[Federal Register Volume 60, Number 5 (Monday, January 9, 1995)]
[Proposed Rules]
[Pages 2352-2364]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-171]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[PS-76-92]; [PS-51-93]
RIN 1545-AR48; RIN 1545-AR93
Recognition of Gain or Loss by Contributing Partner on
Distribution of Contributed Property or Other Property
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking and notice of public hearing.
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SUMMARY: This document contains proposed regulations relating to the
recognition of gain or loss on certain distributions of contributed
property by a partnership under section 704(c)(1)(B) of the Internal
Revenue Code of 1986 (Code). This document also contains proposed
regulations relating to the recognition of gain on certain
distributions to a contributing partner under section 737. Changes to
the applicable law were made by the Revenue Reconciliation Act of 1989
and the Energy Policy Act of 1992. The proposed regulations affect
partnerships and their partners and are necessary to provide guidance
for complying with the applicable tax law.
DATES: Written comments must be received by April 10, 1995. Requests to
speak (with outlines of oral comments) at a public hearing scheduled
for June 19, 1995, at 10 a.m. must be received by May 29, 1995.
ADDRESSES: Send submissions to: CC:DOM:CORP:T:R (PS-76-92; PS-51-93),
Room 5228, Internal Revenue Service, POB 7604, Ben Franklin Station,
Washington, DC. 20044. In the alternative, submissions may be hand
delivered between the hours of 8:00 a.m. and 5:00 p.m. to:
CC:DOM:CORP:T:R (PS-76-92; PS-51-93), Courier's Desk, Internal Revenue
Service, 1111 Constitution Avenue NW, Washington, DC. The public
hearing has been scheduled to be held in the Auditorium, Internal
Revenue Building, 1111 Constitution Avenue, NW, Washington, DC.
FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Stephen J.
Coleman, (202) 622-3060; concerning submissions and the hearing,
Michael Slaughter, (202) 622-7190 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Introduction
This document proposes to add new Secs. 1.704-4, 1.737-1, 1.737-2,
1.737-3, 1.737-4, and 1.737-5 to the Income Tax Regulations (26 CFR
part 1) under sections 704(c)(1)(B), 704(c)(2), and 737 of the Code.
Background
Section 704(c)(1)(A) of the Internal Revenue Code (Code) requires
that gain or loss with respect to property contributed to a partnership
by a partner be shared among the partners so as to take into account
any built-in gain or loss in the property at the time of the
contribution. Prior to its amendment by the Revenue Reconciliation Act
of 1989 (1989 Act), section 704(c) did not require the recognition of
built-in gain or loss by a contributing partner on a distribution of
contributed property by the partnership. The 1989 Act added sections
704(c)(1)(B) and 704(c)(2) to the Code. Section 704(c)(1)(B) provides
that in the case of a distribution of contributed property to another
partner within five years of its contribution to the partnership, the
contributing partner must recognize gain or loss in an amount equal to
the gain or loss the partner would have been allocated under section
704(c)(1)(A) on a sale of the property by the partnership at its fair
market value at the time of the distribution. Section 704(c)(2)
provides for an exception for distributions of certain like-kind
property. The legislative history of the 1989 Act indicates that
Congress intended section 704(c)(1)(B) to eliminate the inconsistent
treatment of sales and distributions by a partnership and thereby
prevent partners from circumventing the rule requiring pre-contribution
gain or loss on contributed property to be allocated to the
contributing partner by distributing the property to another partner.
H.R. Rep. No. 101-247, 101st Cong., 1st Sess. 406 (1989).
Prior to the enactment of the Energy Policy Act of 1992 (1992 Act),
a partner who contributed appreciated property to a partnership did not
recognize gain on a distribution to the distributee partner of
partnership property other than money. The 1992 Act added section 737
to the Code to require a contributing partner to recognize gain to the
extent of the lesser of (i) the net precontribution gain on property
contributed to the partnership by the partner, or (ii) the excess of
the value of the distributed property over the adjusted basis of the
partner's interest in the partnership. H.R. Rep. No. 102-1018, 102d
Cong., 2d Sess. 428 (1992).
Explanation of Provisions
A. Overview
Section 704(c)(1)(B) generally requires a contributing partner to
recognize gain or loss when the property contributed by that partner is
distributed to another partner within five years of its contribution to
the partnership. Section 737 generally requires a contributing partner
to recognize gain when the partner receives, within five years of the
contribution, a distribution of other property with a fair market value
in excess of the partner's adjusted basis in the partnership. Both
sections apply only to distributions made to a partner in the partner's
capacity as a partner. Section 704(c)(1)(B) and section 737 do not
apply to transactions or distributions in which the partner is not
acting in the capacity of a partner (e.g., transactions or
distributions subject to section 707(a) or section 751(b)).
The proposed regulations provide rules for determining when section
704(c)(1)(B) and section 737 apply and the amount of gain or loss that
must be recognized by the contributing partner under the applicable
section. The proposed regulations also provide rules for determining
the character of such gain or loss and for making the necessary basis
adjustments. The proposed regulations contain several exceptions that
are based on the [[Page 2353]] statutory language and the legislative
history. The proposed regulations also contain special rules dealing
with specific situations such as the partnership's exchange of the
contributed property for other property in a nonrecognition transaction
and the transfer of a contributing partner's interest in the
partnership. The proposed regulations also provide for coordination
between section 704(c)(1)(B) and section 737 in situations in which
both sections may apply to a distribution or distributions by a
partnership. In fashioning these specific rules, the proposed
regulations focus on the purpose of section 704(c)(1)(B) and section
737, rather than simply relying on the literal language of the
provisions in situations that would be inconsistent with the underlying
purpose of the provisions.
The proposed regulations under section 704(c)(1)(B) and section 737
contain an anti-abuse rule providing that the rules of the applicable
section must be applied in a manner consistent with its purpose.
Accordingly, the anti-abuse rules contained in the proposed regulations
provide that, if a principal purpose of a transaction is to achieve a
tax result inconsistent with the purpose of the applicable section, the
Commissioner can recast the transaction for federal tax purposes as
appropriate to achieve tax results that are consistent with such
purpose.
Whether a tax result is inconsistent with the purpose of the
applicable section is determined based on all the facts and
circumstances. The proposed regulations also provide examples
illustrating how these anti-abuse rules apply.
B. Section 704(c)(1)(B)
In General
Under the proposed regulations, the contributing partner must
recognize gain or loss on a distribution of the contributed property to
another partner within five years of its contribution to the
partnership. The amount of gain or loss recognized is the amount that
would have been allocated to the contributing partner under section
704(c)(1)(A) and Sec. 1.704-3 if the distributed property had been sold
by the partnership to the distributee partner at its fair market value
at the time of the distribution. The amount of gain or loss recognized
may vary depending on the particular method used by the partnership in
making allocations under section 704(c)(1)(A) and Sec. 1.704-3 because
the amount of remaining built-in gain or loss may vary depending on the
particular method of allocation adopted. In addition, because the
property is treated as having been sold by the partnership to the
distributee partner, the proposed regulations provide that any loss
that would have been disallowed under section 707(b)(1) if the
distributed property had actually been sold to the distributee partner
is disallowed.
Five-Year Period
Section 704(c)(1)(B) applies only to property distributed within
five years of its contribution to the partnership. The proposed
regulations provide that a new five-year period begins for property
deemed contributed to a new partnership following a termination of the
partnership under section 708(b)(1)(B), but only to the extent that the
pre-termination gain or loss on such property was not already required
to be allocated to the original contributor under section 704(c)(1)(A)
and Sec. 1.704-3. The effect of this provision is to begin a new five-
year period for post-contribution changes in the value of partnership
property whenever there is a termination of the partnership under
section 708(b)(1)(B). This provision is consistent with the legislative
history of section 704(c)(1)(B).
Character of Gain or Loss
The proposed regulations provide that the character of the
contributing partner's gain or loss is the same as the character that
would have been recognized if the property had been sold by the
partnership to the distributee partner. Thus, if the distributee
partner holds more than a 50 percent capital or profits interest in the
partnership, any gain recognized by the contributing partner may be
ordinary income under section 707(b)(2).
Exceptions and Special Rules
The proposed regulations provide that section 704(c)(1)(B) does not
apply to (i) a distribution of property contributed to the partnership
on or before October 3, 1989, or (ii) a distribution of property in
connection with a termination of the partnership under section
708(b)(1)(B). The proposed regulations also provide that section
704(c)(1)(B) does not apply to a distribution of a portion of
contributed property to a noncontributing partner in a complete
liquidation of the partnership if a portion of the contributed property
is distributed to the contributing partner and that portion has
unrecognized gain or loss in the hands of the contributing partner,
determined immediately after the distribution, at least equal to the
built-in gain or loss that would have been allocated to the
contributing partner under section 704(c)(1)(A) on a sale of the
contributed property by the partnership at the time of the
distribution. This exception is consistent with the purpose of section
704(c)(1)(B) to prevent the shifting of built-in gain or loss among
partners because no shift has occurred in this limited situation.
The proposed regulations provide that property received by a
partnership in exchange for contributed property in a nonrecognition
transaction is treated as the contributed property. This result is
consistent with the rule under Sec. 1.704-3(a)(8) of the regulations.
The proposed regulations also provide that the transferee of a
contributing partner is treated as the contributing partner to the
extent of the built-in gain or loss allocated to the transferee
partner. The gain or loss allocated to the transferee partner may be
offset, however, by the basis adjustments to partnership property by a
partnership with a section 754 election in effect. This result is
consistent with the result under Sec. 1.704-3(a)(7) of the regulations.
The proposed regulations also provide a special rule under section
704(c)(2) for cases in which the contributing partner receives like-
kind property no later than the earlier of: (1) 180 days following the
date of the distribution of contributed property to another partner, or
(2) the due date (determined with regard to extensions) of the
contributing partner's income tax return for the taxable year of the
distribution to the other partner. Under this rule, the contributing
partner's gain that otherwise would be recognized under section
704(c)(1)(B) is reduced by the amount of built-in gain or loss in the
distributed like-kind property in the hands of the contributing
partner. The amount of the built-in gain or loss is determined by
reference to the contributing partner's basis in the property
immediately after the distribution under section 732(a) or (b). The
proposed regulations provide that the basis in the distributed like-
kind property in this situation is determined without taking into
account any increase in the basis of the contributing partner's
partnership interest for any gain recognized under section
704(c)(1)(B). This special rule implements the statutory objective of
not requiring gain or loss on distributions where gain or loss would
not have been recognized outside of a partnership. When gain or loss is
not recognized in exchanges of like-kind property outside of
partnerships, the built-in gain or loss on the exchanged property is
generally preserved in the property received in the exchange. To the
extent that this built-in gain or loss [[Page 2354]] is not preserved
in the case of a distribution of property by the partnership, the
exception does not apply.
