Internal Revenue Bulletin: 2005-26 |
June 27, 2005 |
Table of Contents
DEPARTMENT OF THE TREASURY
Internal
Revenue Service
26 CFR Parts 1 and 602
This document contains final regulations relating to the definition of liabilities under section 752 of the Internal Revenue Code (Code). These regulations provide rules regarding a partnership’s assumption of certain fixed and contingent obligations in connection with the issuance of a partnership interest and provide conforming changes to certain regulations. These regulations also provide rules under section 358(h) for assumptions of liabilities by corporations from partners and partnerships. Finally, this document also contains temporary regulations relating to the assumption of certain liabilities under section 358(h). The text of the temporary regulations also serves as the text of the proposed regulations (REG-106736-00) set forth in the notice of proposed rulemaking on this subject in this issue of the Bulletin.
Effective Date: These regulations are effective May 26, 2005.
Applicability Dates: The final §1.752-6 regulations apply to assumptions of liabilities by a partnership occurring after October 18, 1999, and before June 24, 2003. All of the other final regulations in this Treasury Decision, as well as the temporary regulations under section 358, apply to liabilities assumed on or after June 24, 2003, except as otherwise noted.
The collection of information contained in these final regulations has been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)) under control number 1545-1843. Responses to these collections of information are mandatory and are required to obtain a benefit. The collections of information in this final regulation is in §1.752-7(e), (f), (g), and (h). This information is required for a former or current partner of a partnership to take deductions, losses, or capital expenses attributable to the satisfaction of the §1.752-7 liability. This information will be used by the partner in order to take a deduction, loss, or capital expense. An additional collection of information in this final regulation is in §1.752-7(k)(2). This information is required to inform the IRS of partnerships making the designated election and to report income appropriately. The collection of information is required to obtain a benefit, i.e., to elect to apply the provisions of §1.752-7 of the regulations in lieu of §1.752-6. The likely respondents are business or other for-profit institutions and small businesses or organizations.
An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays a valid control number assigned by the Office of Management and Budget.
Estimated total annual reporting burden: 125 hours.
The estimated annual burden per respondent varies from 20 to 40 minutes, depending on individual circumstances, with an estimated average of 30 minutes.
Estimated number of respondents: 250.
Estimated annual frequency of responses: On occasion.
Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be sent to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, Washington, DC 20224, and to the Office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503.
Books or records relating to this collection of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as required by 26 U.S.C. 6103.
This document contains amendments to 26 CFR part 1 under sections 358, 704, 705, 737 and 752 of the Internal Revenue Code (Code).
As part of the Community Renewal Tax Relief Act of 2000 (the Act) (114 Stat. 2763), Congress enacted, on December 15, 2000, section 358(h), effective October 18, 1999, to address certain situations in which property is transferred to a corporation in exchange for both stock and the corporation’s assumption of certain obligations of the transferor. In these situations, transferors took the position that the obligations were not liabilities within the meaning of section 357(c) or that they were described in section 357(c)(3), and, therefore, the obligations did not reduce the basis of the transferor’s stock. These assumed obligations, however, did reduce the value of the stock. The transferors then sold the stock and claimed a loss. In this way, taxpayers attempted to duplicate a loss in corporate stock and to accelerate deductions that typically are allowed only on the economic performance of these types of obligations.
Section 358(h) addresses these transactions by requiring that, after the application of section 358(d), the basis in stock received in an exchange to which section 351, 354, 355, 356, or 361 applies be reduced (but not below the fair market value of the stock) by the amount of any liability assumed in the exchange. Exceptions to section 358(h) are provided where: (1) the trade or business with which the liability is associated is transferred to the person assuming the liability as part of the exchange; or (2) substantially all of the assets with which the liability is associated are transferred to the person assuming the liability as part of the exchange. The Secretary, however, has the authority to limit these exceptions. The term liability for purposes of section 358(h) includes any fixed or contingent obligation to make payment without regard to whether the obligation is otherwise taken into account for purposes of the Code.
Congress recognized that taxpayers were attempting to use partnerships and S corporations to carry out the same types of abuses that section 358(h) was designed to deter. Therefore, in sections 309(c) and (d)(2) of the Act, Congress directed the Secretary to prescribe rules to provide “appropriate adjustments under subchapter K of chapter 1 of the Code to prevent the acceleration or duplication of losses through the assumption of (or transfer of assets subject to) liabilities described in section 358(h)(3) . . . in transactions involving partnerships.” Under the statute, these rules are to “apply to assumptions of liability after October 18, 1999, or such later date as may be prescribed in such rules.”
In response to this directive, a notice of proposed rulemaking (REG-106736-00, 2003-2 C.B. 60) under sections 358, 704, 705, and 752 was published in the Federal Register (68 FR 37434) on June 24, 2003. In addition, temporary regulations (T.D. 9062, 2003-2 C.B. 46) were published on that same day (68 FR 37414). The proposed and temporary regulations provide rules to prevent the duplication and acceleration of loss through the assumption by a partnership of certain liabilities from a partner. Section 1.752-6T of the temporary regulations (the temporary regulations) applies to liabilities assumed by a partnership after October 18, 1999, and before June 24, 2003. Section 1.752-7 of the proposed regulations (the proposed regulations) applies to liabilities assumed by a partnership on or after June 24, 2003. However, taxpayers may elect to apply the proposed regulations, instead of the temporary regulations, to liabilities assumed by a partnership after October 18, 1999, and before June 24, 2003.
The temporary regulations adopt the approach of section 358(h), with some modifications. For example, the exception for contributions of “substantially all of the assets with which the liability is associated” does not apply to certain abusive transactions described in Notice 2000-44, 2000-2 C.B. 255, released to the public on August 11, 2000, and published on September 5, 2000.
