Federal Register / Vol. 60, No. 247 / Tuesday, December 26, 1995 / Rules and Regulations 66727

Aviation Information Management,

Research and Special Programs

Administration (RSPA)’’ and add

‘‘Office of Airline Information, Bureau

of Transportation Statistics (BTS)’’ in its

place.

57. In § 385.27(d), remove the term

‘‘RSPA’’ and add ‘‘BTS’’ in its place.

58. In § 385.27(i), remove the term

‘‘RSPA’’ and add ‘‘BTS’’ in its place,

and remove the term Administrator,

RSPA’’ and add ‘‘Director, BTS’’ in its

place.

59. In § 385.27(m), remove the term

‘‘and with the policy set forth in

§ 399.100 of this chapter’’.

PART 399—STATEMENTS OF

GENERAL POLICY

60. The authority citation for part 399

continues to read as follows:

Authority: 49 U.S.C. chapters 401, 411,

413, 415, 417, 419, 461.

§ 399.50 [Amended]

61. In § 399.50, remove the term

‘‘Board’’ and add ‘‘Bureau of

Transportation Statistics’’ in its place,

and remove the term ‘‘section 901(a) of

the Act’’ and add ‘‘49 U.S.C. 46301’’ in

its place.

§ 399.51 [Amended]

62. In § 399.51, remove the term

‘‘Board’’ and add ‘‘Bureau of

Transportation Statistics’’ in its place.

§ 399.52 [Amended]

63. In § 399.52, remove the term

‘‘Board’’ and add ‘‘DOT’’ in its place.

§ 399.100 [Removed]

64. Section 399.100 is removed.

Issued in Washington, DC, on December

19, 1995.

T.R. Lakshmanan,

Director, Bureau of Transportation Statistics.

[FR Doc. 95–31188 Filed 12–22–95; 8:45 am]

BILLING CODE 4910–FE–P

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[T.D. 8642]

RIN 1545–AR48; 1545–AR93

Recognition of Gain or Loss by

Contributing Partner on Distribution of

Contributed Property or Other Property

AGENCY: Internal Revenue Service (IRS),

Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final

regulations relating to the recognition of

gain or loss on certain distributions of

contributed property by a partnership

under section 704(c)(1)(B) of the

Internal Revenue Code of 1986 (Code).

This document also contains final

regulations relating to the recognition of

gain on certain distributions to a

contributing partner under section 737.

The final regulations affect partnerships

and their partners and are necessary to

provide guidance for complying with

the applicable tax law.

EFFECTIVE DATE: These regulations are

effective for January 9, 1995.

FOR FURTHER INFORMATION CONTACT:

Stephen J. Coleman, (202) 622- 3060

(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

The Revenue Reconciliation Act of

1989 added section 704(c)(1)(B) and

section 704(c)(2) to the Internal Revenue

Code. Section 704(c)(1)(B) provides that,

in the case of a distribution of

contributed property to another partner

within five years of its contribution, the

contributing partner must recognize

gain or loss in an amount equal to the

gain or loss the partner would have been

allocated under section 704(c)(1)(A) on

a sale of the property by the partnership

at its fair market value at the time of the

distribution. Section 704(c)(2) provides

an exception for distributions of certain

like-kind property.

The Energy Policy Act of 1992 added

section 737 to the Code. Section 737

requires a partner who contributes

appreciated property to recognize gain

on a subsequent distribution of other

property to the contributing partner to

the extent of the lesser of (i) the net

precontribution gain on property

contributed by the partner, or (ii) the

excess of the value of the distributed

property over the adjusted basis of the

partner’s interest in the partnership.

On January 9, 1995, a notice of

proposed rulemaking (PS–76–92; PS–

51–93) under section 704(c)(1)(B) and

section 737 was published in the

Federal Register (60 FR 2352). Written

comments responding to this notice

were received. No public hearing was

held because no hearing was requested.

After consideration of all comments

received, the proposed regulations

under section 704(c)(1)(B) and section

737 are adopted as revised by this

Treasury decision.

Summary of Significant Comments and

Revisions

The significant comments on the

proposed regulations and the revisions

made in the final regulations are

discussed below.

A. Section 704(c)(1)(B)

Determination of Gain and Loss

The proposed regulations provide that

section 704(c)(1)(B) applies only to a

distribution that is properly

characterized as a distribution to a

partner acting in the capacity of a

partner within the meaning of section

731 and section 737, and not to a

transaction or distribution that is subject

to provisions other than section 731(a)

or section 737. Comments requested that

the provision be clarified. The final

regulations clarify that section

704(c)(1)(B) applies only to the extent

that a transaction is a distribution under

section 731. References to transactions

and distributions not subject to section

704(c)(1)(B) have been deleted.

One commentator suggested certain

clarifying revisions to the proposed

regulations’ definition of fair market

value. The definition in the proposed

regulations, however, is identical to the

definition of fair market value in the

704(b) regulations, and distributed

property should have the same fair

market value for purposes of

determining gain and loss under section

704(c)(1)(B) and determining capital

account adjustments under section

704(b). The final regulations therefore

adopt the definition in the proposed

regulations without change.

The proposed regulations provide that

the amount of gain or loss resulting from

a distribution of partnership property is

determined as if the distributed

property had been sold by the

partnership to the distributee partner.

As a result, if built-in loss property is

distributed to a partner that holds more

than a 50 percent interest in partnership

capital or profits, the built-in loss that

otherwise would be recognized is

disallowed under section 707(b)(1)(A).

One commentator suggested that section

704(c)(1)(B) was intended to address

disguised sales between partners and

that, therefore, a loss should be

disallowed on a distribution only if it

would be disallowed on a direct sale

between the partners. Section

704(c)(1)(B), however, respects the form

of the transaction as between the

partnership and a partner and does not

recast the transaction as a disguised

sale. See H.R. Rep. No. 247, 101st Cong.,

1st Sess. 406 (1989). The final

regulations therefore adopt the proposed

regulations without change.

Several of the provisions in the

proposed regulations refer to

distributions that are part of ‘‘the same

plan or arrangement.’’ Commentators

requested clarification of this term. The

reference to distributions that are part of

the same plan or arrangement was
66728 Federal Register / Vol. 60, No. 247 / Tuesday, December 26, 1995 / Rules and Regulations

intended to reflect the fact that

distributions of multiple properties to

one partner or distributions of different

properties to more than one partner over

a period of time may be treated as part

of the same distribution under general

principles of taxation, such as the step

transaction doctrine. The final

regulations remove the reference to

‘‘same plan or arrangement’’ and refers

to distributions that are part of the same

distribution. This change is made for

simplification only and is not intended

as a substantive change to the scope of

a distribution for tax purposes. As under

current law, distributions do not need to

be contemporaneous to be part of the

same distribution.

Several comments were received

regarding the effect of a partnership

termination under section 708(b)(1)(B).

One comment suggested that it was not

clear whether property that had

previously been contributed to the

partnership (and was therefore already

subject to a five-year period) was subject

to a new five- year period after the

termination. The final regulations

clarify that a new five-year period does

not begin to the extent of any pretermination gain or loss that would have

been allocated to a contributing partner

under section 704(c)(1)(A) on a sale of

contributed property immediately

before the termination.

The legislative history of section

704(c)(1)(B) indicates that a constructive

termination does not change the

application of section 704(c) to precontribution gain or loss on property

contributed to the partnership before

termination. One comment read this

legislative history as possibly suggesting

that a pro rata distribution is deemed to

occur under section 708(b)(1)(B) for

section 704(c)(1)(A) purposes, but a

different distribution is deemed to occur

for section 704(c)(1)(B) purposes. The

comment expressed concern about the

complexity of such a system. Section

704(c)(1)(B), however, does not require

or impose such a ‘‘hybrid system.’’ The

amount of gain or loss under section

704(c)(1)(B) is determined by reference

to the amount of gain or loss that would

have been allocated to the partner under

section 704(c)(1)(A) if the property had

been sold. Thus, property of a

partnership that terminates under

section 708(b)(1)(B) is deemed to be

distributed to the partners in the same

manner for both sections.

Another comment suggested it was

unclear whether section 704(c)(1)(B)

could apply to property that had not

been contributed by a partner to the

partnership prior to the termination.

The final regulations confirm that a new

five-year period begins for all property

that is deemed contributed to the new

partnership after the termination (which

would include property not actually

contributed to the partnership), except

to the extent that such built-in gain or

loss would have been allocated to the

contributing partner under section

704(c)(1)(A) on a sale of the contributed

property immediately before the

termination.

Commentators also requested

guidance on the interaction of section

708(b)(1)(B) and section 704(c) in

general. The IRS and Treasury recognize

the need for additional guidance on this

issue, but such guidance is beyond the

scope of these regulations. The IRS and

Treasury are considering a separate

project involving the interaction of

section 704(c) and section 708(b)(1)(B)

and invite additional comments and

suggestions regarding the project.

Exceptions

The proposed regulations provide that

section 704(c)(1)(B) does not apply to

property contributed to the partnership

on or before October 3, 1989. One

commentator requested an exception for

property required to be contributed

under a binding contract entered into on

or before October 3, 1989. The statutory

effective date provisions, however, do

not contain a binding contract

exception. Accordingly, the final

regulations adopt the proposed

regulations without change.

One commentator suggested an

additional exception for distributions of

an undivided interest in property. The

final regulations provide that section

704(c)(1)(B) does not apply to such a

distribution to the extent that the

distributed interest does not exceed the

undivided interest contributed by the

distributee partner.

One commentator also requested an

additional exception for distributions of

fungible property because the partners

may not be able to track the specific

contributed property. The final

regulations do not provide such an

exception. Contributed property may be

fungible from an economic perspective,

but such property is generally not

fungible for tax purposes because each

contributed property will have its own

individual tax basis.

The proposed regulations provide an

exception for distributions of section

704(c) property to a noncontributing

partner in liquidation of the partnership

if the contributing partner receives an

interest in the contributed property and

the built-in gain or loss in that property

is equal to or greater than the built-in

gain or loss that would have otherwise

been allocated to the contributing

partner. One commentator suggested

that the exception more clearly indicate

the amount of built-in gain or loss that

must be reflected in the property

distributed to the contributing partner.

The final regulations clarify that the

amount of the built-in gain or loss must

be equal to the gain or loss that would

have been allocated to the contributing

partner under section 704(c)(1)(A) if the

contributed property had been sold

immediately before the distribution.

One commentator also suggested

expanding this exception to apply to the

extent of the built-in gain or loss in the

property distributed to the contributing

partner. This comment is not adopted in

the final regulations. The exception was

intended to apply only in the limited

situation in which a partnership

liquidates and the value of the

contributed property exceeds the

contributing partner’s capital account.

In that situation, the portion of the

contributed property in excess of the

contributing partner’s capital account

would have to be distributed to another

partner, thereby triggering section

704(c)(1)(B). The exception allows a

partner to avoid section 704(c)(1)(B) in

this situation, so long as the built-in

gain or loss in the property distributed

to the contributing partner is at least

equal to the gain or loss that would have

been allocated to the contributing

partner under section 704(c)(1)(A) if the

contributed property had been sold

immediately before the distribution.

