Determination of Distributive Share When a Partner's Interest Changes, 17119-17128 [E9-8438]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 74, Number 70 (Tuesday, April 14, 2009)]
[Proposed Rules]
[Pages 17119-17128]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E9-8438]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-144689-04]
RIN 1545-BD71


Determination of Distributive Share When a Partner's Interest 
Changes

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed regulations regarding the 
determination of partners' distributive shares of partnership items of 
income, gain, loss, deduction and credit when a partner's interests 
varies during a partnership taxable year. Also, the proposed 
regulations modify the existing regulations regarding the required 
taxable year of a partnership. These proposed regulations affect 
partnerships and their partners.

DATES: Written or electronic comments and requests for a public hearing 
must be received by July 13, 2009.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-144689-04), Room 
5203, Internal Revenue Service, PO 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-
144689-04), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC; or sent electronically via the Federal 
eRulemaking Portal at www.regulations.gov (IRS REG-144689-04).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Laura Fields or Jonathan Cornwell at (202) 622-3050, concerning 
submissions of comments and the hearing, Richard Hurst at (202) 622-
7180 (not toll-free numbers) or Richard.A.Hurst@irscounsel.treas.gov.

SUPPLEMENTARY INFORMATION:

Background

    These proposed regulations contain amendments to the Income Tax 
Regulations (26 CFR part 1) under section 706 of the Internal Revenue 
Code (Code). These amendments are proposed to conform the Income Tax 
Regulations for certain of the provisions of section 1246 of the 
Taxpayer Relief Act of 1997, Public Law 105-34 (111 Stat. 788 (1997)) 
(the 1997 Act) and section 72 of the Deficit Reduction Act

[[Page 17120]]

of 1984, Public Law 98-369 (98 Stat. 494 (1984)) (the 1984 Act).
    Also, under section 706(d)(1), the Treasury Secretary may provide 
in regulations various methods for determining a partner's distributive 
share of partnership items of income, gain, loss, deduction and credit 
that takes into account the varying interests of the partners for any 
taxable year of the partnership in which there is a change in the 
interest of a partner. Pursuant to that grant of regulatory authority, 
the proposed regulations provide methods for determining a partner's 
distributive share of partnership items to take into account the 
varying interests of the partners in any year in which there is a 
change in a partner's interest in the partnership. Also, the proposed 
regulations provide that a deemed disposition of a partner's entire 
interest under other sections of the regulations is a deemed 
disposition of a partner's entire interest for the purpose of section 
706(d).
    Finally, the proposed regulations amend the rules applicable to the 
determination of the taxable year of a partnership in those instances 
in which partnership interests are held by ``disregarded foreign 
partners'' (as that term is defined in Sec.  1.706-1(b)(6)(i)).

1. Varying Interest Rule

a. In General
    Section 702(a) of the Code provides that the partner in determining 
the partner's income tax shall take into account separately the 
partner's distributive share of partnership items of income, gain, 
loss, deduction, or credit.
    Section 706(a) provides that, in computing the taxable income of a 
partner for a taxable year, the inclusions required by sections 702 and 
707(c) with respect to a partnership shall be based on the income, 
gain, loss, deduction, or credit of the partnership for any taxable 
year of the partnership ending within or with the taxable year of the 
partner.
    Section 706(c)(1) provides that, except in the case of a 
termination of a partnership and except as provided in section 
706(c)(2), the taxable year of a partnership shall not close as the 
result of the death of a partner, the entry of a new partner, the 
liquidation of a partner's interest in the partnership, or the sale or 
exchange of a partner's interest in the partnership. Under section 
706(c)(2)(A), the taxable year of a partnership shall close with 
respect to a partner whose entire interest terminates (whether by 
reason of death, liquidation, or otherwise). Under section 
706(c)(2)(B), the taxable year of a partnership shall not close (other 
than at the end of a partnership's taxable year as determined under 
section 706(b)(1)) with respect to a partner who sells or exchanges 
less than his entire interest in the partnership or with respect to a 
partner whose interest is reduced (whether by entry of a new partner, 
partial liquidation of a partner's interest, gift, or otherwise).
    Section 706(d)(1) provides that, except as required by sections 
706(d)(2) and (d)(3), if there is a change in a partner's interest in 
the partnership during the partnership's taxable year, each partner's 
distributive share of any partnership item of income, gain, loss, 
deduction or credit for such taxable year is determined by the use of 
any method prescribed by the Secretary by regulations which takes into 
account the varying interests of the partners in the partnership during 
such taxable year (the varying interests rule). Section 706(d)(1) was 
added by the 1984 Act, in part, to clarify that the varying interests 
rule applies to the disposition of a partner's entire interest in the 
partnership as well as the disposition of less than a partner's entire 
interest, and to authorize the Secretary to prescribe methods for 
determining a partner's distributive share of partnership items when 
there is a change in the partners' interests during the taxable year of 
the partnership.
    The existing regulations under section 706 have not been revised to 
reflect the changes made to that section by the 1984 Act. Section 
1.706-1(c)(2)(ii) provides that in the case of a disposition of a 
partner's entire interest in a partnership the partner's distributive 
share of partnership items for the taxable year of the partnership in 
which the disposition occurs may be determined by a closing of the 
partnership's books as of the date of disposition (interim closing 
method). Alternatively, the partners by agreement may determine the 
departing partner's distributive share by taking his pro rata part of 
the amount of partnership items that such partner would have included 
in his taxable income had he remained a partner until the end of the 
partnership taxable year (proration method). Section 1.706-1(c)(2)(ii). 
The proration may be based on the portion of the taxable year that has 
elapsed prior to the disposition or may be determined under any other 
method that is reasonable. Moreover, the transferee of such departing 
partner's interest shall include in his taxable income as his 
distributive share of partnership items with respect to the acquired 
interest the pro rata part (determined by the method used by the 
transferor partner) of the amount of such items that would have been 
included had he been a partner from the beginning of the partnership's 
taxable year. The existing regulations, however, do not specifically 
provide for the use of these methods when there has been a disposition 
of less a partner's entire interest in the partnership.
    In Rev. Rul. 77-310 (1977-2 CB 217) (see Sec.  
601.601(d)(2)(ii)(b)), the IRS provided an example of an acceptable 
method for allocating a partnership loss for the partnership's taxable 
year among the partners where their profit and loss sharing percentages 
were changed substantially one month before the end of the taxable year 
as a result of capital contributions of several existing partners. The 
ruling provided that an acceptable method, under the facts of the 
ruling, was to allocate the partnership's loss among the partners based 
on their differing profit and loss sharing percentages and the periods 
during the year each partner's differing percentage interests existed. 
See also Rev. Rul. 77-311 (1977-2 CB 218), (applying the same method to 
a partnership's distributive share of a loss from a lower-tier 
partnership). See Sec.  601.601(d)(2)(ii)(b).
    Finally, the existing regulations under section 706 have not been 
revised to reflect the change to that section by the 1997 Act requiring 
that the taxable year of the partnership shall close with respect to a 
partner whose entire interest in the partnership terminates by reason 
of death. In that regard, Sec.  1.706-1(c)(3) provides that, when a 
partner dies, the partnership taxable year shall not close with respect 
to such partner prior to the end of the partnership's taxable year.
b. Change in Partnership Allocations Among Contemporaneous Partners
    Section 761(c) provides that a partnership agreement includes any 
modifications of the partnership agreement made prior to, or at, the 
time prescribed by law for the filing of the partnership return for the 
taxable year (not including extensions). In Lipke v. Commissioner, 81 
T.C. 689 (1983), the Tax Court held that section 706(c)(2)(B) (as in 
effect prior to the 1984 Act) prohibited retroactive allocations of 
partnership losses where the allocations resulted from additional 
capital contributions made by both new and existing partners. However, 
the Tax Court held that the prohibition on retroactive allocations 
under section 706(c)(2)(B) did not apply to changes in the allocations 
among partners who were members of the partnership for the entire year 
(contemporaneous partners)

