[Federal Register Volume 68, Number 121 (Tuesday, June 24, 2003)]
[Proposed Rules]
[Pages 37434-37446]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-15282]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-106736-00]
RIN 1545-AX93


Assumption of Partner Liabilities

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking; notice of proposed rulemaking by 
cross-reference to temporary regulations; and notice of public hearing.

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SUMMARY: This document contains proposed regulations relating to the 
definition of liabilities under section 752 of the Internal Revenue 
Code. These regulations provide rules regarding a partnership's 
assumption of certain fixed and contingent obligations in exchange for 
a partnership interest and provide conforming changes to certain 
regulations. These regulations also provide rules under section 358(h) 
for assumptions of liabilities by corporations from partners and 
partnerships. In addition, this document provides notice that the IRS 
and Treasury intend to issue supplemental guidance that may apply 
certain of the rules outlined in these proposed regulations to 
transactions involving corporations. This document also provides notice 
of public hearing on the proposed regulations.

DATES: Written or electronic comments and requests to speak at the 
public hearing scheduled for Tuesday, October 14, 2003, must be 
received by September 22, 2003.

ADDRESSES: Send submissions to: CC:PA:RU (REG-106736-00), room 5226, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. Submissions may be hand-delivered between the hours of 8 a.m. 
and 4 p.m. to CC:PA:RU (REG-106736-00), Courier's Desk, Internal 
Revenue Service, 1111 Constitution Avenue, NW., Washington, DC or sent 
electronically, via the IRS Internet site at: www.irs.gov/regs. The 
public hearing will be held in the auditorium, Internal

[[Page 37435]]

Revenue Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Horace Howells at (202) 622-3050; 
concerning submissions, the hearing, and/or placement on the building 
access list to attend the hearing, Sonya Cruse, (202) 622-7180 (not 
toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in this notice of proposed 
rulemaking has been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507(d)). Comments on the collection of information should be 
sent to the Office of Management and Budget, Attn: Desk Officer for the 
Department of the Treasury, Office of Information and Regulatory 
Affairs, Washington, DC 20503, with copies to the Internal Revenue 
Service, Attn: IRS Reports Clearance Officer, W:CAR:MP:T:T:SP 
Washington, DC 20224. Comments on the collection of information should 
be received by August 25, 2003. Comments are specifically requested 
concerning:
    Whether the proposed collection of information is necessary for the 
proper performance of the functions of the Internal Revenue Service, 
including whether the information will have practical utility; The 
accuracy of the estimated burden associated with the proposed 
collection of information (see below);
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
    How the burden of complying with the proposed collection of 
information may be minimized, including through the application of 
automated collection techniques or other forms of information 
technology; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of services to provide information.
    The collection of information in this proposed regulation is in 
Sec.  1.752-7(e), (f), (g), and (h). This information is required for a 
former or current partner of a partnership to take deductions 
attributable to the economic performance of certain fixed or contingent 
obligations assumed from the partner by a partnership. This information 
will be used by the partner to permit the partner to take a deduction. 
An additional collection of information in this proposed regulation is 
in Sec.  1.752-7(j)(2). This information is required to inform the IRS 
of partnerships making the designated election and to report income 
appropriately. The collection of information is required to obtain a 
benefit, i.e., to elect to apply the provisions of Sec.  1.752-7 of the 
proposed regulations in lieu of Sec.  1.752-6T of the temporary 
regulations. The likely respondents are individuals, business or other 
for-profit institutions, and small businesses or organizations.
    Estimated total annual reporting burden: 125 hours.
    The estimated annual burden per respondent varies from 20 to 40 
minutes, depending on individual circumstances, with an estimated 
average of 30 minutes.
    Estimated number of respondents: 250.
    Estimated annual frequency of responses: On occasion.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    With certain exceptions, no gain or loss is recognized if property 
is transferred to a corporation solely in exchange for stock of the 
corporation, and, immediately after the exchange, the transferors 
control the corporation. If, however, the transferee corporation 
assumes a liability of the transferor, then, under section 358(d), the 
transferor's basis in the stock received in the exchange is reduced by 
the amount of that liability. If the amount of the liability exceeds 
the transferor's basis in the property transferred to the corporation, 
then the transferor recognizes gain under section 357(c)(1). Under 
section 357(c)(3), a liability the payment of which would give rise to 
a deduction or that would be described in section 736(a) (regarding 
payments to a retiring partner) is not taken into account in applying 
section 357(c)(1), unless the incurrence of the liability resulted in 
the creation of, or an increase in, the basis of any property.
    Under section 752(a) and (b), similar rules apply where a 
partnership assumes a liability from a partner or a partner contributes 
property to a partnership subject to a liability. The difference 
between the amount of the liability and the partner's share of that 
liability after the partnership's assumption is treated as a 
distribution of money, which reduces the partner's basis in the 
partnership interest and may cause the partner to recognize gain. There 
is no statutory or regulatory definition of liabilities for purposes of 
section 752. Case law and revenue rulings, however, have established 
that, as under section 357(c)(3), the term liabilities for this purpose 
does not include liabilities the payment of which would give rise to a 
deduction, unless the incurrence of the liability resulted in the 
creation of, or an increase in, the basis of property. Rev. Rul. 88-77 
(1988-2 C.B. 128); Salina Partnership LP, FPL Group, Inc. v. 
Commissioner, T.C. Memo 2000-352.
    On December 21, 2000, as part of the Community Renewal Tax Relief 
Act of 2000 (Appendix G of H.R. 4577, Consolidated Appropriations Act, 
2001) Public Law 106-554, 114 Stat. 2763, 2763A-638 (2001) (the Act), 
Congress enacted section 358(h) to address certain situations where 
property was transferred to a corporation in exchange for both stock 
and the corporation's assumption of certain obligations of the 
transferor. In these situations, transferors took the position that the 
obligations were not liabilities within the meaning of section 357(c) 
or that they were described in section 357(c)(3), and, therefore, the 
obligations did not reduce the basis of the transferor's stock. These 
assumed obligations, however, did reduce the value of the stock. The 
transferors then sold the stock and claimed a loss. In this way, 
taxpayers attempted to duplicate a loss in corporate stock and to 
accelerate deductions that typically are allowed only on the economic 
performance of these types of obligations.
    Section 358(h) addresses these transactions by requiring that, 
after application of section 358(d), the basis in stock received in an 
exchange to which section 351, 354, 355, 356, or 361 applies be reduced 
(but not below the fair market value of the stock) by the amount of any 
liability assumed in the exchange. Exceptions to section 358(h) are 
provided where: (1) The trade or business with which the liability is 
associated is transferred to the person assuming the liability as part 
of the exchange; or (2) substantially all of the assets with which the 
liability is associated are transferred to the person assuming the 
liability as part of the exchange. The term liability for purposes of 
section 358(h) includes any fixed or contingent obligation to make 
payment without regard to whether the obligation is otherwise taken 
into

[[Page 37436]]

account for purposes of the Internal Revenue Code (Code).
    Congress recognized that taxpayers were attempting to use 
partnerships and S corporations to carry out the same types of abuses 
that section 358(h) was designed to deter. Therefore, in section 309(c) 
and (d)(2) of the Act, Congress directed the Secretary to prescribe 
rules to provide ``appropriate adjustments under subchapter K of 
chapter 1 of the Code to prevent the acceleration or duplication of 
losses through the assumption of (or transfer of assets subject to) 
liabilities described in section 358(h)(3) * * * transactions involving 
partnerships'' and to prescribe similar rules for S corporations. Under 
the statute, these rules are to ``apply to assumptions of liability 
after October 18, 1999, or such later date as may be prescribed in such 
rules.''
    In response to this directive, these proposed regulations provide 
rules to prevent the duplication and acceleration of loss through the 
assumption by a partnership of a Sec.  1.752-7 liability from a 
partner. For this purpose, a partnership that takes property subject to 
a liability is generally treated as assuming the liability. A Sec.  
1.752-7 liability is any fixed or contingent obligation to make payment 
that is not described in Sec.  1.752-1(a)(1), without regard to whether 
the obligation is otherwise taken into account for purposes of the 
Code.
    The proposed regulations also provide that section 704(c) 
principles shall apply to a Sec.  1.752-7 liability assumed by a 
partnership from a partner. Accordingly, the Sec.  1.752-7 liability is 
treated under section 704(c) principles as having a built-in loss equal 
to the amount of such liability at the time of its assumption by the 
partnership. The amount of the Sec.  1.752-7 liability is the amount 
that a willing assignor would pay to a willing assignee to assume the 
Sec.  1.752-7 liability in an arm's-length transaction.
    In addition, the proposed regulations make conforming amendments to 
Sec. Sec.  1.704-1(b)(2)(iv)(b) (by providing that a partner's capital 
account be reduced by the Sec.  1.752-7 liabilities that the 
partnership assumes from the partner), 1.704-2(b)(3) (by treating a 
Sec.  1.752-7 liability as a nonrecourse liability for purposes of the 
partnership allocation rules), and 1.705-1 (by directing taxpayers to 
Sec.  1.358-1(b) and Sec.  1.752-7 for basis adjustments necessary to 
coordinate section 705 with section 358(h) and Sec.  1.752-7).
    Moreover, the proposed regulations provide rules under section 
358(h) for assumptions of liabilities by corporations from partners and 
partnerships. In addition, in the Explanation of Provisions section of 
this preamble, the IRS and Treasury are alerting taxpayers that they 
are considering adopting the definition of liability proposed in these 
regulations as an appropriate interpretation of the term liability for 
purposes of subchapter C of chapter 1 of the Code. The IRS and Treasury 
are also considering issuing regulations to conform the exceptions to 
section 358(h) to the exceptions described in these regulations. These 
regulations will be retroactive to the extent necessary to prevent 
abuse.
    Section 358(h) applies to S corporations. The Act states that the 
Secretary may prescribe comparable rules which provide appropriate 
adjustments under subchapter S. These proposed regulations do not 
address the assumption of liabilities by S corporations; however, any 
rules applicable to assumptions of liabilities by corporations would, 
in the absence of provisions to the contrary, apply equally to S 
corporations. Comments regarding the assumption of liabilities by S 
corporations are requested.

