[Federal Register Volume 65, Number 211 (Tuesday, October 31, 2000)]
[Rules and Regulations]
[Pages 64888-64890]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-27826]



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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8906]
RIN 1545-AX09


Allocation of Partnership Debt

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the 
allocation of nonrecourse liabilities by a partnership. The final 
regulations revise tier three of the three-tiered allocation structure 
contained in the current nonrecourse liability regulations, and also 
provide guidance regarding the allocation of a single nonrecourse 
liability secured by multiple properties.

DATES: Effective Date: These regulations are effective October 31, 
2000.
    Applicability Date: For dates of applicability of these 
regulations, see Sec. 1.752-5(a).

FOR FURTHER INFORMATION CONTACT: Dan Carmody, (202) 622-3070 (not a 
toll-free number).

SUPPLEMENTARY INFORMATION:

Introduction

    This document revises Sec. 1.752-3 of the Income Tax Regulations 
(26 CFR part 1) relating to the allocation by a partnership of 
nonrecourse liabilities.

Background

    On January 13, 2000, the IRS published in the Federal Register a 
notice of proposed rulemaking [REG-103831-99 (65 FR 2084)] to provide 
guidance relating to the allocation of nonrecourse liabilities by a 
partnership. The IRS and Treasury received public comments concerning 
the proposed regulations, and a public hearing was held on May 3, 2000. 
After consideration of the comments received, the proposed regulations 
are adopted as revised by this Treasury decision.

Explanation of Revisions and Summary of Comments

1. In General

    Treasury regulation Sec. 1.752-3 currently provides a three-tiered 
system for allocating nonrecourse liabilities. The three-tiered system 
applies sequentially. Under the first tier, a partner is allocated an 
amount of the liability equal to that partner's share of partnership 
minimum gain under section 704(b). See Sec. 1.704-2(g)(1). Under the 
second tier, to the extent the entire liability has not been allocated 
under the first tier, a partner will be allocated an amount of 
liability equal to the gain that partner would be allocated under 
section 704(c) if the partnership disposed of all partnership property 
subject to one or more nonrecourse liabilities in full satisfaction of 
the liabilities (section 704(c) minimum gain). Under the third tier, a 
partner is allocated any excess nonrecourse liabilities (i.e., 
nonrecourse liabilities in excess of the portion allocable in the first 
and second tiers) under one of several methods (i.e., partner's share 
of profits or certain reasonably expected deductions) that the 
partnership may choose.
    The proposed regulations modified the third tier to allow an 
additional method under which a partnership may allocate an excess 
nonrecourse liability based on the excess section 704(c) gain (i.e., 
the excess of the amount of section 704(c) built-in gain attributable 
to an item of property over the amount of section 704(c) minimum gain 
on that property) attributable to the properties that are subject to 
the liability. In addition, for purposes of determining section 704(c) 
minimum gain under the second tier, the proposed regulations provided 
that if a partnership holds multiple properties subject to a single 
liability, the liability may be allocated among the properties based on 
any reasonable method. A method is not reasonable under the proposed 
regulations if it allocates to any property an amount that exceeds the 
fair market value of the property.

2. Allocation of Debt in Accordance With Reverse Section 704(c) Gain

    One commentator noted that the additional method provided in the 
proposed regulations under the third tier covers only built-in gain on 
section 704(c) property, which includes built-in gain (i.e., book value 
minus adjusted basis) attributable to contributed property, but not 
built-in gain attributable to property subject to a revaluation 
(pursuant to Sec. 1.704-1(b)(2)(iv)(f)) (i.e., reverse section 704(c) 
gain). The commentator noted that this distinction is not made in 
allocating nonrecourse liabilities in accordance with section 704(c) 
minimum gain under the second tier and questioned the policy reason for 
excluding the reverse section 704(c) gain in applying the third tier. 
In response to this comment, the final regulations provide that an 
excess nonrecourse liability may be allocated under the third tier in 
accordance with excess section 704(c) gain as well as excess reverse 
section 704(c) gain (i.e., the excess of the amount of reverse section 
704(c) gain attributable to an item of property over the section 704(c) 
minimum gain on that property) with respect to property that is subject 
to such liability.