The proposed regulations deviate somewhat from the rules of section 358(h). In particular, the proposed regulations do not reduce the partner’s basis in the partnership at the time of the assumption of a §1.752-7 liability by the partnership, but delay that reduction until an event occurs that separates the partner from the liability (triggering event). The triggering events are: (1) a disposition (or partial disposition) of the partnership interest by the partner; (2) a liquidation of the partner’s interest in the partnership; and (3) the assumption of the liability by another partner. After a triggering event, the partnership’s (or the assuming partner’s) deduction on the economic performance of the §1.752-7 liability is limited. However, if the partnership (or the assuming partner) notifies the partner of the economic performance of the §1.752-7 liability, then the partner may take a loss or deduction in the amount of the prior basis reduction.
The proposed regulations include an exception, similar to the exception in section 358(h)(2)(A), for transactions in which the partner contributes to the partnership the trade or business with which the liability is associated as part of the exchange (the trade or business exception), but do not include an exception, similar to the exception in section 358(h)(2)(B), for transactions in which the partner contributes to the partnership substantially all of the assets associated with the liability as part of the exchange. The proposed regulations also include an additional exception for situations in which, immediately before the triggering event, the amount of the remaining built-in loss with respect to all §1.752-7 liabilities assumed by the partnership (other than §1.752-7 liabilities assumed by the partnership with an associated trade or business) in one or more §1.752-7 liability transfers is less than the lesser of 10% of the gross value of partnership assets or $1,000,000 (the de minimis exception).
In addition, the proposed regulations provide detailed rules to address the treatment of the liability between the date of the assumption of that liability by the partnership and the date of a triggering event and to address tiered entity situations.
The proposed regulations distinguish between a §1.752-1 liability, for which a basis reduction is required when the liability is assumed by the partnership from a partner, and a §1.752-7 liability, for which a basis reduction is not required until the occurrence of a triggering event. Under the proposed regulations, an obligation is a §1.752-1 liability to the extent the obligation creates or increases the basis of any of the obligor’s assets (including cash), gives rise to an immediate deduction to the obligor, or gives rise to an expense that is not deductible in computing the obligor’s taxable income and is not properly chargeable to capital. All remaining obligations are §1.752-7 liabilities. Under the proposed regulations, §1.752-7 liabilities are subject to the rules of section 704(c) and the regulations thereunder.
The American Jobs Creation Act of 2004, Public Law 108-357 (118 Stat. 1418) (the Act), was enacted on October 22, 2004. Section 833(a) of the Act amended section 704(c) of the Code by adding section 704(c)(1)(C), effective for contributions of property to a partnership after October 22, 2004. Under new section 704(c)(1)(C), if “built-in loss” property is contributed to a partnership, the built-in loss shall be taken into account only in determining the items allocated to the contributing partner, and, except as provided in regulations, in determining the amount of items allocated to the other partners, the basis of the contributed property shall be treated as being equal to its fair market value at the time of contribution. For this purpose, a “built-in loss” is defined to mean the excess of the adjusted basis of the property in the hands of the contributing partner over its fair market value at the time of its contribution to the partnership.
Section 833(b) of the Act requires basis adjustments to be made following certain transfers of interests in partnerships for which no section 754 election is in effect. As amended by the Act, section 743(a) and (b) of the Code requires a partnership to reduce the basis of partnership property upon the transfer of an interest in the partnership by sale or exchange or upon the death of a partner, if, at the time of the relevant transfer, the partnership has a “substantial built-in loss.” Section 743(d)(1) provides that, for purposes of section 743, a partnership has a substantial built-in loss with respect to a transfer of a partnership interest if the partnership’s adjusted basis in the partnership’s property exceeds by more than $250,000 the fair market value of such property. Exceptions are provided for electing investment partnerships and for securitization partnerships, as defined in the Act. See also sections 734(b) and (d), as amended by section 833(c) of the Act (requiring a basis adjustment to be made following a distribution from a partnership for which no section 754 election is in effect in the case of a “substantial basis reduction”).
The IRS and the Treasury Department are aware of certain similarities between the treatment of §1.752-7 liabilities in these regulations and the treatment of built-in losses under sections 704(c)(1)(C), 734, and 743 of the Code, as added by the Act. For example, it is possible to view the contribution of property with an adjusted tax basis equal to the fair market value of the property, determined without regard to any §1.752-7 liabilities, as “built-in loss” property after the §1.752-7 liability is taken into account in those cases where the §1.752-7 liability is related to the contributed property. Although a partnership’s assumption of a §1.752-7 liability as part of the contribution of property to the partnership can be analogized to a property with an adjusted tax basis greater than fair market value, the purposes of section 704(c)(1)(C) and §1.752-7 are different in certain respects. Section 704(c)(1)(C) and the other changes in section 833 of the Act are directed toward loss duplication whereas §1.752-7 is directed at both loss duplication and loss acceleration. Therefore, to the extent of any built-in loss attributable to a §1.752-7 liability, §1.752-7 shall be applied without regard to the amendments made by the Act, unless future guidance provides to the contrary. Any such guidance would be prospective in application.
Written comments were received in response to the notice of proposed rulemaking, and a public hearing was held on October 14, 2003. Two commentators requested to speak at that hearing. After consideration of the comments, the proposed and temporary regulations are adopted as modified by this Treasury decision.
These final regulations generally follow the proposed and temporary regulations with the changes described below.
Several commentators suggested that the issuance of §1.752-6T exceeded the authority granted to the Secretary in section 309 of the Act. More specifically, some commentators suggested that §1.752-6T results in the inappropriate denial of a bona fide loss, that §1.752-6T was issued to bootstrap the IRS’s litigating position regarding transactions described in Notice 2000-44, 2000-2 C.B. 255, and that section 309 of the Act only granted the Secretary the authority to prescribe rules to address situations in which a partnership liability is assumed by a corporation. In addition, several commentators argued that the Treasury Department and the IRS exceeded their authority in providing that §1.752-6T applies retroactively to assumptions of liabilities occurring after October 18, 1999, and before June 24, 2003, the date the regulations were issued.
The Treasury Department and the IRS believe that §1.752-6T does not result in the inappropriate denial of a bona fide loss. The exceptions in §1.752-6T generally limit the application of the regulations to transactions that are abusive in nature and that lack a business purpose. In addition, the regulations allow taxpayers to elect into §1.752-7 so as to avoid the immediate basis reduction under §1.752-6T. Recognizing, however, that some taxpayers may not have expected the approach taken in §1.752-7 when engaging in transactions in prior years, §1.752-6T employs rules similar to section 358(h) for partnership transactions.