Explanation of Provisions

1. Addition of Sec.  1.752-1(a)(1)--Definition of Liability

    The question of what constitutes a liability for purposes of 
section 752 was addressed in Rev. Rul. 88-77 (1988-2 C.B. 128). Rev. 
Rul. 88-77 holds that partnership liabilities include an obligation 
only if, and to the extent that, incurring the obligation creates or 
increases the basis to the partnership of any of the partnership's 
assets (including cash attributable to borrowings), gives rise to an 
immediate deduction to the partnership, or, under section 705(a)(2)(B) 
(relating to noncapital, nondeductible expenditures of a partnership) 
currently decreases a partner's basis in the partner's partnership 
interest. Section 1.752-1T(g) (1989-1 C.B. 180), included a definition 
of a liability for purposes of section 752 that reaffirmed the position 
of the IRS in Rev. Rul. 88-77. This definition was removed from the 
final version of those regulations in response to comments that the 
definition was redundant and therefore unnecessary. The Service 
continues to follow the definition of liability set forth in Rev. Rul. 
88-77. See Rev. Rul. 95-26 (1995-1 C.B. 131).
    Because these proposed regulations define a Sec.  1.752-7 liability 
as a fixed or contingent obligation to make payment to which section 
752 does not apply, Treasury and the IRS believe that it is appropriate 
to describe in these regulations the liabilities to which section 752 
does apply. Therefore, following the principles set forth in Sec.  
1.752-1T(g) and Rev. Rul. 88-77, the proposed regulations provide that 
an obligation is a liability if and to the extent that incurring the 
obligation: (A) Creates or increases the basis of any of the obligor's 
assets (including cash); (B) gives rise to an immediate deduction to 
the obligor; or (C) gives rise to an expense that is not deductible in 
computing the obligor's taxable income and is not properly chargeable 
to capital. An obligation for this purpose is any fixed or contingent 
obligation to make payment without regard to whether the obligation is 
otherwise taken into account for purposes of the Code. Obligations 
include, but are not limited to, debt obligations, environmental 
obligations, tort obligations, contract obligations, pension 
obligations, obligations under a short sale, and obligations under 
derivative financial instruments such as options, forward contracts, 
and futures contracts. The definition of a liability contained in these 
proposed regulations does not follow Helmer v. Commissioner, T.C. Memo 
1975-160. (The Tax Court, in Helmer, held that a partnership's issuance 
of an option to acquire property did not create a partnership liability 
for purposes of section 752.)
    Treasury and the IRS are considering adopting the definition of 
liability proposed in these regulations as an appropriate 
interpretation of the term liability for purposes of subchapter C of 
chapter 1 of the Code. Treasury and the IRS request comments on the 
scope and substance of such regulations, which will be retroactive to 
the extent necessary to prevent abuse.

2. Sec.  1.752-7--Partnership Assumption of Partner's Sec.  1.752-7 
Liability

    In the corporate context, section 358(h) prevents the duplication 
and acceleration of loss with respect to obligations not encompassed by 
section 358(d) by reducing the transferor shareholder's basis in 
corporate stock received in the exchange. Treasury and the IRS do not 
believe that this is the best approach for partnerships given their 
passthrough nature. Ultimately, the partners' shares of a partnership's 
deductions are limited by the partners' bases in their partnership 
interests (their outside bases). If, at the time of an assumption of a 
Sec.  1.752-7 liability by a partnership from a partner (the Sec.  
1.752-7 liability partner), the partner's outside basis were reduced by 
the amount of the Sec.  1.752-7 liability, then the partner would not 
have sufficient outside basis

[[Page 37437]]

to absorb any deduction with respect to the Sec.  1.752-7 liability 
that passed through the partnership.
    For this reason, these proposed regulations do not reduce the 
outside basis of the Sec.  1.752-7 liability partner upon the 
partnership's assumption of the Sec.  1.752-7 liability. If the 
partnership satisfies the Sec.  1.752-7 liability while the Sec.  
1.752-7 liability partner is a partner in the partnership, then the 
deduction with respect to the portion of the Sec.  1.752-7 liability 
assumed by the partnership from the Sec.  1.752-7 liability partner 
(the built-in loss associated with the Sec.  1.752-7 liability) is 
allocated to the Sec.  1.752-7 liability partner, reducing that 
partner's outside basis. If, instead, one of three events occur that 
separate the Sec.  1.752-7 liability partner from the Sec.  1.752-7 
liability, then the Sec.  1.752-7 liability partner's outside basis is 
reduced at that time. These events are: (1) A disposition (or partial 
disposition) of the partnership interest by the Sec.  1.752-7 liability 
partner, (2) a liquidation of the Sec.  1.752-7 liability partner's 
partnership interest, and (3) the assumption (or partial assumption) of 
the Sec.  1.752-7 liability by a partner other than the Sec.  1.752-7 
liability partner. Immediately before the occurrence of one of these 
events, the Sec.  1.752-7 liability partner's basis in the partnership 
interest generally is reduced by the lesser of: (1) The excess of the 
Sec.  1.752-7 liability partner's basis in the partnership interest 
over the adjusted value of that interest, or (2) the remaining built-in 
loss associated with the Sec.  1.752-7 liability (the Sec.  1.752-7 
liability reduction). For this purpose, the adjusted value of a 
partner's interest in a partnership is the fair market value of that 
interest increased by the partner's share of partnership liabilities 
under Sec. Sec.  1.752-1 through 1.752-5. In the case of a partial 
disposition of the Sec.  1.752-7 liability partner's partnership 
interest or a partial assumption of the Sec.  1.752-7 liability by 
another partner, the Sec.  1.752-7 liability reduction is pro rated 
based on the portion of the interest sold or the portion of the Sec.  
1.752-7 liability assumed.
    After the occurrence of such an event, the partnership (or the 
assuming partner) is not entitled to any deduction or capital expense 
on the economic performance of the Sec.  1.752-7 liability to the 
extent of the remaining built-in loss associated with the Sec.  1.752-7 
liability. If, however, the partnership (or the assuming partner) 
notifies the Sec.  1.752-7 liability partner of the partial or complete 
economic performance of the Sec.  1.752-7 liability, then the Sec.  
1.752-7 liability partner is entitled to a deduction or loss. The 
amount of that deduction or loss is, in the case of a partial 
satisfaction of the Sec.  1.752-7 liability, the amount paid by the 
partnership in satisfaction of the Sec.  1.752-7 liability (but not 
more than the Sec.  1.752-7 liability reduction) or, in the case of a 
complete satisfaction of the Sec.  1.752-7 liability, the remaining 
Sec.  1.752-7 liability reduction. To the extent of the amount paid in 
satisfaction of the Sec.  1.752-7 liability, the character of that 
deduction or loss is determined as if the Sec.  1.752-7 liability 
partner had satisfied the Sec.  1.752-7 liability. To the extent that 
the Sec.  1.752-7 liability reduction exceeds the amount paid in 
satisfaction of the Sec.  1.752-7 liability, the character of the Sec.  
1.752-7 liability partner's loss is capital.
    The proposed regulations further provide that, solely for purposes 
of section 705 (adjustments to the basis of a partnership interest) and 
Sec.  1.704-1(b)(2)(iv)(b) (partnership capital accounting rules), the 
remaining built-in loss associated with the Sec.  1.752-7 liability is 
not treated as a nondeductible, noncapital expense to the partnership. 
Therefore, the remaining partners' bases in their partnership interests 
and capital accounts are not reduced by the remaining built-in loss 
associated with the Sec.  1.752-7 liability.
    If the Sec.  1.752-7 liability is assumed by a partner other than 
the Sec.  1.752-7 liability partner, then, on economic performance of 
the Sec.  1.752-7 liability, the assuming partner is treated as 
contributing cash to the partnership in the amount of the lesser of: 
(1) The amount paid to satisfy the Sec.  1.752-7 liability; or (2) the 
remaining built-in loss associated with the Sec.  1.752-7 liability as 
of the time of the assumption. Adjustments as a result of this deemed 
cash contribution may include adjusting the basis of the partnership 
interest, any assets (other than cash, accounts receivable, or 
inventory) distributed by the partnership to the partner, or gain or 
loss on the disposition of the partnership interest or of property 
distributed by the partnership, as the case may be. However, the 
assuming partner cannot take into account any adjustments to 
depreciable basis, reduction in gain, or increase in loss until 
economic performance of the Sec.  1.752-7 liability. Any adjustment to 
the basis of an asset under this provision is taken into account over 
the recovery period of that asset.

3. Exceptions

    Certain exceptions apply to these rules. In the corporate context, 
section 358(h) does not apply in the following two situations: (1) 
Where the trade or business with which the liability is associated is 
transferred to the corporation assuming the liability; and (2) where 
substantially all of the assets with which the liability is associated 
are transferred to the corporation assuming the liability. Section 
358(h)(2) authorizes the Secretary to limit the application of these 
exceptions.
    The statutory provision relating to partnerships does not specify 
whether the exceptions in section 358(h)(2) should apply. The only 
cross-reference to section 358(h) in this statutory provision is to 
section 358(h)(3), which defines the term liability. Treasury and IRS 
believe it is appropriate to provide for a variation on one of the two 
exceptions to section 358(h), as well as an additional exception that 
is not included in section 358(h), in these proposed regulations. 
Treasury and the IRS request comments on these exceptions and on 
whether additional exceptions should be included in the final 
regulations.
    The first exception applies where the partnership assumes the Sec.  
1.752-7 liability as part of the contribution of the trade or business 
with which the liability is associated and the partnership continues to 
conduct that trade or business after the contribution. For this 
purpose, a trade or business is a specific group of activities carried 
on by a person for the purpose of earning income or profit if the 
activities included in that group include every operation that forms a 
part of, or a step in, the process of earning income or profit.
    The proposed regulations provide that the activity of acquiring, 
holding, or disposing of financial instruments constitutes a trade or 
business for this purpose if and only if the activity is conducted by 
an entity registered with the Securities and Exchange Commission as a 
management company under the Investment Company Act of 1940, as 
amended. Treasury and the IRS are concerned that certain activities 
involving acquiring, holding, or disposing of financial instruments 
could be structured to accomplish the types of transactions that 
section 309(c) of the Act was designed to prevent. Nonetheless, 
Treasury and the IRS recognize that many persons contribute such 
activities to partnerships for substantial business purposes. For 
example, mutual funds often contribute substantially all of their 
assets to a master partnership to save administrative costs. Under some 
circumstances, such a mutual fund may transfer portfolio positions 
(including hedge positions that could be

[[Page 37438]]

considered Sec.  1.752-7 liabilities under the proposed regulations) to 
the master partnership. Because a contribution by a mutual fund to a 
master partnership is not the type of abusive loss duplication 
transaction that section 309(c) of the Act was designed to address, the 
proposed regulations treat this type of contribution as a contribution 
of a trade or business. Treasury and the IRS request comments on 
additional types of activities that should be treated as trades or 
businesses for purposes of these regulations.
    The proposed regulations do not include the section 358(h) 
exception for situations in which substantially all of the assets with 
which the liability is associated are transferred to the partnership 
assuming the liability. Treasury and the IRS are concerned that 
taxpayers would rely on that exception to facilitate transactions of 
the type that section 309(c) of the Act was designed to prevent.
    An additional de minimis exception, not present in section 358(h), 
is included in the proposed regulations. Under this exception, the 
proposed regulations do not apply where, immediately before the 
disposition of the partnership interest by the Sec.  1.752-7 liability 
partner, the liquidation of the Sec.  1.752-7 liability partner's 
partnership interest, or the assumption of the Sec.  1.752-7 liability 
by another partner, the amount of the remaining built-in loss with 
respect to all Sec.  1.752-7 liabilities assumed by the partnership 
(other than Sec.  1.752-7 liabilities that are assumed by the 
partnership with an associated trade or business) is less than the 
lesser of 10% of the gross value of the partnership's assets or 
$1,000,000. This exception was added in recognition of the fact that 
loss acceleration and duplication strategies typically are engaged in 
only if the accelerated or duplicated loss is substantial.

4. Advanced Notice of Proposed Rulemaking Under Section 358(h)(2)

    Treasury and the IRS are considering exercising their regulatory 
authority under section 358(h)(2) to limit the exceptions to section 
358(h)(1) to follow the exceptions set forth in these proposed 
regulations (other than the de minimis exception). Treasury and the IRS 
request comments on the scope and substance of such regulations, which 
will be retroactive to the extent necessary to prevent abuse.

