95-171. Recognition of Gain or Loss by Contributing Partner on Distribution of Contributed Property or Other Property  

  • [Federal Register Volume 60, Number 5 (Monday, January 9, 1995)]
    [Proposed Rules]
    [Pages 2352-2364]
    From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
    [FR Doc No: 95-171]
    
    
    
    =======================================================================
    -----------------------------------------------------------------------
    
    DEPARTMENT OF THE TREASURY
    
    Internal Revenue Service
    
    26 CFR Part 1
    
    [PS-76-92]; [PS-51-93]
    RIN 1545-AR48; RIN 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: Notice of proposed rulemaking and notice of public hearing.
    
    -----------------------------------------------------------------------
    
    SUMMARY: This document contains proposed 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 proposed 
    regulations relating to the recognition of gain on certain 
    distributions to a contributing partner under section 737. Changes to 
    the applicable law were made by the Revenue Reconciliation Act of 1989 
    and the Energy Policy Act of 1992. The proposed regulations affect 
    partnerships and their partners and are necessary to provide guidance 
    for complying with the applicable tax law.
    
    DATES: Written comments must be received by April 10, 1995. Requests to 
    speak (with outlines of oral comments) at a public hearing scheduled 
    for June 19, 1995, at 10 a.m. must be received by May 29, 1995.
    
    ADDRESSES: Send submissions to: CC:DOM:CORP:T:R (PS-76-92; PS-51-93), 
    Room 5228, Internal Revenue Service, POB 7604, Ben Franklin Station, 
    Washington, DC. 20044. In the alternative, submissions may be hand 
    delivered between the hours of 8:00 a.m. and 5:00 p.m. to: 
    CC:DOM:CORP:T:R (PS-76-92; PS-51-93), Courier's Desk, Internal Revenue 
    Service, 1111 Constitution Avenue NW, Washington, DC. The public 
    hearing has been scheduled to be held in the Auditorium, Internal 
    Revenue Building, 1111 Constitution Avenue, NW, Washington, DC.
    
    FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Stephen J. 
    Coleman, (202) 622-3060; concerning submissions and the hearing, 
    Michael Slaughter, (202) 622-7190 (not toll-free numbers).
    
    SUPPLEMENTARY INFORMATION:
    
    Introduction
    
        This document proposes to add new Secs. 1.704-4, 1.737-1, 1.737-2, 
    1.737-3, 1.737-4, and 1.737-5 to the Income Tax Regulations (26 CFR 
    part 1) under sections 704(c)(1)(B), 704(c)(2), and 737 of the Code.
    
    Background
    
        Section 704(c)(1)(A) of the Internal Revenue Code (Code) requires 
    that gain or loss with respect to property contributed to a partnership 
    by a partner be shared among the partners so as to take into account 
    any built-in gain or loss in the property at the time of the 
    contribution. Prior to its amendment by the Revenue Reconciliation Act 
    of 1989 (1989 Act), section 704(c) did not require the recognition of 
    built-in gain or loss by a contributing partner on a distribution of 
    contributed property by the partnership. The 1989 Act added sections 
    704(c)(1)(B) and 704(c)(2) to the 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 to the partnership, 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 for an exception for distributions of certain like-kind 
    property. The legislative history of the 1989 Act indicates that 
    Congress intended section 704(c)(1)(B) to eliminate the inconsistent 
    treatment of sales and distributions by a partnership and thereby 
    prevent partners from circumventing the rule requiring pre-contribution 
    gain or loss on contributed property to be allocated to the 
    contributing partner by distributing the property to another partner. 
    H.R. Rep. No. 101-247, 101st Cong., 1st Sess. 406 (1989).
        Prior to the enactment of the Energy Policy Act of 1992 (1992 Act), 
    a partner who contributed appreciated property to a partnership did not 
    recognize gain on a distribution to the distributee partner of 
    partnership property other than money. The 1992 Act added section 737 
    to the Code to require a contributing partner to recognize gain to the 
    extent of the lesser of (i) the net precontribution gain on property 
    contributed to the partnership 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. H.R. Rep. No. 102-1018, 102d 
    Cong., 2d Sess. 428 (1992).
    
