[Federal Register Volume 64, Number 152 (Monday, August 9, 1999)]
[Proposed Rules]
[Pages 43117-43123]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-20368]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-106527-98]
RIN 1545-AW22


Capital Gains, Partnership, Subchapter S, and Trust Provisions

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 sales 
or exchanges of interests in partnerships, S corporations, and trusts. 
The proposed regulations interpret the look-through provisions of 
section 1(h), added by section 311 of the Taxpayer Relief Act of 1997 
and amended by sections 5001 and 6005(d) of the Internal Revenue 
Service Restructuring and Reform Act of 1998, and explain the rules 
relating to the division of the holding period of a

[[Page 43118]]

partnership interest. The proposed regulations affect partnerships, 
partners, S corporations, S corporation shareholders, trusts, and trust 
beneficiaries.

DATES: Written comments must be received by November 8, 1999. Requests 
to speak and outlines of topics to be discussed at the public hearing 
scheduled for November 18, 1999, must be received by October 28, 1999.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-106527-98), room 
5226, Internal Revenue Service, POB 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand delivered Monday through 
Friday between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-
106527-98), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW, Washington, DC. Alternatively, taxpayers may submit 
comments electronically via the Internet by selecting the ``Tax Regs'' 
option on the IRS Home Page, or by submitting comments directly to the 
IRS Internet site at http://www.irs.ustreas.gov/tax__regs/
regslist.html. The public hearing will be held in room 3411, Internal 
Revenue Building, 1111 Constitution Avenue, NW, Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Jeanne Sullivan (202) 622-3050; concerning submissions of comments, the 
hearing, and/or to be placed on the building access list to attend the 
hearing, LaNita VanDyke (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION

Paperwork Reduction Act

    The collections of information contained in this notice of proposed 
rulemaking have been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507(d)).
    Comments on the collections of information should be sent to the 
Office of Management and Budget, Attn: Desk Officer for the Department 
of the Treasury, Office of Information and Regulatory Affairs, 
Washington, DC 20503, with copies to the IRS, Attn: IRS Reports 
Clearance Officer, OP:FS:FP, Washington, DC 20224. Comments on the 
collections of information should be received by October 8, 1999. 
Comments are specifically requested concerning:
    Whether the proposed collections of information are necessary for 
the proper performance of the functions of the IRS, including whether 
the collections will have a practical utility;
    The accuracy of the estimated burden associated with the proposed 
collections of information (see below);
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
    How the burden of complying with the proposed collections of 
information may be minimized, including through application of 
automated collection techniques or other forms of information 
technology; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of services to provide information.
    The collections of information in these proposed regulations are in 
Sec. 1.1(h)-1(e). This information is required by the IRS to implement 
section 311 of the Taxpayer Relief Act of 1997, as amended by the 
Internal Revenue Service Restructuring and Reform Act of 1998. The 
collections of information are required to provide information to the 
IRS regarding the capital gain attributable to collectibles and section 
1250 property held by a partnership when a partner sells or exchanges 
an interest in that partnership and the capital gain attributable to 
collectibles when a shareholder sells or exchanges an interest in an S 
corporation or a trust beneficiary sells or exchanges an interest in a 
trust. This information will be used to verify compliance with section 
1(h) and to determine that the tax on capital gains has been computed 
correctly. The collection of information is mandatory. The likely 
respondents are individuals and businesses.
    Respondent taxpayers provide information by attaching a statement 
to the appropriate tax return. The burden for this requirement is 
reflected in the burden estimates for: Form 1040, U.S. Individual 
Income Tax Return; Form 1065, U.S. Partnership Return of Income; Form 
1041, U.S. Income Tax Return for Estates and Trusts; and Form 1120S, 
U.S. Income Tax Return for an S Corporation. The estimated burden of 
information collection for the statement required is 10 minutes.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    This document contains proposed amendments to the Income Tax 
Regulations (26 CFR Part 1) relating to taxation of capital gains in 
the case of sales or exchanges of interests in partnerships, S 
corporations, and trusts. The Taxpayer Relief Act of 1997, Public Law 
105-34, 111 Stat. 788, 831 (1997 Act), amended section 1(h) of the 
Internal Revenue Code to reduce the maximum statutory tax rates for 
long-term capital gains of individuals in general. Certain technical 
corrections and other amendments to section 1(h) were enacted as part 
of the Internal Revenue Service Restructuring and Reform Act of 1998, 
Public Law 105-206, 112 Stat. 685, 787, 800 (1998 Act).
    Section 1(h) provides that intermediate level rates apply to long-
term capital gains from certain transactions, such as sales or 
exchanges of collectibles, section 1202 stock (with respect to a 
portion of the gain), and section 1250 property with gain attributable 
to straight-line depreciation. Section 1(h)(11) provides authority to 
the Secretary to issue such regulations as are appropriate to apply 
these rules in the case of sales or exchanges by pass-thru entities and 
of interests in pass-thru entities. This document provides rules for 
sales or exchanges of interests in partnerships, S corporations, and 
trusts. This document also provides rules relating to dividing the 
holding period of a partnership interest.

