a) Table of contents.
(b) Application of section 514(c)(9)(E), relating to debt-financed
real property held by partnerships.
(1) In general.
(i) The fractions rule.
(ii) Substantial economic effect.
(2) Manner in which fractions rule is applied.
(i) In general.
(ii) Subsequent changes.
(c) General definitions.
(1) Overall partnership income and loss.
(i) Items taken into account in determining overall partnership
income and loss.
(ii) Guaranteed payments to qualified organizations.
(2) Fractions rule percentage.
(3) Definitions of certain terms by cross reference to
partnership regulations.
(4) Example.
(d) Exclusion of reasonable preferred returns and guaranteed
payments.
(1) Overview.
(2) Preferred returns.
(3) Guaranteed payments.
(4) Reasonable amount.
(i) In general.
(ii) Safe harbor.
(5) Unreturned capital.
(i) In general.
(ii) Return of capital.
(6) Timing rules.
(i) Limitation on allocations of income with respect to
reasonable preferred returns for capital.
(ii) Reasonable guaranteed payments may be deducted only when
paid in cash.
(7) Examples.
(e) Chargebacks and offsets.
(1) In general.
(2) Disproportionate allocations.
(i) In general.
(ii) Limitation on chargebacks of partial allocations.
(3) Minimum gain chargebacks attributable to nonrecourse
deductions.
(4) Minimum gain chargebacks attributable to distribution of
nonrecourse debt proceeds.
(i) Chargebacks disregarded until allocations made.
(ii) Certain minimum gain chargebacks related to returns of
capital.
(5) Examples.
(f) Exclusion of reasonable partner-specific items of deduction or
loss.
(g) Exclusion of unlikely losses and deductions.
(h) Provisions preventing deficit capital account balances.
(i) [Reserved].
(j) Exception for partner nonrecourse deductions.
(1) Partner nonrecourse deductions disregarded until actually
allocated.
(2) Disproportionate allocation of partner nonrecourse
deductions to a qualified organization.
(k) Special rules.
(1) Changes in partnership allocations arising from a change in
the partners' interests.
(2) De minimis interest rule.
(i) In general.
(ii) Example.
(3) De minimis allocations disregarded.
(4) Anti-abuse rule.
(l) [Reserved].
(m) Tiered partnerships.
(1) In general.
(2) Examples.
(n) Effective date.
(1) In general.
(2) General effective date of the regulations.
(3) Periods after June 24, 1990, and prior to December 30, 1992.
(4) Periods prior to the issuance of Notice 90-41.
(5) Material modifications to partnership agreements.
(b) Application of section 514(c)(9)(E), relating to debt-financed
real property held by partnerships--(1) In general. This Sec. 1.514(c)-
2 provides rules governing the application of section 514(c)(9)(E). To
comply with section 514(c)(9)(E), the following two requirements must
be met:
(i) The fractions rule. The allocation of items to a partner that
is a qualified organization cannot result in that partner having a
percentage share of overall partnership income for any partnership
taxable year greater than that partner's fractions rule percentage (as
defined in paragraph (c)(2) of this section).
(ii) Substantial economic effect. Each partnership allocation must
have substantial economic effect. However, allocations that cannot have
economic effect must be deemed to be in accordance with the partners'
interests in the partnership pursuant to Sec. 1.704-1(b)(4), or (if
Sec. 1.704-1(b)(4) does not provide a method for deeming the
allocations to be in accordance with the partners' interests in the
partnership) must otherwise comply with the requirements of Sec. 1.704-
1(b)(4). Allocations attributable to nonrecourse liabilities or partner
nonrecourse debt must comply with the requirements of Sec. 1.704-2(e)
or Sec. 1.704-2(i).
(2) Manner in which fractions rule is applied--(i) In general. A
partnership must satisfy the fractions rule both on a prospective basis
and on an actual basis for each taxable year of the partnership,
commencing with the first taxable year of the partnership in which the
partnership holds debt-financed real property and has a qualified
organization as a partner. Generally, a partnership does not qualify
for the unrelated business income tax exception provided by section
514(c)(9)(A) for any taxable year of its existence unless it satisfies
the fractions rule for every year the fractions rule applies. However,
if an actual allocation described in paragraph (e)(4), (h), (j)(2), or
(m)(1)(ii) of this section (regarding certain allocations that are
disregarded or not taken into account for purposes of the fractions
rule until an actual allocation is made) causes the partnership to
violate the fractions rule, the partnership ordinarily is treated as
violating the fractions rule only for the taxable year of the actual
allocation and subsequent taxable years. For purposes of applying the
fractions rule, the term partnership agreement is defined in accordance
with Sec. 1.704-1(b)(2)(ii)(h), and informal understandings are
considered part of the partnership agreement in appropriate
circumstances. See paragraph (k) of this section for rules relating to
changes in the partners' interests and de minimis exceptions to the
fractions rule.
(ii) Subsequent changes. A subsequent change to a partnership
agreement that causes the partnership to violate the fractions rule
ordinarily causes the partnership's income to fail the exception
provided by section 514(c)(9)(A) only for the taxable year of the
change and subsequent taxable years.
(c) General definitions--(1) Overall partnership income and loss.
Overall partnership income is the amount by which the aggregate items
of partnership income and gain for the taxable year exceed the
aggregate items of partnership loss and deduction for the year. Overall
partnership loss is the amount by which the aggregate items of
partnership loss and deduction for the taxable year exceed the
aggregate items of partnership income and gain for the year.