[[Page 17121]]

if the changes in the allocations did not result from capital 
contributions. Lipke v. Commissioner, supra, at 696 (1983).

As previously discussed, the 1984 Act amended section 706, in part, to 
clarify that the varying interests rule applies to any change in a 
partner's interest, whether in connection with a complete disposition 
of the partner's interest or otherwise. To that end, Congress in the 
1984 Act replaced the varying interests rule in section 706(c)(2)(B) 
with the rule that now appears in Section 706(d)(1). The legislative 
history pertaining to this amendment reflects Congress's intention that 
the new rule of section 706(d)(1) be comparable to the pre-1984 law 
without overruling the longstanding rule of section 761(c).

    The committee wishes to make clear that the varying interests 
rule is not intended to override the longstanding rule of section 
761(c) with respect to interest shifts among partners who are 
members of the partnership for the entire taxable year, provided 
such shifts are not, in substance, attributable to the influx of new 
capital from such partners. See Lipke v. Commissioner, 81 T.C. 689 
(1983).

S. Prt. 98-169, Vol. I, 98th Cong., 2d Sess. 218-19 (1984); see also H. 
Rep. No. 432, Pt. 2, 98th Cong., 2d Sess. 1212-13 (1984) (containing 
similar language).
c. Conventions
    Section 1.706-1(c)(2)(ii) provides that, in determining the 
distributive share of partnership items under section 702(a) with 
respect to a partner whose entire interest in the partnership 
terminates, a partnership may use the interim closing method or 
alternatively, the partners may by agreement choose to use the 
proration method. Under the proration method, the partnership's income 
and losses may be prorated based on the portion of the taxable year 
that has elapsed prior to the date upon which the partners' interests 
varied, or ``under any other method that is reasonable.'' These other 
reasonable methods have become known as conventions.
    Staff of J. Comm. On Taxation, 98th Cong., General Explanation of 
the Revenue Provisions of the Deficit Reduction Act of 1984, 222 (Comm. 
Print 1984), provides,

    [I]n any case in which there is a disposition of less than an 
entire interest in the partnership by a partner (including the entry 
of a new partner), the partners may elect to determine the varying 
interests of the partners by using one or more conventions that 
treat any change in any partner's interest in the partnership during 
a particular month as occurring on one or more specified days in the 
month. The actual method for applying a convention is to be provided 
by Treasury regulations. The regulations may deny the use of any 
convention when the occurrence of significant, discrete events 
(e.g., a large, unusual gain or loss) would mean that use of the 
convention could result in significant tax avoidance.

* * * Congress intended that the regulations providing for these 
conventions will be effective on a prospective basis only. Until 
these regulations are proposed, and for a reasonable transition 
period thereafter, it is expected that Treasury will permit any 
reasonable convention to be used. This may include a method under 
which any partner entering during a month is treated as entering on 
the first day of the month, a method under which partners entering 
during the first 15 days of a month are treated as entering on the 
first day of the month and partners entering after the 15th of the 
month are treated as entering on the 16th day of the month, or any 
other method that is not abusive under the relevant facts and 
circumstances. As a general rule, use of a convention is not 
permitted when the occurrence of significant, discrete events (e.g., 
a large, unusual gain or loss) would result in significant tax 
avoidance if the convention is used.

    On December 13, 1984, the IRS issued a news release (IR-84-129) 
(https://www.irs.gov/puv/irs-drop/ir-84-129.pdf) announcing that 
partnerships using the interim closing method were permitted to use a 
semi-monthly convention. Under a semi-monthly convention, partners 
entering during the first 15 days of the month are treated as entering 
on the first day of the month, and partners entering after the 15th day 
of the month (but before the end of the month) are treated as entering 
on the 16th day of the month (except to the extent that section 
706(c)(2)(A) applied). The news release provided that, until 
regulations were issued, partnerships that use the proration method 
were required to use a daily convention.
d. Deemed Dispositions
    Section 1.1502-76(b)(2)(i) provides that the federal income tax 
returns for the years that end and begin with a corporation becoming 
(or ceasing to be) a member (as defined in Sec.  1.1502-1(b)) of a 
consolidated group (as defined in Sec.  1.1502-1(h)) are separate tax 
years for all Federal income tax purposes. The periods ending and 
beginning with the corporation's change in status are different tax 
years, and the corporation's items of income, gain, loss, deduction and 
credit must be allocated between such separate tax years. Under Sec.  
1.1502-76(b)(2)(vi), if the corporation is a partner in a partnership, 
the corporation is treated for purposes of determining the year to 
which the partnership's items are allocated as selling the 
corporation's entire interest in the partnership immediately before the 
corporation's change in status.
    Section 1.1362-3(a) provides that, if an S election (as defined in 
section 1362(a)) terminates under section 1362(d) on a date other than 
the first day of the taxable year of the S corporation (as defined in 
section 1361(a)), the portion of the year ending as of the close of the 
day prior to the termination is treated as a short taxable year for 
which the corporation is an S corporation (S short year) and the 
portion of the S termination year beginning on the day of the 
termination is effective is treated as a short taxable year for which 
the corporation is a C corporation (as defined in section 1362(a)(2)) 
(C short year). Under Sec.  1.1362-3(a), the corporation's items of 
income, gain, loss, deduction and credit must be allocated between the 
S short year and C short year using the pro rata allocation approach 
stated in section 1362(e)(2) unless an election is made to allocate the 
items using its normal accounting method or in certain other instances 
described in sections 1362(e)(3), 1362(e)(6)(C) or 1362(e)(6)(D). Under 
Sec.  1.1362-3(c)(1), for purposes of section 706(c) only, the 
termination of the S election of a corporation that is a partner in a 
partnership is treated as a sale or exchange of the corporation's 
entire interest in the partnership on the last day of the S short year 
if (i) the pro rata allocation rules do not apply and (ii) the taxable 
year of the partnership ends with or within the C short year.
    Under section 1377(a)(2), if a shareholder terminates the 
shareholder's entire interest in an S corporation and all affected 
shareholders (as defined in section 1377(a)(2)(B)) and the corporation 
agree, the S corporation may elect under section 1377(a)(2) 
(terminating election) to apply the pro rata allocation method (as 
defined in section 1377(a)(1)) as if the S corporation's taxable year 
consisted of two separate taxable years, the first of which ends at the 
close of the day on which the shareholder's entire interest in the S 
corporation is terminated. (See Sec.  1.1377-1(b)(1) for certain 
exceptions to the preceding rule.) Under Sec.  1.1377(b)(3)(iv), a 
terminating election by an S corporation that is a partner in a 
partnership is treated as a sale or exchange of the corporation's 
entire interest in the partnership for purposes of section 706(c) if 
the taxable year of the partnership ends after the shareholder's 
interest is terminated and within the taxable year of the S 
corporation.