Those commentators who suggested that the IRS issued §1.752-6T to “bootstrap” its litigating position in Notice 2000-44 pointed to the fact that Notice 2000-44 did not mention that regulations would be issued in the future to challenge the transactions described in that notice. As discussed earlier, the Act was enacted with a retroactive effective date and granted the Treasury Department and the IRS the authority to issue retroactive regulations. The Treasury Department and the IRS believe that they have appropriately exercised this grant of authority. Also, Notice 2000-44 was released on August 11, 2000. The Act was not enacted into law until December 15, 2000, after the release of Notice 2000-44. Therefore, the Treasury Department and the IRS could not reference regulations promulgated under the Act in Notice 2000-44.
The Treasury Department and the IRS have concluded that the Secretary’s authority under section 309(c) is not limited to addressing assumptions of liabilities by corporations from partnerships. The plain language of the legislative directive is not so limited and the legislative history does not support such a limitation.
To the contrary, the Treasury Department and the IRS believe that the rules of §1.752-6T carry out the explicit directive of section 309(c) of the Act by applying to partnership transactions rules that are analogous to the rules that apply to corporate transactions under section 358(h). For example, if the transactions described in Notice 2000-44 were effected through a contribution to a corporation, rather than a contribution to a partnership, section 358(h) would generally apply to such a transaction, causing a basis reduction identical to that provided by §1.752-6T.
Section 7805(b) addresses when a regulation (temporary, proposed, or final) may be effective retroactively. Section 7805(b)(1) generally provides that no temporary, proposed, or final regulations relating to the internal revenue laws shall apply to any taxable period ending before the earliest of the following dates: (A) the date on which such regulation is filed with the Federal Register; (B) in the case of any final regulation, the date on which any proposed or temporary regulation to which such final regulation relates was filed with the Federal Register; or (C) the date on which any notice substantially describing the expected contents of any temporary, proposed, or final regulation is issued to the public. However, section 7805(b) provides a list of exceptions to the general rule stated above. Included in that list, and relevant in this context, is section 7805(b)(6). Section 7805(b)(6) provides that the limitation may be superseded “by a legislative grant from Congress authorizing the Secretary to prescribe the effective date with respect to any regulation.” Also included among the exceptions to the general rule in section 7805(b)(1) is section 7805(b)(3). Section 7805(b)(3) states that the “Secretary may provide that any regulation may take effect or apply retroactively to prevent abuse.”
The retroactive effective date of §1.752-6T is in accordance with the directive in section 309(c) and (d)(2) of the Act and section 7805(b)(6). Furthermore, pursuant to section 7805(b)(3), the Secretary has determined that a retroactive effective date is appropriate to prevent abuse.
For these reasons, the Treasury Department and the IRS have concluded that §1.752-6T is a valid exercise of the Secretary’s regulatory authority under the Code and section 309 of the Act.
Section 1.752-6T(d)(2) provides that partnerships may elect to apply the provisions of §1.752-7 of the proposed regulations to all assumptions of liabilities by the partnership occurring after October 18, 1999, and before June 24, 2003, in lieu of applying §1.752-6T of the temporary regulations. The election must be filed with the first Federal income tax return filed by the partnership on or after September 24, 2003.
Several commentators expressed a need for additional time to make this election. In response to these comments, the election period described in §1.752-6T(d)(2) has been extended. Under the extension, an election to apply the regulations under §1.752-7, rather than the regulations under §1.752-6, to all liabilities assumed by a partnership after October 18, 1999, and before June 24, 2003, must be filed with a Federal income tax return filed by the partnership on or after September 24, 2003, and on or before December 31, 2005.
The preamble to the proposed regulations advised taxpayers that, with respect to an exchange to which §358(a)(1) applies, the Treasury Department and the IRS were considering exercising their authority under §358(h)(2) to issue regulations that would limit the exceptions to §358(h)(1) to follow the exceptions set forth in the proposed regulations under §1.752-7 (other than the de minimis exception). The preamble indicated that such regulations would be retroactive to the extent necessary to prevent abuse. No comments were received regarding the appropriate scope or substance of such regulations. The Treasury Department and the IRS have determined that removing the exception of §358(h)(2)(B) (which applies where substantially all of the assets with which the liability is associated are transferred to the person assuming the liability as part of the exchange) is necessary to prevent the abuse that §358(h) was designed to prevent. Therefore, with respect to an exchange to which §358(a)(1) applies, this document contains temporary regulations providing that the exception contained in §358(h)(2)(B) does not apply to exchanges under §358(a)(1) in which liabilities are assumed on or after June 24, 2003.
Commentators have asked for clarification on whether an obligation could be a §1.752-1 liability in part and a §1.752-7 liability in part. Certain obligations that create liabilities under §1.752-1 may also create §1.752-7 liabilities. For example, a fixed obligation that gives rise to basis can have a component portion that changes in value between the time the obligation is first incurred by the partner and the time that the partnership assumes the obligation due to changes in interest rates, stock price, or other similar factors. In these and other cases, the value of the obligation to the holder has increased and, as a result, the cost to the obligor has increased by a like amount. The final regulations clarify that an obligation can be treated in part as a §1.752-7 liability and in part as a §1.752-1 liability.
The proposed regulations allow the §1.752-7 liability partner to claim a loss or deduction upon “economic performance” of the obligation. Certain §1.752-7 liabilities may be settled in cash or in kind, extinguished, satisfied or otherwise resolved under circumstances where there may not be an “economic performance” of the obligation within the meaning of that term. See section 461(h) and §1.461-4. In addition, economic performance only applies to “liabilities” as defined in §1.446-1(c)(1)(ii)(B), and it is possible that some §1.752-7 liabilities may not come within the meaning of that term. As a result, the final regulations allow the §1.752-7 liability partner to claim a loss or deduction under §1.752-7 upon the “satisfaction of the §1.752-7 liability”. A §1.752-7 liability is treated as satisfied on the date upon which, but for §1.752-7, the partnership, or the assuming partner, would have been allowed to take the §1.752-7 liability into account for federal tax purposes. The final regulations provide a nonexclusive list of examples of when the §1.752-7 liability would be taken into account for these purposes.