(i) Items taken into account in determining overall partnership
income and loss. Except as otherwise provided in this section, the
partnership items that are included in computing overall partnership
income or loss are those items of income, gain, loss, and deduction
(including expenditures described in section 705(a)(2)(B)) that
increase or decrease the partners' capital accounts under Sec. 1.704-
1(b)(2)(iv). Tax items allocable pursuant to section 704(c) or
Sec. 1.704-1(b)(2)(iv)(f)(4) are not included in computing overall
partnership income or loss. Nonetheless, allocations pursuant to
section 704(c) or Sec. 1.704-1(b)(2)(iv)(f)(4) may be relevant in
determining that this section is being applied in a manner that is
inconsistent with the fractions rule. See paragraph (k)(4) of this
section.
(ii) Guaranteed payments to qualified organizations. Except to the
extent otherwise provided in paragraph (d) of this section--
(A) A guaranteed payment to a qualified organization is not treated
as an item of partnership loss or deduction in computing overall
partnership income or loss; and
(B) Income that a qualified organization may receive or accrue with
respect to a guaranteed payment is treated as an allocable share of
overall partnership income or loss for purposes of the fractions rule.
(2) Fractions rule percentage. A qualified organization's fractions
rule percentage is that partner's percentage share of overall
partnership loss for the partnership taxable year for which that
partner's percentage share of overall partnership loss will be the
smallest.
(3) Definitions of certain terms by cross reference to partnership
regulations. Minimum gain chargeback, nonrecourse deduction,
nonrecourse liability, partner nonrecourse debt, partner nonrecourse
debt minimum gain, partner nonrecourse debt minimum gain chargeback,
partner nonrecourse deduction, and partnership minimum gain have the
meanings provided in Sec. 1.704-2.
(4) Example. The following example illustrates the provisions of
this paragraph (c).
Example. Computation of overall partnership income and loss for
a taxable year. (i) Taxable corporation TP and qualified
organization QO form a partnership to own and operate encumbered
real property. Under the partnership agreement, all items of income,
gain, loss, deduction, and credit are allocated 50 percent to TP and
50 percent to QO. Neither partner is entitled to a preferred return.
However, the partnership agreement provides for a $900 guaranteed
payment for services to QO in each of the partnership's first two
taxable years. No part of the guaranteed payments qualify as a
reasonable guaranteed payment under paragraph (d) of this section.
(ii) The partnership violates the fractions rule. Due to the
existence of the guaranteed payment, QO's percentage share of any
overall partnership income in the first two years will exceed QO's
fractions rule percentage. For example, the partnership might have
bottom-line net income of $5,100 in its first taxable year that is
comprised of $10,000 of rental income, $4,000 of salary expense, and
the $900 guaranteed payment to QO. The guaranteed payment would not
be treated as an item of deduction in computing overall partnership
income or loss because it does not qualify as a reasonable
guaranteed payment. See paragraph (c)(1)(ii)(A) of this section.
Accordingly, overall partnership income for the year would be
$6,000, which would consist of $10,000 of rental income less $4,000
of salary expense. See paragraph (c)(1)(i) of this section. The $900
QO would include in income with respect to the guaranteed payment
would be treated as an allocable share of the $6,000 of overall
partnership income. See paragraph (c)(1)(ii)(B) of this section.
Therefore, QO's allocable share of the overall partnership income
for the year would be $3,450, which would be comprised of the $900
of income pertaining to QO's guaranteed payment, plus QO's $2,550
allocable share of the partnership's net income for the year (50
percent of $5,100). QO's $3,450 allocable share of overall
partnership income would equal 58 percent of the $6,000 of overall
partnership income and would exceed QO's fractions rule percentage,
which is less than 50 percent. (If there were no guaranteed payment,
QO's fractions rule percentage would be 50 percent. However, the
existence of the guaranteed payment to QO that is not disregarded
for purposes of the fractions rule pursuant to paragraph (d) of this
section means that QO's fractions rule percentage is less than 50
percent.)
(d) Exclusion of reasonable preferred returns and guaranteed
payments--(1) Overview. This paragraph (d) sets forth requirements for
disregarding reasonable preferred returns for capital and reasonable
guaranteed payments for capital or services for purposes of the
fractions rule. To qualify, the preferred return or guaranteed payment
must be set forth in a binding, written partnership agreement.
(2) Preferred returns. Items of income (including gross income) and
gain that may be allocated to a partner with respect to a current or
cumulative reasonable preferred return for capital (including
allocations of minimum gain attributable to nonrecourse liability (or
partner nonrecourse debt) proceeds distributed to the partner as a
reasonable preferred return) are disregarded in computing overall
partnership income or loss for purposes of the fractions rule.
Similarly, if a partnership agreement effects a reasonable preferred
return with an allocation of what would otherwise be overall
partnership income, those items comprising that allocation are
disregarded in computing overall partnership income for purposes of the
fractions rule.
(3) Guaranteed payments. A current or cumulative reasonable
guaranteed payment to a qualified organization for capital or services
is treated as an item of deduction in computing overall partnership
income or loss, and the income that the qualified organization may
receive or accrue from the current or cumulative reasonable guaranteed
payment is not treated as an allocable share of overall partnership
income or loss. The treatment of a guaranteed payment as reasonable for
purposes of section 514(c)(9)(E) does not affect its possible
characterization as unrelated business taxable income under other
provisions of the Internal Revenue Code.
(4) Reasonable amount--(i) In general. A guaranteed payment for
services is reasonable only to the extent the amount of the payment is
reasonable under Sec. 1.162-7 (relating to the deduction of
compensation for personal services). A preferred return or guaranteed
payment for capital is reasonable only to the extent it is computed,
with respect to unreturned capital, at a rate that is commercially
reasonable based on the relevant facts and circumstances.
(ii) Safe harbor. For purposes of this paragraph (d)(4), a rate is
deemed to be commercially reasonable if it is no greater than four
percentage points more than, or if it is no greater than 150 percent
of, the highest long-term applicable federal rate (AFR) within the
meaning of section 1274(d), for the month the partner's right to a
preferred return or guaranteed payment is first established or for any
month in the partnership taxable year for which the return or payment
on capital is computed. A rate in excess of the rates described in the
preceding sentence may be commercially reasonable, based on the
relevant facts and circumstances.