    Explanation of Provisions
    
    A. Overview
    
        Section 704(c)(1)(B) generally requires a contributing partner to 
    recognize gain or loss when the property contributed by that partner is 
    distributed to another partner within five years of its contribution to 
    the partnership. Section 737 generally requires a contributing partner 
    to recognize gain when the partner receives, within five years of the 
    contribution, a distribution of other property with a fair market value 
    in excess of the partner's adjusted basis in the partnership. Both 
    sections apply only to distributions made to a partner in the partner's 
    capacity as a partner. Section 704(c)(1)(B) and section 737 do not 
    apply to transactions or distributions in which the partner is not 
    acting in the capacity of a partner (e.g., transactions or 
    distributions subject to section 707(a) or section 751(b)).
        The proposed regulations provide rules for determining when section 
    704(c)(1)(B) and section 737 apply and the amount of gain or loss that 
    must be recognized by the contributing partner under the applicable 
    section. The proposed regulations also provide rules for determining 
    the character of such gain or loss and for making the necessary basis 
    adjustments. The proposed regulations contain several exceptions that 
    are based on the [[Page 2353]] statutory language and the legislative 
    history. The proposed regulations also contain special rules dealing 
    with specific situations such as the partnership's exchange of the 
    contributed property for other property in a nonrecognition transaction 
    and the transfer of a contributing partner's interest in the 
    partnership. The proposed regulations also provide for coordination 
    between section 704(c)(1)(B) and section 737 in situations in which 
    both sections may apply to a distribution or distributions by a 
    partnership. In fashioning these specific rules, the proposed 
    regulations focus on the purpose of section 704(c)(1)(B) and section 
    737, rather than simply relying on the literal language of the 
    provisions in situations that would be inconsistent with the underlying 
    purpose of the provisions.
        The proposed regulations under section 704(c)(1)(B) and section 737 
    contain an anti-abuse rule providing that the rules of the applicable 
    section must be applied in a manner consistent with its purpose. 
    Accordingly, the anti-abuse rules contained in the proposed regulations 
    provide that, if a principal purpose of a transaction is to achieve a 
    tax result inconsistent with the purpose of the applicable section, the 
    Commissioner can recast the transaction for federal tax purposes as 
    appropriate to achieve tax results that are consistent with such 
    purpose.
        Whether a tax result is inconsistent with the purpose of the 
    applicable section is determined based on all the facts and 
    circumstances. The proposed regulations also provide examples 
    illustrating how these anti-abuse rules apply.
    
