[Federal Register Volume 71, Number 196 (Wednesday, October 11, 2006)]
[Rules and Regulations]
[Pages 59669-59674]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E6-16719]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 9289]
RIN 1545-BD48


Treatment of Disregarded Entities Under Section 752

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations under section 752 for 
taking into account certain obligations of a business entity that is 
disregarded as separate from its owner under section 856(i) or section 
1361(b)(3) of the Internal Revenue Code, or Sec. Sec.  301.7701-1 
through 301.7701-3 of the Procedure and Administration Regulations. 
These final regulations clarify the existing regulations concerning 
when a partner may be treated as bearing the economic risk of loss for 
a partnership liability based upon an obligation of a disregarded 
entity. The rules affect partnerships and their partners.

DATES: Effective Date: These regulations are effective on October 11, 
2006.
    Applicability Date: These regulations generally are applicable for 
liabilities incurred or assumed by a partnership on or after October 
11, 2006.

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

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in these final regulations 
has been reviewed and approved by the Office of Management and Budget 
in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 
3507(d)) under control number 1545-1905. Response to this collection of 
information is mandatory.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information, unless the collection of 
information displays a valid control number.
    The estimated annual burden per respondent varies from 6 minutes to 
4 hours, depending on individual circumstances, with an estimated 
average of 2 hours. Comments concerning the accuracy of this burden 
estimate and suggestions for reducing this burden should be sent to the 
Internal Revenue Service, Attn: IRS Reports Clearance Officer, 
SE:W:CAR:MP:T:T:SP, Washington, DC 20224, and to the Office of 
Management and Budget, Attn: Desk Officer for the Department of 
Treasury, Office of Information and Regulatory Affairs, Washington, DC 
20503.
    Books and records relating to these collections 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 
return information are confidential, as required by 26 U.S.C. 6103.

Background

    On August 12, 2004, the IRS and the Treasury Department issued 
proposed regulations under section 752 providing rules for taking into 
account certain obligations of disregarded entities (69 FR 49832). 
Comments were received in response to the notice of proposed 
rulemaking, and a public hearing was scheduled. However, the public 
hearing was later cancelled when no one requested to speak. After 
consideration of all the comments, the proposed regulations are adopted 
as amended by this Treasury decision.

Summary of Comments and Explanation of Provisions

1. Net Value Approach In General

    The proposed regulations provide that a payment obligation under 
Sec.  1.752-2(b)(1) (Sec.  1.752-2(b)(1) payment obligation) of a 
disregarded entity for which a partner is treated as bearing the 
economic risk of loss is taken into account only to the extent of the 
net value of the disregarded entity. Certain commentators disagreed 
with the approach taken in the proposed regulations, arguing that the 
regulations will result in inconsistent treatment of similar economic 
situations and unwarranted complexity.
    Some commentators argued that the presumption of deemed 
satisfaction of Sec.  1.752-2(b)(1) payment obligations of partners and 
related persons that is provided in Sec.  1.752-2(b)(6) (presumption of 
deemed satisfaction) should be applied to disregarded entities that 
have Sec.  1.752-2(b)(1) payment obligations. Other commentators argued 
that the presumption of deemed satisfaction should apply only to 
certain disregarded entities, such as disregarded entities that 
comprise substantially all of the owner's assets, or disregarded 
entities that hold active trades or businesses.
    The IRS and the Treasury Department believe that applying the 
presumption of deemed satisfaction to a disregarded entity that shields 
the federal tax partner from liability for the entity's obligations 
would, in many cases, cause partnership liabilities that are 
economically indistinguishable from nonrecourse liabilities to be 
classified as recourse for purposes of section 752. Applying the 
presumption of deemed satisfaction to disregarded entities would 
distort the allocation of partnership liabilities in those cases. 
Accordingly, these comments are not adopted in the final regulations.
    One commentator suggested that Sec.  1.752-2 be amended to provide 
that, in addition to statutory and contractual obligations, statutory 
and contractual limitations should be taken into account in determining 
a partner's economic risk of loss. The IRS and the Treasury Department 
believe that such limitations are already taken into account under 
Sec.  1.752-2(b)(3). As a result, the comment is not adopted.
    Another commentator suggested that the goal of the proposed 
regulation could be better achieved by adding an example to the current 
anti-abuse rule in Sec.  1.752-2(j) (or by publishing a revenue ruling) 
to illustrate a situation under which a partner's Sec.  1.752-2(b)(1) 
payment obligation is limited because the partner holds its interest in 
a partnership through a disregarded entity with a principal purpose to 
eliminate the partner's economic risk of loss with respect to the 
partnership's liabilities. The IRS and the Treasury Department agree 
that, in certain circumstances, the current anti-abuse rule under 
section 752 prevents allocation of partnership liabilities to a partner 
that is a disregarded entity. However, if a partner holds a partnership 
interest through a disregarded entity, and only the assets of the 
disregarded entity are available to satisfy Sec.  1.752-2(b)(1) payment 
obligations undertaken by the disregarded entity, the IRS and the 
Treasury Department believe that a partner should be treated as bearing 
the economic risk of loss for a partnership liability only to the 
extent of the net value of a disregarded entity's assets, whether or 
not the principal purpose of the arrangement is to limit the partner's 
economic risk of loss. As a result, the comment is not adopted.

