[Federal Register Volume 70, Number 222 (Friday, November 18, 2005)]
[Proposed Rules]
[Pages 69919-69922]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 05-22281]


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 Proposed Rules
                                                 Federal Register
 ________________________________________________________________________
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 This section of the FEDERAL REGISTER contains notices to the public of 
 the proposed issuance of rules and regulations. The purpose of these 
 notices is to give interested persons an opportunity to participate in 
 the rule making prior to the adoption of the final rules.
 
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 

  Federal Register / Vol. 70, No. 222 / Friday, November 18, 2005 / 
Proposed Rules  

[[Page 69919]]



DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-144620-04]
RIN 1545-BD70


Partner's Distributive Share

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: The proposed regulations provide rules for testing the 
substantiality of an allocation under section 704(b) where the partners 
are look-through entities or members of a consolidated group, provide 
additional guidance on the effect of other provisions, such as section 
482, upon the tax treatment of a partner with respect to the partner's 
distributive share under section 704(b), and revise the existing rules 
for determining the partners' interests in a partnership. The proposed 
regulations affect partnerships and their partners. This document also 
provides notice of a public hearing on these proposed regulations.

DATES: Written or electronic comments must be received by January 25, 
2006. Outlines of topics to be discussed at the public hearing 
scheduled for February 15, 2006, at 10 a.m., must be received by 
January 25, 2006.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-144620-04), room 
5203, Internal Revenue Service, POB 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand-delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to: CC:PA:LPD:PR (REG-
144620-04), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC, or sent electronically, via the IRS 
internet site at http://www.irs.gov/regs or via the Federal eRule 
making Portal at http://www.regulations.gov (IRS REG-144620-04). The 
public hearing will be held in the Auditorium, Internal Revenue 
Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Timothy J. Leska, (202) 622-3050; concerning submissions and the 
hearing LaNita Van Dyke, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

    Subchapter K is intended to permit taxpayers to conduct joint 
business activities through a flexible economic arrangement without 
incurring an entity-level tax. To achieve this goal of a flexible 
economic arrangement, partners are generally permitted to decide among 
themselves how a partnership's items will be allocated. Section 704(a) 
of the Internal Revenue Code (Code) provides that a partner's 
distributive share of income, gain, loss, deduction, or credit shall, 
except as otherwise provided, be determined by the partnership 
agreement.
    Section 704(b) places a significant limitation on the general 
flexibility of section 704(a). Specifically, section 704(b) provides 
that a partner's distributive share of income, gain, loss, deduction, 
or credit (or item thereof) shall be determined in accordance with the 
partner's interest in the partnership (determined by taking into 
account all facts and circumstances) if the allocation to a partner 
under the partnership agreement of income, gain, loss, deduction, or 
credit (or item thereof) does not have substantial economic effect. 
Thus, the statute provides that partnership allocations either must 
have substantial economic effect or must be in accordance with the 
partner's interest in the partnership.
    Section 1.704-1(b)(2)(i) provides that the determination of whether 
an allocation of income, gain, loss, or deduction to a partner has 
substantial economic effect involves a two-part analysis. First, the 
allocation must have economic effect within the meaning of Sec.  1.704-
1(b)(2)(ii). Second, the economic effect of the allocation must be 
substantial within the meaning of Sec.  1.704-1(b)(2)(iii).
    For an allocation to have economic effect, it must be consistent 
with the underlying economic arrangement of the partners. This means 
that, in the event that there is an economic benefit or burden that 
corresponds to the allocation, the partner to whom the allocation is 
made must receive such economic benefit or bear such economic burden. 
Sec.  1.704-1(b)(2)(ii)(a). Under Sec.  1.704-1(b)(2)(ii)(b), an 
allocation of income, gain, loss, or deduction (or item thereof) to a 
partner generally has economic effect if, and only if, throughout the 
full term of the partnership, the partnership agreement provides: (1) 
For the determination and maintenance of the partners' capital accounts 
in accordance with Sec.  1.704-1(b)(2)(iv); (2) for liquidating 
distributions to the partners to be made in accordance with the 
positive capital account balances of the partners; and (3) for each 
partner to be unconditionally obligated to restore the deficit balance 
in the partner's capital account following the liquidation of the 
partner's partnership interest. In lieu of satisfying the third 
requirement, the partnership may satisfy the qualified income offset 
rules set forth in Sec.  1.704-1(b)(2)(ii)(d). An allocation also may 
be deemed to have economic effect if it satisfies the economic effect 
equivalence rules of Sec.  1.704-1(b)(2)(ii)(i).
    Section 1.704-1(b)(2)(iii)(a) provides as a general rule that the 
economic effect of an allocation (or allocations) is substantial if 
there is a reasonable possibility that the allocation (or allocations) 
will affect substantially the dollar amounts to be received by the 
partners from the partnership, independent of tax consequences. 
Notwithstanding the previous sentence, the economic effect of the 
allocation (or allocations) is not substantial if, at the time the 
allocation (or allocations) becomes part of the partnership agreement, 
(1) the after-tax economic consequences of at least one partner may, in 
present value terms, be enhanced compared to such consequences if the 
allocation (or allocations) were not contained in the partnership 
agreement, and (2) there is a strong likelihood that the after-tax 
economic consequences of no partner will, in present value terms, be 
substantially diminished compared to such consequences if the 
allocation (or allocations) were not contained in the partnership 
agreement. In determining the after-tax economic benefit or detriment 
to a partner, tax consequences that result from the interaction of the 
allocation with such partner's tax