(5) Unreturned capital--(i) In general. Unreturned capital is
computed on a weighted-average basis and equals the excess of--
(A) The amount of money and the fair market value of property
contributed by the partner to the partnership (net of liabilities
assumed, or taken subject to, by the partnership); over
(B) The amount of money and the fair market value of property (net
of liabilities assumed, or taken subject to, by the partner)
distributed by the partnership to the partner as a return of capital.
(ii) Return of capital. In determining whether a distribution
constitutes a return of capital, all relevant facts and circumstances
are taken into account. However, the designation of distributions in a
written partnership agreement generally will be respected in
determining whether a distribution constitutes a return of capital, so
long as the designation is economically reasonable.
(6) Timing rules--(i) Limitation on allocations of income with
respect to reasonable preferred returns for capital. Items of income
and gain (or part of what would otherwise be overall partnership
income) that may be allocated to a partner in a taxable year with
respect to a reasonable preferred return for capital are disregarded
for purposes of the fractions rule only to the extent the allocable
amount will not exceed--
(A) The aggregate of the amount that has been distributed to the
partner as a reasonable preferred return for the taxable year of the
allocation and prior taxable years, on or before the due date (not
including extensions) for filing the partnership's return for the
taxable year of the allocation; minus
(B) The aggregate amount of corresponding income and gain (and what
would otherwise be overall partnership income) allocated to the partner
in all prior years.
(ii) Reasonable guaranteed payments may be deducted only when paid
in cash. If a partnership that avails itself of paragraph (d)(3) of
this section would otherwise be required (by virtue of its method of
accounting) to deduct a reasonable guaranteed payment to a qualified
organization earlier than the taxable year in which it is paid in cash,
the partnership must delay the deduction of the guaranteed payment
until the taxable year it is paid in cash. For purposes of this
paragraph (d)(6)(ii), a guaranteed payment that is paid in cash on or
before the due date (not including extensions) for filing the
partnership's return for a taxable year may be treated as paid in that
prior taxable year.
(7) Examples. The following examples illustrate the provisions of
this paragraph (d).
Facts. Qualified organization QO and taxable corporation TP form
a partnership. QO contributes $9,000 to the partnership and TP
contributes $1,000. The partnership borrows $50,000 from a third
party lender and purchases an office building for $55,000. At all
relevant times the safe harbor rate described in paragraph
(d)(4)(ii) of this section equals 10 percent.
Example 1. Allocations made with respect to preferred returns.
(i) The partnership agreement provides that in each taxable year the
partnership's distributable cash is first to be distributed to QO as
a 10 percent preferred return on its unreturned capital. To the
extent the partnership has insufficient cash to pay QO its preferred
return in any taxable year, the preferred return is compounded (at
10 percent) and is to be paid in future years to the extent the
partnership has distributable cash. The partnership agreement first
allocates gross income and gain 100 percent to QO, to the extent
cash has been distributed to QO as a preferred return. All remaining
profit or loss is allocated 50 percent to QO and 50 percent to TP.
(ii) The partnership satisfies the fractions rule. Items of
income and gain that may be specially allocated to QO with respect
to its preferred return are disregarded in computing overall
partnership income or loss for purposes of the fractions rule
because the requirements of paragraph (d) of this section are
satisfied. After disregarding those allocations, QO's fractions rule
percentage is 50 percent (see paragraph (c)(2) of this section), and
under the partnership agreement QO may not be allocated more than 50
percent of overall partnership income in any taxable year.
(iii) The facts are the same as in paragraph (i) of this Example
1, except that QO's preferred return is computed on unreturned
capital at a rate that exceeds a commercially reasonable rate. The
partnership violates the fractions rule. The income and gain that
may be specially allocated to QO with respect to the preferred
return is not disregarded in computing overall partnership income or
loss to the extent it exceeds a commercially reasonable rate. See
paragraph (d) of this section. As a result, QO's fractions rule
percentage is less than 50 percent (see paragraph (c)(2) of this
section), and allocations of income and gain to QO with respect to
its preferred return could result in QO being allocated more than 50
percent of the overall partnership income in a taxable year.
Example 2. Guaranteed payments and the computation of overall
partnership income or loss. (i) The partnership agreement allocates
all bottom-line partnership income and loss 50 percent to QO and 50
percent to TP throughout the life of the partnership. The
partnership agreement provides that QO is entitled each year to a 10
percent guaranteed payment on unreturned capital. To the extent the
partnership is unable to make a guaranteed payment in any taxable
year, the unpaid amount is compounded at 10 percent and is to be
paid in future years.
(ii) Assuming the requirements of paragraph (d)(6)(ii) of this
section are met, the partnership satisfies the fractions rule. The
guaranteed payment is disregarded for purposes of the fractions rule
because it is computed with respect to unreturned capital at the
safe harbor rate described in paragraph (d)(4)(ii) of this section.
Therefore, the guaranteed payment is treated as an item of deduction
in computing overall partnership income or loss, and the
corresponding income that QO may receive or accrue with respect to
the guaranteed payment is not treated as an allocable share of
overall partnership income or loss. See paragraph (d)(3) of this
section. Accordingly, QO's fractions rule percentage is 50 percent
(see paragraph (c)(2) of this section), and under the partnership
agreement QO may not be allocated more than 50 percent of overall
partnership income in any taxable year.