[[Page 59670]]

2. Net Value Approach Not Extended to Other Entities

    The proposed regulations requested comments regarding whether the 
rules of the proposed regulations should be extended to the Sec.  
1.752-2(b)(1) payment obligations of other entities, such as entities 
that are capitalized with nominal equity. Some commentators opposed 
expanding the approach of the proposed regulations to thinly 
capitalized entities as unnecessary. Other commentators suggested that 
the anti-abuse rule of Sec.  1.752-2(j) could be expanded to cover 
certain situations involving thinly capitalized entities. Specifically, 
a commentator suggested that the anti-abuse rule should apply if a 
substantially undercapitalized subsidiary of a consolidated group of 
corporations or a substantially undercapitalized passthrough entity 
(other than a disregarded entity) is utilized as the partner (or 
related obligor) for a principal purpose of limiting its owner's risk 
of loss in respect of existing partnership liabilities, and obtaining 
tax benefits for its owners (or other members of the consolidated 
group) that would not be available but for the additional tax basis in 
the partnership interest that results from the presumption of deemed 
satisfaction rule. The commentator also suggested that the regulations 
provide a safe harbor for determining entities that are not 
substantially undercapitalized.
    Under the anti-abuse rule of Sec.  1.752-2(j), a Sec.  1.752-
2(b)(1) payment obligation of a partner or a related person may be 
disregarded if the facts and circumstances indicate that a principal 
purpose of the arrangement between the parties is to eliminate the 
partner's economic risk of loss with respect to that obligation or to 
create the appearance of the economic risk of loss where the substance 
of the arrangement is otherwise. Thus, the anti-abuse rule of Sec.  
1.752-2(j) can apply to abusive transactions involving thinly 
capitalized entities. Although these regulations do not modify the 
anti-abuse rule of Sec.  1.752-2(j) and do not extend the net value 
approach to thinly capitalized entities, the IRS and the Treasury 
Department may continue to study these issues in connection with future 
guidance projects.

3. Calculating the Net Value of a Disregarded Entity

    Under the proposed regulations, the net value of a disregarded 
entity equals the fair market value of all assets owned by the 
disregarded entity that may be subject to creditors' claims under local 
law, including the disregarded entity's enforceable rights to 
contributions from its owner but excluding the disregarded entity's 
interest in the partnership for which the net value is being determined 
(if any) and the fair market value of property pledged to secure a 
partnership liability (which is already taken into account under Sec.  
1.752-2(h)(1)), less obligations of the disregarded entity that do not 
constitute, and are senior or of equal priority to, Sec.  1.752-2(b)(1) 
payment obligations of the disregarded entity.
    One commentator suggested that the final regulations should provide 
(or clarify) that the net value of a disregarded entity can vary 
depending upon the priority of the Sec.  1.752-2(b)(1) payment 
obligation for which the value is being computed. A commentator also 
suggested that obligations of the disregarded entity that are of equal 
priority to Sec.  1.752-2(b)(1) payment obligations of the disregarded 
entity should not be subtracted in their entirety. Instead, the 
commentator suggested that in determining the net value of the 
disregarded entity, the final regulations should subtract only the pro 
rata portion of the amount of any obligation of the disregarded entity 
that is not a Sec.  1.752-2(b)(1) payment obligation of the disregarded 
entity and that is of equal priority to the Sec.  1.752-2(b)(1) payment 
obligation of the disregarded entity. Other commentators suggested that 
prorating a disregarded entity's net value among equal priority 
obligations would add unnecessary complexity.
    The comments illustrate the difficulty of taking into account 
priorities among obligations of the disregarded entity in determining 
the net value of the entity and the divergent views regarding the 
approach that best measures the economic risk of loss of a partner. The 
IRS and the Treasury Department believe that the regulations should 
provide clear and administrable rules that avoid unwarranted 
complexity. As a result, the final regulations provide that the net 
value of a disregarded entity is determined by subtracting all 
obligations (regardless of priority) of the disregarded entity that do 
not constitute Sec.  1.752-2(b)(1) payment obligations from the fair 
market value of the assets of the entity. That net value is reported by 
the owner to each partnership for which the disregarded entity may have 
one or more Sec.  1.752-2(b)(1) payment obligations. Each such 
partnership independently takes the net value of the disregarded entity 
into account under Sec.  1.752-2(k)(3) and allocates the net value 
among liabilities of that partnership in a reasonable and consistent 
manner, taking into account the relative priorities of those 
liabilities.
    One commentator suggested that the final regulations clarify that a 
disregarded entity's interest in another partnership (other than the 
one for which the net value is being determined) is included as an 
asset to be valued for purposes of the net value calculation. This 
comment is adopted.