2. Taxable Years of Partnerships

    A partnership must determine its taxable year under section 
706(b)(1)(B)

[[Page 17122]]

unless the partnership establishes to the satisfaction of the Secretary 
a business purpose for a different year. In general, the required 
taxable year of a partnership is determined by reference to the taxable 
year of its partners. If partners owning a majority interest in a 
partnership have the same taxable year, the partnership is required to 
have the same taxable year as the majority interest owners (majority 
interest taxable year). If a taxable year for the partnership cannot be 
determined under the majority interest taxable year rule, the taxable 
year of the partnership shall be the taxable year of all of its 
principal partners (principal partner taxable year). Finally, if there 
is not taxable year described under the majority interest taxable year 
rule or principal partner taxable year rule, then the partnership is 
required under the regulations to have the taxable year that results in 
the least aggregate deferral of income. Section 1.706-1(b)(2)(C).
    Under Sec.  1.706-1(b)(6)(i), the interest held by a disregarded 
foreign partner is not taken into account in determining the taxable 
year of the partnership under the foregoing rules. A foreign partner is 
a disregarded foreign partner unless such partner is allocated gross 
income that was effectively connected with the conduct of a trade or 
business of the partnership within the U.S. and taxation of such income 
is not otherwise precluded under any U.S. income tax treaty. The 
interest of a disregarded foreign partner is taken into account in 
determining the taxable year of the partnership, however, if the 
partners that are not disregarded foreign partners (regarded partners) 
hold a minority interest in the partnership (minority interest rule). 
Section 1.706-1(b)(6)(iii). Regarded partners hold a minority interest 
for this purpose if each regarded partner holds less than a 10-percent 
interest in capital or profits of the partnership, and the regarded 
partners in the aggregate hold less than a 20-percent interest in the 
capital or profits of the partnership.

Explanation of Provisions

1. Varying Interests Rule

a. In General
    The proposed regulations amend Sec.  1.706-1(c) to reflect the 
change made to section 706(c)(2)(A) in the 1997 Act which requires that 
the taxable year of the partnership close with respect to a partner who 
dies. The proposed regulations do not change the provisions in Sec.  
1.706-1(c)(3)(iv) that the sale or exchange of a partnership interest 
does not include any transfer of a partnership interest which occurs at 
death as a result of inheritance or any testamentary disposition or in 
Sec.  1.706-1(c)(5) that the transfer of a partnership interest by gift 
does not close the partnership taxable year with respect to the donor.
    Also, the proposed regulations add Sec.  1.706-4 to provide for the 
application of the varying interests rule in all cases in which a 
partner's interest changes during the taxable year, whether by reason 
of a disposition of the partner's entire interest in the partnership or 
a disposition of less than the partner's entire interest in the 
partnership.
b. Methods and Conventions
    Proposed Sec.  1.706-4(a) provides that, if a partner's interest 
changes during the partnership's taxable year, the partnership shall 
determine the partner's distributive share using the interim closing 
method. However, the partnership by agreement of the partners may use 
the proration method. For each partnership taxable year in which a 
partner's interest varies, the proposed regulations provide that the 
partnership must use the same method to take into account all changes 
occurring within that year.
    Proposed Sec.  1.706-4(c) generally provides that a partnership 
shall take into account any variation in the partners' interests in the 
partnership during the taxable year by determining the distributive 
share of partnership items under section 702(a) for each segment of 
that taxable year using an interim closing of the books method and by 
allocating those items among the partners in accordance with their 
respective partnership interests during that segment. Proposed Sec.  
1.706-4(c)(1) and (2) incorporate the principles of the former Sec.  
1.706-1(c)(2)(ii) (as finalized in TD 6175).
    Proposed Sec.  1.706-4(d) provides that by agreement among the 
partners a partnership may use a proration method, rather than the 
interim closing method, to take into account any variation in a 
partner's interest in the partnership during the taxable year. Under 
this method, except for extraordinary items (as defined in Sec.  1.706-
4(d)(3)), the partnership allocates the distributive share of 
partnership items under section 702(a) among the partners in accordance 
with their pro rata shares of these same items for the entire taxable 
year. In determining a partner's pro rata share of partnership items, 
the partnership shall take into account that partner's interest in such 
items during each segment of the taxable year. Proposed Sec.  1.706-
4(d)(1) and (2) incorporate the principles of the former Sec.  1.706-
2(c)(2)(ii) (as finalized in TD 6175).
    For purposes of accounting for the partners' varying interests in 
the partnership, proposed Sec.  1.706-4 requires that for each partner 
whose interest changes in the taxable year the partnership shall 
maintain segments to account for such changes. A segment is specific 
portion of a partnership's taxable year. The first segment of a taxable 
year for a partner that incurs a change will begin on the partnership's 
first day of its taxable year and end as of the close of business 
immediately preceding the date of the change as determined under the 
applicable convention (discussed in this preamble) used by the 
partnership and its partners. The next segment will begin on the day 
prescribed by the applicable convention and end on the earlier of the 
close of the day immediately preceding the date of the subsequent 
change as determined by the applicable convention, or the end of the 
partnership's taxable year. Proposed Sec.  1.706-4(a)(2) provides that 
the partnership shall determine the items for each segment of the 
taxable year created by the variation event for a partner in accordance 
with the partnership's method of accounting used for its entire taxable 
year. Each segment is treated as a separate period.
    For purposes of the interim closing method in Sec.  1.706-4(c) and 
the proration method in Sec.  1.706-4(d), the proposed regulations 
provide a special accounting rule that must be used to account for 
certain items. For example, for an interim closing method, the 
partnership may compute a net capital loss for a segment even though 
the partnership has net capital gain for the complete taxable year. 
Also, any limitation applicable to the partnership year as a whole (for 
example, the limitation under section 179) must be apportioned among 
the segments using any reasonable method provided that the method may 
not exceed any limitation applicable to the partnership as a whole. See 
proposed Sec. Sec.  1.706-4(a)(2)(i) and (ii).
    In addition, proposed Sec.  1.706-4(d)(3) requires a partnership 
using the proration method to allocate extraordinary items among the 
partners in proportion to their interests at the beginning of the day 
on which they are taken into account. For this purpose, an 
extraordinary item is (i) any item from the disposition or abandonment 
(other than in the ordinary course of business) of a capital asset as 
defined in section 1221 (determined without the application of any 
other rules of law); (ii) any item from the disposition or abandonment 
of property used in a trade or business (other than in the ordinary 
course of business) as defined

