[Federal Register Volume 60, Number 232 (Monday, December 4, 1995)]
[Rules and Regulations]
[Pages 62026-62032]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-29282]



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DEPARTMENT OF THE TREASURY
26 CFR Part 1

[TD 8629]
RIN 1545-AL57


Certain Publicly Traded Partnerships Treated as Corporations

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the 
classification of certain publicly traded partnerships as corporations. 
These regulations provide guidance needed by taxpayers to comply with 
changes to the law made by the Omnibus Budget Reconciliation Act of 
1987. The regulations affect the classification of certain partnerships 
for federal tax purposes.

DATES: These regulations are effective December 4, 1995.
    For dates of applicability of these regulations, see Sec. 1.7704-
1(l).

FOR FURTHER INFORMATION CONTACT: Christopher T. Kelley, (202) 622-3080 
(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Introduction

    This document adds Sec. 1.7704-1 to the Income Tax Regulations (26 
CFR part 1) relating to the definition of a publicly traded partnership 
under section 7704(b) of the Internal Revenue Code (Code).

Background

    Section 7704 was added to the Code by section 10211(a) of the 
Omnibus Budget Reconciliation Act of 1987 (Public Law 100-203), as 
amended by sections 2004(f)(1)-(5) of the Technical and Miscellaneous 
Revenue Act of 1988 (Public Law 100-647). Section 7704(a) provides that 
a publicly traded partnership is treated as a corporation for federal 
tax purposes unless the partnership meets the 90 percent qualifying 
income test of section 7704(c) or qualifies as an existing partnership. 
The term existing partnership is defined in Sec. 1.7704-2. Under 
section 7704(b), a partnership is a publicly traded partnership if 
interests in the partnership are traded on an established securities 
market or are readily tradable on a secondary market or the substantial 
equivalent thereof. Section 7704 applies to all domestic and foreign 
entities treated as partnerships under section 7701, including limited 
liability companies and other entities treated as partnerships for 
federal tax purposes.
    Notice 88-75 (1988-2 C.B. 386) was issued to provide interim 
guidance on the definition of a publicly traded partnership under 
section 7704(b). Notice 88-75 provides that interests in a partnership 
are not treated as readily tradable on a secondary market or the 
substantial equivalent thereof for purposes of section 7704(b)(2) if 
the interests are: (1) Issued in certain private placements; (2) 
transferred pursuant to transfers not involving trading; (3) traded in 
amounts that meet the requirements of a 5-percent or 2-percent safe 
harbor; (4) transferred through a matching service that meets certain 
requirements; or (5) transferred pursuant to a qualifying redemption or 
repurchase agreement. Notice 88-75 does not address when partnership 
interests are treated as traded on an established securities market for 
purposes of section 7704(b)(1).
    On May 2, 1995, the IRS published in the Federal Register a notice 
of proposed rulemaking (60 FR 21475) to provide guidance regarding 
section 7704(b). A number of public comments were received concerning 
the proposed regulations, and a public hearing was held on July 31, 
1995. After consideration of the comments received, the proposed 
regulations are adopted as revised by this Treasury decision.

Summary of Significant Comments and Revisions

    The significant comments on the proposed regulations and the 
revisions made in the final regulations are discussed below.

Public Trading

    Several commentators requested clarification of the definition of 
an established securities market, a secondary market, and the 
substantial equivalent of a secondary market. The definitions in the 
proposed regulations, however, are drawn directly from the legislative 
history to section 7704(b) and incorporate the most important elements 
of public trading within the meaning of section 7704(b). As a result, 
the final regulations generally adopt the definitions in the proposed 
regulations.
    The final regulations contain two changes to the definition of a 
secondary market and the substantial equivalent thereof. The final 
regulations clarify that the determination of whether interests in a 
partnership are readily tradable on 

[[Page 62027]]
a secondary market or the substantial equivalent thereof is based on 
all the facts and circumstances. In addition, the final regulations 
eliminate the separate definitions of a secondary market and the 
substantial equivalent thereof. This distinction is relevant in the 
proposed regulations because several of the safe harbors apply only to 
the substantial equivalent of a secondary market. As discussed below, 
this distinction is eliminated in the safe harbors. As a result, the 
separate definitions of a secondary market and the substantial 
equivalent thereof are no longer necessary, and they are combined into 
one definition in the final regulations.
    The proposed regulations provide that the transfer of an interest 
in a partnership is taken into account for purposes of section 7704(b) 
only if the partnership recognizes the transfer of the interest or the 
interest is redeemed by the partnership. The preamble to the proposed 
regulations explains that this provision is intended to prevent a 
partnership from becoming publicly traded without the knowledge or 
participation of the partnership. Several commentators requested a 
clarification of this provision because the definition of a secondary 
market requires only that the interests be readily tradable, thereby 
creating some concern that the partnership could be publicly traded 
even if there were no actual transfer of an interest in the 
partnership.
    The final regulations address this concern by providing more 
explicitly that interests in a partnership will not be treated as 
readily tradable on a secondary market or the substantial equivalent 
thereof unless (i) the partnership participates in the establishment of 
the market or the inclusion of its interests thereon, or (ii) the 
partnership recognizes transfers made on that market. This rule also 
applies to an established securities market that consists of an 
interdealer quotation system that regularly disseminates firm buy or 
sell quotations. These modifications will prevent a partnership from 
being publicly traded without the participation or consent of the 
partnership. This rule is not extended to established securities 
markets that consist of the exchanges described in the regulation 
because these exchanges list interests in the partnership only with the 
knowledge and participation of the partnership. In addition, the final 
regulations provide that transfers not recognized by the partnership 
are treated as private transfers and therefore do not count for 
purposes of the two-percent and 10-percent limitations in the safe 
harbors described below.

