Certain Distributions Treated as Sales or Exchanges, 65151-65174 [2014-25487]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 79, Number 212 (Monday, November 3, 2014)]
[Proposed Rules]
[Pages 65151-65174]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2014-25487]


========================================================================
Proposed Rules
                                                Federal Register
________________________________________________________________________

This section of the FEDERAL REGISTER contains notices to the public of 
the proposed issuance of rules and regulations. The purpose of these 
notices is to give interested persons an opportunity to participate in 
the rule making prior to the adoption of the final rules.

========================================================================


Federal Register / Vol. 79, No. 212 / Monday, November 3, 2014 / 
Proposed Rules

[[Page 65151]]



DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-151416-06]
RIN 1545-BG21


Certain Distributions Treated as Sales or Exchanges

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

-----------------------------------------------------------------------

SUMMARY: This document contains proposed regulations that prescribe how 
a partner should measure its interest in a partnership's unrealized 
receivables and inventory items, and that provide guidance regarding 
the tax consequences of a distribution that causes a reduction in that 
interest. The proposed regulations take into account statutory changes 
that have occurred subsequent to the issuance of the existing 
regulations. The proposed regulations affect partners in partnerships 
that own unrealized receivables and inventory items and that make a 
distribution to one or more partners.

DATES: Comments and requests for a public hearing must be received by 
February 2, 2015.

ADDRESSES: Send submissions to CC:PA:LPD:PR (REG-151416-06), Room 5203, 
Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, 
Washington, DC, 20044. Submissions may be hand-delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
151416-06), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue NW., Washington, DC 20224, or via the Federal eRulemaking Portal 
at www.regulations.gov (IRS REG-151416-06).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Allison R. Carmody at (202) 317-5279 or Frank J. Fisher at (202) 317-
6850; concerning submissions of comments and requests for hearing, 
Oluwafunmilayo Taylor at (202) 317-6901 (not toll-free numbers).

SUPPLEMENTARY INFORMATION: 

Paperwork Reduction Act

    The collection of information contained in this notice of proposed 
rulemaking has been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507(d)). Comments on the collection of information should be 
sent 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, with copies to the Internal Revenue 
Service, Attn: IRS Reports Clearance Officer, SE-:CAR:MP:T:T:SP, 
Washington, DC 20224. Comments on the collection of information should 
be received by January 2, 2015.
    Comments are specifically requested concerning:
    Whether the proposed collection of information is necessary for the 
proper performance of the Internal Revenue Service, including whether 
the information will have practical utility;
    The accuracy of the estimated burden associated with the proposed 
collection of information;
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
    How the burden of complying with the proposed collection of 
information may be minimized, including through the application of 
automated collection techniques or other forms of information 
technology; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of service to provide information.
    The collection of information required by this proposed regulation 
is in Sec.  1.751-1(b)(3) and (b)(6), and in Sec.  1.755-1(c)(2)(vi). 
This information is required for a partnership and certain partners to 
report the information to the IRS necessary to ensure that the partners 
of the partnership properly report in accordance with the rules of the 
proposed regulations the correct amount of ordinary income and/or 
capital gain upon a distribution of property from the partnership to 
its partners. The collection of information is necessary to ensure tax 
compliance.
    The likely respondents are business or other for-profit 
institutions.
    Estimated total annual reporting burden: 22,500 hours.
    Estimated average annual burden hours per respondent vary from 30 
minutes to 2 hours, depending on individual circumstances, with an 
estimated average of 1 hour.
    Estimated number of respondents: 22,500.
    Estimated annual frequency of responses: Annually.
    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.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by section 6103.

Background

    This document contains proposed amendments to the Income Tax 
Regulations (26 CFR part 1) under section 751(b) of the Internal 
Revenue Code (the Code). In 1954, Congress enacted section 751 to 
prevent the use of a partnership to convert potential ordinary income 
into capital gain. See H.R. Rep. No. 1337 at 70 (1954), reprinted in 
1954 U.S.C.C.A.N. 4017, 4097. To that end, section 751(a) provides that 
the amount of any money, or the fair market value of any property, 
received by a transferor partner in exchange for all or part of that 
partner's interest in the partnership's unrealized receivables and 
inventory items is considered as an amount realized from the sale or 
exchange of property other than a capital asset. Further, section 
751(b) overrides the nonrecognition provisions of section 731 to the 
extent a partner receives a distribution from the partnership that 
causes a shift between the partner's interest in the partnership's 
unrealized receivables or substantially appreciated inventory items 
(collectively, the partnership's ``section 751 property'') and the 
partner's interest in the partnership's other property.

[[Page 65152]]

    Whether section 751(b) applies depends on the partner's interest in 
the partnership's section 751 property before and after a distribution. 
The statute does not define a partner's interest in a partnership's 
section 751 property, but the legislative history indicates that 
Congress believed a partner's interest in a partnership's section 751 
property equals the partner's rights to income from the partnership's 
section 751 property:

    The provisions relating to unrealized receivables and 
appreciated inventory items are necessary to prevent the use of the 
partnership as a device for obtaining capital-gain treatment on fees 
or other rights to income and on appreciated inventory. Amounts 
attributable to such rights would be treated as ordinary income if 
realized in normal course by the partnership. The sale of a 
partnership interest or distributions to partners should not be 
permitted to change the character of this income. The statutory 
treatment proposed, in general, regards the income rights as 
severable from the partnership interest and as subject to the same 
tax consequences which would be accorded an individual entrepreneur.

S. Rep. No. 1622 at 99 (1954), reprinted in 1954 U.S.C.C.A.N. 4621, 
4732. (Emphasis added.)
    In 1984, Congress amended section 704(c), making mandatory its 
application to property contributed to a partnership. While Congress 
did not specifically address the overlap of section 704(c) and section 
751, the Conference Report indicates that the 1984 Congress understood 
that the section 704(c) amendment would impact other provisions in 
subchapter K and provides regulatory authority to the Secretary of the 
Treasury to address those repercussions. See H.R. Conf. Rep. No. 861, 
98th Cong., 2d Sess., June 23, 1984, reprinted in 1984 U.S.C.C.A.N. 
1445, 1545.
    The IRS and the Treasury Department first issued regulations 
implementing section 751 in 1956. Following the changes to section 
704(c) making its application mandatory, the IRS and the Treasury 
Department amended the regulations under section 751(a) to provide 
generally that a partner's interest in section 751 property is the 
amount of income or loss from section 751 property that would be 
allocated to the partner if the partnership had sold all of its 
property in a fully taxable transaction for cash in an amount equal to 
the fair market value of such property. (See TD 8847, 64 FR 69903, Dec. 
15, 1999.) However, the 1956 regulations with respect to section 751(b) 
remained unchanged.
    The examples in the current regulations under section 751(b) 
determine a partner's interest in section 751 property by reference to 
the partner's share of the gross value of the partnership's assets (the 
``gross value'' approach), not by reference to the partner's share of 
the unrealized gain or loss in the property. See, for example, Sec.  
1.751-1(g), Example 2. Because the gross value approach focuses on a 
partner's share of the asset's value rather than the partner's share of 
the unrealized gain, the examples in the current regulations may be too 
narrow in some respects, and too broad in others, to carry out the 
intended purpose of section 751(b). That is, the gross value approach 
may allow a distribution that reduces a partner's share of the 
unrealized gain in the partnership's section 751 property without 
triggering section 751(b), and, conversely, may trigger section 751(b) 
even if the partner's share of the unrealized gain in the partnership's 
section 751 property is not reduced. For example, Rev. Rul. 84-102 (84-
102 CB 119) provides that deemed distributions under section 752 
resulting from shifting allocations of indebtedness may result in the 
partners' shares of asset gross value changing, even though the 
partners' shares of unrealized gain associated with section 751 
property would not necessarily have changed.
    If the distribution results in a shift between the partner's 
interest in the partnership's section 751 property and the 
partnership's other property, the current regulations require a deemed 
asset exchange of both section 751 property and other property between 
the partner and the partnership to determine the tax consequences of 
the distribution (the ``asset exchange'' approach). See, for example, 
Sec.  1.751-1(g), Example 6, of the current regulations. The asset 
exchange approach is complex, requiring the partnership and partner to 
determine the tax consequences of both a deemed distribution of 
relinquished property and a deemed taxable exchange of that property 
back to the partnership. The asset exchange approach also often 
accelerates capital gain unnecessarily by requiring certain partners to 
recognize capital gain even when their shares of partnership capital 
gain have not been reduced.
    In 2006, the IRS and the Treasury Department published Notice 2006-
14 (2006-1 CB 498), which suggested, and requested comments on, 
alternative approaches to section 751(b) that were intended to better 
achieve the purpose of the statute while providing greater simplicity. 
See Sec.  601.601(d)(2)(ii)(b). Specifically, Notice 2006-14 asked for 
comments on: (1) Replacing the gross value approach with a 
``hypothetical sale'' approach for purposes of determining a partner's 
interest in the partnership's section 751 property, and (2) replacing 
the asset exchange approach with a ``hot asset sale'' approach to 
determine the tax consequences when section 751(b) applies. The 
hypothetical sale approach and the hot asset sale approach are 
described in Parts 1.A and 3, respectively, of the Summary of Comments 
and Explanation of Provisions section of this preamble. Notice 2006-14 
also requested comments on other possible approaches to simplifying 
compliance with section 751(b).
    As described in Notice 2006-14, the hypothetical sale approach for 
section 751(b) is similar to the approach taken in the 1999 regulations 
issued under section 751(a), shifting the focus to tax gain and away 
from gross value. Under the hypothetical sale approach, a partner's 
interest in section 751 property is determined by reference to the 
amount of ordinary income that would be allocated to the partner if the 
partnership disposed of all of its property for fair market value 
immediately before the distribution. More specifically, the 
hypothetical sale approach applies section 704(c) principles in 
comparing: (1) The amount of ordinary income that each partner would 
recognize if the partnership sold all of its property for fair market 
value immediately before the distribution, with (2) the amount of 
ordinary income each partner would recognize if the partnership sold 
all of its property (and the distributee partners sold the distributed 
assets) for fair market value immediately after the distribution. If 
the distribution reduces the amount of ordinary income (or increases 
the amount of ordinary loss) from section 751 property that would be 
allocated to, or recognized by, a partner (thus reducing that partner's 
interest in the partnership's section 751 property), the distribution 
triggers section 751(b).
    Notice 2006-14 indicated that changes to the framework of 
subchapter K since the promulgation of the existing regulations would 
work in tandem with the hypothetical sale approach to achieve the 
statute's objective of ensuring that a partner recognizes its proper 
share of the partnership's income from section 751 property without 
unnecessarily accelerating the recognition of that income. For example, 
regulations under section 704(b) allow a partnership to revalue its 
assets upon a distribution in consideration of a partnership interest. 
Any revaluation gain or loss is subject to the rules of section 704(c), 
which generally preserve

[[Page 65153]]

each partner's share of the unrealized gain and loss in the 
partnership's assets.
    Notice 2006-14 also requested comments on using the hot asset sale 
approach, rather than the asset exchange approach, to determine the tax 
consequences of the distribution that is subject to section 751(b). The 
hot asset sale approach deems the partnership to distribute the 
relinquished section 751 property to the partner whose interest in the 
partnership's section 751 property is reduced, and then deems the 
partner to sell the relinquished section 751 property back to the 
partnership immediately before the actual distribution.

Summary of Comments and Explanation of Provisions

    The IRS and the Treasury Department received both formal and 
informal responses to Notice 2006-14. In addition, a number of 
commentators published articles analyzing the proposals outlined in 
Notice 2006-14. Commentators' responses to Notice 2006-14 were 
predominantly favorable.
    These proposed regulations adopt many of the principles described 
in Notice 2006-14. Part 1 of this section describes the rules included 
in the proposed regulations for determining partners' interests in 
section 751 property. Part 2 of this section sets forth the proposed 
regulations' test to determine whether section 751(b) applies to a 
partnership distribution, including anti-abuse principles that may 
apply in certain situations in which the test would not otherwise be 
satisfied. Part 3 of this section explains the tax consequences of a 
section 751(b) distribution under the proposed regulations. Finally, 
Part 4 of this section describes certain ancillary issues relating to 
the proposed regulations, including a clarification to the scope of 
Sec.  1.751-1(a).

1. Determination of a Partner's Interest in Section 751 Property

    Section 751(b) applies to a partnership distribution to the extent 
the distribution reduces a partner's interest in section 751 property. 
As discussed further in this Part 1, the proposed regulations establish 
an approach for measuring partners' interests in section 751 property, 
provide new rules under section 704(c) to help partnerships compute 
partner gain in section 751 property more precisely, and describe how 
basis adjustments under sections 734(b) and 743(b) affect the 
computation of partners' interests in section 751 property.
A. Adoption of Hypothetical Sale Approach
    The first step in computing the effect of section 751(b) is to 
measure the partners' interests in section 751 property. Commentators 
generally agreed that the hypothetical sale approach is a substantial 
improvement over the gross value approach in the existing regulations. 
As described in this preamble, the hypothetical sale approach requires 
a partnership to compare: (1) The amount of ordinary income (or 
ordinary loss) that each partner would recognize if the partnership 
sold its property for fair market value immediately before the 
distribution with (2) the amount of ordinary income (or ordinary loss) 
each partner would recognize if the partnership sold its property, and 
the distributee partner sold the distributed assets, for fair market 
value immediately after the distribution. The commentators agreed that, 
when compared against the gross value approach, the hypothetical sale 
approach is more consistent with Congress's intent in enacting section 
751(b), is easier to apply, and reduces the likelihood that section 
751(b) would unnecessarily accelerate ordinary income. Accordingly, 
these proposed regulations adopt the hypothetical sale approach as the 
method by which the partners must measure their respective interests in 
section 751 property for the purpose of determining whether a 
distribution reduces a partner's interest in the partnership's section 
751 property. (A distribution that reduces a partner's interest in the 
partnership's section 751 property is referred to as a ``section 751(b) 
distribution.'')
B. Revaluations
    Because the hypothetical sale approach relies on the principles of 
section 704(c) to preserve a partner's share of the unrealized gain and 
loss in the partnership's section 751 property, these proposed 
regulations make several changes to the regulations relating to section 
704(c). Specifically, the proposed regulations revise Sec.  1.704-
1(b)(2)(iv)(f), regarding revaluations of partnership property, to make 
its provisions mandatory if a partnership distributes money or other 
property to a partner as consideration for an interest in the 
partnership, and the partnership owns section 751 property immediately 
after the distribution. (A partnership that does not own section 751 
property immediately after the distribution may still revalue its 
property under the existing regulation, but is not required to do so 
under these proposed regulations.) If a partnership does not maintain 
capital accounts in accordance with Sec.  1.704-1(b)(2)(iv), the 
partnership must comply with this requirement by computing each 
partner's share of gain or loss in each partnership asset prior to a 
distribution, and making future allocations of partnership items in a 
manner that takes these amounts into account (making subsequent 
adjustments for cost recovery and other events that affect the property 
basis of each such asset).
    In addition, the proposed regulations contain a special revaluation 
rule for distributing partnerships that own an interest in a lower-tier 
partnership. Because a partnership's section 751 property includes, 
under section 751(f), the partnership's proportionate share of section 
751 property owned by any other partnership in which the distributing 
partnership is a partner, these proposed regulations also require a 
partnership in which the distributing partnership owns a controlling 
interest (which is defined as a greater than 50 percent interest) to 
revalue its property if the lower-tier partnership owns section 751 
property immediately after the distribution. If the distributing 
partnership owns a non-controlling (that is, less than or equal to 50 
percent) interest in a lower-tier partnership, these proposed 
regulations require the distributing partnership to allocate its 
distributive share of the lower-tier partnership's items among its 
partners in a manner that reflects the allocations that would have been 
made had the lower-tier partnership revalued its partnership property. 
The IRS and the Treasury Department are aware that in some instances a 
distributing partnership may be unable to obtain sufficient information 
to comply with this requirement from a lower-tier partnership in which 
the distributing partnership holds a non-controlling interest. We 
request comments on reasonable approaches to address this issue.
    Upon the revaluation of partnership property in connection with a 
partnership distribution, the regulations under section 704(c) permit a 
partnership to choose any reasonable method to account for the built-in 
gain or built-in loss that is consistent with the purpose of section 
704(c). If property with built-in gain decreases in value (or property 
with built-in loss increases in value), then the partnership may be 
unable to allocate tax losses (or gains) to a non-contributing partner 
in an amount equal to the partner's economic loss (or gain). If the 
property with built-in gain (or loss) is section 751 property, then the 
inability to allocate those tax losses (or gains) may cause

