64888 Federal Register / Vol. 65, No. 211 / Tuesday, October 31, 2000 / Rules and Regulations

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8906]

RIN 1545–AX09

Allocation of Partnership Debt

AGENCY: Internal Revenue Service (IRS),

Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final

regulations relating to the allocation of

nonrecourse liabilities by a partnership.

The final regulations revise tier three of

the three-tiered allocation structure

contained in the current nonrecourse

liability regulations, and also provide

guidance regarding the allocation of a

single nonrecourse liability secured by

multiple properties.

DATES: Effective Date: These regulations

are effective October 31, 2000.

Applicability Date: For dates of

applicability of these regulations, see

§ 1.752–5(a).

FOR FURTHER INFORMATION CONTACT: Dan

Carmody, (202) 622–3070 (not a toll-free

number).

SUPPLEMENTARY INFORMATION:

Introduction

This document revises § 1.752–3 of

the Income Tax Regulations (26 CFR

part 1) relating to the allocation by a

partnership of nonrecourse liabilities.

Background

On January 13, 2000, the IRS

published in the Federal Register a

notice of proposed rulemaking [REG–

103831–99 (65 FR 2084)] to provide

guidance relating to the allocation of

nonrecourse liabilities by a partnership.

The IRS and Treasury received public

comments concerning the proposed

regulations, and a public hearing was

held on May 3, 2000. After

consideration of the comments received,

the proposed regulations are adopted as

revised by this Treasury decision.

Explanation of Revisions and Summary

of Comments

1. In General

Treasury regulation § 1.752–3

currently provides a three-tiered system

for allocating nonrecourse liabilities.

The three-tiered system applies

sequentially. Under the first tier, a

partner is allocated an amount of the

liability equal to that partner’s share of

partnership minimum gain under

section 704(b). See § 1.704–2(g)(1).

Under the second tier, to the extent the

entire liability has not been allocated

under the first tier, a partner will be

allocated an amount of liability equal to

the gain that partner would be allocated

under section 704(c) if the partnership

disposed of all partnership property

subject to one or more nonrecourse

liabilities in full satisfaction of the

liabilities (section 704(c) minimum

gain). Under the third tier, a partner is

allocated any excess nonrecourse

liabilities (i.e., nonrecourse liabilities in

excess of the portion allocable in the

first and second tiers) under one of

several methods (i.e., partner’s share of

profits or certain reasonably expected

deductions) that the partnership may

choose.

The proposed regulations modified

the third tier to allow an additional

method under which a partnership may

allocate an excess nonrecourse liability

based on the excess section 704(c) gain

(i.e., the excess of the amount of section

704(c) built-in gain attributable to an

item of property over the amount of

section 704(c) minimum gain on that

property) attributable to the properties

that are subject to the liability. In

addition, for purposes of determining

section 704(c) minimum gain under the

second tier, the proposed regulations

provided that if a partnership holds

multiple properties subject to a single

liability, the liability may be allocated

among the properties based on any

reasonable method. A method is not

reasonable under the proposed

regulations if it allocates to any property

an amount that exceeds the fair market

value of the property.

2. Allocation of Debt in Accordance

With Reverse Section 704(c) Gain

One commentator noted that the

additional method provided in the

proposed regulations under the third

tier covers only built-in gain on section

704(c) property, which includes built-in

gain (i.e., book value minus adjusted

basis) attributable to contributed

property, but not built-in gain

attributable to property subject to a

revaluation (pursuant to § 1.704–

1(b)(2)(iv)(f)) (i.e., reverse section 704(c)

gain). The commentator noted that this

distinction is not made in allocating

nonrecourse liabilities in accordance

with section 704(c) minimum gain

under the second tier and questioned

the policy reason for excluding the

reverse section 704(c) gain in applying

the third tier. In response to this

comment, the final regulations provide

that an excess nonrecourse liability may

be allocated under the third tier in

accordance with excess section 704(c)

gain as well as excess reverse section

704(c) gain (i.e., the excess of the

amount of reverse section 704(c) gain

attributable to an item of property over

the section 704(c) minimum gain on that

property) with respect to property that

is subject to such liability.

3. Interplay With the Disguised Sales

Rules

One commentator noted that the

proposed amendments to § 1.752–3

would impact the disguised sales rules

relating to transfers of encumbered

property. The disguised sale rules treat

a contribution of property encumbered

by a ‘‘non-qualified’’ liability (generally,

a liability incurred within two years of

the contribution to the partnership that

is incurred in anticipation of such

contribution) as a disguised sale to the

extent that the amount of the liability

exceeds the contributing partner’s share

of the liability immediately after the

contribution. Section 1.707–5(a)(2)(ii)

provides that a partner’s share of a

nonrecourse liability, for purposes of

the disguised sale rules, is determined

by applying the same percentage used to

determine the partner’s share of the

excess nonrecourse liability under

§ 1.752–3(a)(3).