5. Rules Applicable to Tiered Structures

    Proposed Sec.  1.752-7(e) and (i) provide rules to address a 
contribution of a partnership interest to another partnership. First, 
under Sec.  1.752-7(e)(3), a transfer by a partner of an interest in a 
partnership (lower-tier partnership) to another partnership (upper-tier 
partnership) is not treated as a transfer of a partnership interest for 
purposes of applying these rules. Therefore, the partner does not have 
to reduce the basis of the partnership interest before such a transfer. 
However, look-through rules in Sec.  1.752-7(i) apply to treat the 
transfer of the partnership interest as a transfer of the partner's 
share of the assets and Sec.  1.752-7 liabilities of the partnership. 
Therefore, a transfer of a partnership interest to another partnership 
may be treated as an assumption of a Sec.  1.752-7 liability by a 
partnership under these proposed regulations. Under proposed Sec.  
1.358-7(a), similar rules apply to a contribution of a partnership 
interest to a corporation.
    Also, Sec.  1.752-7(i)(2) provides a limitation on the trade or 
business exception where a partnership (upper-tier partnership) assumes 
a Sec.  1.752-7 liability from a partner, and then another partnership 
(lower-tier partnership) assumes the Sec.  1.752-7 liability from the 
upper-tier partnership. In such a case, the trade or business exception 
does not apply on the assumption of the Sec.  1.752-7 liability by the 
lower-tier partnership from the upper-tier partnership unless it 
applied on the assumption of the Sec.  1.752-7 liability by the upper-
tier partnership from the Sec.  1.752-7 liability partner. Section 
1.358-7(c) of these proposed regulations provide for similar rules 
where a corporation assumes an obligation described in section 
358(h)(3) from a partnership that the partnership had previously 
assumed from a partner. In addition, Sec.  1.358-7(b) of these proposed 
regulations provide special rules for adjusting the partners' bases in 
a partnership when a corporation assumes a Sec.  1.752-7 liability from 
the partnership.
    Additional rules are provided for look-through treatment where a 
partnership is a Sec.  1.752-7 liability partner in another 
partnership. The proposed regulations also provide special rules for 
situations in which the Sec.  1.752-7 liability partner disposes of the 
partner's interest in the partnership and then another partnership (or 
a corporation) assumes the Sec.  1.752-7 liability from the 
partnership.

Effective Date

    The regulations described above are proposed to apply to 
assumptions of Sec.  1.752-7 liabilities occurring on or after June 24, 
2003. In the Rules and Regulations section of this issue of the Federal 
Register, the IRS is issuing temporary regulations (Sec.  1.752-6T) 
that apply to liabilities assumed by a partnership after October 18, 
1999, and before June 24, 2003. The text of those temporary regulations 
published in the Rules and Regulation section of this issue of the 
Federal Register serves as the text of Sec.  1.752-6 of these 
regulations. In lieu of applying Sec.  1.752-6T of the temporary Income 
Tax Regulations, partnerships may elect to be subject to the proposed 
rules of Sec.  1.358-7 and 1.752-7 and the proposed revisions of Sec.  
1.704-1(b)(2)(iv)(b), 1.704-2(b)(3), 1.705-1(a)(7), and 1.752-1, 
published as part of this Notice of Proposed Rulemaking, with respect 
to all liabilities (including Sec.  1.752-7 liabilities) assumed by the 
partnership after October 18, 1999 and before June 24, 2003. The 
election must be filed with the first Federal income tax return filed 
by the partnership on or after September 22, 2003. The election will be 
valid only if the partnership and its partners promptly amend any 
returns for open taxable years that would be affected by the election.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It is hereby 
certified that these regulations will not have a significant economic 
impact on a substantial number of small entities. This certification is 
based upon the fact that few partnerships engage in the type of 
transactions that are subject to these regulations (assumptions of 
liabilities not described in section 752(a) and (b) from a partner). In 
addition, available data indicates that most partnerships that engage 
in the type of transactions that are subject to these regulations are 
large partnerships. Certain broad exceptions to the application of 
these regulations (including a de minimis exception) further limit the 
economic impact of these regulations on small entities. Therefore, a 
Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 
U.S.C. chapter 6) is not required. Pursuant to section 7805(f) of the 
Code, this notice of proposed rulemaking will be submitted to the Chief 
Counsel for Advocacy of the Small Business Administration for comment 
on its impact on small business. Comments are sought as to the number 
of legitimate business transactions that will be affected by the 
proposed regulations.

[[Page 37439]]

Drafting Information

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

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and record keeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 continues to read in part as follows:

PART 1--INCOME TAXES

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

    Authority: 26 U.S.C. 7805 * * *
    Section 1.752-1(a) also issued under Public Law 106-554, 114 
Stat. 2763, 2763A-638 (2001) * * *
    Section 1.752-6 also issued under Public Law 106-554, 114 Stat. 
2763, 2763A-638 (2001) * * *
    Section 1.752-7 also issued under Public Law 106-554, 114 Stat. 
2763, 2763A-638 (2001) * * *

    2. Section 1.358-7 is added to read as follows:


Sec.  1.358-7  Transfers by partners and partnerships to corporations.

    (a) Contributions of partnership interests. For purposes of section 
358(h), a transfer of a partnership interest to a corporation is 
treated as a transfer of the partner's share of each of the 
partnership's assets and an assumption by the corporation of the 
partner's share of partnership liabilities (including section 358(h) 
liabilities, as defined in paragraph (d) of this section). See 
paragraph (e), Example 1 of this section.
    (b) Contributions by partnerships. If a corporation assumes a 
section 358(h) liability from a partnership in an exchange to which 
section 358(a) applies, then, for purposes of applying section 705 
(determination of basis of partner's interest) and Sec.  1.704-1(b), 
any reduction, under section 358(h)(1), in the partnership's basis in 
corporate stock received in the transaction is treated as an 
expenditure of the partnership described in section 705(a)(2)(B). See 
paragraph (e), Example 2 of this section. This expenditure must be 
allocated among the partners in accordance with section 704(b) and (c) 
and Sec.  1.752-7(c). If a partner's share of the reduction, under 
section 358(h)(1), in the partnership's basis in corporate stock 
exceeds the partner's basis in the partnership interest, then the 
partner recognizes gain equal to the excess, which is treated as gain 
from the sale or exchange of a partnership interest. This paragraph 
does not apply to the extent that Sec.  1.752-7(i)(4) applies to the 
assumption of the Sec.  1.752-7 liability by the corporation.
    (c) Assumption of section 358(h) liability by partnership followed 
by transfer of partnership interest or partnership property to a 
corporation--trade or business exception. Where a partnership assumes a 
section 358(h) liability from a partner and, subsequently, the partner 
transfers all or part of the partner's partnership interest to a 
corporation in an exchange to which section 358(a) applies, the section 
358(h) liability is treated as associated only with the contribution 
made to the partnership by that partner. Similar rules apply where a 
partnership assumes a section 358(h) liability of a partner and a 
corporation subsequently assumes that section 358(h) liability from the 
partnership in an exchange to which section 358(a) applies. See 
paragraph (e), Example 1 of this section.
    (d) Section 358(h) liabilities defined. For purposes of this 
section, section 358(h) liabilities are liabilities described in 
section 358(h)(3).
    (e) Examples. The following examples illustrate the provisions of 
this section. Assume, for purposes of these examples, that the 
obligation assumed by the corporation does not reduce the shareholder's 
basis in the corporate stock under section 358(d). The examples are as 
follows:

    Example 1. Contribution of partnership interest to corporation. 
In 2004, A contributes undeveloped land with a value and basis of 
$4,000,000 in exchange for a 50% interest in PRS and an assumption 
by PRS of $2,000,000 of pension liabilities from a separate business 
that A conducts. A's basis in the PRS interest immediately after the 
contribution is A's basis in the land, $4,000,000, unreduced by the 
amount of the pension liabilities. PRS develops the land as a 
landfill. Before PRS has economically performed with respect to the 
pension liabilities, A contributes A's interest in PRS to 
Corporation X, in an exchange to which section 351 applies. At the 
time of the exchange, the value of A's PRS interest is $2,000,000, 
A's basis in PRS is $4,000,000, and A has no share of partnership 
liabilities other than the pension liabilities. For purposes of 
applying section 358(h), the contribution of the PRS interest to 
Corporation X is treated as a contribution to Corporation X of A's 
share of PRS assets and of A's share of the pension liabilities of 
PRS ($2,000,000). Because the pension liabilities were not assumed 
by PRS from A in an exchange in which either the trade or business 
associated with the liability or substantially all of the assets 
associated with the liability were transferred to PRS, the 
contribution of the PRS interest to Corporation X is not excepted 
from section 358(h) under section 358(h)(2). Under section 358(h), 
A's basis in the Corporation X stock is reduced by the $2,000,000 of 
pension liabilities.
    Example 2. Contribution of partnership property to corporation. 
In 2004, in an exchange to which section 351(a) applies, PRS, a cash 
basis taxpayer, contributes $2,000,000 cash to Corporation X, also a 
cash basis taxpayer, in exchange for Corporation X shares and the 
assumption by Corporation X of $1,000,000 of accounts payable 
incurred by PRS. At the time of the exchange, PRS has two partners, 
A, a 90% partner, who has a $2,000,000 basis in the PRS interest, 
and B, a 10% partner, who has a $50,000 basis in the PRS interest. 
Assume that, under section 358(h)(1), PRS's basis in the Corporation 
X stock is reduced by the accounts payable assumed by Corporation X 
($1,000,000). Under paragraph (b) of this section, A's and B's bases 
in PRS must be reduced, but not below zero, by their respective 
shares of the section 358(h)(1) basis reduction. If either partner's 
share of the section 358(h)(1) basis reduction exceeds the partner's 
basis in the partnership interest, then the partner recognizes gain 
equal to the excess. A's share of the section 358(h) basis reduction 
is $900,000 (90% of $1,000,000). Therefore, A's basis in the PRS 
interest is reduced to $1,100,000 ($2,000,000--$900,000). B's share 
of the section 358(h) basis reduction is $100,000 (10% of 
$1,000,000). Because B's share of the section 358(h) basis reduction 
($100,000) exceeds B's basis in the PRS interest ($50,000), B's 
basis in the PRS interest is reduced to $0 and B recognizes $50,000 
of gain. This gain is treated as gain from the sale of the PRS 
interest.

    (f) Effective date. This section applies to assumptions of 
liabilities by a corporation occurring on or after June 24, 2003.


Sec.  1.704-1  [Amended]

    3. Section 1.704-1 is amended as follows:
    1. Paragraph (b)(1)(ii) is amended by removing the language ``The'' 
at the beginning of the first sentence and adding ``Except as otherwise 
provided in this section, the'' in its place.
    2. Paragraph (b)(2)(iv)(b)(2) is amended by removing the language 
``secured by such contributed property'' in the parenthetical.
    3. Paragraph (b)(2)(iv)(b)(2) is further amended by removing the 
language ``under section 752'' in the parenthetical.
    4. Paragraph (b)(2)(iv)(b)(5) is amended by removing the language 
``secured by such distributed property'' in the parenthetical.
    5. Paragraph (b)(2)(iv)(b)(5) is further amended by removing the 
language ``under section 752'' in the parenthetical.
    6. Paragraph (b)(2)(iv)(b) is further amended by adding a sentence 
at the end of the paragraph.

