[Federal Register Volume 65, Number 184 (Thursday, September 21, 2000)]
[Rules and Regulations]
[Pages 57092-57101]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-24038]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 8902]
RIN 1545-AW22


Capital Gains, Partnership, Subchapter S, and Trust Provisions

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to sales or 
exchanges of interests in partnerships, S corporations, and trusts. The 
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 partnership interest. The regulations affect 
partnerships, partners, S corporations, S corporation shareholders, 
trusts, and trust beneficiaries.

DATES: Effective Date: These regulations are effective September 21, 
2000.

FOR FURTHER INFORMATION CONTACT: Jeanne M. Sullivan or David J. Sotos 
(202) 622-3050 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collections of information contained in these final regulations 
have been reviewed and approved by the Office of Management and Budget 
in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507) 
under control number 1545-1654. Responses to these collections of 
information are required to verify compliance with section 1(h) and to 
determine that the tax on capital gains has been computed correctly.
    An agency may not conduct or sponsor, and a person is not required 
to

[[Page 57093]]

respond to, a collection of information unless the collection of 
information displays a valid control number assigned by the Office of 
Management and Budget.
    The estimated annual burden per respondent/recordkeeper is 10 
minutes.
    Comments concerning the accuracy of this burden estimate and 
suggestions for reducing this burden should be sent to the Internal 
Revenue Service, Attn: IRS reports Clearance Officer, OP:FS:FP, 
Washington, DC 20224, and 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.
    Books or records relating to this 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

    Section 311 of the Taxpayer Relief Act of 1997, Public Law 105-34 
(111 Stat. 788, 831) (the 1997 Act), as modified by sections 5001 and 
6005(d) of the Internal Revenue Service Restructuring and Reform Act of 
1998, Public Law 105-206 (112 Stat. 685, 787, 800) (the 1998 Act), 
reduced the maximum statutory tax rates for long-term capital gains of 
individuals in general and provided regulatory authority to apply the 
rules to sales and exchanges of interests in pass-thru entities and to 
sales and exchanges by pass-thru entities. On August 9, 1999, the IRS 
published in the Federal Register a notice of proposed rulemaking (REG-
106527-98, 64 FR 43117) relating to the taxation of capital gains in 
the case of sales or exchanges of interests in partnerships, S 
corporations, and trusts. The regulations interpreted rules added by 
the 1997 Act and amended by the 1998 Act, and provided guidance 
relating to the division of the holding period of a partnership 
interest. The IRS received no requests to speak at a public hearing 
that was scheduled for November 18, 1999, and canceled the hearing. 
Written comments were received in response to the notice of proposed 
rulemaking. After consideration of the comments, the proposed 
regulations under sections 1(h), 741, and 1223 are adopted, as revised 
by this Treasury decision. The comments received and revisions made are 
discussed below.

Explanation of Revisions and Summary of Comments

1. Look-Through Capital Gain

a. In General
    Section 1(h) provides maximum capital gains rates 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. Twenty-
eight percent rate gain includes 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 and certain 
other types of gain.
    Capital gain attributable to the sale or exchange of an interest in 
a pass-thru entity held for more than one year generally is in the 20-
percent rate gain category. However, the proposed regulations provide 
that, when a taxpayer sells or exchanges an interest in a partnership, 
S corporation, or trust that holds collectibles, rules similar to the 
rules under section 751(a) apply to determine the capital gain that is 
attributable to certain unrealized gain in the collectibles. 
Furthermore, under the proposed regulations, rules similar to the rules 
under section 751(a) also apply to determine the capital gain 
attributable to certain unrealized gain in section 1250 property held 
by a partnership when a taxpayer sells or exchanges an interest in a 
partnership that holds such property.
b. Net Collectibles Loss
    Twenty-eight percent rate gain is the excess (if any) of (i) the 
sum of collectibles gain and section 1202 gain, over (ii) the sum of 
collectibles loss, the net short-term loss, and the amount of long-term 
capital loss carried under section 1212(b)(1)(B) to the taxable year. 
One commentator suggested that, when an interest in a partnership, S 
corporation, or trust is transferred, net collectibles loss as well as 
net collectibles gain in property held by such an entity should be 
taken into account in determining a taxpayer's overall collectibles 
gain or collectibles loss. The Treasury Department (Treasury) and the 
IRS believe that the proposed regulations are consistent with the rule 
in section 1(h)(6)(B), which, in providing look-through treatment with 
respect to collectibles, refers only to ``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 * 
* * '' Accordingly, the comment is not adopted in the final 
regulations.
c. Limitations With Respect to Section 1231 Property
    Section 1(h)(7)(B) limits the amount of unrecaptured section 1250 
gain recognized as a consequence of sales, exchanges, and conversions 
described in section 1231(a)(3)(A) to the taxpayer's net section 1231 
gain (as defined in section 1231(c)(3)) for the taxable year. The 
proposed regulations provide that, upon a partner's transfer of a 
partnership interest, the partner's allocable share of section 1250 
capital gain (as defined in Sec. 1.1(h)-1(b)(3)) is not treated as 
section 1231 gain for purposes of applying the limitation in section 
1(h)(7)(B). There has been some confusion regarding whether the section 
1(h)(7)(B) limitation applies to all unrecaptured section 1250 gain, 
including section 1250 capital gain recognized on the transfer of a 
partnership interest.
    Because the transfer of an interest in a partnership is not 
described in section 1231(a)(3)(A), the limitation provided in section 
1(h)(7)(B) is not applicable with respect to such transfers. 
Accordingly, under the final regulations (and consistent with the 
proposed regulations), where a partner sells an interest in a 
partnership, the partner must take into account the entire allocable 
share of section 1250 capital gain in determining the unrecaptured 
section 1250 gain under section 1(h)(7)(A), without regard to the 
limitation set forth in section 1(h)(7)(B).
d. Redemption of a Partnership Interest
    Some practitioners have expressed concern that the look-through 
capital gains provisions of the proposed regulations apply to the 
redemption of a partnership interest. To apply the regulations in the 
context of redemptions, it would be necessary to import the concepts 
utilized in section 751(b). Treasury and the IRS believe that this 
would not be advisable. Accordingly, these regulations do not apply to 
any transaction that is treated as a redemption of a partnership 
interest for Federal income tax purposes.
e. Allocating Section 704(c) Gain and Loss
    Certain commentators requested that the final regulations provide 
guidance with respect to the proportionate part of the section 704(c) 
built-in gain or loss that is transferred to the purchaser when a 
section 704(c) partner sells a portion of a partnership interest. This 
issue is