Basis Adjustments
The contributing partner's basis in the partnership interest and
the partnership's basis in the distributed property are increased or
decreased by the amount of gain or loss recognized by the contributing
partner. These adjustments are taken into account in determining (1)
the noncontributing partner's basis in the property distributed to that
partner, (2) the contributing partner's basis in any property
distributed to that partner in the same transaction (except to the
extent that the distributed property is like-kind property subject to
the special rule discussed above), (3) the basis adjustments, if any,
to partnership property by a partnership with a section 754 election in
effect, and (4) the amount of the contributing partner's gain under
section 731 or section 737 on a related distribution of money or
property, respectively, to the contributing partner.
C. Section 737
In General
Under the proposed regulations, a partner that contributes property
with built-in gain to a partnership and receives a distribution of
property other than money within five years of that contribution must
recognize gain in an amount equal to the lesser of (1) the excess (if
any) of the fair market value of the distributed property over the
adjusted basis of the partner's interest in the partnership (excess
distribution); or (2) the net precontribution gain of the partner.
Excess Distribution
In determining the amount of the excess distribution, the proposed
regulations provide that the distributee partner's adjusted basis in
the partnership interest is first adjusted for all basis adjustments
resulting from the distribution subject to section 737 (for example,
basis adjustments under section 752) and any basis adjustments
resulting from any other distribution that is part of the same plan or
arrangement (for example, basis adjustments required under sections
704(c)(1)(B) and 751(b)). Two basis adjustments, however, are not taken
into account in determining whether there is an excess distribution:
(1) the partner's basis is not increased for the gain recognized under
section 737, and (2) is not decreased by the adjustment required under
section 733 for property distributed to the distributee partner in the
transaction (other than property previously contributed to the
partnership by the partner). The first exception is consistent with
section 737(c)(1) and the second is necessary to prevent an
inappropriate decrease in the partner's basis (and corresponding
increase in the partner's gain) under section 737. The reduction in the
partner's adjusted basis for a distribution of property previously
contributed to the partnership by the partner is necessary to give
effect to the statutory requirement that a distribution of previously
contributed property not be taken into account in determining the
amount of an excess distribution.
The proposed regulations also provide that, in determining the
amount of an excess distribution, the fair market value of distributed
property is not reduced by the amount of any liability assumed or taken
subject to by the partner. The distributee partner's basis in the
partnership interest, however, is increased by the amount of any
liability assumed or taken subject to by the distributee partner and
this increase is taken into account in determining the amount of the
excess distribution. (The partner's basis is also adjusted for the
decrease in the partner's share of partnership liabilities as a result
of the distribution for this purpose.) As a result, the gross fair
market value of the property will be offset by the basis increase in
the partner's interest in the partnership under section 752 and, as a
result, the amount of the excess distribution should be limited to the
net value of the distributed property.
Net Precontribution Gain
The distributee partner's net precontribution gain is the net gain
(if any) that the partner would have recognized under section
704(c)(1)(B) if the partnership had distributed to another partner all
property contributed to the partnership by the distributee partner
within five years of the date of the distribution. The amount of gain
or loss that the distributee partner would recognize under section
704(c)(1)(B) is determined under the proposed regulations to section
704(c)(1)(B) contained in this notice.
The proposed regulations under section 737 provide special rules
for determining the amount of the partner's net precontribution gain.
Property contributed on or before October 3, 1989, is not included in
determining the amount of net precontribution gain because net
precontribution gain is determined by reference to section
704(c)(1)(B), and that section does not apply to property contributed
to the partnership on or before October 3, 1989.
Net precontribution gain is reduced as a result of a basis increase
to the contributed property under section 734(b)(1)(A) to reflect gain
recognized by the partner under section 731 on a distribution of money
in the same plan or arrangement as the distribution of property subject
to section 737. This reduction is appropriate because some or all of
the precontribution gain is recognized by the contributing partner
under section 731 on the distribution.
The proposed regulations also provide that a transferee partner
succeeds to the transferor's net precontribution gain in an amount
proportionate to the interest transferred. This provision is consistent
with the provision in Sec. 1.704-3(a)(7) (and Sec. 1.704-4(d)(2) of the
proposed regulations) requiring a transferee partner to succeed to all
or a portion of the transferor's built-in gain or loss. The transferee
partner, however, may not recognize the same amount of gain that the
transferor partner would have recognized on a subsequent distribution
because the transferee's basis in the partnership interest may be
higher or lower than the transferor's basis, and the amount of gain
allocated to the transferee partner under section 704(c)(1)(A) will be
affected by any basis adjustment required under section 754.
Net precontribution gain is also reduced by the amount of gain
recognized by the contributing partner under section 704(c)(1)(B) in a
distribution of contributed property in a related distribution to
another partner, and by the amount of gain that the partner would have
recognized under section 704(c)(1)(B) on the distribution of
contributed property to another partner but for the exception of
section 704(c)(2). This reduction is necessary to avoid gain
recognition under both section 704(c)(1)(B) and section 737 with
respect to the same built-in gain. The reduction for gain not
recognized as a result of the section 704(c)(2) exception only applies
in situations where there is an actual distribution of contributed
property to another partner.
Character of Gain
The character of the contributing partner's recognized gain is
determined by reference to the character of the partner's net
precontribution gain. The character of such gain is determined by
netting all of the precontribution gains and losses according to the
character that such property would have had on a sale by the
partnership to an unrelated third party. The character of the
[[Page 2355]] contributing partner's gain under section 737 is the same
(and in the same proportion) as the character of any net positive
amounts resulting from the netting of the precontribution gains and
losses. Character for this purpose is broadly defined in the proposed
regulations to include any item that the contributing partner would
have been required to take into account separately under section 702(a)
and Sec. 1.702-1(a) had the partnership sold all the property
contributed by that partner.
Because the contributed property is not actually transferred by the
partnership to any particular partner, it is appropriate to treat the
hypothetical dispositions by the partnership as occurring with an
unrelated third party. As a result, the character conversion rule of
section 707(b)(2) does not apply for purposes of determining the
character of the distributee partner's gain. (Compare section
704(c)(1)(B) and Sec. 1.704-4(b)(1) in which the character conversion
rule does apply because the contributed property is actually
distributed to another partner.)
Exceptions and Special Rules
The proposed regulations provide that section 737 does not apply to
a deemed distribution of property on a termination of the partnership
under section 708(b)(1)(B). As noted above (with respect to the
discussion of the proposed regulations under section 704(c)(1)(B)),
however, a new five-year period begins for property to the extent that
the pre-termination gains and losses, if any, were not already required
to be allocated to the original contributor under section 704(c)(1)(A)
and Sec. 1.704-3.
A transferee partner in a transfer that causes a termination under
section 708(b)(1)(B) will generally not have any net precontribution
gain immediately after the deemed formation of the new partnership. The
basis of the property deemed contributed by the transferee partner to
the new partnership is determined under section 732 and, as a result,
the transferee partner may be treated as having contributed built-in
gain and built-in loss property to the new partnership. These built-in
gain and loss properties, however, should net to zero, assuming that
the transferee partner's total basis in the properties is equal to
their total fair market value. Section 737, however, does apply to the
transferee partner and could result in gain recognition on a subsequent
distribution if the distribution occurs at a time when the partner has
a net precontribution gain. The transferee partner could have a net
precontribution gain on a subsequent distribution if, for example, the
partnership sells some or all of the built-in loss property (that is
deemed contributed by that partner to the new partnership in the
section 708(b)(1)(B) termination) and retains the built-in gain
property.
The proposed regulations also provide that section 737 does not
apply to partnership mergers and similar transactions because the
partners have merely converted their interests in the transferor
partnership to an interest in the transferee partnership. As a result
of this treatment, however, distributions by the transferee partnership
are subject to section 737 to the same extent that distributions from
the transferor partnership would have been subject to section 737.
Under the proposed regulations, section 737 applies to an
incorporation of the partnership involving an actual distribution of
property by the partnership to the partners followed by a contribution
to a corporation. (As discussed below, however, section 737 does not
apply to the extent that the property actually distributed to a partner
was previously contributed to the partnership by that partner.) Section
737 does not apply to an incorporation of a partnership by methods not
involving an actual distribution of partnership property to the
partners, provided that the incorporation is followed by a complete
liquidation of the partnership as part of the same plan or arrangement
as the incorporation. Section 737 does not apply in these situations
because the partners are converting their partnership interests into a
stock interest in the corporation in a nonrecognition transaction and,
under the rules of either sections 732 or 358, the built-in gain in a
partner's partnership interest is preserved in the stock received by
the contributing partner. This exception is similar to the general
carry-over treatment provided in Sec. 1.704-3(a)(8) for section 704(c)
property exchanged in a nonrecognition transaction. Incorporation by
means of a distribution of partnership property to the partners also
results in the same conversion of a partnership interest into stock of
a corporation, but that method of incorporation involves an actual
distribution of property to the partners and the form of incorporation
chosen by the partners governs the tax consequences of incorporation,
including the application of section 737.
The proposed regulations provide that a related distribution of
property previously contributed to the partnership by the distributee
partner is not taken into account in determining the amount of the
excess distribution or the partner's net precontribution gain. The
proposed regulations also provide, consistent with section 737(d)(1),
for a limitation in the case of a distribution of a previously
contributed interest in an entity. This limitation is intended to
prevent a partner from avoiding section 737 by contributing an interest
in an entity to the partnership and having the partnership contribute
property to that entity, followed by a distribution of an interest in
the entity to the contributing partner under the previously contributed
property exception. This limitation does not apply to the extent that
the property contributed by the partnership to the entity was
contributed by the same partner that contributed the interest in the
entity because, in that case, the distributee partner is receiving only
a distribution of property that it previously contributed to the
partnership.
The proposed regulations also provide that any property received by
the partnership in exchange for previously contributed property is
treated as previously contributed property to the extent such property
is treated as section 704(c) property with regard to the contributing
partner under Sec. 1.704-3(a)(8). This provision is consistent with the
general treatment of nonrecognition transactions involving section
704(c) property under Sec. 1.704-3(a)(8).