Explanation of Provisions

    In general, prior to the 1997 Act, individuals were taxed on 
capital gains at the same rate as ordinary income, except that the rate 
for net capital gain was capped at 28 percent. The 1997 Act provided 
for lower maximum rates of taxation on gain from the sale or exchange 
of certain types of property. As amended by the 1998 Act, section 1(h) 
currently provides for maximum capital gains rates on the sale or 
exchange of certain types of property in three categories: 20-percent 
rate gain, 25-percent rate gain, and 28-percent rate gain. Twenty 
percent rate gain is net capital gain from the sale or exchange of 
capital assets held for more than one year, reduced by the sum of 25-
percent rate gain and 28-percent rate gain. Twenty-five percent rate 
gain is limited to unrecaptured section 1250 gain. Unrecaptured section 
1250 gain is the amount of long-term capital gain (not otherwise 
treated as ordinary income) which would be treated as ordinary income 
if section 1250(b)(1) included all depreciation and the applicable 
percentage under section 1250(a) were

[[Page 43119]]

100 percent, reduced by any net loss in the 28-percent rate gain 
category.Twenty-eight percent rate gain is capital gains and losses 
from the sale or exchange of collectibles (as defined in section 408(m) 
without regard to section 408(m)(3)) held for more than one year, a 
portion of the gain attributable to the sale of section 1202 stock, and 
capital gains and losses determined under the rules of section 
1(h)(13), reduced by net short-term capital loss for the taxable year 
and any long-term capital loss carryover under section 1212(b)(1)(B).

Collectibles Gain and Unrecaptured Section 1250 Gain

    The sale or exchange of an interest in a partnership with a long-
term holding period generally will result in capital gain in the 20-
percent rate gain category to the extent that section 751(a) is not 
applicable. Section 751(a) generally provides that an amount received 
in exchange for a partnership interest, to the extent attributable to 
unrealized receivables and inventory, shall be considered as an amount 
realized from the sale or exchange of property other than a capital 
asset. Section 1250 property is treated as an unrealized receivable for 
purposes of section 751 to the extent of the amount that would be 
treated as gain to which section 1250(a) would apply.
    The sale or exchange of stock in an S corporation with a long-term 
holding period generally will result in gain or loss in the 20-percent 
rate gain category, unless an exception to capital gain treatment 
applies. Certain of those exceptions are provided in sections 304, 306, 
341, and 1254.
    The sale or exchange of an interest in a trust with a long-term 
holding period generally will result in gain or loss in the 20-percent 
rate gain category. However, if the transferor is treated as the owner 
of the portion of the trust attributable to an interest under sections 
673 through 679, the transferor is treated as transferring an undivided 
interest in the assets of the trust rather than an interest in the 
trust itself.
    Effective for taxable years ending after May 6, 1997, when an 
interest in a partnership, an S corporation, or a trust held for more 
than one year (or more than 18 months during certain periods in 1997) 
is sold or exchanged, section 1(h) provides special treatment for 
``collectibles gain'' in property held by a partnership, S corporation, 
or trust and for ``section 1250 capital gain'' in property held by a 
partnership. Specifically, section 1(h)(6)(B) provides that any gain 
from the sale of an interest in a partnership, S corporation, or trust 
which is attributable to unrealized appreciation in the value of 
collectibles shall be treated as gain from the sale or exchange of a 
collectible, applying rules similar to section 751(a) to determine the 
amount of the gain. In addition, under section 1(h)(7)(A) (in 
conjunction with sections 751(a) and (c)), the amount of long-term 
capital gain (not otherwise treated as ordinary income under section 
751(a)) that would be treated as ordinary income under section 751(a) 
if section 1250 applied to all depreciation (section 1250 capital gain) 
must be taken into account in computing unrecaptured section 1250 gain 
when an interest in a partnership (with a holding period of more than 
one year, or more than 18 months during certain periods in 1997) is 
sold or exchanged. See H. Rep. No. 105-356, 105th Cong. 1st Sess. 
(1997), at 16, fn. 11; S. Rep. No. 105-174, 105th Cong. 2d Sess. 
(1998), at 149, fn. 65.
    The proposed regulations provide guidance with respect to the 
application of these rules to a sale or exchange of an interest in a 
partnership, S corporation, or trust holding assets with collectibles 
gain and a partnership holding assets with section 1250 capital gain. 
Generally, the amount of such gain is determined by reference to the 
gain that would be allocated to the selling partner, shareholder, or 
beneficiary (to the extent attributable to the portion of the 
transferred interest that is subject to long-term capital gain) if the 
partnership, S corporation, or trust had sold all of its collectibles 
or if the partnership had sold all of its section 1250 property in a 
fully taxable transaction immediately before the transfer of the 
partnership, S corporation, or trust interest. Special rules are 
provided where the partner, S corporation shareholder, or trust 
beneficiary recognizes less than all of the gain upon the sale or 
exchange of its interest.
    In addition, for purposes of applying section 1(h)(7)(B), which 
provides that a taxpayer's unrecaptured section 1250 gain cannot exceed 
the taxpayer's net section 1231 gain, gain from the sale of a 
partnership interest that results in section 1250 capital gain is not 
treated as section 1231 gain even if section 1231 could apply to the 
disposition of the underlying partnership property. Although section 
1(h)(7) (in combination with section 751) applies a limited look-thru 
rule for purposes of determining the capital gain rate applicable to 
the sale of a partnership interest, no similar look-thru rule applies 
for purposes of applying section 1231. Anomalous results would follow 
if section 1250 capital gain derived from the sale of a partnership 
interest were treated as section 1231 gain for purposes of applying the 
limitation in section 1(h)(7)(B) but not for purposes of actually 
applying section 1231.

