[Federal Register Volume 61, Number 249 (Thursday, December 26, 1996)]
[Rules and Regulations]
[Pages 67936-67942]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-32854]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8707]
RIN 1545-AT19


Distribution of Marketable Securities by a Partnership

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations providing rules for 
partnership distributions of marketable securities under section 731(c) 
of the

[[Page 67937]]

Internal Revenue Code of 1986, as amended, and for determining when 
those distributions are taxable to the distributee partner. The 
regulations reflect changes to the law made by the Uruguay Round 
Agreements Act enacted on December 8, 1994.

DATES: These regulations are effective on December 26, 1996.

FOR FURTHER INFORMATION CONTACT: Terri A. Belanger or William M. Kostak 
at (202) 622-3080 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    This document amends 26 CFR part 1 to provide rules relating to the 
treatment of partnership distributions of marketable securities under 
section 731(c). Under section 731(a), in the case of a distribution by 
a partnership to a partner, gain is recognized to the partner only to 
the extent that any money distributed exceeds the adjusted basis of the 
partner's interest in the partnership. Prior to the enactment of 
section 731(c), marketable securities were not considered money and, 
therefore, the distribution of marketable securities by a partnership 
to a partner was not a taxable event. Section 731(c) now treats a 
partnership distribution of marketable securities as a distribution of 
money and as a taxable event if the value of the distributed securities 
exceeds the adjusted basis of the partner's interest in the 
partnership. Section 731(c) also provides several exceptions to the 
general rule that a distribution of marketable securities will be 
treated as a distribution of money.
    On January 2, 1996, the IRS published in the Federal Register (61 
FR 28) a notice of proposed rulemaking (PS-2-95) to provide guidance 
regarding section 731(c). A number of public comments were received 
concerning the proposed regulations. However, the public hearing 
scheduled for April 3, 1996, was cancelled because no one requested to 
speak. After consideration of the written comments received, the 
proposed regulations are adopted as revised by this Treasury decision.

Explanation of Provisions

I. General Background

    The proposed regulations provide rules for determining when and the 
extent to which a distribution of marketable securities by a 
partnership to a partner will be treated as a distribution of money for 
purposes of section 731(a). Although modified in response to comments, 
the final regulations generally adopt the rules contained in the 
proposed regulations.

II. Public Comments

    Several comments requested that the IRS reconsider the requirement 
in Sec. 1.731-2(d) (2)(ii) of the proposed regulations that a 
marketable security must be actively traded on the date of distribution 
to qualify for the ``nonrecognition transaction'' exception to section 
731(c). Because of this rule, financial instruments (securities) that 
are treated as marketable securities under section 731(c)(2)(B) on the 
date of distribution, but that are not actively traded, would not 
qualify for this exception. Commentators suggested that the final 
regulations should not include this requirement or should include a 
more narrowly drafted provision. In response to these comments, the 
final regulations provide that a security that falls within the 
definition of marketable security may qualify for the exceptions under 
Sec. 1.731-2(d) of the final regulations even if the security is not 
actively traded on the date of distribution. An anti-stuffing rule has 
been added to address the concern to which the actively-traded 
requirement of the proposed regulations was directed.
    Several comments also suggested that Sec. 1.731-2(d)(2) of the 
proposed regulations should allow a de minimis amount of cash and 
marketable securities to be transferred in a nonrecognition 
transaction. The final regulations provide that if the value of money 
and marketable securities transferred in a nonrecognition transaction 
is less than 20 percent of the total amount of all property transferred 
in exchange for the distributed security, the entire value of the 
distributed security will qualify for the nonrecognition transaction 
exception under Sec. 1.731-2(d)(1)(ii) of the final regulations.
    Several commentators also suggested that the five-year rules of 
Sec. 1.731-2(d)(2) and (3) of the proposed regulations be eliminated. 
Section 1.731-2(d)(2) of the proposed regulations provided that a 
marketable security that was acquired in a nonrecognition transaction 
in exchange for other property and distributed within five years by the 
partnership would not be subject to section 731(c). Section 1.731-
2(d)(3) of the proposed regulations provided that a marketable security 
that was acquired by the partnership before it became actively traded 
would also not be subject to section 731(c) if it was distributed by 
the partnership within five years of becoming actively traded. One 
commentator, for example, argued that a security is no less a 
substitute for the underlying assets in a nonrecognition transaction 
after five years than before five years. These five-year rules were 
included in the proposed regulations because of administrative 
concerns. For example, it may be difficult, after the passage of many 
years, for taxpayers or the IRS to determine the circumstances in which 
a partnership acquired a particular security. Moreover, it is not clear 
whether certain exceptions should apply to a distribution of securities 
if those securities were acquired by a partnership many years ago and 
are now distributed to a partner who was not a partner at the time the 
securities were acquired. These administrative concerns remain valid, 
and a five year time limitation provides a reasonable and simple 
solution to such problems. Therefore, the final regulations retain both 
five-year rules.
    One comment requested clarification regarding whether a section 
708(b)(1)(B) termination affects a partnership's qualification for the 
exceptions under Sec. 1.731-2 (d) and (e) of the regulations. Another 
commentator suggested that the regulations be modified to provide that 
marketable securities will not be treated as money when there is a 
deemed distribution of marketable securities by the terminating 
partnership as the result of a section 708(b)(1)(B) termination. In 
response to these comments, the final regulations provide that a 
section 708(b)(1)(B) termination does not have any effect on a 
partnership's qualification for the exceptions under section 731(c). In 
addition, a deemed distribution occurring as a result of a section 
708(b)(1)(B) termination will not be subject to section 731(c).
    Several comments suggested that the 10-percent test in the 
investment partnership look-through rule under Sec. 1.731-2(e)(4) of 
the proposed regulations should be modified or eliminated. A 
partnership can qualify for the investment partnership exception only 
if it has never been engaged in a trade or business and substantially 
all of its assets are investment assets. Under the proposed 
regulations, a partnership is treated as engaged in a trade or business 
engaged in by, or as holding a proportionate share of the assets of, a 
lower-tier partnership in which the partnership holds a partnership 
interest unless 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. According to the 
comments, the requirement that the upper-tier partnership not 
participate in