    B. Section 704(c)(1)(B)
    
    In General
        Under the proposed regulations, the contributing partner must 
    recognize gain or loss on a distribution of the contributed property to 
    another partner within five years of its contribution to the 
    partnership. The amount of gain or loss recognized is the amount that 
    would have been allocated to the contributing 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 at its fair market value 
    at the time of the distribution. The amount of gain or loss recognized 
    may vary depending on the particular method used by the partnership in 
    making allocations under section 704(c)(1)(A) and Sec. 1.704-3 because 
    the amount of remaining built-in gain or loss may vary depending on the 
    particular method of allocation adopted. In addition, because the 
    property is treated as having been sold by the partnership to the 
    distributee partner, the proposed regulations provide that any loss 
    that would have been disallowed under section 707(b)(1) if the 
    distributed property had actually been sold to the distributee partner 
    is disallowed.
    Five-Year Period
        Section 704(c)(1)(B) applies only to property distributed within 
    five years of its contribution to the partnership. The proposed 
    regulations provide that a new five-year period begins for property 
    deemed contributed to a new partnership following a termination of the 
    partnership under section 708(b)(1)(B), but only to the extent that the 
    pre-termination gain or loss on such property was not already required 
    to be allocated to the original contributor under section 704(c)(1)(A) 
    and Sec. 1.704-3. The effect of this provision is to begin a new five-
    year period for post-contribution changes in the value of partnership 
    property whenever there is a termination of the partnership under 
    section 708(b)(1)(B). This provision is consistent with the legislative 
    history of section 704(c)(1)(B).
    Character of Gain or Loss
        The proposed regulations provide that the character of the 
    contributing partner's gain or loss is the same as the character that 
    would have been recognized if the property had been sold by the 
    partnership to the distributee partner. Thus, if the distributee 
    partner holds more than a 50 percent capital or profits interest in the 
    partnership, any gain recognized by the contributing partner may be 
    ordinary income under section 707(b)(2).
    Exceptions and Special Rules
        The proposed regulations provide that section 704(c)(1)(B) does not 
    apply to (i) a distribution of property contributed to the partnership 
    on or before October 3, 1989, or (ii) a distribution of property in 
    connection with a termination of the partnership under section 
    708(b)(1)(B). The proposed regulations also provide that section 
    704(c)(1)(B) does not apply to a distribution of a portion of 
    contributed property to a noncontributing partner in a complete 
    liquidation of the partnership if a portion of the contributed property 
    is distributed to the contributing partner and that portion has 
    unrecognized gain or loss in the hands of the contributing partner, 
    determined immediately after the distribution, at least equal to the 
    built-in gain or loss that would have been allocated to the 
    contributing partner under section 704(c)(1)(A) on a sale of the 
    contributed property by the partnership at the time of the 
    distribution. This exception is consistent with the purpose of section 
    704(c)(1)(B) to prevent the shifting of built-in gain or loss among 
    partners because no shift has occurred in this limited situation.
        The proposed regulations provide that property received by a 
    partnership in exchange for contributed property in a nonrecognition 
    transaction is treated as the contributed property. This result is 
    consistent with the rule under Sec. 1.704-3(a)(8) of the regulations. 
    The proposed regulations also provide that the transferee of a 
    contributing partner is treated as the contributing partner to the 
    extent of the built-in gain or loss allocated to the transferee 
    partner. The gain or loss allocated to the transferee partner may be 
    offset, however, by the basis adjustments to partnership property by a 
    partnership with a section 754 election in effect. This result is 
    consistent with the result under Sec. 1.704-3(a)(7) of the regulations.
        The proposed regulations also provide a special rule under section 
    704(c)(2) for cases in which the contributing partner receives like-
    kind property no later than the earlier of: (1) 180 days following the 
    date of the distribution of contributed property to another partner, or 
    (2) 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 other partner. Under this rule, the contributing 
    partner's gain that otherwise would be recognized under section 
    704(c)(1)(B) is reduced by the amount of built-in gain or loss in the 
    distributed like-kind property in the hands of the contributing 
    partner. The amount of the built-in gain or loss is determined by 
    reference to the contributing partner's basis in the property 
    immediately after the distribution under section 732(a) or (b). The 
    proposed regulations provide that the basis in the distributed like-
    kind property in this situation is determined without taking into 
    account any increase in the basis of the contributing partner's 
    partnership interest for any gain recognized under section 
    704(c)(1)(B). This special rule implements the statutory objective of 
    not requiring gain or loss on distributions where gain or loss would 
    not have been recognized outside of a partnership. When gain or loss is 
    not recognized in exchanges of like-kind property outside of 
    partnerships, the built-in gain or loss on the exchanged property is 
    generally preserved in the property received in the exchange. To the 
    extent that this built-in gain or loss [[Page 2354]] is not preserved 
    in the case of a distribution of property by the partnership, the 
    exception does not apply.
    Basis Adjustments
        The contributing partner's basis in the partnership interest and 
    the partnership's basis in the distributed property are increased or 
    decreased by the amount of gain or loss recognized by the contributing 
    partner. These adjustments are taken into account in determining (1) 
    the noncontributing partner's basis in the property distributed to that 
    partner, (2) the contributing partner's basis in any property 
    distributed to that partner in the same transaction (except to the 
    extent that the distributed property is like-kind property subject to 
    the special rule discussed above), (3) the basis adjustments, if any, 
    to partnership property by a partnership with a section 754 election in 
    effect, and (4) the amount of the contributing partner's gain under 
    section 731 or section 737 on a related distribution of money or 
    property, respectively, to the contributing partner.
    
