Application of Section 108(i) to Partnerships and S Corporations, 49380-49394 [2010-20058]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 75, Number 156 (Friday, August 13, 2010)]
[Rules and Regulations]
[Pages 49380-49394]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2010-20058]


=======================================================================
-----------------------------------------------------------------------

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 9498]
RIN 1545-BJ00


Application of Section 108(i) to Partnerships and S Corporations

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary regulations.

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

SUMMARY: This document contains temporary regulations relating to the 
application of section 108(i) of the Internal Revenue Code (Code) to 
partnerships and S corporations and provides rules regarding the 
deferral of discharge of indebtedness income and original issue 
discount deductions by a partnership or an S corporation with respect 
to reacquisitions of applicable debt instruments after December 31, 
2008, and before January 1, 2011. The regulations affect partnerships 
and S corporations with respect to reacquisitions of applicable debt 
instruments and their partners and shareholders. The text of these 
temporary regulations also serves as the text of the proposed 
regulations set forth in the Notice of Proposed Rulemaking on this 
subject in the Proposed Rules section of this issue of the Federal 
Register.

DATES: Effective Date: These regulations are effective on August 13, 
2010.
    Applicability Date: For dates of applicability, see Sec.  1.108(i)-
0T(b).

FOR FURTHER INFORMATION CONTACT: Megan A. Stoner or Joseph R. Worst, 
Office of Associate Chief Counsel (Passthroughs and Special 
Industries), (202) 622-3070 (not a toll-free number).

SUPPLEMENTARY INFORMATION: 

Paperwork Reduction Act

    The collection of information contained in these temporary 
regulations has been reviewed and approved by the Office of Management 
and Budget in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507) under control number 1545-2147. The collection of 
information in these temporary regulations is in Sec.  1.108(i)-
2T(b)(3)(iv). Under Sec.  1.108(i)-2T(b)(3)(iv), a partner in a 
partnership that makes an election under section 108(i) is required to 
provide certain information to the partnership so that the partnership 
can correctly determine the partner's deferred section 752 amount with

[[Page 49381]]

respect to an applicable debt instrument.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless the collection of 
information 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 
return information are confidential, as required by 26 U.S.C. 6103.

Background

    Section 1231 of the American Recovery and Reinvestment Tax Act of 
2009, Public Law 111-5 (123 Stat. 338 (2009)), added section 108(i) to 
the Code. Section 108(i) generally provides for an elective deferral of 
discharge of indebtedness income (COD income) realized by a taxpayer 
from a reacquisition of an applicable debt instrument that occurs after 
December 31, 2008, and before January 1, 2011. COD income deferred 
under section 108(i) is included in gross income ratably over a five 
taxable-year period (inclusion period) beginning with the taxpayer's 
fourth or fifth taxable year following the taxable year of the 
reacquisition. In circumstances where a debt instrument is issued (or 
treated as issued) as part of the reacquisition, some or all of any 
original issue discount (OID) expense accruing from the debt instrument 
in a taxable year prior to the first taxable year of the inclusion 
period may also be required to be deferred (deferred OID deduction). 
The aggregate amount of deferred OID deductions is limited to the 
amount of COD income deferred with respect to the applicable debt 
instrument for which the section 108(i) election is made and the 
aggregate amount of deferred OID deductions is taken into account 
ratably over the inclusion period. In general, COD income deferred 
under section 108(i) and related deferred OID deductions with respect 
to an applicable debt instrument that have not been previously taken 
into account (deferred items) are accelerated and taken into account in 
the taxable year in which an acceleration event occurs. A section 
108(i) election is irrevocable and, if a section 108(i) election is 
made, sections 108(a)(1)(A), (B), (C), and (D) do not apply to the COD 
income that is deferred under section 108(i). Section 108(i)(7) 
authorizes the Secretary to prescribe regulations as may be necessary 
or appropriate for purposes of applying section 108(i).
    After section 108(i) was enacted, the IRS and the Treasury 
Department received a number of comments regarding the application of 
section 108(i) to partnerships and S corporations. In August 2009, the 
IRS and the Treasury Department issued Rev. Proc. 2009-37 (2009-36 IRB 
309), which provides election procedures for taxpayers (including 
partnerships and S corporations) and other guidance under section 
108(i). With respect to COD income realized by a partnership or S 
corporation, the election is made at the entity level. Partnerships and 
S corporations that make an election under section 108(i) (electing 
partnership or electing S corporation) must follow the election 
procedures and reporting requirements of Rev. Proc. 2009-37.
    These temporary regulations address issues relating to partnerships 
and S corporations with respect to section 108(i), including issues 
raised by commenters.