Under §1.752-7(c), any §1.752-7 liability assumed by a partnership in a §1.752-7 liability transfer is treated under section 704(c) principles as having a built-in loss equal to the amount of the §1.752-7 liability as of the date of the partnership’s assumption of the §1.752-7 liability. The proposed regulations provide that, if a §1.752-7 liability is assumed from the partnership by a partner other than the §1.752-7 liability partner, and the trade or business or de minimis exceptions do not apply, then section 704(c)(1)(B) does not apply to the assumption and instead the rules of §1.752-7(g) apply. Commentators asked whether section 704(c)(1)(B) applies to the assumption of a §1.752-7 liability by another partner if the trade or business or de minimis exceptions apply to that assumption. In addition, commentators questioned whether the successor partner rule of §1.704-3(a)(7) applies to the built-in loss amount of the §1.752-7 liability. The successor partner rule provides that, if a contributing partner transfers a partnership interest, built-in gain or loss must be allocated to the transferee partner as it would have been allocated to the transferor partner.
The intent of the Treasury Department and the IRS was that all of the rules of section 704(c), §1.704-3, and §1.704-4, including section 704(c)(1)(B), apply to §1.752-7 liabilities unless otherwise specifically stated. The §1.752-7 regulations have been modified to make this clear. In addition, §1.704-3 has been amended to provide that §1.752-7 liabilities are section 704(c) property and to provide that in general, the successor partner rule does not apply to §1.752-7 liabilities.
Comments were also received regarding the application of section 704(c) principles to the extent that a §1.752-7 liability has decreased after the partnership’s assumption of the liability. Consistent with the principles of §1.704-3, the final regulations provide that, if there is a post-assumption change in the value of the §1.752-7 liability, resulting in an obligation amount that is either greater or less than the initial amount of the obligation, the change in the amount will be treated as a section 704(b) and not a section 704(c) item, thereby creating book income or loss to be allocated to the partners. The final regulations also provide that, if the value of the §1.752-7 liability decreases after the assumption of the obligation by the partnership, the “ceiling rule” applies, and the partnership and the partners are entitled to adopt one of the reasonable methods specified in §1.704-3 to correct any ceiling rule disparities.
The proposed regulations make reference in several places to a “deduction or capital expense”, but no rules are provided as to how the capital expense is taken into account. For example, no rules are provided in the proposed regulations for situations where the contributing partner is still a partner in the partnership at the time that the obligation is recognized for federal tax purposes and capitalized into the tax basis of one or more assets of the partnership.
The final regulations add a rule to §1.704-3 providing that, to the extent a partnership properly capitalizes all or a portion of an item as described in paragraph §1.704-3(a)(12), then the item or items to which such cost is properly capitalized is treated as section 704(c) property with the same amount of built-in loss as corresponds to the amount capitalized. Similar rules are provided under §§1.704-4 and 1.737-2.
In addition, the proposed regulations do not provide any guidance as to the appropriate tax treatment if a triggering event occurs after a §1.752-7 liability has been capitalized into the basis of one or more assets of the partnership. Under the final regulations, no reduction in the partner’s basis in the partnership interest is required with respect to such a capitalized amount as a result of the triggering event, but, after the triggering event, neither the partnership nor the remaining partners may use the capitalized basis.
The proposed regulations contain an exception to §1.752-7(e), (f), and (g) for assumptions of liabilities in connection with the contribution of an associated trade or business, provided that the partnership continues to carry on that trade or business after the contribution. The proposed regulations provide that, for this purpose, a trade or business generally does not include the activity of acquiring, holding, or disposing of financial instruments, unless such activity is carried on by an entity registered with the Securities and Exchange Commission as a management company under the Investment Company Act of 1940, as amended (15 U.S.C. 80a).
The exception for entities registered as management companies was intended to apply narrowly to master-feeder partnerships; however, it appears that the exception could apply to a broader range of entities, some of which could be carrying on the types of transactions that section 309 of the Act and these regulations were intended to address. Consequently, the Treasury Department and the IRS have removed the exception for entities registered as management companies.
The Treasury Department and the IRS do not believe that eliminating the exception will create a substantial burden for master-feeder partnerships, because interests in these partnerships are not regularly sold, and because distributions by these partnerships typically take the form of nonliquidating distributions of cash. Accordingly, master-feeder partnerships are unlikely to engage in triggering events that would implicate this regulation.
Therefore, under the final regulations, the activity of acquiring, holding, dealing in, or disposing of financial instruments is not treated as a trade or business even if engaged in by an entity registered as a management company. For assumptions of liabilities on or after June 24, 2003, and before May 26, 2005, however, entities registered as management companies may rely on the exception to the trade or business definition in the proposed regulations.
Section 1.708-1(b)(4) provides that if a partnership is terminated under section 708(b)(1)(B) by a sale or exchange of an interest, the partnership is deemed to contribute all of its assets and liabilities to a new partnership in exchange for an interest in the new partnership; and, immediately thereafter, the terminated partnership is deemed to distribute interests in the new partnership to the purchasing partner and the other remaining partners.
A commentator asked whether the rules provided in §1.752-7 apply to the contribution and distribution of partnership interests deemed to occur under §1.708-1(b)(4). Rules have been added to the final regulations to clarify how the regulations apply to technical terminations and partnership mergers and divisions. These rules are designed to ensure that, after a technical termination, merger, or division, the partners that were §1.752-7 liability partners of the prior partnership continue to be §1.752-7 liability partners of the new partnership, and that built-in loss associated with the §1.752-7 liability does not shift from one partner to another partner. In addition, these rules are designed to ensure that a deemed assumption of a liability as a result of a technical termination of a partnership does not create any new §1.752-7 liabilities that did not exist prior to the technical termination.
