[Federal Register Volume 60, Number 247 (Tuesday, December 26, 1995)]
[Rules and Regulations]
[Pages 66727-66739]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-30870]
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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.
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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
[[Page 66728]]
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 pre-termination 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 pre-contribution 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
[[Page 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
like-kind 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 anti-abuse 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.
[[Page 66730]]
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:
Sec. 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 Sec. 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 Sec. 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 five-year 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 built-in gain or loss, if any, on such property would
not have been allocated to the contributing partner under section
704(c)(1)(A) and Sec. 1.704-3 on a sale of the contributed property to
an unrelated party immediately before the termination. See Sec. 1.704-
3(a)(3)(ii) for the definitions of built-in gain and built-in 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 Sec. 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 Sec. 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 Sec. 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
[[Page 66731]]
time of the distribution, A would have recognized $7,000 of gain under
section 704(c)(1)(A) and Sec. 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 Sec. 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 Sec. 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
five-year period for certain property deemed contributed to a new
partnership following a termination of the partnership under section
708(b)(1)(B). See also Sec. 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 Sec. 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 Sec. 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 Sec. 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
[[Page 66732]]
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
Sec. 1.704-3(a)(8). See Sec. 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 Sec. 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 like-
kind 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 Sec. 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
Sec. 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 like-kind 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 Sec. 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 Sec. 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 Sec. 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 Sec. 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
[[Page 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 Sec. 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 five-year
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:
Sec. 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.
[[Page 66734]]
(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 Sec. 1.704-4(e)(1)
for a rule in the context of section 704(c)(1)(B). See also Sec. 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 Sec. 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 Sec. 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
Sec. 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 Sec. 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 Sec. 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 Sec. 1.704-3(a)(7) and
Sec. 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 Sec. 1.704-4 (or that would have been
recognized by the partner except for the like-kind exception in section
704(c)(2) and Sec. 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 Sec. 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
Sec. 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 Sec. 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
[[Page 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 Sec. 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 Adjusted
value 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, foreign-source 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 x $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 x $1,000 net long-term, foreign-
source capital gain/$3,000 total net precontribution gain).
Sec. 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
Sec. 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 Sec. 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
[[Page 66736]]
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 Sec. 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
Sec. 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 Sec. 1.704-3(a)(8). See Sec. 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 Sec. 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 Adjusted
value 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 one-half 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.
Sec. 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 Sec. 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
[[Page 66737]]
in the distributed property other than property previously contributed
by the partner. See Sec. 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 Sec. 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 Sec. 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
Sec. 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 Sec. 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 Sec. 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 Adjusted
value 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 Sec. 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
Sec. 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 Sec. 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 Adjusted
value 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.-
[[Page 66738]]
source capital gain or loss. The character of gain on Property A4 is
long-term, foreign-source 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, foreign-source capital
gain ($3,000 total gain under section 737 x $2,000 net long-term,
foreign-source 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).
Sec. 1.737-4 Anti-abuse rule.
(a) In general. The rules of section 737 and Secs. 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 Sec. 1.704-4(f) for an anti-abuse rule and
examples in the context of section 704(c)(1)(B). The anti-abuse rule
and examples under section 704(c)(1)(B) and Sec. 1.704-4(f) are
relevant to section 737 and Secs. 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
Sec. 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
[[Page 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.
Sec. 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