Because the proposed amendments to

§ 1.752–3(a)(3) would allow excess

nonrecourse liabilities to be allocated

according to an amount, rather than a

percentage, the potential for ambiguity

exists. The commentator suggested that

the disguised sale rules should be

modified to define a partner’s share of

a nonrecourse liability by crossreference to § 1.752–3(a), rather than

limiting the definition to the third tier.

The commentator noted that

maintaining separate definitions for the

same term was burdensome and

confusing for practitioners, and noted

that the disguised sale rules provide

consistency between sections 707(a) and

752 with respect to the definition of a

partner’s share of a recourse liability by

reference to § 1.752–2 without

limitation.

The preamble to § 1.707–5 explains

that the cross-reference defining a

partner’s share of nonrecourse liabilities

is limited to the third tier of § 1.752–3(a)

because the adoption of the full threetier approach in the disguised sale

context would provide an inverse

relationship between the gain inherent

in the contributed property and the

extent to which a disguised sale of the

property results from the encumbrance.

See preamble (57 FR 44974). The

contributing partner’s share of the

liability under § 1.752–3(a) generally

will increase as the amount of built-in

gain on the property increases, which in

turn would reduce the extent to which

Federal Register / Vol. 65, No. 211 / Tuesday, October 31, 2000 / Rules and Regulations 64889

the contribution would be treated as a

disguised sale.

The same problem would exist if the

proposed modifications to the third tier

were taken into account for purposes of

§ 1.707–5(a)(2)(ii). To the extent that

excess section 704(c) gain exists with

respect to a property, the partnership

could allocate excess nonrecourse

liabilities to the contributing partner.

The greater the built-in gain with

respect to a property, the less likely it

would be that a disguised sale would

result from the contribution. In order to

avoid this inappropriate result, the final

regulations clarify that the

modifications made to the third tier do

not apply for purposes of § 1.707–

5(a)(2)(ii). Thus, for purposes of the

disguised sale rules, the partner’s share

of nonrecourse liabilities continues to

be determined under the third tier by

reference to the partner’s share of profits

or certain reasonably expected

deductions.

4. Treatment of ‘‘Extra’’ Excess Section

704(c) Gain

Rev. Rul. 95–41 (1995–1 C.B. 132)

holds that if a partnership determines

the partners’ interests in partnership

profits based on all of the facts and

circumstances relating to the economic

arrangement of the partners, excess

section 704(c) gain is one factor, but not

the only factor, to be considered under

§ 1.752–3(a)(3). The preamble to the

proposed regulations provides that this

holding will remain relevant where a

partnership does not allocate

nonrecourse debt under the third tier

based on the excess section 704(c) gain

attributable to the property that is

subject to the debt. The preamble also

provides that once a partnership has

allocated nonrecourse indebtedness

pursuant to the rule in the proposed

regulations based upon excess section

704(c) gain, that excess section 704(c)

gain cannot again be considered in

determining a partner’s interest in

partnership profits.

One commentator asked, in situations

where the amount of a liability allocated

to a partner under the third tier

pursuant to the rule contained in the

proposed regulations is less than the

partner’s share of excess 704(c) gain,

whether the remaining excess 704(c)

gain should be taken into account for

purposes of determining a partner’s

interest in partnership profits under the

third tier with regard to other liabilities.

The statement contained in the

preamble regarding the impact of the

proposed regulations on Rev. Rul. 95–41

reflects a concern on the part of IRS and

Treasury that taxpayers might count the

same excess section 704(c) gain in

applying the rule in the proposed

regulations and then again in

determining a partner’s interest in

partnership profits under the third tier.

To the extent that a portion of excess

section 704(c) gain remains after a

liability has been fully allocated, there

is no double-counting, and the

remaining portion of the gain should be

taken into account as one factor to be

considered in determining a partner’s

interest in partnership profits under

§ 1.752–3(a)(3) and Rev. Rul. 95–41.

5. Applicability of § 1.752–3(b) to ThirdTier Allocations

The proposed regulations provide

rules regarding the allocation of a single

liability among multiple properties. The

proposed regulations generally provide

that if a partnership has multiple

properties subject to a single liability,

for purposes of determining the amount

of section 704(c) minimum gain in

applying the second tier, the

partnership may allocate to each

property an amount of the liability that,

when combined with any other

liabilities allocated to the property, do

not exceed the property’s fair market

value. The portion of the liability

allocated to each property will be

treated as a separate loan in determining

the section 704(c) minimum gain

attributable to the property.

One commentator asked that the rule

for allocating a single liability among

multiple properties under the second

tier also apply to third tier allocations.