[[Page 57094]]

relevant because, in determining a taxpayer's share of collectibles 
gain or section 1250 capital gain on the sale of a partnership 
interest, it is necessary to calculate how much of such gain would be 
allocated with respect to the partnership interest sold if the 
underlying collectibles or section 1250 property held by the 
partnership were sold for their fair market value. In making this 
determination where a partner sells only a portion of its interest in a 
partnership, it is necessary to determine how much section 704(c) gain 
relating to collectibles or section 1250 property is allocable to the 
portion of the partnership interest that is sold. Although relevant, 
Treasury and the IRS believe that this issue is beyond the scope of 
these regulations. Accordingly, this comment is not addressed in these 
regulations.
f. Look-Through Capital Gain Where the Pass-Thru Entity Has a Short-
Term Holding Period in Collectibles
    The final regulations modify the proposed regulations to provide 
that a pass-thru entity's holding period in the collectibles is not 
relevant in determining whether long-term capital gain recognized on 
the sale of an interest in the entity is collectibles gain (taxable at 
a 28-percent rate). Consistent with the purpose of the look-through 
provisions contained in section 1(h), these regulations characterize a 
transferor's long-term capital gain recognized on the sale of the 
interest in a pass-thru entity by reference to the entity's underlying 
assets that give rise to such gain. Where a transferor recognizes long-
term capital gain on the sale of an interest in a partnership, S 
corporation, or trust, it would be anomalous to provide the transferor 
with a better tax result if the entity has a short-term holding period 
in collectibles than if the entity has a long-term holding period in 
such property. This rule is not relevant with respect to section 1250 
property. Because all depreciation with respect to section 1250 
property held for one year or less is treated as additional 
depreciation under section 1250(b)(1), such amounts will be treated as 
unrealized receivables under section 751(c) and thus will give rise to 
ordinary income under section 751(a) upon a disposition of the 
partnership interest.

2. Determination of Holding Period in a Partnership

a. In General
    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. Under the proposed regulations, the holding period of a 
portion of a partnership interest generally is 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.
    Under the proposed regulations, a selling partner generally cannot 
identify and use the actual holding period for a portion of the 
partner's interest. However, the proposed regulations provide that a 
selling partner is permitted to identify the portion of a partnership 
interest sold with its holding period 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.
b. Contributions of Cash by Existing Partners
    The proposed regulations include an example of a pro rata 
contribution of cash by partners that results in a divided holding 
period in those partners' interests in the partnership. Commentators 
suggested that it is inappropriate to provide for a divided holding 
period where an existing partner contributes cash to the partnership, 
particularly where the contribution is pro rata by all of the partners. 
According to these commentators, such an approach may unfairly convert 
portions of long-term appreciation of partnership assets into a short-
term capital gain on the sale of a long held partnership interest. 
(This conversion occurs regardless of whether the partner sells all or 
a portion of a partnership interest.)
    The conversion of long-term appreciation in partnership assets into 
short-term capital gain upon the sale of a partnership interest as a 
result of cash contributions to the partnership is largely the product 
of partners having unitary bases in their partnership interests. See 
Rev. Rul. 84-53 (1984-1 C.B. 159) (a partner has a single basis in a 
partnership interest). Under this rule, gain attributable to previously 
contributed or acquired assets may be allocated to the short-term 
portion of a partnership interest even though the value of the short-
term portion is no greater than the amount of cash contributed to the 
partnership. If basis from contributed cash or property could be traced 
to a segregated interest in the partnership, this conversion of long-
term capital appreciation into short-term capital gain would not occur. 
Larger problems would arise, however, in the context of partnership 
taxation if a partner were allowed to have a divided basis in a 
partnership interest.
    An aggregate approach to determining the holding period of an 
interest in a partnership would make it more likely that a contribution 
of cash would not give rise to a short-term holding period. Under an 
aggregate approach, one could trace contributed funds into the 
partnership and determine whether a new holding period was created by 
reference to whether the funds were used for capital expenditures (in 
which circumstance, a short-term holding period generally would be 
appropriate) or for operating expenditures of the partnership (in which 
circumstance, no new holding period should be created). On the other 
hand, to the extent that a partnership interest is a capital asset that 
is distinct from the partnership's assets (an entity approach), its 
holding period and basis should be determined independently and should 
not be affected by the partnership's use of the contributed funds. In 
choosing the entity approach in the proposed regulations, Treasury and 
the IRS concluded that tracing funds to their ultimate use in the 
partnership is not an administrable means of determining whether a 
contribution to a partnership creates a new holding period.
    Furthermore, the proposed regulations are consistent with general 
rules relating to the holding period of capital and section 1231 
assets. Where a capital asset (including a capital asset held for one 
year or less) or property described in section 1231 is contributed to a 
partnership, section 1223(1) requires the tacking of the holding period 
in the partnership interest, whether the partners make pro rata 
contributions of property or instead make non-pro rata contributions 
that increase the proportionate interests of one or more partners.
    In addition, the proposed regulations avoid inappropriate results 
that may occur if cash contributions are ignored after the formation of 
a partnership. If cash contributions were ignored, it would be possible 
for partners to form shelf partnerships with nominal cash contributions 
in order to start their holding period in the interests, where the 
majority of cash would not be