Accordingly, §1.752-7(b)(6)(ii) of the final regulations provides that, in determining if a deemed contribution of assets and assumption of liability as a result of a technical termination is treated as a §1.752-7 liability transfer, only liabilities that were §1.752-7 liabilities of the terminating partnership are taken into account and, then, only to the extent of the amount of the liability that was subject to §1.752-7 prior to the technical termination.
In addition, the definition of a §1.752-7 liability partner has been amended to clarify that, if, in a transaction described in §1.752-7(e)(3), a partnership (lower-tier partnership) assumes a §1.752-7 liability from another partnership (upper-tier partnership), then any partners that were §1.752-7 liability partners of the upper-tier partnership continue to be §1.752-7 liability partners of the lower-tier partnership with respect to the remaining built-in loss associated with the §1.752-7 liability at the time of the assumption of the §1.752-7 liability by the lower-tier partnership from the upper-tier partnership. Any new built-in loss associated with the §1.752-7 liability that is created on the assumption of the §1.752-7 liability from the upper-tier partnership by the lower-tier partnership is shared by all the partners of the upper-tier partnership in accordance with their interests in the upper-tier partnership, and each partner of the upper-tier partnership is treated as a §1.752-7 liability partner with respect to that new built-in loss.
The definition of §1.752-7 liability partner has also been amended to provide that, if, in a transaction described in §1.752-7(e)(3), an interest in a partnership (lower-tier partnership) that has assumed a §1.752-7 liability is distributed by a partnership (upper-tier partnership) that is the §1.752-7 liability partner with respect to that liability, then the persons receiving interests in the lower-tier partnership are §1.752-7 liability partners with respect to the lower-tier partnership to the same extent that they were prior to the distribution. In addition, §1.752-7(e)(3) has been amended to provide that a distribution of an interest in a lower-tier partnership is exempt from the application of §1.752-7(e) only if the partners that were §1.752-7 liability partners with respect to the lower-tier partnership prior to the distribution continue to be §1.752-7 liability partners with respect to the lower-tier partnership after the distribution.
Section 707(a)(2)(B) provides that where there is a direct or indirect transfer of money or other property by a partner to a partnership and a related direct or indirect transfer of money or property by the partnership to such partner and the transfers, when viewed together, are properly characterized as a sale or exchange, such transfers shall be treated either as a transaction between the partnership and one who is not a partner, or as a transaction between two or more partners acting other than in their capacity as members of the partnership. Section 1.752-7(a)(2) of the proposed regulations provides that the assumption of a §1.752-7 liability is not treated as an assumption of a liability or as a transfer of cash for purposes of section 707(a)(2)(B). One commentator noted that the language contained in the proposed regulations was not consistent with §1.707-5(a), which takes into account all liabilities, regardless of whether those liabilities are taken into account under section 752.
The intent of the proposed regulations under section 752 was not to override the disguised sale rules under section 707, which may include §1.752-7 liabilities as consideration. Therefore, §1.752-7(a)(2) has been removed.
Under section 704(b), a partner’s distributive share of income, gain, loss, deduction, or credit (or item thereof) is determined in accordance with the partnership agreement provided that those allocations have substantial economic effect. If the allocations under the partnership agreement do not have substantial economic effect or the partnership agreement does not provide as to a partner’s distributive share of partnership items, then the partner’s distributive share of such items is determined in accordance with the partner’s interest in the partnership (determined by taking into account all facts and circumstances).
Section 1.704-1(b) describes various requirements that must be met for partnership allocations to have substantial economic effect. Among these requirements is that (except as otherwise provided in §1.704-1(b)) the partnership agreement must provide for the determination and maintenance of capital accounts in accordance with the rules of §1.704-1(b)(2)(iv).
Section 1.704-1(b)(2)(iv)(b) generally requires that a partner’s capital account be increased by the value of property contributed by the partner to the partnership net of liabilities secured by such contributed property that the partnership is considered to assume or take subject to under section 752, and be decreased by the value of property distributed by the partnership to the partner net of liabilities secured by such distributed property that the partner is considered to assume or take subject to under section 752. Section 1.704-1(b)(2)(iv)(c) requires that a partner’s capital account be increased by liabilities of the partnership that are assumed by such partner (other than liabilities described in §1.704-1(b)(2)(iv)(b)(5)), and be decreased by liabilities of the partner that are assumed by the partnership (other than liabilities described in §1.704-1(b)(2)(iv)(b)(2)). The proposed regulations revised §1.704-1(b)(2)(iv)(b) to take into account all liabilities to which the contributed or distributed property is subject, not just liabilities described in section 752. The proposed regulations did not revise §1.704-1(b)(2)(iv)(c), because that section is not limited to assumptions of liabilities described in section 752.
A commentator suggested that, if all liabilities are covered by §1.704-1(b)(2)(iv)(b), then §1.704-1(b)(2)(iv)(c) did not have any effect and should be removed. The final regulations do not adopt this comment, because the Treasury Department and the IRS believe that §1.704-1(b)(2)(iv)(c) has significance even though §1.704-1(b)(2)(iv)(b) is no longer limited to liabilities described in section 752. Section 1.704-1(b)(2)(iv)(b) applies only to situations in which liabilities are assumed by the partnership or the partner in connection with the contribution or distribution of property, or contributed or distributed property is taken subject to liabilities. Section 1.704-1(b)(2)(iv)(b) does not apply if liabilities are assumed by the partnership or a partner other than in connection with a contribution or distribution; these assumptions are covered by §1.704-1(b)(2)(iv)(c).
One commentator suggested that, to prevent the loss of a deduction to the §1.752-7 partner, the regulations should require the assuming partnership or partner to notify the §1.752-7 liability partner of the satisfaction of the §1.752-7 liability. The proposed regulations impose no penalty on the partnership for failure to notify the §1.752-7 liability partner. The commentator also suggested that the §1.752-7 liability partner be required to keep contact information current with the assuming partnership or partner.
The Treasury Department and the IRS do not believe that imposing additional requirements is necessary in these circumstances. It is anticipated that the §1.752-7 liability partner, upon entering the partnership, will negotiate with the partnership for the necessary notification. Therefore, this comment was not adopted.