(e) Chargebacks and offsets--(1) In general. The following
allocations are disregarded in computing overall partnership income or
loss for purposes of the fractions rule--
(i) Allocations of what would otherwise be overall partnership
income that may be made to chargeback (i.e., reverse) prior
disproportionately large allocations of overall partnership loss (or
part of the overall partnership loss) to a qualified organization, and
allocations of what would otherwise be overall partnership loss that
may be made to chargeback prior disproportionately small allocations of
overall partnership income (or part of the overall partnership income)
to a qualified organization;
(ii) Allocations of income or gain that may be made to a partner
pursuant to a minimum gain chargeback attributable to prior allocations
of nonrecourse deductions to the partner;
(iii) Allocations of income or gain that may be made to a partner
pursuant to a minimum gain chargeback attributable to prior allocations
of partner nonrecourse deductions to the partner and allocations of
income or gain that may be made to other partners to chargeback
compensating allocations of other losses, deductions, or section
705(a)(2)(B) expenditures to the other partners; and
(iv) Allocations of items of income or gain that may be made to a
partner pursuant to a qualified income offset, within the meaning of
Sec. 1.704-1(b)(2)(ii)(d).
(2) Disproportionate allocations--(i) In general. To qualify under
paragraph (e)(1)(i) of this section, prior disproportionate allocations
may be reversed in full or in part, and in any order, but must be
reversed in the same ratio as originally made. A prior allocation is
disproportionately large if the qualified organization's percentage
share of that allocation exceeds its fractions rule percentage. A prior
allocation is disproportionately small if the qualified organization's
percentage share of that allocation is less than its fractions rule
percentage. However, a prior allocation (or allocations) is not
considered disproportionate unless the balance of the overall
partnership income or loss for the taxable year of the allocation is
allocated in a manner that would independently satisfy the fractions
rule.
(ii) Limitation on chargebacks of partial allocations. Except in
the case of a chargeback allocation pursuant to paragraph (e)(4) of
this section, and except as otherwise provided by the Internal Revenue
Service by revenue ruling, revenue procedure, or, on a case-by-case
basis, by letter ruling, paragraph (e)(1)(i) of this section applies to
a chargeback of an allocation of part of the overall partnership income
or loss only if that part consists of a pro rata portion of each item
of partnership income, gain, loss, and deduction (other than
nonrecourse deductions, as well as partner nonrecourse deductions and
compensating allocations) that is included in computing overall
partnership income or loss.
(3) Minimum gain chargebacks attributable to nonrecourse
deductions. Commencing with the first taxable year of the partnership
in which a minimum gain chargeback (or partner nonrecourse debt minimum
gain chargeback) occurs, a chargeback to a partner is attributable to
nonrecourse deductions (or separately, on a debt-by-debt basis, to
partner nonrecourse deductions) in the same proportion that the
partner's percentage share of the partnership minimum gain (or
separately, on a debt-by-debt basis, the partner nonrecourse debt
minimum gain) at the end of the immediately preceding taxable year is
attributable to nonrecourse deductions (or partner nonrecourse
deductions). The partnership must determine the extent to which a
partner's percentage share of the partnership minimum gain (or partner
nonrecourse debt minimum gain) is attributable to deductions in a
reasonable and consistent manner. For example, in those cases in which
none of the exceptions contained in Sec. 1.704-2(f) (2) through (5) are
relevant, a partner's percentage share of the partnership minimum gain
generally is attributable to nonrecourse deductions in the same ratio
that--
(i) The aggregate amount of the nonrecourse deductions previously
allocated to the partner but not charged back in prior taxable years;
bears to
(ii) The sum of the amount described in paragraph (e)(3)(i) of this
section, plus the aggregate amount of distributions previously made to
the partner of proceeds of a nonrecourse liability allocable to an
increase in partnership minimum gain but not charged back in prior
taxable years.
(4) Minimum gain chargebacks attributable to distribution of
nonrecourse debt proceeds--(i) Chargebacks disregarded until
allocations made. Allocations of items of income and gain that may be
made pursuant to a provision in the partnership agreement that charges
back minimum gain attributable to the distribution of proceeds of a
nonrecourse liability (or a partner nonrecourse debt) are taken into
account for purposes of the fractions rule only to the extent an
allocation is made. (See paragraph (d)(2) of this section, pursuant to
which there is permanently excluded chargeback allocations of minimum
gain that are attributable to proceeds distributed as a reasonable
preferred return.)
(ii) Certain minimum gain chargebacks related to returns of
capital. Allocations of items of income or gain that (in accordance
with Sec. 1.704-2(f)(1)) may be made to a partner pursuant to a minimum
gain chargeback attributable to the distribution of proceeds of a
nonrecourse liability are disregarded in computing overall partnership
income or loss for purposes of the fractions rule to the extent that
the allocations (subject to the requirements of paragraph (e)(2) of
this section) also charge back prior disproportionately large
allocations of overall partnership loss (or part of the overall
partnership loss) to a qualified organization. This exception applies
only to the extent the disproportionately large allocation consisted of
depreciation from real property (other than items of nonrecourse
deduction or partner nonrecourse deduction) that subsequently was used
to secure the nonrecourse liability providing the distributed proceeds,
and only if those proceeds were distributed as a return of capital and
in the same proportion as the disproportionately large allocation.
(5) Examples. The following examples illustrate the provisions of
this paragraph (e).
Example 1. Chargebacks of disproportionately large allocations
of overall partnership loss. (i) Qualified organization QO and
taxable corporation TP form a partnership. QO contributes $900 to
the partnership and TP contributes $100. The partnership agreement
allocates overall partnership loss 50 percent to QO and 50 percent
to TP until TP's capital account is reduced to zero; then 100
percent to QO until QO's capital account is reduced to zero; and
thereafter 50 percent to QO and 50 percent to TP. Overall
partnership income is allocated first 100 percent to QO to
chargeback overall partnership loss allocated 100 percent to QO, and
thereafter 50 percent to QO and 50 percent to TP.