    C. Section 737
    
    In General
        Under the proposed regulations, a partner that contributes property 
    with built-in gain to a partnership and receives a distribution of 
    property other than money within five years of that contribution must 
    recognize gain in an amount equal to the lesser of (1) the excess (if 
    any) of the fair market value of the distributed property over the 
    adjusted basis of the partner's interest in the partnership (excess 
    distribution); or (2) the net precontribution gain of the partner.
    Excess Distribution
        In determining the amount of the excess distribution, the proposed 
    regulations provide that the distributee partner's adjusted basis in 
    the partnership interest is first adjusted for all basis adjustments 
    resulting from the distribution subject to section 737 (for example, 
    basis adjustments under section 752) and any basis adjustments 
    resulting from any other distribution that is part of the same plan or 
    arrangement (for example, basis adjustments required under sections 
    704(c)(1)(B) and 751(b)). Two basis adjustments, however, are not taken 
    into account in determining whether there is an excess distribution: 
    (1) the partner's basis is not increased for the gain recognized under 
    section 737, and (2) is not decreased by the adjustment required under 
    section 733 for property distributed to the distributee partner in the 
    transaction (other than property previously contributed to the 
    partnership by the partner). The first exception is consistent with 
    section 737(c)(1) and the second is necessary to prevent an 
    inappropriate decrease in the partner's basis (and corresponding 
    increase in the partner's gain) under section 737. The reduction in the 
    partner's adjusted basis for a distribution of property previously 
    contributed to the partnership by the partner is necessary to give 
    effect to the statutory requirement that a distribution of previously 
    contributed property not be taken into account in determining the 
    amount of an excess distribution.
        The proposed regulations also provide that, in determining the 
    amount of an excess distribution, the fair market value of distributed 
    property is not reduced by the amount of any liability assumed or taken 
    subject to by the partner. The distributee partner's basis in the 
    partnership interest, however, is increased by the amount of any 
    liability assumed or taken subject to by the distributee partner and 
    this increase is taken into account in determining the amount of the 
    excess distribution. (The partner's basis is also adjusted for the 
    decrease in the partner's share of partnership liabilities as a result 
    of the distribution for this purpose.) As a result, the gross fair 
    market value of the property will be offset by the basis increase in 
    the partner's interest in the partnership under section 752 and, as a 
    result, the amount of the excess distribution should be limited to the 
    net value of the distributed property.
    Net Precontribution Gain
        The distributee partner's net precontribution gain is the net gain 
    (if any) that the partner would have recognized under section 
    704(c)(1)(B) if the partnership had distributed to another partner all 
    property contributed to the partnership by the distributee partner 
    within five years of the date of the distribution. The amount of gain 
    or loss that the distributee partner would recognize under section 
    704(c)(1)(B) is determined under the proposed regulations to section 
    704(c)(1)(B) contained in this notice.
        The proposed regulations under section 737 provide special rules 
    for determining the amount of the partner's net precontribution gain. 
    Property contributed on or before October 3, 1989, is not included in 
    determining the amount of net precontribution gain because net 
    precontribution gain is determined by reference to section 
    704(c)(1)(B), and that section does not apply to property contributed 
    to the partnership on or before October 3, 1989.
        Net precontribution gain is reduced as a result of a basis increase 
    to the contributed property under section 734(b)(1)(A) to reflect gain 
    recognized by the partner under section 731 on a distribution of money 
    in the same plan or arrangement as the distribution of property subject 
    to section 737. This reduction is appropriate because some or all of 
    the precontribution gain is recognized by the contributing partner 
    under section 731 on the distribution.
        The proposed regulations also provide that a transferee partner 
    succeeds to the transferor's net precontribution gain in an amount 
    proportionate to the interest transferred. This provision is consistent 
    with the provision in Sec. 1.704-3(a)(7) (and Sec. 1.704-4(d)(2) of the 
    proposed regulations) requiring a transferee partner to succeed to all 
    or a portion of the transferor's built-in gain or loss. The transferee 
    partner, however, may not recognize the same amount of gain that the 
    transferor partner would have recognized on a subsequent distribution 
    because the transferee's basis in the partnership interest may be 
    higher or lower than the transferor's basis, and the amount of gain 
    allocated to the transferee partner under section 704(c)(1)(A) will be 
    affected by any basis adjustment required under section 754.
        Net precontribution gain is also reduced by the amount of gain 
    recognized by the contributing partner under section 704(c)(1)(B) in a 
    distribution of contributed property in a related distribution to 
    another partner, and by the amount of gain that the partner would have 
    recognized under section 704(c)(1)(B) on the distribution of 
    contributed property to another partner but for the exception of 
    section 704(c)(2). This reduction is necessary to avoid gain 
    recognition under both section 704(c)(1)(B) and section 737 with 
