[Federal Register Volume 61, Number 1 (Tuesday, January 2, 1996)]
[Proposed Rules]
[Pages 28-33]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-31457]



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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[PS-2-95]
RIN 1545-AT19


Distribution of Marketable Securities by a Partnership

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 
treatment of a distribution of marketable securities by a partnership 
under section 731(c) of the Internal Revenue Code of 1986, as amended 
(Code). These proposed regulations provide taxpayers with guidance 
needed to comply with certain changes made by the Uruguay Round 
Agreements Act of 1994 (Pub. L. No. 103-465). This document also 
provides notice of a public hearing on these proposed regulations.

DATES: Written comments and requests to speak (with outlines of oral 
comments) at a public hearing scheduled for 10 a.m. on Wednesday, April 
3, 1996 must be received by Wednesday, March 13, 1996.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (PS-2-95), 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 a.m. and 5 p.m. to: CC:DOM:CORP:R (PS-2-95), Courier's 
Desk, Internal Revenue Service, 1111 Constitution Avenue NW., 
Washington, DC. The public hearing will be held in the IRS Auditorium.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Terri A. 
Belanger or William M. Kostak, (202) 622-3080; concerning submissions 
and the hearing, Christina Vasquez, (202) 622-7190 (not toll-free 
numbers).

SUPPLEMENTARY INFORMATION:

Introduction

    This document proposes to add Sec. 1.731-2 to the Income Tax 
Regulations (26 CFR part 1) under section 731(c) of the Code. Section 
731(c) was amended by section 741(a) of the Uruguay Round Agreements 
Act of 1994 (Public Law 103-465).

Background

    Section 731(a)(1) of the Code provides that a partner must 
recognize gain on a distribution from a partnership to the extent that 
any money distributed exceeds the adjusted basis of the partner's 
interest in the partnership immediately before the distribution. 
Section 737 provides that a partner must recognize gain on a 
distribution of property other than money in an amount equal to the 
lesser of (i) the partner's net precontribution gain or (ii) the excess 
of the fair market value of the distributed property over the partner's 
basis in the partnership interest.
    Section 731(c) provides that the term money includes marketable 
securities for purposes of section 731(a)(1) and section 737. As 
discussed in the legislative history accompanying section 731(c), 
treating marketable securities as money for this purpose is appropriate 
because marketable securities are economically equivalent to money. 
Section 731(c) affects only the tax consequences to the distributee 
partner; section 731(c) does not require the partnership or any partner 
other than the distributee partner to recognize gain on a distribution 
of marketable securities.

Explanation of Provisions

Marketable Securities Treated as Money

    Distributions of marketable securities are treated as distributions 
of money under section 731(c) only for purposes of sections 731(a)(1) 
and 737. For example, a distribution of marketable securities is not 
treated as a distribution of money to the extent it is subject to 
section 707 or section 751(b) because the distribution is not subject 
to section 731(a)(1) or section 737. In addition, marketable securities 
are not treated as money for purposes of section 731(a)(2), so that a 
partner does not recognize a loss on a distribution of marketable 
securities. Finally, marketable securities contributed by a partner are 
treated as property other than money for purposes of determining the 
partner's net precontribution gain under section 737(b).

Reduction of Amount Treated as Money

    Under section 731(c)(3)(B), the amount of marketable securities 
that is treated as money is reduced by the excess of (i) the partner's 
share of the net gain of the partnership's securities of the same class 
and issuer as the distributed securities immediately before the 
distribution over (ii) the partner's share of such net gain immediately 
after the distribution. This provision allows a partner to withdraw the 
partner's share of appreciation in the partnership's marketable 
securities without recognizing gain on the distribution. As a result, 
section 731(c) generally applies only when a partner receives a 
distribution of marketable securities in exchange for the partner's 
share of appreciated assets other than marketable securities.
    Under the authority of section 731(c)(3)(B), the proposed 
regulations provide that all marketable securities held by a 
partnership are treated as marketable securities of the same class and 
issuer as the distributed securities. Treating all marketable 
securities as a single asset for this purpose is consistent with the 
basic rationale of section 731(c) that marketable securities are the 
economic equivalent of money. As a result, the amount of the 
distribution that is not treated as money will depend on the partner's 
share of the net appreciation in all partnership securities, not on the 
partner's share of the appreciation in the type of securities 
distributed.