[[Page 17123]]

in section 1231(b) (determined without the application of any holding 
period requirement); (iii) any item from the disposition or abandonment 
of an asset described in sections 1221(1), (3), (4), or (5), if 
substantially all the assets in the same category from the same trade 
or business are disposed of or abandoned in one transaction (or series 
of related transactions); (iv) any item from assets disposed of in an 
applicable asset acquisition under section 1060(c); (v) any section 
481(a) adjustment; (vi) any item from the discharge or retirement of 
indebtedness (for example, if a debtor partnership transfers a capital 
or profits interest in such partnership to a creditor in satisfaction 
of its recourse or nonrecourse indebtedness, any discharge of 
indebtedness income recognized under section 108(e)(8) must be 
allocated among the persons who were partners in the partnership 
immediately before the discharge); (vii) any item from the settlement 
of a tort or similar third-party liability; (viii) any credit, to the 
extent it arises from activities or items that are not ratably 
allocated (for example, the rehabilitation credit under section 47, 
which is based on placement in service); and (ix) any item which, in 
the opinion of the Commissioner, would, if ratably allocated, result in 
a substantial distortion of income in any consolidated return or 
separate return in which the item is included. The IRS and the Treasury 
Department request comments concerning whether any items should be 
added to or removed from the definition of extraordinary items.
    Under proposed Sec.  1.706-4(e), a partnership using the interim 
closing method may use either a calendar day convention or a semi-
monthly convention. A partnership using the proration method may use 
only the calendar day convention. The calendar day convention requires 
that, with respect to a partner whose interest terminates, the 
partnership's taxable year closes as of the close of the day on which 
the change occurs. Section 1.706-4(e)(1). The semi-monthly convention 
requires that any variation in a partner's interest occurring during 
the first through 15th day of the calendar month is deemed to occur at 
the beginning of the first day of the month, and any variation in a 
partner's interest occurring during the 16th through the last day of 
the month is deemed to occur at the beginning of the 16th day of that 
month. Section 1.706-4(e)(2).
    A partnership must use the same method and convention for all 
variations in the partners' interests during the taxable year of the 
partnership. For example, a partnership could not use the proration 
method and interim closing method in the same taxable year. 
Additionally, a partnership using the interim closing method could not 
use the calendar day convention to account for a variation in one 
partner's interest during the partnership's taxable year while using a 
monthly convention to account for that partner's, or a different 
partner's, variation in an interest during the partnership's taxable 
year. Comments are requested with regard to the possible expansion of 
this rule to include other conventions or other methods.
    The IRS and the Treasury Department are aware that some publicly 
traded partnerships (as defined in section 7704) are using conventions 
other than a monthly or semi-monthly convention and are using these 
conventions with the proration method. Thus, the IRS and the Treasury 
Department are requesting comments concerning the use of conventions 
other than monthly or semi-monthly convention. The proposed regulations 
regarding the use of conventions will not apply to existing publicly 
traded partnerships.
c. Change in Partnership Allocations Among Contemporaneous Partners
    Proposed Sec.  1.706-4(b)(1) provides that the varying interests 
rule will not preclude changes in the allocations among contemporaneous 
partners resulting from amendments to the partnership agreement made no 
later than the due date of the partnership return for the taxable year 
(excluding extensions). This exception applies only to allocations that 
are valid under section 704(b) and the regulations promulgated in 
association with that section. Moreover, consistent with the Tax 
Court's decision in Lipke, this exception to the varying interests rule 
will not apply to any changes in interests of the partners attributable 
to contributions of money or other property to the partnership. The 
proposed regulations further provide that this exception will not apply 
to changes in the interests of the partners as a result of 
distributions of capital from the partnership to a partner.
d. Safe Harbors for Service Partnerships and Publicly Traded 
Partnerships
    Proposed Sec.  1.706-4(b)(2) provides that service partnerships (as 
defined in that section) may allocate items relating to the provision 
of services among the partners whose interests vary during the year 
using any reasonable method to account for such changes even though 
such method is not described in paragraph (a) of the proposed 
regulations and the partnership does not use the methods or conventions 
described in paragraphs (c) and (d), and paragraph (e) of the proposed 
regulations, respectively. However, the allocations must be valid under 
section 704(b).
    Proposed Sec.  1.706-4(b)(3) provides that publicly traded 
partnerships (as defined in section 7704(b)) may treat all transfers of 
its publicly traded units (as described in Sec.  1.7704-1(b)(1)) during 
a calendar month as occurring on the first day of the following month 
under a consistent method adopted by the partnership or may use the 
semi-monthly convention described in Sec.  1.706-4(e)(2). Block 
transfers of publicly traded partnership (PTP) units (as described in 
Sec.  1.7704-1(e)(2)) will not qualify for this safe harbor.
e. Deemed Dispositions
    The proposed regulations amend Sec.  1.706-1(c) to provide that a 
deemed disposition of a partner's entire interest in the partnership 
pursuant to Sec. Sec.  1.1502-76(b)(2)(vi), 1.1362-3(c)(1), and 1.1377-
1(b)(3)(iv) shall be treated as a disposition of the partner's entire 
interest for purposes of section 706. The IRS and Treasury Department 
request comments concerning the relationship of Sec.  1.1502-
76(b)(2)(vi)(B) and the proposed regulations regarding the deemed 
disposition of partnership interests.