4. Valuation Events

    Under the proposed regulations, after the net value of a 
disregarded entity is initially determined, the net value of the 
disregarded entity is not redetermined unless (1) the obligations of 
the disregarded entity that do not constitute, and are senior or of 
equal priority to, Sec.  1.752-2(b)(1) payment obligations of the 
disregarded entity change by more than a de minimis amount or (2) there 
is more than a de minimis contribution to or distribution from the 
disregarded entity, of property other than property pledged to secure a 
partnership liability under Sec.  1.752-2(h)(1). In the preamble to the 
proposed regulations, the IRS and the Treasury Department requested 
comments on whether other events (such as a sale of substantially all 
of a disregarded entity's assets) should be specified as valuation 
events.
    One commentator suggested that the disposition of a non-de minimis 
asset should require an adjustment to the net value of the disregarded 
entity only to the extent such asset changed in value, without valuing 
other assets held by the disregarded entity. The final regulations 
adopt this suggestion.
    A commentator suggested that the regulations provide that changes 
in the owner's legally enforceable obligation to contribute to the 
disregarded entity be a valuation event. The final regulations adopt 
this comment.
    Commentators suggested that certain events that would require the 
net value of a disregarded entity to be redetermined under the proposed 
regulations be eliminated as valuation events. For example, one 
commentator suggested that net value should not be redetermined if a 
disregarded entity refinances an obligation of the disregarded entity 
in the same amount. The IRS and the Treasury Department believe that 
the refinancing of a disregarded entity's obligation is an appropriate 
and administrable time to redetermine the net value of a disregarded 
entity. Accordingly, this suggestion is not adopted.
    Another commentator suggested that the net value of a disregarded 
entity should not be redetermined with respect to a particular 
partnership in which the

[[Page 59671]]

disregarded entity holds an interest if (1) a contribution by the owner 
of the disregarded entity to the disregarded entity corresponds to an 
equal contribution by the disregarded entity to the partnership or (2) 
a distribution from the partnership to the disregarded entity 
corresponds to an equal distribution by the disregarded entity to the 
owner of the disregarded entity. The IRS and the Treasury Department 
agree that these transfers to a disregarded entity, which remain in the 
disregarded entity only briefly, should not be valuation events. 
Accordingly, the final regulations adopt this comment.

5. Timing Issues

    Commentators requested that the final regulations clarify the 
timing of the reallocation of partnership liabilities that may occur as 
a result of a change in the net value of a disregarded entity. The 
commentators suggested that, under the proposed regulations, a change 
in net value could result in a deemed distribution under section 752(b) 
that would require a determination of a partner's share of partnership 
liabilities for basis purposes under Sec. Sec.  1.705-1(a) and 1.752-
4(d).
    The final regulations clarify when the net value of a disregarded 
entity initially must be determined if a partnership interest is held 
by a disregarded entity, and the partnership has or incurs a liability, 
all or a portion of which may be allocable to the owner of the 
disregarded entity under Sec.  1.752-2(k). The final regulations 
clarify that a disregarded entity's net value generally is determined 
as of the earlier of (A) the first date occurring on or after the date 
on which the requirement to determine the net value of a disregarded 
entity arises on which the partnership otherwise determines a partner's 
share of partnership liabilities under Sec. Sec.  1.705-1(a) and 1.752-
4(d), or (B) the end of the partnership's taxable year in which the 
requirement to determine the net value of a disregarded entity arises. 
For example, if a valuation event occurs during the partnership's 
taxable year, and subsequently, but before the end of the taxable year, 
the partnership makes a distribution that requires a determination of 
the distributee partner's basis in the partnership, the net value of 
the disregarded entity must be redetermined as of the date of the 
distribution.
    Several commentators requested that the final regulations permit an 
election to redetermine the net value of a disregarded entity annually, 
regardless of the occurrence of a valuation event, and that if only one 
valuation event occurs during a partnership's taxable year, the owner 
have the option of using the net value of the disregarded entity as of 
the date of the valuation event rather than as of the date on which the 
partnership allocates liabilities under section 752. Because a change 
in the net value of a disregarded entity may require a shift of 
liabilities among partners, the IRS and the Treasury Department believe 
that valuations should be limited and should be required only as the 
result of a valuation event. Moreover, the timing of the net value 
determination should generally coincide with the date on which the 
partnership otherwise determines partners' shares of partnership 
liabilities. Accordingly, the final regulations do not adopt these 
comments.