Basis Adjustments
The contributing partner's basis in the partnership interest is
increased by the amount of gain recognized by the partner. This
increase is taken into account in determining a partner's basis in
property received by that partner, but is not taken into account in
determining the amount of gain recognized by the partner under section
737 or the amount of gain recognized under section 731 on any
distribution of money in the same distribution as the distribution of
property subject to section 737.
The partnership's basis in property contributed by the partner is
also increased by the gain recognized by the partner. The basis
increase is limited to built-in gain property held by the partnership
after the distribution with the same character as the character of the
gain recognized by the contributing partner under section 737. No basis
increase is allocated to any previously contributed property that is
part of the distribution to which section 737 applied. This previously
contributed property is not taken into account in determining the
amount of net precontribution gain and therefore it is not appropriate
to increase the basis of that property. There is also no basis increase
to any property distributed to another partner in a related
distribution [[Page 2356]] to which section 704(c)(1)(B) applies. The
basis in the distributed property in that case will be increased or
decreased for any gain or loss recognized by the contributing partner
under section 704(c)(1)(B) and therefore should not be adjusted for
gain recognized under section 737.
The basis increase is allocated to built-in gain property with the
same character as the character of the gain recognized by the partner.
The amount of the basis increase allocated to property of a particular
character is allocated to the property in the order contributed to the
partnership, starting with the earliest contributed property. This
ordering rule preserves the effect of the five-year rule to the extent
possible. Allocating the adjustment to all property of a similar
character based on any other rule would reduce the net precontribution
gain attributable to later-contributed property before such gain was
entirely eliminated on earlier contributed property.
Any increase to the adjusted tax basis of partnership property
under the proposed regulations is recovered using any applicable
recovery period and depreciation (or other cost recovery) method
(including first-year conventions) available to the partnership for
newly purchased property (of the type adjusted) placed in service at
the time of the distribution.
Proposed Effective Date
These regulations are proposed to apply to distributions of
property by a partnership to a partner on or after January 9, 1995.
Special Analyses
It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in Executive Order
12866. Therefore, a regulatory assessment is not required. It has also
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, this notice of proposed
rulemaking will be submitted to the Chief Counsel for Advocacy of the
Small Business Administration for comment on its impact on small
business.
Comments and Public Hearing
Before these proposed regulations are adopted as final regulations,
consideration will be given to any written comments (a signed original
and eight (8) copies) that are timely submitted to the IRS. All
comments will be available for public inspection and copying.
A public hearing has been scheduled for June 19, 1995, at 10 a.m.
in the auditorium of the Internal Revenue Building. Because of access
restrictions, visitors will not be admitted beyond the Internal Revenue
Building lobby more than 15 minutes before the hearing starts.
The rules of 26 CFR 601.601(a)(3) apply to the hearing.
Persons that wish to present oral comments at the hearing must
submit written comments by April 10, 1995 and submit an outline of the
topics to be discussed and the time to be devoted to each topic (signed
original and eight (8) copies) by May 22, 1995.
A period of 10 minutes will be allotted for each person for making
comments.
An agenda showing the scheduling of the speakers will be prepared
after the deadline for receiving outlines has passed. Copies of the
agenda will be available free of charge at the hearing.
Drafting Information
Several persons from the Office of Chief Counsel and the Treasury
Department participated in the development of these regulations.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Proposed Amendments to the Regulations
Accordingly, 26 CFR part 1 is proposed to be amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 is amended by adding
the following citation:
Authority: 26 U.S.C. 7805 * * *
Section 1.704-4 also issued under 26 U.S.C. 704(c) * * *
Par. 2. Section 1.704-4 is added to read as follows:
Sec. 1.704-4 Distribution of contributed property.
(a) Determination of gain--(1) In general. A partner that
contributes section 704(c) property to a partnership must recognize
gain or loss under section 704(c)(1)(B) and this section on the
distribution of such property to another partner within five years of
its contribution to the partnership, in an amount equal to the gain or
loss that would have been allocated to such partner under section
704(c)(1)(A) and Sec. 1.704-3 if the distributed property had been sold
by the partnership to the distributee partner for its fair market value
at the time of the distribution. See Sec. 1.704-3(a)(3)(i) for a
definition of section 704(c) property.
(2) Transactions to which section 704(c)(1)(B) applies. Section
704(c)(1)(B) and this section apply only to a distribution that is
properly characterized as a distribution to a partner acting in the
capacity of a partner within the meaning of section 731 and section
737. Section 704(c)(1)(B) and this section do not apply to a
transaction or distribution that is subject to provisions other than
section 731(a) or section 737 (for example, a transaction or
distribution subject to sections 707(a), 736(a), or 751(b)).
(3) Fair market value of property. The fair market value of the
distributed section 704(c) property is the price at which the property
would change hands between a willing buyer and a willing seller at the
time of the distribution, neither being under any compulsion to buy or
sell and both having reasonable knowledge of the relevant facts. The
fair market value that a partnership assigns to distributed section
704(c) property will be regarded as correct, provided that the value is
reasonably agreed to among the partners in an arm's-length negotiation
and the partners have sufficiently adverse interests.
(4) Determination of five-year period--(i) General rule. The five-
year period specified in paragraph (a)(1) of this section begins on and
includes the date of contribution.
(ii) Section 708(b)(1)(B) terminations. A termination of the
partnership under section 708(b)(1)(B) begins a new five-year period
for each partner with respect to the built-in gain and built-in loss
property that the partner is deemed to recontribute to a new
partnership following the termination, but only to the extent that the
pre-termination built-in gain or loss, if any, on such property was not
already required to be allocated to the original contributor under
section 704(c)(1)(A) and Sec. 1.704-3. See Sec. 1.704-3(a)(3)(ii) for
the definitions of built-in gain and built-in loss on section 704(c)
property.
(5) Examples. The following examples illustrate the rules of this
paragraph (a). Unless otherwise specified, partnership income equals
partnership expenses (other than depreciation deductions for
contributed property) for each year of the partnership, the fair market
value of partnership property does not change, all distributions by the
partnership are subject to section 704(c)(1)(B), and all partners are
unrelated.
[[Page 2357]] Example 1. Recognition of gain. (i) On January 1,
1995, A, B, and C form partnership ABC as equal partners. A
contributes $10,000 cash and Property A, nondepreciable real
property with a fair market value of $10,000 and an adjusted tax
basis of $4,000. Thus, there is a built-in gain of $6,000 on
Property A at the time of contribution. B contributes $10,000 cash
and Property B, nondepreciable real property with a fair market
value and adjusted tax basis of $10,000. C contributes $20,000 cash.
(ii) On December 31, 1998, Property A and Property B are
distributed to C in complete liquidation of C's interest in the
partnership.
(iii) A would have recognized $6,000 of gain under section
704(c)(1)(A) and Sec. 1.704-3 on the sale of Property A at the time
of the distribution ($10,000 fair market value less $4,000 adjusted
tax basis). As a result, A must recognize $6,000 of gain on the
distribution of Property A to C. B would not have recognized any
gain or loss under section 704(c)(1)(A) and Sec. 1.704-3 on the sale
of Property B at the time of distribution because Property B was not
section 704(c) property. As a result, B does not recognize any gain
or loss on the distribution of Property B.
Example 2. Effect of post-contribution depreciation deductions.
(i) On January 1, 1995, A, B, and C form partnership ABC as equal
partners. A contributes Property A, depreciable property with a fair
market value of $30,000 and an adjusted tax basis of $20,000.
Therefore, there is a built-in gain of $10,000 on Property A. B and
C each contribute $30,000 cash. ABC uses the traditional method of
making section 704(c) allocations described in Sec. 1.704-3(b) with
respect to Property A.
(ii) Property A is depreciated using the straight-line method
over its remaining 10-year recovery period. The partnership has book
depreciation of $3,000 per year (10 percent of the $30,000 book
basis), and each partner is allocated $1,000 of book depreciation
per year (one-third of the total annual book depreciation of
$3,000). The partnership has a tax depreciation deduction of $2,000
per year (10 percent of the $20,000 tax basis in Property A). This
$2,000 tax depreciation deduction is allocated equally between B and
C, the noncontributing partners with respect to Property A.
(iii) At the end of the third year, the book value of Property A
is $21,000 ($30,000 initial book value less $9,000 aggregate book
depreciation) and the adjusted tax basis is $14,000 ($20,000 initial
tax basis less $6,000 aggregate tax depreciation). A's remaining
section 704(c)(1)(A) built-in gain with respect to Property A is
$7,000 ($21,000 book value less $14,000 adjusted tax basis).
(iv) On December 31, 1998, Property A is distributed to B in
complete liquidation of B's interest in the partnership. If Property
A had been sold for its fair market value at the time of the
distribution, A would have recognized $7,000 of gain under section
704(c)(1)(A) and Sec. 1.704-3(b). Therefore, A recognizes $7,000 of
gain on the distribution of Property A to B.
Example 3. Effect of remedial method. (i) On January 1, 1995, A,
B, and C form partnership ABC as equal partners. A contributes
Property A1, nondepreciable real property with a fair market value
of $10,000 and an adjusted tax basis of $5,000, and Property A2,
nondepreciable real property with a fair market value and adjusted
tax basis of $10,000. B and C each contribute $20,000 cash. ABC uses
the remedial method of making section 704(c) allocations described
in Sec. 1.704-3(d) with respect to Property A1.
(ii) On December 31, 1998, when the fair market value of
Property A1 has decreased to $7,000, Property A1 is distributed to C
in partial liquidation of C's interest in the partnership. If
Property A1 had been sold by the partnership at the time of the
distribution, ABC would have recognized the $2,000 of remaining
built-in gain under section 704(c)(1)(A) on the sale (fair market
value of $7,000 less $5,000 adjusted tax basis). All of this gain
would have been allocated to A. ABC would also have recognized a
book loss of $3,000 ($10,000 original book value less $7,000 current
fair market value of the property). Book loss in the amount of
$2,000 would have been allocated equally between B and C. Under the
remedial method, $2,000 of tax loss would also have been allocated
equally to B and C to match their share of the book loss. As a
result, $2,000 of gain would also have been allocated to A as an
offsetting remedial allocation. A would have recognized $4,000 of
total gain under section 704(c)(1)(A) on the sale of Property A1
($2,000 of section 704(c) recognized gain plus $2,000 remedial
gain). Therefore, A recognizes $4,000 of gain on the distribution of
Property A1 to C under this section.
(b) Character of gain or loss--(1) General rule. Gain or loss
recognized by the contributing partner under section 704(c)(1)(B) and
this section has the same character as the gain or loss that would have
resulted if the distributed property had been sold by the partnership
to the distributee partner at the time of the distribution.