[[Page 69920]]

attributes that are unrelated to the partnership will be taken into 
account.
    If the partnership agreement provides for an allocation of income, 
gain, loss, deduction or credit to a partner that does not have 
substantial economic effect, then the partner's distributive share of 
that item is determined in accordance with the partner's interest in 
the partnership. References in section 704(b) or Sec.  1.704-1 to a 
partner's interest in the partnership, or to the partners' interests in 
the partnership, signify the manner in which the partners have agreed 
to share the economic benefit or burden (if any) corresponding to the 
income, gain, loss, deduction, or credit (or item thereof) that is 
allocated, taking into account all facts and circumstances relating to 
the economic arrangement of the partners.
    Section 1.704-1(b)(3)(i) provides that all partners' interests are 
presumed to be equal (determined on a per capita basis). However, this 
presumption may be rebutted by the taxpayer or the IRS by establishing 
facts and circumstances that show that the partners' interests in the 
partnership are otherwise.
    Section 1.704-1(b)(1)(iii) provides that an allocation that is 
respected under section 704(b) nevertheless may be reallocated under 
other provisions, such as section 482, section 704(e)(2), section 
706(d) (and related assignment of income principles), and Sec.  1.751-
1(b)(2)(ii).
    On April 21, 2004, temporary regulations (TD 9121) relating to the 
proper allocation of partnership expenditures for foreign taxes were 
published in the Federal Register (69 FR 21405). In the preamble to 
those regulations, the IRS and the Treasury Department indicated a 
concern that some partnerships are taking the position that, in 
determining if the economic effect of a partnership allocation is 
substantial, they need not consider the tax consequences to an owner of 
the partner that result from the allocation. This position is 
inconsistent with the policies underlying the substantial economic 
effect rules, because it would allow a partnership to make tax-
advantaged allocations if the tax advantages of the allocations accrue 
to an owner of a partner, rather than to the partner itself.