[[Page 37440]]

    The addition reads as follows:


Sec.  1.704-1  Partner's distributive share.

* * * * *
    (b) * * *
    (2) * * *
    (iv) * * *
    (b) * * * For liabilities assumed before June 24, 2003, references 
to liabilities in this paragraph (b)(2)(iv)(b) shall include only 
liabilities secured by the contributed or distributed property that are 
taken into account under section 752(a) and (b).
* * * * *


Sec.  1.704-2  [Amended]

    4. In Sec.  1.704-2, paragraph (b)(3) is amended by adding the 
language ``or a Sec.  1.752-7 liability (as defined in Sec.  1.752-
7(b)(2)(i)) assumed by the partnership from a partner on or after June 
24, 2003'' at the end of the sentence.
    5. Section 1.705-1 is amended by adding paragraph (a)(8) to read as 
follows:


Sec.  1.705-1  Determination of basis of partner's interest.

    (a) * * *
    (8) For basis adjustments necessary to coordinate sections 705 and 
358(h), see Sec.  1.358-7(b). For certain basis adjustments with 
respect to a Sec.  1.752-7 liability assumed by a partnership from a 
partner, see Sec.  1.752-7.
* * * * *


Sec.  1.752-0  [Amended]

    6. Section 1.752-0 is amended as follows:
    1. The section heading and introductory text of Sec.  1.752-0 are 
revised.
    2. The entries for Sec.  1.752-1(a)(1) through (a)(3) are 
redesignated as Sec.  1.752-1(a)(2) through (a)(4).
    3. A new entry for Sec.  1.752-1(a)(1) is added.
    4. The entries for Sec.  1.752-1(a)(1)(i), (ii), (iii), and (iv) 
are added.
    5. The entries for Sec. Sec.  1.752-6 and 1.752-7 are added.
    The revision and additions read as follows:


Sec.  1.752-0  Table of contents.

    This section lists the major captions that appear in Sec. Sec.  
1.752-1 through 1.752-7.

Sec.  1.752-1 Treatment of partnership liabilities.

(a) Definitions.
(1) Liability defined.
(i) In general.
(ii) Obligation.
(iii) Other liabilities.
(iv) Effective date.
* * * * *

1.752-6 Partnership assumption of partner's Sec.  358(h)(3) 
liability after October 18, 1999, and before June 24, 2003.

(a) In general.
(b) Exceptions.
(1) In general.
(2) Transactions described in Notice 2000-44.
(c) Example.
(d) Effective date.
(1) In general.
(2) Election to apply Sec.  1.752-7.

Sec.  1.752-7 Partnership assumption of partner's Sec.  1.752-7 
liability on or after June 24, 2003.

(a) General rules.
(1) Purpose and structure.
(2) Exception from disguised sale rules.
(b) Definitions.
(1) Assumption.
(2) Sec.  1.752-7 liability.
(i) In general.
(ii) Amount and share of Sec.  1.752-7 liability.
(3) Sec.  1.752-7 liability partner.
(4) Remaining built-in loss associated with a Sec.  1.752-7 
liability.
(5) Sec.  1.752-7 liability reduction.
(i) In general.
(ii) Partial dispositions and assumptions.
(6) Sec.  1.752-7 liability transfer.
(7) Testing date.
(8) Trade or business.
(i) In general.
(ii) Trading and investment partnerships.
(A) In general.
(B) Financial instruments.
(iii) Examples.
(9) Adjusted value.
(c) Application of section 704(c) to assumed Sec.  1.752-7 
liabilities.
(1) In general.
(2) Example.
(d) Special rules for sales of partnership interests, distributions 
of partnership assets, and assumptions of the Sec.  1.752-7 
liability after a Sec.  1.752-7 liability transfer.
(1) In general.
(2) Exceptions.
(i) In general.
(ii) Examples.
(e) Transfer of Sec.  1.752-7 liability partner's partnership 
interest.
(1) In general.
(2) Examples.
(3) Exception for nonrecognition transactions.
(i) In general.
(ii) Examples.
(f) Distribution in liquidation of Sec.  1.752-7 liability partner's 
partnership interest.
(1) In general.
(2) Example.
(g) Assumption of Sec.  1.752-7 liability by a partner other than 
Sec.  1.752-7 liability partner.
(1) In general.
(2) Consequences to Sec.  1.752-7 liability partner.
(3) Consequences to partnership.
(4) Consequences to assuming partner.
(5) Example.
(h) Notification by the partnership (or successor) of the economic 
performance of the Sec.  1.752-7 liability.
(i) Tiered partnerships.
(1) Look-through treatment.
(2) Trade or business exception.
(3) Partnership as a Sec.  1.752-7 liability partner.
(4) Transfer of Sec.  1.752-7 liability by partnership to another 
partnership or corporation after a transaction described in 
paragraphs (e), (f), or (g).
(i) In general.
(ii) Subsequent transfers.
(5) Example.
(j) Effective date.
(1) In general.
(2) Election to apply this section to assumptions of liabilities 
occurring after October 18, 1999 and before June 24, 2003.
(i) In general.
(ii) Manner of making election.
(iii) Filing of amended returns.
(iv) Time for making election.

    7. In Sec.  1.752-1, paragraphs (a)(1) through (a)(3) are 
redesignated as paragraphs (a)(2) through (a)(4) and a new paragraph 
(a)(1) is added to read as follows:


Sec.  1.752-1  Treatment of partnership liabilities.

    (a) Definitions--(1) Liability defined--(i) In general. An 
obligation is a liability for purposes of section 752 and the 
regulations thereunder, only if and to the extent that incurring the 
obligation--
    (A) Creates or increases the basis of any of the obligor's assets 
(including cash);
    (B) Gives rise to an immediate deduction to the obligor; or
    (C) Gives rise to an expense that is not deductible in computing 
the obligor's taxable income and is not properly chargeable to capital.
    (ii) Obligation. For purposes of this paragraph and Sec.  1.752-7, 
an obligation is any fixed or contingent obligation to make payment 
without regard to whether the obligation is otherwise taken into 
account for purposes of the Internal Revenue Code. Obligations include, 
but are not limited to, debt obligations, environmental obligations, 
tort obligations, contract obligations, pension obligations, 
obligations under a short sale, and obligations under derivative 
financial instruments such as options, forward contracts, and futures 
contracts.
    (iii) Other liabilities. For obligations that are not liabilities 
as defined in paragraph (a)(1)(i) of this section, see Sec. Sec.  
1.752-6 and 1.752-7.
    (iv) Effective date. This paragraph (a)(1) applies to liabilities 
that are incurred or assumed by a partnership on or after June 24, 
2003.
* * * * *

[[Page 37441]]

Sec.  1.752-5(a)  [Amended]

    8. Section 1.752-5 is amended as follows:
    1. Paragraph 1.752-5(a) is amended by removing the language 
``Unless'' at the beginning of the first sentence and adding ``Except 
as otherwise provided in Sec. Sec.  1.752-1 through 1.752-4, unless'' 
in its place.
    9. Section 1.752-6 is added to read as follows:


Sec.  1.752-6  Partnership assumption of partner's section 358(h)(3) 
liability after October 18, 1999, and before June 24, 2003.

    The text of proposed Sec.  1.752-6 is the same as the text of Sec.  
1.752-6T published elsewhere in this issue of the Federal Register.
    10. Section 1.752-7 is added to read as follows:


Sec.  1.752-7  Partnership assumption of partner's Sec.  1.752-7 
liability on or after June 24, 2003.

    (a) General rules--(1) Purpose and structure. The purpose of this 
section is to prevent the acceleration or duplication of loss through 
the assumption of obligations not described in Sec.  1.752-1(a)(1) in 
transactions involving partnerships. Under paragraph (c) of this 
section, any such obligation that is assumed by a partnership from a 
partner in a transaction governed by section 721(a) must be taken into 
account by applying principles under section 704(c). Paragraphs (e), 
(f), and (g) of this section provide rules for situations where a 
partnership assumes such an obligation from a partner and, 
subsequently, that partner sells or exchanges all or part of the 
partnership interest, that partner receives a distribution in 
liquidation of the partnership interest, or another partner assumes 
part or all of that obligation from the partnership. These rules 
prevent the duplication of loss by prohibiting the partnership and any 
person other than the partner from whom the obligation was assumed from 
claiming a deduction or capital expense to the extent of the built-in 
loss associated with the obligation. These rules also prevent the 
acceleration of loss by deferring the partner's deduction or loss 
attributable to the obligation (if any) until economic performance 
occurs. Paragraph (d) of this section provides a number of exceptions 
to paragraphs (e), (f), and (g) of this section, including a de minimis 
exception. Paragraph (i) of this section provides special rules for 
tiered partnership transactions.
    (2) Exception from disguised sale rules. The assumption of a Sec.  
1.752-7 liability is not treated as an assumption of a liability or as 
a transfer of cash for purposes of section 707(a)(2)(B).
    (b) Definitions. For purposes of this section, the following 
definitions apply--
    (1) Assumption. A person that takes property subject to a Sec.  
1.752-7 liability of another person is treated as assuming the Sec.  
1.752-7 liability, but only to the extent of the fair market value of 
the property taken subject to the Sec.  1.752-7 liability.
    (2) Sec.  1.752-7 liability--(i) In general. A Sec.  1.752-7 
liability is an obligation (as defined in Sec.  1.752-1(a)(1)(ii)) that 
is not described in Sec.  1.752-1(a)(1)(i).
    (ii) Amount and share of Sec.  1.752-7 liability. The amount of a 
Sec.  1.752-7 liability is the amount of cash that a willing assignor 
would pay to a willing assignee to assume the Sec.  1.752-7 liability 
in an arm's-length transaction. A partner's share of a partnership's 
Sec.  1.752-7 liability is the amount of deduction that would be 
allocated to the partner with respect to the Sec.  1.752-7 liability if 
the partnership disposed of all of its assets, satisfied all of its 
liabilities (other than Sec.  1.752-7 liabilities), and paid an 
unrelated person to assume all of its Sec.  1.752-7 liabilities in a 
fully taxable arm's-length transaction (assuming such payment would 
give rise to an immediate deduction to the partnership).
    (3) Sec.  1.752-7 liability partner. A Sec.  1.752-7 liability 
partner is a partner from whom a partnership assumes a Sec.  1.752-7 
liability as part of a Sec.  1.752-7 liability transfer or any person 
who acquires a partnership interest from the Sec.  1.752-7 liability 
partner in a transaction described in paragraph (e)(3) of this section. 
If a partnership (lower-tier partnership) assumes a Sec.  1.752-7 
liability from another partnership (upper-tier partnership), then both 
the upper-tier partnership and the partners of the upper-tier 
partnership are Sec.  1.752-7 liability partners. Therefore, paragraphs 
(e) and (f) of this section apply on a sale or liquidation of any 
partner's interest in the upper-tier partnership and on a sale or 
liquidation of the upper-tier partnership's interest in the lower-tier 
partnership. See paragraph (i)(3) of this section.
    (4) Remaining built-in loss associated with a Sec.  1.752-7 
liability. The remaining built-in loss associated with a Sec.  1.752-7 
liability equals the amount of the Sec.  1.752-7 liability as of the 
time of the assumption of the Sec.  1.752-7 liability by the 
partnership, reduced by the portion of the Sec.  1.752-7 liability 
previously taken into account by the Sec.  1.752-7 liability partner 
under paragraph (i)(4) of this section and adjusted as provided in 
paragraph (c) of this section and Sec.  1.704-3 for--
    (i) Partnership allocations of loss or deduction with respect to 
the Sec.  1.752-7 liability on or prior to the testing date; and
    (ii) Any assumption of all or part of the Sec.  1.752-7 liability 
by the Sec.  1.752-7 liability partner (including any assumption that 
occurs on the testing date).
    (5) Sec.  1.752-7 liability reduction--(i) In general. The Sec.  
1.752-7 liability reduction is the amount by which the Sec.  1.752-7 
liability partner is required to reduce the basis in the partner's 
partnership interest by operation of paragraphs (e), (f), and (g) of 
this section. The Sec.  1.752-7 liability reduction is the lesser of--
    (A) The excess of the Sec.  1.752-7 liability partner's basis in 
the partner's partnership interest over the adjusted value of that 
interest (as defined in paragraph (b)(9) of this section); or
    (B) The remaining built-in loss associated with the Sec.  1.752-7 
liability.
    (ii) Partial dispositions and assumptions. In the case of a partial 
disposition of the Sec.  1.752-7 liability partner's partnership 
interest or a partial assumption of the Sec.  1.752-7 liability by 
another partner, the Sec.  1.752-7 liability reduction is pro rated 
based on the portion of the interest sold or the portion of the Sec.  
1.752-7 liability assumed.
    (6) Sec.  1.752-7 liability transfer. A Sec.  1.752-7 liability 
transfer is any assumption of a Sec.  1.752-7 liability by a 
partnership from a partner in a transaction governed by section 721(a).
    (7) Testing date. The testing date is--
    (i) For purposes of paragraph (e) of this section, the date of the 
sale, exchange, or other disposition of part or all of the Sec.  1.752-
7 liability partner's partnership interest;
    (ii) For purposes of paragraph (f) of this section, the date of the 
partnership's distribution in liquidation of the Sec.  1.752-7 
liability partner's partnership interest; and
    (iii) For purposes of paragraph (g) of this section, the date of 
the assumption (or partial assumption) of the Sec.  1.752-7 liability 
by a partner other than the Sec.  1.752-7 liability partner.
    (8) Trade or business--(i) In general. A trade or business is a 
specific group of activities carried on by a person for the purpose of 
earning income or profit if the activities included in that group 
include every operation that forms a part of, or a step in, the process 
of earning income or profit. Such group of activities ordinarily 
includes the collection of income and the payment of expenses. Subject 
to paragraph (b)(8)(ii)