3. Interplay With the Disguised Sales Rules

    One commentator noted that the proposed amendments to Sec. 1.752-3 
would impact the disguised sales rules relating to transfers of 
encumbered property. The disguised sale rules treat a contribution of 
property encumbered by a ``non-qualified'' liability (generally, a 
liability incurred within two years of the contribution to the 
partnership that is incurred in anticipation of such contribution) as a 
disguised sale to the extent that the amount of the liability exceeds 
the contributing partner's share of the liability immediately after the 
contribution. Section 1.707-5(a)(2)(ii) provides that a partner's share 
of a nonrecourse liability, for purposes of the disguised sale rules, 
is determined by applying the same percentage used to determine the 
partner's share of the excess nonrecourse liability under Sec. 1.752-
3(a)(3).
    Because the proposed amendments to Sec. 1.752-3(a)(3) would allow 
excess nonrecourse liabilities to be allocated according to an amount, 
rather than a percentage, the potential for ambiguity exists. The 
commentator suggested that the disguised sale rules should be modified 
to define a partner's share of a nonrecourse liability by cross-
reference to Sec. 1.752-3(a), rather than limiting the definition to 
the third tier. The commentator noted that maintaining separate 
definitions for the same term was burdensome and confusing for 
practitioners, and noted that the disguised sale rules provide 
consistency between sections 707(a) and 752 with respect to the 
definition of a partner's share of a recourse liability by reference to 
Sec. 1.752-2 without limitation.
    The preamble to Sec. 1.707-5 explains that the cross-reference 
defining a partner's share of nonrecourse liabilities is limited to the 
third tier of Sec. 1.752-3(a) because the adoption of the full three-
tier approach in the disguised sale context would provide an inverse 
relationship between the gain inherent in the contributed property and 
the extent to which a disguised sale of the property results from the 
encumbrance. See preamble (57 FR 44974). The contributing partner's 
share of the liability under Sec. 1.752-3(a) generally will increase as 
the amount of built-in gain on the property increases, which in turn 
would reduce the extent to which

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the contribution would be treated as a disguised sale.
    The same problem would exist if the proposed modifications to the 
third tier were taken into account for purposes of Sec. 1.707-
5(a)(2)(ii). To the extent that excess section 704(c) gain exists with 
respect to a property, the partnership could allocate excess 
nonrecourse liabilities to the contributing partner. The greater the 
built-in gain with respect to a property, the less likely it would be 
that a disguised sale would result from the contribution. In order to 
avoid this inappropriate result, the final regulations clarify that the 
modifications made to the third tier do not apply for purposes of 
Sec. 1.707-5(a)(2)(ii). Thus, for purposes of the disguised sale rules, 
the partner's share of nonrecourse liabilities continues to be 
determined under the third tier by reference to the partner's share of 
profits or certain reasonably expected deductions.

4. Treatment of ``Extra'' Excess Section 704(c) Gain

    Rev. Rul. 95-41 (1995-1 C.B. 132) holds that if a partnership 
determines the partners' interests in partnership profits based on all 
of the facts and circumstances relating to the economic arrangement of 
the partners, excess section 704(c) gain is one factor, but not the 
only factor, to be considered under Sec. 1.752-3(a)(3). The preamble to 
the proposed regulations provides that this holding will remain 
relevant where a partnership does not allocate nonrecourse debt under 
the third tier based on the excess section 704(c) gain attributable to 
the property that is subject to the debt. The preamble also provides 
that once a partnership has allocated nonrecourse indebtedness pursuant 
to the rule in the proposed regulations based upon excess section 
704(c) gain, that excess section 704(c) gain cannot again be considered 
in determining a partner's interest in partnership profits.
    One commentator asked, in situations where the amount of a 
liability allocated to a partner under the third tier pursuant to the 
rule contained in the proposed regulations is less than the partner's 
share of excess 704(c) gain, whether the remaining excess 704(c) gain 
should be taken into account for purposes of determining a partner's 
interest in partnership profits under the third tier with regard to 
other liabilities.
    The statement contained in the preamble regarding the impact of the 
proposed regulations on Rev. Rul. 95-41 reflects a concern on the part 
of IRS and Treasury that taxpayers might count the same excess section 
704(c) gain in applying the rule in the proposed regulations and then 
again in determining a partner's interest in partnership profits under 
the third tier. To the extent that a portion of excess section 704(c) 
gain remains after a liability has been fully allocated, there is no 
double-counting, and the remaining portion of the gain should be taken 
into account as one factor to be considered in determining a partner's 
interest in partnership profits under Sec. 1.752-3(a)(3) and Rev. Rul. 
95-41.