(2) Example. The following example illustrates the rule of this
paragraph (b). Unless otherwise specified, partnership income equals
partnership expenses (other than depreciation deductions for
contributed property) for each year of the partnership, the fair market
value of partnership property does not change, all distributions by the
partnership are subject to section 704(c)(1)(B), and all partners are
unrelated.
Example. Character of gain. (i) On January 1, 1995, A and B form
partnership AB. A contributes $10,000 and Property A, nondepreciable
real property with a fair market value of $10,000 and an adjusted
tax basis of $4,000, in exchange for a 25 percent interest in
partnership capital and profits. B contributes $60,000 cash for a 75
percent interest in partnership capital and profits.
(ii) On December 31, 1998, Property A is distributed to B in
partial liquidation of B's interest in the partnership. Property A
is used in a trade or business of B.
(iii) A would have recognized $6,000 of gain under section
704(c)(1)(A) on a sale of Property A at the time of the distribution
(the difference between the fair market value ($10,000) and the
adjusted tax basis ($4,000) of the property at that time). Because
Property A is not a capital asset in the hands of Partner B and B
holds more than 50 percent of partnership capital and profits, the
character of the gain on a sale of Property A to B would have been
ordinary income under section 707(b)(2). Therefore, the character of
the gain to A on the distribution of Property A to B is ordinary
income.
(c) Exceptions--(1) Property contributed on or before October 3,
1989. Section 704(c)(1)(B) and this section do not apply to property
contributed to the partnership on or before October 3, 1989.
(2) Certain complete liquidations. Section 704(c)(1)(B) and this
section do not apply to a distribution of an interest in section 704(c)
property to a partner other than the contributing partner in a complete
liquidation of the partnership if--
(i) The contributing partner receives an interest in the
contributed section 704(c) property; and
(ii) The built-in gain or loss in the interest distributed to the
contributing partner, determined immediately after the distribution, is
equal to or greater than the built-in gain or loss on the property that
would have been allocated to the contributing partner without regard to
this paragraph (c)(2).
(3) Section 708(b)(1)(B) termination. Section 704(c)(1)(B) and this
section do not apply to a deemed distribution of property caused by a
termination of the partnership under section 708(b)(1)(B). See
paragraph (a)(4)(iii) of this section for a special rule regarding a
new five-year period for certain property deemed contributed to a new
partnership following a termination of the partnership under section
708(b)(1)(B). See also Sec. 1.737-2(a) for a similar rule in the
context of section 737.
(4) Example. The following example illustrates the rule of
paragraph (c)(2) of this section. Unless otherwise specified,
partnership income equals partnership expenses (other than depreciation
deductions for contributed property) for each year of the partnership,
the fair market value of partnership property does not change, all
distributions by the partnership are subject to section 704(c)(1)(B),
and all partners are unrelated.
Example. Complete liquidation. (i) On January 1, 1995, A and B
form partnership AB, as equal partners. A contributes Property A,
nondepreciable real property with a fair market value and adjusted
tax basis of $20,000. B contributes Property B, nondepreciable real
property with a fair market value of $20,000 and an adjusted tax
basis of $10,000. Property B therefore has a [[Page 2358]] built-in
gain of $10,000 at the time of contribution.
(ii) On December 31, 1998, the partnership completely liquidates
when the fair market value of Property A has not changed, but the
fair market value of Property B has increased to $40,000.
(iii) In the liquidation, A receives Property A and a 25 percent
interest in Property B. This interest in Property B has a fair
market value of $10,000 to A, reflecting the fact that A was
entitled to 50 percent of the $20,000 post-contribution appreciation
in Property B. The partnership distributes to B a 75 percent
interest in Property B with a fair market value of $30,000. B's
basis in this portion of Property B is $10,000 under section 732(b).
As a result, B has a built-in gain of $20,000 in this portion of
Property B immediately after the distribution ($30,000 fair market
value less $10,000 adjusted tax basis). This built-in gain is
greater than the $10,000 of built-in gain in Property B at the time
of contribution to the partnership. B therefore does not recognize
any gain on the distribution of a portion of Property B to A under
this section.
(d) Special rules--(1) Nonrecognition transactions. Property
received by the partnership in exchange for section 704(c) property in
a nonrecognition transaction is treated as the section 704(c) property
for purposes of section 704(c)(1)(B) and this section to the extent
that the property received is treated as section 704(c) property under
Sec. 1.704-3(a)(8). See Sec. 1.737-2(d)(3) for a similar rule in the
context of section 737.
(2) Transfers of a partnership interest. The transferee of all or a
portion of the partnership interest of a contributing partner is
treated as the contributing partner for purposes of section
704(c)(1)(B) and this section to the extent of the share of built-in
gain or loss allocated to the transferee partner. See Sec. 1.704-
3(a)(7).
(3) Distributions of like-kind property. If section 704(c) property
is distributed to a partner other than the contributing partner and
like-kind property (within the meaning of section 1031) is distributed
to the contributing partner no later than the earlier of (i) 180 days
following the date of the distribution to the non-contributing partner,
or (ii) the due date (determined with regard to extensions) of the
contributing partner's income tax return for the taxable year of the
distribution to the noncontributing partner, the amount of gain or
loss, if any, that the contributing partner would otherwise have
recognized under section 704(c)(1)(B) and this section is reduced by
the amount of built-in gain or loss in the distributed like-kind
property in the hands of the contributing partner immediately after the
distribution. The contributing partner's basis in the distributed like-
kind property is determined as if the like-kind property were
distributed in an unrelated distribution prior to the distribution of
any other property distributed as part of the same plan or arrangement
and is determined without regard to the increase in the contributing
partner's adjusted tax basis in the partnership interest under section
704(c)(1)(B) and this section.
(4) Example. The following example illustrates the rules of this
paragraph (d). Unless otherwise specified, partnership income equals
partnership expenses (other than depreciation deductions for
contributed property) for each year of the partnership, the fair market
value of partnership property does not change, all distributions by the
partnership are subject to section 704(c)(1)(B), and all partners are
unrelated.
Example. Distribution of like-kind property. (i) On January 1,
1995, A, B, and C form partnership ABC as equal partners. A
contributes Property A, nondepreciable real property with a fair
market value of $20,000 and an adjusted tax basis of $10,000. B and
C each contribute $20,000 cash. The partnership subsequently buys
Property X, nondepreciable real property of a like-kind to Property
A with a fair market value and adjusted tax basis of $8,000. The
fair market value of Property X subsequently increases to $10,000.
(ii) On December 31, 1998, Property A is distributed to B in
partial liquidation of B's interest in the partnership. At the same
time, Property X is distributed to A in partial liquidation of A's
interest in the partnership. A's basis in Property X is $8,000 under
section 732(a)(1). A therefore has $2,000 of built-in gain in
Property X ($10,000 fair market value less $8,000 adjusted tax
basis).
(iii) A would generally recognize $10,000 of gain under section
704(c)(1)(B) on the distribution of Property A, the difference
between the fair market value ($20,000) of the property and its
adjusted tax basis ($10,000). This gain is reduced, however, by the
amount of the built-in gain of Property X in the hands of A. As a
result, A recognizes only $8,000 of gain on the distribution of
Property A to B under section 704(c)(1)(B) and this section.
(e) Basis adjustments--(1) Contributing partner's basis in the
partnership interest. The basis of the contributing partner's interest
in the partnership is increased by the amount of the gain, or decreased
by the amount of the loss, recognized by the partner under section
704(c)(1)(B) and this section. This increase or decrease is taken into
account in determining (i) the contributing partner's adjusted tax
basis under section 732 for any property distributed to the partner in
a distribution that is part of the same plan or arrangement as the
distribution of the contributed property, other than like-kind property
described in paragraph (d)(3) of this section (pertaining to the
special rule for distributions of like-kind property), and (ii) the
amount of the gain recognized by the contributing partner under section
731 or section 737, if any, on a distribution of money or property to
the contributing partner that is part of the same plan or arrangement
as the distribution of the contributed property. For a determination of
basis in a distribution subject to section 737, see Sec. 1.737-3(a).
(2) Partnership's basis in partnership property. The partnership's
adjusted tax basis in the distributed section 704(c) property is
increased or decreased immediately before the distribution by the
amount of gain or loss recognized by the contributing partner under
section 704(c)(1)(B) and this section. Any increase or decrease in
basis is therefore taken into account in determining the distributee
partner's adjusted tax basis in the distributed property under section
732. For a determination of basis in a distribution subject to section
737, see Sec. 1.737-3(b).
(3) Section 754 adjustments. The basis adjustment to partnership
property made pursuant to paragraph (e)(2) of this section is not
elective and must be made regardless of whether the partnership has an
election in effect under section 754. Any adjustments to the bases of
partnership property (including the distributed section 704(c)
property) under section 734(b) pursuant to a section 754 election must
be made after (and must take into account) the adjustments to basis
made under paragraph (e)(2) of this section. See Sec. 1.737-3(c)(4) for
a similar rule in the context of section 737.
(4) Example. The following example illustrates the rules of this
paragraph (e). Unless otherwise specified, partnership income equals
partnership expenses (other than depreciation deductions for
contributed property) for each year of the partnership, the fair market
value of partnership property does not change, all distributions by the
partnership are subject to section 704(c)(1)(B), and all partners are
unrelated.
Example. Basis adjustment. (i) On January 1, 1995, A, B, and C
form partnership ABC as equal partners. A contributes $10,000 cash
and Property A, nondepreciable real property with a fair market
value of $10,000 and an adjusted tax basis of $4,000. B and C each
contribute $20,000 cash.
(ii) On December 31, 1998, Property A is distributed to B in
partial liquidation of B's interest in the partnership.
(iii) Under paragraph (a) of this section, A recognizes $6,000
of gain on the distribution of Property A because that is the amount
of gain that would have been allocated to A under section
704(c)(1)(A) and Sec. 1.704-3 on [[Page 2359]] a sale of Property A
for its fair market value at the time of the distribution (fair
market value of Property A ($10,000) less its adjusted tax basis at
the time of distribution ($4,000)). The adjusted tax basis of A's
partnership interest is increased from $14,000 to $20,000 to reflect
this gain. The partnership's adjusted tax basis in Property A is
increased from $4,000 to $10,000 immediately prior to its
distribution to B. B's adjusted tax basis in Property A is therefore
$10,000 under section 732(a)(1).