[[Page 37442]]

of this section, the group of activities must constitute the carrying 
on of a trade or business under section 162(a) (determined as though 
the activities were conducted by an individual).
    (ii) Trading and investment partnerships--(A) In general. The 
activity of acquiring, holding, or disposing of financial instruments 
constitutes a trade or business for purposes of this paragraph (b)(8) 
if and only if the activity is conducted by an entity registered with 
the Securities and Exchange Commission as a management company under 
the Investment Company Act of 1940, as amended (15 U.S.C. 80a).
    (B) Financial instruments. For purposes of paragraph (b)(8)(ii) of 
this section, financial instruments include stock in corporations; 
notes, bonds, debentures, or other evidences of indebtedness; interest 
rate, currency, or equity notional principal contracts; evidences of an 
interest in, or derivative financial instruments in, stock, securities, 
currencies, or commodities, including options, forward or futures 
contracts, or short positions; or any similar financial instrument.
    (iii) Examples. The following examples illustrate the provisions of 
paragraph (b)(8) of this section:

    Example 1. Corporation Y owns, manages, and derives rental 
income from an office building and also owns vacant land that may be 
subject to environmental liabilities. Corporation Y contributes the 
land subject to the environmental liabilities to PRS in a 
transaction governed by section 721(a). PRS plans to develop the 
land as a landfill. The contribution of the vacant land does not 
constitute the contribution of a trade or business because 
Corporation Y did not conduct any significant business or 
development activities with respect to the land prior to the 
contribution.
    Example 2. For the past 5 years, Corporation X has owned and 
operated gas stations in City A, City B, and City C. Corporation X 
transfers all of the assets associated with the operation of the gas 
station in City A to PRS for interests in PRS and the assumption by 
PRS of the Sec.  1.752-7 liabilities associated with that gas 
station. PRS continues to operate the gas station in City A after 
the contribution. The contribution of the gas station to PRS 
constitutes the contribution of a trade or business.
    Example 3. For the past 7 years, Corporation Z has engaged in 
the manufacture and sale of household products. Throughout this 
period, Corporation Z has maintained a research department for use 
in connection with its manufacturing activities. The research 
department has 10 employees actively engaged in the development of 
new products. Corporation Z contributes the research department to 
PRS in exchange for a PRS interest and the assumption by PRS of 
pension liabilities with respect to the employees of the research 
department. PRS continues the research operations on a contractual 
basis with several businesses, including Corporation Z. The 
contribution of the research operations to PRS constitutes a 
contribution of a trade or business.

    (9) Adjusted value. The adjusted value of a partner's interest in a 
partnership is the fair market value of that interest increased by the 
partner's share of partnership liabilities under ``'1.752-1 through 
1.752-5.
    (c) Application of section 704(c) to assumed Sec.  1.752-7 
liabilities--(1) In general. Any Sec.  1.752-7 liability assumed by a 
partnership in a Sec.  1.752-7 liability transfer is treated under 
section 704(c) principles as having a built-in loss equal to the amount 
of the Sec.  1.752-7 liability as of the date of the partnership's 
assumption of the Sec.  1.752-7 liability. Thus, items of deduction or 
loss with respect to the Sec.  1.752-7 liability, if any, must be 
allocated, first, to the Sec.  1.752-7 liability partner to the extent 
of the built-in loss. Deductions or losses with respect to the Sec.  
1.752-7 liability that exceed the built-in loss are shared among the 
partners in accordance with section 704(b) and the regulations 
thereunder.
    (2) Example. The following example illustrates the provisions of 
this paragraph (c):

    Example --(i) Facts. In 2004, A, B, and C form partnership PRS. 
A contributes Property 1 with a fair market value and basis of 
$400X, subject to a Sec.  1.752-7 liability of $100X, for a 25% 
interest in PRS. B contributes $300X cash for a 25% interest in PRS, 
and C contributes $600X cash for a 50% interest in PRS. Assume that 
the partnership complies with the substantial economic effect safe 
harbor of Sec.  1.704-1(b)(2). Under Sec.  1.704-1(b)(2)(iv)(b), A's 
capital account is credited with $300X (the fair market value of 
Property 1, $400X, less the Sec.  1.752-7 liability assumed by PRS, 
$100X). In 2005, PRS earns $200X of income and uses it to satisfy 
the Sec.  1.752-7 liability. Assume that the cost to PRS of 
satisfying the Sec.  1.752-7 liability is deductible by PRS. The 
$200X of partnership income is allocated according to the 
partnership agreement, $50X to A, $50X to B, and $100X to C.
    ii. Analysis. Pursuant to paragraph (c) of this section, $100X 
of the deduction attributable to the economic performance of the 
Sec.  1.752-7 liability is specially allocated to A, the Sec.  
1.752-7 liability partner, under section 704(c)(1)(A) and the 
regulations thereunder. No book item corresponds to this tax 
allocation. The remaining $100X of deduction attributable to 
economic performance of the Sec.  1.752-7 liability is allocated, 
for both book and tax purposes, according to the partnership 
agreement, $25X to A, $25X to B, and $50X to C. If the partnership, 
instead, satisfied the Sec.  1.752-7 liability over a number of 
years, the first $100X of deduction with respect to the Sec.  1.752-
7 liability would be allocated to A, the Sec.  1.752-7 liability 
partner, before any deduction with respect to the Sec.  1.752-7 
liability would be allocated to the other partners. For example, if 
PRS were to satisfy $50X of the Sec.  1.752-7 liability at a time 
when PRS reasonably believed that it would cost $200X to satisfy the 
Sec.  1.752-7 liability in full, the $50X deduction with respect to 
the Sec.  1.752-7 liability would be allocated to A for tax purposes 
only. No deduction would arise for book purposes. If PRS later paid 
a further $100X in satisfaction of the Sec.  1.752-7 liability, $50X 
of the deduction with respect to the Sec.  1.752-7 liability would 
be allocated, solely for tax purposes, to A and the remaining $50X 
would be allocated, for both book and tax purposes, according to the 
partnership agreement.

    (d) Special rules for sales of partnership interests, distributions 
of partnership assets, and assumptions of the Sec.  1.752-7 liability 
after a Sec.  1.752-7 liability transfer--(1) In general. Except as 
provided in paragraph (d)(2) of this section, paragraphs (e), (f), and 
(g) of this section apply to certain partnership transactions occurring 
after a Sec.  1.752-7 liability transfer.
    (2) Exceptions--(i) In general. Paragraphs (e), (f), and (g) of 
this section do not apply--
    (A) If the partnership assumes the Sec.  1.752-7 liability as part 
of a contribution to the partnership of the trade or business with 
which the liability is associated, and the partnership continues to 
carry on that trade or business after the contribution (for the 
definition of a trade or business see paragraph (b)(8) of this 
section); or
    (B) If, immediately before the testing date, the amount of the 
remaining built-in loss with respect to all Sec.  1.752-7 liabilities 
assumed by the partnership (other than Sec.  1.752-7 liabilities 
assumed by the partnership with an associated trade or business) in one 
or more Sec.  1.752-7 liability transfers is less than the lesser of 
10% of the gross value of partnership assets or $1,000,000.
    (ii) Examples. The following examples illustrate the principles of 
this paragraph (d)(2):

    Example 1. For the past 5 years, Corporation X, a C corporation, 
has been engaged in Business A and Business B. In 2004, Corporation 
X contributes Business A, in a transaction governed by section 
721(a), to PRS in exchange for a PRS interest and the assumption by 
PRS of pension liabilities with respect to the employees engaged in 
Business A. PRS plans to carry on Business A after the contribution. 
Because PRS has assumed the pension liabilities as part of a 
contribution to PRS of the trade or business with which the 
liabilities are associated, paragraphs (e), (f), and (g) of this 
section do not apply to any transaction occurring after the Sec.  
1.752-7 liability transfer.
    Example 2 --(i) Facts. The facts are the same as in Example 1, 
except that PRS also

[[Page 37443]]

assumes from Corporation X certain pension liabilities with respect 
to the employees of Business B. At the time of the assumption, the 
amount of the pension liabilities with respect to the employees of 
Business A is $3,000,000 (the A liabilities) and the amount of the 
pension liabilities associated with the employees of Business B (the 
B liabilities) is $2,000,000. Two years later, Corporation X sells 
its interest in PRS to Y for $9,000,000. At the time of the sale, 
the remaining built-in loss associated with the A liabilities is 
$2,100,000, the remaining built-in loss associated with the B 
liabilities is $900,000, and the gross value of PRS's assets 
(excluding Sec.  1.752-7 liabilities) is $20,000,000. Assume that 
PRS has no Sec.  1.752-7 liabilities other than those assumed from 
Corporation X.
    (ii) Analysis. The only liabilities assumed by PRS from 
Corporation X that were not assumed as part of Corporation X's 
contribution of Business A were the B liabilities. Immediately 
before the testing date, the remaining built-in loss associated with 
the B liabilities ($900,000) was less than the lesser of 10% of the 
gross value of PRS's assets ($2,000,000) or $1,000,000. Therefore, 
paragraph (d)(2)(i)(B) of this section applies to exclude 
Corporation X's sale of the PRS interest to Y from the application 
of paragraph (e) of this section.