Definition of Marketable Securities

    In general, the term marketable securities includes any financial 
instruments--such as stocks, options, and derivatives--that are 
actively traded within the meaning of section 1092(d)(1). In addition, 
section 731(c)(2)(B)(v) provides that an interest in an entity is a 
marketable security if substantially all of the assets of the entity 
consist of marketable securities or money. The proposed regulations 
provide that substantially all of the assets of an entity consist of 
marketable securities or money only if 90 percent or more of the assets 
of the entity at the time of the distribution consist of such assets.
    Section 731(c)(2)(B)(vi) provides that, to the extent provided in 
regulations, an interest in an entity not described in section 
731(c)(2)(B)(v) is a marketable security to the extent that the value 
of such interest is attributable to marketable securities or money. The 
proposed regulations provide that an interest in an entity is a 
marketable security to the extent that the value of the interest is 
attributable to marketable securities or money that constitute less 
than 90 percent but 20 percent or more of the assets of the entity. The 
20 percent threshold means that an interest in an entity holding only a 
small 

[[Page 29]]
amount of marketable securities will not be treated as a marketable 
security.
    The proposed regulations also provide that a marketable security 
will continue to be treated as a marketable security, even if the 
partnership or its partners are restricted by agreement or otherwise 
from selling or exchanging the security. This provision is intended to 
prevent a partnership from avoiding section 731(c) by temporarily 
restricting the transferability of the distributed security.

Exceptions

    Consistent with the provisions of section 731(c)(3)(A), the 
proposed regulations provide three exceptions to section 731(c). First, 
the proposed regulations provide that if the marketable security was 
contributed to the partnership by the distributee partner, section 
731(c) does not apply to the distribution of that security.
    Second, the proposed regulations provide that section 731(c) does 
not apply to the distribution of a marketable security to the extent 
that the security was acquired by the partnership in a nonrecognition 
transaction in exchange for property other than marketable securities 
or cash and (i) the security is actively traded as of the date of 
distribution and (ii) the security is distributed by the partnership 
within five years of either the date the security was acquired by the 
partnership or, if later, the date the security became actively traded. 
For example, if a partnership contributed substantially all of its 
assets to a corporation in a transaction described in section 351 and 
the stock of the corporation became marketable, the distribution of the 
stock by the partnership within five years would not be subject to 
section 731(c). This exception recognizes that the marketable security 
in these situations is simply a substitute for the underlying assets 
exchanged in the nonrecognition transaction.
    The proposed regulations also provide that section 731(c) does not 
apply to the distribution of a marketable security if (i) the security 
was not actively traded on the date acquired by the partnership and the 
entity to which the security relates had no outstanding actively traded 
securities at the time the security was acquired by the partnership; 
(ii) the security is actively traded as of the date of distribution; 
and (iii) the security was held by the partnership for at least six 
months before it became actively traded and the security was 
distributed by the partnership within five years of the date on which 
the security became actively traded.
    In addition, the proposed regulations provide a successor security 
rule that applies to these exceptions. This rule provides that the 
exceptions continue to apply to a security acquired in a nonrecognition 
transaction in exchange for a security that was already subject to an 
exception.

Investment Partnerships

    Section 731(c) does not apply to the distribution of marketable 
securities by an investment partnership to an eligible partner. An 
investment partnership is defined as a partnership that has never been 
engaged in a trade or business and substantially all of the assets of 
which consist of the investment assets described in section 
731(c)(3)(C)(i). The proposed regulations provide that a partner can 
qualify as an eligible partner even if the partner contributed services 
to the partnership. In addition, the proposed regulations provide that 
a partnership will not be treated as engaged in a trade or business if 
the partnership provides reasonable and customary management services 
to a lower-tier investment partnership. This exception allows an upper-
tier investment partnership to manage the investments and other 
activities of a lower-tier investment partnership without disqualifying 
the upper-tier partnership as an investment partnership. The exception 
does not extend to management services provided to lower-tier 
partnerships other than investment partnerships because, as discussed 
below, the tiering rules of section 731(c)(3)(C)(iv) treat the upper-
tier management partnership as engaged in the trade or business of the 
lower-tier partnership, thereby preventing the upper-tier partnership 
from qualifying as an investment partnership.
    The proposed regulations also provide that a partnership will not 
be treated as engaged in a trade or business if the partnership 
provides reasonable and customary services in assisting the formation, 
capitalization, expansion, or offering of interests in an entity in 
which the partnership holds a significant equity interest, provided 
that the anticipated receipt of compensation for the services does not 
represent a significant purpose for the partnership's investment in the 
entity and is incidental to the investment in the entity.
    Section 731(c)(3)(C)(iv) provides that, except as otherwise 
provided in regulations, a partnership is treated as engaged in any 
trade or business engaged in by (and as holding the assets of) any 
partnership in which the partnership holds an interest. The proposed 
regulations provide that this look-through rule does not apply if the 
upper-tier partnership does not participate in the management of the 
lower-tier partnership and the interest held by the upper-tier 
partnership is less than 10 percent of the total profits and capital 
interests in the lower-tier partnership.