Explanation of Provisions

    These proposed regulations provide that the interaction of a 
partnership allocation with the tax attributes of owners of look-
through entities must be taken into account when testing the 
substantiality of the allocation to a partner that is a look-through 
entity. For this purpose, look-through entities include partnerships, S 
corporations, trusts, certain controlled foreign corporations, and 
entities that are disregarded for federal tax purposes, such as 
qualified subchapter S subsidiaries under section 1361(b)(3), entities 
that are disregarded under Sec. Sec.  301.7701-1 through 301.7701-3 of 
the Procedure and Administration Regulations, or qualified real estate 
investment trusts (REIT) subsidiaries within the meaning of section 
856(i)(2). In general, look-through entities are entities that flow 
certain tax consequences through to their owners. Although regulated 
investment companies (RICs) and REITs have certain flow-through 
characteristics, the regulations do not include them in the list of 
look-through entities, because the Treasury Department and the IRS 
believe that the burdens of a rule requiring taxpayers to look through 
these entities in determining the substantiality of partnership 
allocations generally would outweigh the benefits of such a rule. 
However, if necessary, RICs and REITs or other look-through entities 
may be added to the list of look-through entities in future guidance. 
Comments are requested regarding the treatment of controlled foreign 
corporations as look-through partners for purposes of Sec.  1.704-
1(b)(2)(iii)(a)(2) of these proposed regulations. Specifically, 
comments are requested concerning whether the rule should be limited to 
those situations in which the controlled foreign corporation owns 
greater than a threshold minimum percentage interest in the 
partnership, or only by taking into account the tax attributes of those 
U.S. shareholders of the controlled foreign corporation owning above a 
threshold percentage of the stock of the controlled foreign 
corporation.
    The regulations also provide that the interaction of a partnership 
allocation with the tax attributes of the consolidated group must be 
taken into account when testing the substantiality of the allocation to 
a partner that is a member of a consolidated group. A member of a 
consolidated group is a member of a group filing (or required to file) 
consolidated returns for the tax year. See Sec.  1.1502-1(h).
    The proposed regulations clarify that for purposes of Sec.  1.704-
1(b)(2)(iii)(a)(1), the after-tax economic consequences of a partner 
resulting from an allocation or allocations must be compared to the 
after-tax economic consequences to that partner if the allocation or 
allocations were made in accordance with the partners' interests in the 
partnership. The proposed regulations also remove the per capita 
presumption in Sec.  1.704-1(b)(3)(i), which reaches the correct result 
in very few cases. Finally, the regulations include an example 
illustrating a fact pattern to which, apart from the application of 
section 704(b), other sections may apply.

Proposed Effective Date

    These regulations are generally proposed to apply for partnership 
taxable years beginning on or after the date on which final regulations 
are published in the Federal Register. No inference is intended as to 
the tax consequences of partnership allocations made in taxable years 
beginning before the effective date of these regulations.

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 has also 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations, and because 
the regulation does not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. 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 and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written (a signed original and eight 
(8) copies) or electronic comments that are submitted timely to the 
IRS. The IRS and Treasury Department request comments on the clarity of 
the proposed rules and how they can be made easier to understand. All 
comments will be available for public inspection and copying.
    A public hearing has been scheduled for February 15, 2006, at 10 
a.m. in the Auditorium, Internal Revenue Building, 1111 Constitution 
Avenue, NW., Washington, DC. Because of access restrictions, visitors 
will not be admitted beyond the immediate entrance area more than 30 
minutes before the hearing starts. For information about having your 
name on the building access list to attend the hearing, see the FOR 
FURTHER INFORMATION CONTACT portion of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments must submit

[[Page 69921]]

written or electronic comments by January 25, 2006, and an outline of 
the topics to be discussed and the time to be devoted to each topic (a 
signed original and eight (8) copies) by January 25, 2006. A period of 
10 minutes will be allotted to each person for making comments. An 
agenda showing the scheduling of the speakers will be prepared after 
the deadline for receiving outlines has passed. Copies of the agenda 
will be available free of charge at the hearing.