Special Rules

The proposed regulations provide a

special rule under section 704(c)(2) for

situations in which the partnership

distributes like-kind property to a

contributing partner within a specified

period of the distribution of the

property contributed by that partner.

Under this rule, the gain or loss that

otherwise would have been recognized

on the distribution of the contributed

property is reduced by the amount of

the contributing partner’s built-in gain

or loss in the distributed like-kind

property. One commentator criticized

this rule as inconsistent with the

statutory provision.

Section 704(c)(2) provides that

‘‘[u]nder regulations prescribed by the

Secretary, * * * to the extent of the

value of the [like-kind property

distributed to the contributing partner,

the calculation of the contributing

partner’s gain or loss attributable to the

distribution of the contributed property]

shall be [determined] as if the

contributing partner had contributed to

the partnership the [like-kind]

property.’’ This provision is generally

intended to treat the contributing

partner as if the partner had exchanged
Federal Register / Vol. 60, No. 247 / Tuesday, December 26, 1995 / Rules and Regulations 66729

the contributed property for like-kind

property in a nontaxable exchange

outside of the partnership. This allows

the contributing partner to avoid

recognition of gain or loss under section

704(c)(1)(B) on the distribution of the

contributed property to another partner

because the contributing partner is

treated as having contributed the likekind property, not the property that is

actually distributed to the other partner.

If the contributing partner, however,

had engaged in a like- kind exchange

outside of the partnership, the partner’s

built-in gain or loss in the like-kind

property received would have been the

same as the property that was

surrendered. The rule in the proposed

regulations reflects this result by

limiting the application of section

704(c)(2) to the extent that the built-in

gain or loss in the contributed property

is not preserved in the like-kind

property distributed to the contributing

partner. The IRS and Treasury continue

to believe that the regulations properly

implement Congress’ objective with

respect to this provision. Therefore, the

regulations are finalized without

change.

One commentator also suggested a

clarification of the interaction of the

like-kind exception and the disguised

sale rules of 707(a)(2)(B). The proposed

regulations provide that the like-kind

exception reduces any gain that would

have otherwise been recognized under

section 704(c)(1)(B). The proposed

regulations also provide that section

704(c)(1)(B) applies only to a

distribution to a partner within the

meaning of section 731. There is no

suggestion in section 704(c)(2) or the

proposed regulations that the like-kind

exception was intended as an exception

to the disguised sale provisions. The

final regulations confirm that the

disguised sale provisions can apply to a

distribution, even if the distribution

would otherwise have qualified for the

section 704(c)(2) like-kind exception.

Anti-Abuse Rule

Commentators made several

suggestions for clarifying or modifying

the anti-abuse rule in the proposed

regulations. In particular, these

commentators requested clarification of

the relationship between this rule and

the general partnership anti-abuse rule

in Treas. Reg. section 1.701–2. The

general anti-abuse regulation is a rule of

general applicability that provides

general principles to be applied in

interpreting and applying all of the

provisions of subchapter K. In certain

situations, however, more specific antiabuse rules are needed to carry out the

purpose of a particular provision. The

final regulations therefore adopt the rule

in the proposed regulations without

modification.

B. Section 737

Determination of Gain

The final regulations are clarified to

provide that section 737 applies only to

the extent that a transaction is a

distribution under section 731. In

accordance with section 737(d)(2), the

final regulations also provide that

section 737 does not apply to the extent

that section 751(b) applies to the

distribution.

Net Precontribution Gain

The proposed regulations provide that

a distributee partner’s net

precontribution gain is determined

without regard to the like-kind

exception of section 704(c)(2) in

situations in which the contributed

property is not actually distributed to

another partner. One commentator

suggested deleting this provision as

superfluous. The final regulations adopt

the proposed regulations without

change. This provision clarifies that

section 737 does not contain a like-kind

exception similar to the exception in

section 704(c)(2). Section 737 applies

even if the property received by the

partner is of a like-kind with the

contributed property.

Character of Gain

One commentator suggested that the

proposed regulations fail to clarify

whether there are two groups (ordinary

and capital) for purposes of determining

the character of a partner’s net

precontribution gain or whether there

may be an additional section 1231 group

or section 1245 and section 1250

groups. The final regulations adopt the

proposed regulations without change.

The proposed regulations provide that

character for purposes of a partner’s net

precontribution gain is determined as if

the contributed property were sold to an

unrelated third party. As a result, all of

the provisions that are relevant in

determining the character of gain or loss

on a sale are relevant in determining the

character of the net precontribution

gain. For example, if the sale of property

would have resulted in part capital gain

and part ordinary income, the character

of the net precontribution gain for that

property is part ordinary and part

capital. The same approach applies in

determining the allocation of any

adjustment to the partnership’s basis in

partnership property as a result of gain

recognized by the distributee partner. A

basis adjustment attributable to gain

treated as capital gain under section

1231 would be allocated to the property

that entered into the calculation of the

amount of section 1231 gain.

One commentator also suggested that

the proposed regulations do not clarify

whether character is determined at the

partnership or the partner level. This

determination may be important in

situations such as section 1231 where

the character of the gain or loss may

depend on the partner’s particular tax

circumstances. The final regulations

clarify that the character of the gain or

loss is determined at the partnership

level for this purpose.

Exceptions

One commentator suggested adding

an exception for certain divisive

transactions in which the contributing

partner continued to own an indirect

interest in the contributed property. The

final regulations add a new exception

under which section 737 does not apply

to a transfer of contributed property by

a transferor partnership to a transferee

partnership, followed by a distribution

of an interest in the transferee

partnership (and no other property) to

the contributing partner in complete

liquidation of the partner’s interest.

This exception is added because the

distributee partner has simply converted

an interest in the transferor partnership

into an interest in a transferee

partnership that holds the same

contributed section 704(c) property. The

limitations on this exception ensure that

the partner’s basis in the transferee

partnership attributable to the

contributed property is the same as the

partner’s basis in the transferor

partnership attributable to that property.

This allows a partnership to engage in

a divisive split-up transaction, while

preventing any avoidance of section 737

that might occur as a result of the basis

allocation rules for non-liquidating

distributions.

The proposed regulations provide that

section 737 does not apply to an

incorporation of a partnership other

than an incorporation involving an

actual distribution of partnership

property to the partners. One

commentator suggested that this

distinction between methods of

incorporation creates an unnecessary

trap for the unwary and may have a

chilling effect on the conversion of

partnerships into S corporations. The

final regulations adopt the proposed

regulations without change. The form of

incorporation chosen by the partners is

respected for Federal tax purposes and,

as a result, the distribution of property

in connection with the incorporation is

treated as a distribution for purposes of

section 737.
66730 Federal Register / Vol. 60, No. 247 / Tuesday, December 26, 1995 / Rules and Regulations

One commentator suggested an

additional exception for distributions of

an undivided interest in property

similar to that described with respect to

the regulations under section

704(c)(1)(B). The final regulations

provide a comparable rule under section

737.

Anti-Abuse Rule

Commentators made several

suggestions regarding the anti-abuse

rule in the proposed regulations. These

suggestions are essentially the same as

the comments regarding the anti-abuse

rule in the section 704(c)(1)(B)

regulations, and thus the comments are

discussed above.

Effective Date

These regulations are effective for

distributions by a partnership to a

partner on or after January 9, 1995.

Special Analyses

It has been determined that this

Treasury decision is not a significant

regulatory action as defined in EO

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) 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 Chief Counsel for

Advocacy of the Small Business

Administration for comment on its

impact on small business.

Drafting Information

Several persons from the Office of

Chief Counsel and the Treasury

Department participated in the

development of these 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

Paragraph 1. The authority citation

for part 1 is amended by adding the

following citation:

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

Section 1.704–4 also issued under 26

U.S.C. 704(c) * * *

Par. 2. Section 1.704–4 is added to

read as follows:

§ 1.704–4 Distribution of contributed

property.

(a) Determination of gain and loss—

(1) In general. A partner that contributes

section 704(c) property to a partnership

must recognize gain or loss under

section 704(c)(1)(B) and this section on

the distribution of such property to

another partner within five years of its

contribution to the partnership in an

amount equal to the gain or loss that

would have been allocated to such

partner under section 704(c)(1)(A) and

§ 1.704–3 if the distributed property had

been sold by the partnership to the

distributee partner for its fair market

value at the time of the distribution. See

§ 1.704–3(a)(3)(i) for a definition of

section 704(c) property.

(2) Transactions to which section

704(c)(1)(B) applies. Section 704(c)(1)(B)

and this section apply only to the extent

that a distribution by a partnership is a

distribution to a partner acting in the

capacity of a partner within the meaning

of section 731.

(3) Fair market value of property. The

fair market value of the distributed

section 704(c) property is the price at

which the property would change hands

between a willing buyer and a willing

seller at the time of the distribution,

neither being under any compulsion to

buy or sell and both having reasonable

knowledge of the relevant facts. The fair

market value that a partnership assigns

to distributed section 704(c) property

will be regarded as correct, provided

that the value is reasonably agreed to

among the partners in an arm’s-length

negotiation and the partners have

sufficiently adverse interests.

(4) Determination of five-year

period—(i) General rule. The five-year

period specified in paragraph (a)(1) of

this section begins on and includes the

date of contribution.

(ii) Section 708(b)(1)(B) terminations.

A termination of the partnership under

section 708(b)(1)(B) begins a new fiveyear period for each partner with

respect to the built-in gain and built-in

loss property that the partner is deemed

to recontribute to a new partnership

following the termination, but only to

the extent that the pre-termination builtin gain or loss, if any, on such property

would not have been allocated to the

contributing partner under section

704(c)(1)(A) and § 1.704–3 on a sale of

the contributed property to an unrelated

party immediately before the

termination. See § 1.704–3(a)(3)(ii) for

the definitions of built-in gain and builtin loss on section 704(c) property.

(5) Examples. The following examples

illustrate the rules of this paragraph (a).

Unless otherwise specified, partnership

income equals partnership expenses

(other than depreciation deductions for

contributed property) for each year of

the partnership, the fair market value of

partnership property does not change,

all distributions by the partnership are

subject to section 704(c)(1)(B), and all

partners are unrelated.

Example 1. Recognition of gain. (i) On

January 1, 1995, A, B, and C form partnership

ABC as equal partners. A contributes $10,000

cash and Property A, nondepreciable real

property with a fair market value of $10,000

and an adjusted tax basis of $4,000. Thus,

there is a built-in gain of $6,000 on Property

A at the time of contribution. B contributes

$10,000 cash and Property B, nondepreciable

real property with a fair market value and

adjusted tax basis of $10,000. C contributes

$20,000 cash.

(ii) On December 31, 1998, Property A and

Property B are distributed to C in complete

liquidation of C’s interest in the partnership.