[[Page 65154]]

ordinary income to shift among the partners. The regulations under 
section 704(c) provide two reasonable methods for a partnership to 
allocate items to cure or remediate that shift. However, the 
regulations under section 704(c) also provide a third reasonable 
method, the traditional method, under which the shift of ordinary 
income is not cured. The IRS and the Treasury Department are aware that 
distortions created under the section 704(c) traditional method may 
cause ordinary income to shift among partners. However, the regulations 
under section 704(c) contain an anti-abuse rule that provides that a 
method is not reasonable if, for example, the event that results in a 
reverse section 704(c) allocation and the corresponding allocation of 
tax items with respect to the property are made with a view to shifting 
the tax consequences of built-in gain or built-in loss among the 
partners in a manner that substantially reduces the present value of 
the partners' aggregate tax liability. The IRS and the Treasury 
Department believe that this anti-abuse provision under section 704(c) 
properly addresses the possibility that taxpayers would use the 
traditional method to shift ordinary income.
    Some commentators suggested changing the regulations under section 
704(c) to minimize the situations in which section 751(b) applies. 
Generally, when a partnership revalues its assets, the partnership 
allocates a reverse section 704(c) amount with respect to each 
partnership asset, as opposed to an aggregate section 704(c) amount 
with respect to all assets (subject to certain exceptions). As a 
result, any distribution of appreciated section 751 property in which 
another partner has a share of income would trigger section 751(b) 
under the hypothetical sale approach. The commentators recommended that 
the IRS and the Treasury Department narrow the application of section 
751(b) by allowing partners (subject to the substantiality requirements 
of Sec.  1.704-1(b)(2)(iii)) to ``exchange'' reverse section 704(c) 
amounts resulting from a section 751 distribution. These proposed 
regulations do not adopt this comment because it is beyond the scope of 
these regulations and would impact other provisions of subchapter K. 
However, the IRS and the Treasury Department believe that the issue 
merits further study and request comments on how such permissible 
exchanges of reverse section 704(c) amounts might be addressed in 
future regulations.
C. Effect of Basis Adjustments on Section 751(b) Computations
    While section 704(c) revaluations generally preserve partners' 
interests in section 751 property upon a partnership distribution, 
certain basis adjustments under sections 732(c) or 734(b) may alter 
partners' interests in section 751 property following the distribution. 
Accordingly, these proposed regulations provide rules on the effect of 
these basis adjustments on the computation of partners' interests in 
section 751 property.
    If a distribution of capital gain property results in a basis 
adjustment under section 734(b), that basis adjustment is allocated to 
capital gain property of the partnership under Sec.  1.755-1(c)(1). 
However, some property that is characterized as capital gain property 
for purposes of section 755 can also result in ordinary income when 
sold. For example, section 1231 property is characterized as a capital 
asset for purposes of section 755, but selling the property can also 
result in ordinary income from recapture under section 1245(a)(1). The 
regulations under section 755 do not differentiate between the capital 
gain aspect of the property and the ordinary income aspect of the 
property for this purpose. Accordingly, allocating a section 734(b) 
positive basis adjustment to such property as capital gain property may 
reduce the amount of ordinary income that would result on a sale of the 
property. Under these proposed regulations, that reduction in ordinary 
income would constitute a reduction in the partners' shares of 
unrealized gain in the partnership's section 751 property, which could 
trigger section 751(b) in situations in which 751(b) would not have 
otherwise applied. A similar reduction in section 751 property could 
occur if the basis of the distributed property increases under section 
732.
    One commentator recommended allowing partnerships to avoid this 
result by eliminating a positive section 734(b) adjustment to the 
extent the section 734(b) adjustment would reduce the partnership's 
ordinary income. Another commentator recommended allocating the section 
734(b) adjustment to other partnership capital gain property. The same 
commentator alternatively recommended treating a positive section 
734(b) adjustment that reduced the partnership's ordinary income as a 
separate asset.
    Although these proposed regulations do not treat the section 734(b) 
adjustment as a separate asset, the proposed regulations reach a 
similar result to this last recommendation. They provide that a basis 
adjustment under section 732(c) or section 734(b) (as adjusted for 
recovery of the basis adjustment) that is allocated to capital gain 
property and that reduces the ordinary income (attributable, for 
example, to recapture under section 1245(a)(1)) that the partner or 
partnership would recognize on a taxable disposition of the property is 
not taken into account in determining (1) the partnership's basis for 
purposes of sections 617(d)(1), 1245(a)(1), 1250(a)(1), 1252(a)(1), and 
1254(a)(1), and (2) the partner or partnership's respective gain or 
loss for purposes of sections 995(c), 1231(a), and 1248(a). The IRS and 
the Treasury Department intend for these amendments to apply for 
purposes of other provisions that cross-reference those sections (for 
example, the reference in Sec.  1.367(b)-2(c) to section 1248). The IRS 
and the Treasury Department are aware that these rules may result in 
additional administrative burden and, therefore, permit a partnership 
and its partners to elect to recognize ordinary income currently under 
section 751(b) in lieu of applying these rules.
    In addition, one commentator raised questions about the application 
of section 751(b) upon the distribution to a partner of section 751 
property for which another partner has a basis adjustment under section 
743(b) (the transferee partner). The commentator questioned whether the 
distributee partner's share of section 751 property could be increased 
inappropriately if the special basis adjustment is not taken into 
account in determining the distributee's basis in the section 751 
property under section 732. The IRS and the Treasury Department believe 
that although the distributee partner does not take the section 743(b) 
basis adjustment into account in determining its basis in the 
distributed property, the reallocation of the section 743(b) basis 
adjustment pursuant to Sec.  1.743-1(g)(2)(ii) should generally reduce 
the transferee partner's share of section 751 property, triggering an 
income inclusion to that partner under section 751(b) which is offset 
by the basis adjustment. The IRS and the Treasury Department 
acknowledge that, in situations in which the partnership holds no other 
section 751 property (and the section 743(b) basis adjustment is 
temporarily suspended under Sec. Sec.  1.743-1(g)(2)(ii) and 1.755-
1(c)(4) until the partnership acquires additional ordinary income 
property), the application of section 751(b) may be unclear. 
Accordingly, the proposed regulations require that

[[Page 65155]]

partners include the effect of carryover basis adjustments when 
determining their shares of section 751 property, as though those basis 
adjustments were immediately allocable to ordinary income property. See 
Example 4 in Sec.  1.751-1(g) of the proposed regulations.

2. Distributions to Which Section 751(b) Applies

A. General Principle
    The purpose of section 751 is to prevent a partner from converting 
its share of potential ordinary income into capital gain. A 
distribution of partnership property (including money) is a section 
751(b) distribution if the distribution reduces any partner's share of 
net section 751 unrealized gain or increases any partner's share of net 
section 751 unrealized loss (as determined under the hypothetical sale 
approach described in Part 1.A of the Summary of Comments and 
Explanation of Provisions section of this preamble). For this purpose, 
a partner's net section 751 unrealized gain or loss immediately before 
a distribution equals the amount of net gain or loss, as the case may 
be, from section 751 property that would be allocated to the partner if 
the partnership disposed of all of the partnership's assets for cash in 
an amount equal to the fair market value of such property (taking into 
account section 7701(g)). A partner's net section 751 unrealized gain 
or loss includes any remedial allocations under Sec.  1.704-3(d).
    A partner's net section 751 unrealized gain or loss also takes into 
account any section 743 basis adjustment pursuant to Sec.  1.743-
1(j)(3), including any carryover basis adjustment that results under 
any of Sec.  1.743-1(g)(2)(ii), Sec.  1.755-1(b)(5)(iii)(D), or Sec.  
1.755-1(c)(4) when the partnership must adjust the basis of a specific 
class of assets, but that adjustment is suspended because the 
partnership does not own assets in that class. The regulations take 
such suspended basis adjustments into account as though the basis 
adjustment is applied to the basis of notional partnership section 751 
property with a fair market value of zero. For example, if A and B are 
partners in the AB partnership, which owns capital assets and a single 
ordinary income asset that is the subject of a section 743(b) 
adjustment with respect to B, and that asset is distributed to partner 
A, B's basis adjustment is suspended because the partnership lacks 
other ordinary income property. However, the basis adjustment will 
eventually benefit B when the partnership acquires new ordinary income 
property. For this reason, the proposed regulations require B to take 
the suspended adjustment into account when determining whether section 
751(b) applies to B with respect to the distribution.
    A partner's share of net section 751 unrealized gain or loss from 
section 751 property immediately following a distribution is computed 
using the same formula. However, the distributee partner also includes 
in its post-distribution amount its share of net income or loss from a 
hypothetical sale of the distributed section 751 property.
    If section 751(b) applies to a distribution, each partner must 
generally recognize or take into account currently ordinary income 
equal to its ``section 751(b) amount.'' If a partner has net section 
751 unrealized gain both before and after the distribution, then the 
partner's section 751(b) amount equals the partner's net section 751 
unrealized gain immediately before the distribution less the partner's 
net section 751 unrealized gain immediately after the distribution. If 
a partner has net section 751 unrealized loss both before and after the 
distribution, then the partner's section 751(b) amount equals the 
partner's net section 751 unrealized loss immediately after the 
distribution less the partner's net section 751 unrealized loss 
immediately before the distribution. If a partner has net section 751 
unrealized gain before the distribution and net section 751 unrealized 
loss after the distribution, then the partner's section 751(b) amount 
equals the sum of the partner's net section 751 unrealized gain 
immediately before the distribution and the partner's net section 751 
unrealized loss immediately after the distribution.
    Commentators requested a de minimis exception to section 751(b). 
The IRS and the Treasury Department continue to study the issue and 
request comments describing the parameters of a de minimis rule that 
would be helpful.
B. Section 751 Anti-Abuse Rule
    The IRS and the Treasury Department believe that, despite the 
general principle that section 751(b) should apply only at the time 
that a partner's share of net section 751 unrealized gain is reduced 
(or net section 751 loss is increased), the deferral of ordinary income 
upon the receipt of a distribution is inappropriate in certain 
circumstances. Specifically, deferral is inappropriate if a partner 
engages in a transaction that relies on the rules of section 704(c) to 
defer or eliminate ordinary income while monetizing most of the value 
of the partnership interest. Accordingly, these proposed regulations 
provide an anti-abuse rule that requires taxpayers to apply the rules 
set forth in the proposed regulations in a manner consistent with the 
purpose of section 751, and that allows the Commissioner to recast 
transactions for federal tax purposes as appropriate to achieve tax 
results that are consistent with the purpose of section 751.
    The proposed regulations provide a list of situations that are 
presumed inconsistent with the purpose of section 751. Under this list, 
a distribution is presumed inconsistent with the purpose of section 751 
if section 751(b) would apply but for the application of section 704(c) 
principles, and one or more of the following conditions exists: (1) A 
partner's interest in net section 751 unrealized gain is at least four 
times greater than the partner's capital account immediately after the 
distribution, (2) a distribution reduces a partner's interest to such 
an extent that the partner has little or no exposure to partnership 
losses and does not meaningfully participate in partnership profits 
aside from a preferred return for the use of capital, (3) the net value 
of the partner (or its successor) becomes less than its potential tax 
liability from section 751 property as a result of a transaction, (4) a 
partner transfers a portion of its partnership interest within five 
years after the distribution to a tax-indifferent party in a manner 
that would not trigger ordinary income recognition in the absence of 
this anti-abuse rule, or (5) a partnership transfers to a corporation 
in a nonrecognition transaction section 751 property other than 
pursuant to a transfer of all property used in a trade or business 
(excluding assets that are not material to a continuation of the trade 
or business). In addition, the proposed regulations provide that an 
amendment to the partnership agreement that results in a reduction in a 
partner's interest in section 751 property is also presumed 
inconsistent with the purpose of section 751. A partnership or a 
partner taking a position on its return that section 751 does not apply 
to a transaction that meets one or more of these situations must 
disclose its position on Form 8275, Disclosure Statement.

3. Tax Consequences of a Section 751(b) Distribution

    If section 751(b) applies to a distribution under the principles 
set forth in Part 2 of the Summary of Comments and Explanation of 
Provisions section of this preamble, then the partners must determine 
the consequences of its application to the partnership and its 
partners. As described in the Background section of this preamble, 
Notice 2006-14 discussed replacing the asset exchange

[[Page 65156]]

approach with a hot asset sale approach to determine these 
consequences. While most commentators agreed that the hot asset sale 
approach is an improvement over the existing regulations' asset 
exchange approach, commentators were able to identify situations in 
which the hot asset sale approach fails to achieve the correct result 
or causes undesirable results under other Code provisions. Two 
commentators advocated adopting, in lieu of the hot asset sale 
approach, an approach similar to that taken in section 704(c)(1)(B) 
(referred to in this preamble as a ``deemed gain'' approach), in which 
a section 751(b) distribution results in: (1) The partnership 
recognizing ordinary income in the aggregate amount of each partner's 
reduction in the partner's interest in section 751 property, (2) the 
partnership allocating ordinary income to the partner or partners whose 
interest in section 751(b) property was reduced by the distribution, 
and (3) the partnership making appropriate basis adjustments to its 
assets to reflect its ordinary income recognition. One variation of the 
deemed gain approach would require capital gain recognition in certain 
cases.
    The IRS and the Treasury Department determined that a deemed gain 
approach produces an appropriate outcome in the greatest number of 
circumstances out of the approaches under consideration, and that the 
hot asset sale approach also produced an appropriate outcome in most 
circumstances. However, no one approach produced an appropriate outcome 
in all circumstances. Therefore, these proposed regulations withdraw 
the asset exchange approach of the current regulations, but do not 
require the use of a particular approach for determining the tax 
consequences of a section 751(b) distribution. Instead, these proposed 
regulations provide that if, under the hypothetical sale approach, a 
distribution reduces a partner's interest in the partnership's section 
751 property, giving rise to a section 751(b) amount, then the 
partnership must use a reasonable approach that is consistent with the 
purpose of section 751(b) to determine the tax consequences of the 
reduction. Except in limited situations, a partnership must continue to 
use the same approach, once chosen, including after a termination of 
the partnership under section 708(b)(1)(B). These proposed regulations 
include examples in which the approach adopted is generally reasonable 
based on the facts of the examples, and one example in which it is 
determined that the adopted approach is not reasonable based on the 
facts of the example.
    Finally, some commentators recommended allowing taxpayers to elect 
to recognize capital gain in certain situations (for example, in the 
situation described in Example 2 in Notice 2006-14 involving 
distributions of section 751(b) property to a partner that has 
insufficient basis in its partnership interest to absorb fully the 
partnership's basis in the distributed property). Recognition of gain 
may be appropriate where failing to recognize gain would cause an 
adjustment to the basis of distributed property (under section 732) or 
to the basis of partnership property (under section 734(b)) if those 
basis adjustments would change the partners' shares of ordinary income 
already determined under the principles described in Part 1 of the 
Summary of Comments and Explanation of Provisions section of this 
preamble. Such changes in ordinary income amounts could (in the case of 
certain adjustments under section 734(b)) decrease partners' shares of 
partnership ordinary income, requiring the recognition of additional 
income under section 751(b), or could (in the case of certain 
adjustments under section 732) convert a distributee partner's share of 
capital gain into ordinary income. Thus, these proposed regulations 
require that distributee partners recognize capital gain in certain 
situations, and permit distributee partners to elect to recognize 
capital gain in certain other situations.
    The proposed regulations require a distributee partner to recognize 
capital gain to the extent necessary to prevent the distribution from 
triggering a basis adjustment under section 734(b) that would reduce 
other partners' shares of net unrealized section 751 gain or loss. 
Capital gain recognition is necessary in this situation because the 
section 734(b) basis adjustment was not taken into account in 
determining the partners' net section 751 unrealized gain or loss 
immediately after the section 751 distribution, and the IRS and the 
Treasury Department believe that an approach under which a partnership 
redetermines a partner's net section 751 unrealized gain or loss to 
account for section 734(b) basis adjustments would be both 
administratively burdensome and would accelerate ordinary income 
unnecessarily. See Examples 5 and 6 in Sec.  1.751-1(g) of the proposed 
regulations. Gain recognized in this event is generally capital; 
however, if the partnership makes an election under Sec.  1.755-
1(c)(2)(vi), then the partner must characterize all or a portion of the 
gain recognized under this rule as ordinary income or a dividend, as 
appropriate, to preserve the character of the gain in the adjusted 
asset. See Example 9 in Sec.  1.751-1(g) of the proposed regulations.
    These proposed regulations also allow distributee partners to elect 
to recognize capital gain in certain circumstances to avoid decreases 
to the basis of distributed section 751 property. Elective capital gain 
recognition is appropriate to eliminate a negative section 732(a)(2) or 
(b) basis adjustment to the asset or assets received in distribution 
if, and to the extent that, the distributee partner's net section 751 
unrealized gain would otherwise be greater immediately after the 
distribution than it was immediately before the distribution (or would 
cause the distributee partner's net section 751 unrealized loss to be 
less immediately after the distribution than it was immediately before 
the distribution). For example, elective capital gain recognition is 
appropriate if a partner with zero basis in its partnership interest 
receives a distribution of partnership section 751 property with basis 
in the hands of the partnership equal to its value, and the 
distribution otherwise increases the distributee partner's net section 
751 unrealized gain.

4. Miscellaneous

A. Section 751(a)
    As described in Parts 2.A and 2.B of this preamble, these proposed 
regulations generally defer the recognition of ordinary income upon a 
distribution when the partner's unrealized gain and loss in the 
partnership's section 751 property is preserved through the application 
of the principles of section 704(c). This approach is consistent with 
the 1984 amendment to section 704(c). By mandating the application of 
section 704(c) principles, that amendment partially severed the 
relationship that had generally existed between a partner's 
distributive share (that is, the right to share in the economic gain or 
loss) associated with a partnership item and the partner's share of tax 
gain or loss from the sale of that item. The IRS and the Treasury 
Department believe that, by mandating the application of section 704(c) 
principles in 1984, Congress intended that impacted provisions be 
interpreted consistent with this new emphasis on tax gain or loss. 
Congress provided a broad delegation of authority to the Treasury 
Department to address these repercussions of amending section 704(c) on 
other provisions in subchapter K.