(f) Anti-abuse rule--(1) In general. The rules of section
704(c)(1)(B) and this section must be applied in a manner consistent
with the purpose of section 704(c)(1)(B). Accordingly, if a principal
purpose of a transaction is to achieve a tax result that is
inconsistent with the purpose of section 704(c)(1)(B), the Commissioner
can recast the transaction for federal tax purposes as appropriate to
achieve tax results that are consistent with the purpose of section
704(c)(1)(B) and this section. Whether a tax result is inconsistent
with the purpose of section 704(c)(1)(B) and this section must be
determined based on all the facts and circumstances. See Sec. 1.737-4
for an anti-abuse rule and examples in the context of section 737.
(2) Examples. The following examples illustrate the anti-abuse rule
of this paragraph (f). The examples set forth below do not delineate
the boundaries of either permissible or impermissible types of
transactions. Further, the addition of any facts or circumstances that
are not specifically set forth in an example (or the deletion of any
facts or circumstances) may alter the outcome of the transaction
described in the example. Unless otherwise specified, partnership
income equals partnership expenses (other than depreciation deductions
for contributed property) for each year of the partnership, the fair
market value of partnership property does not change, all distributions
by the partnership are subject to section 704(c)(1)(B), and all
partners are unrelated.
Example 1. Distribution in substance made within five-year
period; results inconsistent with the purpose of section
704(c)(1)(B). (i) On January 1, 1995, A, B, and C form partnership
ABC as equal partners. A contributes Property A, nondepreciable real
property with a fair market value of $10,000 and an adjusted tax
basis of $1,000. B and C each contributes $10,000 cash.
(ii) On December 31, 1998, the partners tentatively agree to
distribute Property A to B in complete liquidation of B's interest
in the partnership. If Property A were distributed at that time, A
would recognize $9,000 of gain under section 704(c)(1)(B), the
difference between the $10,000 fair market value and the $1,000
adjusted tax basis of Property A, because Property A was contributed
to the partnership less than five years before December 31, 1998. On
becoming aware of this potential gain recognition, and with a
principal purpose of avoiding such gain, the partners amend the
partnership agreement on December 31, 1998, and take any other steps
necessary to provide that substantially all of the economic risks
and benefits of Property A are allocated to B as of December 31,
1998, and that substantially all of the economic risks and benefits
of all other partnership property are allocated to A and C. The
partnership holds Property A until January 5, 2000, at which time it
is distributed to B in complete liquidation of B's interest in the
partnership.
(iii) The distribution of Property A occurred more than five
years after the contribution of the property to the partnership. The
steps taken by the partnership on December 31, 1998, however, are
the functional equivalent of an actual distribution of Property A to
B in complete liquidation of B's interest in the partnership as of
that date. Section 704(c)(1)(B) requires recognition of gain when
contributed section 704(c) property is in substance distributed to
another partner within five years of its contribution to the
partnership. Allowing a contributing partner to avoid section
704(c)(1)(B) through arrangements such as those in this Example 1
that have the effect of a distribution of property within five years
of the date of its contribution to the partnership would effectively
undermine the purpose of section 704(c)(1)(B) and this section. As a
result, the steps taken by the partnership on December 31, 1998, are
treated as causing a distribution of Property A to B for purposes of
section 704(c)(1)(B) on that date, and A recognizes gain of $9,000
under section 704(c)(1)(B) and this section at that time.
(iv) Alternatively, if on becoming aware of the potential gain
recognition to A on a distribution of Property A on December 31,
1998, the partners had instead agreed that B would continue as a
partner with no changes to the partnership agreement or to B's
economic interest in partnership operations, the distribution of
Property A to B on January 5, 2000, would not have been inconsistent
with the purpose of section 704(c)(1)(B) and this section. In that
situation, Property A would not have been distributed until after
the expiration of the five-year period specified in section
704(c)(1)(B) and this section. Deferring the distribution of
Property A until the end of the five-year period for a principal
purpose of avoiding the recognition of gain under section
704(c)(1)(B) and this section is not inconsistent with the purpose
of section 704(c)(1)(B). Therefore, A would not have recognized gain
on the distribution of Property A in that case.
Example 2. Suspension of five-year period in manner consistent
with the purpose of section 704(c)(1)(B). (i) A, B, and C form
partnership ABC on January 1, 1995, to conduct bona fide business
activities. A contributes Property A, nondepreciable real property
with a fair market value of $10,000 and an adjusted tax basis of
$1,000, in exchange for a 49.5 percent interest in partnership
capital and profits. B contributes $10,000 in cash for a 49.5
percent interest in partnership capital and profits. C contributes
cash for a 1 percent interest in partnership capital and profits. A
and B are wholly owned subsidiaries of the same affiliated group and
continue to control the management of Property A by virtue of their
controlling interests in the partnership. The partnership is formed
pursuant to a plan a principal purpose of which is to minimize the
period of time that A would have to remain a partner with a
potential acquiror of Property A.
(ii) On December 31, 1997, D is admitted as a partner to the
partnership in exchange for $10,000 cash.
(iii) On January 5, 2000, Property A is distributed to D in
complete liquidation of D's interest in the partnership.
(iv) The distribution of Property A to D occurred more than five
years after the contribution of the property to the partnership. On
these facts, however, a principal purpose of the transaction was to
minimize the period of time that A would have to remain partners
with a potential acquiror of Property A, and treating the five-year
period of section 704(c)(1)(B) as running during a time when
Property A was still effectively owned through the partnership by
members of the contributing affiliated group of which A is a member
is inconsistent with the purpose of section 704(c)(1)(B). Prior to
the admission of D as a partner, the pooling of assets between A and
B, on the one hand, and C, on the other hand, although sufficient to
constitute ABC as a valid partnership for federal income tax
purposes, is not a sufficient pooling of assets for purposes of
running the five-year period with respect to the distribution of
Property A to D. Allowing a contributing partner to avoid section
704(c)(1)(B) through arrangements such as those in this Example 2
would have the effect of substantially nullifying the five-year
requirement of section 704(c)(1)(B) and this section and elevating
the form of the transaction over its substance. As a result, with
respect to the distribution of Property A to D, the five-year period
of section 704(c)(1)(B) is tolled until the admission of D as a
partner on December 31, 1997. Therefore, the distribution of
Property A occurred before the end of the five-year period of
section 704(c)(1)(B), and A recognizes gain of $9,000 under section
704(c)(1)(B) on the distribution.
(g) Effective date. This section applies to distributions by a
partnership to a partner on or after January 9, 1995.
Par. 3. Sections 1.737-1, 1.737-2, 1.737-3, 1.737-4, and 1.737-5
are added under the heading ``Distributions by a Partnership'' to read
as follows:
Sec. 1.737-1 Recognition of precontribution gain.
(a) Determination of gain--(1) In general. A partner that receives
a distribution of property (other than money) must recognize gain under
section 737 and this section in an amount equal to the lesser of the
excess distribution (as defined in paragraph (b) of this section) or
the partner's net precontribution gain (as defined in
[[Page 2360]] paragraph (c) of this section). Gain recognized under
section 737 and this section is in addition to any gain recognized
under section 731.
(2) Transactions to which section 737 applies. Section 737 and this
section apply only to a distribution that is properly characterized as
a distribution to a partner acting in the capacity of a partner within
the meaning of section 731. Section 737 does not apply to a transaction
or distribution that is subject to provisions other than sections
731(a) or 737 (for example, a transaction or distribution subject to
sections 707(a), 736(a), or 751(b)).
(b) Excess distribution--(1) Definition. The excess distribution is
the amount (if any) by which the fair market value of the distributed
property (other than money) exceeds the distributee partner's adjusted
tax basis in the partner's partnership interest.
(2) Fair market value of property. The fair market value of the
distributed property is the price at which the property would change
hands between a willing buyer and a willing seller at the time of the
distribution, neither being under any compulsion to buy or sell and
both having reasonable knowledge of the relevant facts. The fair market
value that a partnership assigns to distributed property will be
regarded as correct, provided that the value is reasonably agreed to
among the partners in an arm's-length negotiation and the partners have
sufficiently adverse interests.
(3) Distributee partner's adjusted tax basis--(i) General rule. In
determining the amount of the excess distribution, the distributee
partner's adjusted tax basis in the partnership interest includes any
basis adjustment resulting from the distribution that is subject to
section 737 (for example, adjustments required under section 752) and
from any other distribution or transaction that is part of the same
plan or arrangement, except for--
(A) The increase required under section 737(c)(1) for the gain
recognized by the partner under section 737; and
(B) The decrease required under section 733(2) for any property
distributed to the partner other than property previously contributed
to the partnership by the distributee partner. See Sec. 1.704-4(e)(1)
for a rule in the context of section 704(c)(1)(B). See also Sec. 1.737-
3(b)(2) for a special rule for determining a partner's adjusted tax
basis in distributed property previously contributed by the partner to
the partnership.
(ii) Advances or drawings. The distributee partner's adjusted tax
basis in the partnership interest is determined as of the last day of
the partnership's taxable year if the distribution to which section 737
applies is properly characterized as an advance or drawing against the
partner's distributive share of income. See Sec. 1.731-1(a)(1)(ii).
(c) Net precontribution gain--(1) General rule. The distributee
partner's net precontribution gain is the net gain (if any) that the
partner would have recognized under section 704(c)(1)(B) and
Sec. 1.704-4 if, at the time of the distribution to which section 737
applies, the partnership had actually distributed to another partner
all section 704(c) property contributed to the partnership by the
distributee partner. See Sec. 1.704-4 for provisions determining a
contributing partner's gain or loss under section 704(c)(1)(B) on an
actual distribution of contributed section 704(c) property to another
partner.
(2) Special rules--(i) Property contributed on or before October 3,
1989. Property contributed to the partnership on or before October 3,
1989, is not taken into account in determining a partner's net
precontribution gain. See Sec. 1.704-4(c)(1) for a similar rule in the
context of section 704(c)(1)(B).
(ii) Section 734(b)(1)(A) adjustments. For distributions to a
distributee partner of money by a partnership with a section 754
election in effect that are part of the same plan or arrangement as the
distribution of property subject to section 737, for purposes of
paragraph (a) and (c)(1) of this section the distributee partner's net
precontribution gain is reduced by the basis adjustments (if any) made
to section 704(c) property contributed by the distributee partner under
section 734(b)(1)(A). See Sec. 1.737-3(c)(4) for rules regarding basis
adjustments for partnerships with a section 754 election in effect.