Drafting Information

    The principal author of this regulation is Timothy J. Leska, Office 
of the Associate Chief Counsel (Passthroughs & Special Industries). 
However, other personnel from the IRS and Treasury Department 
participated in its development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

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

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

    Par. 2. Section 1.704-1 is amended as follows:
    1. Paragraph (b)(1)(ii)(a) is amended by adding a sentence at the 
end of the paragraph.
    2. Paragraph (b)(1)(iii) is amended by revising the first three 
sentences and adding a new fourth sentence.
    3. Paragraph (b)(2)(iii)(a) is redesignated as paragraph 
(b)(2)(iii)(a)(1) and revised.
    4. A new paragraph (b)(2)(iii)(a)(2) is added.
    5. The last two sentences of paragraph (b)(3)(i) are removed.
    6. Paragraph (b)(5) Example 29 and Example 30 are added.
    The additions and revisions read as follows:


Sec.  1.704-1  Partner's distributive share.

* * * * *
    (b) * * *
    (1) * * *
    (ii) Effective dates. (a)* * * Paragraph (b)(2)(iii)(a)(2) and 
paragraph (b)(5) Example 30 of this section apply to taxable years 
beginning on or after the date on which final regulations are published 
in the Federal Register.
    (iii) Effect of other sections. The determination of a partner's 
distributive share of income, gain, loss, deduction, or credit (or item 
thereof) under section 704(b) and this paragraph (b) is not conclusive 
as to the tax treatment of a partner with respect to such distributive 
share. For example, an allocation of loss or deduction to a partner 
that is respected under section 704(b) and this paragraph (b) may not 
be deductible by such partner if the partner lacks the requisite motive 
for economic gain (see, e.g., Goldstein v. Commissioner, 364 F.2d 734 
(2d. Cir. 1966)), or may be disallowed for that taxable year (and held 
in suspense) if the limitations of section 465 or section 704(d) are 
applicable. Similarly, an allocation that is respected under section 
704(b) and this paragraph (b) nevertheless may be reallocated under 
other provisions, such as section 482, section 704(e)(2), section 
706(d) (and related assignment of income principles), and Sec.  1.751-
1(b)(2)(ii). See paragraph (b)(5) Example 29 of this section. * * *
    (2) * * *
    (iii) Substantiality--(a) In general--(1) Fundamental principles. 
Except as otherwise provided in this paragraph (b)(2)(iii), the 
economic effect of an allocation (or allocations) is substantial if 
there is a reasonable possibility that the allocation (or allocations) 
will affect substantially the dollar amounts to be received by the 
partners from the partnership, independent of tax consequences. 
Notwithstanding the preceding sentence, the economic effect of an 
allocation (or allocations) is not substantial if, at the time the 
allocation (or allocations) becomes part of the partnership agreement, 
the after-tax economic consequences of at least one partner may, in 
present value terms, be enhanced compared to such consequences if the 
allocation (or allocations) were not contained in the partnership 
agreement (and, thus, the allocation or allocations were allocated 
among the partners in accordance with the partners' interests in the 
partnership), and there is a strong likelihood that the after-tax 
economic consequences of no partner will, in present value terms, be 
substantially diminished compared to such consequences if the 
allocation (or allocations) were not contained in the partnership 
agreement (and, thus, the allocation or allocations were allocated 
among the partners in accordance with the partners' interests in the 
partnership). In determining the after-tax economic benefit or 
detriment to a partner, tax consequences that result from the 
interaction of the allocation with such partner's tax attributes that 
are unrelated to the partnership will be taken into account. See 
paragraph (b)(5) Examples 5 and 9 of this section. The economic effect 
of an allocation is not substantial in the two situations described in 
paragraphs (b)(2)(iii)(b) and (c) of this section. However, even if an 
allocation is not described therein, its economic effect may be 
insubstantial under the general rules stated in this paragraph 
(b)(2)(iii)(a). References in this paragraph (b)(2)(iii) to allocations 
include capital account adjustments made pursuant to paragraph 
(b)(2)(iv)(k) of this section.
    (2) Partners that are look-through entities or members of a 
consolidated group--(i) Rule. For purposes of this paragraph 
(b)(2)(iii), in determining the after-tax economic benefit or detriment 
to any partner that is a look-through entity, the tax consequences that 
result from the interaction of the allocation with the tax attributes 
of any person that owns an interest in such a partner, whether directly 
or indirectly through one or more look-through entities, must be taken 
into account, and, in determining the after-tax economic benefit or 
detriment to any partner that is a member of a consolidated group 
(within the meaning of Sec.  1.1502-1(h)), the tax consequences that 
result from the interaction of the allocation with the tax attributes 
of the consolidated group and with the tax attributes of another member 
with respect to a separate return year must be taken into account. See 
paragraph (b)(5) Example 30 of this section.
    (ii) Definition. For purposes of this paragraph (b)(2)(iii)(a)(2), 
a look-through entity means--
    (A) A partnership;
    (B) A subchapter S corporation;
    (C) A trust;
    (D) An entity that is disregarded for Federal tax purposes, such as 
a qualified subchapter S subsidiary under section 1361(b)(3), an entity 
that is disregarded as an entity separate from its owner under 
Sec. Sec.  301.7701-1 through 301.7701-3 of this chapter, or a 
qualified REIT subsidiary within the meaning of section 856(i)(2).
    (E) A controlled foreign corporation, as defined in section 957(a), 
but only with respect to allocations of items of income, gain, loss, or 
deduction that enter into the corporation's computation of subpart F 
income or would enter into that computation if such items were 
allocated to the corporation (collectively, subpart F items). For 
purposes of this paragraph (b)(2)(iii)(a)(2)(ii)(E), the rule in 
paragraph (b)(2)(iii)(a)(2)(i) of this section shall apply only by 
taking into account the tax attributes of a person that is a United 
States shareholder of the controlled foreign corporation the