(ii) The partnership satisfies the fractions rule. QO's
fractions rule percentage is 50 percent. See paragraph (c)(2) of
this section. Therefore, the 100 percent allocation of overall
partnership loss to QO is disproportionately large. See paragraph
(e)(2)(i) of this section. Accordingly, the 100 percent allocation
to QO of what would otherwise be overall partnership income (if it
were not disregarded), which charges back the disproportionately
large allocation of overall partnership loss, is disregarded in
computing overall partnership income and loss for purposes of the
fractions rule. The 100 percent allocation is in the same ratio as
the disproportionately large loss allocation, and the rest of the
allocations for the taxable year of the disproportionately large
loss allocation will independently satisfy the fractions rule. See
paragraph (e)(2)(i) of this section. After disregarding the
chargeback allocation of 100 percent of what would otherwise be
overall partnership income, QO will not be allocated a percentage
share of overall partnership income in excess of its fractions rule
percentage for any taxable year.
Example 2. Chargebacks of disproportionately small allocations
of overall partnership income. (i) Qualified organization QO and
taxable corporation TP form a partnership. QO contributes $900 to
the partnership and TP contributes $100. The partnership purchases
real property with money contributed by its partners and with money
borrowed by the partnership on a recourse basis. In any year, the
partnership agreement allocates the first $500 of overall
partnership income 50 percent to QO and 50 percent to TP; the next
$100 of overall partnership income 100 percent to TP (as an
incentive for TP to achieve significant profitability in managing
the partnership's operations); and all remaining overall partnership
income 50 percent to QO and 50 percent to TP. Overall partnership
loss is allocated first 100 percent to TP to chargeback overall
partnership income allocated 100 percent to TP at any time in the
prior three years and not reversed; and thereafter 50 percent to QO
and 50 percent to TP.
(ii) The partnership satisfies the fractions rule. QO's
fractions rule percentage is 50 percent because qualifying
chargebacks are disregarded pursuant to paragraph (e)(1)(i) in
computing overall partnership income or loss. See paragraph (c)(2)
of this section. The zero percent allocation to QO of what would
otherwise be overall partnership loss is a qualifying chargeback
that is disregarded because it is in the same ratio as the income
allocation it charges back, because the rest of the allocations for
the taxable year of that income allocation will independently
satisfy the fractions rule (see paragraph (e)(2)(i) of this
section), and because it charges back an allocation of zero overall
partnership income to QO, which is proportionately smaller (i.e.,
disproportionately small) than QO's 50 percent fractions rule
percentage. After disregarding the chargeback allocation of 100
percent of what would otherwise be overall partnership loss, QO will
not be allocated a percentage share of overall partnership income in
excess of its fractions rule percentage for any taxable year.
Example 3. Chargebacks of partner nonrecourse deductions and
compensating allocations of other items. (i) Qualified organization
QO and taxable corporation TP form a partnership to own and operate
encumbered real property. QO and TP each contribute $500 to the
partnership. In addition, QO makes a $300 nonrecourse loan to the
partnership. The partnership agreement contains a partner
nonrecourse debt minimum gain chargeback provision and a provision
that allocates partner nonrecourse deductions to the partner who
bears the economic burden of the deductions in accordance with
Sec. 1.704-2. The partnership agreement also provides that to the
extent partner nonrecourse deductions are allocated to QO in any
taxable year, other compensating items of partnership loss or
deduction (and, if appropriate, section 705(a)(2)(B) expenditures)
will first be allocated 100 percent to TP. In addition, to the
extent items of income or gain are allocated to QO in any taxable
year pursuant to a partner nonrecourse debt minimum gain chargeback
of deductions, items of partnership income and gain will first be
allocated 100 percent to TP. The partnership agreement allocates all
other overall partnership income or loss 50 percent to QO and 50
percent to TP.
(ii) The partnership satisfies the fractions rule on a
prospective basis. The allocations of the partner nonrecourse
deductions and the compensating allocation of other items of loss,
deduction, and expenditure that may be made to TP (but which will
not be made unless there is an allocation of partner nonrecourse
deductions to QO) are not taken into account for purposes of the
fractions rule until a taxable year in which an allocation is made.
See paragraph (j)(1) of this section. In addition, partner
nonrecourse debt minimum gain chargebacks of deductions and
allocations of income or gain to other partners that chargeback
compensating allocations of other deductions are disregarded in
computing overall partnership income or loss for purposes of the
fractions rule. See paragraph (e)(1)(iii) of this section. Since all
other overall partnership income and loss is allocated 50 percent to
QO and 50 percent to TP, QO's fractions rule percentage is 50
percent (see paragraph (c)(2) of this section), and QO will not be
allocated a percentage share of overall partnership income in excess
of its fractions rule percentage for any taxable year.
(iii) The facts are the same as in paragraph (i) of this Example
3, except that the partnership agreement provides that compensating
allocations of loss or deduction (and section 705(a)(2)(B)
expenditures) to TP will not be charged back until year 10. The
partners expect $300 of partner nonrecourse deductions to be
allocated to QO in year 1 and $300 of income or gain to be allocated
to QO in year 2 pursuant to the partner nonrecourse debt minimum
gain chargeback provision.
(iv) The partnership fails to satisfy the fractions rule on a
prospective basis under the anti-abuse rule of paragraph (k)(4) of
this section. If the partners' expectations prove correct, at the
end of year 2, QO will have been allocated $300 of partner
nonrecourse deductions and an offsetting $300 of partner nonrecourse
debt minimum gain. However, the $300 of compensating deductions and
losses that may be allocated to TP will not be charged back until
year 10. Thus, during the period beginning at the end of year 2 and
ending eight years later, there may be $300 more of unreversed
deductions and losses allocated to TP than to QO, which would be
inconsistent with the purpose of the fractions rule.