6. Value of Pledged Property

    Some commentators suggested that the final regulations conform the 
rules regarding the valuation of property pledged by partners as 
security for partnership liabilities with the rules regarding the 
determination of the net value of a disregarded entity. The 
commentators also suggested allowing, but not requiring, partners to 
revalue pledged property annually. In response to these comments, the 
final regulations provide that if additional property is made subject 
to a pledge, the addition is treated as a new pledge and the net fair 
market value of all of the pledged property must be determined at that 
time. The IRS and the Treasury Department may continue to study whether 
further modifications to the pledge rule are necessary.

7. Compliance, Reporting, and Effective Date

    Some commentators asked that the regulations provide that the 
partnership may make certain assumptions if a partner does not provide 
the information required. The IRS and the Treasury Department believe 
that partnerships are responsible for obtaining the required 
information in order to allocate partnership liabilities correctly 
among the partners, and that the partnership agreement should require 
that partners comply with the reporting requirements in the 
regulations. Thus, the final regulations do not adopt this comment.
    Some commentators suggested that the estimated burden of complying 
with the paperwork requirements in the proposed regulations was too 
low. The estimated number of respondents has been increased from 500 to 
1,500, and the average estimated time per respondent has been increased 
from 1 hour to 2 hours.
    A commentator also suggested certain grandfathering provisions for 
partnerships with existing liabilities as of the effective date of the 
regulations. The IRS and the Treasury Department believe that the same 
rules should apply to all partnership liabilities incurred or assumed 
by a partnership on or after the date the regulations are final. 
Accordingly, this comment is not adopted.

Effective Date

    The final regulations apply to liabilities incurred or assumed by a 
partnership on or after October 11, 2006 other than liabilities 
incurred or assumed by a partnership pursuant to a written binding 
contract in effect prior to October 11, 2006.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It also has been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations. It is hereby 
certified that the collection of information in these regulations will 
not have a significant economic impact on a substantial number of small 
entities. This certification is based on the fact that the amount of 
time necessary to report the required information will be minimal. 
Accordingly, a Regulatory Flexibility Analysis under the Regulatory 
Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to 
section 7805(f) of the Internal Revenue Code, the notice of proposed 
rulemaking preceding these final regulations was submitted to the Chief 
Counsel for Advocacy of the Small Business Administration for comment 
on its impact on small business.

Drafting Information

    The principal author of these regulations is Charlotte Chyr, Office 
of Associate Chief Counsel (Passthroughs and Special Industries).

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR parts 1 and 602 are amended as follows:

[[Page 59672]]

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read, in 
part, as follows:

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

0
Par. 2. Section 1.704-2 is amended as follows:
0
1. The text of paragraph (f)(2), the first sentence of paragraph 
(g)(3), and the third sentence of paragraph (i)(4) are revised.
0
2. Paragraph (l)(1)(iv) is added.
    The revisions and addition read as follows:


Sec.  1.704-2  Allocations attributable to nonrecourse liabilities.

* * * * *
    (f) * * *
    (2) * * * A partner is not subject to the minimum gain chargeback 
requirement to the extent the partner's share of the net decrease in 
partnership minimum gain is caused by a recharacterization of 
nonrecourse partnership debt as partially or wholly recourse debt or 
partner nonrecourse debt, and the partner bears the economic risk of 
loss (within the meaning of Sec.  1.752-2) for the liability.
* * * * *
    (g) * * *
    (3) * * * A partner's share of partnership minimum gain is 
increased to the extent provided in this paragraph (g)(3) if a recourse 
or partner nonrecourse liability becomes partially or wholly 
nonrecourse. * * *
* * * * *
    (i) * * *
    (4) * * * A partner is not subject to this minimum gain chargeback, 
however, to the extent the net decrease in partner nonrecourse debt 
minimum gain arises because a partner nonrecourse liability becomes 
partially or wholly a nonrecourse liability. * * *
* * * * *
    (l) * * *
    (1) * * *
    (iv) Paragraph (f)(2), the first sentence of paragraph (g)(3), and 
the third sentence of paragraph (i)(4) of this section apply to 
liabilities incurred or assumed by a partnership on or after October 
11, 2006 other than liabilities incurred or assumed by a partnership 
pursuant to a written binding contract in effect prior to October 11, 
2006. The rules applicable to liabilities incurred or assumed (or 
subject to a binding contract in effect) prior to October 11, 2006 are 
contained in this section in effect prior to October 11, 2006. (See 26 
CFR part 1 revised as of April 1, 2006.)
* * * * *

0
Par. 3. Section 1.752-2 is amended as follows:
0
1. Paragraph (a), the last sentence of paragraph (b)(6), and paragraph 
(h)(3) are revised.
0
2. Paragraphs (k) and (l) are added.
    The revisions and additions read as follows:


Sec.  1.752-2  Partner's share of recourse liabilities.