[[Page 65157]]

    Some commentators interpret section 751(a) as limiting the amount 
of ordinary income that a transferor partner may recognize upon a 
transfer of a partnership interest to the amount of any money or 
property received by the transferor partner, without taking into 
account the total amount of ordinary income attributable to the 
partnership interest transferred that relates to section 751 property. 
However, interpreting section 751(a) as limiting ordinary income in 
this way would contravene Congress's intent to tax partners on their 
shares of partnership ordinary income as determined by applying section 
704(c) principles. The IRS and the Treasury Department believe that 
section 751(a) should be interpreted in a manner that accounts for the 
impact of section 704(c). Thus, these proposed regulations provide that 
the amount of money or the fair market value of property received for 
purposes of section 751(a) takes into account the transferor partner's 
share of income or gain from section 751 property.
    The IRS and the Treasury Department alternatively considered 
addressing this issue by deeming a partner that sells or exchanges its 
partnership interest to receive a distribution of the partner's share 
of the section 751 property, followed by a sale of the property back to 
the partnership for its fair market value, recognizing the deferred 
ordinary income inherent in the section 751 property. The partner would 
then be deemed to contribute the cash proceeds to the partnership 
thereby increasing the partner's basis in the partner's partnership 
interest. Finally, upon the sale or exchange of the partnership 
interest, the partner would recognize the appropriate amount of capital 
loss. This potential multi-step deemed approach would result in 
additional complexity and would reach the same result that the current 
regulations under Sec.  1.751-1(a) reach as clarified by these proposed 
regulations. Therefore, the IRS and the Treasury Department are not 
proposing this alternative approach.
B. Previously Contributed Property Exception
    Section 751(b)(2)(A) provides that section 751(b) does not apply to 
a distribution of property that the distributee contributed to the 
partnership (``previously contributed property exception''). Unlike 
other provisions in subchapter K that include similar previously 
contributed property exceptions, the current regulations under section 
751(b) do not contain successor rules for purposes of applying the 
section 751(b) previously contributed property exception. These 
proposed regulations add successor rules to section 751(b) similar to 
the successor rules contained in other previously contributed property 
exceptions within subchapter K.
C. Mergers and Divisions
    A commentator requested guidance confirming how the rules of 
section 751(b) apply in the case of an incorporation, merger, or 
division of a partnership. The proposed regulations do not adopt this 
comment because the IRS and the Treasury Department believe such 
guidance is beyond the scope of these proposed regulations.
D. Substantial Appreciation Test
    These proposed regulations also make a number of technical 
corrections to account for changes in the law since the issuance of 
existing regulations under section 751. For example, these proposed 
regulations remove the language ``substantially appreciated'' from the 
first sentence of Sec.  1.751-1(a)(1), which applies with respect to 
sales or exchanges of an interest in a partnership. In addition to 
conforming the language of the regulations to that of the Code, this 
change is intended to clarify that, upon a sale or exchange of a 
partnership interest, unrealized receivables and inventory items are 
treated in the same manner. Thus, a transferor partner may recognize an 
ordinary loss with respect to inventory items pursuant to section 
751(a) to the extent the transferor would be allocated a net ordinary 
loss pursuant to Sec.  1.751-1(a)(2). These proposed regulations also 
update the definition of ``inventory items which have appreciated 
substantially in value'' with respect to section 751(b) to reflect the 
1993 amendment to the statute that eliminated the 10-percent test from 
the definition of ``substantial appreciation.'' See Public Law 103-66, 
Sec. 13206(e)(1). These proposed regulations also clarify that 
unrealized receivables are not included in the term ``inventory items 
which have appreciated substantially in value.''
E. Other Changes Relating to Revaluations
    Finally, these proposed regulations address some of the comments 
received in response to Notice 2009-70 (2009-2 CB 255), in which the 
IRS and the Treasury Department requested comments on, among other 
things, whether additional events should be added to the list of events 
permitting a revaluation of partnership property pursuant to Sec.  
1.704-1(b)(2)(iv)(f) and whether, in a tiered partnership structure, a 
revaluation at one partnership in the tier should permit another 
partnership in the tier to revalue that partnership's property. 
Commentators recommended that partnership recapitalizations (changes to 
the way partners agree to share partnership profits and losses) be 
added as a permissible revaluation event. The IRS and the Treasury 
Department agree that partnership recapitalizations should be added as 
a permissible event because, absent providing for a special allocation 
of any unrealized gain or loss in partnership assets that arose prior 
to the recapitalization, a revaluation is necessary to preserve each 
partner's share of such unrealized amounts. In addition, commentators 
recommended that a partnership in a tiered partnership structure be 
able to revalue its partnership property if another partnership in the 
tiered structure was permitted to revalue its partnership property. The 
IRS and the Treasury Department agree and believe that permitting 
successive revaluations in a tiered partnership structure is necessary 
to properly allocate items with respect to a reverse section 704(c) 
allocation to the appropriate partner.

Availability of IRS Documents

    IRS notices cited in this preamble are made available by the 
Superintendent of Documents, U.S. Government Printing Office, 
Washington, DC 20402.

Effect on Other Documents

    The following publication will be obsolete as of the date of 
publication of a Treasury decision adopting these rules as final 
regulations in the Federal Register:
    Rev. Rul. 84-102 (1984-2 CB 119).

Proposed Effective/Applicability Date

    The regulations, as proposed, apply to distributions occurring in 
any taxable period ending on or after the date of publication of a 
Treasury decision adopting these rules as final regulations in the 
Federal Register. The rules contained in Sec.  1.751-1(a)(2) would 
apply to transfers of partnership interests that occur on or after 
November 3, 2014. However, the rules contained in Sec.  1.751-1(a)(2) 
are a clarification of existing rules, and no inference is intended 
from the change to Sec.  1.751-1(a)(2) with respect to sales or 
exchanges of partnership interests prior to the effective date for 
Sec.  1.751-1(a)(2). The rules contained in Sec.  1.751-1(a)(3) 
continue to apply to transfers of partnership interests that occur on 
or after December 15, 1999. A partnership and its partners would be 
able to rely on Sec.  1.751-1(b)(2) of these proposed regulations for 
purposes of determining

[[Page 65158]]

a partner's interest in the partnership's section 751 property on or 
after November 3, 2014 provided the partnership and its partners apply 
each of Sec.  1.751-1(a)(2), Sec.  1.751-1(b)(2), and Sec.  1.751-
1(b)(4) of these proposed regulations consistently for all partnership 
distributions and sales or exchanges, including for any distributions 
and sales or exchanges the partnership makes after a termination of the 
partnership under section 708(b)(1)(B).

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866, as supplemented by Executive Order 13653. 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) 
does not apply to these regulations. It is hereby certified that the 
collection of information in these regulations will not have a 
significant economic impact on a substantial number of small entities. 
This certification is based on the fact that the amount of time 
necessary to prepare the required disclosure is not lengthy and few 
small businesses are likely to be partners or partnerships required to 
make the disclosures required by the rule. Accordingly, a Regulatory 
Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. 
chapter 6) does not apply. Pursuant to section 7805(f) of the Code, 
this notice of proposed rulemaking has been submitted to the Chief 
Counsel for Advocacy of the Small Business Administration for comment 
on its impact on small business.

Comments and Requests for Public Hearing

    The IRS and the Treasury Department request comments on all aspects 
of the proposed rules. In particular, the IRS and the Treasury 
Department request comments, in addition to those previously requested 
in this preamble, on: (1) Whether and how carryover adjustments to 
ordinary income property under sections 734(b) and 743(b) should be 
taken into account under the hypothetical sale approach, (2) whether 
the final regulations should exclude certain types of transactions from 
the previously contributed property successor rules provided in these 
proposed regulations, (3) whether the regulations should specifically 
describe approaches as generally reasonable approaches for determining 
the tax consequences of a section 751(b) distribution, and which 
approaches should be specified as generally reasonable, (4) whether the 
final regulations should provide rules similar to those proposed in new 
Sec.  1.755-1(c)(2)(iii) through (vi) in Sec.  1.755-1(b)(5) with 
respect to section 743(b) adjustments in substituted basis 
transactions, and (5) what disclosures the IRS and the Treasury 
Department should require from partners and partnerships that either 
recognize gain under section 751(a) or (b), or rely on reverse section 
704(c) allocations to defer the gain recognition required by section 
751(a) or (b).
    The IRS and the Treasury Department also request comments on a 
topic that, although not specific to section 751, may impact the rules 
under section 751. The IRS and the Treasury Department are aware that 
the regulations under Sec.  1.1245-1(e)(3) (concerning the interaction 
of section 1245 and section 743), and Sec.  1.1250-1(f), by reference 
to Sec.  1.1245-1(e)(3), are out of date. The intent of the regulations 
under Sec.  1.1245-1(e)(3) is, in part, to ensure that a transferee 
partner does not recognize ordinary income with respect to section 1245 
property to the extent a section 743 adjustment has displaced that 
ordinary income. For example, if a partner sells in a fully taxable 
exchange its interest in a partnership that has elected under section 
754, and the selling partner recognizes ordinary income under section 
751(a) with respect to partnership section 1245 property, then the 
rules under sections 1245 and 743 are intended to ensure that the 
transferee partner recognizes no ordinary income on an immediately 
subsequent disposition of the section 1245 property in a fully taxable 
transaction. However, the regulations under Sec.  1.1245-1(e)(3) have 
not been amended to take into account changes to subchapter K, 
including the regulations under section 751, resulting in issues and 
uncertainties. The IRS and the Treasury Department are studying these 
issues and request comments in this area.
    Finally, the IRS and the Treasury Department request comments as to 
how section 751(b) should interact with rules for withholding and 
reporting with respect to nonresident aliens and foreign corporations. 
For example, the IRS and the Treasury Department are considering 
whether regulations should provide that for purposes of withholding 
under chapter 3 of Subtitle A (for example, under section 1446), income 
recognized as a result of a section 751(b) distribution is treated as 
recognized by the partnership regardless of the approach chosen to 
determine the U.S. tax consequences of the section 751(b) distribution. 
The IRS and the Treasury Department are also considering whether 
additional guidance with respect to tax or information returns (for 
example, pursuant to section 6031(b) or section 6050K) is necessary for 
gain recognized on section 751(b) distributions affecting these 
taxpayers.
    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any comments that are submitted timely 
to the IRS as prescribed in this preamble under the ``Addresses'' 
heading. All comments will be available at www.regulations.gov or upon 
request. A public hearing will be scheduled if requested in writing by 
any person who submits timely written or electronic comments. If a 
public hearing is scheduled, notice of the date, time, and place for 
the public hearing will be published in the Federal Register.

Drafting Information

    The principal authors of these regulations are Allison R. Carmody 
and Frank J. Fisher, Office of the Associate Chief Counsel 
(Passthroughs and Special Industries). However, other personnel from 
the IRS and the Treasury Department participated in their development.

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

0
Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

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

0
Par. 2. Section 1.617-4 is amended by adding a new sentence at the end 
of paragraph (c)(3)(ii)(g) to read as follows:


Sec.  1.617-4  Treatment of gain from disposition of certain mining 
property.

* * * * *
    (c) * * *
    (3) * * *
    (ii) * * *
    (g) * * * See also Sec. Sec.  1.732-1(c)(2)(iii) and 1.755-
1(c)(2)(iii) for rules governing the application of section 617 to 
partnership property in certain situations.
* * * * *
0
Par. 3. Section 1.704-1 is amended by:

[[Page 65159]]

0
a. Revising paragraph (b)(2)(iv)(f) introductory text.
0
b. Redesignating paragraph (b)(2)(iv)(f)(5)(v) as paragraph 
(b)(2)(iv)(f)(5)(vi).
0
c. Adding new paragraph (b)(2)(iv)(f)(5)(v).
0
d. Designating the undesignated text after paragraph 
(b)(2)(iv)(f)(5)(vi) as paragraph (b)(2)(iv)(f)(5)(vii).
    The revisions and additions read as follows:


Sec.  1.704-1  Partner's distributive share.

* * * * *
    (b) * * *
    (2) * * *
    (iv) * * *
    (f) Revaluations of property. A partnership agreement may, upon the 
occurrence of certain events, and must in the circumstances described 
in Sec.  1.751-1(b)(2)(iv), increase or decrease the capital accounts 
of the partners to reflect a revaluation of partnership property 
(including intangible assets such as goodwill) on the partnership's 
books. If a partnership that revalues its property pursuant to this 
paragraph owns an interest in another partnership, that partnership in 
which it owns an interest may also revalue its property in accordance 
with this section. Similarly, if an interest in a partnership that 
revalues its property pursuant to this paragraph is owned by another 
partnership, the partnership owning that interest may also revalue its 
property in accordance with this section. Capital accounts so adjusted 
will not be considered to be determined and maintained in accordance 
with the rules of this paragraph (b)(2)(iv) unless--
* * * * *
    (5) * * *
    (v) In connection with an agreement to change (other than a de 
minimis change) the manner in which the partners share any item or 
class of items of income, gain, loss, deduction or credit of the 
partnership under the partnership agreement, or
* * * * *
0
Par. 4. Section 1.704-3 is amended in paragraph (a)(9) by adding a 
sentence immediately following the first sentence to read as follows:


Sec.  1.704-3  Contributed property.

    (a) * * *
    (9) * * * If a partnership (the upper-tier partnership) owns an 
interest in another partnership (the lower-tier partnership), and both 
the upper-tier partnership and the lower-tier partnership 
simultaneously revalue partnership property pursuant to Sec.  1.704-
1(b)(2)(iv)(f), the principles of this paragraph (a)(9) shall apply to 
any reverse section 704(c) allocations created upon the revaluation. * 
* *
* * * * *
0
Par. 5. Section 1.732-1 is amended by adding paragraphs (c)(2)(iii), 
(iv), (v), (vi), and (vii), and revising paragraph (c)(5) to read as 
follows:


Sec.  1.732-1  Basis of distributed property other than money.

* * * * *
    (c) * * *
    (2) * * *
    (iii) Property subject to section 1245. Any increase in basis 
allocated to capital gain property pursuant to the second sentence in 
paragraph (c)(2)(ii) of this section is not taken into account in 
determining the recomputed or adjusted basis in the property for 
purposes of section 1245(a)(1). Notwithstanding the prior sentence, any 
depreciation or amortization of the increase in basis that is allowed 
or allowable is taken into account in computing the property's 
recomputed basis. In the case of property that is subject to section 
617(d)(1), section 1250(a)(1), section 1252(a)(1), or section 
1254(a)(1), rules similar to the rule in this paragraph (c)(2)(iii) 
shall apply. See Examples 2 and 3 in Sec.  1.755-1(c)(6).
    (iv) Section 1231 property. Any increase in basis allocated to 
capital gain property pursuant to the second sentence in paragraph 
(c)(2)(ii) of this section is not taken into account in determining 
section 1231 gain and loss, as defined in section 1231(a)(3). See 
Examples 2 and 3 in Sec.  1.755-1(c)(6).
    (v) Property subject to section 1248. Any increase in basis 
allocated to stock in a foreign corporation pursuant to the second 
sentence in paragraph (c)(2)(ii) of this section or any decrease in 
basis allocated to stock in a foreign corporation pursuant to the 
second sentence in paragraph (c)(2)(i) of this section is not taken 
into account in determining the amount of gain recognized on the sale 
or exchange of such stock for purposes of section 1248(a). In the case 
of property that is subject to section 995(c), rules similar to the 
rule set forth in this paragraph (c)(2)(v) shall apply. See Examples 8 
and 9 in Sec.  1.751-1(g).
    (vi) Special rule. Any basis adjustment to an asset that is not 
taken into account under paragraph (c)(2)(iii), (iv), or (v) of this 
section shall, upon a taxable disposition, be treated as gain or loss, 
as the case may be, from the sale or exchange of a capital asset with 
the same holding period as the underlying asset. See Examples 2 and 3 
in Sec.  1.755-1(c)(6).
    (vii) Election not to apply the provisions of paragraphs 
(c)(2)(iii), (iv), and (v). See Sec.  1.755-1(c)(2)(vi) for rules 
regarding an election to have the provisions of paragraphs (c)(2)(iii), 
(iv), and (v) of this section, and Sec.  1.755-1(c)(2)(iii), (iv), and 
(v) not apply. See Examples 2 and 3 in Sec.  1.755-1(c)(6).
* * * * *
    (5) Effective/applicability date. This paragraph (c) applies to 
distributions of property from a partnership that occur on or after 
December 15, 1999, except that paragraphs (c)(2)(iii), (iv), (v), (vi), 
and (vii) of this section apply to distributions of property from a 
partnership that occur on or after the date of publication of a 
Treasury decision adopting these rules as final regulations in the 
Federal Register.
* * * * *


Sec.  1.736-1  [Amended]

0
Par. 6. Section 1.736-1 is amended in paragraph (b)(4) by removing the 
language ``paragraph (b)(3)(iii)'' from the last sentence and adding 
the language ``paragraph (b)(3)'' in its place.
0
Par. 7. Section 1.751-1 is amended by:
0
a. Revising paragraphs (a)(1) and (2).
0
b. Revising the first sentence of paragraph (b)(1)(i) and adding a new 
sentence at the end of paragraph (b)(1)(i).
0
c. Removing the last four sentences of paragraph (b)(1)(ii).
0
d. Revising paragraphs (b)(1)(iii) and (b)(2) and (3).
0
e. Redesignating paragraphs (b)(4) and (5) as paragraphs (b)(5) and 
(6).
0
f. Adding a new paragraph (b)(4).
0
g. Revising the paragraph heading of newly designated paragraph (b)(5).
0
h. Further redesignating newly redesignated paragraph (b)(5)(ii) as 
paragraph (b)(5)(vi) and adding paragraphs (b)(5)(ii), (iii), (iv), and 
(v).
0
i. Revising newly designated paragraph (b)(6).
0
j. Revising paragraph (c)(4)(vi).
0
k. Adding paragraph (c)(4)(x).
0
l. Removing paragraphs (c)(5) and (6).
0
m. Revising the first and second sentences of paragraph (d)(1).
0
n. Revising paragraphs (e), (f), and (g).
    The additions and revisions read as follows:


Sec.  1.751-1  Unrealized receivables and inventory items.