Example 4. Minimum gain chargeback attributable to distributions
of nonrecourse debt proceeds. (i) Qualified organization QO and
taxable corporation TP form a partnership. QO contributes $900 to
the partnership and TP contributes $100. The partnership agreement
generally allocates overall partnership income and loss 90 percent
to QO and 10 percent to TP. However, the partnership agreement
contains a minimum gain chargeback provision, and also provides that
in any partnership taxable year in which there is a chargeback of
partnership minimum gain to QO attributable to distributions of
proceeds of nonrecourse liabilities, all other items comprising
overall partnership income or loss will be allocated in a manner
such that QO is not allocated more than 90 percent of the overall
partnership income for the year.
(ii) The partnership satisfies the fractions rule on a
prospective basis. QO's fractions rule percentage is 90 percent. See
paragraph (c)(2) of this section. The chargeback that may be made to
QO of minimum gain attributable to distributions of nonrecourse
liability proceeds is taken into account for purposes of the
fractions rule only to the extent an allocation is made. See
paragraph (e)(4) of this section. Accordingly, that potential
allocation to QO is disregarded in applying the fractions rule on a
prospective basis (see paragraph (b)(2) of this section), and QO is
treated as not being allocated a percentage share of overall
partnership income in excess of its fractions rule percentage in any
taxable year. (Similarly, QO is treated as not being allocated items
of income or gain in a taxable year when the partnership has an
overall partnership loss.)
(iii) In year 3, the partnership borrows $400 on a nonrecourse
basis and distributes it to QO as a return of capital. In year 8,
the partnership has $400 of gross income and cash flow and $300 of
overall partnership income, and the partnership repays the $400
nonrecourse borrowing.
(iv) The partnership violates the fractions rule for year 8 and
all future years. Pursuant to the minimum gain chargeback provision,
the entire $400 of partnership gross income is allocated to QO.
Accordingly, notwithstanding the curative provision in the
partnership agreement that would allocate to TP the next $44
(($400.9) x 10%) of income and gain included in computing
overall partnership income, the partnership has no other items of
income and gain to allocate to QO. Because the $400 of gross income
actually allocated to QO is taken into account for purposes of the
fractions rule in the year an allocation is made (see paragraph
(e)(4) of this section), QO's percentage share of overall
partnership income in year 8 is greater than 100 percent. Since this
exceeds QO's fractions rule percentage (i.e., 90 percent), the
partnership violates the fractions rule for year 8 and all
subsequent taxable years. See paragraph (b)(2) of this section.
(f) Exclusion of reasonable partner-specific items of deduction or
loss. Provided that the expenditures are allocated to the partners to
whom they are attributable, the following partner-specific expenditures
are disregarded in computing overall partnership income or loss for
purposes of the fractions rule--
(1) Expenditures for additional record-keeping and accounting
incurred in connection with the transfer of a partnership interest
(including expenditures incurred in computing basis adjustments under
section 743(b));
(2) Additional administrative costs that result from having a
foreign partner;
(3) State and local taxes or expenditures relating to those taxes;
and
(4) Expenditures designated by the Internal Revenue Service by
revenue ruling or revenue procedure, or, on a case-by-case basis, by
letter ruling. (See Sec. 601.601(d)(2)(ii)(b) of this chapter).
(g) Exclusion of unlikely losses and deductions. Unlikely losses or
deductions (other than items of nonrecourse deduction) that may be
specially allocated to partners that bear the economic burden of those
losses or deductions are disregarded in computing overall partnership
income or loss for purposes of the fractions rule, so long as a
principal purpose of the allocation is not tax avoidance. To be
excluded under this paragraph (g), a loss or deduction must have a low
likelihood of occurring, taking into account all relevant facts,
circumstances, and information available to the partners (including
bona fide financial projections). The types of events that may give
rise to unlikely losses or deductions, depending on the facts and
circumstances, include tort and other third-party litigation that give
rise to unforeseen liabilities in excess of reasonable insurance
coverage; unanticipated labor strikes; unusual delays in securing
required permits or licenses; abnormal weather conditions (considering
the season and the job site); significant delays in leasing property
due to an unanticipated severe economic downturn in the geographic
area; unanticipated cost overruns; and the discovery of environmental
conditions that require remediation. No inference is drawn as to
whether a loss or deduction is unlikely from the fact that the
partnership agreement includes a provision for allocating that loss or
deduction.
(h) Provisions preventing deficit capital account balances. A
provision in the partnership agreement that allocates items of loss or
deduction away from a qualified organization in instances where
allocating those items to the qualified organization would cause or
increase a deficit balance in its capital account that the qualified
organization is not obligated to restore (within the meaning of
Sec. 1.704-1(b)(2)(ii) (b) or (d)), is disregarded for purposes of the
fractions rule in taxable years of the partnership in which no such
allocations are made pursuant to the provision. However, this exception
applies only if, at the time the provision becomes part of the
partnership agreement, all relevant facts, circumstances, and
information (including bona fide financial projections) available to
the partners reasonably indicate that it is unlikely that an allocation
will be made pursuant to the provision during the life of the
partnership.
(i) [Reserved]
(j) Exception for partner nonrecourse deductions--(1) Partner
nonrecourse deductions disregarded until actually allocated. Items of
partner nonrecourse deduction that may be allocated to a partner
pursuant to Sec. 1.704-2, and compensating allocations of other items
of loss, deduction, and section 705(a)(2)(B) expenditures that may be
allocated to other partners, are not taken into account for purposes of
the fractions rule until the taxable years in which they are allocated.
(2) Disproportionate allocation of partner nonrecourse deductions
to a qualified organization. A violation of the fractions rule will be
disregarded if it arises because an allocation of partner nonrecourse
deductions to a qualified organization that is not motivated by tax
avoidance reduces another qualified organization's fractions rule
percentage below what it would have been absent the allocation of the
partner nonrecourse deductions.