Commentators have requested that the final regulations include guidance on the recourse or nonrecourse treatment of §1.752-7 liabilities for all purposes of subchapter K. Under the proposed regulations, a §1.752-7 liability is treated as a nonrecourse liability solely for purposes of §1.704-2, dealing with the allocation of nonrecourse deductions among the partners. The only other provision that the Treasury Department and the IRS are aware of for which the characterization of a §1.752-7 liability as recourse or nonrecourse is §1.707-5 (addressing the treatment of liabilities for purposes of the disguised sale rules of section 707(a)(2)(B)), and §1.707-5 already provides adequate rules for determining if a §1.752-7 liability is recourse or nonrecourse. Because a §1.752-7 liability is not, by definition, a §1.752-1 liability, the recourse or nonrecourse nature of a §1.752-7 liability is not relevant for purposes of §§1.752-1 through 1.752-5. For this reason, this comment was not adopted.
Comments were received requesting that the final regulations include guidance on acceptable methods for identifying and valuing §1.752-7 liabilities, as well as identifying the appropriate discount rate for determining the liability’s present value.
The Treasury Department and the IRS believe that such matters are best left to the negotiation of the financial arrangement among the parties and are beyond the scope of this regulation. In an arm’s length transaction, the parties will take the potential occurrence of these obligations into account in arriving at the agreement among the parties that will govern their affairs, including the appropriate valuation methodology to apply to these obligations. Accordingly, the final regulations do not adopt this comment.
However, the final regulations clarify that, if the obligation arose under a contract in exchange for rights granted to the obligor under that contract, and those contractual rights are contributed to the partnership in connection with the partnership’s assumption of the contractual obligation, then the amount of the §1.752-7 liability is the amount of cash, if any, that a willing assignor would pay to a willing assignee to assume the entire contract.
The final §1.752-6 regulations apply to assumptions of liabilities by a partnership occurring after October 18, 1999, and before June 24, 2003. All of the other final regulations in this Treasury decision apply to liabilities assumed on or after June 24, 2003, except as otherwise noted.
These final and temporary regulations are necessary to prevent abusive transactions involving transfers to partnerships and corporations of the type section 358(h) was enacted to prevent. Accordingly, good cause is found for dispensing with notice and public procedure pursuant to 5 U.S.C. 553(b)(B) with respect to the temporary regulations, and for dispensing with a delayed effective date pursuant to 5 U.S.C. 553(d)(1) and (3) with respect to the final and temporary regulations.
It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It is hereby certified that the final regulations in this document will not have a significant economic impact on a substantial number of small entities. This certification is based upon the fact that few partnerships engage in the type of transactions that are subject to these regulations (assumptions of liabilities not described in section 752(a) and (b) from a partner). In addition, available data indicates that most partnerships that engage in the type of transactions that are subject to these regulations are large partnerships. Certain broad exceptions to the application of these regulations (including a de minimis exception) further limit the economic impact of these regulations on small entities. Therefore, a Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. For the applicability of the Regulatory Flexibility Act to the temporary regulations in this document (§1.358-5T), refer to the cross-reference notice of proposed rulemaking published in this issue of the Bulletin. Pursuant to section 7805(f) of the Code, the notice of proposed rulemaking that preceded these regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.
Accordingly, 26 CFR parts 1 and 602 are amended as follows:
Paragraph 1. The authority citation for part 1 is amended by adding entries in numerical order to read, in part, as follows:
Section 1.358-5T also issued under 26 U.S.C. 358(h)(2). * * *
Section 1.358-7 also issued under Public Law 106-554, 114 Stat. 2763, 2763A-638 (2001) * * *
Section 1.752-1(a) also issued under Public Law 106-554, 114 Stat. 2763, 2763A-638 (2001).
Section 1.752-6 also issued under Public Law 106-554, 114 Stat. 2763, 2763A-638 (2001).
Section 1.752-7 also issued under Public Law 106-554, 114 Stat. 2763, 2763A-638 (2001). * * *
Par. 2. Section 1.358-5T is added to read as follows:
(a) In general. Section 358(h)(2)(B) does not apply to an exchange occurring on or after June 24, 2003.
(b) Effective dates. This section applies to exchanges occurring on or after June 24, 2003.
Par. 3. Section 1.358-7 is added to read as follows:
(a) Transfers by partners of partnership interests. For purposes of section 358(h), a transfer of a partnership interest to a corporation is treated as a transfer of the partner’s share of each of the partnership’s assets and an assumption by the corporation of the partner’s share of partnership liabilities (including section 358(h) liabilities, as defined in paragraph (d) of this section). See paragraph (e) Example 2 of this section.
(b) Transfers by partnerships. If a corporation assumes a section 358(h) liability from a partnership in an exchange to which section 358(a) applies, then, for purposes of applying section 705 (determination of basis of partner’s interest) and §1.704-1(b), any reduction, under section 358(h)(1), in the partnership’s basis in corporate stock received in the transaction is treated as an expenditure of the partnership described in section 705(a)(2)(B). See paragraph (e) Example 1 of this section. This expenditure must be allocated among the partners in accordance with section 704(b) and (c) and §1.752-7(c). If a partner’s share of the reduction, under section 358(h)(1), in the partnership’s basis in corporate stock exceeds the partner’s basis in the partnership interest, then the partner recognizes gain equal to the excess, which is treated as gain from the sale or exchange of a partnership interest. This paragraph does not apply to the extent that §1.752-7(j)(4) applies to the assumption of the §1.752-7 liability by the corporation.
(c) Assumption of section 358(h) liability by partnership followed by transfer of partnership interest or partnership property to a corporation—trade or business exception. Where a partnership assumes a section 358(h) liability from a partner and, subsequently, the partner transfers all or part of the partner’s partnership interest to a corporation in an exchange to which section 358(a) applies, then, for purposes of applying section 358(h)(2), the section 358(h) liability is treated as associated only with the contribution made to the partnership by that partner. See paragraph (e) Example 2 of this section. Similar rules apply where a partnership assumes a section 358(h) liability of a partner and a corporation subsequently assumes that section 358(h) liability from the partnership in an exchange to which section 358(a) applies.