    (a) * * * (1) Character of amount realized. To the extent that 
money or property received by a partner in exchange for all or part of 
his partnership interest is attributable to his share of the value of 
partnership unrealized receivables or inventory items, the money or 
fair market value of

[[Page 65160]]

the property received shall be considered as an amount realized from 
the sale or exchange of property other than a capital asset. The 
remainder of the total amount realized on the sale or exchange of the 
partnership interest is realized from the sale or exchange of a capital 
asset under section 741. For definition of ``unrealized receivables'' 
and ``inventory items,'' see section 751(c) and (d). See paragraph (e) 
of this section for the definition of section 751 property.
    (2) Determination of gain or loss. The income or loss realized by a 
partner upon the sale or exchange of its interest in section 751 
property is the amount of income or loss from section 751 property 
(taking into account allocations of tax items applying the principles 
of section 704(c), including any remedial allocations under Sec.  
1.704-3(d), and any section 743 basis adjustment pursuant to Sec.  
1.743-1(j)(3)) that would have been allocated to the partner (to the 
extent attributable to the partnership interest sold or exchanged) if 
the partnership had sold all of its property in a fully taxable 
transaction for cash in an amount equal to the fair market value of 
such property (taking into account section 7701(g)) immediately prior 
to the partner's transfer of the interest in the partnership. Any gain 
or loss recognized that is attributable to section 751 property will be 
ordinary gain or loss. The difference between the amount of capital 
gain or loss that the partner would realize in the absence of section 
751 and the amount of ordinary income or loss determined under this 
paragraph (a)(2) is the transferor's capital gain or loss on the sale 
of its partnership interest. For purposes of section 751(a) and 
paragraph (a) of this section, the amount of money or the fair market 
value of property received by the partner in exchange for all or part 
of his partnership interest must take into account the partner's share 
of income or gain from section 751 property. See Example 1 in paragraph 
(g) of this section. See Sec.  1.460-4(k)(2)(iv)(E) for rules relating 
to the amount of ordinary income or loss attributable to a contract 
accounted for under a long-term contract method of accounting.
* * * * *
    (b) Certain distributions treated as sales or exchanges--(1) In 
general. (i) Certain distributions to which section 751(b) applies are 
treated in whole or in part as sales or exchanges of property, and not 
as distributions to which sections 731 through 736 apply. * * * For 
purposes of section 751 and this section, a partner's interest in the 
partnership's section 751 property includes allocations of tax items 
applying the principles of section 704(c).
* * * * *
    (iii) If a distribution is a section 751(b) distribution, as 
described in paragraph (b)(2)(i) of this section, the tax consequences 
of the section 751(b) distribution, as determined under paragraph 
(b)(3) of this section, shall first apply, and then the rules of 
sections 731 through 736 shall apply. See paragraph (b)(5)(vi) of this 
section for treatment of payments under section 736(a).
    (2) Distributions to which section 751(b) applies--(i) Section 
751(b) amount. A distribution is a section 751(b) distribution if it 
gives rise to a ``section 751(b) amount'' for any partner. A partner's 
section 751(b) amount (if any) associated with a distribution of 
partnership property (including money) equals the greatest of--
    (A) The amount by which the partner's net section 751 unrealized 
gain immediately before the distribution exceeds the partner's net 
section 751 unrealized gain immediately after the distribution;
    (B) The amount by which the partner's net section 751 unrealized 
loss immediately after the distribution exceeds the partner's net 
section 751 unrealized loss immediately before the distribution; and
    (C) The amount of the partner's net section 751 unrealized gain 
immediately before the distribution, increased by the total amount of 
the partner's net section 751 unrealized loss immediately after the 
distribution (where neither of those numbers equals zero).
    (ii) Net section 751 unrealized gain or loss before a distribution. 
A partner's net section 751 unrealized gain or loss immediately before 
a distribution equals the amount of net income or loss, as the case may 
be, from section 751 property that would be allocated to the partner if 
the partnership disposed of all of the partnership's assets for cash in 
an amount equal to the fair market value of such property (taking into 
account section 7701(g)). For this purpose, a partner's net section 751 
unrealized gain or loss includes any remedial allocations under Sec.  
1.704-3(d), and takes into account any section 743 basis adjustment 
pursuant to Sec.  1.743-1(j)(3) and any carryover basis adjustment 
described in Sec. Sec.  1.743-1(g)(2)(ii), 1.755-1(b)(5)(iii)(D), or 
1.755-1(c)(4) as though the carryover basis adjustment was applied to 
the basis of new partnership section 751 property with fair market 
value of zero.
    (iii) Net section 751 unrealized gain or loss after a distribution. 
A partner's net section 751 unrealized gain or loss immediately after a 
distribution equals the sum of (to the extent applicable)--
    (A) With respect to a partner remaining in the partnership 
immediately after the distribution (including a distributee partner 
remaining in the partnership), the amount of net income or loss, as the 
case may be (including any remedial allocations under Sec.  1.704-3(d) 
and taking into account any section 743 basis adjustment pursuant to 
Sec.  1.743-1(j)(3) and any carryover basis adjustment described in 
Sec. Sec.  1.743-1(g)(2)(ii), 1.755-1(b)(5)(iii)(D), or 1.755-1(c)(4) 
as though the carryover basis adjustment was applied to the basis of 
new partnership section 751 property with fair market value of zero), 
from section 751 property that would be allocated to the partner if the 
partnership disposed of all of the partnership's assets for cash in an 
amount equal to the fair market value of such property (taking into 
account section 7701(g)); and
    (B) With respect to a partner receiving a distribution, the amount 
of net income or loss, as the case may be, from section 751 property 
that would be recognized by the distributee if, immediately after the 
distribution, the distributee disposed of the distributed assets for 
cash in an amount equal to the fair market value of such property 
(taking into account section 7701(g)).
    (iv) Revaluation of assets. For a partnership that distributes 
money or property (other than a de minimis amount) to a partner as 
consideration for an interest in the partnership, and that owns section 
751 property immediately after the distribution, if the partnership 
maintains capital accounts in accordance with Sec.  1.704-1(b)(2)(iv), 
the partnership must revalue its assets immediately prior to the 
distribution in accordance with Sec.  1.704-1(b)(2)(iv)(f). If a 
partnership does not maintain capital accounts in accordance with Sec.  
1.704-1(b)(2)(iv), the partnership must comply with this section by 
computing its partners' shares of partnership gain or loss immediately 
before the distribution as if the partnership assets were sold for cash 
in a fully taxable transaction (taking into account section 7701(g)), 
and by taking those computed shares of gain or loss into account under 
the principles of section 704(c) (making subsequent adjustments for 
cost recovery and other events that affect the basis of the property). 
In addition, if the partnership (upper-tier partnership) owns another 
partnership directly or indirectly through one or more

[[Page 65161]]

partnerships (lower-tier partnership), and the same persons own, 
directly or indirectly (through one or more entities), more than 50 
percent of the capital and profits interests in both the upper-tier 
partnership and the lower-tier partnership, the lower-tier partnership 
must also revalue its assets immediately prior to the distribution in 
accordance with Sec.  1.704-1(b)(2)(iv)(f) if the lower-tier 
partnership owns section 751 property. If the same persons do not own, 
directly or indirectly, more than 50 percent of the capital and profits 
interests in both the upper-tier partnership and the lower-tier 
partnership, the upper-tier partnership must allocate its distributive 
share of the lower-tier partnership's items among its partners in a 
manner that reflects the allocations that would have been made had the 
lower-tier partnership revalued its property.
    (3) Tax consequences of a section 751(b) distribution--(i) 
Reasonable approach. In the case of a section 751(b) distribution 
described in paragraph (b)(2) of this section, the partnership must 
choose a reasonable approach that is consistent with the purpose of 
section 751(b) under which each partner with a section 751(b) amount 
recognizes ordinary income (or takes it into account by eliminating a 
basis adjustment) equal to that section 751(b) amount immediately prior 
to the section 751(b) distribution. In certain circumstances described 
in paragraph (b)(3)(ii) of this section, a distributee partner may also 
be permitted or required to recognize capital gain. To be reasonable, 
an approach must conform to the general principles and anti-abuse rules 
described in paragraph (b)(4) of this section. An approach is not 
necessarily unreasonable merely because another approach would result 
in a higher aggregate tax liability. Once the partnership has adopted a 
reasonable approach, it must apply that approach consistently for all 
section 751(b) distributions, including for any distributions the 
partnership makes after a termination of the partnership under section 
708(b)(1)(B). If the application of the adopted approach to a later 
section 751(b) distribution produces results inconsistent with the 
purpose of section 751, the partnership must adopt another reasonable 
approach that achieves the purposes of section 751 for that 
distribution only. See Example 3 through Example 8 in paragraph (g) of 
this section.
    (ii) Gain Recognition--(A) Mandatory recognition. A partner's net 
section 751 unrealized gain or net section 751 unrealized loss for 
purposes of paragraph (b)(3)(i) of this section is determined before 
taking into account any basis adjustments required by paragraph 
(b)(3)(iii) of this section. In certain instances, the application of 
paragraph (b)(3)(iii) of this section may cause a partner to receive 
distributed property with a basis that differs from the basis of the 
property in the hands of the distributing partnership. If an adjustment 
to the basis of the distributed section 751 property results in a 
section 734(b) basis adjustment, and that basis adjustment would have 
altered the amount of net section 751 unrealized gain or loss computed 
under paragraph (b)(2) of this section if the section 734(b) adjustment 
had been included immediately prior to the distribution, then the 
distributee partner must recognize capital gain immediately prior to 
the distribution in an amount sufficient to eliminate that section 
734(b) basis adjustment. See Examples 5 and 6 in paragraph (g) of this 
section. If, however, the partnership makes an election under Sec.  
1.755-1(c)(2)(vi), then the partner must characterize all or a portion 
of the gain recognized under this paragraph as ordinary income or a 
dividend, as appropriate, to preserve the character of the gain in the 
adjusted asset. See Example 9 in paragraph (g) of this section.
    (B) Elective recognition. A distributee partner may elect to 
recognize capital gain (in addition to amounts required to be 
recognized under this section) to eliminate section 732(a)(2) or (b) 
basis adjustments to the asset or assets received in distribution if, 
and to the extent that, the basis adjustments required by paragraph 
(b)(3)(iii) of this section would otherwise cause the distributee 
partner's net section 751 unrealized gain to be greater immediately 
after the distribution than it was immediately before the distribution 
or would cause the distributee partner's net section 751 unrealized 
loss to be less immediately after the distribution than it was 
immediately before the distribution. A distributee partner elects under 
this paragraph (b)(3)(ii)(B) by providing the partnership with written 
notification of its intent to make the election and reporting the 
capital gain on its return. An extension of time to make an election 
under this paragraph (b)(3)(ii)(B) will not be granted under Sec.  
301.9100-3 of this chapter. The requirement in paragraph (b)(1)(i) of 
this section that a partnership apply a chosen reasonable method 
consistently across all partnership distributions does not apply for 
purposes of this paragraph. See Example 7 in paragraph (g) of this 
section.
    (iii) Adjustments to Basis. The partnership and its partners must 
make appropriate adjustments to the adjusted basis of the partners' 
interests in the partnership, and of section 751 property and other 
property held by the partnership or partners, in a manner consistent 
with the adopted approach to reflect any ordinary income or capital 
gain recognized upon application of paragraph (b)(3) of this section, 
and section 704(c) amounts must be adjusted accordingly.
    (4) General principles and anti-abuse rules. (i) The purpose of 
section 751 is to prevent a partner from converting its rights to 
ordinary income into capital gain, including by relying on the rules of 
section 704(c) to defer ordinary income while monetizing most of the 
value of the partnership interest. The partnership and all partners of 
the partnership must apply the rules of section 751 and Sec.  1.751-1 
in a manner consistent with the purpose of section 751. Accordingly, if 
a principal purpose of a transaction is to achieve a tax result that is 
inconsistent with the purpose of section 751, the Commissioner may 
recast the transaction for federal tax purposes as appropriate to 
achieve tax results that are consistent with the purpose of section 
751. The Commissioner will determine whether a tax result is 
inconsistent with the purpose of section 751 based on all the facts and 
circumstances. The existence of one or more of the situations set forth 
below is presumed to establish that a transaction is inconsistent with 
the purpose of section 751 and disclosure to the Internal Revenue 
Service in accordance with Sec.  1.751-1(b)(4)(ii) is required.
    (A) Circumstances in which a partner received a distribution that 
would otherwise be subject to section 751(b), but for the application 
of the principles of section 704(c), and one or more of the following 
conditions exist (whether at the time of the distribution or, in the 
case of paragraph (b)(4)(i)(A)(2), (3), (4), or (5) of this section, a 
later date):
    (1) The partner's interest in net section 751 unrealized gain is at 
least four times greater than the partner's capital account immediately 
after the distribution, pursuant to Sec.  1.704-1(b)(2)(iv) (or 
comparable amount for partnerships not maintaining capital accounts 
under Sec.  1.704-1(b)(2)(iv));
    (2) The partner is substantially protected from losses from the 
partnership's activities and has little or no participation in the 
profits from the partnership's activities other than a preferred return 
that is in the nature of a payment for the use of capital;

[[Page 65162]]

    (3) The partner engages in a transaction that, at the time of the 
transaction, causes the net value of the partner (or its successor) to 
be less than the tax liability that the partner (or its successor) 
would incur with respect to its interest in the partnership's section 
751 property upon a sale of its partnership interest for its fair 
market value at the time of the transaction. For this purpose, the net 
value of the partner (or its successor) equals--
    (i) The fair market value of all assets owned by the partner (or 
its successor) that may be subject to creditor's claims under local law 
(including the partner's enforceable right to contributions from its 
owner or owners), less
    (ii) All obligations of the partner (or its successor) other than 
the partner's obligation with respect to the tax liability for which 
the net value is being determined;
    (4) The partner transfers a portion of its partnership interest 
within five years after the distribution in a manner that does not 
trigger ordinary income recognition, and ordinary income or gain with 
respect to the partnership interest is subject to Federal income tax in 
the hands of the transferor partner immediately before the transfer, 
but any ordinary income or gain with respect to the partnership 
interest is exempt from, or otherwise not subject to, Federal income 
tax in the hands of the transferee partner immediately after the 
transfer;
    (5) The partnership transfers to a corporation in a nonrecognition 
transaction section 751 property other than pursuant to a transfer of 
all property used in a trade or business (excluding assets that are not 
material to a continuation of the trade or business); or
    (B) The partners agree to change (other than a de minimis change) 
the manner in which the partners share any item or class of items of 
income, gain, loss, deduction or credit of the partnership under the 
partnership agreement and that change reduces the partner's net section 
751 unrealized gain.
    (ii) If a partner participates in a transaction described in 
paragraph (b)(4)(i)(A) or (B) of this section and does not recognize 
and report its share of ordinary income from section 751 property on 
its tax return for the taxable year of the transaction, the partner 
must file Form 8275-R, Regulation Disclosure Statement, or any 
appropriate successor form, disclosing its participation in the 
transaction for the taxable year in which the transaction occurred.
    (5) Special rules. * * *
* * * * *
    (ii) The transferee in a nonrecognition transaction of all or a 
portion of the partnership interest of a contributing partner is 
treated as the contributing partner for purposes of section 751(b)(2) 
in an amount attributable to the interest transferred.
    (iii) For purposes of section 751(b)(2), if a partnership disposes 
of contributed section 751 property in a nonrecognition transaction, 
the substituted basis property (within the meaning of section 
7701(a)(42)) received in exchange for such substituted basis property 
is treated as the contributed section 751 property with regard to the 
contributing partner. If a partnership transfers contributed section 
751 property together with other property in a nonrecognition 
transaction, the substituted basis property (within the meaning of 
section 7701(a)(42)) is treated as the contributed section 751 property 
with regard to the contributing partner in the same proportion as the 
fair market value of the contributed section 751 property, at the time 
of the transfer, bears to the fair market value of the other property 
transferred at the time of the transfer. If a transfer described in 
this paragraph (b)(5)(iii) was in exchange for an interest in an 
entity, the interest in the entity will not be treated as the 
contributed section 751 property with regard to the contributing 
partner to the extent the value of the interest is attributable to 
other property the partnership contributed to the entity.
    (iv) For purposes of section 751(b)(2), an interest in an entity 
previously contributed to the partnership is not treated as previously 
contributed property to the extent the value of the interest is 
attributable to property the partnership 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.
    (v) For purposes of section 751(b)(2), the distribution of an 
undivided interest in property is treated as the distribution of 
previously contributed property to the extent that the undivided 
interest does not exceed the undivided interest, if any, contributed by 
the distributee partner in the same property.
* * * * *
    (6) Statements required--(i) Partnership. A partnership that makes 
a section 751(b) distribution must submit with its return for the year 
of the distribution a statement for each section 751(b) distribution 
made during the year that includes the following:
    (A) A caption identifying the statement as the disclosure of a 
section 751(b) distribution and the date of the distribution; and
    (B) A brief description of the reasonable approach adopted by the 
partnership pursuant to paragraph (b)(3)(i) of this section for 
recognizing the ordinary income; if applicable, the capital gain 
required to be recognized; and if relevant, whether the approach varies 
from an approach previously adopted within any of the three tax years 
preceding the current tax year.
    (ii) Partner. A partnership that makes a section 751(b) 
distribution during the partnership's tax year must submit with its 
return for the year of the distribution a statement for each partner 
that has a section 751(b) amount greater than $0 in connection with 
that distribution. The statement must be attached to the statement for 
that partner required by section 6031(b) and Sec.  1.6031(b)-1T(a), and 
must include the following:
    (A) The date of the section 751(b) distribution;
    (B) The amount of ordinary income the partner recognized pursuant 
to paragraph (b)(3)(i) of this section; and
    (C) The amount of capital gain the partner recognized, if any, 
pursuant to paragraph (b)(3)(ii)(A) or (B) of this section.
    (c) * * *
    (4) * * *
    (vi) With respect to any taxable year of a partnership beginning 
after July 18, 1984, amounts treated as ordinary income under section 
467 are treated as ordinary income under this section in the same 
manner as amounts treated as ordinary income under section 1245 (see 
paragraph (c)(4)(iii) of this section) or section 1250 (see paragraph 
(c)(4)(v) of this section).
* * * * *
    (x) With respect to any taxable year of a partnership beginning 
after July 18, 1984, the term unrealized receivables, for purposes of 
this section and sections 731, 732, and 741 (but not for purposes of 
section 736), includes any market discount bond (as defined in section 
1278) and any short-term obligation (as defined in section 1283) but 
only to the extent of the amount that would be treated as ordinary 
income if (at the time of the transaction described in this section or 
section 731, 732, or 741, as the case may be) such property had been 
sold by the partnership.
* * * * *
    (d) Inventory items which have substantially appreciated in value-- 
(1) Substantial appreciation. Partnership

[[Page 65163]]

inventory items shall be considered to have appreciated substantially 
in value if, at the time of the distribution, the total fair market 
value of all the inventory items of the partnership exceeds 120 percent 
of the aggregate adjusted basis for such property in the hands of the 
partnership (without regard to any special basis adjustment to the 
partner). The terms ``inventory items which have appreciated 
substantially in value'' or ``substantially appreciated inventory 
items'' refer to the aggregate of all partnership inventory items but 
do not include any unrealized receivables. * * *
* * * * *
    (e) Section 751 property and other property. For purposes of 
paragraph (a) of this section, section 751 property means unrealized 
receivables or inventory items. For purposes of paragraph (b) of this 
section, section 751 property means unrealized receivables or 
substantially appreciated inventory items. For purposes of all 
paragraphs of this section, other property means all property 
(including money) that is not section 751 property.
    (f) Applicability date. The rules contained in paragraph (a)(2) of 
this section apply to transfers of partnership interests that occur on 
or after November 3, 2014. The rules contained in paragraph (a)(3) of 
this section apply to transfers of partnership interests that occur on 
or after December 15, 1999. The rules contained in paragraphs (b)(2) 
and (3) of this section apply to distributions of partnership property 
that occur on or after the date of publication of a Treasury decision 
adopting these rules as final regulations in the Federal Register. 
However, a partnership and its partners may apply the rules contained 
in paragraph (b)(2) of this section for purposes of determining a 
partner's interest in the partnership's section 751 property on or 
after November 3, 2014, provided the partnership and its partners apply 
paragraphs (a)(2), (b)(2), and (b)(4) of this section consistently for 
all partnership sales, exchanges, and distributions, including for any 
distributions the partnership makes after a termination of the 
partnership under section 708(b)(1)(B).
    (g) Examples. Application of the provisions of section 751 may be 
illustrated by the following examples. In each of Examples 2 through 9 
of this paragraph (g), none of the section 751 property qualifies as 
property that the distributee previously contributed as described in 
section 751(b)(2)(A), and no distribution to a retiring partner is a 
payment described in section 736(a):