[[Page 57095]]

contributed (and significant operating assets of the partnership would 
not be acquired) until some time in the future. This clearly would not 
be a proper result.
    Based upon the foregoing, Treasury and the IRS continue to believe 
that the approach taken in the proposed regulations is appropriate. 
However, in response to comments, Treasury and the IRS have provided 
one exception, and explicitly grant authority for another, where the 
contribution of cash will not create a new holding period in a 
partnership interest.
    If a partner makes cash contributions and receives cash 
distributions from a partnership during the one-year period before sale 
of all or a portion of the interest in the partnership, Treasury and 
the IRS believe it is appropriate that the net cash contribution to the 
partnership determine the portion of the interest that is held for one 
year or less. Therefore, the final regulations provide that, if a 
partner makes one or more cash contributions and receives one or more 
cash distributions with respect to the partnership during the one-year 
period ending on the date of the sale or exchange of all or a portion 
of the partner's interest in the partnership, in applying the rules for 
determining the partner's holding period in its partnership interest 
with respect to cash contributions, the partner may reduce the cash 
contributions made during the year by cash distributions received on a 
last-in-first-out basis, treating all cash distributions as if they 
were received by the partner immediately before the sale or exchange. 
This rule also applies in determining the holding period of a 
partnership interest where gain or loss is recognized under section 
731(a) upon a distribution by the partnership.
    In addition, the final regulations include authority for the 
Secretary to provide, in published guidance, additional exceptions to 
the general holding period rules with respect to other cash 
contributions, including de minimis cash contributions, to a 
partnership. Treasury and the IRS request comments as to the 
appropriate level for a de minimis exception.
c. Treatment of Deemed Cash Contributions Under Section 752(a)
    Section 752(a) provides that an increase in a partner's share of 
partnership liabilities, or an increase in a partner's individual 
liabilities by reason of the partner's assumption of partnership 
liabilities, shall be treated as a contribution of money by the partner 
to the partnership. Some practitioners have questioned whether a 
partner's deemed contribution of cash under section 752(a) will give 
rise to a new holding period in that partner's interest in the 
partnership. A deemed contribution of cash resulting from a shift among 
partners in their share of liabilities or as a result of a partnership 
incurring new debt does not expand the net asset base of the partners 
represented by their interests in the partnership. Accordingly, it is 
inappropriate to create a new holding period as a result of such deemed 
contributions. However, to the extent that a partner actually assumes a 
debt of the partnership, thus causing an increase in the net asset base 
of the partnership, the creation of a new holding period with respect 
to a portion of the partner's interest is appropriate.
    In addressing a similar issue, the capital account rules regarding 
the treatment of liabilities under Sec. 1.704-1(b)(2)(iv)(c) attempt to 
measure the increase or decrease in a partner's economic interest in 
the partnership resulting from the assumption of liabilities by either 
the partner or the partnership. Those rules provide:

    * * * (1) money contributed by a partner to a partnership 
includes the amount of any partnership liabilities that are assumed 
by such partner (other than [certain] liabilities * * * that are 
assumed by a distributee partner [in connection with a distribution 
of property by the partnership]) but does not include increases in 
such partner's share of partnership liabilities (see section 
752(a)), and (2) money distributed to a partner by a partnership 
includes the amount of such partner's individual liabilities that 
are assumed by the partnership (other than [certain] liabilities * * 
* that are assumed by the partnership [in connection with a 
contribution of property to the partnership]) but does not include 
decreases in such partner's share of partnership liabilities (see 
section 752(b)) * * *