    (a) * * * A partner's share of a recourse partnership liability 
equals the portion of that liability, if any, for which the partner or 
related person bears the economic risk of loss. The determination of 
the extent to which a partner bears the economic risk of loss for a 
partnership liability is made under the rules in paragraphs (b) through 
(k) of this section.
* * * * *
    (b) * * *
    (6) * * * See paragraphs (j) and (k) of this section.
* * * * *
    (h) * * *
    (3) Valuation. The extent to which a partner bears the economic 
risk of loss for a partnership liability as a result of a direct pledge 
described in paragraph (h)(1) of this section or an indirect pledge 
described in paragraph (h)(2) of this section is limited to the net 
fair market value of the property (pledged property) at the time of the 
pledge or contribution. If a partner provides additional pledged 
property, the addition is treated as a new pledge and the net fair 
market value of the pledged property (including but not limited to the 
additional property) must be determined at that time. For purposes of 
this paragraph (h), if pledged property is subject to one or more other 
obligations, those obligations must be taken into account in 
determining the net fair market value of pledged property at the time 
of the pledge or contribution.
* * * * *
    (k) Effect of a disregarded entity--(1) In general. In determining 
the extent to which a partner bears the economic risk of loss for a 
partnership liability, an obligation under paragraph (b)(1) of this 
section (Sec.  1.752-2(b)(1) payment obligation) of a business entity 
that is disregarded as an entity separate from its owner under sections 
856(i) or 1361(b)(3) or Sec. Sec.  301.7701-1 through 301.7701-3 of 
this chapter (disregarded entity) is taken into account only to the 
extent of the net value of the disregarded entity as of the allocation 
date (as defined in paragraph (k)(2)(iv) of this section) that is 
allocated to the partnership liability as determined under the rules of 
this paragraph (k). The rules of this paragraph (k) do not apply to a 
Sec.  1.752-2(b)(1) payment obligation of a disregarded entity to the 
extent that the owner of the disregarded entity is otherwise required 
to make a payment (that satisfies the requirements of paragraph (b)(1) 
of this section) with respect to the obligation of the disregarded 
entity.
    (2) Net value of a disregarded entity--(i) Definition. For purposes 
of this paragraph (k), the net value of a disregarded entity equals the 
following--
    (A) The fair market value of all assets owned by the disregarded 
entity that may be subject to creditors' claims under local law 
(including the disregarded entity's enforceable rights to contributions 
from its owner and the fair market value of an interest in any 
partnership other than the partnership for which net value is being 
determined, but excluding the disregarded entity's interest in the 
partnership for which the net value is being determined and the net 
fair market value of property pledged to secure a liability of the 
partnership under paragraph (h)(1) of this section); less
    (B) All obligations of the disregarded entity that do not 
constitute Sec.  1.752-2(b)(1) payment obligations of the disregarded 
entity.
    (ii) Timing of the net value determination--(A) Initial 
determination. If a partnership interest is held by a disregarded 
entity, and the partnership has or incurs a liability, all or a portion 
of which may be allocable to the owner of the disregarded entity under 
this paragraph (k), the disregarded entity's net value must be 
initially determined on the allocation date described in paragraph 
(k)(2)(iv) of this section.
    (B) Other events. If a partnership interest is held by a 
disregarded entity, and the partnership has or incurs a liability, all 
or a portion of which may be allocable to the owner of the disregarded 
entity under this paragraph (k), then, if one or more valuation events 
(as defined in paragraph (k)(2)(iii) of this section) occur during the 
partnership taxable year, except as provided in paragraph 
(k)(2)(iii)(E) of this section, the net value of the disregarded entity 
is determined on the allocation date described in paragraph (k)(2)(iv) 
of this section.
    (iii) Valuation events. The following are valuation events for 
purposes of this paragraph (k):
    (A) A more than de minimis contribution to a disregarded entity of 
property other than property pledged to secure a partnership liability 
under paragraph (h)(1) of this section, unless the contribution is 
followed immediately by a contribution of equal