    Example 1.  (i)(A) A and B are equal partners in personal 
service partnership PRS. A contributed nondepreciable capital assets 
(the ``Capital Assets'') to PRS with a basis and fair market value 
of $14,000. B contributed unrealized receivables described in 
paragraph (c) of this section (the ``Unrealized Receivables'') to 
PRS with a basis of zero and fair market value of $14,000. Later, 
when the fair market value of the Capital Assets had declined to 
$2,000, B transferred its interest in PRS to T for $9,000 when PRS's 
balance sheet (reflecting a cash receipts and disbursements method 
of accounting) was as follows:

------------------------------------------------------------------------
                                                            Fair market
                                          Adjusted basis       value
------------------------------------------------------------------------
                                 Assets
------------------------------------------------------------------------
Cash....................................         $ 4,000         $ 4,000
Capital Assets..........................          14,000           2,000
Unrealized Receivables..................               0          14,000
                                         -------------------------------
    Total...............................          18,000          20,000
------------------------------------------------------------------------
                         Liabilities and Capital
------------------------------------------------------------------------
Liabilities.............................          $2,000          $2,000
Capital:
    A...................................          15,000           9,000
    B...................................           1,000           9,000
------------------------------------------------------------------------
        Total...........................          18,000          20,000
------------------------------------------------------------------------

    (B) The total amount realized by B is $10,000, consisting of the 
cash received, $9,000, plus $1,000, B's share of the partnership 
liabilities assumed by T. See section 752. B's interest in the 
partnership property includes an interest in the partnership's 
Unrealized Receivables. B's basis in its partnership interest is 
$2,000 ($1,000, plus $1,000, B's share of partnership liabilities). 
If section 751(a) did not apply to the sale, B would recognize 
$8,000 of capital gain from the sale of the interest in PRS. 
However, section 751(a) does apply to the sale.
    (ii) For purposes of section 751(a), the amount of money or the 
fair market value of property received by the partner in exchange 
for all or part of his partnership interest must take into account 
the partner's share of income or gain from section 751 property. If 
PRS sold all of its section 751 property in a fully taxable 
transaction immediately prior to the transfer of B's partnership 
interest to T, B would have been allocated $14,000 of ordinary 
income from the sale of PRS's Unrealized Receivables under section 
704(c). Therefore, B will recognize $14,000 of ordinary income with 
respect to the Unrealized Receivables. The difference between the 
amount of capital gain or loss that the partner would realize in the 
absence of section 751 ($8,000) and the amount of ordinary income or 
loss determined under paragraph (a)(2) of this section ($14,000) is 
the transferor's capital gain or loss on the sale of its partnership 
interest. In this case, B will recognize a $6,000 capital loss.
    Example 2.  (i) A, B, and C each contribute $120 to partnership 
ABC in exchange for a 1/3 interest. A, B, and C each share in the 
profits and losses of ABC in accordance with their 1/3 interest. ABC 
purchases land for $100 in Year 1. At the end of Year 3, when ABC 
holds $260 in cash and land with a value of $100 and has generated 
$90 in zero-basis unrealized receivables, ABC distributes $50 cash 
to C in a current distribution, reducing C's interest in ABC from 1/
3 to 1/4. ABC has a section 754 election in effect. To determine if 
the distribution is a distribution to which section 751(b) applies, 
ABC must apply the test set forth in paragraph (b)(2) of this 
section.
    (ii)(A) Pursuant to paragraph (b)(2)(iv) of this section, ABC 
revalues its assets and its partners' capital accounts are increased 
under Sec.  1.704-1(b)(2)(iv)(f) to reflect each partner's share of 
the unrealized gain in the partnership's assets. Before the 
distribution, ABC's balance sheet is as follows:

[[Page 65164]]



----------------------------------------------------------------------------------------------------------------
                                           Tax          Book            Capital             Tax          Book
----------------------------------------------------------------------------------------------------------------
Cash.................................         $260         $260  A                             $120         $150
Unrealized Receivable................            0           90  B                              120          150
Real Property........................          100          100  C                              120          150
                                      --------------------------------------------------------------------------
    Totals...........................          360          450  .....................          360          450
----------------------------------------------------------------------------------------------------------------

    (B) If ABC disposed of all of its assets for cash in an amount 
equal to the fair market value of such property immediately before 
the distribution, A, B, and C would each be allocated $30 of net 
income from ABC's section 751 property. Accordingly, A, B, and C's 
net section 751 unrealized gain immediately before the distribution 
is $30 each under paragraph (b)(2)(ii) of this section.
    (iii)(A) After the distribution (but before taking into account 
any consequences under this section), ABC's balance sheet would be 
as follows:

----------------------------------------------------------------------------------------------------------------
                                           Tax          Book            Capital             Tax          Book
----------------------------------------------------------------------------------------------------------------
Cash.................................         $210         $210  A                             $120         $150
Unrealized Receivable................            0           90  B                              120          150
Real Property........................          100          100  C                               70          100
                                      --------------------------------------------------------------------------
    Totals...........................          310          400  .....................          310          400
----------------------------------------------------------------------------------------------------------------

    (B) If ABC disposed of all of its assets in exchange for cash in 
amounts equal to the fair market values of those assets immediately 
after the distribution, A, B, and C would each still be allocated 
$30 of net income from ABC's section 751 property pursuant to Sec.  
1.704-3(a)(6). C did not receive any section 751 property in the 
distribution. Accordingly, A, B, and C's net section 751 unrealized 
gain immediately after the distribution is $30 each under paragraph 
(b)(2)(iii) of this section.
    (iv) Because no partner's net section 751 unrealized gain is 
greater immediately before the distribution than immediately after 
the distribution, and because no partner's net section 751 
unrealized loss is greater immediately after the distribution than 
immediately before the distribution, the distribution is not a 
section 751(b) distribution under paragraph (b)(2)(i) of this 
section. Accordingly, section 751(b) does not apply to the 
distribution.
    Example 3.  (i) Assume the same facts as in Example 2 of this 
paragraph (g), but assume ABC distributes $150 cash to C in complete 
liquidation of C's interest. To determine if the distribution is a 
distribution to which section 751(b) applies, ABC must apply the 
test set forth in paragraph (b)(2) of this section.
    (ii)(A) Pursuant to paragraph (b)(2)(iv) of this section, ABC 
revalues its assets and its partners' capital accounts are increased 
under Sec.  1.704-1(b)(2)(iv)(f) to reflect each partner's share of 
the unrealized gain in the partnership's assets. Before the 
distribution, ABC's balance sheet is as follows:

----------------------------------------------------------------------------------------------------------------
                                           Tax          Book            Capital             Tax          Book
----------------------------------------------------------------------------------------------------------------
Cash.................................         $260         $260  A                             $120         $150
Unrealized Receivable................            0           90  B                              120          150
Real Property........................          100          100  C                              120          150
                                      --------------------------------------------------------------------------
    Totals...........................          360          450  .....................          360          450
----------------------------------------------------------------------------------------------------------------

    (B) If ABC disposed of all of its assets in exchange for cash in 
amounts equal to the fair market values of these assets immediately 
before the distribution, A, B, and C would each be allocated $30 of 
net income from ABC's section 751 property. Accordingly, A, B, and 
C's net section 751 unrealized gain immediately before the 
distribution is $30 each under paragraph (b)(2)(ii) of this section.
    (iii)(A) Because ABC has elected under section 754, and because 
A recognizes $30 gain on the distribution of cash, the basis of the 
real property is increased to $130 under section 734(b). After the 
distribution (but before taking into account any consequences under 
this section), ABC's balance sheet would be as follows:

----------------------------------------------------------------------------------------------------------------
                                           Tax          Book            Capital             Tax          Book
----------------------------------------------------------------------------------------------------------------
Cash.................................         $110         $110  A                             $120         $150
Unrealized Receivable................            0           90  B                              120          150
Real Property........................          130          100  C                                0            0
                                      --------------------------------------------------------------------------
    Totals...........................          240          300  .....................          240          300
----------------------------------------------------------------------------------------------------------------

    (B) Because C is no longer a partner in ABC, C would not be 
allocated any net income from ABC's section 751 property immediately 
after the distribution. Also, C did not receive any section 751 
property in the distribution. Accordingly, C's net section 751 
unrealized gain immediately after the distribution is $0 under 
paragraph (b)(2)(iii) of this section.
    (iv) Because C's net section 751 unrealized gain is greater 
immediately before the distribution than immediately after the 
distribution, section 751(b) applies to the distribution. Under 
paragraph (b)(2)(i) of this section, C has a section 751(b) amount 
equal to $30, the amount by which C's share of pre-distribution net 
section 751 unrealized gain ($30) exceeds C's share of post-
distribution net section 751 unrealized gain ($0). Accordingly, 
paragraph (b)(3)(i) of this section requires C to recognize $30 of 
ordinary income using a reasonable approach consistent with the 
purpose of this section. ABC considers two approaches, the first of 
which is described in paragraphs (v) and (vi) of this example, and 
the second of which is described in paragraphs (vii) and (viii) of 
this example.

[[Page 65165]]

    (v) Assume ABC adopts an approach under which, immediately 
before the section 751(b) distribution, C is deemed to recognize $30 
of ordinary income. To reflect C's recognition of $30 of ordinary 
income, C increases its basis in its ABC partnership interest by 
$30, and the partnership increases its basis in the unrealized 
receivable by the $30 of income recognized by C, immediately before 
the distribution. Provided the partnership applies the approach 
consistently for all section 751(b) distributions, ABC's adopted 
approach is reasonable. After taking into account the tax 
consequences of the section 751(b) distribution immediately prior to 
the cash distribution, ABC's modified balance sheet is as follows:

----------------------------------------------------------------------------------------------------------------
                                           Tax          Book            Capital             Tax          Book
----------------------------------------------------------------------------------------------------------------
Cash.................................         $260         $260  A                             $120         $150
Unrealized Receivable................           30           90  B                              120          150
Real Property........................          100          100  C                              150          150
                                      --------------------------------------------------------------------------
    Totals...........................          390          450  .....................          390          450
----------------------------------------------------------------------------------------------------------------

    (vi) After determining the tax consequences of the section 
751(b) distribution, the rules of sections 731 through 736 apply. 
Accordingly, C recognizes no gain or loss under section 731(a) upon 
the distribution. Because C recognizes no gain on the distribution, 
the basis of the partnership real property is not adjusted. After 
the distribution, ABC's balance sheet is as follows:

----------------------------------------------------------------------------------------------------------------
                                           Tax          Book            Capital             Tax          Book
----------------------------------------------------------------------------------------------------------------
Cash.................................         $110         $110  A                             $120         $150
Unrealized Receivable................           30           90  B                              120          150
Real Property........................          100          100  C                                0            0
                                      --------------------------------------------------------------------------
    Totals...........................          240          300  .....................          240          300
----------------------------------------------------------------------------------------------------------------

    (vii) Assume alternatively that ABC adopts an approach under 
which, immediately before the section 751(b) distribution, C is 
deemed to--
    (A) Receive a distribution of ABC's unrealized receivables with 
a fair market value of $30 and a tax basis of $0;
    (B) Sell the unrealized receivable to ABC in exchange for $30, 
recognizing $30 of ordinary income; and
    (C) Contribute the $30 to ABC. Provided the partnership applies 
the approach consistently for all section 751(b) distributions, 
ABC's adopted approach is reasonable. After taking into account the 
tax consequences of the section 751(b) distribution immediately 
prior to the cash distribution, ABC's modified balance sheet is the 
same as the balance sheet shown in paragraph (v) of this example.
    (viii) After determining the tax consequences of the section 
751(b) distribution, the rules of sections 731 through 736 apply. 
The tax consequences under the rules of sections 731 through 736 are 
the same tax consequences described in paragraph (vi) of this 
example.
    Example 4. (i) A and B are equal partners in a partnership, AB, 
that owns Unrealized Receivable with a fair market value of $50 and 
nondepreciable real property with a basis of $50 and a fair market 
value of $100. A has an adjusted basis in its partnership interest 
of $25, and B has an adjusted basis in its partnership interest of 
$50. The partnership has a section 754 election in effect, and B has 
a basis adjustment under section 743(b) of $25 that is allocated to 
Unrealized Receivable. AB distributes Unrealized Receivable to A in 
a current distribution. To determine if the distribution is a 
distribution to which section 751(b) applies, AB must apply the test 
set forth in paragraph (b)(2) of this section.
    (ii)(A) AB makes a non-mandatory revaluation of its assets and 
its partners' capital accounts are increased under Sec.  1.704-
1(b)(2)(iv)(f) to reflect each partner's share of the unrealized 
gain in the partnership's assets. Before the distribution, AB's 
balance sheet is as follows:

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                                  Special
                                                  Tax       Basis adj.      Book                Capital                Tax         basis         Book
--------------------------------------------------------------------------------------------------------------------------------------------------------
Unrealized Receivable.......................            0           25           50  A                                      25  ...........           75
Real Property...............................           50  ...........          100  B                                      25           25           75
                                             -----------------------------------------------------------------------------------------------------------
    Totals..................................           50           25          150  ............................           50           25          150
--------------------------------------------------------------------------------------------------------------------------------------------------------

    (B) If AB disposed of all of its assets in exchange for cash in 
amounts equal to the fair market values of these assets immediately 
before the distribution, A and B would each be allocated $25 of net 
income from AB's section 751 property. However, B's net income from 
Unrealized Receivable would be offset by its $25 section 743 
adjustment. Sec.  1.743-1(j)(3). Accordingly, A and B's net section 
751 unrealized gain immediately before the distribution are $25 and 
$0, respectively, under paragraph (b)(2)(ii) of this section.
    (iii)(A) After the distribution (but before taking into account 
any consequences under this section), AB's balance sheet would be as 
follows:

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                                 Carryover
                                                  Tax       Basis adj.      Book                Capital                Tax       adjustment      Book
--------------------------------------------------------------------------------------------------------------------------------------------------------
Carryover Adjustment........................  ...........           25            0  A                                      25  ...........           25
Real Property...............................           50  ...........          100  B                                      25           25           75
                                             -----------------------------------------------------------------------------------------------------------
    Totals..................................           50           25          100  ............................           50           25          100
--------------------------------------------------------------------------------------------------------------------------------------------------------


[[Page 65166]]

    (B) If AB disposed of all of its assets in exchange for cash in 
amounts equal to the fair market values of those assets immediately 
after the distribution, no partner would be allocated net income or 
loss from section 751 property. However, B has a carryover basis 
adjustment to ordinary income property of $25 under Sec. Sec.  
1.743-1(g)(2)(ii) and 1.755-1(c)(4), which B must treat as applied 
to section 751 property with fair market value of $0 pursuant to 
paragraph (b)(2)(ii) of this section. Accordingly, B's net section 
751 unrealized loss immediately after the distribution is $25 under 
paragraph (b)(2)(iii)(A) of this section. If, immediately after the 
distribution, A disposed of Unrealized Receivable in exchange for 
$50 cash, A would recognize $50 of net income from section 751 
property. Accordingly, A's net section 751 unrealized gain 
immediately after the distribution is $50 under paragraph 
(b)(2)(iii)(B) of this section.
    (iv) Because B's net section 751 unrealized loss immediately 
after the distribution ($25) exceeds B's net section 751 unrealized 
loss immediately before the distribution ($0), the distribution is a 
section 751(b) distribution. Under paragraph (b)(2)(i) of this 
section, B has a section 751(b) amount equal to $25, the difference 
of B's share of pre-distribution net section 751 unrealized gain 
($0) and B's share of post-distribution net section 751 unrealized 
loss ($25). Accordingly, paragraph (b)(3)(i) of this section 
requires B to account for $25 of ordinary income using a reasonable 
approach consistent with the purpose of this section.
    (v) Assume AB adopts an approach under which, immediately before 
the section 751(b) distribution, B is deemed to--
    (A) Receive a distribution of Unrealized Receivable with a fair 
market value of $25 and a tax basis of $25 (which consists of B's 
section 743(b) basis adjustment and is determined solely for 
purposes of applying a reasonable method consistent with the 
purposes of section 751(b));
    (B) Sell Unrealized Receivable to AB in exchange for $25, so 
that B recognizes $0 of ordinary income, and AB receives Unrealized 
Receivable with a basis of $25; and
    (C) Contribute the $25 to AB. Provided the partnership applies 
the approach consistently for all section 751(b) distributions, AB's 
adopted approach is reasonable. After taking into account the tax 
consequences of the section 751(b) distribution, AB's modified 
balance sheet is as follows:

----------------------------------------------------------------------------------------------------------------
                                           Tax          Book            Capital             Tax          Book
----------------------------------------------------------------------------------------------------------------
                                                                 A                                0           25
Real Property........................           50          100  B                               50           75
    Totals...........................           50          100  .....................           50          100
----------------------------------------------------------------------------------------------------------------

    (vi) After determining the tax consequences of the section 
751(b) distribution, the rules of sections 731 through 736 apply. 
Accordingly, A recognizes no gain on the distribution of Unrealized 
Receivable, which A takes with a basis of $25.
    Example 5. Capital Gain Recognition Required. (i) A, B, and C 
are each 1/3 partners in a partnership, ABC, that holds Unrealized 
Receivable 1 with a fair market value of $90, Unrealized Receivable 
2 with a fair market value of $30, and nondepreciable real property 
with a fair market value of $180. The partnership has a section 754 
election in effect. Each of the partners has an adjusted basis in 
its partnership interest of $0 with a fair market value of $100. 
None of the partners has a capital loss carryforward. ABC 
distributes to A Unrealized Receivable 1 in a current distribution. 
To determine if the distribution is a distribution to which section 
751(b) applies, ABC must apply the test set forth in paragraph 
(b)(2) of this section.
    (ii)(A) Pursuant to paragraph (b)(2)(iv) of this section, ABC 
revalues its assets and its partners' capital accounts are increased 
under Sec.  1.704-1(b)(2)(iv)(f) to reflect each partner's share of 
the unrealized gain in the partnership's assets. Before the 
distribution, ABC's balance sheet is as follows:

----------------------------------------------------------------------------------------------------------------
                                           Tax          Book            Capital             Tax          Book
----------------------------------------------------------------------------------------------------------------
Unrealized Receivable 1..............           $0          $90  A                               $0         $100
Unrealized Receivable 2..............            0           30  B                                0          100
Real Property........................            0          180  C                                0          100
                                      --------------------------------------------------------------------------
    Totals...........................            0          300  .....................            0          300
----------------------------------------------------------------------------------------------------------------

    (B) If ABC disposed of all of its assets for cash in an amount 
equal to the fair market value of such property immediately before 
the distribution, A, B, and C would each be allocated $40 of net 
income from ABC's section 751 property ($30 each from Unrealized 
Receivable 1 and $10 each from Unrealized Receivable 2). 
Accordingly, A, B, and C's net section 751 unrealized gain 
immediately before the distribution is $40 each under paragraph 
(b)(2)(ii) of this section.
    (iii)(A) After the distribution (but before taking into account 
any consequences under this section), ABC's balance sheet would be 
as follows:

----------------------------------------------------------------------------------------------------------------
                                           Tax          Book            Capital             Tax          Book
----------------------------------------------------------------------------------------------------------------
Unrealized Receivable 2..............           $0          $30  A                               $0          $10
                                                                 B                                0          100
Real Property........................            0          180  C                                0          100
                                      --------------------------------------------------------------------------
    Totals...........................            0          210  .....................            0          210
----------------------------------------------------------------------------------------------------------------

    (B) If ABC disposed of all of its assets in exchange for cash in 
amounts equal to the fair market values of those assets immediately 
after the distribution, A, B, and C would each be allocated $10 of 
net income from ABC's section 751 property ($10 each from Unrealized 
Receivable 2). If immediately after the distribution, A disposed of 
Unrealized Receivable 1 in exchange for $90 cash, A would recognize 
$90 of net income from section 751 property. Accordingly, B and C's 
net section 751 unrealized gain immediately after the distribution 
is $10 each under paragraph (b)(2)(iii)(A) of this section, and A's 
is $100 under paragraphs (b)(2)(iii)(A) and (B) of this section.
    (iv) Because B and C's net section 751 unrealized gain is 
greater immediately before the distribution than immediately after 
the distribution, the distribution is a section 751(b) distribution. 
Under paragraph (b)(2)(i) of this section, each of B and C has a 
section 751(b) amount equal to $30, the amount by which each 
partner's share of pre-distribution net section 751 unrealized gain 
($40) exceeds its share of post-distribution net section 751 
unrealized gain ($10). Accordingly, paragraph (b)(3)(i) of this 
section requires each of B and C to recognize

[[Page 65167]]

$30 of ordinary income using a reasonable approach consistent with 
the purpose of this section. ABC considers three approaches, the 
first of which is described in paragraphs (v) and (vi) of this 
example, the second of which is described in paragraphs (vii) and 
(viii) of this example, and the third of which is described in 
paragraph (ix) of this example.
    (v) Assume ABC adopts an approach under which, immediately 
before the section 751(b) distribution, B and C are each deemed to 
recognize $30 of ordinary income. To reflect B and C's recognition 
of $30 of ordinary income, B and C increase their bases in their ABC 
partnership interests by $30 each, and the partnership increases its 
basis in Unrealized Receivable 1 by $60 immediately before the 
distribution to A. Following the distribution to A, A's basis in 
Unrealized Receivable 1 is $0 under section 732(a)(2). Because ABC 
has elected under section 754, the distribution of Unrealized 
Receivable 1 to A would result in a $60 section 734(b) adjustment to 
Unrealized Receivable 2. See Sec.  1.755-1(c)(1). Because that basis 
adjustment would have altered the amount of net section 751 
unrealized gain or loss computed under paragraph (b)(2) of this 
section, A must recognize $60 of capital gain prior to the 
distribution of Unrealized Receivable 1 pursuant to paragraph 
(b)(3)(ii)(A) of this section. This gain recognition increases A's 
basis in its ABC partnership interest by $60 immediately before the 
distribution to A, eliminating the section 734(b) adjustment. See 
section 732(a)(2). In addition, the partnership increases its basis 
in Real Property by $60 pursuant to paragraph (b)(3)(iii) of this 
section, and treats A's gain recognized as reducing A's $60 reverse 
section 704(c) amount in the Real Property. Provided the partnership 
applies the approach consistently for all section 751(b) 
distributions, ABC's adopted approach is reasonable. After taking 
into account the tax consequences of the deemed gain approach 
described in this example, ABC's modified balance sheet immediately 
prior to the distribution is as follows:

----------------------------------------------------------------------------------------------------------------
                                           Tax          Book            Capital             Tax          Book
----------------------------------------------------------------------------------------------------------------
Unrealized Receivable 1..............          $60          $90  A                              $60         $100
Unrealized Receivable 2..............            0           30  B                               30          100
Real Property........................           60          180  C                               30          100
                                      --------------------------------------------------------------------------
    Totals...........................          120          300  .....................          120          300
----------------------------------------------------------------------------------------------------------------

    (vi) After determining the tax consequences of the section 
751(b) distribution, the rules of sections 731 through 736 apply. 
Thus, Unrealized Receivable 1 would take a $60 basis in A's hands 
under section 732(a), and no section 734(b) adjustment would be made 
to Unrealized Receivable 2. After the distribution, ABC's balance 
sheet is as follows:

----------------------------------------------------------------------------------------------------------------
                                           Tax          Book            Capital             Tax          Book
----------------------------------------------------------------------------------------------------------------
Unrealized Receivable 2..............           $0          $30  A                               $0          $10
                                                                 B                               30          100
Real Property........................           60          180  C                               30          100
                                      --------------------------------------------------------------------------
    Totals...........................           60          210  .....................           60          210
----------------------------------------------------------------------------------------------------------------

    (vii) Assume alternatively that ABC adopts an approach under 
which, immediately before the section 751(b) distribution, B and C 
are each deemed to:
    (A) Receive a distribution of Unrealized Receivable 1 with a 
fair market value of $30 and tax basis of $0;
    (B) Sell the unrealized receivable to ABC for $30, recognizing 
$30 of ordinary income; and
    (C) Contribute the $30 to ABC. For the same reasons stated in 
paragraph (v) of this example, A recognizes capital gain of $60. To 
accomplish this, A, immediately before the section 751(b) 
distribution, is deemed to:
    (1) Receive a distribution of Real Property with a fair market 
value of $60 and tax basis of $0;
    (2) Sell the Real Property to ABC for $60, recognizing $60 of 
capital gain; and
    (3) Contribute the $60 to ABC.
    (viii) The partnership treats the $60 of gain recognized by A as 
reducing A's $60 reverse section 704(c) amount in the Real Property. 
Provided the partnership applies the approach consistently for all 
section 751(b) distributions, ABC's adopted approach is reasonable. 
Before taking into account the tax consequences of the section 
751(b) distribution, ABC's balance sheet is the same as the balance 
sheet shown in paragraph (v) of this example. After determining the 
tax consequences of the section 751(b) distribution, the rules of 
sections 731 through 736 apply. The tax consequences under the rules 
of sections 731 through 736 are the same tax consequences described 
in paragraph (vi) of this example.
    (ix) Assume alternatively that A does not recognize capital gain 
of $60. As a result, upon the distribution of Unrealized Receivable 
1 to A, ABC makes a $60 section 734(b) adjustment to Unrealized 
Receivable 2. The adopted approach is not reasonable because it is 
contrary to paragraph (b)(3)(ii)(A) of this section.
    Example 6. Capital Gain Recognition Required. (i)(A) Assume the 
same facts as Example 5 of this paragraph (g), except that 
Unrealized Receivable 1 has a $9 tax basis, and each of the partners 
has an adjusted basis in its partnership interest of $3. Before the 
distribution, ABC's balance sheet is as follows:

----------------------------------------------------------------------------------------------------------------
                                           Tax          Book            Capital             Tax          Book
----------------------------------------------------------------------------------------------------------------
Unrealized Receivable 1..............           $9          $90  A                               $3         $100
Unrealized Receivable 2..............            0           30  B                                3          100
Real Property........................            0          180  C                                3          100
                                       ...........  ...........  .....................  ...........  ...........
    Totals...........................            9          300  .....................            9          300
----------------------------------------------------------------------------------------------------------------

    (B) If ABC disposed of all of its assets for cash in an amount 
equal to the fair market value of such property immediately before 
the distribution, A, B, and C would each be allocated $37 of net 
income from ABC's section 751 property ($27 each from Unrealized 
Receivable 1 and $10 each from Unrealized Receivable 2). 
Accordingly, A, B, and C's net section 751 unrealized gain 
immediately before the distribution is $37 each under paragraph 
(b)(2)(ii) of this section.
    (ii)(A) After the distribution (but before taking into account 
any consequences under this section), ABC's balance sheet would be 
as follows:

[[Page 65168]]



----------------------------------------------------------------------------------------------------------------
                                           Tax          Book            Capital             Tax          Book
----------------------------------------------------------------------------------------------------------------
Unrealized Receivable 2..............           $6          $30  A                               $0          $10
                                                                 B                                3          100
Real Property........................            0          180  C                                3          100
                                      --------------------------------------------------------------------------
    Totals...........................            6          210  .....................            6          210
----------------------------------------------------------------------------------------------------------------

    (B) If ABC disposed of all of its assets for cash in an amount 
equal to the fair market value of such property immediately after 
the distribution, taking into account the $6 section 734(b) 
adjustment allocated to Unrealized Receivable 2, A, B, and C would 
each be allocated $8 of net income from ABC's section 751 property 
($8 each from Unrealized Receivable 2). If, immediately after the 
distribution, A disposed of Unrealized Receivable 1 for cash in an 
amount equal to its fair market value, A would recognize $87 of net 
income from section 751 property. Accordingly, B and C's net section 
751 unrealized gain immediately after the distribution is $8 each 
under paragraph (b)(2)(iii)(A) of this section, and A's is $95 under 
paragraphs (b)(2)(iii)(A) and (B) of this section.
    (iii) Because B and C's net section 751 unrealized gain is 
greater immediately before the distribution than immediately after 
the distribution, the distribution is a section 751(b) distribution. 
Under paragraph (b)(2)(i) of this section, each of B and C has a 
section 751(b) amount equal to $29, the amount by which each 
partner's share of pre-distribution net section 751 unrealized gain 
($37) exceeds its share of post-distribution net section 751 
unrealized gain ($8). Accordingly, paragraph (b)(3)(i) of this 
section requires each of B and C to recognize $29 of ordinary income 
using a reasonable approach consistent with the purpose of this 
section. ABC considers two approaches, the first of which is 
described in paragraphs (iv) and (v) of this example, and the second 
of which is described in paragraphs (vi) and (vii) of this example.
    (iv) Assume ABC adopts an approach under which, immediately 
before the section 751(b) distribution, B and C are each deemed to 
recognize $29 of ordinary income. To reflect B and C's recognition 
of $29 of ordinary income, B and C increase their bases in their ABC 
partnership interests by $29 each, and the partnership increases its 
basis in Unrealized Receivable 1 by $58 to $67 immediately before 
the distribution to A. Following the distribution to A, A's basis in 
Unrealized Receivable 1 is $3 under section 732(a)(2). Because ABC 
has elected under section 754, the distribution of Unrealized 
Receivable 1 to A would result in a $64 section 734(b) adjustment to 
Unrealized Receivable 2 (rather than the $6 section 734(b) 
adjustment computed prior to the application of this section). See 
Sec.  1.755-1(c)(1). Because that additional basis adjustment would 
have altered the amount of net section 751 unrealized gain or loss 
computed under paragraph (b)(2) of this section, A must recognize 
$58 of capital gain prior to the distribution of Unrealized 
Receivable 1 pursuant to paragraph (b)(3)(ii)(A) of this section. 
This gain recognition increases A's basis in its ABC partnership 
interest by $58 to $61 immediately before the distribution to A. In 
addition, the partnership increases its basis in Real Property by 
$58 pursuant to paragraph (b)(3)(iii) of this section, and treats 
A's gain recognized as reducing A's $60 reverse section 704(c) 
amount in the Real Property. Provided the partnership applies the 
approach consistently for all section 751(b) distributions, ABC's 
adopted approach is reasonable. After taking into account the tax 
consequences of the deemed gain approach described in this example, 
ABC's modified balance sheet immediately prior to the distribution 
is as follows:

----------------------------------------------------------------------------------------------------------------
                                           Tax          Book            Capital             Tax          Book
----------------------------------------------------------------------------------------------------------------
Unrealized Receivable 1..............          $67          $90  A                              $61         $100
Unrealized Receivable 2..............            0           30  B                               32          100
Real Property........................           58          180  C                               32          100
                                      --------------------------------------------------------------------------
    Totals...........................          125          300  .....................          125          300
----------------------------------------------------------------------------------------------------------------

    (v) After determining the tax consequences of the section 751(b) 
distribution, the rules of sections 731 through 736 apply. Thus, A 
would take a $61 tax basis in Unrealized Receivable 1 under section 
732(a), and a $6 section 734(b) adjustment would be made to 
Unrealized Receivable 2. After the distribution, ABC's balance sheet 
is as follows:

----------------------------------------------------------------------------------------------------------------
                                           Tax          Book            Capital             Tax          Book
----------------------------------------------------------------------------------------------------------------
Unrealized Receivable 2..............           $6          $30  A                               $0          $10
                                                                 B                               32          100
Real Property........................           58          180  C                               32          100
                                      --------------------------------------------------------------------------
    Totals...........................           64          210  .....................           64          210
----------------------------------------------------------------------------------------------------------------

    (vi) Assume alternatively that ABC adopts an approach under 
which, immediately before the section 751(b) distribution, B and C 
are each deemed to:
    (A) Receive a distribution of Unrealized Receivable 1 with a 
fair market value of $29 and tax basis of $0;
    (B) Sell the unrealized receivable to ABC for $29, recognizing 
$29 of ordinary income; and
    (C) Contribute the $29 to ABC. For the same reasons stated in 
paragraph (iv) of this example, A recognizes capital gain of $58. To 
accomplish this, A, immediately before the section 751(b) 
distribution, is deemed to:
    (1) Receive a distribution of Real Property with a fair market 
value of $58 and tax basis of $0;
    (2) Sell the Real Property to ABC for $58, recognizing $58 of 
capital gain; and
    (3) Contribute the $58 to ABC.
    (vii) The partnership treats the $58 of gain recognized by A as 
reducing A's $60 reverse section 704(c) amount in the Real Property. 
Provided the partnership applies the approach consistently for all 
section 751(b) distributions, ABC's adopted approach is reasonable. 
After taking into account the tax consequences of the section 751(b) 
distribution, ABC's balance sheet is the same as the balance sheet 
shown in paragraph (iv) of this example. After determining the tax 
consequences of the section 751(b) distribution, the rules of 
sections 731 through 736 apply. The tax consequences under the rules 
of sections 731 through 736 are the same tax consequences described 
in paragraph (v) of this example.
    Example 7. Capital Gain Recognition Elective.  (i)(A) Assume the 
same facts as described in Example 6 of this paragraph (g),

[[Page 65169]]

including that ABC adopts the deemed gain approach described in 
paragraph (iv), except that ABC does not have a section 754 election 
in effect. As in Example 6, each of A, B, and C has net section 751 
unrealized gain of $37 immediately before the distribution. After 
the distribution (but before taking into account any consequences 
under this section), ABC's balance sheet would be as follows:

----------------------------------------------------------------------------------------------------------------
                                           Tax          Book            Capital             Tax          Book
----------------------------------------------------------------------------------------------------------------
Unrealized Receivable 2..............           $0          $30  A                                0           10
                                                                 B                                3          100
Real Property........................            0          180  C                                3          100
                                      --------------------------------------------------------------------------
    Totals...........................            0          210  .....................            6          210
----------------------------------------------------------------------------------------------------------------

    (B) If ABC disposed of all of its assets for cash in an amount 
equal to the fair market value of such property immediately after 
the distribution, because there is no section 734(b) adjustment 
allocated to Unrealized Receivable 2, A, B, and C would each be 
allocated $10 of net income from ABC's section 751 property ($10 
each from Unrealized Receivable 2). If, immediately after the 
distribution, A disposed of Unrealized Receivable 1 for cash in an 
amount equal to its fair market value, A would recognize $87 of net 
income from section 751 property. Accordingly, B and C's net section 
751 unrealized gain immediately after the distribution is $10 each 
under paragraph (b)(2)(iii)(A) of this section, and A's is $97 under 
paragraphs (b)(2)(iii)(A) and (B) of this section.
    (ii) Because B and C's net section 751 unrealized gain is 
greater immediately before the distribution than immediately after 
the distribution, the distribution is a section 751(b) distribution. 
Under paragraph (b)(2)(i) of this section B and C each have a 
section 751(b) amount equal to $27, the amount by which those 
partners' shares of pre-distribution net section 751 unrealized gain 
($37), exceeds their shares of post-distribution net section 751 
unrealized gain ($10). Accordingly, paragraph (b)(3)(i) of this 
section requires each of B and C to recognize $27 of ordinary income 
using a reasonable approach consistent with the purpose of this 
section.
    (iii) Assume ABC adopts an approach under which, immediately 
before the section 751(b) distribution, B and C are each deemed to 
recognize $27 of ordinary income. To reflect B and C's recognition 
of $27 of ordinary income, B and C increase their bases in their ABC 
partnership interests by $27, and the partnership increases its 
basis in Unrealized Receivable 1 by $54 to $63 immediately before 
the distribution to A. The distribution to A results in an 
adjustment to the basis of the distributed Unrealized Receivable 1 
under section 732(a)(2), reducing the basis of Unrealized Receivable 
1 in the hands of A to $3. Because ABC has not elected under section 
754 and does not have a substantial basis reduction under section 
734(d), this $60 decrease to the basis of Unrealized Receivable 1 
will not affect the basis of other assets held by ABC. Thus, the 
distribution does not alter the amount of net section 751 unrealized 
gain or loss computed under paragraph (b)(2) of this section. 
Accordingly, A is not obligated under paragraph (b)(3)(ii)(A) of 
this section to recognize gain or income upon the distribution of 
Unrealized Receivable 1. However, A may elect to recognize $60 of 
capital gain under paragraph (b)(3)(ii)(B) of this section to 
eliminate the section 732 basis adjustment to the distributed 
Unrealized Receivable 1 which would otherwise cause A's net section 
751 unrealized gain to be greater immediately after the distribution 
than it was immediately before the distribution. This gain 
recognition increases A's basis in its ABC partnership interest by 
$60 immediately before the distribution to A. In addition, the 
partnership increases its basis in Real Property by $60 pursuant to 
paragraph (b)(3)(iii) of this section, and treats A's gain 
recognized as reducing A's $60 reverse section 704(c) amount in the 
Real Property. A receives the distributed Unrealized Receivable 1 
with a basis of $63, so that the distribution does not increase A's 
net section 751 unrealized gain. After the distribution, ABC's 
balance sheet is as follows:

----------------------------------------------------------------------------------------------------------------
                                           Tax          Book            Capital             Tax          Book
----------------------------------------------------------------------------------------------------------------
Unrealized Receivable 2..............           $0          $30  A                                0           10
                                                                 B                               30          100
Real Property........................           60          180  C                               30          100
                                      --------------------------------------------------------------------------
    Totals...........................           60          210  .....................           60          210
----------------------------------------------------------------------------------------------------------------

    Example 8.  (i) A, B, and C, each domestic corporations, are 1/3 
partners in a domestic partnership ABC. ABC purchased 100% of the 
stock in two foreign corporations, X and Y. X and Y each have one 
share of stock outstanding. ABC has a basis of $15 in its X share 
with a fair market value of $150, and a basis of $3 in its Y share 
with a fair market value of $30. The earnings and profits of X that 
are attributable to ABC's X stock under section 1248 are $135; the 
earnings and profits of Y that are attributable to ABC's Y stock are 
$27. ABC has a section 754 election in effect. Each of A, B, and C 
has a partnership interest with an adjusted basis of $6 and a fair 
market value of $60. On January 1, 2013, ABC distributes the Y share 
to A in a current distribution. To determine if the distribution is 
a distribution to which section 751(b) applies, ABC must apply the 
test set forth in paragraph (b)(2) of this section.
    (ii)(A) Pursuant to paragraph (b)(2)(iv) of this section, ABC 
revalues its assets. Its partners' capital accounts are increased 
under Sec.  1.704-1(b)(2)(iv)(f) to reflect each partner's share of 
the unrealized gain in the partnership's assets. Before the 
distribution, ABC's balance sheet is as follows (with the shares of 
X and Y each reflected as having both an unrealized receivable 
component and a capital gain component):

----------------------------------------------------------------------------------------------------------------
                                           Tax          Book            Capital             Tax          Book
----------------------------------------------------------------------------------------------------------------
X stock (total)......................          $15         $150  A                               $6          $60
Unrealized receivable................            0          135  B                                6           60
Capital gain asset...................           15           15  C                                6           60
Y stock (total)......................            3           30  .....................  ...........  ...........
Unrealized receivable................            0           27  .....................  ...........  ...........
Capital gain asset...................            3            3  .....................  ...........  ...........
                                      --------------------------------------------------------------------------
    Totals...........................           18          180  .....................           18          180
----------------------------------------------------------------------------------------------------------------


[[Page 65170]]

    (B) If ABC disposed of all of its assets for cash in an amount 
equal to the assets' fair market value immediately before the 
distribution, A, B, and C would each be allocated $54 of net income 
from ABC's section 751 property ($45 each from X stock and $9 each 
from Y stock). Accordingly, A, B, and C's net section 751 unrealized 
gain immediately before the distribution is $54 each under paragraph 
(b)(2)(ii) of this section.
    (iii)(A) After the distribution (but before taking into account 
any consequences under this section), ABC's balance sheet is as 
follows:

----------------------------------------------------------------------------------------------------------------
                                           Tax          Book            Capital             Tax          Book
----------------------------------------------------------------------------------------------------------------
X stock (total)......................          $15         $150  A                               $3          $30
Unrealized receivable................            0          135  B                                6           60
Capital gain asset...................           15           15  C                                6           60
                                      --------------------------------------------------------------------------
    Totals...........................           15          150  .....................           15          150
----------------------------------------------------------------------------------------------------------------

    (B) If ABC disposed of its asset for cash in an amount equal to 
the fair market value of that asset immediately after the 
distribution, A, B, and C would each be allocated $45 of net income 
from ABC's section 751 property pursuant to Sec.  1.704-3(a)(6). A, 
however, received Y stock, which continues to be section 751 
property in A's hands under section 735(a), with a holding period 
that includes the partnership's holding period under section 735(b). 
If A disposed of its Y stock for cash in an amount equal to its fair 
market value, A would recognize $27 of gain under section 751(b) on 
the Y stock (a foreign corporation described in section 1248) that 
is included in A's income under section 1248 as a dividend to the 
extent of the attributable earnings. Accordingly, B and C's net 
section 751 unrealized gain immediately after the distribution is 
$45 each under paragraph (b)(2)(iii)(A) of this section, and A's is 
$72 under paragraphs (b)(2)(iii)(A) and (B) of this section.
    (iv) Because B and C's net section 751 unrealized gain is 
greater immediately before the distribution than immediately after 
the distribution, the distribution is a section 751(b) distribution. 
Under paragraph (b)(2)(i) of this section, B and C each have a 
section 751(b) amount equal to $9, the amount by which those 
partners shares of pre-distribution net section 751 unrealized gain 
($54) exceeds their shares of post-distribution net section 751 
unrealized gain ($45). Accordingly, paragraph (b)(3)(i) of this 
section requires each of B and C to recognize $9 as a dividend under 
section 1248 using a reasonable approach consistent with the purpose 
of this section. ABC considers two approaches, the first of which is 
described in paragraphs (v) and (vi) of this example, and the second 
of which is described in paragraph (vii) of this example.
    (v) Assume ABC adopts an approach under which, immediately 
before the section 751(b) distribution, B and C are each deemed to 
recognize $9 of gain includible as a dividend with respect to the 
distribution of the Y stock, which is treated as a sale or exchange 
for purposes of section 1248. To reflect B and C's recognition of $9 
of dividend income, B and C increase the bases in their ABC 
partnership interests by $9 each, and the partnership increases its 
basis in the Y share unrealized receivable component by $18 
immediately before the distribution. The portion of the unrealized 
receivable component of the Y share that is deemed to be sold or 
exchanged under section 1248 has a new holding period beginning on 
the day after the section 751(b) distribution (``the new holding 
period portion''). The earnings and profits of $18 attributable to 
the new holding period portion of the Y share are 2/3 of the total 
earnings and profits attributable to the Y share immediately before 
the distribution (B and C's $18 aggregate gain recognized under 
section 751(b) divided by $27, the aggregate of all the partners' 
net section 751 unrealized gain immediately before the 
distribution). The remaining earnings and profits are allocated to 
the remainder of the Y share. Provided the partnership applies the 
approach consistently for all section 751(b) distributions, ABC's 
adopted approach is reasonable. After taking into account the tax 
consequences of the deemed gain approach described in this example, 
ABC's modified balance sheet immediately before the distribution is 
as follows:

----------------------------------------------------------------------------------------------------------------
                                           Tax          Book            Capital             Tax          Book
----------------------------------------------------------------------------------------------------------------
X stock..............................          $15         $150  A                               $6          $60
Unrealized receivable................            0          135  B                               15           60
Capital gain asset...................           15           15  C                               15           60
Y stock..............................           21           30  .....................  ...........  ...........
New holding period portion...........           18           18  .....................  ...........  ...........
Unrealized receivable................            0            9  .....................  ...........  ...........
Capital gain asset...................            3            3  .....................  ...........  ...........
                                      --------------------------------------------------------------------------
    Totals...........................           36          180  .....................           36          180
----------------------------------------------------------------------------------------------------------------

    (vi) After determining the tax consequences of the section 
751(b) distribution, the rules of sections 731 through 736 apply. 
Accordingly, the basis of the distributed Y stock in A's hands is 
limited under section 732(a)(2) to A's $6 basis in its partnership 
interest. Pursuant to section 732(c)(3)(B), the $15 decrease in 
basis from $21 to $6 must be allocated to the distributed components 
of the Y stock in proportion to their respective adjusted bases. A 
must allocate the $15 decrease in basis in the Y stock between the 
new holding period portion (which has a basis of $18) and the 
remainder of the Y share (which has a basis of $3). Accordingly, A 
receives the new holding period portion of the Y share with an 
adjusted basis of $5.14 ($6 multiplied by ($18 divided by $21)), and 
the remainder of the Y share with an adjusted basis of $0.86 ($6 
multiplied by ($3 divided by $21)). Because the basis of the 
distributed Y stock in A's hands was reduced from $21 (the basis of 
the Y stock in the hands of ABC) to $6 (the basis in A's hands), ABC 
must increase the basis of its remaining asset under section 
734(b)(1)(B) by $15. ABC must allocate the $15 under Sec.  1.755-
1(c)(1)(i) to the capital gain portion of the X stock. After the 
distribution, ABC's balance sheet is as follows:

----------------------------------------------------------------------------------------------------------------
                                           Tax          Book            Capital             Tax          Book
----------------------------------------------------------------------------------------------------------------
X stock..............................          $30         $150  A                               $0          $30
Unrealized receivable................            0          135  B                               15           60
Capital gain asset...................           30           15  C                               15           60
                                      --------------------------------------------------------------------------

[[Page 65171]]

 
    Totals...........................           30          150  .....................           30          150
----------------------------------------------------------------------------------------------------------------

    (vii) Assume alternatively that ABC adopts an approach under 
which, immediately before the section 751(b) distribution, B and C 
are each deemed to:
    (A) Receive a distribution of the portion of the partnership's Y 
stock with a fair market value of $9 and a tax basis of $0;
    (B) Sell the Y stock back to ABC for $9, recognizing $9 of gain 
includible as a dividend; and
    (C) Contribute the $9 to ABC. ABC will be deemed to have 
purchased for $18 a portion of the Y stock unrealized receivable 
component, which will have a new holding period. The deemed sale of 
Y stock by B and C to ABC will be treated as a sale or exchange for 
purposes of section 1248. Provided that the partnership applies the 
approach consistently for all section 751(b) distributions, 
Partnership ABC's adopted approach is reasonable. After taking into 
account the tax consequences of the deemed transaction, ABC's 
balance sheet is the same as the balance sheet shown in paragraph 
(v) of this example. After taking into account the tax consequences 
of the section 751(b) distribution, ABC's balance sheet is the same 
as the balance sheet shown in paragraph (vi) of this example.
    (viii) Assume that in a later unrelated transaction, A sells its 
Y stock at a time when its fair market value, earnings and profits, 
and adjusted basis have not changed. The sale of Y stock by A is a 
sale or exchange subject to section 1248. Pursuant to Sec.  1.732-
1(c)(2)(v), in determining the dividend portion of its gain on the Y 
stock under section 1248, A does not take into account the $15 
decrease in basis under section 732. Accordingly, upon the sale of 
the Y stock, A recognizes $9 of gain, the lesser of $9 ($0 gain on 
the new holding period portion ($18 fair market value minus $18 
basis) plus $9 gain on the remainder ($12 fair market value minus $3 
basis)) or $9 (earnings and profits attributable to the remainder of 
the Y share) as dividend income under section 1248. A recognizes $15 
of capital gain in addition to the $9 of dividend income ($30 amount 
realized minus $15 ($6 aggregate basis in Y share plus $9 section 
1248 dividend income)).
    (ix) Assume that ABC also sells its X stock in a later unrelated 
transaction at a time when its fair market value has declined to 
$120 but earnings and profits have remained the same. ABC has not 
made an election under Sec.  1.755-1(c)(2)(vi). In determining the 
dividend portion of its gain on the X stock under section 1248, ABC 
does not take into account the $15 increase in basis under section 
734(b). Upon the sale of the stock, ABC recognizes $105, the lesser 
of $105 ($120-$15) or $135 (earnings and profits attributable to the 
X stock for the partnership's holding period) as dividend income. In 
addition to the $105 of gain includible as a dividend, ABC 
recognizes $15 of capital loss ($120 amount realized minus $135 ($30 
aggregate basis in X stock plus $105 section 1248 dividend income)).
    Example 9.  (i) Assume the same facts as in Example 8 of this 
paragraph (g), except assume that Partnership ABC makes an election 
under Sec.  1.755-1(c)(2)(vi). As in Example 8, paragraph (b)(3)(i) 
of this section requires each of B and C to recognize $9 as a 
dividend under section 1248 using a reasonable approach consistent 
with the purpose of this section for the reasons described in 
paragraphs (ii) through (iv) of Example 8. Further assume that ABC 
adopts the deemed gain approach described in paragraph (v) of 
Example 8. As in Example 8, B and C are each deemed to recognize $9 
of dividend income with respect to the distribution of the Y stock, 
which is treated as a sale or exchange for purposes of section 1248. 
To reflect B and C's recognition of $9 of dividend income, B and C 
increase the bases in their ABC partnership interests by $9 each. 
The partnership increases its basis in the Y share unrealized 
receivable component by $18 immediately before the distribution. The 
portion of the unrealized receivable component of the Y share that 
is deemed to be sold or exchanged under section 1248 has a new 
holding period beginning on the day after the section 751(b) 
distribution (``the new holding period portion'').
    (ii) Because ABC makes an election under Sec.  1.755-
1(c)(2)(vi), the distribution of the Y share to A results in a $15 
section 734(b) adjustment to the unrealized receivable component of 
the X share. Because that basis adjustment would have altered the 
amount of net section 751 unrealized gain or loss computed under 
paragraph (b)(2) of this section, A must recognize $15 of gain with 
respect to the X share pursuant to paragraph (b)(3)(ii)(A) of this 
section. Also pursuant to paragraph (b)(3)(ii)(A) of this section, 
A's recognition of income with respect to the X stock is a sale or 
exchange for purposes of section 1248 and begins a new holding 
period for this portion of ABC's X stock, including for purposes of 
attributing earnings and profits. This income recognition increases 
A's basis in its ABC partnership interest by $15 immediately before 
the distribution to A. In addition, the partnership increases its 
basis in the X share by $15, immediately before the distribution to 
A. The partnership treats the $15 of dividend income recognized by A 
as reducing A's $15 reverse section 704(c) amount in the X stock. 
Provided the partnership applies the approach consistently for all 
section 751(b) distributions, ABC's adopted approach is reasonable. 
After taking into account the tax consequences of the deemed gain 
approach described above, ABC's balance sheet is as follows:

----------------------------------------------------------------------------------------------------------------
                                           Tax          Book            Capital             Tax          Book
----------------------------------------------------------------------------------------------------------------
X stock..............................          $30         $150  A                              $21          $60
Unrealized receivable................            0          120  B                               15           60
Capital gain asset...................           30           30  C                               15           60
Y stock..............................           21           30                         ...........  ...........
Unrealized receivable................            0            9                         ...........  ...........
Capital gain asset...................           21           21                         ...........  ...........
                                      --------------------------------------------------------------------------
    Totals...........................           51          180  .....................           51          180
----------------------------------------------------------------------------------------------------------------

    (iii)(A) After determining the tax consequences of the section 
751(b) distribution, the rules of sections 731 through 736 apply. 
Accordingly, the Y stock would take a $21 basis in A's hands under 
section 732(a), and no section 734(b) adjustment would be made to 
the X stock. After the distribution, ABC's balance sheet is as 
follows:

----------------------------------------------------------------------------------------------------------------
                                           Tax          Book            Capital             Tax          Book
----------------------------------------------------------------------------------------------------------------
X stock..............................          $30         $150  A                               $0          $30
Unrealized receivable................            0          120  B                               15           60
Capital gain asset...................           30           30  C                               15           60
                                      --------------------------------------------------------------------------
    Totals...........................           30          150  .....................           30          150
----------------------------------------------------------------------------------------------------------------


[[Page 65172]]

    (B) If the partnership sells the X stock, the gain recognized is 
$120 ($150--$30), all of which is recharacterized as a dividend 
under section 1248. Because A's recognition of $15 of dividend 
income reduced A's reverse section 704(c) amount in the X stock, 
this gain is allocated $45 to B, $45 to C, and $30 to A.
0
Par. 8. Section 1.755-1 is amended by:
0
a. Adding paragraphs (c)(2)(iii), (iv), (v), and (vi).
0
b. Revising the paragraph heading and the introductory text of 
paragraph (c)(6).
0
c. Removing the paragraph heading ``Example.'' in paragraph (c)(6) and 
adding ``Example 1.'' in its place.
0
d. Adding Examples 2 and 3 to paragraph (c)(6).
0
e. Revising paragraph (e)(2).
    The additions and revisions read as follows:


Sec.  1.755-1  Rules for allocation of basis.