    respect to the same built-in gain. The reduction for gain not 
    recognized as a result of the section 704(c)(2) exception only applies 
    in situations where there is an actual distribution of contributed 
    property to another partner.
    Character of Gain
        The character of the contributing partner's recognized gain is 
    determined by reference to the character of the partner's net 
    precontribution gain. The character of such gain is determined by 
    netting all of the precontribution gains and losses according to the 
    character that such property would have had on a sale by the 
    partnership to an unrelated third party. The character of the 
    [[Page 2355]] contributing partner's gain under section 737 is the same 
    (and in the same proportion) as the character of any net positive 
    amounts resulting from the netting of the precontribution gains and 
    losses. Character for this purpose is broadly defined in the proposed 
    regulations to include any item that the contributing partner would 
    have been required to take into account separately under section 702(a) 
    and Sec. 1.702-1(a) had the partnership sold all the property 
    contributed by that partner.
        Because the contributed property is not actually transferred by the 
    partnership to any particular partner, it is appropriate to treat the 
    hypothetical dispositions by the partnership as occurring with an 
    unrelated third party. As a result, the character conversion rule of 
    section 707(b)(2) does not apply for purposes of determining the 
    character of the distributee partner's gain. (Compare section 
    704(c)(1)(B) and Sec. 1.704-4(b)(1) in which the character conversion 
    rule does apply because the contributed property is actually 
    distributed to another partner.)
    Exceptions and Special Rules
        The proposed regulations provide that section 737 does not apply to 
    a deemed distribution of property on a termination of the partnership 
    under section 708(b)(1)(B). As noted above (with respect to the 
    discussion of the proposed regulations under section 704(c)(1)(B)), 
    however, a new five-year period begins for property to the extent that 
    the pre-termination gains and losses, if any, were not already required 
    to be allocated to the original contributor under section 704(c)(1)(A) 
    and Sec. 1.704-3.
        A transferee partner in a transfer that causes a termination under 
    section 708(b)(1)(B) will generally not have any net precontribution 
    gain immediately after the deemed formation of the new partnership. The 
    basis of the property deemed contributed by the transferee partner to 
    the new partnership is determined under section 732 and, as a result, 
    the transferee partner may be treated as having contributed built-in 
    gain and built-in loss property to the new partnership. These built-in 
    gain and loss properties, however, should net to zero, assuming that 
    the transferee partner's total basis in the properties is equal to 
    their total fair market value. Section 737, however, does apply to the 
    transferee partner and could result in gain recognition on a subsequent 
    distribution if the distribution occurs at a time when the partner has 
    a net precontribution gain. The transferee partner could have a net 
    precontribution gain on a subsequent distribution if, for example, the 
    partnership sells some or all of the built-in loss property (that is 
    deemed contributed by that partner to the new partnership in the 
    section 708(b)(1)(B) termination) and retains the built-in gain 
    property.
        The proposed regulations also provide that section 737 does not 
    apply to partnership mergers and similar transactions because the 
    partners have merely converted their interests in the transferor 
    partnership to an interest in the transferee partnership. As a result 
    of this treatment, however, distributions by the transferee partnership 
    are subject to section 737 to the same extent that distributions from 
    the transferor partnership would have been subject to section 737.
        Under the proposed regulations, section 737 applies to an 
    incorporation of the partnership involving an actual distribution of 
    property by the partnership to the partners followed by a contribution 
    to a corporation. (As discussed below, however, section 737 does not 
    apply to the extent that the property actually distributed to a partner 
    was previously contributed to the partnership by that partner.) Section 
    737 does not apply to an incorporation of a partnership by methods not 
    involving an actual distribution of partnership property to the 
    partners, provided that the incorporation is followed by a complete 
    liquidation of the partnership as part of the same plan or arrangement 
    as the incorporation. Section 737 does not apply in these situations 
    because the partners are converting their partnership interests into a 
    stock interest in the corporation in a nonrecognition transaction and, 
    under the rules of either sections 732 or 358, the built-in gain in a 
    partner's partnership interest is preserved in the stock received by 
    the contributing partner. This exception is similar to the general 
    carry-over treatment provided in Sec. 1.704-3(a)(8) for section 704(c) 
    property exchanged in a nonrecognition transaction. Incorporation by 
    means of a distribution of partnership property to the partners also 
    results in the same conversion of a partnership interest into stock of 
    a corporation, but that method of incorporation involves an actual 
    distribution of property to the partners and the form of incorporation 
    chosen by the partners governs the tax consequences of incorporation, 
    including the application of section 737.
        The proposed regulations provide that a related distribution of 
    property previously contributed to the partnership by the distributee 
    partner is not taken into account in determining the amount of the 