Coordination With Other Sections

    The proposed regulations provide rules for coordinating section 
731(c) with section 704(c)(1)(B) and section 737. This coordination is 
necessary because a distribution of marketable securities could occur 
as part of a larger distribution in which property contributed by the 
distributee partner is distributed to another partner (section 
704(c)(1)(B)) or the distributee partner receives property in addition 
to marketable securities (section 737).
    Under the proposed regulations, the basis increase in the partner's 
interest in the partnership as a result of any gain recognized by the 
partner under section 704(c)(1)(B) is taken into account in determining 
the distributee partner's gain under section 731(c) and the partner's 
basis in the distributed securities. Taking the stepped-up basis into 
account for purposes of section 731 reflects the fact that the general 
effect of section 704(c)(1)(B) is to treat the contributing partner as 
having contributed property with a full fair market value basis at the 
time of contribution. The proposed regulations, however, provide that 
the basis increase in the partner's interest as a result of any gain 
recognized by the partner under section 737 is not taken into account 
for these purposes. The proposed regulations are consistent with 
section 737, which generally treats a distribution of money as 
occurring before, and independent of, a distribution of other property.

Anti-Abuse Rule

    The proposed regulations provide that the provisions of section 
731(c) and this section must be applied in a manner that is consistent 
with the purpose of section 731(c) and the substance of the 
transaction.

Proposed Effective Date

    This section is proposed to apply to distributions of marketable 
securities by a partnership to a partner on or after December 29, 1995.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in EO 12866. Therefore, 
a regulatory 

[[Page 30]]
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, 
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 Wednesday, April 3, 1996 at 
10:00 a.m. in the Auditorium of the Internal Revenue Building, 1111 
Constitution Avenue NW., Washington, DC. 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 Wednesday, March 13, 1996 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 Wednesday, March 
13, 1996.
    A period of 10 minutes will be allotted to 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

    The principal authors of these regulations are Terri A. Belanger 
and William M. Kostak, Office of Assistant Chief Counsel (Passthroughs 
and Special Industries), IRS. 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.

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 
an entry in numerical order to read as follows:

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

    Section 1.731-2 also issued under 26 U.S.C. 731(c).* * *
    Par. 2. Section 1.731-2 is added to read as follows:


Sec. 1.731-2  Partnership distributions of marketable securities.