* * * * *
    (c) * * *
    (2) * * *
    (iii) Coordination with section 1245 and similar provisions. Any 
increase in basis allocated to capital gain property pursuant to the 
second sentence in paragraph (c)(2)(i) of this section is not taken 
into account in determining the recomputed or adjusted basis in the 
property for purposes of section 1245(a)(1). Notwithstanding the prior 
sentence, any depreciation or amortization of the increase in basis 
that is allowed or allowable is taken into account in computing the 
property's recomputed basis. In the case of property that is subject to 
section 617(d)(1), 1250(a)(1), 1252(a)(1), or 1254(a)(1), rules similar 
to the rule in this paragraph (c)(2)(iii) shall apply.
    (iv) Coordination with section 1231. Any increase in basis 
allocated to capital gain property pursuant to the second sentence in 
paragraph (c)(2)(i) of this section is not taken into account in 
determining section 1231 gain and loss, as defined in section 
1231(a)(3). Any basis adjustment to an asset not taken into account 
pursuant to this paragraph (c)(2)(iv) shall be treated as gain from the 
sale or exchange of a capital asset with the same holding period as the 
underlying asset.
    (v) Coordination with sections 1248 and 995. Any increase in basis 
allocated to stock in a foreign corporation pursuant to the second 
sentence in paragraph (c)(2)(i) of this section, or any decrease in 
basis allocated to stock in a foreign corporation pursuant to the 
second sentence in paragraph (c)(2)(ii) of this section, is not taken 
into account in determining the amount of gain recognized on the sale 
or exchange of such stock for purposes of section 1248(a). In the case 
of property that is subject to section 995(c), rules similar to the 
rule set forth in this paragraph (c)(2)(v) shall apply.
    (vi) Election not to apply the provisions of paragraphs 
(c)(2)(iii), (iv), and (v). A partnership may elect not to apply 
paragraphs (c)(2)(iii), (iv), and (v) of this section, and Sec.  1.732-
1(c)(2)(iii), (iv), and (v). An election made under this paragraph 
(c)(2)(vi) shall apply to all property distributions taking place in 
the partnership taxable year for which the election is made and in all 
subsequent partnership taxable years (including after a termination of 
the partnership under section 708(b)(1)(B)). An election under this 
paragraph (c)(2)(vi) must be made in a written statement filed with the 
partnership return for the first taxable year in which any of paragraph 
(c)(2)(iii), (iv), or (v) of this section, or Sec.  1.732-1(c)(2)(iii), 
(iv), and (v), would have applied if no election was made. An election 
under this paragraph (c)(2)(vi) is valid only if the required statement 
is included with a partnership return that is filed not later than the 
time prescribed by paragraph (e) of this section or Sec.  1.6031(a)-1 
(including extensions thereof) for filing the return for such taxable 
year. This election is a method of accounting under section 446, and 
once the election is made, it can be revoked only with the consent of 
the Commissioner. The revocation of the election, or the making of a 
late election, under this paragraph (c)(2)(vi) is a change in method of 
accounting to which the provisions of section 446(e) and the 
regulations under section 446(e) apply. See paragraph (c)(6), Example 
3, of this section for the treatment of a section 734(b) adjustment if 
an election under this paragraph (c)(2)(vi) is made, and certain 
consequences of the election under section 751(b). The statement 
required by this paragraph (c)(2)(vi) shall--
    (A) Set forth the name and address of the partnership making the 
election;
    (B) Be signed by any officer, manager, or member of the partnership 
who is authorized (under local law or the partnership's organizational 
documents) to make the election and who represents to having such 
authorization under penalties of perjury; and
    (C) Contain a declaration that the partnership elects not to apply 
paragraphs (c)(2)(iii), (iv), and (v) of this section and Sec.  1.732-
1(c)(2)(iii), (iv), and (v).
* * * * *
    (6) Examples. The following examples illustrate this paragraph (c):
* * * * *
    Example 2.  (i) A, B, and C are equal partners in ABC. Each 
partner has an outside basis in its partnership interest of $20. ABC 
owns depreciable equipment X with an adjusted basis of $30 and a 
fair market value of $150 and depreciable equipment Y with an 
adjusted basis of $30 and a fair market value of $30. ABC has made 
an election under section 754.
    (ii) The depreciable equipment X has $120 of adjustments 
reflected in its adjusted basis within the meaning of Sec.  1.1245-
2(a)(2). Accordingly, the entire $120 of the gain with respect to 
depreciable equipment X would be treated as gain to which section 
1245(a)(1) would apply if the partnership sold the depreciable 
equipment X for its fair market value. ABC, therefore, has a $120 
unrealized receivable within the meaning of Sec.  1.751-
1(c)(4)(iii). Assume ABC makes a current distribution of the 
depreciable equipment Y to A. Because A's basis in his partnership 
interest is only $20, A's basis in the depreciable equipment Y will 
be limited to $20 under section 732(a). Under section 734(b), ABC 
will increase the basis in its capital gain property by $10 and will 
not adjust the basis of ordinary income property. Assume ABC has not 
made an election under Sec.  1.755-1(c)(2)(vi).
    (iii) Allocation between classes. Pursuant to Sec.  1.755-
1(a)(1), ABC's $120 unrealized receivable associated with the 
depreciable equipment X is treated as a separate asset that is 
ordinary income property. Thus, ABC is treated as having two assets 
(each actually a component of the single asset, equipment X) after 
the distribution, one that is capital gain property with a basis of 
$30 and a fair market value of $30, and one that is ordinary income 
property with a basis of $0 and a fair market value of $120.
    (iv) Allocation within class. ABC must allocate the $10 basis 
increase entirely to the capital gain portion of the depreciable 
equipment X, as it holds no other capital gain property after it 
distributes the depreciable equipment Y to A. Therefore, ABC 
increases the basis of the capital gain property to $40.
    (v) Treatment of section 734(b) adjustment. Pursuant to 
paragraph (c)(2)(iii) of this section, if ABC sold its depreciable 
equipment X for $150 immediately after the distribution to A, ABC 
would not take into account the $10 section 734(b) adjustment in 
determining ABC's recomputed or adjusted basis in the depreciable 
equipment X for purposes of section 1245(a)(1) and, accordingly, 
would recognize $120 of ordinary income. Also pursuant to paragraph 
(c)(2)(iv) of this section, the $10 section 734(b) adjustment is not 
taken into account for purposes of determining section 1231 gain or 
loss. Thus, pursuant to paragraph (c)(2)(vi) of this section, ABC 
would recognize a $10 capital loss.
    (vi) Treatment of additional depreciation and appreciation. (A) 
Assume, instead, that ABC continues to own the equipment and takes 
additional depreciation deductions of $16 ($15 with respect to the 
original remaining $30 basis and $1 with respect to the additional 
$10 basis resulting from the section 734(b) adjustment). At a time 
when the equipment has appreciated in value to $170, ABC sells the 
depreciable equipment X

[[Page 65173]]

for $170 in a taxable transaction. In that same taxable year, ABC 
does not sell any other property used in its trade or business.
    (B) Pursuant to section 1245(a)(1), ABC must recognize ordinary 
income in an amount by which the lesser of the following two amounts 
exceeds ABC's adjusted basis in the depreciable equipment X--
    (1) ABC's recomputed basis in the depreciable equipment, or
    (2) ABC's amount realized;
    (C) Pursuant to section 1245(a)(2)(A), ABC's recomputed basis is 
an amount equal to the sum of--
    (1) ABC's adjusted basis of the property, plus
    (2) The amount of adjustments reflected in the adjusted basis on 
account of deductions allowed or allowable.
    (D) Pursuant to (c)(2)(iii) of this section, the $9 remaining 
section 734(b) adjustments is not taken into account in determining 
ABC's recomputed or adjusted basis in the property for purposes of 
section 1245(a)(1). Thus, ABC's adjusted basis in the property is 
$15 (the remaining original basis). Also pursuant to (c)(2)(iii) of 
this section, however, any depreciation, or amortization of the 
section 734(b) adjustment that is allowed or allowable is taken into 
account in computing the property's recomputed basis. Thus, ABC's 
amount of adjustments reflected in the adjusted basis is $136 (the 
original $120 adjustment for depreciation deductions plus the 
additional $15 adjustment for depreciation deductions plus the 
additional $1 adjustment for depreciation deductions taken with 
respect to the section 734(b) adjustment). Accordingly, ABC's 
recomputed basis is $151 ($15 adjusted basis plus $136 of 
adjustments), which is lower than ABC's amount realized of $170. 
ABC, therefore, must recognize ordinary income in an amount by which 
ABC's recomputed basis of $151 exceeds ABC's adjusted basis in the 
depreciable equipment X. Pursuant to (c)(2)(iii) of this section, 
the $9 remaining section 734(b) adjustments is not taken into 
account in determining the adjusted basis in the property for 
purposes of section 1245(a)(1). Accordingly, ABC must recognize $136 
of ordinary income (the excess of ABC's $151 recomputed basis in the 
depreciable equipment X over ABC's $15 adjusted basis in the 
depreciable equipment X).
    (E) Pursuant to paragraph (c)(2)(iv) of this section, the 
section 734(b) adjustment is not taken into account in determining 
ABC's section 1231 gain or loss. Accordingly, pursuant to section 
1231(a)(1), ABC recognizes $19 of capital gain (ABC's $170 amount 
realized on the disposition of the depreciable equipment X over 
ABC's adjusted basis of $15 in the depreciable equipment X, reduced 
by the $136 of ordinary income ABC recognized under section 
1245(a)(1)). Pursuant to paragraph (c)(2)(vi) of this section, ABC 
also recognizes a capital loss equal to the remaining $9 section 
734(b) adjustment.
    Example 3.  (i) Assume the same facts as Example 2 of this 
paragraph (c), except ABC has made an election under paragraph 
(c)(2)(vi) of this section.
    (ii) Treatment of section 734(b) adjustment. Because ABC has 
made an election under paragraph (c)(2)(vi) of this section, 
paragraph (c)(2)(iii) of this section does not apply. Thus, if ABC 
sold its depreciable equipment X immediately after the distribution 
to A, ABC would take into account the $10 section 734(b) adjustment 
in determining ABC's recomputed or adjusted basis in the depreciable 
equipment X for purposes of section 1245(a)(1) and, accordingly, 
would recognize $110 of ordinary income (including for purposes of 
applying section 751).
* * * * *
    (e) * * *
    (2) Special rules. Paragraphs (a) and (b)(3)(iii) of this section 
apply to transfers of partnership interests and distributions of 
property from a partnership that occur on or after June 9, 2003, and 
paragraphs (c)(2)(iii), (iv), (v), (vi), and (c)(6) of this section and 
Examples 2 and 3 of paragraph (c) of this section apply to 
distributions of property from a partnership that occur on or after the 
date of publication of a Treasury decision adopting these rules as 
final regulations in the Federal Register.
    Par. 9. Section 1.995-4 is amended by revising the section heading 
and adding a new sentence at the end of paragraph (a)(1) to read as 
follows:


Sec.  1.995-4  Gain on certain dispositions of stock in a DISC.

    (a) * * * (1) * * * But see Sec. Sec.  1.732-1(c)(2)(v) and 1.755-
1(c)(2)(v) for rules governing the application of section 995(c) to 
partnership property in situations in which the basis of the property 
is increased or decreased under section 732 or 734(b).
* * * * *
    Par. 10. Section 1.1231-1 is amended by adding a new sentence after 
the third sentence in the introductory text of paragraph (d) to read as 
follows:


Sec.  1.1231-1  Gains and losses from the sale or exchange of certain 
property used in the trade or business.

* * * * *
    (d) * * * See also Sec. Sec.  1.732-1(c)(2)(iv) and 1.755-
1(c)(2)(iv) for rules governing the application of section 1231 to 
partnership property in situations in which the basis of the property 
is increased under section 732 or 734(b). * * *
* * * * *


Sec.  1.1245-2  [Amended]

    Par. 11. Section 1.1245-2 is amended by removing paragraph 
(c)(6)(ii) and redesignating paragraph (c)(6)(iii) as paragraph 
(c)(6)(ii).
    Par. 12. Section 1.1245-4 is amended by revising paragraphs 
(f)(2)(ii) and (f)(3) and Example 2 to read as follows:


Sec.  1.1245-4  Exceptions and limitations.

* * * * *
    (f) * * *
    (2) * * *
    (ii) The portion of such potential section 1245 income which is 
recognized as ordinary income under paragraphs (b)(3)(i) and (b)(4)(i) 
of Sec.  1.751-1.
    (3) * * *
    Example 2.  Assume the same facts as in Example 1 of this 
paragraph (f) except that the machine had been purchased by the 
partnership. Assume further that upon the distribution, $4,000 of 
gain is recognized as ordinary income under section 751(b). Under 
section 1245(b)(3), gain to be taken into account under section 
1245(a)(1) by the partnership is limited to $4,000. Immediately 
after the distribution, the amount of adjustments reflected in the 
adjusted basis of the property is $2,000 (that is, potential section 
1245 income of the partnership, $6,000, minus gain recognized under 
section 751(b), $4,000). Thus, if the adjusted basis of the machine 
in the hands of C were $10,000, the recomputed basis of the machine 
would be $12,000 ($10,000 plus $2,000).
* * * * *
0
Par. 13. Section 1.1248-1 is amended by adding a new sentence at the 
end of paragraph (a)(1) to read as follows:


Sec.  1.1248-1  Treatment of gain from certain sales or exchanges of 
stock in certain foreign corporations.

    (a) * * * (1) * * * See also Sec. Sec.  1.732-1(c)(2)(v) and 1.755-
1(c)(2)(v) for rules governing the application of section 1248 to 
partnership property in situations in which the basis of the property 
is increased or decreased under section 732 or 734(b).
* * * * *
0
Par. 14. Section 1.1250-1 is amended by revising the section heading 
and adding a new sentence at the end of paragraph (f) to read as 
follows:


Sec.  1.1250-1  Gain from disposition of certain depreciable property.

    (f) * * * See also Sec. Sec.  1.732-1(c)(2)(iii) and 1.755-
1(c)(2)(iii) for rules governing the application of section 1250 to 
partnership property in situations in which the basis of the property 
is increased under section 732 or 734(b).
* * * * *
0
Par. 15. Section 1.1252-2 is amended by adding a new sentence at the 
end of paragraph (c)(2)(vii) to read as follows:


Sec.  1.1252-2  Special rules.

* * * * *
    (c) * * *
    (2) * * *
    (vii) * * * See also Sec. Sec.  1.732-1(c)(2)(iii) and 1.755-
1(c)(2)(iii) for rules governing the application of section 1252 to 
partnership property in situations in which the basis of the

[[Page 65174]]

property is increased under section 732 or 734(b).
* * * * *
0
Par. 16. Section 1.1254-5 is amended by revising the introductory text 
of paragraph (b)(1) to read as follows:


Sec.  1.1254-5  Special rules for partnerships and their partners.

* * * * *
    (b) Determination of gain treated as ordinary income under section 
1254 upon the disposition of natural resource recapture property by a 
partnership--(1) General rule. Upon a disposition of natural resource 
recapture property by a partnership, the amount treated as ordinary 
income under section 1254 is determined at the partner level. See also 
Sec. Sec.  1.732-1(c)(2)(iii) and 1.755-1(c)(2)(iii) for rules 
governing the application of section 1254 to partnership property in 
certain situations. Each partner must recognize as ordinary income 
under section 1254 the lesser of--
* * * * *
0
Par. 17. Section 1.6050K-1 is amended by revising paragraph (a)(4)(ii) 
and adding a new sentence after the third sentence of paragraph (c) 
introductory text to read as follows:


Sec.  1.6050K-1  Returns relating to sales or exchanges of certain 
partnership interests.

    (a) * * *
    (4) * * *
    (ii) Section 751 property. For purposes of this section, the term 
``section 751 property'' means unrealized receivables, as defined in 
section 751(c) and the regulations, and inventory items, as defined in 
section 751(d) and the regulations.
* * * * *
    (c) * * * With respect to any statement required to be furnished to 
a transferor, the statement shall, in addition to the other information 
required, include the amount of any gain or loss attributable to 
section 751 property that is required to be recognized pursuant to 
paragraph (a)(2) of Sec.  1.751-1. * * *
* * * * *
0
Par. 18. For each section listed in the table, remove the language in 
the ``Remove'' column and add in its place the language in the ``Add'' 
column as set forth below:

------------------------------------------------------------------------
             Section                    Remove                Add
------------------------------------------------------------------------
Sec.   1.704-3, paragraph         Sec.   1.743-1(b)   Sec.   1.743-1(b),
 (a)(6)(ii).                       or 1.751-1(a)(2).   1.751-1(a)(2), or
                                                       1.751-1(b).
Sec.   1.751-1, paragraph         sections 731, 736,  sections 731, 732,
 (c)(4)(i) first and last          741, and 751.       and 741 (but not
 sentences.                                            for purposes of
                                                       section 736).
Sec.   1.751-1, paragraph         sections 731, 736,  sections 731, 732,
 (c)(4)(ii), first and last        741, and 751.       and 741 (but not
 sentences.                                            for purposes of
                                                       section 736).
Sec.   1.751-1, paragraph         sections 731, 736,  sections 731, 732,
 (c)(4)(iii) first and last        741, and 751.       and 741 (but not
 sentences.                                            for purposes of
                                                       section 736).
Sec.   1.751-1, paragraph         sections 731, 736,  sections 731, 732,
 (c)(4)(iv) first and last         741, and 751.       and 741 (but not
 sentences.                                            for purposes of
                                                       section 736).
Sec.   1.751-1, paragraph         sections 731, 736,  sections 731, 732,
 (c)(4)(v) first and last          741, and 751.       and 741 (but not
 sentences.                                            for purposes of
                                                       section 736).
Sec.   1.751-1, paragraph         sections 731, 736,  sections 731, 732,
 (c)(4)(vii) first and last        741, and 751.       and 741 (but not
 sentences.                                            for purposes of
                                                       section 736).
Sec.   1.751-1, paragraph         sections 731, 736,  sections 731, 732,
 (c)(4)(viii) first and last       741, and 751.       and 741 (but not
 sentences.                                            for purposes of
                                                       section 736).
Sec.   1.751-1, paragraph         sections 731, 736,  sections 731, 732,
 (c)(4)(ix) first and last         741, and 751.       and 741 (but not
 sentences.                                            for purposes of
                                                       section 736).
Sec.   1.751-1, paragraph         section 1221(1)...  section
 (d)(2)(i) last sentence.                              1221(a)(1).
Sec.   1.751-1, paragraph         section 1221(4)...  section
 (d)(2)(ii) second sentence.                           1221(a)(4).
Sec.   1.1245-1, paragraph (a)    see section         see section
 last sentence.                    1245(b) and Sec.    1245(b), and Sec.
                                    1.1245-4.           Sec.   1.732-
                                                       1(c)(2)(iii),
                                                       1.755-1(c)(2)(iii
                                                       ), and 1.1245-4.
Sec.   1.1245-2, paragraph        1245(b)(6)(B).....  1245(b)(5)(B).
 (c)(6)(i).
------------------------------------------------------------------------


John Dalrymple,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 2014-25487 Filed 10-31-14; 8:45 am]
BILLING CODE 4830-01-P