    excess distribution or the partner's net precontribution gain. The 
    proposed regulations also provide, consistent with section 737(d)(1), 
    for a limitation in the case of a distribution of a previously 
    contributed interest in an entity. This limitation is intended to 
    prevent a partner from avoiding section 737 by contributing an interest 
    in an entity to the partnership and having the partnership contribute 
    property to that entity, followed by a distribution of an interest in 
    the entity to the contributing partner under the previously contributed 
    property exception. This limitation does not apply to the extent that 
    the property contributed by the partnership to the entity was 
    contributed by the same partner that contributed the interest in the 
    entity because, in that case, the distributee partner is receiving only 
    a distribution of property that it previously contributed to the 
    partnership.
        The proposed regulations also provide that any property received by 
    the partnership in exchange for previously contributed property is 
    treated as previously contributed property to the extent such property 
    is treated as section 704(c) property with regard to the contributing 
    partner under Sec. 1.704-3(a)(8). This provision is consistent with the 
    general treatment of nonrecognition transactions involving section 
    704(c) property under Sec. 1.704-3(a)(8).
    Basis Adjustments
        The contributing partner's basis in the partnership interest is 
    increased by the amount of gain recognized by the partner. This 
    increase is taken into account in determining a partner's basis in 
    property received by that partner, but is not taken into account in 
    determining the amount of gain recognized by the partner under section 
    737 or the amount of gain recognized under section 731 on any 
    distribution of money in the same distribution as the distribution of 
    property subject to section 737.
        The partnership's basis in property contributed by the partner is 
    also increased by the gain recognized by the partner. The basis 
    increase is limited to built-in gain property held by the partnership 
    after the distribution with the same character as the character of the 
    gain recognized by the contributing partner under section 737. No basis 
    increase is allocated to any previously contributed property that is 
    part of the distribution to which section 737 applied. This previously 
    contributed property is not taken into account in determining the 
    amount of net precontribution gain and therefore it is not appropriate 
    to increase the basis of that property. There is also no basis increase 
    to any property distributed to another partner in a related 
    distribution [[Page 2356]] to which section 704(c)(1)(B) applies. The 
    basis in the distributed property in that case will be increased or 
    decreased for any gain or loss recognized by the contributing partner 
    under section 704(c)(1)(B) and therefore should not be adjusted for 
    gain recognized under section 737.
        The basis increase is allocated to built-in gain property with the 
    same character as the character of the gain recognized by the partner. 
    The amount of the basis increase allocated to property of a particular 
    character is allocated to the property in the order contributed to the 
    partnership, starting with the earliest contributed property. This 
    ordering rule preserves the effect of the five-year rule to the extent 
    possible. Allocating the adjustment to all property of a similar 
    character based on any other rule would reduce the net precontribution 
    gain attributable to later-contributed property before such gain was 
    entirely eliminated on earlier contributed property.
        Any increase to the adjusted tax basis of partnership property 
    under the proposed regulations 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.
    Proposed Effective Date
        These regulations are proposed to apply to distributions of 
    property by a partnership to a partner on or after January 9, 1995.
    Special Analyses
        It has been determined that this notice of proposed rulemaking is 
    not a significant regulatory action as defined in Executive Order 
    12866. Therefore, a regulatory assessment is not required. It has also 
    been determined that section 553(b) of the Administrative Procedure Act 
    (5 U.S.C. chapter 5) 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, this notice of proposed 
    rulemaking will be submitted to the Chief Counsel for Advocacy of the 
    Small Business Administration for comment on its impact on small 
    business.
    Comments and Public Hearing
        Before these proposed regulations are adopted as final regulations, 
    consideration will be given to any written comments (a signed original 
    and eight (8) copies) that are timely submitted to the IRS. All 
    comments will be available for public inspection and copying.
        A public hearing has been scheduled for June 19, 1995, at 10 a.m. 
    in the auditorium of the Internal Revenue Building. Because of access 
    restrictions, visitors will not be admitted beyond the Internal Revenue 
    Building lobby more than 15 minutes before the hearing starts.
        The rules of 26 CFR 601.601(a)(3) apply to the hearing.
        Persons that wish to present oral comments at the hearing must 
    submit written comments by April 10, 1995 and submit an outline of the 
    topics to be discussed and the time to be devoted to each topic (signed 
    original and eight (8) copies) by May 22, 1995.
        A period of 10 minutes will be allotted for each person for making 
    comments.
        An agenda showing the scheduling of the speakers will be prepared 
    after the deadline for receiving outlines has passed. Copies of the 
    agenda will be available free of charge at the hearing.
    Drafting Information
        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.
    