2. Taxable Years of Partnerships

    The proposed regulations amend the minority interest rule in Sec.  
1.706-1(b)(6)(iii) to provide that regarded partners have a minority 
interest only if each regarded partner has less than a 10-percent 
interest in capital and profits, and the regarded partners collectively 
have less than a 20-percent interest in partnership capital and 
profits. This modification means that the interests of foreign partners 
will be taken into account in determining the taxable year of the 
partnership only if the regarded partners have interests below the 
stated thresholds in partnership capital and profits, rather than the 
current rule which requires only an interest below the threshold in 
either capital or profits. For example, under the current regulations, 
the taxable year of disregarded foreign partners would not be ignored 
in determining the taxable year of the partnership if the regarded 
partners had aggregate capital interests of less than 20-percent but 
profits interests of more than 20-percent. By contrast, under the 
proposed regulations, in that example, the taxable year of the 
disregarded foreign partners

[[Page 17124]]

would not be applicable in determining the taxable year of the 
partnership.

Additional Requests for Comments

    The IRS and the Treasury Department are also requesting comments 
relating to any other outstanding issues arising under section 706(d). 
Specifically, the IRS and the Treasury Department are seeking comments 
with regard to issues that arise concerning allocable cash basis items 
and/or tiered partnerships.
    Section 706(d)(2)(A) provides a special rule for determining a 
partner's distributive share of an allocable cash basis item. Section 
706(d)(2) effectively requires a cash method partnership to use an 
economic accrual method solely for the purpose of allocating certain 
items. Under the statute, a partner's distributive share of any 
allocable cash basis item is determined by assigning a pro rata share 
of any allocable cash basis item to each day within a specified period 
to which it is attributable and then allocating each day's portion in 
an amount equivalent to each partner's interest in the partnership on 
that day. A list of allocable cash basis items is found in section 
706(d)(2)(B). The IRS and the Treasury Department are seeking comments 
as to whether that list should be expanded (to include, for example, 
items such as property insurance), as well as on any other issue with 
regard to allocating cash basis items.
    Section 706(d)(3) provides that if during any taxable year of the 
partnership there is a change in any partner's interest in the 
partnership (upper-tier partnership), and such partnership is a partner 
in another partnership (lower-tier partnership), then (except to the 
extent provided by regulations) each partner's distributive share of 
any item of the upper-tier partnership attributable to the lower-tier 
partnership shall be determined by first assigning the appropriate 
portion of each such item to the appropriate days during which the 
upper-tier partnership is a partner in the lower-tier partnership, and 
then allocating the portion assigned to any such day among the partners 
in proportion to their interests in the upper-tier partnership at the 
close of such day. Thus, the daily allocation method, used for cash 
basis items, is applicable to all items of the lower-tier partnership 
if there is a change in the partnership interests in the upper-tier 
partnership. The IRS and the Treasury Department are seeking comments 
on this and any other issue related to tiered partnerships and 
determining a partner's varying interests.

Proposed Effective Date

    In accord with the legislative history to section 706(d), the 
proposed regulations provide a reasonable transition period for 
taxpayers in the effective date provisions of this proposed regulation. 
Thus, the proposed amendments to Sec. Sec.  1.706-1 (with the exception 
of the change to Sec.  1.706-1(b)(6)(iii)), 1.706-4, and 1.706-5 are 
proposed to apply to partnership taxable years that begin after the 
date the final regulations are published in the Federal Register, but 
not before taxable years beginning after December 31, 2009.
    The proposed amendment to Sec.  1.706-1(b)(6)(iii) generally is 
applicable to the first taxable year of a partnership that begins on or 
after the date final regulations are published in the Federal Register, 
subject to two special rules. First, under the current regulations, 
partnerships formed prior to September 23, 2002 (``existing 
partnerships'') generally are exempt from the rules of Sec.  1.706-
1(b)(6) unless they have voluntarily elected to apply them or unless 
they have undergone a technical termination under section 708(b)(1)(B). 
The proposed regulation retains this special rule, such that an 
existing partnership will not be subject to the modified minority 
interest rule in proposed Sec.  1.706-1(b)(6)(iii) unless there has 
been such an election or technical termination. Second, because the 
proposed regulation would modify Sec.  1.706-1(b)(6)(iii) but otherwise 
leave the rules of Sec.  1.706-1(b)(6) unchanged, it is appropriate to 
exempt other partnerships from the modified minority interest rule if 
they are already subject to Sec.  1.706-1(b)(6) and the minority 
interest rule of the current regulations (``interim period 
partnerships''). Thus, interim period partnerships will be exempt from 
the modified minority interest rule of proposed Sec.  1.706-
1(b)(6)(iii) unless they voluntarily elect to be subject to this rule 
or undergo a technical termination. Accordingly, the proposed amendment 
to Sec.  1.706-1(b)(6)(iii) would apply to the first taxable year of a 
partnership that begins on or after the date final regulations are 
published in the Federal Register, subject to these special rules for 
existing partnerships and interim period partnerships.
    The proposed amendments in Sec. Sec.  1.706-4(c)(2) and (d)(2) are 
proposed to apply for the taxable year of a partnership other than an 
existing publicly traded partnership that begin after the date the 
final regulations are published in the Federal Register, but not before 
taxable years beginning after December 31, 2009.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It has also 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations, and because 
the regulation does not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Code, this regulation has 
been submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business.

Comments and Request for a Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) or electronic comments that are submitted timely 
to the IRS. The IRS and the Treasury Department specifically request 
comments on the clarity of the proposed rules and how they can be made 
easier to understand. All comments will be available for public 
inspection and copying.
    A public hearing will be scheduled if requested in writing by any 
person that timely submits written comments. If a public hearing is 
scheduled, notice of the date, time, and place for the pubic hearing 
will be published in the Federal Register.

Drafting Information

    The principal authors of these proposed regulations are Laura 
Fields and Jonathan Cornwell, 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

    Paragraph 1. The authority citation for part 1 is amended by adding 
a new entry in numerical order to read as follows:

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

[[Page 17125]]

    Section 1.706-2 also issued under 26 U.S.C. 706(d). * * *

    Par. 2. Section 1.706-0 is added to read as follows:


Sec.  1.706-0  Table of contents.

    This section lists the captions contained in the regulations under 
section 706.


Sec.  1.706-1  Taxable years of partner and partnership.