Safe Harbors

    Several commentators requested clarification that, as in Notice 88-
75, the failure of a partnership to satisfy the safe harbors does not 
establish or give rise to a presumption that the partnership was 
publicly traded. In response, the final regulations clarify that the 
fact that a partnership does not qualify for a safe harbor or that a 
transfer of an interest in the partnership is not within a safe harbor 
is disregarded in determining whether interests in the partnership are 
readily tradable on a secondary market or the substantial equivalent 
thereof. Thus, these transfers are examined under the general facts and 
circumstances test in the regulations.

Private Transfers

    Several commentators requested that the definition of a block 
transfer be expanded to include transfers by a partner or any person 
related to the partner within the meaning of section 267(b) or section 
707(b)(1). The commentators noted that interests in a partnership are 
often held by related persons and that, while the related group as a 
whole may hold more than a two-percent interest in the partnership, no 
individual partner in the group might hold more than a two-percent 
interest. This comment is adopted in the final regulations.
    One commentator also suggested that the exception for transfers at 
death be clarified to include transfers from an estate or a 
testamentary trust. This comment is adopted in the final regulations.
    Another commentator suggested that the exception for transfers by 
one or more partners of interests representing more than 50 percent of 
the total interests be expanded to include transfers of less than 50 
percent. This comment is not adopted in the final regulations. The 
exception is provided to allow acquisition of control of a partnership 
without raising a concern that the transfers pursuant to the 
acquisition would result in the partnership being publicly traded. The 
exception is, however, amended by reducing the required amount to 50 
percent or more of the interests in partnership capital and profits to 
coordinate the exception with section 708(b)(1)(B) terminations.

Redemption and Repurchase Agreements

    Several commentators suggested that redemptions by an investment 
partnership for the net asset value of the redeemed interest should not 
be treated as a transfer for purposes of section 7704(b) because these 
transfers do not involve a third party broker or a commission or mark-
up. This comment is not adopted in the final regulations. The 
redemption of a partnership interest combined with the issuance of an 
interest to a new partner can result in the creation of a secondary 
market or the substantial equivalent thereof within the meaning of 
section 7704(b), even if no third party or commission is present.

Qualified Matching Service

    The proposed regulations provide that, to qualify as a matching 
service, the selling partner cannot enter into a binding agreement to 
sell an interest until the 15th calendar day after the date information 
regarding the offering is made available to potential buyers and the 
closing cannot occur until the 30th calendar day after the date the 
selling partner can enter into a binding agreement. One commentator 
suggested a reduction in these fixed time periods. This comment is not 
adopted in the final regulations. The time periods are necessary to 
ensure that the matching service does not rise to the level of a 
secondary market or the substantial equivalent thereof.
    Several commentators raised various concerns about the provisions 
in the proposed regulations requiring subscribers to make certain 
representations and the provisions preventing the operator of the 
matching service from quoting certain prices and buying or selling 
interests for itself or on behalf of others. These provisions are 
deleted in the final regulations because the requirements for a 
matching service already provide that the service cannot list quotes 
that commit any person to buy or sell an interest. This modification, 
however, does not affect the general rule that a secondary market may 
exist if anyone, including the operator of a matching service, quotes 
prices at which it stands ready to buy or sell partnership interests.