Determination of Holding Period in a Partnership

    In view of the long-established principle that a partner has a 
single basis in a partnership interest (see Rev. Rul. 84-53 (1984-1 
C.B. 159)), there is some confusion under current law as to how the 
principles of section 1223 apply to the sale of an interest, or a 
portion of an interest, in a partnership. The proposed regulations 
provide rules relating to the allocation of a divided holding period 
with respect to an interest in a partnership. These rules generally 
provide that the holding period of a partnership interest will be 
divided if a partner acquires portions of an interest at different 
times or if an interest is acquired in a single transaction that gives 
rise to different holding periods under section 1223. The holding 
period of a portion of a partnership interest shall be determined based 
on a fraction that is equal to the fair market value of the portion of 
the partnership interest to which the holding period relates 
(determined immediately after the acquisition) over the fair market 
value of the entire partnership interest. A selling partner may use the 
actual holding period of the portion of a partnership interest sold if 
the partnership is a ``publicly traded partnership'' (as defined under 
section 7704(b)), the partnership interest is divided into identifiable 
units with ascertainable holding periods, and the selling partner can 
identify the portion of the interest transferred. Otherwise, the 
holding period(s) of the transferred interest must be divided in the 
same ratio as the holding period(s) of the partner's entire partnership 
interest.
    These proposed regulations do not contain a specific anti-abuse 
rule regarding holding periods. However, there may be situations where 
taxpayers will attempt to undertake abusive transactions using the 
rules in these regulations. For instance, taxpayers may attempt to 
shift gain from property with a short-term holding period to property 
with a long-term holding period by contributing the short-term property 
to a partnership and selling the partnership interest. Because the 
basis of a partnership interest cannot be segregated to a portion of an 
interest, basis in the portion of a partnership interest with a long-
term holding period could reduce gain attributable to the portion of a 
partnership interest with a short-term holding period in situations

[[Page 43120]]

where such interest was recently received in exchange for contributed 
short-term capital gain property. In appropriate situations, the IRS 
may attack such abusive transactions under a variety of judicial 
doctrines, including substance over form or step transaction, or under 
Sec. 1.701-2 of the regulations.

Proposed Effective Date

    The amendments are proposed to be effective for all transfers of 
interests in a partnership, S corporation, or trust and for all 
distributions from a partnership on or after the date the regulations 
are published as final regulations in the Federal Register.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. Pursuant to 
section 7805(f), 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. It is hereby certified 
that the collection of information in these regulations will not have a 
significant economic impact on a substantial number of small entities. 
This certification is based on the facts that: (1) the time required to 
prepare and file the statement is minimal (currently estimated at 10 
minutes per statement); and (2) it is anticipated that, as a result of 
these regulations, small entities will file no more than one statement 
per year. Furthermore, taxpayers will have to respond to the requests 
for information contained in Sec. 1.1(h)-1(e) only if there is a sale 
or exchange of an interest in a partnership, an S corporation, or a 
trust that holds certain property. Therefore, a Regulatory Flexibility 
Analysis under the Regulatory Flexibility Act (5 U.S.C. Chapter 6) is 
not required.

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 submitted timely to the IRS. The IRS and 
Treasury request comments on the clarity of the proposed rule and how 
it may be made easier to understand. All comments will be available for 
public inspection and copying.
    A public hearing has been scheduled for November 18, 1999, 
beginning at 1 p.m. in room 3411 of the Internal Revenue Building, 1111 
Constitution Avenue, NW., Washington, DC. Due to building security 
procedures, visitors must enter at the 10th Street entrance, located 
between Constitution and Pennsylvania Avenues, NW. In addition, all 
visitors must present photo identification to enter the building. 
Because of access restrictions, visitors will not be admitted beyond 
the immediate entrance area more than 15 minutes before the hearing 
starts. For information about having your name placed on the building 
access list to attend the hearing, see the FOR FURTHER INFORMATION 
CONTACT section of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must request to speak and 
submit written comments and an outline of the topics to be discussed 
and the time to be devoted to each topic (signed original and eight (8) 
copies) by October 28, 1999. 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 author of these proposed 
regulations is Jeanne Sullivan, Office of the Assistant 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.