    Proposed Amendments to the Regulations
    
        Accordingly, 26 CFR part 1 is proposed to be amended as follows:
    
    PART 1--INCOME TAXES
    
        Paragraph 1. The authority citation for part 1 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--(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 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. Section 704(c)(1)(B) and this section do not apply to a 
    transaction or distribution that is subject to provisions other than 
    section 731(a) or section 737 (for example, a transaction or 
    distribution subject to sections 707(a), 736(a), or 751(b)).
        (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 was not 
    already required to be allocated to the original contributor under 
    section 704(c)(1)(A) and Sec. 1.704-3. 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.
    
        [[Page 2357]] 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, 1998, 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 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 partial liquidation of C's interest in the partnership. 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 
    partial liquidation of B's interest in the partnership. 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 complete 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 complete 
    liquidation of the partnership if--
        (i) The contributing partner receives an interest in the 
    contributed section 704(c) 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 without regard to 
    this paragraph (c)(2).
        (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)(iii) 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) 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. Complete liquidation. (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 [[Page 2358]] built-in 
    gain of $10,000 at the time of contribution.
        (ii) On December 31, 1998, the partnership completely 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 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 plan or arrangement 
    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.
        (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 
    partial liquidation of B's interest in the partnership. At the same 
    time, Property X is distributed to A in partial liquidation of A's 
    interest in the partnership. 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 plan or arrangement 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 plan or arrangement 
    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 adjustment to partnership 
    property made pursuant to paragraph (e)(2) of this section is 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. (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. B and C each 
    contribute $20,000 cash.
        (ii) On December 31, 1998, Property A is distributed to B in 
    partial liquidation of B's interest in the partnership.
        (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 [[Page 2359]] 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 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 tentatively agree to 
    distribute Property A to B in complete liquidation of B's interest 
    in the partnership. If Property A were distributed at that time, 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 allocated to B as of December 31, 
    1998, and that substantially all of the economic risks and benefits 
    of all other partnership property are allocated to 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 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 under the heading ``Distributions by a Partnership'' 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 
    [[Page 2360]] paragraph (c) of this section). Gain recognized under 
    section 737 and this section is in addition to any gain recognized 
    under section 731.
        (2) Transactions to which section 737 applies. Section 737 and this 
    section apply 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. Section 737 does not apply to a transaction 
    or distribution that is subject to provisions other than sections 
    731(a) or 737 (for example, a transaction or distribution subject to 
    sections 707(a), 736(a), or 751(b)).
        (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 
    plan or arrangement, 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 the 
    partner would have recognized under section 704(c)(1)(B) and 
    Sec. 1.704-4 if, at the time of the distribution to which section 737 
    applies, the partnership had actually distributed to another partner 
    all section 704(c) property contributed to the partnership by the 
    distributee partner. 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 plan or arrangement 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 plan or arrangement 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)(2) 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. 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 is allocated 