Private Placements

    The proposed regulations generally provide that interests in a 
partnership are not readily tradable on the substantial equivalent of a 
secondary market if (i) all interests in the partnership were issued in 
a transaction not required to be registered under the Securities Act of 
1933; (ii) the partnership does not have more than 500 partners or the 
initial offering price of each unit was at least $20,000; and (iii) if 
the partnership has more than 50 partners, no more than 10 percent of 
the total interests in capital or profits are transferred during the 
year. Several 

[[Page 62028]]
commentators suggested expanding this safe harbor to apply to the 
determination of a secondary market. Other commentators suggested 
eliminating the 10-percent limitation. Several commentators suggested 
increasing the 50-partner limit, such as to 100, and modifying the rule 
for counting the number of partners that looked through partners that 
were partnerships, grantor trusts, or S corporations. In response to 
these comments, the final regulations modify the private placement 
exception in the following respects.
    First, the safe harbor is expanded to apply to a secondary market 
as well as the substantial equivalent of a secondary market. As a 
result, interests in a partnership that qualifies for the private 
placement safe harbor will not be readily tradable on a secondary 
market or the substantial equivalent thereof.
    Second, the final regulations provide that the safe harbor does not 
apply to partnerships subject to Regulation S (17 CFR 230.901 et seq.), 
unless the offering and sale of interests in the partnership would not 
have been required to be registered if offered and sold within the 
United States. Regulation S, adopted after the issuance of Notice 88-
75, provides an exception from registration for any offerings and sales 
outside of the United States, even if registration would have been 
required if the interests were offered and sold within the United 
States. This modification ensures that the private placement exception 
applies in a similar manner to offerings within and outside of the 
United States.
    Third, the 10-percent limitation is not adopted in the final 
regulations. Instead, the final regulations provide that the safe 
harbor applies only if the partnership has no more than 100 partners at 
any time during the taxable year of the partnership.
    Finally, the final regulations provide a new rule for determining 
the number of partners in a partnership. Under the proposed 
regulations, each person owning an interest in a partnership (lower-
tier partnership) through another partnership, an S corporation, or a 
grantor trust (flow-through entity) is treated as a partner in the 
lower-tier partnership. The final regulations provide that an owner of 
a flow-through entity is treated as a partner in the lower-tier 
partnership only if (i) substantially all of the value of the flow-
through entity is attributable to the lower-tier partnership interest, 
and (ii) a principal purpose for the tiered arrangement is to permit 
the partnership to satisfy the 100-partner requirement.
    The requirement that substantially all of the value of the flow-
through entity be attributable to the lower-tier partnership is 
intended to limit the look-through rule to flow-through entities that 
are economically equivalent to an interest in the lower-tier 
partnership. For example, if the only asset held by a flow-through 
entity is an interest in a lower-tier partnership, an interest in the 
flow-through entity is economically equivalent to an interest in the 
lower-tier partnership and the members of the flow-through entity 
should be counted as partners in the partnership. The requirement that 
there be a principal purpose to avoid the 100 partner rule recognizes 
that looking through a flow-through entity is not appropriate in all 
cases, even if the flow-through entity owns no interest other than an 
interest in the lower-tier partnership, but should be limited to 
situations in which a principal purpose of the flow-through entity is 
to avoid the 100 partner limitation.

Lack of Actual Trading

    The proposed regulations provide that interests in a partnership 
are not readily tradable on the substantial equivalent of a secondary 
market if the sum of the percentage interests transferred during the 
taxable year does not exceed two percent. Several commentators 
suggested expanding this safe harbor to secondary markets so that 
partnerships could be assured that some level of trading would not 
result in public trading. This comment is adopted in the final 
regulations.

Qualifying Income

    Several commentators requested guidance on the definition of 
qualifying income and financial business for purposes of the qualifying 
income exception of section 7704. These regulations are intended to 
address only the definition of public trading and therefore do not 
provide guidance on the definition of qualifying income. The IRS and 
Treasury, however, are actively considering guidance on the definition 
of qualifying income and financial businesses for investment 
partnerships and other partnerships engaged in various types of 
securities transactions. The IRS and Treasury invite comments on the 
scope and form of such guidance.

Transitional Relief

    The proposed regulations provide that they will be effective for 
taxable years of a partnership beginning on or after the date final 
regulations are published. The preamble to the proposed regulations 
requests comments on whether transitional relief is necessary for 
partnerships that qualified for an exclusion under Notice 88-75. Many 
commentators suggested some form of transitional relief, ranging from 
180 days to a permanent grandfather provision.
    The final regulations provide that, for partnerships that were 
actively engaged in an activity before December 4, 1995, the 
regulations apply for taxable years beginning after December 31, 2005. 
This ten-year grandfather provision is similar to the grandfather rule 
provided on the enactment of section 7704. The final regulations 
provide that this transitional relief expires if the partnership adds a 
substantial new line of business within the meaning of Sec. 1.7704-2. 
The transitional relief is not affected by a termination of the 
partnership under section 708(b)(1)(B). Finally, partnerships subject 
to transitional relief may continue to rely on Notice 88-75 for 
guidance.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in EO 12866. Therefore, a 
regulatory assessment is not required. It also has been determined that 
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) 
and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to 
these regulations and, therefore, a Regulatory Flexibility Analysis is 
not required. Pursuant to section 7805(f) of the Internal Revenue Code, 
the notice of proposed rulemaking preceding these regulations was 
submitted to the Small Business Administration for comment on its 
impact on small business.