(iii) A would have recognized $6,000 of

gain under section 704(c)(1)(A) and § 1.704–

3 on the sale of Property A at the time of the

distribution ($10,000 fair market value less

$4,000 adjusted tax basis). As a result, A

must recognize $6,000 of gain on the

distribution of Property A to C. B would not

have recognized any gain or loss under

section 704(c)(1)(A) and § 1.704–3 on the sale

of Property B at the time of distribution

because Property B was not section 704(c)

property. As a result, B does not recognize

any gain or loss on the distribution of

Property B.

Example 2. Effect of post-contribution

depreciation deductions. (i) On January 1,

1995, A, B, and C form partnership ABC as

equal partners. A contributes Property A,

depreciable property with a fair market value

of $30,000 and an adjusted tax basis of

$20,000. Therefore, there is a built-in gain of

$10,000 on Property A. B and C each

contribute $30,000 cash. ABC uses the

traditional method of making section 704(c)

allocations described in § 1.704–3(b) with

respect to Property A.

(ii) Property A is depreciated using the

straight-line method over its remaining 10-

year recovery period. The partnership has

book depreciation of $3,000 per year (10

percent of the $30,000 book basis), and each

partner is allocated $1,000 of book

depreciation per year (one-third of the total

annual book depreciation of $3,000). The

partnership has a tax depreciation deduction

of $2,000 per year (10 percent of the $20,000

tax basis in Property A). This $2,000 tax

depreciation deduction is allocated equally

between B and C, the noncontributing

partners with respect to Property A.

(iii) At the end of the third year, the book

value of Property A is $21,000 ($30,000

initial book value less $9,000 aggregate book

depreciation) and the adjusted tax basis is

$14,000 ($20,000 initial tax basis less $6,000

aggregate tax depreciation). A’s remaining

section 704(c)(1)(A) built-in gain with respect

to Property A is $7,000 ($21,000 book value

less $14,000 adjusted tax basis).

(iv) On December 31, 1997, Property A is

distributed to B in complete liquidation of

B’s interest in the partnership. If Property A

had been sold for its fair market value at the
Federal Register / Vol. 60, No. 247 / Tuesday, December 26, 1995 / Rules and Regulations 66731

time of the distribution, A would have

recognized $7,000 of gain under section

704(c)(1)(A) and § 1.704–3(b). Therefore, A

recognizes $7,000 of gain on the distribution

of Property A to B.

Example 3. Effect of remedial method. (i)

On January 1, 1995, A, B, and C form

partnership ABC as equal partners. A

contributes Property A1, nondepreciable real

property with a fair market value of $10,000

and an adjusted tax basis of $5,000, and

Property A2, nondepreciable real property

with a fair market value and adjusted tax

basis of $10,000. B and C each contribute

$20,000 cash. ABC uses the remedial method

of making section 704(c) allocations

described in § 1.704–3(d) with respect to

Property A1.

(ii) On December 31, 1998, when the fair

market value of Property A1 has decreased to

$7,000, Property A1 is distributed to C in a

current distribution. If Property A1 had been

sold by the partnership at the time of the

distribution, ABC would have recognized the

$2,000 of remaining built-in gain under

section 704(c)(1)(A) on the sale (fair market

value of $7,000 less $5,000 adjusted tax

basis). All of this gain would have been

allocated to A. ABC would also have

recognized a book loss of $3,000 ($10,000

original book value less $7,000 current fair

market value of the property). Book loss in

the amount of $2,000 would have been

allocated equally between B and C. Under the

remedial method, $2,000 of tax loss would

also have been allocated equally to B and C

to match their share of the book loss. As a

result, $2,000 of gain would also have been

allocated to A as an offsetting remedial

allocation. A would have recognized $4,000

of total gain under section 704(c)(1)(A) on the

sale of Property A1 ($2,000 of section 704(c)

recognized gain plus $2,000 remedial gain).

Therefore, A recognizes $4,000 of gain on the

distribution of Property A1 to C under this

section.

(b) Character of gain or loss—(1)

General rule. Gain or loss recognized by

the contributing partner under section

704(c)(1)(B) and this section has the

same character as the gain or loss that

would have resulted if the distributed

property had been sold by the

partnership to the distributee partner at

the time of the distribution.

(2) Example. The following example

illustrates the rule of this paragraph (b).

Unless otherwise specified, partnership

income equals partnership expenses

(other than depreciation deductions for

contributed property) for each year of

the partnership, the fair market value of

partnership property does not change,

all distributions by the partnership are

subject to section 704(c)(1)(B), and all

partners are unrelated.

Example. Character of gain. (i) On January

1, 1995, A and B form partnership AB. A

contributes $10,000 and Property A,

nondepreciable real property with a fair

market value of $10,000 and an adjusted tax

basis of $4,000, in exchange for a 25 percent

interest in partnership capital and profits. B

contributes $60,000 cash for a 75 percent

interest in partnership capital and profits.

(ii) On December 31, 1998, Property A is

distributed to B in a current distribution.

Property A is used in a trade or business of

B.

(iii) A would have recognized $6,000 of

gain under section 704(c)(1)(A) on a sale of

Property A at the time of the distribution (the

difference between the fair market value

($10,000) and the adjusted tax basis ($4,000)

of the property at that time). Because

Property A is not a capital asset in the hands

of Partner B and B holds more than 50

percent of partnership capital and profits, the

character of the gain on a sale of Property A

to B would have been ordinary income under

section 707(b)(2). Therefore, the character of

the gain to A on the distribution of Property

A to B is ordinary income.

(c) Exceptions—(1) Property

contributed on or before October 3,

1989. Section 704(c)(1)(B) and this

section do not apply to property

contributed to the partnership on or

before October 3, 1989.

(2) Certain liquidations. Section

704(c)(1)(B) and this section do not

apply to a distribution of an interest in

section 704(c) property to a partner

other than the contributing partner in a

liquidation of the partnership if—

(i) The contributing partner receives

an interest in the section 704(c) property

contributed by that partner (and no

other property); and

(ii) The built-in gain or loss in the

interest distributed to the contributing

partner, determined immediately after

the distribution, is equal to or greater

than the built-in gain or loss on the

property that would have been allocated

to the contributing partner under

section 704(c)(1)(A) and § 1.704–3 on a

sale of the contributed property to an

unrelated party immediately before the

distribution.

(3) Section 708(b)(1)(B) termination.

Section 704(c)(1)(B) and this section do

not apply to a deemed distribution of

property caused by a termination of the

partnership under section 708(b)(1)(B).

See paragraph (a)(4)(ii) of this section

for a special rule regarding a new fiveyear period for certain property deemed

contributed to a new partnership

following a termination of the

partnership under section 708(b)(1)(B).

See also § 1.737–2(a) for a similar rule

in the context of section 737.

(4) Complete transfer to another

partnership. Section 704(c)(1)(B) and

this section do not apply to a transfer by

a partnership (transferor partnership) of

all of its assets and liabilities to a

second partnership (transferee

partnership) in an exchange described

in section 721, followed by a

distribution of the interest in the

transferee partnership in liquidation of

the transferor partnership as part of the

same plan or arrangement. A subsequent

distribution of section 704(c) property

by the transferee partnership to a

partner of the transferee partnership is

subject to section 704(c)(1)(B) to the

same extent that a distribution by the

transferor partnership would have been

subject to section 704(c)(1)(B). See

§ 1.737–2(b) for a similar rule in the

context of section 737.

(5) Incorporation of a partnership.

Section 704(c)(1)(B) and this section do

not apply to an incorporation of a

partnership by any method of

incorporation (other than a method

involving an actual distribution of

partnership property to the partners

followed by a contribution of that

property to a corporation), provided that

the partnership is liquidated as part of

the incorporation transaction. See

§ 1.737–2(c) for a similar rule in the

context of section 737.

(6) Undivided interests. Section

704(c)(1)(B) and this section do not

apply to a distribution of an undivided

interest in property to the extent that the

undivided interest does not exceed the

undivided interest, if any, contributed

by the distributee partner in the same

property. See § 1.737–2(d)(4) for the

application of section 737 in a similar

context. The portion of the undivided

interest in property retained by the

partnership after the distribution, if any,

that is treated as contributed by the

distributee partner, is reduced to the

extent of the undivided interest

distributed to the distributee partner.

(7) Example. The following example

illustrates the rule of paragraph (c)(2) of

this section. Unless otherwise specified,

partnership income equals partnership

expenses (other than depreciation

deductions for contributed property) for

each year of the partnership, the fair

market value of partnership property

does not change, all distributions by the

partnership are subject to section

704(c)(1)(B), and all partners are

unrelated.

Example. (i) On January 1, 1995, A and B

form partnership AB, as equal partners. A

contributes Property A, nondepreciable real

property with a fair market value and

adjusted tax basis of $20,000. B contributes

Property B, nondepreciable real property

with a fair market value of $20,000 and an

adjusted tax basis of $10,000. Property B

therefore has a built-in gain of $10,000 at the

time of contribution.

(ii) On December 31, 1998, the partnership

liquidates when the fair market value of

Property A has not changed, but the fair

market value of Property B has increased to

$40,000.

(iii) In the liquidation, A receives Property

A and a 25 percent interest in Property B.

This interest in Property B has a fair market
66732 Federal Register / Vol. 60, No. 247 / Tuesday, December 26, 1995 / Rules and Regulations

value of $10,000 to A, reflecting the fact that

A was entitled to 50 percent of the $20,000

post-contribution appreciation in Property B.

The partnership distributes to B a 75 percent

interest in Property B with a fair market

value of $30,000. B’s basis in this portion of

Property B is $10,000 under section 732(b).

As a result, B has a built-in gain of $20,000

in this portion of Property B immediately

after the distribution ($30,000 fair market

value less $10,000 adjusted tax basis). This

built-in gain is greater than the $10,000 of

built-in gain in Property B at the time of

contribution to the partnership. B therefore

does not recognize any gain on the

distribution of a portion of Property B to A

under this section.

(d) Special rules—(1) Nonrecognition

transactions. Property received by the

partnership in exchange for section

704(c) property in a nonrecognition

transaction is treated as the section

704(c) property for purposes of section

704(c)(1)(B) and this section to the

extent that the property received is

treated as section 704(c) property under

§ 1.704–3(a)(8). See § 1.737–2(d)(3) for a

similar rule in the context of section

737.

(2) Transfers of a partnership interest.

The transferee of all or a portion of the

partnership interest of a contributing

partner is treated as the contributing

partner for purposes of section

704(c)(1)(B) and this section to the

extent of the share of built-in gain or

loss allocated to the transferee partner.

See § 1.704–3(a)(7).

(3) Distributions of like-kind property.

If section 704(c) property is distributed

to a partner other than the contributing

partner and like-kind property (within

the meaning of section 1031) is

distributed to the contributing partner

no later than the earlier of (i) 180 days

following the date of the distribution to

the non-contributing partner, or (ii) the

due date (determined with regard to

extensions) of the contributing partner’s

income tax return for the taxable year of

the distribution to the noncontributing

partner, the amount of gain or loss, if

any, that the contributing partner would

otherwise have recognized under

section 704(c)(1)(B) and this section is

reduced by the amount of built-in gain

or loss in the distributed like-kind

property in the hands of the

contributing partner immediately after

the distribution. The contributing

partner’s basis in the distributed likekind property is determined as if the

like-kind property were distributed in

an unrelated distribution prior to the

distribution of any other property

distributed as part of the same

distribution and is determined without

regard to the increase in the

contributing partner’s adjusted tax basis

in the partnership interest under section

704(c)(1)(B) and this section. See

§ 1.707–3 for provisions treating the

distribution of the like-kind property to

the contributing partner as a disguised

sale in certain situations.