(d) Section 358(h) liabilities defined. For purposes of this section, section 358(h) liabilities are liabilities described in section 358(h)(3).
(e) Examples. The following examples illustrate the provisions of this section. Assume, for purposes of these examples, that the obligation assumed by the corporation does not reduce the shareholder’s basis in the corporate stock under section 358(d). The examples are as follows:
Example 1. Transfer of partnership property to corporation.
In 2004, in an exchange to which section 351(a) applies, PRS, a cash basis taxpayer, transfers $2,000,000 cash to Corporation X, also a cash basis taxpayer, in exchange for Corporation X shares and the assumption by Corporation X of $1,000,000 of accounts payable incurred by PRS. At the time of the exchange, PRS has two partners, A, a 90% partner, who has a $2,000,000 basis in the PRS interest, and B, a 10% partner, who has a $50,000 basis in the PRS interest. Assume that, under section 358(h)(1), PRS’s basis in the Corporation X stock is reduced by the accounts payable assumed by Corporation X ($1,000,000). Under paragraph (b) of this section, A’s and B’s bases in PRS must be reduced, but not below zero, by their respective shares of the section 358(h)(1) basis reduction. If either partner’s share of the section 358(h)(1) basis reduction exceeds the partner’s basis in the partnership interest, then the partner recognizes gain equal to the excess. A’s share of the section 358(h) basis reduction is $900,000 (90% of $1,000,000). Therefore, A’s basis in the PRS interest is reduced to $1,100,000 ($2,000,000 - $900,000). B’s share of the section 358(h) basis reduction is $100,000 (10% of $1,000,000). Because B’s share of the section 358(h) basis reduction ($100,000) exceeds B’s basis in the PRS interest ($50,000), B’s basis in the PRS interest is reduced to $0 and B recognizes $50,000 of gain. This gain is treated as gain from the sale of the PRS interest.
Example 2. Transfer of partnership interest to corporation. In 2004, A contributes undeveloped land with a value and basis of $4,000,000 in exchange for a 50% interest in PRS and an assumption by PRS of $2,000,000 of pension liabilities from a separate business that A conducts. A’s basis in the PRS interest immediately after the contribution is A’s basis in the land, $4,000,000, unreduced by the amount of the pension liabilities. PRS develops the land as a landfill. Before PRS has economically performed with respect to the pension liabilities, A transfers A’s interest in PRS to Corporation X, in an exchange to which section 351 applies. At the time of the exchange, the value of A’s PRS interest is $2,000,000, A’s basis in PRS is $4,000,000, and A has no share of partnership liabilities other than the pension liabilities. For purposes of applying section 358(h), the transfer of the PRS interest to Corporation X is treated as a transfer to Corporation X of A’s share of PRS assets and an assumption by Corporation X of A’s share of the pension liabilities of PRS ($2,000,000). Because the pension liabilities were not assumed by PRS from A in an exchange in which the trade or business associated with the liability was transferred to PRS, the transfer of the PRS interest to Corporation X is not excepted from section 358(h) under section 358(h)(2). See paragraph (c) of this section. Under section 358(h), A’s basis in the Corporation X stock is reduced by the $2,000,000 of pension liabilities.
(f) Effective date. This section applies to assumptions of liabilities by a corporation occurring on or after June 24, 2003.
Par. 4. Section 1.704-1 is amended as follows:
1. Paragraph (b)(1)(ii)(a) is amended by removing the language “The” at the beginning of the first sentence and adding “Except as otherwise provided in this section, the” in its place.
2. Paragraph (b)(2)(iv)(b) is amended by adding a sentence at the end of the paragraph.
3. Paragraph (b)(2)(iv)(b)(2) is amended by removing the language “secured by such contributed property” in the parenthetical.
4. Paragraph (b)(2)(iv)(b)(2) is further amended by removing the language “under section 752” in the parenthetical.
5. Paragraph (b)(2)(iv)(b)(5) is amended by removing the language “secured by such distributed property” in the parenthetical.
6. Paragraph (b)(2)(iv)(b)(5) is further amended by removing the language “under section 752” in the parenthetical.
The addition reads as follows:
* * * * *
(b) * * *
(2) * * *
(iv) * * *
(b) * * * For liabilities assumed before June 24, 2003, references to liabilities in this paragraph (b)(2)(iv)(b) shall include only liabilities secured by the contributed or distributed property that are taken into account under section 752(a) and (b).
* * * * *
Par. 5. In §1.704-2, paragraph (b)(3) is amended by adding the language “or a §1.752-7 liability (as defined in §1.752-7(b)(3)(i)) assumed by the partnership from a partner on or after June 24, 2003” at the end of the sentence.
Par. 6. Section 1.704-3 is amended as follows:
1. The paragraph heading for (a)(7) is revised.
2. Two sentences are added to the end of paragraph (a)(7).
3. Paragraphs (a)(8)(ii) and (iii) are removed and reserved and paragraph (a)(8)(iv) is added.
4. Paragraph (a)(12) is added.
5. Two additional sentences are added at the end of paragraph (f).
The revisions and additions read as follows:
(a) * * *
(7) Transfer of a partnership interest. * * * This rule does not apply to any person who acquired a partnership interest from a §1.752-7 liability partner in a transaction to which paragraph (e)(1) of §1.752-7 applies. See §1.752-7(c)(1).
(8) Special rules—(i) Disposition in a nonrecognition transaction.* * *
(ii) [Reserved]
(iii) [Reserved]
(iv) Capitalized amounts. To the extent that a partnership properly capitalizes all or a portion of an item as described in paragraph (a)(12) of this section, then the item or items to which such cost is properly capitalized is treated as section 704(c) property with the same amount of built-in loss as corresponds to the amount capitalized.