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 continues to read in 
part as follows:

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

    Par. 2. Section 1.1(h)-1 is added to read as follows:


Sec. 1.1(h)-1  Capital gains look-through rule for sales or exchanges 
of interests in a partnership, S corporation, or trust.

    (a) In general. When an interest in a partnership held for more 
than one year is sold or exchanged, the transferor may recognize 
ordinary income (e.g., section 751(a)), collectibles gain, section 1250 
capital gain, and residual long-term capital gain or loss. When stock 
in an S corporation held for more than one year is sold or exchanged, 
the transferor may recognize ordinary income (e.g., sections 304, 306, 
341, 1254), collectibles gain, and residual long-term capital gain or 
loss. When an interest in a trust held for more than one year is sold 
or exchanged, a transferor who is not treated as the owner of the 
portion of the trust attributable to the interest sold or exchanged 
(sections 673 through 679) (a non-grantor transferor) may recognize 
collectibles gain and residual long-term capital gain or loss.
    (b) Look-through capital gain--(1) In general. Look-through capital 
gain is the share of collectibles gain allocable to an interest in a 
partnership, S corporation, or trust, plus the share of section 1250 
capital gain allocable to an interest in a partnership, determined 
under paragraphs (b)(2) and (3) of this section.
    (2) Collectibles gain and collectibles loss--(i) Definitions. For 
purposes of this section, collectibles gain and collectibles loss mean 
gain or loss, respectively, from the sale or exchange of a collectible 
(as defined in section 408(m) without regard to section 408(m)(3)) that 
is a capital asset held for more than 1 year, but only to the extent 
such gain is taken into account in computing gross income, and such 
loss is taken into account in computing taxable income.
    (ii) Share of collectibles gain allocable to an interest in a 
partnership, S corporation, or trust. When an interest in a 
partnership, S corporation, or trust held for more than one year is 
sold or exchanged in a transaction in which all realized gain is 
recognized, the transferor shall recognize as collectibles gain the 
amount of net collectibles gain (but not net collectibles loss) that 
would be allocated to that partner (taking into account any remedial 
allocation under Sec. 1.704-3(d)), shareholder, or beneficiary (to the 
extent attributable to the portion of the partnership interest, S 
corporation stock, or trust interest transferred that was held for more 
than one year) if the partnership, S corporation, or trust transferred 
all of its collectibles in a fully taxable transaction immediately 
before the transfer of the interest in the partnership, S corporation, 
or trust. If less than all of the realized gain is recognized upon the 
sale or exchange of an interest in a partnership, S corporation, or 
trust, the same methodology shall apply to determine the collectibles 
gain recognized by the transferor, except that the partnership, S 
corporation, or trust shall be treated as transferring only a 
proportionate amount of each of its collectibles determined as a 
fraction that is the amount of gain recognized in the sale or exchange 
over the amount of

[[Page 43121]]

gain realized in the sale or exchange. With respect to the transfer of 
an interest in a trust, this paragraph applies only to transfers by 
non-grantor transferors (as defined in paragraph (a) of this section).
    (3) Section 1250 capital gain--(i) Definition. For purposes of this 
section, section 1250 capital gain means the long-term capital gain 
(not otherwise treated as ordinary income) that would be treated as 
ordinary income if section 1250(b)(1) included all depreciation and the 
applicable percentage under section 1250(a) were 100 percent.
    (ii) Share of section 1250 capital gain allocable to interest in 
partnership. When an interest in a partnership held for more than one 
year is sold or exchanged in a transaction in which all realized gain 
is recognized, there shall be taken into account under section 
1(h)(7)(A)(i) in determining the partner's unrecaptured section 1250 
gain the amount of section 1250 capital gain that would be allocated 
(taking into account any remedial allocation under Sec. 1.704-3(d)) to 
that partner (to the extent attributable to the portion of the 
partnership interest transferred that was held for more than one year) 
if the partnership transferred all of its section 1250 property in a 
fully taxable transaction immediately before the transfer of the 
interest in the partnership. If less than all of the realized gain is 
recognized upon the sale or exchange of an interest in a partnership, 
the same methodology shall apply to determine the section 1250 gain 
recognized by the transferor, except that the partnership shall be 
treated as transferring only a proportionate amount of each section 
1250 property determined as a fraction that is the amount of gain 
recognized in the sale or exchange over the amount of gain realized in 
the sale or exchange.
    (iii) Limitation with respect to net section 1231 gain. In 
determining a transferor partner's net section 1231 gain (as defined in 
section 1231(c)(3)) for purposes of section 1(h)(7)(B), the transferor 
partner's allocable share of section 1250 capital gain in partnership 
property shall not be treated as section 1231 gain, regardless of 
whether the partnership property is used in the trade or business (as 
defined in section 1231(b)).
    (c) Residual long-term capital gain or loss. The amount of residual 
long-term capital gain or loss recognized by a partner, shareholder of 
an S corporation, or beneficiary of a trust on account of the sale or 
exchange of an interest in a partnership, S corporation, or trust shall 
equal the amount of long-term capital gain or loss that the partner 
would recognize under section 741, that the shareholder would recognize 
upon the sale or exchange of stock of an S corporation, or that the 
beneficiary would recognize upon the sale or exchange of an interest in 
a trust (pre-look-through long-term capital gain or loss) minus the 
amount of long-term capital gain determined under paragraph (b) of this 
section (look-through capital gain).
    (d) Special rule for tiered entities. In determining whether a 
partnership, S corporation, or trust has collectibles gain and whether 
a partnership has section 1250 capital gain, such partnership, S 
corporation, or trust shall be treated as owning its proportionate 
share of the property of any partnership, S corporation, or trust in 
which it owns an interest, either directly or indirectly through a 
chain comprised exclusively of such entities.
    (e) Notification requirements. Rules similar to those that apply to 
the partners and the partnership under section 751(a) shall apply in 
the case of sales or exchanges of interests in a partnership, S 
corporation, or trust that holds property with collectibles gain and in 
the case of sales or exchanges of interests in a partnership that holds 
property with section 1250 capital gain. See Sec. 1.751-1(a)(3).
    (f) Examples. The following examples illustrate the requirements of 
this section:

    Example 1. Collectibles gain. (i) A and B are equal partners in 
a personal service partnership (PRS). B transfers B's interest in 
PRS to T for $15,000 when PRS's balance sheet (reflecting a cash 
receipts and disbursements method of accounting) is as follows:

------------------------------------------------------------------------
                                                           Assets
                                                   ---------------------
                                                     Adjusted    Market
                                                      basis      value
------------------------------------------------------------------------
Cash..............................................     $3,000     $3,000
Loans owed to partnership.........................     10,000     10,000
  Collectibles....................................      1,000      3,000
  Other capital assets............................      6,000      2,000
                                                   ---------------------
Capital assets....................................      7,000      5,000
Unrealized receivables............................          0     14,000
                                                   ---------------------
    Total.........................................    $20,000    $32,000
                                                   ---------------------
                                                       Liabilities and
                                                           capital
                                                   ---------------------
Liabilities.......................................     $2,000     $2,000
Capital:
  A...............................................      9,000     15,000
  B...............................................      9,000     15,000
                                                   ---------------------
    Total.........................................    $20,000    $32,000
------------------------------------------------------------------------

    (ii) At the time of the transfer, B has held the interest in PRS 
for more than one year, and none of the property owned by PRS is 
section 704(c) property. The total amount realized by B is $16,000, 
consisting of the cash received, $15,000, plus $1,000, B's share of 
the partnership liabilities assumed by T. See section 752. B's basis 
for the partnership interest is $10,000 ($9,000 plus $1,000, B's 
share of partnership liabilities). B's undivided one-half interest 
in PRS includes a one-half interest in the partnership's unrealized 
receivables and a one-half interest in the partnership's 
collectibles.
    (iii) If PRS were to sell all of its section 751 property in a 
fully taxable transaction immediately prior to the transfer of B's 
partnership interest to T, B would be allocated $7,000 of ordinary 
income from the sale of PRS's unrealized receivables. Therefore, B 
will recognize $7,000 of ordinary income with respect to the 
unrealized receivables. The difference between the amount of capital 
gain or loss that the partner would realize in the absence of 
section 751 ($6,000) and the amount of ordinary income or loss 
determined under Sec. 1.751-1(a)(2) ($7,000) is the partner's 
capital gain or loss on the sale of the partnership interest under 
section 741. In this case, the transferor has a $1,000 pre-look-
through long-term capital loss.
    (iv) If PRS were to sell all of its collectibles in a fully 
taxable transaction immediately prior to the transfer of B's 
partnership interest to T, B would be allocated $1,000 of 
collectibles gain from the sale of the collectibles. Therefore, B 
will recognize $1,000 of collectibles gain on account of the 
collectibles held by PRS.
    (v) The difference between the transferor's pre-look-through 
long-term capital gain or loss (-$1,000) and the look-through 
capital gain determined under this section ($1,000) is the 
transferor's residual long-term capital gain or loss on the sale of 
the partnership interest. Under these facts, B will recognize a 
$2,000 residual long-term capital loss on account of the sale or 
exchange of the interest in PRS.
    Example 2. Special allocations. Assume the same facts as in 
Example 1, except that under the partnership agreement, all gain 
from the sale of the collectibles is specially allocated to B, and B 
transfers B's interest to T for $16,000. All items of income, gain, 
loss, or deduction of PRS, other than the collectibles gain, are 
divided equally between A and B. Under these facts, B's pre-look-
through long-term capital gain would be $0. If PRS were to sell all 
of its collectibles in a fully taxable transaction immediately prior 
to the transfer of B's partnership interest to T, B would be 
allocated $2,000 of collectibles gain from the sale of the 
collectibles. Therefore, B will recognize $2,000 of collectibles 
gain on account of the collectibles held by PRS. B also will 
recognize $7,000 of ordinary income (determined under Sec. 1.751-
1(a)(2)) and a $2,000 long-term capital loss on account of the sale 
of B's interest in PRS.
    Example 3. Net collectibles loss ignored. Assume the same facts 
as in Example 1, except that the collectibles held by PRS have an 
adjusted basis of $3,000 and a fair market