(4) Example. The following example

illustrates the rules of this paragraph

(d). Unless otherwise specified,

partnership income equals partnership

expenses (other than depreciation

deductions for contributed property) for

each year of the partnership, the fair

market value of partnership property

does not change, all distributions by the

partnership are subject to section

704(c)(1)(B), and all partners are

unrelated.

Example. Distribution of like-kind

property. (i) On January 1, 1995, A, B, and

C form partnership ABC as equal partners. A

contributes Property A, nondepreciable real

property with a fair market value of $20,000

and an adjusted tax basis of $10,000. B and

C each contribute $20,000 cash. The

partnership subsequently buys Property X,

nondepreciable real property of a like-kind to

Property A with a fair market value and

adjusted tax basis of $8,000. The fair market

value of Property X subsequently increases to

$10,000.

(ii) On December 31, 1998, Property A is

distributed to B in a current distribution. At

the same time, Property X is distributed to A

in a current distribution. The distribution of

Property X does not result in the contribution

of Property A being properly characterized as

a disguised sale to the partnership under

§ 1.707–3. A’s basis in Property X is $8,000

under section 732(a)(1). A therefore has

$2,000 of built-in gain in Property X ($10,000

fair market value less $8,000 adjusted tax

basis).

(iii) A would generally recognize $10,000

of gain under section 704(c)(1)(B) on the

distribution of Property A, the difference

between the fair market value ($20,000) of

the property and its adjusted tax basis

($10,000). This gain is reduced, however, by

the amount of the built-in gain of Property X

in the hands of A. As a result, A recognizes

only $8,000 of gain on the distribution of

Property A to B under section 704(c)(1)(B)

and this section.

(e) Basis adjustments—(1)

Contributing partner’s basis in the

partnership interest. The basis of the

contributing partner’s interest in the

partnership is increased by the amount

of the gain, or decreased by the amount

of the loss, recognized by the partner

under section 704(c)(1)(B) and this

section. This increase or decrease is

taken into account in determining (i) the

contributing partner’s adjusted tax basis

under section 732 for any property

distributed to the partner in a

distribution that is part of the same

distribution as the distribution of the

contributed property, other than likekind property described in paragraph

(d)(3) of this section (pertaining to the

special rule for distributions of like-kind

property), and (ii) the amount of the

gain recognized by the contributing

partner under section 731 or section

737, if any, on a distribution of money

or property to the contributing partner

that is part of the same distribution as

the distribution of the contributed

property. For a determination of basis in

a distribution subject to section 737, see

§ 1.737–3(a).

(2) Partnership’s basis in partnership

property. The partnership’s adjusted tax

basis in the distributed section 704(c)

property is increased or decreased

immediately before the distribution by

the amount of gain or loss recognized by

the contributing partner under section

704(c)(1)(B) and this section. Any

increase or decrease in basis is therefore

taken into account in determining the

distributee partner’s adjusted tax basis

in the distributed property under

section 732. For a determination of basis

in a distribution subject to section 737,

see § 1.737–3(b).

(3) Section 754 adjustments. The basis

adjustments to partnership property

made pursuant to paragraph (e)(2) of

this section are not elective and must be

made regardless of whether the

partnership has an election in effect

under section 754. Any adjustments to

the bases of partnership property

(including the distributed section 704(c)

property) under section 734(b) pursuant

to a section 754 election must be made

after (and must take into account) the

adjustments to basis made under

paragraph (e)(2) of this section. See

§ 1.737–3(c)(4) for a similar rule in the

context of section 737.

(4) Example. The following example

illustrates the rules of this paragraph (e).

Unless otherwise specified, partnership

income equals partnership expenses

(other than depreciation deductions for

contributed property) for each year of

the partnership, the fair market value of

partnership property does not change,

all distributions by the partnership are

subject to section 704(c)(1)(B), and all

partners are unrelated.

Example. Basis adjustment. On January 1,

1995, A, B, and C form partnership ABC as

equal partners. A contributes $10,000 cash

and Property A, nondepreciable real property

with a fair market value of $10,000 and an

adjusted tax basis of $4,000. B and C each

contribute $20,000 cash.

(ii) On December 31, 1998, Property A is

distributed to B in a current distribution.

(iii) Under paragraph (a) of this section, A

recognizes $6,000 of gain on the distribution

of Property A because that is the amount of

gain that would have been allocated to A

under section 704(c)(1)(A) and § 1.704–3 on

a sale of Property A for its fair market value

at the time of the distribution (fair market

value of Property A ($10,000) less its
Federal Register / Vol. 60, No. 247 / Tuesday, December 26, 1995 / Rules and Regulations 66733

adjusted tax basis at the time of distribution

($4,000)). The adjusted tax basis of A’s

partnership interest is increased from

$14,000 to $20,000 to reflect this gain. The

partnership’s adjusted tax basis in Property A

is increased from $4,000 to $10,000

immediately prior to its distribution to B. B’s

adjusted tax basis in Property A is therefore

$10,000 under section 732(a)(1).

(f) Anti-abuse rule—(1) In general.

The rules of section 704(c)(1)(B) and

this section must be applied in a

manner consistent with the purpose of

section 704(c)(1)(B). Accordingly, if a

principal purpose of a transaction is to

achieve a tax result that is inconsistent

with the purpose of section 704(c)(1)(B),

the Commissioner can recast the

transaction for federal tax purposes as

appropriate to achieve tax results that

are consistent with the purpose of

section 704(c)(1)(B) and this section.

Whether a tax result is inconsistent with

the purpose of section 704(c)(1)(B) and

this section must be determined based

on all the facts and circumstances. See

§ 1.737–4 for an anti-abuse rule and

examples in the context of section 737.

(2) Examples. The following examples

illustrate the anti-abuse rule of this

paragraph (f). The examples set forth

below do not delineate the boundaries

of either permissible or impermissible

types of transactions. Further, the

addition of any facts or circumstances

that are not specifically set forth in an

example (or the deletion of any facts or

circumstances) may alter the outcome of

the transaction described in the

example. Unless otherwise specified,

partnership income equals partnership

expenses (other than depreciation

deductions for contributed property) for

each year of the partnership, the fair

market value of partnership property

does not change, all distributions by the

partnership are subject to section

704(c)(1)(B), and all partners are

unrelated.

Example 1. Distribution in substance made

within five-year period; results inconsistent

with the purpose of section 704(c)(1)(B). (i)

On January 1, 1995, A, B, and C form

partnership ABC as equal partners. A

contributes Property A, nondepreciable real

property with a fair market value of $10,000

and an adjusted tax basis of $1,000. B and C

each contributes $10,000 cash.

(ii) On December 31, 1998, the partners

desire to distribute Property A to B in

complete liquidation of B’s interest in the

partnership. If Property A were distributed at

that time, however, A would recognize

$9,000 of gain under section 704(c)(1)(B), the

difference between the $10,000 fair market

value and the $1,000 adjusted tax basis of

Property A, because Property A was

contributed to the partnership less than five

years before December 31, 1998. On

becoming aware of this potential gain

recognition, and with a principal purpose of

avoiding such gain, the partners amend the

partnership agreement on December 31,

1998, and take any other steps necessary to

provide that substantially all of the economic

risks and benefits of Property A are borne by

B as of December 31, 1998, and that

substantially all of the economic risks and

benefits of all other partnership property are

borne by A and C. The partnership holds

Property A until January 5, 2000, at which

time it is distributed to B in complete

liquidation of B’s interest in the partnership.

(iii) The actual distribution of Property A

occurred more than five years after the

contribution of the property to the

partnership. The steps taken by the

partnership on December 31, 1998, however,

are the functional equivalent of an actual

distribution of Property A to B in complete

liquidation of B’s interest in the partnership

as of that date. Section 704(c)(1)(B) requires

recognition of gain when contributed section

704(c) property is in substance distributed to

another partner within five years of its

contribution to the partnership. Allowing a

contributing partner to avoid section

704(c)(1)(B) through arrangements such as

those in this Example 1 that have the effect

of a distribution of property within five years

of the date of its contribution to the

partnership would effectively undermine the

purpose of section 704(c)(1)(B) and this

section. As a result, the steps taken by the

partnership on December 31, 1998, are

treated as causing a distribution of Property

A to B for purposes of section 704(c)(1)(B) on

that date, and A recognizes gain of $9,000

under section 704(c)(1)(B) and this section at

that time.

(iv) Alternatively, if on becoming aware of

the potential gain recognition to A on a

distribution of Property A on December 31,

1998, the partners had instead agreed that B

would continue as a partner with no changes

to the partnership agreement or to B’s

economic interest in partnership operations,

the distribution of Property A to B on January

5, 2000, would not have been inconsistent

with the purpose of section 704(c)(1)(B) and

this section. In that situation, Property A

would not have been distributed until after

the expiration of the five-year period

specified in section 704(c)(1)(B) and this

section. Deferring the distribution of Property

A until the end of the five-year period for a

principal purpose of avoiding the recognition

of gain under section 704(c)(1)(B) and this

section is not inconsistent with the purpose

of section 704(c)(1)(B). Therefore, A would

not have recognized gain on the distribution

of Property A in that case.

Example 2. Suspension of five-year period

in manner consistent with the purpose of

section 704(c)(1)(B). (i) A, B, and C form

partnership ABC on January 1, 1995, to

conduct bona fide business activities. A

contributes Property A, nondepreciable real

property with a fair market value of $10,000

and an adjusted tax basis of $1,000, in

exchange for a 49.5 percent interest in

partnership capital and profits. B contributes

$10,000 in cash for a 49.5 percent interest in

partnership capital and profits. C contributes

cash for a 1 percent interest in partnership

capital and profits. A and B are wholly

owned subsidiaries of the same affiliated

group and continue to control the

management of Property A by virtue of their

controlling interests in the partnership. The

partnership is formed pursuant to a plan a

principal purpose of which is to minimize

the period of time that A would have to

remain a partner with a potential acquiror of

Property A.

(ii) On December 31, 1997, D is admitted

as a partner to the partnership in exchange

for $10,000 cash.

(iii) On January 5, 2000, Property A is

distributed to D in complete liquidation of

D’s interest in the partnership.