    Drafting Information. The principal author of these regulations 
is Christopher T. Kelley, Office of Chief Counsel (Passthroughs and 
Special Industries). However, other personnel from the IRS and 
Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 2. Section 1.7704-1 is added to read as follows: 

[[Page 62029]]



Sec. 1.7704-1  Publicly traded partnerships.

    (a) In general--(1) Publicly traded partnership. A domestic or 
foreign partnership is a publicly traded partnership for purposes of 
section 7704(b) and this section if--
    (i) Interests in the partnership are traded on an established 
securities market; or
    (ii) Interests in the partnership are readily tradable on a 
secondary market or the substantial equivalent thereof.
    (2) Partnership interest--(i) In general. For purposes of section 
7704(b) and this section, an interest in a partnership includes--
    (A) Any interest in the capital or profits of the partnership 
(including the right to partnership distributions); and
    (B) Any financial instrument or contract the value of which is 
determined in whole or in part by reference to the partnership 
(including the amount of partnership distributions, the value of 
partnership assets, or the results of partnership operations).
    (ii) Exception for non-convertible debt. For purposes of section 
7704(b) and this section, an interest in a partnership does not include 
any financial instrument or contract that--
    (A) Is treated as debt for federal tax purposes; and
    (B) Is not convertible into or exchangeable for an interest in the 
capital or profits of the partnership and does not provide for a 
payment of equivalent value.
    (iii) Exception for tiered entities. For purposes of section 
7704(b) and this section, an interest in a partnership or a corporation 
(including a regulated investment company as defined in section 851 or 
a real estate investment trust as defined in section 856) that holds an 
interest in a partnership (lower-tier partnership) is not considered an 
interest in the lower-tier partnership.
    (3) Definition of transfer. For purposes of section 7704(b) and 
this section, a transfer of an interest in a partnership means a 
transfer in any form, including a redemption by the partnership or the 
entering into of a financial instrument or contract described in 
paragraph (a)(2)(i)(B) of this section.
    (b) Established securities market. For purposes of section 7704(b) 
and this section, an established securities market includes--
    (1) A national securities exchange registered under section 6 of 
the Securities Exchange Act of 1934 (15 U.S.C. 78f);
    (2) A national securities exchange exempt from registration under 
section 6 of the Securities Exchange Act of 1934 (15 U.S.C. 78f) 
because of the limited volume of transactions;
    (3) A foreign securities exchange that, under the law of the 
jurisdiction where it is organized, satisfies regulatory requirements 
that are analogous to the regulatory requirements under the Securities 
Exchange Act of 1934 described in paragraph (b) (1) or (2) of this 
section (such as the London International Financial Futures Exchange; 
the Marche a Terme International de France; the International Stock 
Exchange of the United Kingdom and the Republic of Ireland, Limited; 
the Frankfurt Stock Exchange; and the Tokyo Stock Exchange);
    (4) A regional or local exchange; and
    (5) An interdealer quotation system that regularly disseminates 
firm buy or sell quotations by identified brokers or dealers by 
electronic means or otherwise.
    (c) Readily tradable on a secondary market or the substantial 
equivalent thereof--(1) In general. For purposes of section 7704(b) and 
this section, interests in a partnership that are not traded on an 
established securities market (within the meaning of section 7704(b) 
and paragraph (b) of this section) are readily tradable on a secondary 
market or the substantial equivalent thereof if, taking into account 
all of the facts and circumstances, the partners are readily able to 
buy, sell, or exchange their partnership interests in a manner that is 
comparable, economically, to trading on an established securities 
market.
    (2) Secondary market or the substantial equivalent thereof. For 
purposes of paragraph (c)(1) of this section, interests in a 
partnership are readily tradable on a secondary market or the 
substantial equivalent thereof if--
    (i) Interests in the partnership are regularly quoted by any 
person, such as a broker or dealer, making a market in the interests;
    (ii) Any person regularly makes available to the public (including 
customers or subscribers) bid or offer quotes with respect to interests 
in the partnership and stands ready to effect buy or sell transactions 
at the quoted prices for itself or on behalf of others;
    (iii) The holder of an interest in the partnership has a readily 
available, regular, and ongoing opportunity to sell or exchange the 
interest through a public means of obtaining or providing information 
of offers to buy, sell, or exchange interests in the partnership; or
    (iv) Prospective buyers and sellers otherwise have the opportunity 
to buy, sell, or exchange interests in the partnership in a time frame 
and with the regularity and continuity that is comparable to that 
described in the other provisions of this paragraph (c)(2).
    (3) Secondary market safe harbors. The fact that a transfer of a 
partnership interest is not within one or more of the safe harbors 
described in paragraph (e), (f), (g), (h), or (j) of this section is 
disregarded in determining whether interests in the partnership are 
readily tradable on a secondary market or the substantial equivalent 
thereof.
    (d) Involvement of the partnership required. For purposes of 
section 7704(b) and this section, interests in a partnership are not 
traded on an established securities market within the meaning of 
paragraph (b)(5) of this section and are not readily tradable on a 
secondary market or the substantial equivalent thereof within the 
meaning of paragraph (c) of this section (even if interests in the 
partnership are traded or readily tradable in a manner described in 
paragraph (b)(5) or (c) of this section) unless--
    (1) The partnership participates in the establishment of the market 
or the inclusion of its interests thereon; or
    (2) The partnership recognizes any transfers made on the market 
by--
    (i) Redeeming the transferor partner (in the case of a redemption 
or repurchase by the partnership); or
    (ii) Admitting the transferee as a partner or otherwise recognizing 
any rights of the transferee, such as a right of the transferee to 
receive partnership distributions (directly or indirectly) or to 
acquire an interest in the capital or profits of the partnership.
    (e) Transfers not involving trading--(1) In general. For purposes 
of section 7704(b) and this section, the following transfers (private 
transfers) are disregarded in determining whether interests in a 
partnership are readily tradable on a secondary market or the 
substantial equivalent thereof--
    (i) Transfers in which the basis of the partnership interest in the 
hands of the transferee is determined, in whole or in part, by 
reference to its basis in the hands of the transferor or is determined 
under section 732;
    (ii) Transfers at death, including transfers from an estate or 
testamentary trust;
    (iii) Transfers between members of a family (as defined in section 
267(c)(4));
    (iv) Transfers involving the issuance of interests by (or on behalf 
of) the partnership in exchange for cash, property, or services;
    (v) Transfers involving distributions from a retirement plan 
qualified under section 401(a) or an individual retirement account;