    (a) Year in which partnership income is includible.
    (b) Taxable year.
    (1) Partnership treated as taxpayer.
    (2) Partnership's taxable year.
    (i) Required taxable year.
    (ii) Exceptions.
    (3) Least aggregate deferral.
    (i) Taxable year that results in the least aggregate deferral of 
income.
    (ii) Determination of the taxable year of a partner or 
partnership that uses a 52-53 week taxable year.
    (iii) Special de minimis rule.
    (iv) Examples.
    (4) Measurement of partner's profits and capital interest.
    (i) In general.
    (ii) Profits interest.
    (A) In general.
    (B) Percentage share of partnership net income.
    (C) Distributive share.
    (iii) Capital interest.
    (5) Taxable year of a partnership with tax-exempt partners.
    (i) Certain tax-exempt partners disregarded.
    (ii) Example.
    (iii) Effective date.
    (6) Certain foreign partners disregarded.
    (i) Interests of disregarded foreign partners not taken into 
account.
    (ii) Definition of foreign partner.
    (iii) Minority interest rule.
    (iv) Example.
    (v) Effective date.
    (A) Generally.
    (B) Voluntary change in taxable year.
    (C) Subsequent sale or exchange of interests.
    (D) Transition rule.
    (7) Adoption of taxable year.
    (8) Change in taxable year.
    (i) Partnerships.
    (A) Approval required.
    (B) Short period tax return.
    (C) Change in required taxable year.
    (ii) Partners.
    (9) Retention of taxable year.
    (10) Procedures for obtaining approval or making a section 444 
election.
    (11) Effect on partner elections under section 444.
    (i) Election taken into account.
    (ii) Effective date.
    (c) Closing of partnership year.
    (1) General rule.
    (2) Disposition of entire interest
    (i) In general.
    (ii) Example.
    (iii) Deemed dispositions.
    (3) Disposition of less than entire interest.
    (4) Determination of distributive shares.
    (5) Transfer of interest by gift.
    (d) Effective/applicability date.


Sec.  1.706-2  Certain cash basis items prorated over period to which 
attributable. [Reserved]


Sec.  1.706-3  Items attributable to interest in lower-tier partnership 
prorated over entire taxable year. [Reserved]


Sec.  1.706-4  Determination of distributive share when a partner's 
interest varies.

    (a) General rule.
    (1) Methods.
    (2) Segments.
    (i) General rule.
    (ii) Other provisions.
    (b) Exceptions.
    (1) Permissible changes among contemporaneous partners.
    (2) Safe harbor for certain service partnerships.
    (3) Safe harbor for publicly traded units of publicly traded 
partnerships.
    (c) Interim closing method.
    (1) In general.
    (2) Conventions.
    (3) Example.
    (d) Proration method.
    (1) In general.
    (2) Conventions.
    (3) Extraordinary items.
    (4) Example.
    (e) Conventions.
    (1) Calendar day convention.
    (2) Semi-monthly convention.
    (f) Effective/applicability date.


Sec.  1.706-5  Taxable year determination.

    (a) General rule.
    (b) Effective/applicability date.

    Par. 3. Section 1.706-1 is amended as follows:
    1. The language ``capital or profits'' in the first sentence in 
paragraph (b)(6)(iii) is removed and the language ``capital and 
profits'' is added in its place.
    2. Paragraph (b)(6)(v)(A) is revised.
    3. The last sentence of paragraph (b)(6)(v)(B) is removed and four 
new sentences are added in its place.
    4. Paragraph (b)(6)(v)(C) is revised.
    5. Add a new sentence at the end of paragraph (b)(6)(v)(D).
    6. Paragraph (c)(2) is revised.
    7. Paragraph (c)(3) is removed.
    8. Paragraph (c)(4) is redesignated as (c)(3) and the last sentence 
of newly designated paragraph (c)(3) is removed.
    9. New paragraph (c)(4) is added.
    10. Paragraph (d) is revised.
    The additions and revisions read as follows:


Sec.  1.706-1  Taxable years of partner and partnership.

* * * * *
    (b) * * *
    (6) * * *
    (v) * * * (A) Generally. The provisions of this paragraph (b)(6) 
(other than paragraph (b)(6)(iii) of this section) are applicable for 
the first taxable year of a partnership other than an existing 
partnership that begins on or after July 23, 2002. The provisions of 
paragraph (b)(6)(iii) of this section are applicable for the first 
taxable year of a partnership other than an existing partnership or an 
interim period partnership that begins on or after the date these 
regulations become effective. For this purpose, an existing partnership 
is a partnership that was formed prior to September 23, 2002, and an 
interim period partnership is a partnership that was formed on or after 
September 23, 2002, and prior to the date these regulations become 
effective.
    (B) * * * An existing partnership that makes such a change prior to 
the date these regulations become effective will cease to be exempted 
from the requirements of paragraph (b)(6) (other than paragraph 
(b)(6)(iii)) of this section. An existing partnership that makes such a 
change on or after the date these regulations become effective will 
cease to be exempted from the requirements of paragraph (b)(6) of this 
section. An interim period partnership may change its taxable year to a 
year determined in accordance with paragraph (b)(6)(iii) of this 
section. An interim period partnership that makes such a change will 
cease to be exempted from the requirements of paragraph (b)(6)(iii) of 
this section.
    (C) Subsequent sale or exchange of interests. If an existing 
partnership or an interim period partnership terminates under section 
708(b)(1)(B), the resulting partnership is not an existing partnership 
or an interim period partnership for purposes of paragraph (b)(6)(v)(A) 
of this section.
    (D) * * * If, in the first taxable year beginning on or after the 
date these regulations become effective, an interim period partnership 
voluntarily changes its taxable year to a year determined in accordance 
with paragraph (b)(6)(iii) of this section, then the partners of that 
partnership may apply the provisions of Sec.  1.702-3T to take into 
account all items of income, gain, loss, deduction, and credit 
attributable to the partnership year of change ratably over a four-year 
period.
* * * * *
    (c) * * *
    (2) Disposition of entire interest--(i) In general. A partnership 
taxable year shall close with respect to a partner who sells or 
exchanges his entire interest in the partnership, with respect to a 
partner whose entire interest in the partnership is liquidated and with 
respect to a partner who dies. In the case of a death or liquidation, 
or sale or

[[Page 17126]]

exchange of a partner's entire interest in the partnership, the partner 
shall include in his taxable income for his taxable year within or with 
which the partner's membership in the partnership ends, the partner's 
distributive share of items described in section 702(a), and any 
guaranteed payments under section 707(c), for the partner's partnership 
taxable year ending with the date of such termination. If the decedent 
partner's estate or other successor sells or exchanges its entire 
interest in the partnership, or if its entire interest is liquidated, 
the partnership taxable year with respect to the estate or other 
successor in interest shall close on the date of such sale or exchange, 
or the date of the completion of the liquidation. The sale or exchange 
of a partnership interest does not, for the purpose of this rule, 
include any transfer of a partnership interest which occurs at death as 
a result of inheritance or any testamentary disposition.