[[Page 43122]]

value of $1,000, and the other capital assets have an adjusted basis 
of $4,000 and a fair market value of $4,000. If PRS were to sell all 
of its collectibles in a fully taxable transaction immediately prior 
to the transfer of B's partnership interest to T, B would be 
allocated $1,000 of collectibles loss. Because none of the gain from 
the sale of the interest in PRS is attributable to unrealized 
appreciation in the value of collectibles held by PRS, the net loss 
in collectibles held by PRS is not recognized at the time B 
transfers the interest in PRS. B will recognize $7,000 of ordinary 
income (determined under Sec. 1.751-1(a)(2)) and a $1,000 long-term 
capital loss on account of the sale of B's interest in PRS.
    Example 4. Collectibles gain in an S corporation. (i) A 
corporation (X) has always been an S corporation and is owned by 
individuals A, B, and C. In 1996, X invested in antiques. Subsequent 
to their purchase, the antiques appreciated in value by $300. A owns 
one-third of the shares of X stock and has held that stock for more 
than one year. A's adjusted basis in the X stock is $100. If A were 
to sell all of the X stock to T for $150, A would realize $50 of 
pre-look-through long-term capital gain.
    (ii) If X were to sell its antiques in a fully taxable 
transaction immediately before the transfer to T, A would be 
allocated $100 of collectibles gain on account of the sale. 
Therefore, A will recognize $100 of collectibles gain (look-through 
capital gain) on account of the collectibles held by X.
    (iii) The difference between the transferor's pre-look-through 
long-term capital gain or loss ($50) and the look-through capital 
gain determined under this section ($100) is the transferor's 
residual long-term capital gain or loss on the sale of the S 
corporation stock. Under these facts, A will recognize $100 of 
collectibles gain and a $50 residual long-term capital loss on 
account of the sale of A's interest in X.

    (g) Effective date. This section applies to transfers of interests 
in partnerships, S corporations, and trusts that occur on or after the 
date these regulations are published as final regulations in the 
Federal Register.
    Par. 3. Section 1.1223-3 is added to read as follows:


Sec. 1.1223-3  Rules relating to the holding periods of partnership 
interests.

    (a) In general. A partner shall have a divided holding period in an 
interest in a partnership if:
    (1) The partner acquired portions of an interest at different 
times; or
    (2) The partner acquired portions of the partnership interest in 
exchange for property transferred at the same time but resulting in 
different holding periods determined under section 1223.
    (b) Accounting for holding periods of an interest in a partnership. 
The portion of a partnership interest to which a holding period relates 
shall be determined by reference to a fraction that is the fair market 
value of the portion of the partnership interest received in the 
transaction to which the holding period relates over the fair market 
value of the entire partnership interest (determined immediately after 
the transaction).
    (c) Sale or exchange of all or a portion of an interest in a 
partnership--(1) Sale or exchange of entire interest in a partnership. 
If a partner sells or exchanges the partner's entire interest in a 
partnership, any capital gain or loss recognized shall be divided 
between long-term and short-term capital gain or loss in the same 
proportions as the holding period of the interest in the partnership is 
divided between the portion of the interest held for more than one year 
and the portion of the interest held for one year or less.
    (2) Sale or exchange of a portion of an interest in a partnership. 
(i) If the ownership interest in a publicly traded partnership (as 
defined under section 7704(b)) is divided into identifiable units with 
ascertainable holding periods, and the selling partner can identify the 
portion of the partnership interest transferred, the selling partner 
may use the actual holding period of the portion transferred.
    (ii) If a partner has a divided holding period in a partnership 
interest, and paragraph (c)(2)(i) of this section does not apply, then 
the holding period of the transferred interest shall be divided between 
long-term and short-term capital gain or loss in the same proportions 
as the long-term and short-term capital gain or loss that the 
transferor partner would realize if the entire interest in the 
partnership were transferred in a fully taxable transaction immediately 
before the actual transfer.
    (d) Distributions--(1) In general. A partner's holding period in a 
partnership interest is not affected by distributions from the 
partnership.
    (2) Character of capital gain or loss recognized as a result of a 
distribution from a partnership. If a partner is required to recognize 
capital gain or loss as a result of a distribution from a partnership, 
then the capital gain or loss recognized shall be divided between long-
term and short-term capital gain or loss in the same proportions as the 
long-term and short-term capital gain or loss that the distributee 
partner would realize if such partner's entire interest in the 
partnership were transferred in a fully taxable transaction immediately 
before the distribution.
    (e) Examples. The provisions of this section are illustrated by 
the following examples:

    Example 1. Division of holding period--contribution of money and 
a capital asset. (i) A contributes $5,000 of cash and a 
nondepreciable capital asset A has held for two years to a 
partnership (PRS) for a 50% interest in PRS. A's basis in the 
capital asset is $5,000, and the fair market value of the asset is 
$10,000. After the exchange, A's basis in A's interest in PRS is 
$10,000, and the fair market value of the interest is $15,000. A 
received one-third of the interest in PRS for a cash payment of 
$5,000 ($5,000/$15,000). Therefore, A's holding period in one-third 
of the interest received (attributable to the contribution of money 
to the partnership) begins on the day after the contribution. A 
received two-thirds of the interest in PRS in exchange for the 
capital asset ($10,000/$15,000). Accordingly, pursuant to section 
1223(1), A has a two-year holding period in two-thirds of the 
interest received in PRS.
    (ii) Six months later, when A's basis in PRS is $12,000 (due to 
a $2,000 allocation of partnership income to A), A sells the 
interest in PRS for $15,000. Assuming PRS holds no inventory or 
unrealized receivables (as defined under section 751(c)) and no 
collectibles or section 1250 property, a will realize $3,000 of 
capital gain. As determined above, one-third of A's interest in PRS 
has a holding period of one year or less, and two-thirds of A's 
interest in PRS has a holding period equal to two years and six 
months. Therefore, one-third of the capital gain will be short-term 
capital gain, and two-thirds of the capital gain will be long-term 
capital gain.
    Example 2. Division of holding period--contribution of money, 
section 1231 property, and other property. In exchange for a 30% 
interest in a partnership (ABC), A contributes to ABC $50,000 cash 
and equipment used in a trade or business and held for more than one 
year with a fair market value of $100,000 and an adjusted basis of 
$40,000. The equipment has a recomputed basis under section 1245 of 
$60,000. Accordingly, a portion of the equipment equal in value to 
$20,000 is section 1245 property that is not section 1231 property. 
See Sec. 1.1245-6(a). A's partnership interest has a fair market 
value of $150,000, a basis of $90,000, and a divided holding period. 
A received 46.67% ($70,000/$150,000) of the interest in ABC in 
exchange for property that is neither a capital asset nor section 
1231 property (that is, cash of $50,000 and a portion of the 
equipment attributable to section 1245 recapture in an amount equal 
to $20,000). Therefore, A's holding period for 46.67% of A's 
interest begins on the day after the exchange of the property for 
the partnership interest. A received 53.33% ($80,000/$150,000) of 
A's interest in ABC in exchange for section 1231 property.
    Accordingly, A's holding period for 53.33% of A's interest 
includes A's holding period for the section 1231 property.
    Example 3. Division of holding period when capital account is 
increased by contribution. A, B, C, and D are equal partners in a 
partnership (PRS), and the fair market value of a 25% interest in 
PRS is $90x. A, B, C, and D each contribute an additional $10x to 
partnership capital, thereby increasing the fair market value of 
each partner's interest to $100x. As a result of the contribution, 
each partner has a new holding period in the portion of the 
partner's

[[Page 43123]]

interest in PRS that is attributable to the contribution. That 
portion equals 10% ($10x/$100x) of each partner's interest in PRS.
    Example 4. Sale or exchange of a portion of an interest in a 
partnership. (i) A contributes $5,000 in cash and a capital asset 
with a fair market value of $5,000 and a basis of $2,000 to a 
partnership (PRS) in exchange for an interest in PRS. At the time of 
the contribution, A had held the contributed property for two years. 
Six months later, when A'S basis in PRS is $7,000, A transfers one-
half of A'S interest in PRS to T for $6,000 at a time when PRS's 
balance sheet (reflecting a cash receipts and disbursements method 
of accounting) is as follows:

------------------------------------------------------------------------
                                                      Assets
                                                   -----------   Market
                                                     Adjusted    value
                                                      basis
------------------------------------------------------------------------
Cash..............................................     $5,000     $5,000
Unrealized Receivables............................          0      6,000
  Capital Asset 1.................................      3,000      8,000
  Capital Asset 2.................................      2,000      5,000
                                                   ---------------------
Capital Assets....................................      5,000     13,000
                                                   ---------------------
    Total.........................................    $10,000    $24,000
------------------------------------------------------------------------