(iv) The distribution of Property A to D

occurred more than five years after the

contribution of the property to the

partnership. On these facts, however, a

principal purpose of the transaction was to

minimize the period of time that A would

have to remain partners with a potential

acquiror of Property A, and treating the fiveyear period of section 704(c)(1)(B) as running

during a time when Property A was still

effectively owned through the partnership by

members of the contributing affiliated group

of which A is a member is inconsistent with

the purpose of section 704(c)(1)(B). Prior to

the admission of D as a partner, the pooling

of assets between A and B, on the one hand,

and C, on the other hand, although sufficient

to constitute ABC as a valid partnership for

federal income tax purposes, is not a

sufficient pooling of assets for purposes of

running the five-year period with respect to

the distribution of Property A to D. Allowing

a contributing partner to avoid section

704(c)(1)(B) through arrangements such as

those in this Example 2 would have the effect

of substantially nullifying the five-year

requirement of section 704(c)(1)(B) and this

section and elevating the form of the

transaction over its substance. As a result,

with respect to the distribution of Property A

to D, the five-year period of section

704(c)(1)(B) is tolled until the admission of

D as a partner on December 31, 1997.

Therefore, the distribution of Property A

occurred before the end of the five-year

period of section 704(c)(1)(B), and A

recognizes gain of $9,000 under section

704(c)(1)(B) on the distribution.

(g) Effective date. This section applies

to distributions by a partnership to a

partner on or after January 9, 1995.

Par. 3. Sections 1.737–1, 1.737–2,

1.737–3, 1.737–4, and 1.737–5 are

added to read as follows:

§ 1.737–1 Recognition of precontribution

gain.

(a) Determination of gain—(1) In

general. A partner that receives a

distribution of property (other than

money) must recognize gain under

section 737 and this section in an

amount equal to the lesser of the excess

distribution (as defined in paragraph (b)

of this section) or the partner’s net

precontribution gain (as defined in

paragraph (c) of this section). Gain

recognized under section 737 and this

section is in addition to any gain

recognized under section 731.
66734 Federal Register / Vol. 60, No. 247 / Tuesday, December 26, 1995 / Rules and Regulations

(2) Transactions to which section 737

applies. Section 737 and this section

apply only to the extent that a

distribution by a partnership is a

distribution to a partner acting in the

capacity of a partner within the meaning

of section 731, except that section 737

and this section do not apply to the

extent that section 751(b) applies to the

distribution.

(b) Excess distribution—(1) Definition.

The excess distribution is the amount (if

any) by which the fair market value of

the distributed property (other than

money) exceeds the distributee partner’s

adjusted tax basis in the partner’s

partnership interest.

(2) Fair market value of property. The

fair market value of the distributed

property is the price at which the

property would change hands between

a willing buyer and a willing seller at

the time of the distribution, neither

being under any compulsion to buy or

sell and both having reasonable

knowledge of the relevant facts. The fair

market value that a partnership assigns

to distributed property will be regarded

as correct, provided that the value is

reasonably agreed to among the partners

in an arm’s-length negotiation and the

partners have sufficiently adverse

interests.

(3) Distributee partner’s adjusted tax

basis—(i) General rule. In determining

the amount of the excess distribution,

the distributee partner’s adjusted tax

basis in the partnership interest

includes any basis adjustment resulting

from the distribution that is subject to

section 737 (for example, adjustments

required under section 752) and from

any other distribution or transaction

that is part of the same distribution,

except for—

(A) The increase required under

section 737(c)(1) for the gain recognized

by the partner under section 737; and

(B) The decrease required under

section 733(2) for any property

distributed to the partner other than

property previously contributed to the

partnership by the distributee partner.

See § 1.704–4(e)(1) for a rule in the

context of section 704(c)(1)(B). See also

§ 1.737–3(b)(2) for a special rule for

determining a partner’s adjusted tax

basis in distributed property previously

contributed by the partner to the

partnership.

(ii) Advances or drawings. The

distributee partner’s adjusted tax basis

in the partnership interest is determined

as of the last day of the partnership’s

taxable year if the distribution to which

section 737 applies is properly

characterized as an advance or drawing

against the partner’s distributive share

of income. See § 1.731–1(a)(1)(ii).

(c) Net precontribution gain—(1)

General rule. The distributee partner’s

net precontribution gain is the net gain

(if any) that would have been

recognized by the distributee partner

under section 704(c)(1)(B) and § 1.704–

4 if all property that had been

contributed to the partnership by the

distributee partner within five years of

the distribution and is held by the

partnership immediately before the

distribution had been distributed by the

partnership to another partner other

than a partner who owns, directly or

indirectly, more than 50 percent of the

capital or profits interest in the

partnership. See § 1.704–4 for

provisions determining a contributing

partner’s gain or loss under section

704(c)(1)(B) on an actual distribution of

contributed section 704(c) property to

another partner.

(2) Special rules—(i) Property

contributed on or before October 3,

1989. Property contributed to the

partnership on or before October 3,

1989, is not taken into account in

determining a partner’s net

precontribution gain. See § 1.704–4(c)(1)

for a similar rule in the context of

section 704(c)(1)(B).

(ii) Section 734(b)(1)(A) adjustments.

For distributions to a distributee partner

of money by a partnership with a

section 754 election in effect that are

part of the same distribution as the

distribution of property subject to

section 737, for purposes of paragraph

(a) and (c)(1) of this section the

distributee partner’s net precontribution

gain is reduced by the basis adjustments

(if any) made to section 704(c) property

contributed by the distributee partner

under section 734(b)(1)(A). See § 1.737–

3(c)(4) for rules regarding basis

adjustments for partnerships with a

section 754 election in effect.

(iii) Transfers of a partnership

interest. The transferee of all or a

portion of a contributing partner’s

partnership interest succeeds to the

transferor’s net precontribution gain, if

any, in an amount proportionate to the

interest transferred. See § 1.704–3(a)(7)

and § 1.704–4(d)(2) for similar

provisions in the context of section

704(c)(1)(A) and section 704(c)(1)(B).

(iv) Section 704(c)(1)(B) gain

recognized in related distribution. A

distributee partner’s net precontribution

gain is determined after taking into

account any gain or loss recognized by

the partner under section 704(c)(1)(B)

and § 1.704–4 (or that would have been

recognized by the partner except for the

like-kind exception in section 704(c)(2)

and § 1.704–4(d)(3)) on an actual

distribution to another partner of

section 704(c) property contributed by

the distributee partner that is part of the

same distribution as the distribution to

the distributee partner.

(v) Section 704(c)(2) disregarded. A

distributee partner’s net precontribution

gain is determined without regard to the

provisions of section 704(c)(2) and

§ 1.704–4(d)(3) in situations in which

the property contributed by the

distributee partner is not actually

distributed to another partner in a

distribution related to the section 737

distribution.

(d) Character of gain. The character of

the gain recognized by the distributee

partner under section 737 and this

section is determined by, and is

proportionate to, the character of the

partner’s net precontribution gain. For

this purpose, all gains and losses on

section 704(c) property taken into

account in determining the partner’s net

precontribution gain are netted

according to their character. Character is

determined at the partnership level for

this purpose, and any character with a

net negative amount is disregarded. The

character of the partner’s gain under

section 737 is the same as, and in

proportion to, any character with a net

positive amount. Character for this

purpose is determined as if the section

704(c) property had been sold by the

partnership to an unrelated third party

at the time of the distribution and

includes any item that would have been

taken into account separately by the

contributing partner under section

702(a) and § 1.702–1(a).

(e) Examples. The following examples

illustrate the provisions of this section.

Unless otherwise specified, partnership

income equals partnership expenses

(other than depreciation deductions for

contributed property) for each year of

the partnership, the fair market value of

partnership property does not change,

all distributions by the partnership are

subject to section 737, and all partners

are unrelated.

Example 1. Calculation of excess

distribution and net precontribution gain. (i)

On January 1, 1995, A, B, and C form

partnership ABC as equal partners. A

contributes Property A, depreciable real

property with a fair market value of $30,000

and an adjusted tax basis of $20,000. B

contributes Property B, nondepreciable real

property with a fair market value and

adjusted tax basis of $30,000. C contributes

$30,000 cash.

(ii) Property A has 10 years remaining on

its cost recovery schedule and is depreciated

using the straight-line method. The

partnership uses the traditional method for

allocating items under section 704(c)

described in § 1.704–3(b)(1) for Property A.

The partnership has book depreciation of

$3,000 per year (10 percent of the $30,000

book basis in Property A) and each partner
Federal Register / Vol. 60, No. 247 / Tuesday, December 26, 1995 / Rules and Regulations 66735

is allocated $1,000 of book depreciation per

year (one-third of the total annual book

depreciation of $3,000). The partnership also

has tax depreciation of $2,000 per year (10

percent of the $20,000 adjusted tax basis in

Property A). This $2,000 tax depreciation is

allocated equally between B and C, the

noncontributing partners with respect to

Property A.

(iii) At the end of 1997, the book value of

Property A is $21,000 ($30,000 initial book

value less $9,000 aggregate book

depreciation) and its adjusted tax basis is

$14,000 ($20,000 initial tax basis less $6,000

aggregate tax depreciation).

(iv) On December 31, 1997, Property B is

distributed to A in complete liquidation of

A’s partnership interest. The adjusted tax

basis of A’s partnership interest at that time

is $20,000. The amount of the excess

distribution is $10,000, the difference

between the fair market value of the

distributed Property B ($30,000) and A’s

adjusted tax basis in A’s partnership interest

($20,000). A’s net precontribution gain is

$7,000, the difference between the book

value of Property A ($21,000) and its

adjusted tax basis at the time of the

distribution ($14,000). A recognizes gain of

$7,000 on the distribution, the lesser of the

excess distribution and the net

precontribution gain.

Example 2. Determination of distributee

partner’s basis. (i) On January 1, 1995, A, B,

and C form general partnership ABC as equal

partners. A contributes Property A,

nondepreciable real property with a fair

market value of $10,000 and an adjusted tax

basis of $4,000. B and C each contributes

$10,000 cash.

(ii) The partnership purchases Property B,

nondepreciable real property with a fair

market value of $9,000, subject to a $9,000

nonrecourse liability. This nonrecourse

liability is allocated equally among the

partners under section 752, increasing A’s

adjusted tax basis in A’s partnership interest

from $4,000 to $7,000.

(iii) On December 31, 1998, A receives

$2,000 cash and Property B, subject to the

$9,000 liability, in a current distribution.

(iv) In determining the amount of the

excess distribution, the adjusted tax basis of

A’s partnership interest is adjusted to take

into account the distribution of money and

the shift in liabilities. A’s adjusted tax basis

is therefore increased to $11,000 for this

purpose ($7,000 initial adjusted tax basis,

less $2,000 distribution of money, less $3,000

(decrease in A’s share of the $9,000

partnership liability), plus $9,000 (increase

in A’s individual liabilities)). As a result of

this basis adjustment, the adjusted tax basis

of A’s partnership interest ($11,000) is greater

than the fair market value of the distributed

property ($9,000) and therefore, there is no

excess distribution. A recognizes no gain

under section 737.

Example 3. Net precontribution gain

reduced for gain recognized under section

704(c)(1)(B). (i) On January 1, 1995, A, B, and

C form partnership ABC as equal partners. A

contributes Properties A1 and A2,

nondepreciable real properties located in the

United States each with a fair market value

of $10,000 and an adjusted tax basis of

$6,000. B contributes Property B,

nondepreciable real property located outside

the United States, with a fair market value

and adjusted tax basis of $20,000. C

contributes $20,000 cash.