[[Page 59673]]

net value by the disregarded entity to the partnership for which the 
net value of the disregarded entity otherwise would be determined, 
taking into account any obligations assumed or taken subject to in 
connection with such contributions.
    (B) A more than de minimis distribution from a disregarded entity 
of property other than property pledged to secure a partnership 
liability under paragraph (h)(1) of this section, unless the 
distribution immediately follows a distribution of equal net value to 
the disregarded entity by the partnership for which the net value of 
the disregarded entity otherwise would be determined, taking into 
account any obligations assumed or taken subject to in connection with 
such distributions.
    (C) A change in the legally enforceable obligation of the owner of 
the disregarded entity to make contributions to the disregarded entity.
    (D) The incurrence, refinancing, or assumption of an obligation of 
the disregarded entity that does not constitute a Sec.  1.752-2(b)(1) 
payment obligation of the disregarded entity.
    (E) The sale or exchange of a non-de minimis asset of the 
disregarded entity (in a transaction that is not in the ordinary course 
of business). In this case, the net value of the disregarded entity may 
be adjusted only to reflect the difference, if any, between the fair 
market value of the asset at the time of the sale or exchange and the 
fair market value of the asset when the net value of the disregarded 
entity was last determined. The adjusted net value is taken into 
account for purposes of Sec.  1.752-2(k)(1) as of the allocation date.
    (iv) Allocation Date. For purposes of this paragraph (k), the 
allocation date is the earlier of--
    (A) The first date occurring on or after the date on which the 
requirement to determine the net value of a disregarded entity arises 
under paragraph (k)(2)(ii)(A) or (B) of this section on which the 
partnership otherwise determines a partner's share of partnership 
liabilities under Sec. Sec.  1.705-1(a) and 1.752-4(d); or
    (B) The end of the partnership's taxable year in which the 
requirement to determine the net value of a disregarded entity arises 
under paragraph (k)(2)(ii)(A) or (B) of this section.
    (3) Multiple liabilities. If one or more disregarded entities have 
Sec.  1.752-2(b)(1) payment obligations with respect to one or more 
liabilities of a partnership, the partnership must allocate the net 
value of each disregarded entity among partnership liabilities in a 
reasonable and consistent manner, taking into account the relative 
priorities of those liabilities.
    (4) Reduction in net value of a disregarded entity. For purposes of 
this paragraph (k), the net value of a disregarded entity is determined 
by taking into account a subsequent reduction in the net value of the 
disregarded entity if, at the time the net value of the disregarded 
entity is determined, it is anticipated that the net value of the 
disregarded entity will subsequently be reduced and the reduction is 
part of a plan that has as one of its principal purposes creating the 
appearance that a partner bears the economic risk of loss for a 
partnership liability.
    (5) Information to be provided by the owner of a disregarded 
entity. A partner that may be treated as bearing the economic risk of 
loss for a partnership liability based upon a Sec.  1.752-2(b)(1) 
payment obligation of a disregarded entity must provide information to 
the partnership as to the entity's tax classification and the net value 
of the disregarded entity that is appropriately allocable to the 
partnership's liabilities on a timely basis.
    (6) Examples. The following examples illustrate the rules of this 
paragraph (k):