5. Applicability of Sec. 1.752-3(b) to Third-Tier Allocations

    The proposed regulations provide rules regarding the allocation of 
a single liability among multiple properties. The proposed regulations 
generally provide that if a partnership has multiple properties subject 
to a single liability, for purposes of determining the amount of 
section 704(c) minimum gain in applying the second tier, the 
partnership may allocate to each property an amount of the liability 
that, when combined with any other liabilities allocated to the 
property, do not exceed the property's fair market value. The portion 
of the liability allocated to each property will be treated as a 
separate loan in determining the section 704(c) minimum gain 
attributable to the property.
    One commentator asked that the rule for allocating a single 
liability among multiple properties under the second tier also apply to 
third tier allocations. For purposes of the second tier, where 
nonrecourse debt is cross-collateralized, it is necessary to determine 
how much of the nonrecourse debt is attributable to each partnership 
property, since debt is allocated among the partners under that tier 
based upon the amount by which the debt attributable to each specific 
property exceeds the tax basis of such property. (See Sec. 1.704-
3(a)(2), which provides that, except in limited circumstances, section 
704(c) applies on a property-by-property basis.) Under the proposed 
modification to the third tier, any remaining nonrecourse liability of 
the partnership could be allocated to a partner up to the excess 
section 704(c) gain allocable to the partner on property subject to 
that liability. There is no need to bifurcate cross-collateralized debt 
under this tier, since excess section 704(c) gain is not limited by the 
amount of debt attributable to specific partnership property. So long 
as a partner's share of excess section 704(c) gain is attributable to 
property that is ``subject to'' the debt being allocated, the debt may 
be allocated in accordance with that partner's share of such excess 
section 704(c) gain. Multiple properties may be ``subject to'' the same 
indebtedness. Bifurcating the debt among multiple properties so that 
each property is treated as subject to only a portion of the debt 
actually would limit taxpayers' flexibility and narrow the scope of the 
proposed change to the third tier. Accordingly, the commentator's 
recommendation is not adopted. However, the final regulations add an 
example which clarifies the operation of this rule.

6. Retroactive Effective Date

    One commentator suggested that the regulations should apply on a 
retroactive basis. This suggestion has not been adopted. However, the 
final regulations respond to this recommendation by providing an 
optional effective date for those taxpayers who wish to apply the rules 
currently to liabilities incurred prior to the issuance of these 
regulations.

7. Additional Comments Requested

    The preamble to the proposed regulations requested comments 
regarding the allocation of a single liability among multiple 
partnerships. Although no formal comments were submitted on this issue, 
several commentators have indicated that additional guidance regarding 
appropriate methods of allocating such liabilities would be helpful. 
The IRS and Treasury again request comments regarding this issue.

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) and the Regulatory Flexibility Act (5 U.S.C. chapter 
6) do not apply to these regulations and, therefore, a Regulatory 
Flexibility Analysis is not required. Pursuant to section 7805(f) of 
the Internal Revenue Code, the notice of proposed rulemaking preceding 
these regulations was submitted to the Small Business Administration 
for comment on its impact on small business.

Drafting Information

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

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List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

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

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

    Par. 2. Section 1.752-3 is amended as follows:
    1. Paragraph (a)(3) is amended by adding three sentences 
immediately before the last sentence in the paragraph.
    2. Paragraph (b) is redesignated as paragraph (c).
    3. New paragraph (b) is added.
    4. Newly designated paragraph (c) is amended by revising the 
introductory text and adding a new Example 3.
    The revisions and addition read as follows:


Sec. 1.752-3  Partner's share of nonrecourse liabilities.