    (a) Marketable securities treated as money. Except as otherwise 
provided in section 731(c) and this section, for purposes of section 
731(a)(1) and 737, the term money includes marketable securities and 
such securities are taken into account at their fair market value as of 
the date of the distribution.
    (b) Reduction of amount treated as money--(1) Aggregation of 
securities. For purposes of section 731(c)(3)(B) and this paragraph 
(b), all marketable securities held by a partnership are treated as 
marketable securities of the same class and issuer as the distributed 
security.
    (2) Amount of reduction. The amount of the distribution of 
marketable securities that is treated as a distribution of money under 
section 731(c) and paragraph (a) of this section is reduced (but not 
below zero) by the excess, if any, of--
    (i) The distributee partner's distributive share of the net gain, 
if any, which would be recognized if all the marketable securities held 
by the partnership were sold (immediately before the transaction to 
which the distribution relates) by the partnership for fair market 
value; over
    (ii) The distributee partner's distributive share of the net gain, 
if any, which is attributable to the marketable securities held by the 
partnership immediately after the transaction, determined by using the 
same fair market value as used under paragraph (b)(2)(i) of this 
section.
    (3) Distributee partner's share of net gain. For purposes of 
section 731(c)(3)(B) and paragraph (b)(2) of this section, a partner's 
distributive share of net gain is determined--
    (i) By taking into account any basis adjustments under section 
743(b) with respect to that partner; and
    (ii) Without taking into account any special allocations adopted 
with a principal purpose of avoiding the effect of section 731(c) and 
this section.
    (c) Marketable securities--(1) Actively traded. For purposes of 
section 731(c) and this section, a financial instrument is actively 
traded (and thus is a marketable security) if it is of a type that is, 
as of the date of distribution, actively traded within the meaning of 
section 1092(d)(1). Thus, for example, if XYZ common stock is listed on 
a national securities exchange, particular shares of XYZ common stock 
that are distributed by a partnership are marketable securities even if 
those particular shares cannot be resold by the distributee partner for 
a designated period of time.
    (2) Interests in an entity--(i) Substantially all. For purposes of 
section 731(c)(2)(B)(v) and this section, substantially all of the 
assets of an entity consist (directly or indirectly) of marketable 
securities, money, or both only if 90 percent or more of the assets of 
the entity (by value) at the time of the distribution of an interest in 
the entity consist (directly or indirectly) of marketable securities, 
money, or both.
    (ii) Less than substantially all. For purposes of section 
731(c)(2)(B)(vi) and this section, an interest in an entity is a 
marketable security to the extent that the value of the interest is 
attributable (directly or indirectly) to marketable securities, money, 
or both, if less than 90 percent but 20 percent or more of the assets 
of the entity (by value) at the time of the distribution of an interest 
in the entity consist (directly or indirectly) of marketable 
securities, money, or both.
    (d) Exceptions--(1) Previously contributed property. Section 731(c) 
and this section do not apply to the distribution of a marketable 
security if the security was contributed to the partnership by the 
distributee partner, except to the extent that the value of the 
distributed security is attributable to marketable securities or money 
contributed (directly or indirectly) by the partnership to the entity 
to which the distributed security relates.
    (2) Security acquired in nonrecognition transaction. Section 731(c) 
and this section do not apply to the distribution of a marketable 
security to the extent that--
    (i) The security was acquired by the partnership in a 
nonrecognition transaction in exchange for any property except money or 
marketable securities (including a security that would have been 
treated as a marketable security under paragraph (c)(2) of this section 
if distributed at the time of the exchange);
    (ii) The distributed security is actively traded as of the date of 
distribution; and
    (iii) The security is distributed within five years of either the 
date on which the security was acquired by the partnership or, if 
later, the date on 