For purposes of the second tier, where

nonrecourse debt is cross-collateralized,

it is necessary to determine how much

of the nonrecourse debt is attributable to

each partnership property, since debt is

allocated among the partners under that

tier based upon the amount by which

the debt attributable to each specific

property exceeds the tax basis of such

property. (See § 1.704–3(a)(2), which

provides that, except in limited

circumstances, section 704(c) applies on

a property-by-property basis.) Under the

proposed modification to the third tier,

any remaining nonrecourse liability of

the partnership could be allocated to a

partner up to the excess section 704(c)

gain allocable to the partner on property

subject to that liability. There is no need

to bifurcate cross-collateralized debt

under this tier, since excess section

704(c) gain is not limited by the amount

of debt attributable to specific

partnership property. So long as a

partner’s share of excess section 704(c)

gain is attributable to property that is

‘‘subject to’’ the debt being allocated,

the debt may be allocated in accordance

with that partner’s share of such excess

section 704(c) gain. Multiple properties

may be ‘‘subject to’’ the same

indebtedness. Bifurcating the debt

among multiple properties so that each

property is treated as subject to only a

portion of the debt actually would limit

taxpayers’ flexibility and narrow the

scope of the proposed change to the

third tier. Accordingly, the

commentator’s recommendation is not

adopted. However, the final regulations

add an example which clarifies the

operation of this rule.

6. Retroactive Effective Date

One commentator suggested that the

regulations should apply on a

retroactive basis. This suggestion has

not been adopted. However, the final

regulations respond to this

recommendation by providing an

optional effective date for those

taxpayers who wish to apply the rules

currently to liabilities incurred prior to

the issuance of these regulations.

7. Additional Comments Requested

The preamble to the proposed

regulations requested comments

regarding the allocation of a single

liability among multiple partnerships.

Although no formal comments were

submitted on this issue, several

commentators have indicated that

additional guidance regarding

appropriate methods of allocating such

liabilities would be helpful. The IRS

and Treasury again request comments

regarding this issue.

Special Analyses

It has been determined that this

Treasury decision is not a significant

regulatory action as defined in

Executive Order 12866. Therefore, a

regulatory assessment is not required. It

also has been determined that section

553(b) of the Administrative Procedure

Act (5 U.S.C. chapter 5) and the

Regulatory Flexibility Act (5 U.S.C.

chapter 6) do not apply to these

regulations and, therefore, a Regulatory

Flexibility Analysis is not required.

Pursuant to section 7805(f) of the

Internal Revenue Code, the notice of

proposed rulemaking preceding these

regulations was submitted to the Small

Business Administration for comment

on its impact on small business.

Drafting Information

The principal author of these

regulations is Christopher T. Kelley,

Office of Chief Counsel (Passthroughs

and Special Industries). However, other

personnel from the IRS and Treasury

participated in their development.

64890 Federal Register / Vol. 65, No. 211 / Tuesday, October 31, 2000 / Rules and Regulations

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and

recordkeeping requirements.

Adoption of Amendments to the

Regulations

Accordingly, 26 CFR part 1 is

amended as follows:

PART 1—INCOME TAXES

Par. 1. The authority citation for part

1 continues to read in part as follows:

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

Par. 2. Section 1.752–3 is amended as

follows:

1. Paragraph (a)(3) is amended by

adding three sentences immediately

before the last sentence in the

paragraph.

2. Paragraph (b) is redesignated as

paragraph (c).

3. New paragraph (b) is added.

4. Newly designated paragraph (c) is

amended by revising the introductory

text and adding a new Example 3.

The revisions and addition read as

follows:

§ 1.752–3 Partner’s share of nonrecourse

liabilities.

(a) * * *

(3) * * * Additionally, the

partnership may first allocate an excess

nonrecourse liability to a partner up to

the amount of built-in gain that is

allocable to the partner on section

704(c) property (as defined under

§ 1.704–3(a)(3)(ii)) or property for which

reverse section 704(c) allocations are

applicable (as described in § 1.704–

3(a)(6)(i)) where such property is subject

to the nonrecourse liability to the extent

that such built-in gain exceeds the gain

described in paragraph (a)(2) of this

section with respect to such property.