(ii) On December 31, 1998, Property B is

distributed to A in complete liquidation of

A’s interest and, as part of the same

distribution, Property A1 is distributed to B

in a current distribution.

(iii) A’s net precontribution gain before the

distribution is $8,000 ($20,000 fair market

value of Properties A1 and A2 less $12,000

adjusted tax basis of such properties). A

recognizes $4,000 of gain under section

704(c)(1)(B) and § 1.704–4 on the distribution

of Property A1 to B ($10,000 fair market

value of Property A1 less $6,000 adjusted tax

basis of Property A1). This gain is taken into

account in determining A’s excess

distribution and net precontribution gain. As

a result, A’s net precontribution gain is

reduced from $8,000 to $4,000, and the

adjusted tax basis in A’s partnership interest

is increased by $4,000 to $16,000.

(iv) A recognizes gain of $4,000 on the

receipt of Property B under section 737, an

amount equal to the lesser of the excess

distribution of $4,000 ($20,000 fair market

value of Property B less $16,000 adjusted tax

basis of A’s interest in the partnership) and

A’s remaining net precontribution gain of

$4,000.

Example 4. Character of gain. (i) On

January 1, 1995, A, B, and C form partnership

ABC as equal partners. A contributes the

following nondepreciable property to the

partnership:

Fair market valueAdjusted

tax basis

Property A1 ............... $30,000 $20,000

Property A2 ............... 30,000 38,000

Property A3 ............... 10,000 9,000

(ii) The character of gain or loss on

Property A1 and Property A2 is long-term,

U.S.-source capital gain or loss. The character

of gain on Property A3 is long-term, foreignsource capital gain. B contributes Property B,

nondepreciable real property with a fair

market value and adjusted tax basis of

$70,000. C contributes $70,000 cash.

(iii) On December 31, 1998, Property B is

distributed to A in complete liquidation of

A’s interest in the partnership. A recognizes

$3,000 of gain under section 737, an amount

equal to the excess distribution of $3,000

($70,000 fair market value of Property B less

$67,000 adjusted tax basis in A’s partnership

interest) and A’s net precontribution gain of

$3,000 ($70,000 aggregate fair market value of

properties contributed by A less $67,000

aggregate adjusted tax basis of such

properties).

(iv) In determining the character of A’s

gain, all gains and losses on property taken

into account in determining A’s net

precontribution gain are netted according to

their character and allocated to A’s

recognized gain under section 737 based on

the relative proportions of the net positive

amounts. U.S.-source and foreign-source

gains must be netted separately because A

would have been required to take such gains

into account separately under section 702. As

a result, A’s net precontribution gain of

$3,000 consists of $2,000 of net long-term,

U.S.-source capital gain ($10,000 gain on

Property A1 and $8,000 loss on Property A2)

and $1,000 of net long-term, foreign-source

capital gain ($1,000 gain on Property A3).

(v) The character of A’s gain under

paragraph (d) of this section is therefore

$2,000 long-term, U.S.-source capital gain

($3,000 gain recognized under section 737 ×

$2,000 net long-term, U.S.-source capital

gain/$3,000 total net precontribution gain)

and $1,000 long-term, foreign-source capital

gain ($3,000 gain recognized under section

737 × $1,000 net long-term, foreign-source

capital gain/$3,000 total net precontribution

gain).

§ 1.737–2 Exceptions and special rules.

(a) Section 708(b)(1)(B) terminations.

Section 737 and this section do not

apply to a deemed distribution of

property caused by a termination of the

partnership under section 708(b)(1)(B).

See § 1.704–4(c)(3) for a similar rule in

the context of section 704(c)(1)(B).

(b) Transfers to another partnership—

(1) Complete transfer. Section 737 and

this section do not apply to a transfer by

a partnership (transferor partnership) of

all of its assets and liabilities to a

second partnership (transferee

partnership) in an exchange described

in section 721, followed by a

distribution of the interest in the

transferee partnership in liquidation of

the transferor partnership as part of the

same plan or arrangement. See § 1.704–

4(c)(4) for a similar rule in the context

of section 704(c)(1)(B).

(2) Certain divisive transactions.

Section 737 and this section do not

apply to a transfer by a partnership

(transferor partnership) of all of the

section 704(c) property contributed by a

partner to a second partnership

(transferee partnership) in an exchange

described in section 721, followed by a

distribution as part of the same plan or

arrangement of an interest in the

transferee partnership (and no other

property) in complete liquidation of the

interest of the partner that originally

contributed the section 704(c) property

to the transferor partnership.

(3) Subsequent distributions. A

subsequent distribution of property by

the transferee partnership to a partner of

the transferee partnership that was

formerly a partner of the transferor

partnership is subject to section 737 to

the same extent that a distribution from

the transferor partnership would have

been subject to section 737.

(c) Incorporation of a partnership.

Section 737 and this section do not

apply to an incorporation of a

partnership by any method of

incorporation (other than a method

involving an actual distribution of
66736 Federal Register / Vol. 60, No. 247 / Tuesday, December 26, 1995 / Rules and Regulations

partnership property to the partners

followed by a contribution of that

property to a corporation), provided that

the partnership is liquidated as part of

the incorporation transaction. See

§ 1.704–4(c)(5) for a similar rule in the

context of section 704(c)(1)(B).

(d) Distribution of previously

contributed property—(1) General rule.

Any portion of the distributed property

that consists of property previously

contributed by the distributee partner

(including property treated as

contributed by the partner in connection

with a termination of the partnership

under section 708(b)(1)(B)) (previously

contributed property) is not taken into

account in determining the amount of

the excess distribution or the partner’s

net precontribution gain. See § 1.737–

3(b)(2) for a special rule for determining

the basis of previously contributed

property in the hands of a distributee

partner who contributed the property to

the partnership.

(2) Limitation for distribution of

previously contributed interest in an

entity. An interest in an entity

previously contributed to the

partnership is not treated as previously

contributed property to the extent that

the value of the interest is attributable

to property contributed to the entity

after the interest was contributed to the

partnership. The preceding sentence

does not apply to the extent that the

property contributed to the entity was

contributed to the partnership by the

partner that also contributed the interest

in the entity to the partnership.

(3) Nonrecognition transactions.

Property received by the partnership in

exchange for contributed section 704(c)

property in a nonrecognition transaction

is treated as the contributed property

with regard to the contributing partner

for purposes of section 737 to the extent

that the property received is treated as

section 704(c) property under § 1.704–

3(a)(8). See § 1.704–4(d)(1) for a similar

rule in the context of section

704(c)(1)(B).

(4) Undivided interests. The

distribution of an undivided interest in

property is treated as the distribution of

previously contributed property to the

extent that the undivided interest does

not exceed the undivided interest, if

any, contributed by the distributee

partner in the same property. See

§ 1.704–4(c)(6) for the application of

section 704(c)(1)(B) in a similar context.

The portion of the undivided interest in

property retained by the partnership

after the distribution, if any, that is

treated as contributed by the distributee

partner, is reduced to the extent of the

undivided interest distributed to the

distributee partner.

(e) Examples. The following examples

illustrate the rules of this section.

Unless otherwise specified, partnership

income equals partnership expenses

(other than depreciation deductions for

contributed property) for each year of

the partnership, the fair market value of

partnership property does not change,

all distributions by the partnership are

subject to section 737, and all partners

are unrelated.

Example 1. Distribution of previously

contributed property. (i) On January 1, 1995,

A, B, and C form partnership ABC as equal

partners. A contributes the following

nondepreciable real property to the

partnership:

Fair market valueAdjusted

tax basis

Property A1 ............... $20,000 $10,000

Property A2 ............... 10,000 6,000

(ii) A’s total net precontribution gain on

the contributed property is $14,000 ($10,000

on Property A1 plus $4,000 on Property A2).

B contributes $10,000 cash and Property B,

nondepreciable real property with a fair

market value and adjusted tax basis of

$20,000. C contributes $30,000 cash.

(iii) On December 31, 1998, Property A2

and Property B are distributed to A in

complete liquidation of A’s interest in the

partnership. Property A2 was previously

contributed by A and is therefore not taken

into account in determining the amount of

the excess distribution or A’s net

precontribution gain. The adjusted tax basis

of Property A2 in the hands of A is also

determined under section 732 as if that

property were the only property distributed

to A.

(iv) As a result of excluding Property A2

from these determinations, the amount of the

excess distribution is $10,000 ($20,000 fair

market value of distributed Property B less

$10,000 adjusted tax basis in A’s partnership

interest). A’s net precontribution gain is also

$10,000 ($14,000 total net precontribution

gain less $4,000 gain with respect to

previously contributed Property A2). A

therefore recognizes $10,000 of gain on the

distribution, the lesser of the excess

distribution and the net precontribution gain.

Example 2. Distribution of a previously

contributed interest in an entity. (i) On

January 1, 1995, A, B, and C form partnership

ABC as equal partners. A contributes

Property A, nondepreciable real property

with a fair market value of $10,000 and an

adjusted tax basis of $5,000, and all of the

stock of Corporation X with a fair market

value and adjusted tax basis of $500. B

contributes $500 cash and Property B,

nondepreciable real property with a fair

market value and adjusted tax basis of

$10,000. Partner C contributes $10,500 cash.

On December 31, 1996, ABC contributes

Property B to Corporation X in a

nonrecognition transaction under section

351.

(ii) On December 31, 1998, all of the stock

of Corporation X is distributed to A in

complete liquidation of A’s interest in the

partnership. The stock is treated as

previously contributed property with respect

to A only to the extent of the $500 fair market

value of the Corporation X stock contributed

by A. The fair market value of the distributed

stock for purposes of determining the amount

of the excess distribution is therefore $10,000

($10,500 total fair market value of

Corporation X stock less $500 portion treated

as previously contributed property). The

$500 fair market value and adjusted tax basis

of the Corporation X stock is also not taken

into account in determining the amount of

the excess distribution and the net

precontribution gain.

(iii) A recognizes $5,000 of gain under

section 737, the amount of the excess

distribution ($10,000 fair market value of

distributed property less $5,000 adjusted tax

basis in A’s partnership interest) and A’s net

precontribution gain ($10,000 fair market

value of Property A less $5,000 adjusted tax

basis in Property A).

Example 3. Distribution of undivided

interest in property. (i) On January 1, 1995,

A and B form partnership AB as equal

partners. A contributes $500 cash and an

undivided one-half interest in Property X. B

contributes $500 cash and an undivided onehalf interest in Property X.

(ii) On December 31, 1998, an undivided

one-half interest in Property X is distributed

to A in a current distribution. The

distribution of the undivided one-half

interest in Property X is treated as a

distribution of previously contributed

property because A contributed an undivided

one-half interest in Property X. As a result,

A does not recognize any gain under section

737 on the distribution.

§ 1.737–3 Basis adjustments; Recovery

rules.