    Example 1. Disregarded entity with net value of zero. (i) In 
2007, A forms a wholly owned domestic limited liability company, 
LLC, with a contribution of $100,000. A has no liability for LLC's 
debts, and LLC has no enforceable right to contribution from A. 
Under Sec.  301.7701-3(b)(1)(ii) of this chapter, LLC is a 
disregarded entity. Also in 2007, LLC contributes $100,000 to LP, a 
limited partnership with a calendar year taxable year, in exchange 
for a general partnership interest in LP, and B and C each 
contributes $100,000 to LP in exchange for a limited partnership 
interest in LP. The partnership agreement provides that only LLC is 
required to make up any deficit in its capital account. On January 
1, 2008, LP borrows $300,000 from a bank and uses $600,000 to 
purchase nondepreciable property. The $300,000 debt is secured by 
the property and is also a general obligation of LP. LP makes 
payments of only interest on its $300,000 debt during 2008. LP has a 
net taxable loss in 2008, and under Sec. Sec.  1.705-1(a) and 1.752-
4(d), LP determines its partners' shares of the $300,000 debt at the 
end of its taxable year, December 31, 2008. As of that date, LLC 
holds no assets other than its interest in LP.
    (ii) Because LLC is a disregarded entity, A is treated as the 
partner in LP for Federal tax purposes. Only LLC has an obligation 
to make a payment on account of the $300,000 debt if LP were to 
constructively liquidate as described in paragraph (b)(1) of this 
section. Therefore, under this paragraph (k), A is treated as 
bearing the economic risk of loss for LP's $300,000 debt only to the 
extent of LLC's net value. Because that net value is $0 on December 
31, 2008, when LP determines its partners' shares of its $300,000 
debt, A is not treated as bearing the economic risk of loss for any 
portion of LP's $300,000 debt. As a result, LP's $300,000 debt is 
characterized as nonrecourse under Sec.  1.752-1(a) and is allocated 
as required by Sec.  1.752-3.
    Example 2. Disregarded entity with positive net value. (i) The 
facts are the same as in Example 1 except that on January 1, 2009, A 
contributes $250,000 to LLC. On January 5, 2009, LLC borrows 
$100,000 and LLC shortly thereafter uses the $350,000 to purchase 
unimproved land. LP makes payments of only interest on its $300,000 
debt during 2009. As of December 31, 2009, LLC holds its interest in 
LP and the land, the value of which has declined to $275,000. LP has 
a net taxable loss in 2009, and under Sec. Sec.  1.705-1(a) and 
1.752-4(d), LP determines its partners' shares of the $300,000 debt 
at the end of its taxable year, December 31, 2009.
    (ii) A's contribution of $250,000 to LLC on January 1, 2009, 
constitutes a more than de minimis contribution of property to LLC 
under paragraph (k)(2)(iii)(A) of this section and the debt incurred 
by LLC on January 5, 2009, is a valuation event under paragraph 
(k)(2)(iii)(D) of this section. Accordingly, under paragraph 
(k)(2)(ii) of this section, LLC's value must be redetermined as of 
the end of the partnership's taxable year. At that time LLC's net 
value is $175,000 ($275,000 land--$100,000 debt). Accordingly, 
$175,000 of LP's $300,000 debt will be recharacterized as recourse 
under Sec.  1.752-1(a) and allocated to A under this section, and 
the remaining $125,000 of LP's $300,000 debt will remain 
characterized as nonrecourse under Sec.  1.752-1(a) and is allocated 
as required by Sec.  1.752-3.
    Example 3. Multiple partnership liabilities. (i) The facts are 
the same as in Example 2 except that on January 1, 2010, A forms 
another wholly owned domestic limited liability company, LLC2, with 
a contribution of $120,000. Shortly thereafter, LLC2 uses the 
$120,000 to purchase stock in X corporation. A has no liability for 
LLC2's debts, and LLC2 has no enforceable right to contribution from 
A. Under Sec.  301.7701-3(b)(1)(ii) of this chapter, LLC2 is a 
disregarded entity. On July 1, 2010, LP borrows $100,000 from a bank 
and uses the $100,000 to purchase nondepreciable property. The 
$100,000 debt is secured by the property and is also a general 
obligation of LP. The $100,000 debt is senior in priority to LP's 
existing $300,000 debt. Also, on July 1, 2010, LLC2 agrees to 
guarantee both LP's $100,000 and $300,000 debts. LP makes payments 
of only interest on both its $100,000 and $300,000 debts during 
2010. LP has a net taxable loss in 2010 and, under Sec. Sec.  1.705-
1(a) and 1.752-4(d), must determine its partners' shares of its 
$100,000 and $300,000 debts at the end of its taxable year, December 
31, 2010. As of that date, LLC holds its interest in LP and the 
land, and LLC2 holds the X corporation stock which has appreciated 
in value to $140,000.
    (ii) Both LLC and LLC2 have obligations to make a payment on 
account of LP's debts if LP were to constructively liquidate as 
described in paragraph (b)(1) of this section. Therefore, under 
paragraph (k)(1) of this section, A is treated as bearing the 
economic risk of loss for LP's $100,000 and $300,000 debts only to 
the extent of the net values of

[[Page 59674]]