[[Page 31]]
which the security became actively traded.
    (3) Security not marketable when acquired. Section 731(c) and this 
section do not apply to the distribution of a marketable security if--
    (i) The security was not actively traded as of the date acquired by 
the partnership and the entity to which the security relates had no 
outstanding actively traded securities on that date;
    (ii) The security is actively traded as of the date of 
distribution; and
    (iii) The security was held by the partnership for at least six 
months before the date the security became actively traded and the 
security was distributed within five years of the date on which the 
security became actively traded.
    (4) Successor security. Section 731(c) and this section do not 
apply to the distribution of a marketable security to the extent that 
the security was acquired by the partnership in a nonrecognition 
transaction in exchange for a security the distribution of which 
immediately prior to the exchange would have been excepted under this 
paragraph (d).
    (e) Investment partnerships--(1) In general. Section 731(c) and 
this section do not apply to the distribution of marketable securities 
by an investment partnership (as defined in section 731(c)(3)(C)(i)) to 
an eligible partner (as defined in section 731(c)(3)(C)(iii)).
    (2) Eligible partner. For purposes of section 731(c)(3)(C)(iii) and 
this section, a partner is not treated as a partner other than an 
eligible partner solely because the partner contributed services to the 
partnership.
    (3) Trade or business activities. For purposes of section 
731(c)(3)(C) and this section, a partnership is not treated as engaged 
in a trade or business by reason of--
    (i) Any activity undertaken as an investor, trader, or dealer in 
any asset described in section 731(c)(3)(C)(i), including the receipt 
of commitment fees, break-up fees, guarantee fees, director's fees, or 
similar fees that are customary in and incidental to any activities of 
the partnership as an investor, trader, or dealer in such assets;
    (ii) Reasonable and customary management services (including the 
receipt of reasonable and customary fees in exchange for such 
management services) provided to an investment partnership (within the 
meaning of section 731(c)(3)(C)(i)) in which the partnership holds a 
partnership interest; or
    (iii) Reasonable and customary services provided by the partnership 
in assisting the formation, capitalization, expansion, or offering of 
interests in a corporation (or other entity) in which the partnership 
holds or acquires a significant equity interest (including the 
provision of advice or consulting services, bridge loans, guarantees of 
obligations, or service on a company's board of directors), provided 
that the anticipated receipt of compensation for the services, if any, 
does not represent a significant purpose for the partnership's 
investment in the entity and is incidental to the investment in the 
entity.
    (4) Partnership tiers. For purposes of section 731(c)(3)(C)(iv) and 
this section, a partnership (upper-tier partnership) is not treated as 
engaged in a trade or business engaged in by, or as holding (instead of 
a partnership interest) a proportionate share of the assets of, a 
partnership (lower-tier partnership) in which the partnership holds a 
partnership interest if--
    (i) The upper-tier partnership does not participate in the 
management of the lower-tier partnership; and
    (ii) The interest held by the upper-tier partnership is less than 
10 percent of the total profits and capital interests in the lower-tier 
partnership.
    (f) Basis rules--(1) Partner's basis--(i) Partner's basis in 
distributed securities. The distributee partner's basis in distributed 
marketable securities with respect to which gain is recognized by 
reason of section 731(c) and this section is the basis of the security 
determined under section 732, increased by the amount of such gain. Any 
increase in the basis of the marketable securities attributable to gain 
recognized by reason of section 731(c) and this section is allocated to 
marketable securities in proportion to their respective amounts of 
unrealized appreciation in the hands of the partner before such 
increase.
    (ii) Partner's basis in partnership interest. The basis of the 
distributee partner's interest in the partnership is determined under 
section 733 as if no gain were recognized by the partner on the 
distribution by reason of section 731(c) and this section.
    (2) Basis of partnership property. No adjustment is made to the 
basis of partnership property under section 734 as a result of any gain 
recognized by a partner, or any step-up in the basis in the distributed 
marketable securities in the hands of the distributee partner, by 
reason of section 731(c) and this section.
    (g) Coordination with other sections--(1) Section 704(c)(1)(B). The 
basis of the distributee partner's interest in the partnership for 
purposes of determining the amount of gain, if any, recognized by 
reason of section 731(c) (and for determining the basis of the 
marketable securities in the hands of the distributee partner) includes 
the increase, if any, in the partner's basis that occurs under section 
704(c)(1)(B)(iii) as a result of a distribution to another partner of 
property contributed by the distributee partner in a distribution that 
is part of the same distribution as the marketable securities.
    (2) Section 737--(i) Marketable securities as other property. A 
distribution of marketable securities is treated as a distribution of 
property other than money for purposes of section 737 to the extent 
that the marketable securities are not treated as money under section 
731(c). In addition, marketable securities contributed to the 
partnership are treated as property other than money in determining the 
contributing partner's net precontribution gain under section 737(b).
    (ii) Basis increase under section 737. The basis of the distributee 
partner's interest in the partnership for purposes of determining the 
amount of gain, if any, recognized by reason of section 731(c) (and for 
determining the basis of the marketable securities in the hands of the 
distributee partner) does not include the increase, if any, in the 
partner's basis that occurs under section 737(c)(1) as a result of a 
distribution of property to the distributee partner in a distribution 
that is part of the same distribution as the marketable securities.
    (h) Anti-abuse rule. The provisions of section 731(c) and this 
section must be applied in a manner consistent with the purpose of 
section 731(c) and the substance of the transaction. Accordingly, if a 
principal purpose of a transaction is to achieve a tax result that is 
inconsistent with the purpose of section 731(c) and this section, the 
Commissioner can recast the transaction for federal tax purposes as 
appropriate to achieve tax results that are consistent with the purpose 
of section 731(c) and this section. Whether a tax result is 
inconsistent with the purpose of section 731(c) and this section must 
be determined based on all the facts and circumstances. For example, 
under the provisions of this paragraph (h)--
    (1) A change in partnership allocations or distribution rights with 
respect to marketable securities may be treated as a distribution of 
the marketable securities subject to section 731(c) if the change in 
allocations or distribution rights is, in substance, a distribution of 
the securities;
    (2) A distribution of substantially all of the assets of the 
partnership other than marketable securities and money to some partners 
may also be treated as a distribution of marketable securities to the 
remaining partners if the 