[[Page 67938]]

the management of the lower-tier partnership should be sufficient to 
ensure passive ownership of the interest in the lower-tier partnership. 
The commentators further argued that ownership of more than 10 percent 
of the capital and profits interest in a lower-tier partnership may 
still be consistent with passive ownership. After consideration of 
these comments, the final regulations modify the rule in the proposed 
regulations to increase the threshold ownership percentage amount from 
10 to 20 percent.
    In response to a comment, the final regulations clarify that an 
interest in a lower-tier partnership that qualifies for the exception 
to the investment partnership ``look-through'' rule is treated as 
eligible property for purposes of determining whether the partner who 
contributed the lower-tier partnership interest is an eligible partner 
of the upper-tier investment partnership.
    One commentator recommended that the regulations include an example 
that illustrates the section 732(a)(2) ordering rules for distributions 
that include money, marketable securities and other property, and to 
clarify whether marketable securities are treated as money for purposes 
of section 732(a)(2). Because the statute and the regulations provide 
that marketable securities are treated as money only for purposes of 
sections 731(a)(1) and 737, no additional examples are necessary.
    One comment suggested that the effective date of the regulations 
should be the same as the effective date of section 731(c) because the 
regulations contain guidance for the various exceptions provided for by 
the Internal Revenue Code. In response to this comment, the final 
regulations provide that, for the period between the effective date of 
the statutory provision and the effective date of these regulations, 
taxpayers may apply the rules contained in these regulations. Another 
comment suggested that the final regulations should make clear that the 
rules in the investment partnership exception apply with respect to all 
property contributed to, or held by, a partnership at any time 
(including any period prior to the enactment of section 731(c)). The 
IRS and Treasury believe that this is sufficiently clear from the 
statutory language, and an explicit statement to this effect in these 
regulations is not necessary and may be confusing.
    One comment requested that the regulations provide several examples 
illustrating abusive transactions intended to be covered by the anti-
abuse rules of Sec. 1.731-2(h), and that these rules be coordinated 
with the general anti-abuse rules of Sec. 1.701-2. After consideration 
of this comment, it has been determined that the text of the 
regulations adequately describes several situations that would be 
considered abusive under these rules, and that additional examples are 
unnecessary.
    In response to several comments, the final regulations clarify that 
the 90 percent test of Sec. 1.731-2(c)(2)(i) and the 20 percent test of 
Sec. 1.731-2(c)(2)(ii) are determined using the gross value of the 
entity's assets, disregarding any debt that may encumber or otherwise 
be allocable to those assets, other than debt that is incurred to 
acquire property with a principal purpose of avoiding or reducing the 
effect of section 731(c).
    Finally, the regulations clarify the interaction of the limitation 
on gain rule in section 731(c)(3)(B) and the various exceptions listed 
in paragraph (d). The regulations provide that any gain or loss on a 
distributed security that qualifies for an exception is not taken into 
account in determining the distributee partner's limitation on gain.

III. Effective Dates

    In general, section 731(c) applies to distributions made after 
December 8, 1994. These regulations are effective for distributions 
made on or after December 26, 1996. However, taxpayers may apply the 
rules of this section to distributions made after December 8, 1994, and 
before December 26, 1996.

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) 
does not apply to these regulations, and because the notice of proposed 
rulemaking preceding the regulations was issued prior to March 29, 
1996, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. 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 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.