LLC and LLC2, as allocated among those debts in a reasonable and 
consistent manner pursuant to paragraph (k)(3) of this section.
    (iii) No events have occurred that would allow a valuation of 
LLC under paragraph (k)(2)(iii) of this section. Therefore, LLC's 
net value remains $175,000. LLC2's net value as of December 31, 
2010, when LP determines its partners' shares of its liabilities, is 
$140,000. Under paragraph (k)(3) of this section, LP must allocate 
the net values of LLC and LLC2 between its $100,000 and $300,000 
debts in a reasonable and consistent manner. Because the $100,000 
debt is senior in priority to the $300,000 debt, LP first allocates 
the net values of LLC and LLC2, pro rata, to its $100,000 debt. 
Thus, LP allocates $56,000 of LLC's net value and $44,000 of LLC2's 
net value to its $100,000 debt, and A is treated as bearing the 
economic risk of loss for all of LP's $100,000 debt. As a result, 
all of LP's $100,000 debt is characterized as recourse under Sec.  
1.752-1(a) and is allocated to A under this section. LP then 
allocates the remaining $119,000 of LLC's net value and LLC2's 
$96,000 net value to its $300,000 debt, and A is treated as bearing 
the economic risk of loss for a total of $215,000 of the $300,000 
debt. As a result, $215,000 of LP's $300,000 debt is characterized 
as recourse under Sec.  1.752-1(a) and is allocated to A under this 
section, and the remaining $85,000 of LP's $300,000 debt is 
characterized as nonrecourse under Sec.  1.752-1(a) and is allocated 
as required by Sec.  1.752-3. This example illustrates one 
reasonable method of allocating net values of disregarded entities 
among multiple partnership liabilities.
    Example 4. Disregarded entity with interests in two 
partnerships. (i) In 2007, B forms a wholly owned domestic limited 
liability company, LLC, with a contribution of $175,000. B has no 
liability for LLC's debts and LLC has no enforceable right to 
contribution from B. Under Sec.  301.7701-3(b)(1)(ii) of this 
chapter, LLC is a disregarded entity. LLC contributes $50,000 to LP1 
in exchange for a general partnership interest in LP1, and $25,000 
to LP2 in exchange for a general partnership interest in LP2. LLC 
retains the $100,000 in cash. Both LP1 and LP2 have taxable years 
than end on December 31 and, under both LP1's and LP2's partnership 
agreements, only LLC is required to make up any deficit in its 
capital account. During 2007, LP1 and LP2 incur partnership 
liabilities that are general obligations of the partnership. LP1 
borrows $300,000 (Debt 1), and LP2 borrows $60,000 (Debt 2) and 
$40,000 (Debt 3). Debt 2 is senior in priority to Debt 3. LP1 and 
LP2 make payments of only interest on Debts 1, 2, and 3 during 2007. 
As of the end of taxable year 2007, LP1 and LP2 each have a net 
taxable loss and must determine its partners' shares of partnership 
liabilities under Sec. Sec.  1.705-1(a) and 1.752-4(d) as of 
December 31, 2007. As of that date, LLC's interest in LP1 has a fair 
market value of $45,000, and LLC's interest in LP2 has a fair market 
value of $15,000.
    (ii) Because LLC is a disregarded entity, B is treated as the 
partner in LP1 and LP2 for federal tax purposes. Only LLC has an 
obligation to make a payment on account of Debts 1, 2, and 3 if LP1 
and LP2 were to constructively liquidate as described in paragraph 
(b)(1) of this section. Therefore, under this paragraph (k), B is 
treated as bearing the economic risk of loss for LP1's and LP2's 
liabilities only to the extent of LLC's net value as of the 
allocation date, December 31, 2007.
    (iii) LLC's net value with respect to LP1 is $115,000 ($100,000 
cash + $15,000 interest in LP2). Therefore, under paragraph (k)(1) 
of this section, B is treated as bearing the economic risk of loss 
for $115,000 of Debt 1. Accordingly, $115,000 of LP1's $300,000 debt 
is characterized as recourse under Sec.  1.752-1(a) and is allocated 
to B under this section. The balance of Debt 1 ($185,000) is 
characterized as nonrecourse under Sec.  1.752-1(a) and is allocated 
as required by Sec.  1.752-3.
    (iv) LLC's net value with respect to LP2 is $145,000 ($100,000 
cash + $45,000 interest in LP1). Therefore, under paragraph (k)(1) 
of this section, B is treated as bearing the economic risk of loss 
with respect to Debts 2 and 3 only to the extent of $145,000. 
Because Debt 2 is senior in priority to Debt 3, LP2 first allocates 
$60,000 of LLC's net value to Debt 2. LP2 then allocates $40,000 of 
LLC's net value to Debt 3. As a result, both Debts 2 and 3 are 
characterized as recourse under Sec.  1.752-1(a) and allocated to B. 
This example illustrates one reasonable method of allocating the net 
value of a disregarded entity among multiple partnership 
liabilities.
    (l) Effective dates. Paragraph (a), the last sentence of paragraph 
(b)(6), and paragraphs (h)(3) and (k) of this section apply to 
liabilities incurred or assumed by a partnership on or after October 
11, 2006, other than liabilities incurred or assumed by a partnership 
pursuant to a written binding contract in effect prior to that date. 
The rules applicable to liabilities incurred or assumed (or subject to 
a binding contract in effect) prior to October 11, 2006 are contained 
in Sec.  1.752-2 in effect prior to October 11, 2006, (see 26 CFR part 
1 revised as of April 1, 2006).

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

0
Par. 5. The authority citation for part 602 continues to read as 
follows:

    Authority: 26 U.S.C. 7805.


0
Par. 6. Section 602.101 paragraph (b) is amended by adding a new entry 
to the table for ``1.752-2'' to read as follows:


Sec.  602.101  OMB Control numbers.

* * * * *
    (b) * * *

------------------------------------------------------------------------
                                                             Current OMB
     CFR part or section where identified and described         Control
                                                                 No.
------------------------------------------------------------------------
 
                                * * * * *
1.752-2....................................................    1545-1905
 
                                * * * * *
------------------------------------------------------------------------


Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
    Approved: June 30, 2006.
Eric Solomon,
Acting Deputy Assistant Secretary of the Treasury.

    Editorial Note: This document was received at the Office of the 
Federal Register on October 4, 2006.

 [FR Doc. E6-16719 Filed 10-10-06; 8:45 am]
BILLING CODE 4830-01-P