    (e) Transfer of Sec.  1.752-7 liability partner's partnership 
interest--(1) In general. Except as provided in paragraphs (d)(2) and 
(e)(3) of this section, immediately before the sale, exchange, or other 
disposition of all or a part of a Sec.  1.752-7 liability partner's 
partnership interest, the Sec.  1.752-7 liability partner's basis in 
the partnership interest is reduced by the Sec.  1.752-7 liability 
reduction. No deduction or capital expense is allowed to the 
partnership on the economic performance of the Sec.  1.752-7 liability 
to the extent of the remaining built-in loss associated with the Sec.  
1.752-7 liability. For purposes of section 705(a)(2)(B) and Sec.  
1.704-1(b)(2)(ii)(b) only, the remaining built-in loss associated with 
the Sec.  1.752-7 liability is not treated as a nondeductible, 
noncapital expenditure of the partnership. Therefore, the remaining 
partners' capital accounts and bases in their partnership interests are 
not reduced by the remaining built-in loss associated with the Sec.  
1.752-7 liability. If the partnership (or any successor) notifies the 
Sec.  1.752-7 liability partner of the economic performance of the 
Sec.  1.752-7 liability (as described in paragraph (h) of this 
section), then the Sec.  1.752-7 liability partner is entitled to a 
loss or deduction. The amount of that deduction or loss is, in the case 
of a partial satisfaction of the Sec.  1.752-7 liability, the amount 
paid by the partnership in satisfaction of the Sec.  1.752-7 liability 
(but not more than the Sec.  1.752-7 liability reduction) or, in the 
case of a complete satisfaction of the Sec.  1.752-7 liability, the 
remaining Sec.  1.752-7 liability reduction. To the extent of the 
amount paid in satisfaction of the Sec.  1.752-7 liability, the 
character of that deduction or loss is determined as if the Sec.  
1.752-7 liability partner had satisfied the liability. To the extent 
that the Sec.  1.752-7 liability reduction exceeds the amount paid in 
satisfaction of the Sec.  1.752-7 liability, the character of the Sec.  
1.752-7 liability partner's loss is capital.

    (2) Examples. The following examples illustrates the principles of 
paragraph (e)(1) of this section:

    Example 1 --(i) Facts. In 2004, A, B, and C form partnership 
PRS. A contributes Property 1 with a fair market value of $5,000,000 
and basis of $4,000,000 subject to a Sec.  1.752-7 liability of 
$2,000,000 in exchange for a 25% interest in PRS. B contributes 
$3,000,000 cash in exchange for a 25% interest in PRS, and C 
contributes $6,000,000 cash in exchange for a 50% interest in PRS. 
In 2006, when PRS has a section 754 election in effect, A sells A's 
interest in PRS to D for $3,000,000. At the time of the sale, the 
basis of A's PRS interest is $4,000,000, the remaining built-in loss 
associated with the Sec.  1.752-7 liability is $2,000,000, and PRS 
has no liabilities (as defined in Sec.  1.752-1(a)(1)). Assume that 
none of the exceptions of paragraph (d)(2) of this section apply and 
that economic performance of the Sec.  1.752-7 liability would have 
given rise to a deductible expense to A. In 2007, PRS pays 
$3,000,000 to satisfy the liability.
    (ii) Sale of A's PRS interest. Immediately before the sale of 
the PRS interest to D, A's basis in the PRS interest is reduced (to 
$3,000,000) by the Sec.  1.752-7 liability reduction, i.e., the 
lesser of the excess of A's basis in the PRS interest ($4,000,000) 
over the adjusted value of that interest ($3,000,000), $1,000,000, 
or the remaining built-in loss associated with the Sec.  1.752-7 
liability, $2,000,000. Therefore, A recognizes no gain or loss on 
the sale of the PRS interest to D. D's basis in the PRS interest is 
$3,000,000. D's share of the adjusted basis of partnership property 
equals D's interest in the partnership's previously taxed capital of 
$2,000,000 (the amount of cash that D would receive on a liquidation 
of the partnership, $3,000,000, increased by the amount of tax loss 
that would be allocated to D in the hypothetical transaction, $0, 
and reduced by the amount of tax gain that would be allocated to D 
in the hypothetical transaction, $1,000,000). Therefore, the basis 
adjustment under section 743(b) is $1,000,000.
    (iii) Satisfaction of Sec.  1.752-7 liability. Neither PRS nor 
any of its partners is entitled to a deduction for the economic 
performance of the Sec.  1.752-7 liability to the extent of the 
remaining built-in loss associated with the Sec.  1.752-7 liability 
($2,000,000). PRS is entitled to a deduction, however, for the 
amount by which the cost of satisfying the Sec.  1.752-7 liability 
exceeds the remaining built-in loss associated with the Sec.  1.752-
7 liability. Therefore, in 2007, PRS may deduct $1,000,000 (cost to 
satisfy the Sec.  1.752-7 liability, $3,000,000, less the remaining 
built-in loss associated with the Sec.  1.752-7 liability, 
$2,000,000). If PRS notifies A of the economic performance of the 
Sec.  1.752-7 liability, then A is entitled to an ordinary deduction 
in 2007 of $1,000,000 (the Sec.  1.752-7 liability reduction).
    Example 2 --The facts are the same as in Example 1 except that, 
at the time of A's sale of the PRS interest to D, PRS has a 
nonrecourse liability of $4,000,000, of which A's share is 
$1,000,000. A's basis in PRS is $5,000,000. At the time of the sale 
of the PRS interest to D, the adjusted value of A's interest is 
$4,000,000 (the fair market value of the interest ($3,000,000), 
increased by A's share of partnership liabilities ($1,000,000)). The 
difference between the basis of A's interest ($5,000,000) and the 
adjusted value of that interest ($4,000,000) is $1,000,000. 
Therefore, the Sec.  1.752-7 liability reduction is $1,000,000 (the 
lesser of this difference or the remaining built-in loss associated 
with the Sec.  1.752-7 liability, $2,000,000). Immediately before 
the sale of the PRS interest to D, A's basis is reduced sfrom 
$5,000,000 to $4,0000,000. A's amount realized on the sale of the 
PRS interest to D is $4,000,000 ($3,000,000 paid by D, increased 
under section 752(d) by A's share of partnership liabilities, or 
$1,000,000). Therefore, A recognizes no gain or loss on the sale. 
D's basis in the PRS interest is $4,000,000. Because D's share of 
the adjusted basis of partnership property is $3,000,000 (D's share 
of the partnership's previously taxed capital, $2,000,000, plus D's 
share of partnership liabilities, $1,000,000), the basis adjustment 
under section 743(b) is $1,000,000.

    (3) Exception for nonrecognition transactions--(i) In general. 
Paragraph (e)(1) of this section does not apply where a Sec.  1.752-7 
liability partner transfers all or part of the partner's partnership 
interest in a transaction in which the transferee's basis in the 
partnership interest is determined in whole or in part by reference to 
the transferor's basis in the partnership interest. In addition, 
paragraph (e)(1) of this section does not apply to a distribution of an 
interest in the partnership that has assumed the Sec.  1.752-7 
liability by a partnership that is the Sec.  1.752-7 liability partner.
    (ii) Examples. The following examples illustrate the provisions of 
this paragraph (e)(3):

    Example 1-- (i) Facts. In 2004, X contributes undeveloped land 
with a value and basis of $2,000,000 and subject to environmental 
liabilities of $1,500,000 to partnership LTP in exchange for a 50% 
interest in LTP. LTP develops the land as a landfill. In 2005, in a 
transaction governed by section 721(a), X contributes the LTP 
interest to UTP in exchange for a 50% interest in UTP. In 2008, X 
sells the UTP interest to A for $500,000. At the time of the sale, 
X's basis in UTP is $2,000,000, the remaining built-in

[[Page 37444]]

loss associated with the environmental liability is $1,500,000, and 
the gross value of UTP's assets is $2,500,000. The environmental 
liabilities were not assumed by LTP as part of a contribution by X 
to LTP of a trade or business with which the liabilities were 
associated. (See paragraph (b)(8)(iii), Example 1 of this section.)
    (ii) Analysis. Because UTP's basis in the LTP interest is 
determined by reference to X's basis in the LTP interest, X's 
contribution of the LTP interest to UTP is exempted from the rules 
of paragraph (e)(1) of this section. Under paragraph (i)(1) of this 
section, X's contribution of the LTP interest to UTP is treated as a 
contribution of X's share of the assets of LTP and UTP's assumption 
of X's share of the LTP liabilities (including Sec.  1.752-7 
liabilities). Therefore, X's transfer of the LTP interest to UTP is 
a Sec.  1.752-7 liability transfer. The Sec.  1.752-7 liabilities 
deemed transferred by X to UTP are not associated with a trade or 
business transferred to UTP for purposes of paragraph (d)(2)(i)(A) 
of this section, because they were not associated with a trade or 
business transferred by X to LTP as part of the original Sec.  
1.752-7 liability transfer. See paragraph (i)(2) of this section. 
Because none of the exceptions described in paragraph (d)(2) of this 
section apply to X's taxable sale of the UTP interest to A in 2008, 
paragraph (e)(1) of this section applies to that sale.
    Example 2. The facts are the same as in Example 1, except that, 
rather than transferring the LTP interest to UTP in 2005, X 
contributes the LTP interest to Corporation Y in an exchange to 
which section 351 applies. Because Corporation Y's basis in the LTP 
interest is determined by reference to X's basis in that interest, 
X's contribution of the LTP interest is exempted from the rules of 
paragraph (e)(1) of this section. But see section 358(h) and Sec.  
1.358-7.