    This rule is incorporated in the final regulations. The final 
regulations provide that deemed contributions and distributions of cash 
under sections 752(a) and (b) will be disregarded in determining a 
partner's holding period in its partnership interest to the same extent 
that such amounts are disregarded under Sec. 1.704-1(b)(2)(iv)(c). 
(Deemed distributions under section 752(b) are relevant as a result of 
the cash netting rule added in these final regulations.)
d. Contribution of Section 751 Assets
    Commentators noted that, if a partner has a short-term holding 
period in a partnership interest on account of the contribution of 
assets described in section 751(c) or (d) (section 751 assets), the 
rules of section 751(a) in conjunction with the proposed regulations 
cause the section 751 assets to be counted twice if a partnership 
interest is sold within 12 months of the contribution, once in applying 
section 751(a) to treat part of the amount received as ordinary income, 
and again in determining the selling partner's short-term capital gain. 
In response to these comments, the final regulations provide that, if a 
partner recognizes ordinary income or loss on account of section 751 
assets, either under section 751(a) as a result of the sale of all or 
part of the partnership interest or as a result of the sale by the 
partnership of the section 751 assets, the section 751 assets shall be 
disregarded in determining the division of the holding period of an 
interest in a partnership upon a sale of such partnership interest 
during the one-year period following the contribution. This rule does 
not apply if, in the absence of the rule, a partner would not be 
treated as having held any portion of the interest for more than one 
year. Accordingly, if a partner's only contributions to a partnership 
are contributions of section 751 assets or section 751 assets and cash 
within the prior one-year period, the adjustment will not be available, 
and the partner appropriately will be treated as having a short-term 
holding period with respect to the entire interest.
    A similar rule disregarding the contribution of section 751 assets 
does not apply in determining the holding period of a partnership 
interest with respect to gain or loss recognized under section 731 upon 
a distribution by a partnership. Properly coordinating the holding 
period rules with gain or loss determinations under section 751(b) 
would be inordinately complex. In addition, where, within a one-year 
period, a partner contributes section 751 assets to a partnership and 
receives a cash distribution large enough to require the recognition of 
gain, it is likely that the contribution and distribution will 
constitute a disguised sale of the section 751 assets to the 
partnership under section 707(a)(2)(B), thus rendering the holding 
period rules irrelevant since the sale of an asset to a partnership 
does not affect the holding period of an interest in the partnership.
e. Treatment of Recapture and Other Unrealized Receivables
    An example in the proposed regulations treats the portion of a 
contributed asset that would be recaptured as ordinary income under 
section 1245 upon disposition as non-section 1231 property for purposes 
of the tacked holding period rule in section 1223(1). Some commentators 
have raised questions regarding the position taken in this example. For

[[Page 57096]]

purposes of these regulations, Treasury and the IRS believe that it is 
appropriate to characterize all properties and potential gain treated 
as unrealized receivables under section 751(c) and the regulations 
thereunder as separate assets that are not capital assets or property 
described in section 1231. Accordingly, while the example in the 
proposed regulations has been eliminated, a specific rule has been 
added in the final regulations to provide for such a result. This rule 
is consistent with the rule added in the final regulations regarding 
the holding period exception for contributed section 751 assets. As 
discussed above, that rule will disregard the contribution of section 
751 assets (including properties and potential gain treated as 
unrealized receivables under section 751(c)) in computing the holding 
period of a partnership interest where the interest is sold within one 
year after contribution. Accordingly, while section 1245 recapture (and 
similar items treated as unrealized receivables) will be treated as a 
separate asset that is not a capital or section 1231 asset, the asset 
will not give rise to a short-term holding period where a partnership 
interest is sold. This rule also is similar to the rule contained in 
Sec. 1.755-1(a), which provides that properties and potential gain 
treated as unrealized receivables under section 751(c) are considered 
separate ordinary income assets for purposes of allocating basis 
adjustments under section 755.
f. Identification of Publicly Traded Partnership Units
    The proposed regulations provide that 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. Commentators 
suggested that it may be appropriate to provide that a partner must be 
consistent in electing, for holding period purposes, to identify units 
of a publicly traded partnership that are sold or exchanged in order to 
avoid distortion in the total long-term and short-term capital gain 
recognized. This suggestion is adopted in the final regulations.
g. Conversion From General Partnership to Limited Partnership
    A commentator requested clarification that a partner's holding 
period in its partnership interest carries over when a partnership 
converts from a general partnership to a limited partnership, as 
described in Rev. Rul. 84-52 (1984-1 C.B. 157). The ruling concludes 
that, pursuant to section 1223(1), there will be no change to the 
holding period of any partner's interest in the partnership as a result 
of such a conversion. The final regulations do not change the result 
set forth in Rev. Rul. 84-52.
h. Other Miscellaneous Issues
    The proposed regulations contain an example which, consistent with 
Rev. Rul. 84-53, states that a partner has a single basis in its 
partnership interest. Certain commentators suggested that the principle 
that a partner has a single basis in its partnership interest should be 
set forth in regulations, rather than simply relying on Rev. Rul. 84-
53. The rules set forth in these regulations address only holding 
period and character issues. In illustrating the operation of certain 
of these rules, the example accurately reflects current law. Treasury 
and the IRS believe that the inclusion of a separate rule providing 
that a partner has a single basis in its partnership interest is 
unnecessary and is beyond the scope of these regulations.
    Finally, it was suggested that the final regulations cross-
reference section 83(f), which provides that in determining the holding 
period of property to which section 83(a) applies, only the holding 
period during which rights are transferable or are not subject to a 
substantial risk of forfeiture shall be included. Treasury and the IRS 
currently are studying the extent to which section 83(a) applies to the 
issuance of certain partnership interests (i.e., a profits interest in 
a partnership) in exchange for services. Section 83(f) is relevant to 
the extent that section 83(a) applies with respect to a partnership 
interest. However, in order to avoid any implication that section 83(a) 
applies to all partnership interests issued in exchange for services, a 
cross reference to section 83(f) has not been included in the final 
regulations.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 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. It is hereby 
certified that the collection of information in these regulations will 
not have a significant impact on a substantial number of small 
businesses. This certification is based upon the fact that the economic 
burden imposed on taxpayers by the collection of information and 
recordkeeping requirements of these regulations is insignificant. For 
example, the estimated average annual burden per respondent is 10 
minutes. Therefore, a Regulatory Flexibility Analysis is not required 
under the Regulatory Flexibility Act (5 U.S.C. chapter 6). Pursuant to 
section 7805(f) of the Internal Revenue Code, the notice of proposed 
rulemaking preceding these regulations was submitted to the Chief 
Counsel for Advocacy of the Small Business Administration for comment 
on its impact on small business.