[[Page 69922]]

amount of whose inclusions of gross income under section 951(a) are 
affected by the partnership's allocations of subpart F items (or would 
be affected if such items were allocated to the corporation).
* * * * *
    (5) Examples. * * *

    Example 29. (i) B, a domestic corporation, and C, a controlled 
foreign corporation, form BC, a partnership organized under the laws 
of country X. B and C each contribute 50 percent of the capital of 
BC. B and C are wholly-owned subsidiaries of A, a domestic 
corporation. Substantially all of BC's income would not be subpart F 
income if earned directly by C. The BC partnership agreement 
provides that, for the first fifteen years, BC's gross income will 
be allocated 10 percent to B and 90 percent to C, and BC's 
deductions and losses will be allocated 90 percent to B and 10 
percent to C. The partnership agreement also provides that, after 
the initial fifteen year period, BC's gross income will be allocated 
90 percent to B and 10 percent to C, and BC's deductions and losses 
will be allocated 10 percent to B and 90 percent to C.
    (ii) Apart from the application of section 704(b), the 
Commissioner may reallocate or otherwise not respect the allocations 
under other sections. See paragraph (b)(1)(iii) of this section. For 
example, BC's allocations of gross income, deductions, and losses 
may be evaluated and reallocated (or not respected), as appropriate, 
if it is determined that the allocations result in the evasion of 
tax or do not clearly reflect income under section 482.
    Example 30. PRS is a partnership with three partners, A, B, and 
C. A is a corporation that is a member of a consolidated group 
within the meaning of Sec.  1.1502-1(h). B is a subchapter S 
corporation that is wholly-owned by D, an individual. C is a 
partnership with two partners, E, an individual, and F, a 
corporation that is member of a consolidated group within the 
meaning of Sec.  1.1502-1(h). For purposes of paragraph (b)(2)(iii) 
of this section, in determining the after-tax economic benefit or 
detriment of an allocation to A, the tax consequences that result 
from the interaction of the allocation to A with the tax attributes 
of the consolidated group in which A is a member must be taken into 
account. In determining the after-tax economic benefit or detriment 
of an allocation to B, the tax consequences that result from the 
interaction of the allocation with the tax attributes of D must be 
taken into account. In determining the after-tax economic benefit or 
detriment of an allocation to C, the tax consequences that result 
from the interaction of the allocation with the tax attributes of E 
and the consolidated group in which F is a member must be taken into 
account.

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 05-22281 Filed 11-17-05; 8:45 am]
BILLING CODE 4830-01-P