[[Page 32]]
distribution of the other property and the withdrawal of the other 
partners is, in substance, equivalent to a distribution of the 
securities to the remaining partners; and
    (3) The distribution of multiple properties to one or more partners 
at different times may also be treated as part of a single distribution 
if the distributions are part of a single plan of distribution.
    (i) [Reserved]
    (j) Examples. The following examples illustrate the rules of this 
section. Unless otherwise specified, all securities held by a 
partnership are marketable securities within the meaning of section 
731(c); the partnership holds no marketable securities other than the 
securities described in the example; all distributions by the 
partnership are subject to section 731(a) and are not subject to 
sections 704(c)(1)(B), 751(b), or 737; and no securities are eligible 
for an exception to section 731(c).

    Example 1. Recognition of gain. (i) A and B form partnership AB 
as equal partners. A contributes property with a fair market value 
of $1,000 and an adjusted tax basis of $250. B contributes $1,000 
cash. AB subsequently purchases Security X for $500 and immediately 
distributes the security to A in a current distribution. The basis 
in A's interest in the partnership at the time of distribution is 
$250.
    (ii) The distribution of Security X is treated as a distribution 
of money in an amount equal to the fair market value of Security X 
on the date of distribution ($500). (The amount of the distribution 
that is treated as money is not reduced under section 731(c)(3)(B) 
and paragraph (b) of this section because, if Security X had been 
sold immediately before the distribution, there would have been no 
gain recognized by AB and A's distributive share of the gain would 
therefore have been zero.) As a result, A recognizes $250 of gain 
under section 731(a)(1) on the distribution ($500 distribution of 
money less $250 adjusted tax basis in A's partnership interest).
    Example 2. Reduction in amount treated as money--in general. (i) 
A and B form partnership AB as equal partners. AB subsequently 
distributes Security X to A in a current distribution. Immediately 
before the distribution, AB held securities with the following fair 
market values, adjusted tax bases, and unrecognized gain or loss:

------------------------------------------------------------------------
                                                                  Gain  
                                               Value    Basis    (loss) 
------------------------------------------------------------------------
Security X..................................      100       70       30 
Security Y..................................      100       80       20 
Security Z..................................      100      110      (10)
------------------------------------------------------------------------

    (ii) If AB had sold the securities for fair market value 
immediately before the distribution to A, the partnership would have 
recognized $40 of net gain ($30 gain on Security X plus $20 gain on 
Security Y minus $10 loss on Security Z). A's distributive share of 
this gain would have been $20 (one-half of $40 net gain). If AB had 
sold the remaining securities immediately after the distribution of 
Security X to A, the partnership would have $10 of net gain ($20 of 
gain on Security Y minus $10 loss on Security Z). A's distributive 
share of this gain would have been $5 (one-half of $10 net gain). As 
a result, the distribution resulted in a decrease of $15 in A's 
distributive share of the net gain in AB's securities ($20 net gain 
before distribution minus $5 net gain after distribution).
    (iii) Under paragraph (b) of this section, the amount of the 
distribution of Security X that is treated as a distribution of 
money is reduced by $15. The distribution of Security X is therefore 
treated as a distribution of $85 of money to A ($100 fair market 
value of Security X minus $15 reduction).
    Example 3. Reduction in amount treated as money--carried 
interest. (i) A and B form partnership AB. A contributes $1,000 and 
provides substantial services to the partnership in exchange for a 
60 percent interest in partnership profits. B contributes $1,000 in 
exchange for a 40 percent interest in partnership profits. AB 
subsequently distributes Security X to A in a current distribution. 
Immediately before the distribution, AB held securities with the 
following fair market values, adjusted tax bases, and unrecognized 
gain:

------------------------------------------------------------------------
                                                Value    Basis     Gain 
------------------------------------------------------------------------
Security X...................................      100       80       20
Security Y...................................      100       90       10
------------------------------------------------------------------------