(a) Distributee partner’s adjusted tax

basis in the partnership interest. The

distributee partner’s adjusted tax basis

in the partnership interest is increased

by the amount of gain recognized by the

distributee partner under section 737

and this section. This increase is not

taken into account in determining the

amount of gain recognized by the

partner under section 737(a)(1) and this

section or in determining the amount of

gain recognized by the partner under

section 731(a) on the distribution of

money in the same distribution or any

related distribution. See § 1.704–4(e)(1)

for a determination of the distributee

partner’s adjusted tax basis in a

distribution subject to section

704(c)(1)(B).

(b) Distributee partner’s adjusted tax

basis in distributed property—(1) In

general. The distributee partner’s

adjusted tax basis in the distributed

property is determined under section

732 (a) or (b) as applicable. The increase

in the distributee partner’s adjusted tax

basis in the partnership interest under

paragraph (a) of this section is taken

into account in determining the

distributee partner’s adjusted tax basis
Federal Register / Vol. 60, No. 247 / Tuesday, December 26, 1995 / Rules and Regulations 66737

in the distributed property other than

property previously contributed by the

partner. See § 1.704–4(e)(2) for a

determination of basis in a distribution

subject to section 704(c)(1)(B).

(2) Previously contributed property.

The distributee partner’s adjusted tax

basis in distributed property that the

partner previously contributed to the

partnership is determined as if it were

distributed in a separate and

independent distribution prior to the

distribution that is subject to section

737 and § 1.737–1.

(c) Partnership’s adjusted tax basis in

partnership property—(1) Increase in

basis. The partnership’s adjusted tax

basis in eligible property is increased by

the amount of gain recognized by the

distributee partner under section 737.

(2) Eligible property. Eligible property

is property that——

(i) Entered into the calculation of the

distributee partner’s net precontribution

gain;

(ii) Has an adjusted tax basis to the

partnership less than the property’s fair

market value at the time of the

distribution;

(iii) Would have the same character of

gain on a sale by the partnership to an

unrelated party as the character of any

of the gain recognized by the distributee

partner under section 737; and

(iv) Was not distributed to another

partner in a distribution subject to

section 704(c)(1)(B) and § 1.704–4 that

was part of the same distribution as the

distribution subject to section 737.

(3) Method of adjustment. For the

purpose of allocating the basis increase

under paragraph (c)(2) of this section

among the eligible property, all eligible

property of the same character is treated

as a single group. Character for this

purpose is determined in the same

manner as the character of the

recognized gain is determined under

§ 1.737–1(d). The basis increase is

allocated among the separate groups of

eligible property in proportion to the

character of the gain recognized under

section 737. The basis increase is then

allocated among property within each

group in the order in which the property

was contributed to the partnership by

the partner, starting with the property

contributed first, in an amount equal to

the difference between the property’s

fair market value and its adjusted tax

basis to the partnership at the time of

the distribution. For property that has

the same character and was contributed

in the same (or a related) transaction,

the basis increase is allocated based on

the respective amounts of unrealized

appreciation in such properties at the

time of the distribution.

(4) Section 754 adjustments. The basis

adjustments to partnership property

made pursuant to paragraph (c)(1) of

this section are not elective and must be

made regardless of whether the

partnership has an election in effect

under section 754. Any adjustments to

the bases of partnership property

(including eligible property as defined

in paragraph (c)(2) of this section) under

section 734(b) pursuant to a section 754

election (other than basis adjustments

under section 734(b)(1)(A) described in

the following sentence) must be made

after (and must take into account) the

adjustments to basis made under

paragraph (a) and paragraph (c)(1) of

this section. Basis adjustments under

section 734(b)(1)(A) that are attributable

to distributions of money to the

distributee partner that are part of the

same distribution as the distribution of

property subject to section 737 are made

before the adjustments to basis under

paragraph (a) and paragraph (c)(1) of

this section. See § 1.737–1(c)(2)(ii) for

the effect, if any, of basis adjustments

under section 734(b)(1)(A) on a partner’s

net precontribution gain. See also

§ 1.704–4(e)(3) for a similar rule

regarding basis adjustments pursuant to

a section 754 election in the context of

section 704(c)(1)(B).

(d) Recovery of increase to adjusted

tax basis. Any increase to the adjusted

tax basis of partnership property under

paragraph (c)(1) of this section is

recovered using any applicable recovery

period and depreciation (or other cost

recovery) method (including first-year

conventions) available to the

partnership for newly purchased

property (of the type adjusted) placed in

service at the time of the distribution.

(e) Examples. The following examples

illustrate the rules of this section.

Unless otherwise specified, partnership

income equals partnership expenses

(other than depreciation deductions for

contributed property) for each year of

the partnership, the fair market value of

partnership property does not change,

all distributions by the partnership are

subject to section 737, and all partners

are unrelated.

(e) Example 1. Partner’s basis in

distributed property. (i) On January 1, 1995,

A, B, and C form partnership ABC as equal

partners. A contributes Property A,

nondepreciable real property with a fair

market value of $10,000 and an adjusted tax

basis of $5,000. B contributes Property B,

nondepreciable real property with a fair

market value and adjusted tax basis of

$10,000. C contributes $10,000 cash.

(ii) On December 31, 1998, Property B is

distributed to A in complete liquidation of

A’s interest in the partnership. A recognizes

$5,000 of gain under section 737, an amount

equal to the excess distribution of $5,000

($10,000 fair market value of Property B less

$5,000 adjusted tax basis in A’s partnership

interest) and A’s net precontribution gain of

$5,000 ($10,000 fair market value of Property

A less $5,000 adjusted tax basis of such

property).

(iii) A’s adjusted tax basis in A’s

partnership interest is increased by the

$5,000 of gain recognized under section 737.

This increase is taken into account in

determining A’s basis in the distributed

property. Therefore, A’s adjusted tax basis in

distributed Property B is $10,000 under

section 732(b).

Example 2. Partner’s basis in distributed

property in connection with gain recognized

under section 704(c)(1)(B). (i) On January 1,

1995, A, B, and C form partnership ABC as

equal partners. A contributes the following

nondepreciable real property to the

partnership:

Fair market valueAdjusted

tax basis

Property A1 ............... $10,000 5,000

Property A2 ............... 10,000 2,000

(ii) B contributes $10,000 cash and

Property B, nondepreciable real property,

with a fair market value and adjusted tax

basis of $10,000. C contributes $20,000 cash.

(iii) On December 31, 1998, Property B is

distributed to A in a current distribution and

Property A1 is distributed to B in a current

distribution. A recognizes $5,000 of gain

under section 704(c)(1)(B) and § 1.704–4 on

the distribution of Property A1 to B, the

difference between the fair market value of

such property ($10,000) and the adjusted tax

basis in distributed Property A1 ($5,000). The

adjusted tax basis of A’s partnership interest

is increased by this $5,000 of gain under

section 704(c)(1)(B) and § 1.704–4(e)(1).

(iv) The increase in the adjusted tax basis

of A’s partnership interest is taken into

account in determining the amount of the

excess distribution. As a result, there is no

excess distribution because the fair market

value of Property B ($10,000) is less than the

adjusted tax basis of A’s interest in the

partnership at the time of distribution

($12,000). A therefore recognizes no gain

under section 737 on the receipt of Property

B. A’s adjusted tax basis in Property B is

$10,000 under section 732(a)(1). The adjusted

tax basis of A’s partnership interest is

reduced from $12,000 to $2,000 under

section 733. See Example 3 of § 1.737–1(e).

Example 3. Partnership’s basis in

partnership property after a distribution with

section 737 gain. (i) On January 31, 1995, A,

B, and C form partnership ABC as equal

partners. A contributes the following

nondepreciable property to the partnership:

Fair market valueAdjusted

tax basis

Property A1 ............... $1,000 $500

Property A2 ............... 4,000 1,500

Property A3 ............... 4,000 6,000

Property A4 ............... 6,000 4,000

(ii) The character of gain or loss on

Properties A1, A2, and A3 is long-term, U.S.-
66738 Federal Register / Vol. 60, No. 247 / Tuesday, December 26, 1995 / Rules and Regulations

source capital gain or loss. The character of

gain on Property A4 is long-term, foreignsource capital gain. B contributes Property B,

nondepreciable real property with a fair

market value and adjusted tax basis of

$15,000. C contributes $15,000 cash.

(iii) On December 31, 1998, Property B is

distributed to A in complete liquidation of

A’s interest in the partnership. A recognizes

gain of $3,000 under section 737, an amount

equal to the excess distribution of $3,000

($15,000 fair market value of Property B less

$12,000 adjusted tax basis in A’s partnership

interest) and A’s net precontribution gain of

$3,000 ($15,000 aggregate fair market value of

the property contributed by A less $12,000

aggregate adjusted tax basis of such

property).

(iv) $2,000 of A’s gain is long-term, foreignsource capital gain ($3,000 total gain under

section 737 x $2,000 net long-term, foreignsource capital gain/$3,000 total net

precontribution gain). $1,000 of A’s gain is

long-term, U.S.-source capital gain ($3,000

total gain under section 737 x $1,000 net

long-term, U.S.-source capital gain/$3,000

total net precontribution gain).

(v) The partnership must increase the

adjusted tax basis of the property contributed

by A by $3,000. All property contributed by

A is eligible property. Properties A1, A2, and

A3 have the same character and are grouped

into a single group for purposes of allocating

this basis increase. Property A4 is in a

separate character group.

(vi) $2,000 of the basis increase must be

allocated to long-term, foreign-source capital

assets because $2,000 of the gain recognized

by A was long-term, foreign-source capital

gain. The adjusted tax basis of Property A4

is therefore increased from $4,000 to $6,000.

$1,000 of the increase must be allocated to

Properties A1 and A2 because $1,000 of the

gain recognized by A is long-term, U.S.-

source capital gain. No basis increase is

allocated to Property A3 because its fair

market value is less than its adjusted tax

basis. The $1,000 basis increase is allocated

between Properties A1 and A2 based on the

unrealized appreciation in each asset before

such basis adjustment. As a result, the

adjusted tax basis of Property A1 is increased

by $167 ($1,000 x $500/$3,000) and the

adjusted tax basis of Property A2 is increased

by $833 ($1,000 x $2,500/3,000).

§ 1.737–4 Anti-abuse rule.

(a) In general. The rules of section 737

and §§ 1.737–1, 1.737–2, and 1.737–3

must be applied in a manner consistent

with the purpose of section 737.

Accordingly, if a principal purpose of a

transaction is to achieve a tax result that

is inconsistent with the purpose of

section 737, the Commissioner can

recast the transaction for federal tax

purposes as appropriate to achieve tax

results that are consistent with the

purpose of section 737. Whether a tax

result is inconsistent with the purpose

of section 737 must be determined

based on all the facts and

circumstances. See § 1.704–4(f) for an

anti-abuse rule and examples in the

context of section 704(c)(1)(B). The antiabuse rule and examples under section

704(c)(1)(B) and § 1.704–4(f) are relevant

to section 737 and §§ 1.737–1, 1.737–2,

and 1.737–3 to the extent that the net

precontribution gain for purposes of

section 737 is determined by reference

to section 704(c)(1)(B).