This additional method does not apply

for purposes of § 1.707–5(a)(2)(ii). To

the extent that a partnership uses this

additional method and the entire

amount of the excess nonrecourse

liability is not allocated to the

contributing partner, the partnership

must allocate the remaining amount of

the excess nonrecourse liability under

one of the other methods in this

paragraph (a)(3). * * *

(b) Allocation of a single nonrecourse

liability among multiple properties—(1)

In general. For purposes of determining

the amount of taxable gain under

paragraph (a)(2) of this section, if a

partnership holds multiple properties

subject to a single nonrecourse liability,

the partnership may allocate the

liability among the multiple properties

under any reasonable method. A

method is not reasonable if it allocates

to any item of property an amount of the

liability that, when combined with any

other liabilities allocated to the

property, is in excess of the fair market

value of the property at the time the

liability is incurred. The portion of the

nonrecourse liability allocated to each

item of partnership property is then

treated as a separate loan under

paragraph (a)(2) of this section. In

general, a partnership may not change

the method of allocating a single

nonrecourse liability under this

paragraph (b) while any portion of the

liability is outstanding. However, if one

or more of the multiple properties

subject to the liability is no longer

subject to the liability, the portion of the

liability allocated to that property must

be reallocated among the properties still

subject to the liability so that the

amount of the liability allocated to any

property does not exceed the fair market

value of such property at the time of

reallocation.

(2) Reductions in principal. For

purposes of this paragraph (b), when the

outstanding principal of a partnership

liability is reduced, the reduction of

outstanding principal is allocated

among the multiple properties in the

same proportion that the partnership

liability originally was allocated to the

properties under paragraph (b)(1) of this

section.

(c) Examples. The following examples

illustrate the principles of this section:

* * * * *

Example 3. Allocation of liability among

multiple properties. (i) A and B are equal

partners in a partnership (PRS). A contributes

$70 of cash in exchange for a 50-percent

interest in PRS. B contributes two items of

property, X and Y, in exchange for a 50-

percent interest in PRS. Property X has a fair

market value (and book value) of $70 and an

adjusted basis of $40, and is subject to a

nonrecourse liability of $50. Property Y has

a fair market value (and book value) of $120,

an adjusted basis of $40, and is subject to a

nonrecourse liability of $70. Immediately

after the initial contributions, PRS refinances

the two separate liabilities with a single $120

nonrecourse liability. All of the built-in gain

attributable to Property X ($30) and Property

Y ($80) is section 704(c) gain allocable to B.

(ii) The amount of the nonrecourse liability

($120) is less than the total book value of all

of the properties that are subject to such

liability ($70 + $120 = $190), so there is no

partnership minimum gain. § 1.704–2(d).

Accordingly, no portion of the liability is

allocated pursuant to paragraph (a)(1) of this

section.

(iii) Pursuant to paragraph (b)(1) of this

section, PRS decides to allocate the

nonrecourse liability evenly between the

Properties X and Y. Accordingly, each of

Properties X and Y are treated as being

subject to a separate $60 nonrecourse liability

for purposes of applying paragraph (a)(2) of

this section. Under paragraph (a)(2) of this

section, B will be allocated $20 of the

liability for each of Properties X and Y (in

each case, $60 liability minus $40 adjusted

basis). As a result, a portion of the liability

is allocated pursuant to paragraph (a)(2) of

this section as follows:

Partner Property Tier 1 Tier 2

A ................ X ................ $0 $0

Y ................ 0 0

B ................ X ................ 0 20

Y ................ 0 20

(iv) PRS has $80 of excess nonrecourse

liability that it may allocate in any manner

consistent with paragraph (a)(3) of this

section. PRS determines to allocate the $80

of excess nonrecourse liabilities to the

partners up to their share of the remaining

section 704(c) gain on the properties, with

any remaining amount of liabilities being

allocated equally to A and B consistent with

their equal interests in partnership profits. B

has $70 of remaining section 704(c) gain ($10

on Property X and $60 on Property Y), and

thus will be allocated $70 of the liability in

accordance with this gain.

The remaining $10 is divided equally

between A and B. Accordingly, the overall

allocation of the $120 nonrecourse liability is

as follows:

Partner Tier 1 Tier 2 Tier 3 Total

A ....... $0 $0 $5 $5

B ....... 0 40 75 115

Par. 3. In § 1.752–5, paragraph (a) is

amended by adding three sentences

after the first sentence:

§ 1.752–5 Effective dates and transition

rules.

(a) In general. * * * However,

§ 1.752–3(a)(3) fifth, sixth, and seventh

sentences, (b), and (c) Example 3, do not

apply to any liability incurred or

assumed by a partnership prior to

October 31, 2000. Nevertheless, § 1.752–

3(a)(3) fifth, sixth, and seventh

sentences, (b), and (c) Example 3, may

be relied upon for any liability incurred

or assumed by a partnership prior to

October 31, 2000 for taxable years

ending on or after October 31, 2000.

***

* * * * *

Approved: October 11, 2000.

David A. Mader,

Acting Deputy Commissioner of Internal

Revenue.

Jonathan Talisman,

Acting Assistant Secretary of the Treasury.

[FR Doc. 00–27826 Filed 10–30–00; 8:45 am]

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