(k) Special rules--(1) Changes in partnership allocations arising
from a change in the partners' interests. A qualified organization that
acquires a partnership interest from another qualified organization is
treated as a continuation of the prior qualified organization partner
(to the extent of that acquired interest) for purposes of applying the
fractions rule. Changes in partnership allocations that result from
other transfers or shifts of partnership interests will be closely
scrutinized (to determine whether the transfer or shift stems from a
prior agreement, understanding, or plan or could otherwise be expected
given the structure of the transaction), but generally will be taken
into account only in determining whether the partnership satisfies the
fractions rule in the taxable year of the change and subsequent taxable
years.
(2) De minimis interest rule--(i) In general. Section
514(c)(9)(B)(vi) does not apply to a partnership otherwise subject to
that section if--
(A) Qualified organizations do not hold, in the aggregate,
interests of greater than five percent in the capital or profits of the
partnership; and
(B) Taxable partners own substantial interests in the partnership
through which they participate in the partnership on substantially the
same terms as the qualified organization partners.
(ii) Example. Partnership PRS has two types of limited partnership
interests that participate in partnership profits and losses on
different terms. Qualified organizations (QOs) only own one type of
limited partnership interest and own no general partnership interests.
In the aggregate, the QOs own less than five percent of the capital and
profits of PRS. Taxable partners also own the same type of limited
partnership interest that the QOs own. These limited partnership
interests owned by the taxable partners are 30 percent of the capital
and profits of PRS. Thirty percent is a substantial interest in the
partnership. Therefore, PRS satisfies paragraph (k)(2) of this section
and section 514(c)(9)(B)(vi) does not apply.
(3) De minimis allocations disregarded. A qualified organization's
fractions rule percentage of the partnership's items of loss and
deduction, other than nonrecourse and partner nonrecourse deductions,
that are allocated away from the qualified organization and to other
partners in any taxable year are treated as having been allocated to
the qualified organization for purposes of the fractions rule if--
(i) The allocation was neither planned nor motivated by tax
avoidance; and
(ii) The total amount of those items of partnership loss or
deduction is less than both--
(A) One percent of the partnership's aggregate items of gross loss
and deduction for the taxable year; and
(B) $50,000.
(4) Anti-abuse rule. The purpose of the fractions rule is to
prevent tax avoidance by limiting the permanent or temporary transfer
of tax benefits from tax-exempt partners to taxable partners, whether
by directing income or gain to tax-exempt partners, by directing
losses, deductions, or credits to taxable partners, or by some other
similar manner. This section may not be applied in a manner that is
inconsistent with the purpose of the fractions rule.
(l) [Reserved].
(m) Tiered partnerships--(1) In general. If a qualified
organization holds an indirect interest in real property through one or
more tiers of partnerships (a chain), the fractions rule is satisfied
only if--
(i) The avoidance of tax is not a principal purpose for using the
tiered-ownership structure (investing in separate real properties
through separate chains of partnerships so that section 514(c)(9)(E)
is, effectively, applied on a property-by-property basis is not, in and
of itself, a tax avoidance purpose); and
(ii) The relevant partnerships can demonstrate under any reasonable
method that the relevant chains satisfy the requirements of paragraphs
(b)(2) through (k) of this section. For purposes of applying
Sec. 1.704-2(k) under the independent chain approach described in
Example 3 of paragraph (m)(2) of this section, allocations of items of
income or gain that may be made pursuant to a provision in the
partnership agreement that charges back minimum gain are taken into
account for purposes of the fractions rule only to the extent an
allocation is made.
(2) Examples. The following examples illustrate the provisions of
this paragraph (m).
Example 1. Tiered partnerships--collapsing approach. (i)
Qualified organization QO3 and taxable individual TP3 form upper-
tier partnership P2. The P2 partnership agreement allocates overall
partnership income 20 percent to QO3 and 80 percent to TP3. Overall
partnership loss is allocated 30 percent to QO3 and 70 percent to
TP3. P2 and taxable individual TP2 form lower-tier partnership P1.
The P1 partnership agreement allocates overall partnership income 60
percent to P2 and 40 percent to TP2. Overall partnership loss is
allocated 40 percent to P2 and 60 percent to TP2. The only asset of
P2 (which has no outstanding debt) is its interest in P1. P1
purchases real property with money contributed by its partners and
with borrowed money. There is no tax avoidance purpose for the use
of the tiered-ownership structure, which is illustrated by the
following diagram.
TR13MY94.006
(ii) P2 can demonstrate that the P2/P1 chain satisfies the
requirements of paragraphs (b)(2) through (k) of this section by
collapsing the tiered-partnership structure. On a collapsed basis,
QO3's fractions rule percentage is 12 percent (30 percent of 40
percent). See paragraph (c)(2) of this section. P2 satisfies the
fractions rule because QO3 may not be allocated more than 12 percent
(20 percent of 60 percent) of overall partnership income in any
taxable year.
Example 2. Tiered partnerships--entity-by-entity approach. (i)
Qualified organization QO3A is a partner with taxable individual
TP3A in upper-tier partnership P2A. Qualified organization QO3B is a
partner with taxable individual TP3B in upper-tier partnership P2B.
P2A, P2B, and taxable individual TP2 are partners in lower-tier
partnership P1, which owns encumbered real estate. None of QO3A,
QO3B, TP3A, TP3B or TP2 has a direct or indirect ownership interest
in each other. P2A has been established for the purpose of investing
in numerous real estate properties independently of P2B and its
partners. P2B has been established for the purpose of investing in
numerous real estate properties independently of P2A and its
partners. Neither P2A nor P2B has outstanding debt. There is no tax
avoidance purpose for the use of the tiered-ownership structure,
which is illustrated by the following diagram.