    (ii) If AB had sold the securities for fair market value 
immediately before the distribution to A, the partnership would have 
recognized $30 of net gain ($20 gain on Security X plus $10 gain on 
Security Y). A's distributive share of this gain would have been $18 
(60 percent of $30 net gain). If AB had sold the remaining 
securities immediately after the distribution of Security X to A, 
the partnership would have $10 of net gain ($10 gain on Security Y). 
A's distributive share of this gain would have been $6 (60 percent 
of $10 net gain). As a result, the distribution resulted in a 
decrease of $12 in A's distributive share of the net gain in AB's 
securities ($18 net gain before distribution minus $6 net gain after 
distribution).
    (iii) Under paragraph (b) of this section, the amount of the 
distribution of Security X that is treated as a distribution of 
money is reduced by $12. The distribution of Security X is therefore 
treated as a distribution of $88 of money to A ($100 fair market 
value of Security X minus $12 reduction).
    Example 4. Reduction in amount treated as money--change in 
partnership allocations. (i) A is admitted to partnership ABC as a 
partner with a 1 percent interest in partnership profits. At the 
time of A's admission, ABC held no securities. ABC subsequently 
acquires Security X. A's interest in partnership profits is 
subsequently increased to 2 percent for securities acquired after 
the increase. A retains a 1 percent interest in all securities 
acquired before the increase. ABC then acquires Securities Y and Z 
and later distributes Security X to A in a current distribution. 
Immediately before the distribution, the securities held by ABC had 
the following fair market values, adjusted tax bases, and 
unrecognized gain or loss:

------------------------------------------------------------------------
                    Value                      Basis     Gain    (loss) 
------------------------------------------------------------------------
Security X..................................    1,000      500      500 
Security Y..................................    1,000      800      200 
Security Z..................................    1,000    1,100     (100)
------------------------------------------------------------------------

    (ii) If ABC had sold the securities for fair market value 
immediately before the distribution to A, the partnership would have 
recognized $600 of net gain ($500 gain on Security X plus $200 gain 
on Security Y minus $100 loss on Security Z). A's distributive share 
of this gain would have been $7 (1 percent of $500 gain on Security 
X plus 2 percent of $200 gain on Security Y minus 2 percent of $100 
loss on Security Z).
    (iii) If ABC had sold the remaining securities immediately after 
the distribution of Security X to A, the partnership would have $100 
of net gain ($200 gain on Security Y minus $100 loss on Security Z). 
A's distributive share of this gain would have been $2 (2 percent of 
$200 gain on Security Y minus 2 percent of $100 loss on Security Z). 
As a result, the distribution resulted in a decrease of $5 in A's 
distributive share of the net gain in ABC's securities ($7 net gain 
before distribution minus $2 net gain after distribution).
    (iv) Under paragraph (b) of this section, the amount of the 
distribution of Security X that is treated as a distribution of 
money is reduced by $5. The distribution of Security X is therefore 
treated as a distribution of $95 of money to A ($100 fair market 
value of Security X minus $5 reduction).
    Example 5. Basis consequences--distribution of marketable 
security. (i) A and B form partnership AB as equal partners. A 
contributes nondepreciable real property with a fair market value 
and adjusted tax basis of $100.
    (ii) AB subsequently distributes Security X with a fair market 
value of $120 and an adjusted tax basis of $90 to A in a current 
distribution. At the time of distribution, the basis in A's interest 
in the partnership is $100. The amount of the distribution that is 
treated as money is reduced under section 731(c)(3)(B) and paragraph 
(b)(2) of this section by $15 (one- half of $30 net gain in Security 
X). As a result, A recognizes $5 of gain under section 731(a) on the 
distribution (excess of $105 distribution of money over $100 
adjusted tax basis in A's partnership interest).
    (iii) A's adjusted tax basis in Security X is $95 ($90 adjusted 
basis of Security X determined under section 732(a)(1) plus $5 of 
gain recognized by A by reason of section 731(c)). The basis in A's 
interest in the partnership is $10 as determined under section 733 
($100 pre-distribution basis minus $90 basis allocated to Security X 
under section 732).
    Example 6. Basis consequences--distribution of marketable 
security and other property. (i) A and B form partnership AB as 
equal partners. A contributes nondepreciable 

