[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