    (ii) Example. H is a member of a partnership having a taxable 
year ending December 31. Both H and his wife W are on a calendar 
year and file joint returns. H dies on March 31, 2010. 
Administration of the estate is completed and the estate, including 
the partnership interest, is distributed to W as legatee on November 
30, 2010. Such distribution by the estate is not a sale or exchange 
of H's partnership interest. The taxable year of the partnership 
will close with respect to H on March 31, 2010, and H will include 
in his final return for his final taxable year (January 1 through 
March 31, 2010) his distributive share of partnership items for that 
period under the rules of Sec.  1.706-4. W will include in her 
return for the taxable year ending December 31, 2010, her 
distributive share of partnership items for the period of April 1 
through December 31, 2010, under the rules of Sec.  1.706-4.

    (iii) Deemed dispositions. A deemed disposition of the partner's 
interest pursuant to Sec. Sec.  1.1502-76(b)(2)(vi) (relating to 
corporate partners that become or cease to be members of a consolidated 
group within the meaning of Sec.  1.1502-1(h)), 1.1362-3(c)(1) 
(relating to the termination of the subchapter S election of an S 
corporation partner), and 1.1377-1(b)(3)(iv) (regarding an election to 
terminate the taxable year of an S corporation partner), shall be 
treated as a disposition of the partner's entire interest in the 
partnership.
* * * * *
    (4) Determination of distributive shares. See Sec.  1.706-4 for 
rules regarding the methods to be used in determining the distributive 
shares of items described in section 702(a) for partners whose 
interests in the partnership vary as a result of a disposition of a 
partner's entire interest in a partnership as described in paragraph 
(c)(2) of this section or as a result of a disposition of less than an 
entire interest as described in paragraph (c)(3) of this section during 
the partnership's taxable year.
* * * * *
    (d) Effective/applicability date. The rules for paragraphs (a) and 
(b) of this section are applicable for partnership taxable years ending 
on or after May 17, 2002, except for paragraph (b)(6)(iii) of this 
section which applies to partnership taxable years beginning the day 
after final regulations are published in the Federal Register. The 
rules for paragraph (c)(1) of this section apply for partnership 
taxable years beginning after December 31, 1953. All other paragraphs 
under paragraph (c) of this section apply for partnership taxable years 
that begin after the date the final regulations are published in the 
Federal Register, but not before taxable years beginning after December 
31, 2009.
    Par. 4. Section 1.706-2 is added and reserved to read as follows:


Sec.  1.706-2  Certain cash basis items prorated over period to which 
attributable. [Reserved]

    Par. 5. Section 1.706-3 is added and reserved to read as follows:


Sec.  1.706-3  Items attributable to interest in lower-tier partnership 
prorated over entire taxable year. [Reserved]

    Par. 6. Section 1.706-4 is added to read as follows:


Sec.  1.706-4  Determination of distributive share when a partner's 
interest varies.

    (a) General rule--(1) Methods. Except as provided in paragraph (b) 
of this section, if a partner's interest in a partnership varies during 
the taxable year as a result of a disposition of an entire interest in 
a partnership as described in Sec.  1.706-1(c)(2) or as a result of the 
disposition of less than the entire interest in a partnership or with 
respect to a partner whose interest in a partnership is reduced as 
described in Sec.  1.706-1(c)(3), the partnership shall determine the 
partner's distributive share of partnership items by using the interim 
closing method (described in paragraph (c) of this section). 
Alternatively, a partnership may, by agreement of the partners, use the 
proration method (described in paragraph (d) of this section). The 
partnership and all of its partners shall use the same method (interim 
closing or proration) and, if applicable, the same convention 
(described in paragraph (e) of this section) for all variations in the 
partners' interests occurring within each partnership taxable year.
    (2) Segments--(i) General rule. For purposes of accounting for a 
variation in a partner's interest within a taxable year of the 
partnership as a result of dispositions or reductions of interests as 
described in Sec.  1.706-1(c)(2) or (c)(3), the partnership shall 
maintain segments, which are specific periods of the partnership's 
taxable year. The first segment to account for a change in a partner's 
interest shall commence with the beginning of the taxable year of the 
partnership and end at the close of the day specified by the convention 
used by the partnership to account for such change. Any additional 
segment shall commence with the day specified by the convention used by 
the partnership to account for a previous change in the partner's 
interest and shall end as a result of an additional change in the 
partner's interest at the close of the day specified by the convention 
used by the partnership to account for such change, provided, however, 
that the last segment of the taxable year of the partnership shall end 
no later than the close of the day of the partnership's taxable year. 
The partnership shall determine the items of income, gain, loss, 
deduction and credit of the partnership for each segment in accordance 
with the method of accounting that it uses for the partnership's entire 
taxable year. In general, a partnership using the interim closing 
method shall treat each segment as though the segment were a separate 
distributive share period. For example, a partnership using the interim 
closing method may compute a net capital loss for a segment of a 
taxable year even though the partnership has a net capital gain for the 
entire taxable year.
    (ii) Other provisions. Any limitation applicable to the partnership 
year as a whole (for example, the limitation under section 179, 
relating to elections to expense certain depreciable business assets) 
must be in connection with the interim closing method apportioned among 
the segments by the partnership using any reasonable method, provided, 
however, that the amounts apportioned among segments shall not exceed 
the limitation applicable to the partnership as a whole.
    (b) Exceptions--(1) Permissible changes among contemporaneous 
partners. The general rule of paragraph (a) of this section, with 
respect to the varying interests of a partner described in Sec.  1.706-
1(c)(3), will not preclude changes in the allocations of the 
distributive share of items described in section 702(a) among 
contemporaneous partners for the entire partnership taxable year, 
provided that--
    (i) Any variation in a partner's interest is not attributable to a 
contribution of money or property by a partner to the capital of the 
partnership or a