* * * * *
(12) §1.752-7 liabilities. Except as otherwise provided in §1.752-7, §1.752-7 liabilities (within the meaning of §1.752-7(b)(2)) are section 704(c) property (built-in loss property that at the time of contribution has a book value that differs from the contributing partner’s adjusted tax basis) for purposes of applying the rules of this section. See §1.752-7(c). To the extent that the built-in loss associated with the §1.752-7 liability exceeds the cost of satisfying the §1.752-7 liability (as defined in §1.752-7(b)(3)), the excess creates a “ceiling rule” limitation, within the meaning of §1.704-3(b)(1), subject to the methods of allocation set forth in §1.704-3(b), (c) and (d).
* * * * *
(f) Effective dates. * * * Except as otherwise provided in §1.752-7(k), paragraphs (a)(8)(iv) and (a)(12) apply to §1.752-7 liability transfers, as defined in §1.752-7(b)(4), occurring on or after June 24, 2003. See §1.752-7(k).
Par. 7. Section 1.704-4 is amended as follows:
1. The paragraph heading for (d)(1) is revised.
2. Paragraphs (d)(1)(ii) and (iii) are removed and reserved and paragraph (d)(1)(iv) is added.
3. Paragraph (g) is revised.
The additions and revisions read as follows:
(d) Special rules—(1) Nonrecognition transactions, installment obligations, contributed contracts, and capitalized costs—(i) Nonrecognition transactions. * * *
(ii) [Reserved]
(iii) [Reserved]
(iv) Capitalized costs. Property to which the cost of section 704(c) property is properly capitalized is treated as section 704(c) property for purposes of section 704(c)(1)(B) and this section to the extent that such property is treated as section 704(c) property under §1.704-3(a)(8)(iv). See §1.737-2(d)(3) for a similar rule in the context of section 737.
* * * * *
(g) Effective dates. This section applies to distributions by a partnership to a partner on or after January 9, 1995, except that paragraph (d)(1)(iv) applies to distributions by a partnership to a partner on or after June 24, 2003.
Par. 8. Section 1.705-1 is amended by adding paragraph (a)(8) to read as follows:
(a) * * *
(8) For basis adjustments necessary to coordinate sections 705 and 358(h), see §1.358-7(b). For certain basis adjustments with respect to a §1.752-7 liability assumed by a partnership from a partner, see §1.752-7.
* * * * *
Par. 9. Section 1.737-2 is amended as follows:
1. The paragraph heading for (d)(3) is revised.
2. Paragraphs (d)(3)(ii) and (iii) are removed and reserved and paragraph (d)(3)(iv) is added.
The additions and revisions read as follows:
(d) * * *
(3) Nonrecognition transactions, installment sales, contributed contracts, and capitalized costs—(i) Nonrecognition transactions. * * *
(ii) [Reserved]
(iii) [Reserved]
(iv) Capitalized costs. Property to which the cost of section 704(c) property is properly capitalized is treated as section 704(c) property for purposes of section 737 to the extent that such property is treated as section 704(c) property under §1.704-3(a)(8)(iv). See §1.704-4(d)(1) for a similar rule in the context of section 704(c)(1)(B).
* * * * *
Par. 10. Section 1.737-5 is revised to read as follows:
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, except that §1.737-2(d)(3)(iv) applies to distributions by a partnership to a partner on or after June 24, 2003.
Par. 11. Section 1.752-0 is amended as follows:
1. The section heading and introductory text of §1.752-0 are revised.
2. An entry for §1.752-1(a)(4) is added.
3. Entries for §1.752-1(a)(4)(i), (ii), (iii), and (iv) are added.
4. Entries for §1.752-6 and §1.752-7 are added.
The revision and additions read as follows:
This section lists the major paragraphs that appear in §§1.752-1 through 1.752-7.
(a) * * *
(4) Liability defined.
(i) In general.
(ii) Obligation.
(iii) Other liabilities.
(iv) Effective date.
* * * * *
(a) In general.
(b) Exceptions.
(1) In general.
(2) Transactions described in Notice 2000-44.
(c) Example.
(d) Effective date.
(1) In general.
(2) Election to apply §1.752-7.
(a) Purpose and structure.
(b) Definitions.
(1) Assumption.
(2) Adjusted value.
(3) §1.752-7 liability.
(i) In general.
(ii) Amount and share of §1.752-7 liability.
(iii) Example.
(4) §1.752-7 liability transfer.
(i) In general.
(ii) Terminations under section 708(b)(1)(B).
(5) §1.752-7 liability partner.
(i) In general.
(ii) Tiered partnerships.
(A) Assumption by a lower-tier partnership.
(B) Distribution of partnership interest.
(6) Remaining built-in loss associated with a §1.752-7 liability.
(i) In general.
(ii) Partial dispositions and assumptions.
(7) §1.752-7 liability reduction.
(i) In general.
(ii) Partial dispositions and assumptions.
(8) Satisfaction of §1.752-7 liability.
(9) Testing date.
(10) Trade or business.
(i) In general.
(ii) Examples.
(c) Application of section 704(b) and (c) to assumed §1.752-7 liabilities.
(1) In general.
(i) Section 704(c).
(ii)Section 704(b).
(2) Example.
(d) Special rules for transfers of partnership interests, distributions of partnership assets, and assumptions of the §1.752-7 liability after a §1.752-7 liability transfer.
(1) In general.
(2) Exceptions.
(i) In general.
(ii) Examples.
(e) Transfer of §1.752-7 liability partner’s partnership interest.
(1) In general.
(2) Examples.
(3) Exception for nonrecognition transactions.
(i) In general.
(ii) Examples.
(f) Distribution in liquidation of §1.752-7 liability partner’s partnership interest.
(1) In general.
(2) Example.
(g) Assumption of §1.752-7 liability by a partner other than §1.752-7 liability partner.
(1) In general.
(2) Consequences to §1.752-7 liability partner.
(3) Consequences to partnership.
(4) Consequences to assuming partner.
(5) Example.
(h) Notification by the partnership (or successor) of the satisfaction of the §1.752-7 liability.
(i) Special rule for amounts that are capitalized prior to the occurrence of an event described in paragraphs (e), (f), or (g).
(1) In general.
(2) Example.
(j) Tiered partnerships.
(1) Look-through treatment.
(2) Trade or business exception.
(3) Partnership as a §1.752-7 l