[[Page 62030]]

    (vi) Block transfers (as defined in paragraph (e)(2) of this 
section);
    (vii) Transfers pursuant to a right under a redemption or 
repurchase agreement (as defined in paragraph (e)(3) of this section) 
that is exercisable only--
    (A) Upon the death, disability, or mental incompetence of the 
partner; or
    (B) Upon the retirement or termination of the performance of 
services of an individual who actively participated in the management 
of, or performed services on a full-time basis for, the partnership;
    (viii) Transfers pursuant to a closed end redemption plan (as 
defined in paragraph (e)(4) of this section);
    (ix) Transfers by one or more partners of interests representing in 
the aggregate 50 percent or more of the total interests in partnership 
capital and profits in one transaction or a series of related 
transactions; and
    (x) Transfers not recognized by the partnership (within the meaning 
of paragraph (d)(2) of this section).
    (2) Block transfers. For purposes of paragraph (e)(1)(vi) of this 
section, a block transfer means the transfer by a partner and any 
related persons (within the meaning of section 267(b) or 707(b)(1)) in 
one or more transactions during any 30 calendar day period of 
partnership interests representing in the aggregate more than 2 percent 
of the total interests in partnership capital or profits.
    (3) Redemption or repurchase agreement. For purposes of section 
7704(b) and this section, a redemption or repurchase agreement means a 
plan of redemption or repurchase maintained by a partnership whereby 
the partners may tender their partnership interests for purchase by the 
partnership, another partner, or a person related to another partner 
(within the meaning of section 267(b) or 707(b)(1)).
    (4) Closed end redemption plan. For purposes of paragraph 
(e)(1)(viii) of this section, a redemption or repurchase agreement (as 
defined in paragraph (e)(3) of this section) is a closed end redemption 
plan only if--
    (i) The partnership does not issue any interest after the initial 
offering (other than the issuance of additional interests prior to 
August 5, 1988); and
    (ii) No partner or person related to any partner (within the 
meaning of section 267(b) or 707(b)(1)) provides contemporaneous 
opportunities to acquire interests in similar or related partnerships 
which represent substantially identical investments.
    (f) Redemption and repurchase agreements. For purposes of section 
7704(b) and this section, the transfer of an interest in a partnership 
pursuant to a redemption or repurchase agreement (as defined in 
paragraph (e)(3) of this section) that is not described in paragraph 
(e)(1) (vii) or (viii) of this section is disregarded in determining 
whether interests in the partnership are readily tradable on a 
secondary market or the substantial equivalent thereof only if--
    (1) The redemption or repurchase agreement provides that the 
redemption or repurchase cannot occur until at least 60 calendar days 
after the partner notifies the partnership in writing of the partner's 
intention to exercise the redemption or repurchase right;
    (2) Either--
    (i) The redemption or repurchase agreement requires that the 
redemption or repurchase price not be established until at least 60 
calendar days after receipt of such notification by the partnership or 
the partner; or
    (ii) The redemption or repurchase price is established not more 
than four times during the partnership's taxable year; and
    (3) The sum of the percentage interests in partnership capital or 
profits transferred during the taxable year of the partnership (other 
than in private transfers described in paragraph (e) of this section) 
does not exceed 10 percent of the total interests in partnership 
capital or profits.
    (g) Qualified matching services--(1) In general. For purposes of 
section 7704(b) and this section, the transfer of an interest in a 
partnership through a qualified matching service is disregarded in 
determining whether interests in the partnership are readily tradable 
on a secondary market or the substantial equivalent thereof.
    (2) Requirements. A matching service is a qualified matching 
service only if--
    (i) The matching service consists of a computerized or printed 
listing system that lists customers' bid and/or ask quotes in order to 
match partners who want to sell their interests in a partnership (the 
selling partner) with persons who want to buy those interests;
    (ii) Matching occurs either by matching the list of interested 
buyers with the list of interested sellers or through a bid and ask 
process that allows interested buyers to bid on the listed interest;
    (iii) The selling partner cannot enter into a binding agreement to 
sell the interest until the 15th calendar day after the date 
information regarding the offering of the interest for sale is made 
available to potential buyers and such time period is evidenced by 
contemporaneous records ordinarily maintained by the operator at a 
central location;
    (iv) The closing of the sale effected by virtue of the matching 
service does not occur prior to the 45th calendar day after the date 
information regarding the offering of the interest for sale is made 
available to potential buyers and such time period is evidenced by 
contemporaneous records ordinarily maintained by the operator at a 
central location;
    (v) The matching service displays only quotes that do not commit 
any person to buy or sell a partnership interest at the quoted price 
(nonfirm price quotes) or quotes that express interest in a partnership 
interest without an accompanying price (nonbinding indications of 
interest) and does not display quotes at which any person is committed 
to buy or sell a partnership interest at the quoted price (firm 
quotes);
    (vi) The selling partner's information is removed from the matching 
service within 120 calendar days after the date information regarding 
the offering of the interest for sale is made available to potential 
buyers and, following any removal (other than removal by reason of a 
sale of any part of such interest) of the selling partner's information 
from the matching service, no offer to sell an interest in the 
partnership is entered into the matching service by the selling partner 
for at least 60 calendar days; and
    (vii) The sum of the percentage interests in partnership capital or 
profits transferred during the taxable year of the partnership (other 
than in private transfers described in paragraph (e) of this section) 
does not exceed 10 percent of the total interests in partnership 
capital or profits.
    (3) Closing. For purposes of paragraph (g)(2)(iv) of this section, 
the closing of a sale occurs no later than the earlier of--
    (i) The passage of title to the partnership interest;
    (ii) The payment of the purchase price (which does not include the 
delivery of funds to the operator of the matching service or other 
closing agent to hold on behalf of the seller pending closing); or
    (iii) The date, if any, that the operator of the matching service 
(or any person related to the operator within the meaning of section 
267(b) or 707(b)(1)) loans, advances, or otherwise arranges for funds 
to be available to the seller in anticipation of the payment of the 
purchase price.
    (4) Optional features. A qualified matching service may be 
sponsored or operated by a partner of the partnership (either formally 
or informally), the underwriter that handled the issuance 