Adoption of 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 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 sections 
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;

[[Page 67939]]

    (ii) Without taking into account any special allocations adopted 
with a principal purpose of avoiding the effect of section 731(c) and 
this section; and
    (iii) Without taking into account any gain or loss attributable to 
a distributed security to which paragraph (d)(1) of this section 
applies.
    (c) Marketable securities--(1) In general. For purposes of section 
731(c) and this section, the term marketable securities is defined in 
section 731(c)(2).
    (2) 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.
    (3) 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.
    (4) Value of assets. For purposes of section 731(c) and this 
section, the value of the assets of an entity is determined without 
regard to any debt that may encumber or otherwise be allocable to those 
assets, other than debt that is incurred to acquire an asset with a 
principal purpose of avoiding or reducing the effect of section 731(c) 
and this section.
    (d) Exceptions--(1) In general. Except as otherwise provided in 
paragraph (d)(2) of this section, section 731(c) and this section do 
not apply to the distribution of a marketable security if--
    (i) The security was contributed to the partnership by the 
distributee partner;
    (ii) The security was acquired by the partnership in a 
nonrecognition transaction, and the following conditions are 
satisfied--
    (A) The value of any marketable securities and money exchanged by 
the partnership in the nonrecognition transaction is less than 20 
percent of the value of all the assets exchanged by the partnership in 
the nonrecognition transaction; and
    (B) The partnership distributed the security within five years of 
either the date the security was acquired by the partnership or, if 
later, the date the security became marketable; or
    (iii) The security was not a marketable security on the date 
acquired by the partnership, and the following conditions are 
satisfied--
    (A) The entity that issued the security had no outstanding 
marketable securities at the time the security was acquired by the 
partnership;
    (B) The security was held by the partnership for at least six 
months before the date the security became marketable; and
    (C) The partnership distributed the security within five years of 
the date the security became marketable.
    (2) Anti-stuffing rule. Paragraph (d)(1) of this section does not 
apply to the extent that 20 percent or more of 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 after the security was 
acquired by the partnership (other than marketable securities 
contributed by the partnership that were originally contributed to the 
partnership by the distributee partner). For purposes of this paragraph 
(d)(2), money contributed by the distributing partnership does not 
include any money deemed contributed by the partnership as a result of 
section 752.
    (3) Successor security. Section 731(c) and this section apply to 
the distribution of a marketable security 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) only to the extent that section 
731(c) and this section otherwise would have applied to the exchanged 
security.
    (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--(i) Contributed services. 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.
    (ii) Contributed partnership interests. For purposes of determining 
whether a partner is an eligible partner under section 731(c)(3)(C), if 
the partner has contributed to the investment partnership an interest 
in another partnership that meets the requirements of paragraph 
(e)(4)(i) of this section after the contribution, the contributed 
interest is treated as property specified in section 731(c)(3)(C)(i).
    (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 actively and substantially

[[Page 67940]]

participate in the management of the lower-tier partnership; and
    (ii) The interest held by the upper-tier partnership is less than 
20 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) Sections 704(c)(1)(B) and 
737--(i) In general. If a distribution results in the application of 
sections 731(c) and one or both of sections 704(c)(1)(B) and 737, the 
effect of the distribution is determined by applying section 
704(c)(1)(B) first, section 731(c) second, and finally section 737.
    (ii) 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 or decrease, 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.
    (iii) Section 737--(A) 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).
    (B) 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.
    (2) Section 708(b)(1)(B). If a partnership termination occurs under 
section 708(b)(1)(B), the successor partnership will be treated as if 
there had been no termination for purposes of section 731(c) and this 
section. Accordingly, a section 708(b)(1)(B) termination will not 
affect whether a partnership qualifies for any of the exceptions in 
paragraphs (d) and (e) of this section. In addition, a deemed 
distribution that may occur as a result of a section 708(b)(1)(B) 
termination will not be subject to section 731(c) and this section.
    (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 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), 707(a)(2)(B), 751(b), or 737; and no securities 
are eligible for an exception to section 731(c). The examples are as 
follows:

    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

[[Page 67941]]

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:

------------------------------------------------------------------------
                                                                   Gain 
                                                Value    Basis    (Loss)
------------------------------------------------------------------------
Security X...................................    1,000      500      500
Security Y...................................    1,000      800      200
Security Z ..................................   11,000    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 $995 of money to A ($1000 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 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

[[Page 67942]]

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 made on 
or after December 26, 1996. However, taxpayers may apply the rules of 
this section to distributions made after December 8, 1994, and before 
December 26, 1996.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
    Approved: November 27, 1996.
Donald C. Lubick,
Acting Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 96-32854 Filed 12-24-96; 8:45 am]
BILLING CODE 4830-01-U