[[Page 33]]
real property, with a fair market value of $100 and an adjusted tax 
basis of $10.
    (ii) AB subsequently distributes Security X with a fair market 
value and adjusted tax basis of $40 to A in a current distribution 
and, as part of the same distribution, AB distributes Property Z to 
A with an adjusted tax basis and fair market value of $40. At the 
time of distribution, the basis in A's interest in the partnership 
is $10. A recognizes $30 of gain under section 731(a) on the 
distribution (excess of $40 distribution of money over $10 adjusted 
tax basis in A's partnership interest).
    (iii) A's adjusted tax basis in Security X is $35 ($5 adjusted 
basis determined under section 732(a)(2) plus $30 of gain recognized 
by A by reason of section 731(c)). A's basis in Property Z is $5, as 
determined under section 732(a)(2). The basis in A's interest in the 
partnership is $0 as determined under section 733 ($10 pre-
distribution basis minus $10 basis allocated between Security X and 
Property Z under section 732).
    (iv) AB's adjusted tax basis in the remaining partnership assets 
is unchanged unless the partnership has a section 754 election in 
effect. If AB made such an election, the aggregate basis of AB's 
assets would be increased by $70 (the difference between the $80 
combined basis of Security X and Property Z in the hands of the 
partnership before the distribution and the $10 combined basis of 
the distributed property in the hands of A under section 732 after 
the distribution). Under section 731(c)(5), no adjustment is made to 
partnership property under section 734 as a result of any gain 
recognized by A by reason of section 731(c) or as a result of any 
step-up in basis in the distributed marketable securities in the 
hands of A by reason of section 731(c).
    Example 7. Coordination with section 737. (i) A and B form 
partnership AB. A contributes Property A, nondepreciable real 
property with a fair market value of $200 and an adjusted basis of 
$100 in exchange for a 25 percent interest in partnership capital 
and profits. AB owns marketable Security X.
    (ii) Within five years of the contribution of Property A, AB 
subsequently distributes Security X, with a fair market value of 
$120 and an adjusted tax basis of $100, to A in a current 
distribution that is subject to section 737. As part of the same 
distribution, AB distributes Property Y to A with a fair market 
value of $20 and an adjusted tax basis of $0. At the time of 
distribution, there has been no change in the fair market value of 
Property A or the adjusted tax basis in A's interest in the 
partnership.
    (iii) If AB had sold Security X for fair market value 
immediately before the distribution to A, the partnership would have 
recognized $20 of gain. A's distributive share of this gain would 
have been $5 (25 percent of $20 gain). Because AB has no other 
marketable securities, A's distributive share of gain in partnership 
securities after the distribution would have been $0. As a result, 
the distribution resulted in a decrease of $5 in A's share of the 
net gain in AB's securities ($5 net gain before distribution minus 
$0 net gain after distribution). Under paragraph (b)(2) of this 
section, the amount of the distribution of Security X that is 
treated as a distribution of money is reduced by $5. The 
distribution of Security X is therefore treated as a distribution of 
$115 of money to A ($120 fair market value of Security X minus $5 
reduction). The portion of the distribution of the marketable 
security that is not treated as a distribution of money ($5) is 
treated as other property for purposes of section 737.
    (iv) A recognizes total gain of $40 on the distribution. A 
recognizes $15 of gain under section 731(a)(1) on the distribution 
of the portion of Security X treated as money ($115 distribution of 
money less $100 adjusted tax basis in A's partnership interest). A 
recognizes $25 of gain under section 737 on the distribution of 
Property Y and the portion of Security X that is not treated as 
money. A's section 737 gain is equal to the lesser of (i) A's 
precontribution gain ($100) or (ii) the excess of the fair market 
value of property received ($20 fair market value of Property Y plus 
$5 portion of Security X not treated as money) over the adjusted 
basis in A's interest in the partnership immediately before the 
distribution ($100) reduced (but not below zero) by the amount of 
money received in the distribution ($115).
    (v) A's adjusted tax basis in Security X is $115 ($100 basis of 
Security X determined under section 732(a) plus $15 of gain 
recognized by reason of section 731(c)). A's adjusted tax basis in 
Property Y is $0 under section 732(a). The basis in A's interest in 
the partnership is $25 ($100 basis before distribution minus $100 
basis allocated to Security X under section 732(a) plus $25 gain 
recognized under section 737).

    (k) Effective date. This section applies to distributions of 
marketable securities made on or after December 29, 1995.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
[FR Doc. 95-31457 Filed 12-29-95; 8:45 am]
BILLING CODE 4830-01-U