Drafting Information

    The principal authors of these regulations are Jeanne M. Sullivan 
and David J. Sotos of the Associate Chief Counsel (Passthroughs and 
Special Industries). However, other personnel from Treasury and the IRS 
participated in their development.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR parts 1 and 602 are 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 in part as follows:

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

    Section 1.1(h)-1 is also issued under 26 U.S.C. 1(h); * * *
    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., under 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., under 
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

[[Page 57097]]

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--(i) Definition. For purposes of this 
section, collectibles gain shall be treated as gain 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.
    (ii) Share of collectibles gain allocable to an interest in a 
partnership, S corporation, or a 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 gain (but not net 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 for cash equal to the fair market value of the assets 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 gain realized in 
the sale or exchange. With respect to the transfer of an interest in a 
trust, this paragraph (b)(2) applies only to transfers by non-grantor 
transferors (as defined in paragraph (a) of this section). This 
paragraph (b)(2) does not apply to a transaction that is treated, for 
Federal income tax purposes, as a redemption of an interest in a 
partnership, S corporation, or trust.
    (3) Section 1250 capital gain--(i) Definition. For purposes of this 
section, section 1250 capital gain means the 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 for cash equal to the fair market value of 
the assets 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 capital 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. This paragraph (b)(3) does not apply to a 
transaction that is treated, for Federal income tax purposes, as a 
redemption of a partnership interest.
    (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 look-through capital gain determined under paragraph (b) of 
this section.
    (d) Special rule for tiered entities. In determining whether a 
partnership, S corporation, or trust has gain from collectibles, such 
partnership, S corporation, or trust shall be treated as owning its 
proportionate share of the collectibles of any partnership, S 
corporation, or trust in which it owns an interest either directly or 
indirectly through a chain of such entities. In determining whether a 
partnership has section 1250 capital gain, such partnership shall be 
treated as owning its proportionate share of the section 1250 property 
of any partnership in which it owns an interest, either directly or 
indirectly through a chain of partnerships.
    (e) Notification requirements. Reporting 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 cause holders of such 
interests to recognize collectibles gain and in the case of sales or 
exchanges of interests in a partnership that cause holders of such 
interests to recognize 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
------------------------------------------------------------------------


[[Page 57098]]


------------------------------------------------------------------------
                                                        LIABILITIES AND
                                                            CAPITAL
                                                     -------------------
                                                      Adjusted   Market
                                                        basis     value
------------------------------------------------------------------------
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 B's basis for the partnership interest 
is $10,000 ($9,000 plus $1,000, B's share of partnership 
liabilities). 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 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 for cash equal to the fair market value of 
the assets 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 for cash equal to the fair market value of the 
assets immediately prior to the transfer of B's partnership interest 
to T, B would be allocated $1,000 of 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 gain from the 
collectibles, are divided equally between A and B. Under these 
facts, B's amount realized is $17,000, consisting of the cash 
received, $16,000, plus $1,000, B's share of the partnership 
liabilities assumed by T. See section 752. B will recognize $7,000 
of ordinary income with respect to the unrealized receivables 
(determined under Sec. 1.751-1(a)(2)). Accordingly, 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 for cash equal to 
the fair market value of the assets immediately prior to the 
transfer of B's partnership interest to T, B would be allocated 
$2,000 of 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 will recognize a $2,000 residual 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 value of $1,000, and the 
other capital assets have an adjusted basis of $4,000 and a fair 
market value of $4,000. (The total adjusted basis and fair market 
value of the partnership's capital assets are the same as in Example 
1.) If PRS were to sell all of its collectibles in a fully taxable 
transaction for cash equal to the fair market value of the assets 
immediately prior to the transfer of B's partnership interest to T, 
B would be allocated $1,000 of loss from the sale of the 
collectibles. 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 A's 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 for cash equal to the fair market value of the assets 
immediately before the transfer to T, A would be allocated $100 of 
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.
    Example 5. Sale or exchange of partnership interest where part 
of the interest has a short-term holding period. (i) A, B, and C 
form an equal partnership (PRS). In connection with the formation, A 
contributes $5,000 in cash and a capital asset with a fair market 
value of $5,000 and a basis of $2,000; B contributes $7,000 in cash 
and a collectible with a fair market value of $3,000 and a basis of 
$3,000; and C contributes $10,000 in cash. 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 A's 
interest in PRS to T for $14,000 at a time when PRS's balance sheet 
(reflecting a cash receipts and disbursements method of accounting) 
is as follows:

------------------------------------------------------------------------
                                                            ASSETS
                                                     -------------------
                                                      Adjusted   Market
                                                        basis     value
------------------------------------------------------------------------
Cash................................................   $22,000   $22,000
Unrealized Receivables..............................         0     6,000
  Capital Asset.....................................     2,000     5,000
  Collectible.......................................     3,000     9,000
Capital Assets......................................     5,000    14,000
                                                     -------------------
    Total...........................................    27,000    42,000
------------------------------------------------------------------------

    (ii) Although at the time of the transfer A has not held A's 
interest in PRS for more than one year, 50 percent of the fair 
market value of A's interest in PRS was received in exchange for a 
capital asset with a long-term holding period. Therefore, 50 percent 
of A'sinterest in PRS has a long-term holding period. See 
Sec. 1.1223-3(b)(1).
    (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 $2,000 of ordinary 
income. Accordingly, A will recognize $2,000 ordinary income and 
$5,000 ($7,000-$2,000) of capital gain on account of the transfer to 
T of A's interest in PRS. Fifty percent ($2,500) of that gain is 
long-term capital gain and 50 percent ($2,500) is short-term capital 
gain. See Sec. 1.1223-3(c)(1).
    (iv) If the collectible were sold or exchanged in a fully 
taxable transaction immediately before A's transfer of the 
partnership interest, A would be allocated $2,000 of gain 
attributable to the collectible. The gain attributable to the 
collectible that is allocable to the portion of the transferred 
interest in PRS with a long-term holding period is $1,000 (50 
percent of $2,000). Accordingly, A will recognize $1,000 of 
collectibles gain on account of the transfer of A's interest in PRS.
    (v) The difference between the amount of pre-look-through long-
term capital gain or loss ($2,500) and the look-through capital gain 
($1,000) is the amount of residual long-term capital gain or loss 
that A will recognize on account of the transfer of A's interest in 
PRS. Under these facts, A will recognize a residual long-term 
capital gain of $1,500 and a short-term capital gain of $2,500.

    (g) Effective date. This section applies to transfers of interests 
in partnerships, S corporations, and trusts that occur on or after 
September 21, 2000.

[[Page 57099]]

    Par. 3. 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. This paragraph (e) applies to 
transfers of interests in partnerships that occur on or after September 
21, 2000.
    (f) For rules relating to dividing the holding period of an 
interest in a partnership, see Sec. 1.1223-3. This paragraph (f) 
applies to transfers of partnership interests and distributions of 
property from a partnership that occur on or after September 21, 2000.
    Par. 4. Section 1.1223-3 is added under the undesignated 
centerheading ``General Rules for Determining Capital Gains and 
Losses'' to read as follows:


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

    (a) In general. A partner shall not have a divided holding period 
in an interest in a partnership unless--
    (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 (e.g., section 1223).
    (b) Accounting for holding periods of an interest in a 
partnership--(1) General rule. The portion of a partnership interest to 
which a holding period relates shall be determined by reference to a 
fraction, the numerator of which is the fair market value of the 
portion of the partnership interest received in the transaction to 
which the holding period relates, and the denominator of which is the 
fair market value of the entire partnership interest (determined 
immediately after the transaction).
    (2) Special rule. For purposes of applying paragraph (b)(1) of this 
section to determine the holding period of a partnership interest (or 
portion thereof) that is sold or exchanged (or with respect to which 
gain or loss is recognized upon a distribution under section 731), if a 
partner makes one or more contributions of cash to the partnership and 
receives one or more distributions of cash from the partnership during 
the one-year period ending on the date of the sale or exchange (or 
distribution with respect to which gain or loss is recognized under 
section 731), the partner may reduce the cash contributions made during 
the year by cash distributions received on a last-in-first-out basis, 
treating all cash distributions as if they were received immediately 
before the sale or exchange (or at the time of the distribution with 
respect to which gain or loss is recognized under section 731).
    (3) Deemed contributions and distributions. For purposes of 
paragraphs (b)(1) and (2) of this section, deemed contributions of cash 
under section 752(a) and deemed distributions of cash under section 
752(b) shall be disregarded to the same extent that such amounts are 
disregarded under Sec. 1.704-1(b)(2)iv)(c).
    (4) Adjustment with respect to contributed section 751 assets. For 
purposes of applying paragraph (b)(1) of this section to determine the 
holding period of a partnership interest (or portion thereof) that is 
sold or exchanged, if a partner receives a portion of the partnership 
interest in exchange for property described in section 751(c) or (d) 
(section 751 assets) within the one-year period ending on the date of 
the sale or exchange of all or a portion of the partner's interest in 
the partnership, and the partner recognizes ordinary income or loss on 
account of such a section 751 asset in a fully taxable transaction 
(either as a result of the sale of all or part of the partner's 
interest in the partnership or the sale by the partnership of the 
section 751 asset), the contribution of the section 751 asset during 
the one-year period shall be disregarded. However, if, in the absence 
of this paragraph, a partner would not be treated as having held any 
portion of the interest for more than one year (e.g., because the 
partner's only contributions to the partnership are contributions of 
section 751 assets or section 751 assets and cash within the prior one-
year period), this adjustment is not available.
    (5) Exception. The Commissioner may prescribe by guidance published 
in the Internal Revenue Bulletin (see Sec. 601.601(d)(2) of this 
chapter) a rule disregarding certain cash contributions (including 
contributions of a de minimis amount of cash) in applying paragraph 
(b)(1) of this section to determine the holding period of a partnership 
interest (or portion thereof) that is sold or exchanged.
    (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) Certain publicly traded partnerships. A selling partner in a 
publicly traded partnership (as defined under section 7704(b)) may use 
the actual holding period of the portion of a partnership interest 
transferred if--
    (A) The ownership interest is divided into identifiable units with 
ascertainable holding periods;
    (B) The selling partner can identify the portion of the partnership 
interest transferred; and
    (C) The selling partner elects to use the identification method for 
all sales or exchanges of interests in the partnership after September 
21, 2000. The selling partner makes the election referred to in this 
paragraph (c)(2)(i)(C) by using the actual holding period of the 
portion of the partner's interest in the partnership first transferred 
after September 21, 2000 in reporting the transaction for federal 
income tax purposes.
    (ii) Other partnerships. 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. Except as provided in paragraph 
(b)(2) of this section, 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) Section 751(c) assets. For purposes of this section, properties 
and potential gain treated as unrealized receivables under section 
751(c) shall be treated as separate assets that are not capital assets

[[Page 57100]]

as defined in section 1221 or property described in section 1231.
    (f) 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 percent 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 $17,000. Assuming PRS holds no inventory or 
unrealized receivables (as defined under section 751(c)) and no 
collectibles or section 1250 property, A will realize $5,000 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 section 
751 asset and a capital asset. A contributes inventory with a basis 
of $2,000 and a fair market value of $6,000 and a capital asset 
which A has held for more than one year with a basis of $4,000 and a 
fair market value of $6,000, and B contributes cash of $12,000 to 
form a partnership (AB). As a result of the contribution, one-half 
of A's interest in AB is treated as having been held for more than 
one year under section 1223(1). Six months later, A transfers one-
half of A's interest in AB to C for $6,000, realizing a gain of 
$3,000. If AB 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 $4,000 of ordinary income 
on account of the inventory. Accordingly, A will recognize $2,000 of 
ordinary income and $1,000 of capital gain ($3,000-$2,000) on 
account of the transfer to C. Because A recognizes ordinary income 
on account of the inventory that was contributed to AB within the 
one year period ending on the date of the sale, the inventory will 
be disregarded in determining the holding period of A's interest in 
AB. All of the capital gain will be long-term.
    Example 3. Netting of cash contributions and distributions. (i) 
On January 1, 2000, A holds a 50 percent interest in the capital and 
profits of a partnership (PS). The value of A's PS interest is $900, 
and A's holding period in the entire interest is long-term. On 
January 2, 2000, when the value of A's PS interest is still $900, A 
contributes $100 to PS. On June 1, 2000, A receives a distribution 
of $40 cash from the partnership. On September 1, 2000, when the 
value of A's interest in PS is $1,350, A contributes an additional 
$230 cash to PS, and on October 1, 2000, A receives another $40 cash 
distribution from PS. A sells A's entire partnership interest on 
November 1, 2000, for $1,600. A's adjusted basis in the PS interest 
at the time of the sale is $1,000.
    (ii) For purposes of netting cash contributions and 
distributions in determining the holding period of A's interest in 
PS, A is treated as having received a distribution of $80 on 
November 1, 2000. Applying that distribution on a last-in-first-out 
basis to reduce prior contributions during the year, the 
contribution made on September 1, 2000, is reduced to $150 ($230-
$80). The holding period then is determined as follows: Immediately 
after the contribution of $100 on January 2, 2000, A's holding 
period in A's PS interest is 90 percent long-term ($900/($900 + 
$100)) and 10 percent short-term ($100/($900 + $100)). The 
contribution of $150 on September 1, 2000, causes 10 percent of A's 
partnership interest ($150/($1,350 + $150)) to have a short-term 
holding period. Accordingly, immediately after the contribution on 
September 1, 2000, A's holding period in A's PS interest is 81 
percent long-term (.90  x  .90) and 19 percent short-term ((.10  x  
.90) + .10). Accordingly, $486 ($600  x  .81) of the gain from A's 
sale of the PS interest is long-term capital gain, and $114 ($600 
x  .19) is short-term capital gain.
    Example 4. 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 percent 
interest in PRS is $100. A, B, C, and D each contribute an 
additional $100 to partnership capital, thereby increasing the fair 
market value of each partner's interest to $200. As a result of the 
contribution, each partner has a new holding period in the portion 
of the partner's interest in PRS that is attributable to the 
contribution. That portion equals 50 percent ($100/$200) of each 
partner's interest in PRS.
    Example 5. Sale or exchange of a portion of an interest in a 
partnership. (i) A, B, and C form an equal partnership (PRS). In 
connection with the formation, A contributes $5,000 in cash and a 
capital asset (capital asset 1) with a fair market value of $5,000 
and a basis of $2,000; B contributes $7,000 in cash and a capital 
asset (capital asset 2) with a fair market value of $3,000 and a 
basis of $3,000; and C contributes $10,000 in cash. 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 $7,000 at a time when PRS's 
balance sheet (reflecting a cash receipts and disbursements method 
of accounting) is as follows:

------------------------------------------------------------------------
                                                            ASSETS
                                                     -------------------
                                                      Adjusted   Market
                                                        basis     value
------------------------------------------------------------------------
Cash................................................   $22,000   $22,000
Unrealized Receivables..............................         0     6,000
  Capital Asset 1...................................     2,000     5,000
  Capital Asset 2...................................     3,000     9,000
Capital Assets......................................     5,000    14,000
                                                     -------------------
    Total...........................................    27,000    42,000
------------------------------------------------------------------------

    (ii) Although at the time of the transfer A has not held A's 
interest in PRS for more than one year, 50 percent of the fair 
market value of A's interest in PRS was received in exchange for a 
capital asset with a long-term holding period. Therefore, 50 percent 
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 $2,000 of ordinary 
income. One-half of that amount ($1,000) is attributable to the 
portion of A's interest in PRS transferred to T. Accordingly, A will 
recognize $1,000 oridnary income and $2,500 ($3,500-$1,000) of 
calital gain on account of the transfer to T of one-half of A's 
interest in PRS. Fifty percent ($1,250) of that gain is long-term 
capital gain and 50 percent ($1,250) is short-term capital gain.
    Example 6. Sale of units of interests in a 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 on January 1, 
1999. On August 1, 2000, A purchases five additional units for 
$10,000. At the time of purchase, 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 and elects to use the 
identification method for all subsequent sales or exchanges of 
interests in the partnership by using the actual holding period in 
reporting the transaction on A's federal income tax return, 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). More than one year later, A receives a 
distribution worth $22,000 from PRS, which reduces A's interest in 
PRS to 36 percent. After the distribution, B owns 64 percent 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--(i) On 
January 1, 1996, A

[[Page 57101]]

contributes property with a basis of $10 and a fair market value of 
$10,000 in exchange for an interest in a partnership (ABC). On 
September 30, 2000, when A's interest in ABC is worth $12,000 (and 
the basis of A's partnership interest is still $10), A contributes 
$12,000 cash in exchange for an additional interest in ABC. A is 
allocated a loss equal to $10,000 by ABC for the taxable year ending 
December 31, 2000, thereby reducing the basis of A's partnership 
interest to $2,010. On February 1, 2001, ABC makes a cash 
distribution to A of $10,000. ABC holds no inventory or unrealized 
receivables. (assume that A is allocated no gain or loss for the 
taxable year ending December 31, 2001, so that the basis of A's 
partnership interest does not increase or decrease as a result of 
such allocations.)
    (ii) The netting rule contained in paragraph (b)(2) of this 
section provides that, in determining the holding period of A's 
interest in ABC, the cash contribution made on September 30, 2000, 
must be reduced by the distribution made on February 1, 2001. 
Accordingly, for purposes of determining the holding period of A's 
interest in ABC, A is treated as having made a cash contribution of 
$2,000 ($12,000-$10,000) to ABC on September 30, 2000. A's holding 
period in one-seventh of A's interest in ABC ($2,000 cash 
contributed over the $14,000 value of the entire interest 
(determined as if only $2,000 were contributed rather than $12,000)) 
begins on the day after the cash contribution. A recognizes $7,990 
of capital gain as a result of the distribution. See section 
731(a)(1). One-seventh of the capital gain recognized as a result of 
the distribution is short-term capital gain, and six-sevenths 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.

    (g) Effective date. This section applies to transfers of 
partnership interests and distributions of property from a partnership 
that occur on or after September 21, 2000.

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

    Par. 5. The authority citation for part 602 continues to read as 
follows:

    Authority: 26 U.S.C. 7805.

    Par. 6. In Sec. 602.101, paragraph (b) is amended by adding an 
entry in numerical order to the table to read as follows:


Sec. 602.101  OMB Control numbers.

* * * * *
    (b) * * *

------------------------------------------------------------------------
                                                                Current
                                                                  OMB
     CFR part or section where  identified and described        control
                                                                  No.
------------------------------------------------------------------------
1.1(h)-1(e).................................................   1545-1654
                  *        *        *        *        *
------------------------------------------------------------------------


Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.

    Approved: August 29, 2000.
Jonathan Talisman,
Acting Assistant Secretary of the Treasury.
[FR Doc. 00-24038 Filed 9-20-00; 8:45 am]
BILLING CODE 4830-01-U