    (ii) Although at the time of the transfer A has not held A's 
interest in PRS for more than one year, 50% of the fair market value 
of A'S interest in PRS was received in exchange for property with a 
long-term holding period. Therefore, 50% of A'S interest in PRS has 
a long-term holding period.
    (iii) If PRS were to sell all of its section 751 property in a 
fully taxable transaction immediately before A'S transfer of the 
partnership interest, A would be allocated $3,000 of ordinary 
income. One-half of that amount ($1,500) is attributable to the 
portion of A'S interest in PRS transferred to T. Accordingly, A will 
recognize $1,500 ordinary income and $1,000 ($2,500 -$1,500) of 
capital gain on account of the transfer to T of one-half of A'S 
interest in PRS. Fifty percent ($500) of that gain is long-term 
capital gain and 50% ($500) is short-term capital gain.
    Example 5. Sale or exchange of a portion of an interest in a 
partnership. (i) The facts are the same as in Example 4, except that 
capital asset 1 is a collectible that was purchased by PRS more than 
one year earlier. If capital asset 1 were sold or exchanged in a 
fully taxable transaction immediately before A's transfer of the 
partnership interest, A would be allocated $2,500 of collectibles 
gain. Fifty percent of that amount ($1,250) is attributable to the 
portion of A's interest in PRS sold to T. The collectibles gain 
allocable to the portion of the transferred interest in PRS with a 
long-term holding period is $625 (50% of $1,250). Accordingly, A 
will recognize $625 of collectibles gain on account of the transfer 
of one-half of the interest in PRS.
    (ii) The difference between the amount of pre-look-through long-
term capital gain or loss ($500) and the look-through capital gain 
($625) is the amount of residual long-term capital gain or loss that 
A will recognize on account of the transfer of one-half of the 
interest in PRS. Under these facts, A will recognize a residual 
long-term capital loss of $125 and a short-term capital gain of 
$500.
    Example 6. Sale of units of interests in partnership. A publicly 
traded partnership (PRS) has ownership interests that are segregated 
into identifiable units of interest. A owns 10 limited partnership 
units in PRS for which A paid $10,000 three years ago. Later, A 
purchases five additional units for $10,000 at a time when the fair 
market value of each unit has increased to $2,000. A's holding 
period for one-third ($10,000/$30,000) of the interest in PRS begins 
on the day after the purchase of the five additional units. Less 
than one year later, A sells five units of ownership in PRS for 
$11,000. At the time, A's basis in the 15 units of PRS is $20,000, 
and A's capital gain on the sale of 5 units is $4,333 (amount 
realized of $11,000--one-third of the adjusted basis or $6,667). For 
purposes of determining the holding period, A can designate the 
specific units of PRS sold. If A properly identifies the five units 
sold as five of the ten units for which A has a long-term holding 
period, the capital gain realized will be long-term capital gain.
    Example 7. Disproportionate distribution. In 1997, A and B each 
contribute cash of $50,000 to form and become equal partners in a 
partnership (PRS). Sometime later, A receives a distribution worth 
$22,000 from PRS, which reduces A's interest in PRS to 36%. After 
the distribution, B owns 64% of PRS. The holding periods of A and B 
in their interests in PRS are not affected by the distribution.
    Example 8. Gain or loss as a result of a distribution. In 1996, 
A contributes property with a basis of $10 and a fair market value 
of $10,000 in exchange for an interest in a partnership (ABC). In 
1999, when A's interest in ABC is worth $12,000, A contributes 
$6,000 cash in exchange for an additional interest in ABC, bringing 
the fair market value of A's interest to $18,000. The holding period 
of A's interest in ABC is determined immediately after that 
exchange. A's holding period in one-third of A's interest in ABC 
($6,000 cash contributed over the $18,000 value of the entire 
interest) begins on the day after the cash contribution. (ABC holds 
no inventory or unrealized receivables.) Later in 1999, ABC makes a 
cash distribution to A of $10,000. A's basis in ABC immediately 
before the distribution is $6,010. Accordingly, A must recognize 
$3990 of capital gain as a result of the distribution. See section 
731(a)(1). One-third of the capital gain recognized as a result of 
the distribution is short-term capital gain, and two-thirds of the 
capital gain is long-term capital gain. After the distribution, A's 
basis in the interest in PRS is $0, and the holding period for the 
interest in PRS continues to be divided in the same proportions as 
before the distribution.

    (f) Effective date. This section applies to transfers of 
partnership interests and distributions of property from a partnership 
that occur on or after the date final regulations are published in the 
Federal Register.
    Par. 4. Section 1.741-1 is amended by adding paragraphs (e) and (f) 
to read as follows:


Sec. 1.741-1  Recognition and character of gain or loss on sale or 
exchange.

* * * * *
    (e) For rules relating to the capital gain or loss recognized when 
a partner sells or exchanges an interest in a partnership that holds 
appreciated collectibles or section 1250 property with section 1250 
capital gain, see Sec. 1.1(h)-1.
    (f) For rules relating to dividing the holding period of an 
interest in a partnership, see Sec. 1.1223-3.
Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
[FR Doc. 99-20368 Filed 8-6-99; 8:45 am]
BILLING CODE 4830-01-U