[[Page 17127]]

distribution of money or property by the partnership to a partner that 
is a return of capital; and
    (ii) The allocations resulting from the modification satisfy the 
provisions of section 704(b) and the regulations promulgated in 
association with that section.
    (2) Safe harbor for certain service partnerships. Notwithstanding 
paragraph (a) of this section, with respect to any taxable year in 
which there is a change in any partner's interest in a service 
partnership (as defined below in this subsection), the partnership and 
such partner may choose to determine the partner's distributive share 
of partnership income, gain, loss, deduction and credit using any 
reasonable method to account for the varying interests of the partners 
in the partnership during the taxable year provided that the 
allocations are valid under section 704(b). A service partnership is a 
partnership in which substantially all the activities involve the 
performance of services in the fields of health, law, engineering, 
architecture, accounting, actuarial science, or consulting.
    (3) Safe harbor for publicly traded units of publicly traded 
partnerships. Notwithstanding paragraph (a) of this section, a publicly 
traded partnership (PTP) (as defined in section 7704(b)) using either 
the interim closing of the books method in paragraph (c) of this 
section or the proration method in paragraph (d) of this section may 
treat all transfers of its publicly traded units (as described in Sec.  
1.7704-1(b)(1)) during a calendar month as occurring for purposes of 
determining partner status on the first day of the following month 
under a consistent method adopted by the partnership or may use the 
semi-monthly convention described in paragraph (e)(2) of this section. 
For example, PRS, a PTP, uses the proration method in paragraph (d) of 
this section. PRS adopts a method treating all transfers of its 
publicly traded units as occurring on the first day of the month 
following the transfer. If on May 5, A, a partner in PRS, sells a unit 
in PRS to B, and on May 12 B sells that unit to C, who holds the 
interest beyond May 31, PRS may allocate all items with respect to that 
unit for the month of May to A, and may allocate all partnership items 
with respect to that unit for the month of June to C. B will not be 
considered a partner and will receive no allocation of partnership 
items. Block transfers of PTP units (as described in Sec.  1.7704-
1(e)(2)) will not qualify for this safe harbor.
    (c) Interim closing method--(1) In general. A partnership shall 
take into account any variation in a partner's interest in the 
partnership as described in Sec.  1.706-1(c)(2) or (c)(3) during the 
partnership's taxable year by determining the distributive share of 
partnership items under section 702(a) for each segment of that taxable 
year using an interim closing of the books method, and by allocating 
those items among the partners in accordance with their respective 
partnership interests during that segment.
    (2) Conventions. A partnership using the interim closing method may 
use either the calendar day convention provided in paragraph (e)(1) of 
this section or the semi-monthly convention provided in paragraph 
(e)(2) of this section to determine when the segments within that 
taxable year end.

    (3) Example. PRS is a partnership that was formed in 2004. It 
has three partners, P,R, and S, who each own a one-third interest in 
the partnership. PRS owns and operates a skiing enterprise and under 
section 706(b)(1)(C), has adopted a calendar year end of June 30th. 
Each partner is an individual who is on the calendar year. On 
December 31, 2010, S sold her entire interest in PRS to Y. PRS, for 
its fiscal year ending June 30, 2011, earned $150,000 of income, and 
under an interim closing of the books on December 31, 2010, $90,000 
of income was earned for the period beginning after December 31, 
2010, and $60,000 of income was earned before January 1, 2011. The 
partnership has no specific provision in the partnership agreement 
relating to which section 706 method to use with regard to varying 
interests of the partnership. Thus, pursuant to Sec.  1.706-4(a)(1), 
PRS will be required to use the interim closing of the books method 
to account for the varying interests of S and Y in the partnership. 
As a result, S is allocated one-third of the income earned prior to 
January 1, 2011, or $20,000. Y is allocated $30,000 which is one-
third of the income earned after December 31, 2010. Since S sold her 
entire interest in PRS, the partnership taxable year closes with 
respect to her pursuant to Sec.  1.706-1(c)(2)(i). Thus, she must 
include her share of PRS's income on her 2010 federal income tax 
return.

    (d) Proration method--(1) In general. Except as provided in 
paragraph (d)(3) of this section, a partnership may, by agreement of 
the partners, take into account any variation in a partner's interest 
in the partnership described in Sec.  1.706-1(c)(2) or (c)(3) during 
the partnership's taxable year by allocating the distributive share of 
partnership items under section 702(a) among the partners according to 
their pro rata shares of such items for the entire taxable year. In 
determining a partner's pro rata share of partnership items, the 
partnership shall take into account that partner's interest in such 
items during each segment. For purposes of this paragraph (d), specific 
items that are aggregated by the partnership at the end of the year 
(other than extraordinary items as defined in paragraph (d)(3) of this 
section) shall be disregarded, and the aggregate of the items shall be 
considered to be the partnership item for the year.
    (2) Conventions. A partnership using the proration method shall use 
the calendar day convention described in paragraph (e)(1) of this 
section.
    (3) Extraordinary items. A partnership must allocate extraordinary 
items among the partners in proportion to their interests at the 
beginning of the calendar day of the day on which they are taken into 
account. For purposes of this paragraph (d), an extraordinary item is--
    (i) Any item from the disposition or abandonment of a capital asset 
(other than in the ordinary course of business) as defined in section 
1221 (determined without the application of any other rules of law);
    (ii) Any item from the disposition or abandonment of property used 
in a trade or business (other than in the ordinary course of business) 
as defined in section 1231(b) (determined without the application of 
any holding period requirement);
    (iii) Any item from the disposition or abandonment of an asset 
described in section 1221(1), (3), (4), or (5), if substantially all 
the assets in the same category from the same trade or business are 
disposed of or abandoned in one transaction (or series of related 
transactions);
    (iv) Any item from assets disposed of in an applicable asset 
acquisition under section 1060(c);
    (v) Any section 481(a) adjustment;
    (vi) Any item from the discharge or retirement of indebtedness (for 
example, if a debtor partnership transfers a capital or profits 
interest in such partnership to a creditor in satisfaction of its 
recourse or nonrecourse indebtedness, any discharge of indebtedness 
income recognized under section 108(e)(8) must be allocated among the 
persons who were partners in the partnership immediately before the 
discharge);
    (vii) Any item from the settlement of a tort or similar third-party 
liability or payment of a judgment;
    (viii) Any credit, to the extent it arises from activities or items 
that are not ratably allocated (for example, the rehabilitation credit 
under section 47, which is based on placement in service); or
    (ix) Any item which, in the opinion of the Commissioner, would, if 
ratably allocated, result in a substantial distortion of income in any 
return in which the item is included.


[[Page 17128]]


    (4) Example. PRS is a partnership that was formed in 2004. It 
has three partners, P, R, and S, who each own a one-third interest 
in the partnership. PRS owns and operates a skiing enterprise, and 
under section 706(b)(1)(C), has adopted a calendar year end of June 
30th. Each partner is an individual who is on the calendar year. On 
December 31, 2010, S sold her entire interest in PRS to Y. PRS, for 
its fiscal year ending June 30, 2010, earned $150,000 of income. The 
partnership has a specific provision in the partnership agreement 
agreeing to use the proration method when accounting for varying 
interests in the partnership. (See Sec.  1.706-4(a)(1)). Using the 
proration method, $75,000 of income is included in the first segment 
of the year that begins July 1, 2010 and ends December 31, 2010, and 
$75,000 is included in the second segment of the year that begins 
January 1, 2011 and ends June 30, 2011. For the first segment, S's 
distributive share of partnership income is one-third of $75,000, or 
$25,000. For the second segment, Y's distributive share of 
partnership income is one-third of $75,000, or $25,000. B