(iii) Transfers of a partnership interest. The transferee of all or
a portion of a contributing partner's partnership interest succeeds to
the transferor's net precontribution gain, if any, in an amount
proportionate to the interest transferred. See Sec. 1.704-3(a)(7) and
Sec. 1.704-4(d)(2) for similar provisions in the context of section
704(c)(1)(A) and section 704(c)(1)(B).
(iv) Section 704(c)(1)(B) gain recognized in related distribution.
A distributee partner's net precontribution gain is determined after
taking into account any gain or loss recognized by the partner under
section 704(c)(1)(B) and Sec. 1.704-4 (or that would have been
recognized by the partner except for the like-kind exception in section
704(c)(2) and Sec. 1.704-4(d)(3)) on an actual distribution to another
partner of section 704(c) property contributed by the distributee
partner that is part of the same plan or arrangement as the
distribution to the distributee partner.
(v) Section 704(c)(2) disregarded. A distributee partner's net
precontribution gain is determined without regard to the provisions of
section 704(c)(2) and Sec. 1.704-4(d)(2) in situations in which the
property contributed by the distributee partner is not actually
distributed to another partner in a distribution related to the section
737 distribution.
(d) Character of gain. The character of the gain recognized by the
distributee partner under section 737 and this section is determined
by, and is proportionate to, the character of the partner's net
precontribution gain. For this purpose, all gains and losses on section
704(c) property taken into account in determining the partner's net
precontribution gain are netted according to their character. Any
character with a net negative amount is disregarded. The character of
the partner's gain under section 737 is the same as, and in proportion
to, any character with a net positive amount. Character for this
purpose is determined as if the section 704(c) property had been sold
by the partnership to an unrelated third party at the time of the
distribution and includes any item that would have been taken into
account separately by the contributing partner under section 702(a) and
Sec. 1.702-1(a).
(e) Examples. The following examples illustrate the provisions of
this section. Unless otherwise specified, partnership income equals
partnership expenses (other than depreciation deductions for
contributed property) for each year of the partnership, the fair market
value of partnership property does not change, all distributions by the
partnership are subject to section 737, and all partners are unrelated.
Example 1. Calculation of excess distribution and net
precontribution gain. (i) On January 1, 1995, A, B, and C form
partnership ABC as equal partners. A contributes Property A,
depreciable real property with a fair market value of $30,000 and an
adjusted tax basis of $20,000. B contributes Property B,
nondepreciable real property with a fair market value and adjusted
tax basis of $30,000. C contributes $30,000 cash.
(ii) Property A has 10 years remaining on its cost recovery
schedule and is depreciated using the straight-line method. The
partnership uses the traditional method for allocating items under
section 704(c) described in Sec. 1.704-3(b)(1) for Property A. The
partnership has book depreciation of $3,000 per year (10 percent of
the $30,000 book basis in Property A) and each partner is allocated
$1,000 of book depreciation per [[Page 2361]] year (one-third of the
total annual book depreciation of $3,000). The partnership also has
tax depreciation of $2,000 per year (10 percent of the $20,000
adjusted tax basis in Property A). This $2,000 tax depreciation is
allocated equally between B and C, the noncontributing partners with
respect to Property A.
(iii) At the end of 1997, the book value of Property A is
$21,000 ($30,000 initial book value less $9,000 aggregate book
depreciation) and its adjusted tax basis is $14,000 ($20,000 initial
tax basis less $6,000 aggregate tax depreciation).
(iv) On December 31, 1997, Property B is distributed to A in
complete liquidation of A's partnership interest. The adjusted tax
basis of A's partnership interest at that time is $20,000. The
amount of the excess distribution is $10,000, the difference between
the fair market value of the distributed Property B ($30,000) and
A's adjusted tax basis in A's partnership interest ($20,000). A's
net precontribution gain is $7,000, the difference between the book
value of Property A ($21,000) and its adjusted tax basis at the time
of the distribution ($14,000). A recognizes gain of $7,000 on the
distribution, the lesser of the excess distribution and the net
precontribution gain.
Example 2. Determination of distributee partner's basis. (i) On
January 1, 1995, A, B, and C form general partnership ABC as equal
partners. A contributes Property A, nondepreciable real property
with a fair market value of $10,000 and an adjusted tax basis of
$4,000. B and C each contribute $10,000 cash.
(ii) The partnership purchases Property B, nondepreciable real
property with a fair market value of $9,000, subject to a $9,000
nonrecourse liability. This nonrecourse liability is allocated
equally among the partners under section 752, increasing A's
adjusted tax basis in A's partnership interest from $4,000 to
$7,000.
(iii) On December 31, 1998, A receives $2,000 cash and Property
B, subject to the $9,000 liability, in partial liquidation of A's
interest in the partnership.
(iv) In determining the amount of the excess distribution, the
adjusted tax basis of A's partnership interest is adjusted to take
into account the distribution of money and the shift in liabilities.
A's adjusted tax basis is therefore increased to $11,000 for this
purpose ($7,000 initial adjusted tax basis, less $2,000 distribution
of money, less $3,000 (decrease in A's share of the $9,000
partnership liability), plus $9,000 (increase in A's individual
liabilities)). As a result of this basis adjustment, the adjusted
tax basis of A's partnership interest ($11,000) is greater than the
fair market value of the distributed property ($9,000) and
therefore, there is no excess distribution. A recognizes no gain
under section 737.
Example 3. Net precontribution gain reduced for gain recognized
under section 704(c)(1)(B). (i) On January 1, 1995, A, B, and C form
partnership ABC as equal partners. A contributes Properties A1 and
A2, nondepreciable real properties each with a fair market value of
$10,000 and an adjusted tax basis of $6,000. B contributes Property
B, nondepreciable real property, with a fair market value and
adjusted tax basis of $20,000. C contributes $20,000 cash.
(ii) On December 31, 1998, Property B is distributed to A in
complete liquidation of A's interest and, as part of the same
distribution, Property A1 is distributed to B in partial liquidation
of B's interest in the partnership.
(iii) A's net precontribution gain before the distribution is
$8,000 ($20,000 fair market value of Properties A1 and A2 less
$12,000 adjusted tax basis of such properties). A recognizes $4,000
of gain under section 704(c)(1)(B) and Sec. 1.704-4 on the
distribution of Property A1 to B ($10,000 fair market value of
Property A1 less $6,000 adjusted tax basis of Property A1). This
gain is taken into account in determining A's excess distribution
and net precontribution gain. As a result, A's net precontribution
gain is reduced from $8,000 to $4,000, and the adjusted tax basis in
A's partnership interest is increased by $4,000 to $16,000.
(iv) A recognizes gain of $4,000 on the receipt of Property B
under section 737, an amount equal to the excess distribution of
$4,000 ($20,000 fair market value of Property B less $16,000
adjusted tax basis of A's interest in the partnership) and A's
remaining net precontribution gain of $4,000.
Example 4. Character of gain. (i) On January 1, 1995, A, B, and
C form partnership ABC as equal partners. A contributes the
following nondepreciable property to the partnership:
------------------------------------------------------------------------
Fair
market Adjusted
value tax basis
------------------------------------------------------------------------
Property A1....................................... $30,000 $20,000
Property A2....................................... 30,000 38,000
Property A3....................................... 10,000 9,000
------------------------------------------------------------------------
(ii) The character of gain or loss on Property A1 and Property
A2 is long-term, U.S.-source capital gain or loss. The character of
gain on Property A3 is long-term, foreign-source capital gain. B
contributes Property B, nondepreciable real property with a fair
market value and adjusted tax basis of $70,000. C contributes
$70,000 cash.
(iii) On December 31, 1998, Property B is distributed to A in
complete liquidation of A's interest in the partnership. A
recognizes $3,000 of gain under section 737, an amount equal to the
excess distribution of $3,000 ($70,000 fair market value of Property
B less $67,000 adjusted tax basis in A's partnership interest) and
A's net precontribution gain of $3,000 ($70,000 aggregate fair
market value of properties contributed by A less $67,000 aggregate
adjusted tax basis of such properties).
(iv) In determining the character of A's gain, all gains and
losses on property taken into account in determining A's net
precontribution gain are netted according to their character and
allocated to A's recognized gain under section 737 based on the
relative proportions of the net positive amounts. U.S.-source and
foreign-source gains must be netted separately because A would have
been required to take such gains into account separately under
section 702. As a result, A's net precontribution gain of $3,000
consists of $2,000 of net long-term, U.S.-source capital gain
($10,000 gain on Property A1 and $8,000 loss on Property A2) and
$1,000 of net long-term, foreign-source capital gain ($1,000 gain on
Property A3).
(v) The character of A's gain under paragraph (d) of this
section is therefore $2,000 long-term, U.S.-source capital gain
($3,000 gain recognized under section 737 x $2,000 net long-term,
U.S.-source capital gain/$3,000 total net precontribution gain) and
$1,000 long-term, foreign-source capital gain ($3,000 gain
recognized under section 737 x $1,000 net long-term, foreign-source
capital gain/$3,000 total net precontribution gain).
Sec. 1.737-2 Exceptions and special rules.
(a) Section 708(b)(1)(B) terminations. Section 737 and this section
do not apply to a deemed distribution of property on a termination of
the partnership under section 708(b)(1)(B). See Sec. 1.704-4(c)(3) for
a similar rule in the context of section 704(c)(1)(B).
(b) Complete transfer to another partnership. Section 737 and this
section do not apply to a transfer by a partnership (transferor
partnership) of all of its assets and liabilities to a second
partnership (transferee partnership) in an exchange described in
section 721, followed by a distribution of the interest in the
transferee partnership in complete liquidation of the transferor
partnership as part of the same plan or arrangement. In addition,
section 737 and this section do not apply to any transaction, such as a
partnership merger under section 708(b)(2)(A), that is treated in a
similar manner. A subsequent distribution of property by the transferee
partnership to the partners of the transferee partnership who were
formerly partners of the transferor partnership is subject to section
737 to the same extent that a distribution from the transferor
partnership would have been subject to section 737.
(c) Incorporation of a partnership. Section 737 and this section do
not apply to an incorporation of a partnership by any method of
incorporation (other than a method involving an actual distribution of
partnership property to the partners followed by a contribution of that
property to a corporation), provided that the partnership is completely
liquidated as part of the same plan or arrangement as the incorporation
transaction.
(d) Distribution of previously contributed property--(1) General
rule. Any portion of the distributed property that consists of property
previously contributed by the distributee partner (including property
treated as contributed by the partner in connection with a termination
of the partnership [[Page 2362]] under section 708(b)(1)(B))
(previously contributed property) is not taken into account in
determining the amount of the excess distribution or the partner's net
precontribution gain. See Sec. 1.737-3(b)(2) for a special rule for
determining the basis of previously contributed property in the hands
of a distributee partner who contributed the property to the
partnership.