TR13MY94.007
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(ii) The P2A/P1 chain (Chain A) will satisfy the fractions rule
if P1 and P2A can demonstrate in a reasonable manner that they
satisfy the requirements of paragraphs (b)(2) through (k) of this
section. The P2B/P1 chain (Chain B) will satisfy the fractions rule
if P1 and P2B can demonstrate in a reasonable manner that they
satisfy the requirements of paragraphs (b)(2) through (k) of this
section. To meet its burden, P1 treats P2A and P2B as qualified
organizations. Provided that the allocations that may be made by P1
would satisfy the fractions rule if P2A and P2B were direct
qualified organization partners in P1, Chain A will satisfy the
fractions rule (for the benefit of QO3A) if the allocations that may
be made by P2A satisfy the requirements of paragraphs (b)(2) through
(k) of this section. Similarly, Chain B will satisfy the fractions
rule (for the benefit of QO3B) if the allocations that may be made
by P2B satisfy the requirements of paragraphs (b)(2) through (k) of
this section. Under these facts, QO3A does not have to know how
income and loss may be allocated by P2B, and QO3B does not have to
know how income and loss may be allocated by P2A. QO3A's and QO3B's
burden would not change even if TP2 were not a partner in P1.
Example 3. Tiered partnerships--independent chain approach. (i)
Qualified organization QO3 and taxable corporation TP3 form upper-
tier partnership P2. P2 and taxable corporation TP2 form lower-tier
partnership P1A. P2 and qualified organization QO2 form lower-tier
partnership P1B. P2 has no outstanding debt. P1A and P1B each
purchase real property with money contributed by their respective
partners and with borrowed money. Each partnership's real property
is completely unrelated to the real property owned by the other
partnership. P1B's allocations do not satisfy the requirements of
paragraphs (b)(2) through (k) of this section because of allocations
that may be made to QO2. However, if P2's interest in P1B were
completely disregarded, the P2/P1A chain would satisfy the
requirements of paragraphs (b)(2) through (k) of this section. There
is no tax avoidance purpose for the use of the tiered-ownership
structure, which is illustrated by the following diagram.
TR13MY94.008
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(ii) P2 satisfies the fractions rule with respect to the P2/P1A
chain, but only if the P2 partnership agreement allocates those
items allocated to P2 by P1A separately from those items allocated
to P2 by P1B. For this purpose, allocations of items of income or
gain that may be made pursuant to a provision in the partnership
agreement that charges back minimum gain, are taken into account for
purposes of the fractions rule only to the extent an allocation is
made. See paragraph (m)(1)(ii) of this section. P2 does not satisfy
the fractions rule with respect to the P2/P1B chain.
(n) Effective date--(1) In general. Section 514(c)(9)(E), as
amended by sections 2004(h) (1) and (2) of the Technical and
Miscellaneous Revenue Act of 1988, Pub. L. 100-647, applies generally
with respect to property acquired by partnerships after October 13,
1987, and to partnership interests acquired after October 13, 1987.
(2) General effective date of the regulations. Section 1.514(c)-2
(a) through (m) applies with respect to partnership agreements entered
into after December 30, 1992, property acquired by partnerships after
December 30, 1992, and partnership interests acquired by qualified
organizations after December 30, 1992 (other than a partnership
interest that at all times after October 13, 1987, and prior to the
acquisition was held by a qualified organization). For this purpose,
paragraphs (a) through (m) of this section will be treated as satisfied
with respect to partnership agreements entered into on or before May
13, 1994, property acquired by partnerships on or before May 13, 1994,
and partnership interests acquired by qualified organizations on or
before May 13, 1994, if the guidance set forth in (paragraphs (a)
through (m) of Sec. 1.514(c)-2 of) PS-56-90, published at 1993-5 I.R.B.
42, February 1, 1993, is satisfied. (See Sec. 601.601(d)(2)(ii)(b) of
this chapter).
(3) Periods after June 24, 1990, and prior to December 30, 1992. To
satisfy the requirements of section 514(c)(9)(E) with respect to
partnership agreements entered into after June 24, 1990, property
acquired by partnerships after June 24, 1990, and partnership interests
acquired by qualified organizations after June 24, 1990, (other than a
partnership interest that at all times after October 13, 1987, and
prior to the acquisition was held by a qualified organization) to which
paragraph (n)(2) of this section does not apply, paragraphs (a) through
(m) of this section must be satisfied as of the first day that section
514(c)(9)(E) applies with respect to the partnership, property, or
acquired interest. For this purpose, paragraphs (a) through (m) of this
section will be treated as satisfied if the guidance in sections I
through VI of Notice 90-41, 90-1 C.B. 350, (see
Sec. 601.601(d)(2)(ii)(b) of this chapter) has been followed.
(4) Periods prior to the issuance of Notice 90-41. With respect to
partnerships commencing after October 13, 1987, property acquired by
partnerships after October 13, 1987, and partnership interests acquired
by qualified organizations after October 13, 1987, to which neither
paragraph (n)(2) nor (n)(3) of this section applies, the Internal
Revenue Service will not challenge an interpretation of section
514(c)(9)(E) that is reasonable in light of the underlying purposes of
section 514(c)(9)(E) (as reflected in its legislative history) and that
is consistently applied as of the first day that section 514(c)(9)(E)
applies with respect to the partnership, property, or acquired
interest. A reasonable interpretation includes an interpretation that
substantially follows the guidance in either sections I through VI of
Notice 90-41, (see Sec. 601.601(d)(2)(ii)(b) of this chapter) or
paragraphs (a) through (m) of this section.
(5) Material modifications to partnership agreements. A material
modification will cause a partnership agreement to be treated as a new
partnership agreement in appropriate circumstances for purposes of this
paragraph (n).
Margaret Milner Richardson,
Commissioner of Internal Revenue.
Approved: April 21, 1994.
Leslie Samuels,
Assistant Secretary of the Treasury.
[FR Doc. 94-11612 Filed 5-11-94; 8:45 am]
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