    (a) * * *
    (3) * * * Additionally, the partnership may first allocate an 
excess nonrecourse liability to a partner up to the amount of built-in 
gain that is allocable to the partner on section 704(c) property (as 
defined under Sec. 1.704-3(a)(3)(ii)) or property for which reverse 
section 704(c) allocations are applicable (as described in Sec. 1.704-
3(a)(6)(i)) where such property is subject to the nonrecourse liability 
to the extent that such built-in gain exceeds the gain described in 
paragraph (a)(2) of this section with respect to such property. This 
additional method does not apply for purposes of Sec. 1.707-
5(a)(2)(ii). To the extent that a partnership uses this additional 
method and the entire amount of the excess nonrecourse liability is not 
allocated to the contributing partner, the partnership must allocate 
the remaining amount of the excess nonrecourse liability under one of 
the other methods in this paragraph (a)(3). * * *
    (b) Allocation of a single nonrecourse liability among multiple 
properties--(1) In general. For purposes of determining the amount of 
taxable gain under paragraph (a)(2) of this section, if a partnership 
holds multiple properties subject to a single nonrecourse liability, 
the partnership may allocate the liability among the multiple 
properties under any reasonable method. A method is not reasonable if 
it allocates to any item of property an amount of the liability that, 
when combined with any other liabilities allocated to the property, is 
in excess of the fair market value of the property at the time the 
liability is incurred. The portion of the nonrecourse liability 
allocated to each item of partnership property is then treated as a 
separate loan under paragraph (a)(2) of this section. In general, a 
partnership may not change the method of allocating a single 
nonrecourse liability under this paragraph (b) while any portion of the 
liability is outstanding. However, if one or more of the multiple 
properties subject to the liability is no longer subject to the 
liability, the portion of the liability allocated to that property must 
be reallocated among the properties still subject to the liability so 
that the amount of the liability allocated to any property does not 
exceed the fair market value of such property at the time of 
reallocation.
    (2) Reductions in principal. For purposes of this paragraph (b), 
when the outstanding principal of a partnership liability is reduced, 
the reduction of outstanding principal is allocated among the multiple 
properties in the same proportion that the partnership liability 
originally was allocated to the properties under paragraph (b)(1) of 
this section.
    (c) Examples. The following examples illustrate the principles of 
this section:
* * * * *
    Example 3. Allocation of liability among multiple properties. 
(i) A and B are equal partners in a partnership (PRS). A contributes 
$70 of cash in exchange for a 50-percent interest in PRS. B 
contributes two items of property, X and Y, in exchange for a 50-
percent interest in PRS. Property X has a fair market value (and 
book value) of $70 and an adjusted basis of $40, and is subject to a 
nonrecourse liability of $50. Property Y has a fair market value 
(and book value) of $120, an adjusted basis of $40, and is subject 
to a nonrecourse liability of $70. Immediately after the initial 
contributions, PRS refinances the two separate liabilities with a 
single $120 nonrecourse liability. All of the built-in gain 
attributable to Property X ($30) and Property Y ($80) is section 
704(c) gain allocable to B.
    (ii) The amount of the nonrecourse liability ($120) is less than 
the total book value of all of the properties that are subject to 
such liability ($70 + $120 = $190), so there is no partnership 
minimum gain. Sec. 1.704-2(d). Accordingly, no portion of the 
liability is allocated pursuant to paragraph (a)(1) of this section.
    (iii) Pursuant to paragraph (b)(1) of this section, PRS decides 
to allocate the nonrecourse liability evenly between the Properties 
X and Y. Accordingly, each of Properties X and Y are treated as 
being subject to a separate $60 nonrecourse liability for purposes 
of applying paragraph (a)(2) of this section. Under paragraph (a)(2) 
of this section, B will be allocated $20 of the liability for each 
of Properties X and Y (in each case, $60 liability minus $40 
adjusted basis). As a result, a portion of the liability is 
allocated pursuant to paragraph (a)(2) of this section as follows:

------------------------------------------------------------------------
             Partner                     Property        Tier 1   Tier 2
------------------------------------------------------------------------
A................................  X..................       $0       $0
                                   Y..................        0        0
B................................  X..................        0       20
                                   Y..................        0       20
------------------------------------------------------------------------

    (iv) PRS has $80 of excess nonrecourse liability that it may 
allocate in any manner consistent with paragraph (a)(3) of this 
section. PRS determines to allocate the $80 of excess nonrecourse 
liabilities to the partners up to their share of the remaining 
section 704(c) gain on the properties, with any remaining amount of 
liabilities being allocated equally to A and B consistent with their 
equal interests in partnership profits. B has $70 of remaining 
section 704(c) gain ($10 on Property X and $60 on Property Y), and 
thus will be allocated $70 of the liability in accordance with this 
gain.
    The remaining $10 is divided equally between A and B. 
Accordingly, the overall allocation of the $120 nonrecourse 
liability is as follows:

------------------------------------------------------------------------
               Partner                 Tier 1   Tier 2   Tier 3   Total
------------------------------------------------------------------------
A...................................       $0       $0       $5       $5
B...................................        0       40       75      115
------------------------------------------------------------------------


    Par. 3. In Sec. 1.752-5, paragraph (a) is amended by adding three 
sentences after the first sentence:


Sec. 1.752-5  Effective dates and transition rules.

    (a) In general. * * * However, Sec. 1.752-3(a)(3) fifth, sixth, and 
seventh sentences, (b), and (c) Example 3, do not apply to any 
liability incurred or assumed by a partnership prior to October 31, 
2000. Nevertheless, Sec. 1.752-3(a)(3) fifth, sixth, and seventh 
sentences, (b), and (c) Example 3, may be relied upon for any liability 
incurred or assumed by a partnership prior to October 31, 2000 for 
taxable years ending on or after October 31, 2000. * * *
* * * * *

    Approved: October 11, 2000.
David A. Mader,
Acting Deputy Commissioner of Internal Revenue.
Jonathan Talisman,
Acting Assistant Secretary of the Treasury.
[FR Doc. 00-27826 Filed 10-30-00; 8:45 am]
BILLING CODE 4830-01-U