(2) Limitation for distribution of previously contributed interest
in an entity. An interest in an entity previously contributed to the
partnership is not treated as previously contributed property to the
extent that the value of the interest is attributable to property
contributed to the entity after the interest was contributed to the
partnership. The preceding sentence does not apply to the extent that
the property contributed to the entity was contributed to the
partnership by the partner that also contributed the interest in the
entity to the partnership.
(3) Nonrecognition transactions. Property received by the
partnership in exchange for contributed section 704(c) property in a
nonrecognition transaction is treated as the contributed property with
regard to the contributing partner for purposes of section 737 to the
extent that the property received is treated as section 704(c) property
under Sec. 1.704-3(a)(8). See Sec. 1.704-4(d)(1) for a similar rule in
the context of section 704(c)(1)(B).
(e) Examples. The following examples illustrate the rules of this
section. Unless otherwise specified, partnership income equals
partnership expenses (other than depreciation deductions for
contributed property) for each year of the partnership, the fair market
value of partnership property does not change, all distributions by the
partnership are subject to section 737, and all partners are unrelated.
Example 1. Distribution of previously contributed property. (i)
On January 1, 1995, A, B, and C form partnership ABC as equal
partners. A contributes the following nondepreciable real property
to the partnership:
------------------------------------------------------------------------
Fair
market Adjusted
value tax basis
------------------------------------------------------------------------
Property A1....................................... $20,000 $10,000
Property A2....................................... 10,000 6,000
------------------------------------------------------------------------
(ii) A's total net precontribution gain on the contributed
property is $14,000 ($10,000 on Property A1 plus $4,000 on Property
A2). B contributes $10,000 cash and Property B, nondepreciable real
property with a fair market value and adjusted tax basis of $20,000.
C contributes $30,000 cash.
(iii) On December 31, 1998, Property A2 and Property B are
distributed to A in complete liquidation of A's interest in the
partnership. Property A2 was previously contributed by A and is
therefore not taken into account in determining the amount of the
excess distribution or A's net precontribution gain. The adjusted
tax basis of Property A2 in the hands of A is also determined under
section 732 as if that property were the only property distributed
to A.
(iv) As a result of excluding Property A2 from these
determinations, the amount of the excess distribution is $10,000
($20,000 fair market value of distributed Property B less $10,000
adjusted tax basis in A's partnership interest). A's net
precontribution gain is also $10,000 ($14,000 total net
precontribution gain less $4,000 gain with respect to previously
contributed Property A2). A therefore recognizes $10,000 of gain on
the distribution, the lesser of the excess distribution and the net
precontribution gain.
Example 2. Distribution of a previously contributed interest in
an entity. (i) On January 1, 1995, A, B, and C form partnership ABC
as equal partners. A contributes Property A, nondepreciable real
property with a fair market value of $10,000 and an adjusted tax
basis of $5,000, and all of the stock of Corporation X with a fair
market value and adjusted tax basis of $500. B contributes $500 cash
and Property B, nondepreciable real property with a fair market
value and adjusted tax basis of $10,000. Partner C contributes
$10,500 cash. On December 31, 1996, ABC contributes Property B to
Corporation X in a nonrecognition transaction under section 351.
(ii) On December 31, 1998, all of the stock of Corporation X is
distributed to A in complete liquidation of A's interest in the
partnership. The stock is treated as previously contributed property
with respect to A only to the extent of the $500 fair market value
of the Corporation X stock contributed by A. The fair market value
of the distributed stock for purposes of determining the amount of
the excess distribution is therefore $10,000 ($10,500 total fair
market value of Corporation X stock less $500 portion treated as
previously contributed property). The $500 fair market value and
adjusted tax basis of the Corporation X stock is also not taken into
account in determining the amount of the excess distribution and the
net precontribution gain.
(iii) A recognizes $5,000 of gain under section 737, the amount
of the excess distribution ($10,000 fair market value of distributed
property less $5,000 adjusted tax basis in A's partnership interest)
and A's net precontribution gain ($10,000 fair market value of
Property A less $5,000 adjusted tax basis in Property A).
Sec. 1.737-3 Basis adjustments; Recovery rules.
(a) Distributee partner's adjusted tax basis in the partnership
interest. The distributee partner's adjusted tax basis in the
partnership interest is increased by the amount of gain recognized by
the distributee partner under section 737 and this section. This
increase is not taken into account in determining the amount of gain
recognized by the partner under section 737(a)(1) and this section or
in determining the amount of gain recognized by the partner under
section 731(a) on the distribution of money in the same distribution or
any related distribution. See Sec. 1.704-4(e)(1) for a determination of
the distributee partner's adjusted tax basis in a distribution subject
to section 704(c)(1)(B).
(b) Distributee partner's adjusted tax basis in distributed
property--(1) In general. The distributee partner's adjusted tax basis
in the distributed property is determined under section 732(a) or (b)
as applicable. The increase in the distributee partner's adjusted tax
basis in the partnership interest under paragraph (a) of this section
is taken into account in determining the distributee partner's adjusted
tax basis in the distributed property other than property previously
contributed by the partner. See Sec. 1.704-4(e)(2) for a determination
of basis in a distribution subject to section 704(c)(1)(B).
(2) Previously contributed property. The distributee partner's
adjusted tax basis in distributed property that the partner previously
contributed to the partnership is determined as if it were distributed
in a separate and independent distribution prior to the distribution
that is subject to section 737 and Sec. 1.737-1.
(c) Partnership's adjusted tax basis in partnership property--(1)
Increase in basis. The partnership's adjusted tax basis in eligible
property is increased by the amount of gain recognized by the
distributee partner under section 737.
(2) Eligible property. Eligible property is property that--
(i) Entered into the calculation of the distributee partner's net
precontribution gain;
(ii) Has an adjusted tax basis to the partnership less than the
property's fair market value at the time of the distribution;
(iii) Would have the same character of gain on a sale by the
partnership to an unrelated party as the character of any of the gain
recognized by the distributee partner under section 737; and
(iv) Was not distributed to another partner in a distribution
subject to section 704(c)(1)(B) and Sec. 1.704-4 that was part of the
same plan or arrangement as the distribution subject to section 737.
(3) Method of adjustment. For the purpose of allocating the basis
increase under paragraph (c)(2) of this section among the eligible
property, all eligible property of the same character is treated as a
single group. Character for this purpose is determined in the same
[[Page 2363]] manner as the character of the recognized gain is
determined under Sec. 1.737-1(d). The basis increase is allocated among
the separate groups of eligible property in proportion to the character
of the gain recognized under section 737. The basis increase is then
allocated among property within each group in the order in which the
property was contributed to the partnership by the partner, starting
with the property contributed first, in an amount equal to the
difference between the property's fair market value and its adjusted
tax basis to the partnership at the time of the distribution. For
property that has the same character and was contributed in the same
(or a related) transaction, the basis increase is allocated based on
the respective amounts of unrealized appreciation in such properties at
the time of the distribution.
(4) Section 754 adjustments. The basis adjustment to partnership
property made pursuant to paragraph (c)(1) of this section is not
elective and must be made regardless of whether the partnership has an
election in effect under section 754. Any adjustments to the bases of
partnership property (including eligible property as defined in
paragraph (c)(2) of this section) under section 734(b) pursuant to a
section 754 election (other than basis adjustments under section
734(b)(1)(A) described in the following sentence) must be made after
(and must take into account) the adjustments to basis made under
paragraph (a) and paragraph (c)(1) of this section. Basis adjustments
under section 734(b)(1)(A) that are attributable to distributions of
money to the distributee partner that are part of the same plan or
arrangement as the distribution of property subject to section 737 are
made before the adjustments to basis under paragraph (a) and paragraph
(c)(1) of this section. See Sec. 1.737-1(c)(2)(ii) for the effect, if
any, of basis adjustments under section 734(b)(1)(A) on a partner's net
precontribution gain. See also Sec. 1.704-4(e)(3) for a similar rule
regarding basis adjustments pursuant to a section 754 election in the
context of section 704(c)(1)(B).
(d) Recovery of increase to adjusted tax basis. Any increase to the
adjusted tax basis of partnership property under paragraph (c)(1) of
this section is recovered using any applicable recovery period and
depreciation (or other cost recovery) method (including first-year
conventions) available to the partnership for newly purchased property
(of the type adjusted) placed in service at the time of the
distribution.
(e) Examples. The following examples illustrate the rules of this
section. Unless otherwise specified, partnership income equals
partnership expenses (other than depreciation deductions for
contributed property) for each year of the partnership, the fair market
value of partnership property does not change, all distributions by the
partnership are subject to section 737, and all partners are unrelated.
Example 1. Partner's basis in distributed property. (i) On
January 1, 1995, A, B, and C form partnership ABC as equal partners.
A contributes Property A, nondepreciable real property with a fair
market value of $10,000 and an adjusted tax basis of $5,000. B
contributes Property B, nondepreciable real property with a fair
market value and adjusted tax basis of $10,000. C contributes
$10,000 cash.
(ii) On December 31, 1998, Property B is distributed to A in
complete liquidation of A's interest in the partnership. A
recognizes $5,000 of gain under section 737, an amount equal to the
excess distribution of $5,000 ($10,000 fair market value of Property
B less $5,000 adjusted tax basis in A's partnership interest) and
A's net precontribution gain of $5,000 ($10,000 fair market value of
Property A less $5,000 adjusted tax basis of such property).
(iii) A's adjusted tax basis in A's partnership interest is
increased by the $5,000 of gain recognized under section 737. This
increase is taken into account in determining A's basis in the
distributed property. Therefore, A's adjusted tax basis in
distributed Property B is $10,000 under section 732(b).
Example 2. Partner's basis in distributed property in connection
with gain recognized under section 704(c)(1)(B). (i) On January 1,
1995, A, B, and C form partnership ABC as equal partners. A
contributes the following nondepreciable real property to the
partnership:
------------------------------------------------------------------------
Fair
market Adjusted
value tax basis
------------------------------------------------------------------------
Property A1....................................... $10,000 $5,000
Property A2....................................... 10,000 2,000
------------------------------------------------------------------------
(ii) B contributes $10,000 cash and Property B, nondepreciable
real property, with a fair market value and adjusted tax basis of
$10,000. C contributes $20,000 cash.