    (f) Distribution in liquidation of Sec.  1.752-7 liability 
partner's partnership interest--(1) In general. Except as provided in 
paragraph (d)(2) of this section, immediately before a distribution in 
liquidation of a Sec.  1.752-7 liability partner's partnership 
interest, the Sec.  1.752-7 liability partner's basis in the 
partnership interest is reduced by the Sec.  1.752-7 liability 
reduction. This rule applies before section 737. No deduction or 
capital expense is allowed to the partnership on the economic 
performance of the Sec.  1.752-7 liability to the extent of the 
remaining built-in loss associated with the Sec.  1.752-7 liability. 
For purposes of section 705(a)(2)(B) and Sec.  1.704-1(b)(2)(ii)(b) 
only, the remaining built-in loss associated with the Sec.  1.752-7 
liability is not treated as a nondeductible, noncapital expenditure of 
the partnership. Therefore, the remaining partners' capital accounts 
and bases in their partnership interests are not reduced by the 
remaining built-in loss associated with the Sec.  1.752-7 liability. If 
the partnership (or any successor) notifies the Sec.  1.752-7 liability 
partner of the economic performance of the Sec.  1.752-7 liability (as 
described in paragraph (h) of this section), then the Sec.  1.752-7 
liability partner is entitled to a loss or deduction. The amount of 
that deduction or loss is, in the case of a partial satisfaction of the 
Sec.  1.752-7 liability, the amount paid by the partnership in 
satisfaction of the Sec.  1.752-7 liability (but not more than the 
Sec.  1.752-7 liability reduction) or, in the case of a complete 
satisfaction of the Sec.  1.752-7 liability, the remaining Sec.  1.752-
7 liability reduction. To the extent of the amount paid in satisfaction 
of the Sec.  1.752-7 liability, the character of that deduction or loss 
is determined as if the Sec.  1.752-7 liability partner had satisfied 
the liability. To the extent that the Sec.  1.752-7 liability reduction 
exceeds the amount paid in satisfaction of the Sec.  1.752-7 liability, 
the character of the Sec.  1.752-7 liability partner's loss is capital.
    (2) Example. The following example illustrates the provision of 
this paragraph (f):

    Example --(i) Facts. In 2004, A, B, and C form partnership PRS. 
A contributes Property 1 with a fair market value and basis of 
$5,000,000 subject to a Sec.  1.752-7 liability of $2,000,000 for a 
25% interest in PRS. B contributes $3,000,000 cash for a 25% 
interest in PRS, and C contributes $6,000,000 cash for a 50% 
interest in PRS. In 2012, when PRS has a section 754 election in 
effect, PRS distributes Property 2, which has a basis and fair 
market value of $3,000,000, to A in liquidation of A's PRS interest. 
At the time of the distribution, the fair market value of A's PRS 
interest is $3,000,000, the basis of that interest is $5,000,000, 
and the remaining built-in loss associated with the Sec.  1.752-7 
liability is $2,000,000. Assume that none of the exceptions of 
paragraph (d)(2) of this section apply to the distribution and that 
the economic performance of the Sec.  1.752-7 liability would have 
given rise to a deductible expense to A. In 2013, PRS pays 
$1,000,000 to satisfy the entire Sec.  1.752-7 liability.
    (ii) Redemption of A's PRS interest. Immediately before the 
distribution of Property 2 to A, A's basis in the PRS interest is 
reduced (to $3,000,000) by the Sec.  1.752-7 liability reduction, 
i.e., the lesser of the excess of A's basis in the PRS interest over 
the adjusted value of that interest ($2,000,000) or the remaining 
built-in loss associated with the Sec.  1.752-7 liability 
($2,000,000). Therefore, A's basis in Property 2 under section 
732(b) is $3,000,000. Because this is the same as the partnership's 
basis in Property 2 immediately before the distribution, the 
partnership's basis adjustment under section 734(b) is $0.
    (iii) Satisfaction of Sec.  1.752-7 liability. PRS is not 
entitled to a deduction for the economic performance of the Sec.  
1.752-7 liability to the extent of the remaining built-in loss 
associated with the Sec.  1.752-7 liability ($2,000,000). Because 
this amount exceeds the amount paid by PRS to satisfy the Sec.  
1.752-7 liability ($1,000,000), PRS is not entitled to any deduction 
for the Sec.  1.752-7 liability in 2013. If, however, PRS notifies A 
of the economic performance of the Sec.  1.752-7 liability, then A 
is entitled to an ordinary deduction in 2013 of $1,000,000 (the 
amount paid in satisfaction of the Sec.  1.752-7 liability) and a 
capital loss of $1,000,000 (the remaining Sec.  1.752-7 liability 
reduction).

    (g) Assumption of Sec.  1.752-7 liability by a partner other than 
Sec.  1.752-7 liability partner--(1) In general. Except as provided in 
paragraph (d)(2) of this section, section 704(c)(1)(B) does not apply 
to an assumption of a Sec.  1.752-7 liability from a partnership by a 
partner other than the Sec.  1.752-7 liability partner. Instead, this 
paragraph (g) applies. The rules of paragraph (g)(2) of this section 
apply only if the Sec.  1.752-7 liability partner is a partner in the 
partnership at the time of the assumption of the Sec.  1.752-7 
liability. The rules of paragraphs (g)(3) and (4) of this section apply 
to any assumption of the Sec.  1.752-7 liability by a partner other 
than the Sec.  1.752-7 liability partner, whether or not the Sec.  
1.752-7 liability partner is a partner in the partnership at the time 
of the assumption.
    (2) Consequences to Sec.  1.752-7 liability partner. If, at the 
time of an assumption of a Sec.  1.752-7 liability from a partnership 
by a partner other than the Sec.  1.752-7 liability partner, the Sec.  
1.752-7 liability partner remains a partner in the partnership, then 
the Sec.  1.752-7 liability partner's basis in the partnership interest 
is reduced by the Sec.  1.752-7 liability reduction. If the assuming 
partner (or any successor) notifies the Sec.  1.752-7 liability partner 
of the economic performance of the Sec.  1.752-7 liability (as 
described in paragraph (h) of this section), then the Sec.  1.752-7 
liability partner is entitled to a deduction or loss. The amount of 
that deduction or loss is, in the case of a partial satisfaction of the 
Sec.  1.752-7 liability, the amount paid by the partnership in 
satisfaction of the Sec.  1.752-7 liability (but not more than the 
Sec.  1.752-7 liability reduction) or, in the case of a complete 
satisfaction of the Sec.  1.752-7 liability, the remaining Sec.  1.752-
7 liability reduction. To the extent of the amount paid in satisfaction 
of the Sec.  1.752-7 liability, the character of that deduction or loss 
is determined as if the Sec.  1.752-7 liability partner had satisfied 
the liability. To the extent that the Sec.  1.752-7 liability reduction 
exceeds the amount paid in satisfaction of the Sec.  1.752-7 liability, 
the character of the Sec.  1.752-7 liability partner's loss is capital.
    (3) Consequences to partnership. Immediately after the assumption 
of the Sec.  1.752-7 liability from the partnership by a partner other 
than the Sec.  1.752-7

[[Page 37445]]

liability partner, the partnership must reduce the basis of partnership 
assets by the remaining built-in loss associated with the Sec.  1.752-7 
liability. The reduction in the basis of partnership assets must be 
allocated among partnership assets as if that adjustment were a basis 
adjustment under section 734(b).
    (4) Consequences to assuming partner. No deduction or capital 
expense is allowed to an assuming partner (other than the Sec.  1.752-7 
liability partner) on the economic performance of a Sec.  1.752-7 
liability assumed from a partnership to the extent of the remaining 
built-in loss associated with the Sec.  1.752-7 liability. Instead, on 
economic performance of the Sec.  1.752-7 liability, the assuming 
partner must adjust the basis of the partnership interest, any assets 
(other than cash, accounts receivable, or inventory) distributed by the 
partnership to the partner, or gain or loss on the disposition of the 
partnership interest, as the case may be. These adjustments are 
determined as if the assuming partner's basis in the partnership 
interest at the time of the assumption were increased by the lesser of 
the amount paid to satisfy the Sec.  1.752-7 liability or the remaining 
built-in loss associated with the Sec.  1.752-7 liability. However, the 
assuming partner cannot take into account any adjustments to 
depreciable basis, reduction in gain, or increase in loss until 
economic performance of the Sec.  1.752-7 liability. Any adjustment to 
the basis of an asset under this provision is taken into account over 
the recovery period of that asset.
    (5) Example. The following example illustrates the provisions of 
this paragraph (g):

    Example --(i) Facts. In 2004, A, B, and C form partnership PRS. 
A contributes Property 1, a nondepreciable capital asset with a fair 
market value and basis of $5,000,000, in exchange for a 25% interest 
in PRS and assumption by PRS of a Sec.  1.752-7 liability of 
$2,000,000. B contributes $3,000,000 cash for a 25% interest in PRS, 
and C contributes $6,000,000 cash for a 50% interest in PRS. PRS 
uses the cash contributed to purchase Property 2. In 2007, PRS 
distributes Property 1, subject to the Sec.  1.752-7 liability to B 
in liquidation of B's interest in PRS. At the time of the 
distribution, A's interest in PRS has a value of $3,000,000 and a 
basis of $5,000,000, and B's interest in PRS has a value and basis 
of $3,000,000. Also at that time, Property 1 has a value and basis 
of $5,000,000, Property 2 has a value and basis of $9,000,000, and 
the remaining built-in loss associated with the Sec.  1.752-7 
liability is $2,000,000. Assume that none of the exceptions of 
paragraph (d)(2)(i) of this section apply to the assumption of the 
Sec.  1.752-7 liability by B and that economic performance of the 
Sec.  1.752-7 liability would have given rise to a deductible 
expense to A. In 2010, B pays $1,000,000 to satisfy the entire Sec.  
1.752-7 liability. At that time, B still owns Property 1, which has 
a basis of $3,000,000.
    (ii) Assumption of Sec.  1.752-7 liability by B. Section 
704(c)(1)(B) does not apply to the assumption of the Sec.  1.752-7 
liability by B. Instead, A's basis in the PRS interest is reduced 
(to $3,000,000) by the Sec.  1.752-7 liability reduction, i.e., the 
lesser of the excess of A's basis in the PRS interest over the 
adjusted value of that interest ($2,000,000), or the remaining 
built-in loss associated with the Sec.  1.752-7 liability as of the 
time of the assumption ($2,000,000). PRS's basis in Property 2 is 
reduced (to $7,000,000) by the $2,000,000 remaining built-in loss 
associated with the Sec.  1.752-7 liability. B's basis in Property 1 
under section 732(b) is $3,000,000 (B's basis in the PRS interest). 
This is $2,000,000 less than PRS's basis in Property 1 before the 
distribution of Property 1 to B. If PRS has a section 754 election 
in effect for 2007, PRS may increase the basis of Property 2 under 
section 734(b) by $2,000,000.
    (iii) Satisfaction of Sec.  1.752-7 liability. B is not entitled 
to a deduction for the economic performance of the Sec.  1.752-7 
liability in 2010 to the extent of the remaining built-in loss 
associated with the Sec.  1.752-7 liability as of the time of the 
assumption ($2,000,000). As this amount exceeds the amount paid by B 
to satisfy the Sec.  1.752-7 liability, B is not entitled to any 
deduction for the Sec.  1.752-7 liability in 2010. B may, however, 
increase the basis of Property 1 by the lesser of the remaining 
built-in loss associated with the Sec.  1.752-7 liability 
($2,000,000) or the amount paid to satisfy the Sec.  1.752-7 
liability ($1,000,000). Therefore, B's basis in Property 1 is 
increased to $4,000,000. If B notifies A of the economic performance 
of the Sec.  1.752-7 liability, then A is entitled to an ordinary 
deduction in 2010 of $1,000,000 (the amount paid in satisfaction of 
the Sec.  1.752-7 liability) and a capital loss of $1,000,000 (the 
remaining Sec.  1.752-7 liability reduction).