[[Page 62031]]
of the partnership interests, or an unrelated third party. In addition, 
a qualified matching service may offer the following features--
    (i) The matching service may provide prior pricing information, 
including information regarding resales of interests and actual prices 
paid for interests; a description of the business of the partnership; 
financial and reporting information from the partnership's financial 
statements and reports; and information regarding material events 
involving the partnership, including special distributions, capital 
distributions, and refinancings or sales of significant portions of 
partnership assets;
    (ii) The operator may assist with the transfer documentation 
necessary to transfer the partnership interest;
    (iii) The operator may receive and deliver funds for completed 
transactions; and
    (iv) The operator's fee may consist of a flat fee for use of the 
service, a fee or commission based on completed transactions, or any 
combination thereof.
    (h) Private placements--(1) In general. For purposes of section 
7704(b) and this section, except as otherwise provided in paragraph 
(h)(2) of this section, interests in a partnership are not readily 
tradable on a secondary market or the substantial equivalent thereof 
if--
    (i) All interests in the partnership were issued in a transaction 
(or transactions) that was not required to be registered under the 
Securities Act of 1933 (15 U.S.C. 77a et seq.); and
    (ii) The partnership does not have more than 100 partners at any 
time during the taxable year of the partnership.
    (2) Exception for certain offerings outside of the United States. 
Paragraph (h)(1) of this section does not apply to the offering and 
sale of interests in a partnership that was not required to be 
registered under the Securities Act of 1933 by reason of Regulation S 
(17 CFR 230.901 through 230.904) unless the offering and sale of the 
interests would not have been required to be registered under the 
Securities Act of 1933 if the interests had been offered and sold 
within the United States.
    (3) Anti-avoidance rule. For purposes of determining the number of 
partners in the partnership under paragraph (h)(1)(ii) of this section, 
a person (beneficial owner) owning an interest in a partnership, 
grantor trust, or S corporation (flow-through entity), that owns, 
directly or through other flow-through entities, an interest in the 
partnership, is treated as a partner in the partnership only if--
    (i) Substantially all of the value of the beneficial owner's 
interest in the flow-through entity is attributable to the flow-through 
entity's interest (direct or indirect) in the partnership; and
    (ii) A principal purpose of the use of the tiered arrangement is to 
permit the partnership to satisfy the 100-partner limitation in 
paragraph (h)(1)(ii) of this section.
    (i) [Reserved].
    (j) Lack of actual trading--(1) General rule. For purposes of 
section 7704(b) and this section, interests in a partnership are not 
readily tradable on a secondary market or the substantial equivalent 
thereof if the sum of the percentage interests in partnership capital 
or profits transferred during the taxable year of the partnership 
(other than in transfers described in paragraph (e), (f), or (g) of 
this section) does not exceed 2 percent of the total interests in 
partnership capital or profits.
    (2) Examples. The following examples illustrate the rules of this 
paragraph (j):