(b) Examples. The following examples

illustrate the rules of this section. The

examples set forth below do not

delineate the boundaries of either

permissible or impermissible types of

transactions. Further, the addition of

any facts or circumstances that are not

specifically set forth in an example (or

the deletion of any facts or

circumstances) may alter the outcome of

the transaction described in the

example. Unless otherwise specified,

partnership income equals partnership

expenses (other than depreciation

deductions for contributed property) for

each year of the partnership, the fair

market value of partnership property

does not change, all distributions by the

partnership are subject to section 737,

and all partners are unrelated.

Example 1. Increase in distributee

partner’s basis by temporary contribution;

results inconsistent with the purpose of

section 737. (i) On January 1, 1995, A, B, and

C form partnership ABC as equal partners. A

contributes Property A1, nondepreciable real

property with a fair market value of $10,000

and an adjusted tax basis of $1,000. B

contributes Property B, nondepreciable real

property with a fair market value of $10,000

and an adjusted tax basis of $10,000. C

contributes $10,000 cash.

(ii) On January 1, 1999, pursuant to a plan

a principal purpose of which is to avoid gain

under section 737, A transfers to the

partnership Property A2, nondepreciable real

property with a fair market value and

adjusted tax basis of $9,000. A treats the

transfer as a contribution to the partnership

pursuant to section 721 and increases the

adjusted tax basis of A’s partnership interest

from $1,000 to $10,000. On January 1, 1999,

the partnership agreement is amended and

all other necessary steps are taken so that

substantially all of the economic risks and

benefits of Property A2 are retained by A. On

February 1, 1999, Property B is distributed to

A in a current distribution. If the

contribution of Property A2 is treated as a

contribution to the partnership for purposes

of section 737, there is no excess distribution

because the fair market value of distributed

Property B ($10,000) does not exceed the

adjusted tax basis of A’s interest in the

partnership ($10,000), and therefore section

737 does not apply. A’s adjusted tax basis in

distributed Property B is $10,000 under

section 732(a)(1) and the adjusted tax basis

of A’s partnership interest is reduced to zero

under section 733.

(iii) On March 1, 2000, A receives Property

A2 from the partnership in complete

liquidation of A’s interest in the partnership.

A recognizes no gain on the distribution of

Property A2 because the property was

previously contributed property. See § 1.737–

2(d).

(iv) Although A has treated the transfer of

Property A2 as a contribution to the

partnership that increased the adjusted tax

basis of A’s interest in the partnership, it

would be inconsistent with the purpose of

section 737 to recognize the transfer as a

contribution to the partnership. Section 737

requires recognition of gain when the value

of distributed property exceeds the

distributee partner’s adjusted tax basis in the

partnership interest. Section 737 assumes

that any contribution or other transaction

that affects a partner’s adjusted tax basis in

the partnership interest is a contribution or

transaction in substance and is not engaged

in with a principal purpose of avoiding

recognition of gain under section 737.

Because the transfer of Property A2 to the

partnership was not a contribution in

substance and was made with a principal

purpose of avoiding recognition of gain

under section 737, the Commissioner can

disregard the contribution of Property A2 for

this purpose. As a result, A recognizes gain

of $9,000 under section 737 on the receipt of

Property B, an amount equal to the lesser of

the excess distribution of $9,000 ($10,000 fair

market value of distributed Property B less

the $1,000 adjusted tax basis of A’s

partnership interest, determined without

regard to the transitory contribution of

Property A2) or A’s net precontribution gain

of $9,000 on Property A1.

Example 2. Increase in distributee

partner’s basis; section 752 liability shift;

results consistent with the purpose of section

737. (i) On January 1, 1995, A and B form

general partnership AB as equal partners. A

contributes Property A, nondepreciable real

property with a fair market value of $10,000

and an adjusted tax basis of $1,000. B

contributes Property B, nondepreciable real

property with a fair market value and

adjusted tax basis of $10,000. The

partnership also borrows $10,000 on a

recourse basis and purchases Property C. The

$10,000 liability is allocated equally between

A and B under section 752, thereby

increasing the adjusted tax basis in A’s

partnership interest to $6,000.

(ii) On December 31, 1998, the partners

agree that A is to receive Property B in a

current distribution. If A were to receive

Property B at that time, A would recognize

$4,000 of gain under section 737, an amount

equal to the lesser of the excess distribution

of $4,000 ($10,000 fair market value of

Property B less $6,000 adjusted tax basis in

A’s partnership interest) or A’s net

precontribution gain of $9,000 ($10,000 fair

market value of Property A less $1,000

adjusted tax basis of Property A).

(iii) With a principal purpose of avoiding

such gain, A and B agree that A will be solely

liable for the repayment of the $10,000

partnership liability and take the steps

necessary so that the entire amount of the

liability is allocated to A under section 752.

The adjusted tax basis in A’s partnership

interest is thereby increased from $6,000 to

$11,000 to reflect A’s share of the $5,000 of

liability previously allocated to B. As a result

of this increase in A’s adjusted tax basis,

there is no excess distribution because the
Federal Register / Vol. 60, No. 247 / Tuesday, December 26, 1995 / Rules and Regulations 66739

fair market value of distributed Property B

($10,000) is less than the adjusted tax basis

of A’s partnership interest. Recognizing A’s

increased adjusted tax basis as a result of the

shift in liabilities is consistent with the

purpose of section 737 and this section.

Section 737 requires recognition of gain only

when the value of the distributed property

exceeds the distributee partner’s adjusted tax

basis in the partnership interest. The $10,000

recourse liability is a bona fide liability of the

partnership that was undertaken for a

substantial business purpose and A’s and B’s

agreement that A will assume responsibility

for repayment of that debt has substance.

Therefore, the increase in A’s adjusted tax

basis in A’s interest in the partnership due

to the shift in partnership liabilities under

section 752 is respected, and A recognizes no

gain under section 737.

§ 1.737–5 Effective date.

Sections 1.737–1, 1.737–2, 1.737–3,

and 1.737–4 apply to distributions by a

partnership to a partner on or after

January 9, 1995.

Dated: December 13, 1995.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

Approved:

Leslie Samuels,

Assistant Secretary of the Treasury.

[FR Doc. 95–30870 Filed 12–22–95; 8:45 am]

BILLING CODE 4830–01–U

26 CFR Parts 1 and 602

[TD 8638]

RIN 1545–AT44

Certain Transfers of Domestic Stock or

Securities by U.S. Persons to Foreign

Corporations

AGENCY: Internal Revenue Service (IRS),

Treasury.

ACTION: Temporary regulations.

SUMMARY: These temporary regulations

provide the public with guidance

necessary to comply with the Tax

Reform Act of 1984. These regulations

amend the Income Tax Regulations with

respect to certain transfers of stock or

securities of domestic corporations by

United States persons to foreign

corporations pursuant to the corporate

organization, reorganization, or

liquidation provisions of the Internal

Revenue Code. This Treasury decision

also removes certain of the existing

temporary regulations regarding

transfers by U.S. persons of stock or

securities of both domestic and foreign

corporations. This action is necessary to

update the existing temporary

regulations and to reflect certain of the

changes announced by Notice 87–85

(1987–2 C.B. 395) (with respect to

transfers of both domestic and foreign

stock or securities) and by Notice 94–46

(1994–1 C.B. 356) (with respect to

transfers of stock or securities of a

domestic corporation). The text of these

temporary regulations also serves as the

text of the proposed regulations set forth

in the notice of proposed rulemaking on

this subject in the Proposed Rules

section of this issue of the Federal

Register. When finalized, the

regulations under section 367(a) relating

to the transfer of stock or securities will

integrate the regulations herein with the

1991 proposed regulations relating to

transfers of stock or securities (see

Proposed Rule §§ 1.367(a)–3 and

1.367(a)–8, published at 56 FR 41993,

August 26, 1991).

EFFECTIVE DATE: April 17, 1994. For

further information, see the

Applicability and Effective Dates

section under SUPPLEMENTARY

INFORMATION.

FOR FURTHER INFORMATION CONTACT:

Philip L. Tretiak at (202) 622–3860 (not

a toll-free number).

SUPPLEMENTARY INFORMATION:

Applicability and Effective Dates

These regulations are generally

applicable to transfers occurring after

April 17, 1994, the effective date of

Notice 94–46. However, the active trade

or business requirement (described in

§ 1.367(a)–3T(c)(1)(iii) of the temporary

regulations herein), which was not

contained in Notice 94–46, is effective

for transfers occurring January 25, 1996.

Moreover, these regulations remove as

‘‘deadwood’’ paragraphs (c)(1) through

(c)(4), (d), (e), (f), (g)(1)(iii) and (h)(1) of

§ 1.367(a)–3T of the existing temporary

regulations with respect to transfers

occurring after December 16, 1987, the

effective date of Notice 87–85.

Paperwork Reduction Act

These regulations are being issued

without prior notice and public

procedure pursuant to the

Administrative Procedure Act (5 U.S.C.

553). For this reason, the collection of

information contained in these

regulations has been reviewed and,

pending receipt and evaluation of

public comments, approved by the

Office of Management and Budget under

control number 1545–1478. Responses

to this collection of information are

required in order for U.S. shareholders

that transfer stock or securities in

section 367(a) exchanges to qualify for

an exception to the general rule of

taxation under section 367(a)(1).

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.

For further information concerning

this collection of information, and

where to submit comments on the

collection of information and the

accuracy of the estimated burden, and

suggestions for reducing this burden,

please refer to the preamble to the crossreferencing notice of proposed

rulemaking published in the Proposed

Rules section of this issue of the Federal

Register. 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

On May 16, 1986, temporary and

proposed regulations under sections 367

(a) and (d) and section 6038B were

published in the Federal Register (51

FR 17936). These regulations were

published to provide the public with

guidance necessary to comply with

changes made to the Internal Revenue

Code by the Tax Reform Act of 1984.

Included in the 1986 temporary

regulations was § 1.367(a)–3T,

concerning transfers of stock or

securities of domestic or foreign

corporations by U.S. persons to foreign

corporations. Subsequently, the IRS and

the Treasury Department issued Notice

87–85 (1987–2 C.B. 395), which set forth

substantial changes to be made to

§ 1.367(a)–3T, effective with respect to

transfers occurring after December 16,

1987. A further notice of proposed

rulemaking, containing rules under

section 367(a), as well as under section

367(b), was published in the Federal

Register on August 26, 1991 (56 FR

41993). The 1991 proposed section

367(a) regulations were generally based

upon the positions announced in Notice

87–85, but the regulations made certain

modifications to Notice 87–85,

particularly with respect to transfers of

stock or securities of foreign

corporations.

Most recently, the IRS and the

Treasury Department issued Notice 94–

46 (1994–1 C.B. 356), announcing

modifications to the positions set forth

in Notice 87–85 (and the 1991 proposed

regulations) with respect to transfers of

stock or securities of domestic

corporations occurring after April 17,

1994. The temporary regulations set

forth herein generally incorporate the

modifications announced in Notice 94–

46. The notice of proposed rulemaking

on this subject in the Proposed Rules

section of this issue of the Federal