    (h) Notification by the partnership (or successor) of the economic 
performance of the Sec.  1.752-7 liability. For purposes of paragraphs 
(e), (f), and (g) of this section, notification by the partnership (or 
successor) of the economic performance of the Sec.  1.752-7 liability 
must be attached to the Sec.  1.752-7 liability partner's return for 
the year in which the loss is being claimed and must include--
    (1) The amount paid in satisfaction of the Sec.  1.752-7 liability, 
and whether the amounts paid were in partial or complete satisfaction 
of the Sec.  1.752-7 liability;
    (2) The name and address of the person satisfying the Sec.  1.752-7 
liability;
    (3) The date of the payment on the Sec.  1.752-7 liability; and
    (4) The character of the loss with respect to the Sec.  1.752-7 
liability.
    (i) Tiered partnerships--(1) Look-through treatment. For purposes 
of this section, a contribution by a partner of an interest in a 
partnership (lower-tier partnership) to another partnership (upper-tier 
partnership) is treated as a contribution of the partner's share of 
each of the lower-tier partnership's assets and an assumption by the 
upper-tier partnership of the partner's share of the lower-tier 
partnership's liabilities (including Sec.  1.752-7 liabilities). See 
paragraph (e)(3)(ii), Example 1 of this section. In addition, a 
partnership is treated as having its share of any Sec.  1.752-7 
liabilities of the partnerships in which it has an interest.
    (2) Trade or business exception. If a partnership (upper-tier 
partnership) assumes a Sec.  1.752-7 liability of a partner, and, 
subsequently, another partnership (lower-tier partnership) assumes that 
Sec.  1.752-7 liability from the upper-tier partnership, then the Sec.  
1.752-7 liability is treated as associated only with any trade or 
business contributed to the upper-tier partnership by the Sec.  1.752-7 
liability partner. The same rule applies where a partnership assumes a 
Sec.  1.752-7 liability of a partner, and, subsequently, the Sec.  
1.752-7 liability partner transfers that partnership interest to 
another partnership. See paragraph (e)(3)(ii), Example 1 of this 
section.
    (3) Partnership as a Sec.  1.752-7 liability partner. If a 
transaction described in paragraph (e), (f), or (g) of this section 
occurs with respect to a partnership (upper-tier partnership) that is a 
Sec.  1.752-7 liability partner of another partnership (lower-tier 
partnership), then such transaction will also be treated as a 
transaction described in paragraph (e), (f), or (g) of this section, as 
appropriate, with respect to the partners of the upper-tier 
partnership, regardless of whether the upper-tier partnership assumed 
the Sec.  1.752-7 liability from those partners. (See paragraph (b)(3) 
of this section for rules relating to the treatment of transactions by 
the partners of the upper-tier partnership.) In such a case, the Sec.  
1.752-7 liability reduction with respect to each partner in the upper-
tier partnership is equal to that partner's share of the Sec.  1.752-7 
liability. The partners of the upper-tier partnership at the time of 
the transaction described in paragraph (e), (f), or (g) of this 
section, and not the upper-tier partnership, are entitled to the loss 
or deduction on the economic performance of the Sec.  1.752-7 
liability. Similar principles apply where the upper-tier partnership is 
itself owned by one or a series of partnerships. This paragraph does 
not apply to the extent that Sec.  1.752-7(i)(4) applies to the 
assumption of the Sec.  1.752-7 liability by the lower-tier 
partnership.

[[Page 37446]]

    (4) Transfer of Sec.  1.752-7 liability by partnership to another 
partnership or corporation after a transaction described in paragraphs 
(e),(f), or (g)--(i) In general. If, after a transaction described in 
paragraphs (e), (f), or (g) of this section with respect to a Sec.  
1.752-7 liability assumed by a partnership (the upper-tier 
partnership), another partnership or a corporation assumes the Sec.  
1.752-7 liability from the upper-tier partnership (or the assuming 
partner) in a transaction in which the basis of property is determined, 
in whole or in part, by reference to the basis of the property in the 
hands of the upper-tier partnership (or assuming partner), then--
    (A) The upper-tier partnership (or assuming partner) must reduce 
its basis in any corporate stock or partnership interest received by 
the remaining built-in loss associated with the Sec.  1.752-7 liability 
(but the partners of the upper-tier partnership do not reduce their 
bases or capital accounts in the upper-tier partnership); and
    (B) No deduction or capital expense is allowed to the assuming 
partnership or corporation on the economic performance of the Sec.  
1.752-7 liability to the extent of the remaining built-in loss 
associated with the Sec.  1.752-7 liability.
    (ii) Subsequent transfers. Similar rules apply to subsequent 
assumptions of the Sec.  1.752-7 liability in transactions in which the 
basis of property is determined, in whole or in part, by reference to 
the basis of the property in the hands of the transferor. If, 
subsequent to an assumption of the Sec.  1.752-7 liability by a 
partnership in a transaction to which paragraph (i)(4)(i) of this 
section applies, the Sec.  1.752-7 liability is assumed from the 
partnership by a partner other than the partner from whom the 
partnership assumed the Sec.  1.752-7 liability, then the rules of 
paragraph (g)(4) of this section apply.
    (5) Example. The following example illustrates the provisions of 
paragraphs (i)(3) and (i)(4) of this section.

    Example --(i) Assumption of Sec.  1.752-7 liability by UTP and 
transfer of Sec.  1.752-7 liability partner's interest in UTP.
    In 2004, A, B, and C form partnership UTP. A contributes 
Property 1 with a fair market value and basis of $5,000,000 subject 
to a Sec.  1.752-7 liability of $2,000,000 in exchange for a 25% 
interest in UTP. B contributes $3,000,000 cash in exchange for a 25% 
interest in UTP, and C contributes $6,000,000 cash in exchange for a 
50% interest in UTP. UTP invests the $9,000,000 cash in Property 2. 
In 2006, A sells A's interest in UTP to D for $3,000,000. At the 
time of the sale, the basis of A's UTP interest is $5,000,000, the 
remaining built-in loss associated with the Sec.  1.752-7 liability 
is $2,000,000, and UTP has no liabilities other than Sec.  1.752-7 
liabilities. Assume that none of the exceptions of paragraph (d)(2) 
of this section apply and that economic performance of the Sec.  
1.752-7 liability would give rise to a deductible expense to the 
payor. Under paragraph (e) of this section, immediately before the 
sale of the UTP interest to D, A's basis in UTP is reduced to 
$3,000,000 by the $2,000,000 Sec.  1.752-7 liability reduction. 
Therefore, A recognizes no gain or loss on the sale of the UTP 
interest to D. D's basis in the UTP interest is $3,000,000.
    (ii) Assumption of Sec.  1.752-7 liability by LTP from UTP. In 
2008, at a time when the estimated amount of the Sec.  1.752-7 
liability has increased to $3,500,000, UTP contributes Property 1 
and Property 2, subject to the Sec.  1.752-7 liability, to LTP in 
exchange for a 50% interest in LTP. At the time of the contribution, 
Property 1 still has a value and basis of $5,000,000 and Property 2 
still has a value and basis of $9,000,000. UTP's basis in LTP under 
section 722 is $14,000,000. Under paragraph (i)(4) of this section, 
UTP must reduce its basis in LTP by the $2,000,000 remaining built-
in loss associated with the Sec.  1.752-7 liability (as of the time 
of the sale of the UTP interest by A). The partners in UTP are not 
required to reduce their bases in UTP by this amount.
    (iii) Sale by UTP of LTP interest. In 2010, UTP sells its 
interest in LTP to E for $10,500,000. At the time of the sale, 
Property 1 still has a value and basis of $5,000,000, Property 2 
still has a value and basis of $9,000,000, and the remaining built-
in loss associated with the Sec.  1.752-7 liability is still 
$3,500,000. Under paragraph (e) of this section, immediately before 
the sale, UTP must reduce its basis in the LTP interest by the Sec.  
1.752-7 liability reduction. Under paragraph (a)(4) of this section, 
the remaining built-in loss associated with the Sec.  1.752-7 
liability is $1,500,000 (remaining built-in loss associated with the 
Sec.  1.752-7 liability, $3,500,000, reduced by the amount of the 
Sec.  1.752-7 liability taken into account under paragraph (i)(4) of 
this section, $2,000,000). The difference between the basis of the 
LTP interest held by UTP ($12,000,000) and the adjusted value of 
that interest ($10,500,000) is also $1,500,000. Therefore, the Sec.  
1.752-7 liability reduction is $1,500,000 and UTP's basis in the LTP 
interest must be reduced to $10,500,000. In addition, UTP's partners 
must reduce their bases in their UTP interests by their 
proportionate shares of the Sec.  1.752-7 liability reduction. Thus, 
the basis of each of B's and D's interest in UTP must be reduced by 
$375,000 and the basis of C's interest in UTP must be reduced by 
$750,000. In 2011, D sells the UTP interest to F.
    (iv) Economic performance of Sec.  1.752-7 liability by LTP. In 
2012, LTP pays $3,500,000 to satisfy the Sec.  1.752-7 liability. 
Under paragraphs (e) and (i)(4) of this section, LTP is not entitled 
to any deduction with respect to the Sec.  1.752-7 liability. Under 
paragraph (i)(3) of this section, UTP also is not entitled to any 
deduction with respect to the Sec.  1.752-7 liability. If LTP 
notifies A, B, C and D of the economic performance of the Sec.  
1.752-7 liability, then A is entitled to a deduction in 2012 of 
$2,000,000, B and D are each entitled to deductions in 2012 of 
$375,000, and C is entitled to a deduction in 2012 of $750,000.

    (j) Effective date--(1) In general. This section applies to Sec.  
1.752-7 liability transfers occurring on or after June 24, 2003.
    (2) Election to apply this section to assumptions of liabilities 
occurring after October 18, 1999 and before June 24, 2003--(i) In 
general. A partnership may elect to apply this section to assumptions 
of liabilities (including Sec.  1.752-7 liabilities) occurring after 
October 18, 1999, and before June 24, 2003. Such an election is binding 
on the partnership and all of its partners. A partnership making such 
an election must apply all of the provisions of these proposed 
regulations (other than Sec.  1.752-6).
    (ii) Manner of making election. A partnership makes an election 
under this paragraph (j)(2) by attaching the following statement to its 
timely filed return: ``[Insert name and employer identification number 
of electing partnership] elects under Sec.  1.752-7 of the Income Tax 
Regulations to be subject to the rules of Sec.  1.358-7, 1.752-7, Sec.  
1.704-1(b)(2)(iv)(b), 1.704-2(b)(3), 1.705-1(a)(7), and 1.752-1 with 
respect to all liabilities (including Sec.  1.752-7 liabilities) 
assumed by the partnership after October 18, 1999 and before June 24, 
2003. In the statement, the partnership must list, with respect to each 
liability (including each Sec.  1.752-7 liability) assumed by the 
partnership after October 18, 1999 and before June 24, 2003--
    (A) The name, address, and taxpayer identification number of the 
partner from whom the liability was assumed;
    (B) The date on which the liability was assumed by the partnership;
    (C) The amount of the liability as of the time of its assumption; 
and
    (D) A description of the liability.
    (iii) Filing of amended returns. An election under this paragraph 
(j)(2) will be valid only if the partnership and its partners promptly 
amend any returns for open taxable years that would be affected by the 
election.
    (iv) Time for making election. An election under this paragraph 
(j)(2) must be filed with the first Federal income tax return filed by 
the partnership on or after September 24, 2003.

David A. Mader,
Assistant Deputy Commissioner of Internal Revenue.
[FR Doc. 03-15282 Filed 6-23-03; 8:45 am]
BILLING CODE 4830-01-P