(iii) On December 31, 1998, Property B is distributed to A in
partial liquidation of A's interest in the partnership and Property
A1 is distributed to B in partial liquidation of B's interest in the
partnership. A recognizes $5,000 of gain under section 704(c)(1)(B)
and Sec. 1.704-4 on the distribution of Property A1 to B, the
difference between the fair market value of such property ($10,000)
and the adjusted tax basis in distributed Property A1 ($5,000). The
adjusted tax basis of A's partnership interest is increased by this
$5,000 of gain under section 704(c)(1)(B) and Sec. 1.704-4(e)(1) .
(iv) The increase in the adjusted tax basis of A's partnership
interest is taken into account in determining the amount of the
excess distribution. As a result, there is no excess distribution
because the fair market value of Property B ($10,000) is less than
the adjusted tax basis of A's interest in the partnership at the
time of distribution ($12,000). A therefore recognizes no gain under
section 737 on the receipt of Property B. A's adjusted tax basis in
Property B is $10,000 under section 732(a)(1). The adjusted tax
basis of A's partnership interest is reduced from $12,000 to $2,000
under section 733. See Example 3 of Sec. 1.737-1(e).
Example 3. Partnership's basis in partnership property after a
distribution with section 737 gain. (i) On January 31, 1995, A, B,
and C form partnership ABC as equal partners. A contributes the
following nondepreciable property to the partnership:
------------------------------------------------------------------------
Fair
market Adjusted
value tax basis
------------------------------------------------------------------------
Property A1....................................... $1,000 $500
Property A2....................................... 4,000 1,500
Property A3....................................... 4,000 6,000
Property A4....................................... 6,000 4,000
------------------------------------------------------------------------
(ii) The character of gain or loss on Properties A1, A2, and A3
is long-term, U.S.-source capital gain or loss. The character of
gain on Property A4 is long-term, foreign-source capital gain. B
contributes Property B, nondepreciable real property with a fair
market value and adjusted tax basis of $15,000. C contributes
$15,000 cash.
(iii) On December 31, 1998, Property B is distributed to A in
complete liquidation of A's interest in the partnership. A
recognizes gain of $3,000 under section 737, an amount equal to the
excess distribution of $3,000 ($15,000 fair market value of Property
B less $12,000 adjusted tax basis in A's partnership interest) and
A's net precontribution gain of $3,000 ($15,000 aggregate fair
market value of the property contributed by A less $12,000 aggregate
adjusted tax basis of such property).
(iv) $2,000 of A's gain is long-term, foreign-source capital
gain ($3,000 total gain under section 737 x $2,000 net long-term,
foreign-source capital gain/$3,000 total net precontribution gain).
$1,000 of A's gain is long-term, U.S.-source capital gain ($3,000
total gain under section 737 x $1,000 net long-term, U.S.-source
capital gain/$3,000 total net precontribution gain).
(v) The partnership must increase the adjusted tax basis of the
property contributed by A by $3,000. All property contributed by A
is eligible property. Properties A1, A2, and A3 have the same
character and are grouped into a single group for purposes of
allocating this basis increase. Property A4 is in a separate
character group.
(vi) $2,000 of the basis increase must be allocated to long-
term, foreign-source capital assets because $2,000 of the gain
recognized by A was long-term, foreign-source capital gain. The
adjusted tax basis of Property A4 is therefore increased from $4,000
to $6,000. $1,000 of the increase must be allocated to Properties A1
and A2 because $1,000 of the gain recognized by A is long-term,
U.S.-source capital gain. No basis increase is allocated to Property
A3 because its fair market value is less than its adjusted tax
basis. The $1,000 basis increase is allocated between Properties A1
and A2 based on the [[Page 2364]] unrealized appreciation in each
asset before such basis adjustment. As a result, the adjusted tax
basis of Property A1 is increased by $167 ($1,000 x $500/$3,000) and
the adjusted tax basis of Property A2 is increased by $833
($1,000 x $2,500/3,000).
Sec. 1.737-4 Anti-abuse rule.
(a) In general. The rules of section 737 and Secs. 1.737-1, 1.737-
2, and 1.737-3 must be applied in a manner consistent with the purpose
of section 737. Accordingly, if a principal purpose of a transaction is
to achieve a tax result that is inconsistent with the purpose of
section 737, the Commissioner can recast the transaction for federal
tax purposes as appropriate to achieve tax results that are consistent
with the purpose of section 737. Whether a tax result is inconsistent
with the purpose of section 737 must be determined based on all the
facts and circumstances. See Sec. 1.704-4(f) for an anti-abuse rule and
examples in the context of section 704(c)(1)(B). The anti-abuse rule
and examples under section 704(c)(1)(B) and Sec. 1.704-4(f) are
relevant to section 737 and Secs. 1.737-1, 1.737-2, and 1.737-3 to the
extent that the net precontribution gain for purposes of section 737 is
determined by reference to section 704(c)(1)(B).
(b) Examples. The following examples illustrate the rules of this
section. The examples set forth below do not delineate the boundaries
of either permissible or impermissible types of transactions. Further,
the addition of any facts or circumstances that are not specifically
set forth in an example (or the deletion of any facts or circumstances)
may alter the outcome of the transaction described in the example.
Unless otherwise specified, partnership income equals partnership
expenses (other than depreciation deductions for contributed property)
for each year of the partnership, the fair market value of partnership
property does not change, all distributions by the partnership are
subject to section 737, and all partners are unrelated.
Example 1. Increase in distributee partner's basis by temporary
contribution; results inconsistent with the purpose of section 737.
(i) On January 1, 1995, A, B, and C form partnership ABC as equal
partners. A contributes Property A1, nondepreciable real property
with a fair market value of $10,000 and an adjusted tax basis of
$1,000. B contributes Property B, nondepreciable real property with
a fair market value of $10,000 and an adjusted tax basis of $10,000.
C contributes $10,000 cash.
(ii) On January 1, 1999, pursuant to a plan a principal purpose
of which is to avoid gain under section 737, A contributes to the
partnership Property A2, nondepreciable real property with a fair
market value and adjusted tax basis of $9,000. A, therefore,
increased the adjusted tax basis of A's partnership interest from
$1,000 to $10,000. The partnership agreement is amended and all
other necessary steps are taken so that substantially all of the
economic risks and benefits of Property A2 are retained by A. On
February 1, 1999, Property B is distributed to A in partial
liquidation of A's interest in the partnership. If the contribution
of Property A2 is taken into account for purposes of section 737,
there is no excess distribution because the fair market value of
distributed Property B ($10,000) does not exceed the adjusted tax
basis of A's interest in the partnership ($10,000), and therefore
section 737 does not apply. A's adjusted tax basis in distributed
Property B is $10,000 under section 732(a)(1) and the adjusted tax
basis of A's partnership interest is reduced to zero under section
733.
(iii) On March 1, 2000, A receives Property A2 from the
partnership in complete liquidation of A's interest in the
partnership. A recognizes no gain on the distribution of Property A2
because the property was previously contributed property. See
Sec. 1.737-2(d).
(iv) Although the contribution of Property A2 increases the
adjusted tax basis of A's interest in the partnership (assuming it
was a valid contribution to the partnership under section 721), it
would be inconsistent with the purpose of section 737 to recognize
the contribution of Property A2 to the partnership as in substance a
bona fide contribution of an asset used in the conduct of joint
business activity. Section 737 requires recognition of gain when the
value of distributed property exceeds the distributee partner's
adjusted tax basis in the partnership interest. Section 737 assumes
that any contribution or other transaction that affects a partner's
adjusted tax basis in the partnership interest is not a transitory
contribution or transaction engaged in with a principal purpose of
avoiding recognition of gain under section 737. Because the
contribution of Property A2 was a transitory contribution made with
a principal purpose of avoiding recognition of gain under section
737, the Commissioner can disregard the contribution of Property A2
for this purpose. As a result, A recognizes gain of $9,000 under
section 737 on the receipt of Property B, an amount equal to the
lesser of the excess distribution of $9,000 ($10,000 fair market
value of distributed Property B less the $1,000 adjusted tax basis
of A's partnership interest, determined without regard to the
transitory contribution of Property A2) or A's net precontribution
gain of $9,000 on Property A1.
Example 2. Increase in distributee partner's basis; section 752
liability shift; results consistent with the purpose of section 737.
(i) On January 1, 1995, A and B form general partnership AB as equal
partners. A contributes Property A, nondepreciable real property
with a fair market value of $10,000 and an adjusted tax basis of
$1,000. B contributes Property B, nondepreciable real property with
a fair market value and adjusted tax basis of $10,000. The
partnership also borrows $10,000 on a recourse basis and purchases
Property C. The $10,000 liability is allocated equally between A and
B under section 752, thereby increasing the adjusted tax basis in
A's partnership interest to $6,000.
(ii) On December 31, 1998, the partners agree that A is to
receive Property B in partial liquidation of A's interest in the
partnership. If A were to receive Property B at that time, A would
recognize $4,000 of gain under section 737, an amount equal to the
lesser of the excess distribution of $4,000 ($10,000 fair market
value of Property B less $6,000 adjusted tax basis in A's
partnership interest) or A's net precontribution gain of $9,000
($10,000 fair market value of Property A less $1,000 adjusted tax
basis of Property A).
(iii) With a principal purpose of avoiding such gain, A and B
agree that A will be solely liable for the repayment of the $10,000
partnership liability and take the steps necessary so that the
entire amount of the liability is allocated to A under section 752.
The adjusted tax basis in A's partnership interest is thereby
increased from $6,000 to $11,000 to reflect A's share of the $5,000
of liability previously allocated to B. As a result of this increase
in A's adjusted tax basis, there is no excess distribution because
the fair market value of distributed Property B ($10,000) is less
than the adjusted tax basis of A's partnership interest. Recognizing
A's increased adjusted tax basis as a result of the shift in
liabilities is consistent with the purpose of section 737 and this
section. Section 737 requires recognition of gain only when the
value of the distributed property exceeds the distributee partner's
adjusted tax basis in the partnership interest. The $10,000 recourse
liability is a bona fide liability of the partnership and A's and
B's agreement that A will assume responsibility for repayment of
that debt has substance. Therefore, the increase in A's adjusted tax
basis in A's interest in the partnership due to the shift in
partnership liabilities under section 752 is respected, and A
recognizes no gain under section 737.
Sec. 1.737-5 Effective date.
Sections 1.737-1, 1.737-2, 1.737-3, and 1.737-4 apply to
distributions by a partnership to a partner on or after January 9,
1995.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
[FR Doc. 95-171 Filed 1-6-95; 8:45 am]
BILLING CODE 4830-01-U