    Example 1. Calculation of percentage interest transferred. (i) 
ABC, a calendar year limited partnership formed in 1996, has 9,000 
units of limited partnership interests outstanding at all times 
during 1997, representing in the aggregate 95 percent of the total 
interests in capital and profits of ABC. The remaining 5 percent is 
held by the general partner.
    (ii) During 1997, the following transactions occur with respect 
to the units of ABC's limited partnership interests--
    (A) 800 units are sold through the use of a qualified matching 
service that meets the requirements of paragraph (g) of this 
section;
    (B) 50 units are sold through the use of a matching service that 
does not meet the requirements of paragraph (g) of this section; and
    (C) 500 units are transferred as a result of private transfers 
described in paragraph (e) of this section.
    (iii) The private transfers of 500 units and the sale of 800 
units through a qualified matching service are disregarded under 
paragraph (j)(1) of this section for purposes of applying the 2 
percent rule. As a result, the total percentage interests in 
partnership capital and profits transferred for purposes of the 2 
percent rule is .528 percent, determined by--
    (A) Dividing the number of units sold through a matching service 
that did not meet the requirements of paragraph (g) of this section 
(50) by the total number of outstanding limited partnership units 
(9,000); and
    (B) Multiplying the result by the percentage of total interests 
represented by limited partnership units (95 percent)
([50/9,000] x .95=.528 percent).
    Example 2. Application of the 2 percent rule. (i) ABC operates a 
service consisting of computerized video display screens on which 
subscribers view and publish nonfirm price quotes that do not commit 
any person to buy or sell a partnership interest and unpriced 
indications of interest in a partnership interest without an 
accompanying price. The ABC service does not provide firm quotes at 
which any person (including the operator of the service) is 
committed to buy or sell a partnership interest. The service may 
provide prior pricing information, including information regarding 
resales of interests and actual prices paid for interests; 
transactional volume information; and information on special or 
capital distributions by a partnership. The operator's fee may 
consist of a flat fee for use of the service; a fee based on 
completed transactions, including, for example, the number of 
nonfirm quotes or unpriced indications of interest entered by users 
of the service; or any combination thereof.
    (ii) The ABC service is not an established securities market for 
purposes of section 7704(b) and this section. The service is not an 
interdealer quotation system as defined in paragraph (b)(5) of this 
section because it does not disseminate firm buy or sell quotations. 
Therefore, partnerships whose interests are listed and transferred 
on the ABC service are not publicly traded for purposes of section 
7704(b) and this section as a result of such listing or transfers if 
the sum of the percentage interests in partnership capital or 
profits transferred during the taxable year of the partnership 
(other than in transfers described in paragraph (e), (f), or (g) of 
this section) does not exceed 2 percent of the total interests in 
partnership capital or profits. In addition, assuming the ABC 
service complies with the necessary requirements, the service may 
qualify as a matching service described in paragraph (g) of this 
section.

    (k) Percentage interests in partnership capital or profits--(1) 
Interests considered--(i) General rule. Except as otherwise provided in 
this paragraph (k), for purposes of this section, the total interests 
in partnership capital or profits are determined by reference to all 
outstanding interests in the partnership.
    (ii) Exceptions--(A) General partner with greater than 10 percent 
interest. If the general partners and any person related to the general 
partners (within the meaning of section 267(b) or 707(b)(1)) own, in 
the aggregate, more than 10 percent of the outstanding interests in 
partnership capital or profits at any one time during the taxable year 
of the partnership, the total interests in partnership capital or 
profits are determined without reference to the interests owned by such 
persons.
    (B) Derivative interests. Any partnership interests described in 
paragraph (a)(2)(i)(B) of this section are taken into account for 
purposes of determining the total interests in partnership capital or 
profits only if and to the extent that the partnership satisfies 
paragraph (d) (1) or (2) of this section.
    (2) Monthly determination. For purposes of this section, except in 
the 