    $1,000 of book depreciation per [[Page 2361]] 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 contribute $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 partial liquidation of A's 
    interest in the partnership.
        (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 each with a fair market value of 
    $10,000 and an adjusted tax basis of $6,000. B contributes Property 
    B, nondepreciable real property, 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 partial liquidation 
    of B's interest in the partnership.
        (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 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 on 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) Complete transfer to another partnership. 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 complete liquidation of the transferor 
    partnership as part of the same plan or arrangement. In addition, 
    section 737 and this section do not apply to any transaction, such as a 
    partnership merger under section 708(b)(2)(A), that is treated in a 
    similar manner. A subsequent distribution of property by the transferee 
    partnership to the partners of the transferee partnership who were 
    formerly partners 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 
    partnership property to the partners followed by a contribution of that 
    property to a corporation), provided that the partnership is completely 
    liquidated as part of the same plan or arrangement as the incorporation 
    transaction.
        (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 [[Page 2362]] 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).
        (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).
    
    
    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 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 plan or arrangement 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 
    [[Page 2363]] 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 adjustment to partnership 
    property made pursuant to paragraph (c)(1) of this section is 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 plan or 
    arrangement 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.
    
        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 
    partial liquidation of A's interest in the partnership and Property 
    A1 is distributed to B in partial liquidation of B's interest in the 
    partnership. 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.-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 [[Page 2364]] 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 contributes to the 
    partnership Property A2, nondepreciable real property with a fair 
    market value and adjusted tax basis of $9,000. A, therefore, 
    increased the adjusted tax basis of A's partnership interest from 
    $1,000 to $10,000. 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 partial 
    liquidation of A's interest in the partnership. If the contribution 
    of Property A2 is taken into account 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 the contribution of Property A2 increases the 
    adjusted tax basis of A's interest in the partnership (assuming it 
    was a valid contribution to the partnership under section 721), it 
    would be inconsistent with the purpose of section 737 to recognize 
    the contribution of Property A2 to the partnership as in substance a 
    bona fide contribution of an asset used in the conduct of joint 
    business activity. 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 not a transitory 
    contribution or transaction engaged in with a principal purpose of 
    avoiding recognition of gain under section 737. Because the 
    contribution of Property A2 was a transitory contribution 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 partial liquidation of A's interest in the 
    partnership. 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 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 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.
    Margaret Milner Richardson,
    Commissioner of Internal Revenue.
    [FR Doc. 95-171 Filed 1-6-95; 8:45 am]
    BILLING CODE 4830-01-U
    
    

Document Information

Published:
01/09/1995
Department:
Internal Revenue Service
Entry Type:
Proposed Rule
Action:
Notice of proposed rulemaking and notice of public hearing.
Document Number:
95-171
Dates:
Written comments must be received by April 10, 1995. Requests to speak (with outlines of oral comments) at a public hearing scheduled for June 19, 1995, at 10 a.m. must be received by May 29, 1995.
Pages:
2352-2364 (13 pages)
PDF File:
95-171.pdf
CFR: (10)
26 CFR 1.704-3(a)(8)
26 CFR 1.702-1(a)
26 CFR 1.704-4(d)(2)
26 CFR 1.737-2(d)
26 CFR 1.704-4
More ...