[[Page 62032]]
case of block transfers (as defined in paragraph (e)(2) of this 
section), the percentage interests in partnership capital or profits 
represented by partnership interests that are transferred during a 
taxable year of the partnership is equal to the sum of the percentage 
interests transferred for each calendar month during the taxable year 
of the partnership in which a transfer of a partnership interest occurs 
(other than a private transfer as described in paragraph (e) of this 
section). The percentage interests in capital or profits of interests 
transferred during a calendar month is determined by reference to the 
partnership interests outstanding during that month.
    (3) Monthly conventions. For purposes of paragraph (k)(2) of this 
section, a partnership may use any reasonable convention in determining 
the interests outstanding for a month, provided the convention is 
consistently used by the partnership from month to month during a 
taxable year and from year to year. Reasonable conventions include, but 
are not limited to, a determination by reference to the interests 
outstanding at the beginning of the month, on the 15th day of the 
month, or at the end of the month.
    (4) Block transfers. For purposes of paragraph (e)(2) of this 
section (defining block transfers), the partnership must determine the 
percentage interests in capital or profits for each transfer of an 
interest during the 30 calendar day period by reference to the 
partnership interests outstanding immediately prior to such transfer.
    (5) Example. The following example illustrates the rules of this 
paragraph (k):

    Example. Conventions. (i) ABC limited partnership, a calendar 
year partnership formed in 1996, has 1,000 units of limited 
partnership interests outstanding on January 1, 1997, representing 
in the aggregate 95 percent of the total interests in capital and 
profits of ABC. The remaining 5 percent is held by the general 
partner.
    (ii) The following transfers take place during 1997--
    (A) On January 15, 10 units of limited partnership interests are 
sold in a transaction that is not a private transfer;
    (B) On July 10, 1,000 additional units of limited partnership 
interests are issued by the partnership (the general partner's 
percentage interest is unchanged); and
    (C) On July 20, 15 units of limited partnership interests are 
sold in a transaction that is not a private transfer.
    (iii) For purposes of determining the sum of the percentage 
interests in partnership capital or profits transferred, ABC chooses 
to use the end of the month convention. The percentage interests in 
partnership capital and profits transferred during January is .95 
percent, determined by dividing the number of transferred units (10) 
by the total number of limited partnership units (1,000) and 
multiplying the result by the percentage of total interests 
represented by limited partnership units ([10/1,000] x .95). The 
percentage interests in partnership capital and profits transferred 
during July is .7125 percent ([15/2,000] x .95). ABC is not required 
to make determinations for the other months during the year because 
no transfers of partnership interests occurred during such months. 
ABC may qualify for the 2 percent rule for its 1997 taxable year 
because less than 2 percent (.95 percent+.7125 percent=1.6625 
percent) of its total interests in partnership capital and profits 
was transferred during that year.
    (iv) If ABC had chosen to use the beginning of the month 
convention, the interests in capital or profits sold during July 
would have been 1.425 percent ([15/1,000] x .95) and ABC would not 
have satisfied the 2 percent rule for its 1997 taxable year because 
2.375 percent (.95 + 1.425) of ABC's interests in partnership 
capital and profits was transferred during that year.

    (l) Effective date--(1) In general. Except as provided in paragraph 
(l)(2) of this section, this section applies to taxable years of a 
partnership beginning after December 31, 1995.
    (2) Transition period. For partnerships that were actively engaged 
in an activity before December 4, 1995, this section applies to taxable 
years beginning after December 31, 2005, unless the partnership adds a 
substantial new line of business after December 4, 1995, in which case 
this section applies to taxable years beginning on or after the 
addition of the new line of business. Partnerships that qualify for 
this transition period may continue to rely on the provisions of Notice 
88-75 (1988-2 C.B. 386) (see Sec. 601.601(d)(2) of this chapter) for 
guidance regarding the definition of readily tradable on a secondary 
market or the substantial equivalent thereof for purposes of section 
7704(b).
    (3) Substantial new line of business. For purposes of paragraph 
(1)(2) of this section--
    (i) Substantial is defined in Sec. 1.7704-2(c); and
    (ii) A new line of business is defined in Sec. 1.7704-2(d), except 
that the applicable date is ``December 4, 1995'' instead of ``December 
17, 1987''.
    (4) Termination under section 708(b)(1)(B). The termination of a 
partnership under section 708(b)(1)(B) due to the sale or exchange of 
50 percent or more of the total interests in partnership capital and 
profits is disregarded in determining whether a partnership qualifies 
for the transition period provided in paragraph (l)(2) of this section.
Margaret Milner Richardson,
Commissioner of Internal Revenue.

    Approved: November 21, 1995.
Leslie Samuels,
Assistant Secretary of the Treasury.
[FR Doc. 95-29282 Filed 11-29-95; 3:02 pm]
BILLING CODE 4830-01-U