Explanation of Provisions

A. Applicable Debt Instrument

    Section 108(i)(3) defines an ``applicable debt instrument'' as any 
debt instrument issued by a C corporation or by any other person in 
connection with the conduct of a trade or business by that person. The 
determination of whether a debt instrument is an applicable debt 
instrument within the meaning of section 108(i)(3) is based on all the 
facts and circumstances.
    Section 1.108(i)-2T(d)(1) provides five safe harbors under which a 
debt instrument issued by a partnership or an S corporation is deemed 
to be issued in connection with the partnership's or S corporation's 
trade or business for purposes of section 108(i). Thus, a debt 
instrument issued by a partnership or an S corporation qualifies as an 
applicable debt instrument for purposes of section 108(i) if the 
electing partnership or electing S corporation can establish that it 
meets the requirements of one of the safe harbors.
    Some commenters asked whether a debt instrument issued by a non-C 
corporation taxpayer to acquire an interest in a partnership or S 
corporation that is conducting a trade or business qualifies as an 
applicable debt instrument, where the issuing taxpayer does not conduct 
a trade or business. While a debt instrument generally does not qualify 
as an applicable debt instrument unless the issuing taxpayer conducts a 
trade or business, one of the safe harbors under Sec.  1.108(i)-
2T(d)(1) provides that if an electing partnership or an electing S 
corporation can establish that at least 95 percent of the interest paid 
or accrued on a debt instrument issued by a partnership or S 
corporation was allocated to a trade or business expenditure under 
Sec.  1.163-8T for the taxable year of issuance, then the debt 
instrument qualifies as an applicable debt instrument for purposes of 
section 108(i).
    Commenters also asked how a debt instrument issued by a disregarded 
entity should be treated under section 108(i). Generally, under Sec.  
301.7701-2 of the Procedure and Administration Regulations, if an 
entity is disregarded, its activities are treated in the same manner as 
a sole proprietorship, branch, or division of the owner. Thus, for 
purposes of determining whether a debt instrument qualifies as an 
applicable debt instrument under section 108(i), a debt instrument 
issued by a disregarded entity is treated as a debt instrument issued 
by the person treated as owning the assets of the disregarded entity 
for federal income tax purposes.

B. Allocation of COD Income

    Section 108(i)(6) requires that a partnership allocate the COD 
income that is deferred under section 108(i) to the partners that were 
partners immediately prior to the transaction giving rise to the COD 
income in the same manner the income would be allocated without regard 
to section 108(i). In addition, section 108(i)(5)(B)(iii) provides that 
the section 108(i) election is to be made by the partnership and not 
its partners separately. The IRS and the Treasury Department recognize 
that there are instances in which the inclusion of COD income would be 
beneficial to some partners, but not to others. As a result, the 
temporary regulations, while not changing the general rules under 
section 704, permit a partnership to determine the portion of each 
partner's allocable share of COD income resulting from a reacquisition 
of an applicable debt instrument that is deferred under section 108(i) 
(deferred amount) and the portion that is not deferred (included 
amount). The temporary regulations therefore require that the electing 
partnership first allocate all of the COD income with respect to an 
applicable debt instrument to its partners that are partners in the 
partnership immediately before the reacquisition in the manner in which 
the income would be included in the distributive shares of the partners 
under section 704 and the regulations under section 704, including 
Sec.  1.704-1(b)(2)(iii), without regard to section 108(i). The 
partnership must then

[[Page 49382]]

determine the portion of each such partner's allocable share of the COD 
income from the applicable debt instrument that is the deferred amount, 
and the portion that is the included amount and therefore included in 
the partner's distributive share of partnership income for the taxable 
year of the partnership in which the reacquisition occurs.
    With respect to S corporations, section 108(i) requires that the 
election to defer COD income be made at the corporate level. Section 
108(i) does not, however, impose a specific allocation rule with 
respect to the COD income realized by an electing S corporation from 
the reacquisition of an applicable debt instrument as it does for 
electing partnerships. The IRS and the Treasury Department believe that 
a rule similar to the partnership allocation rule under section 
108(i)(6) should apply to electing S corporations. Therefore, Sec.  
1.108(i)-2T(c)(1) requires that the deferred COD income of an electing 
S corporation be shared pro rata, on the basis of stock ownership, 
among those shareholders that hold stock in the electing S corporation 
immediately prior to the transaction giving rise to the COD income.

C. Basis Adjustments

    Commenters asked whether a partner is required to adjust the basis 
in its partnership interest under section 705 in the year of the 
reacquisition to account for the partner's share of deferred COD 
income, or whether such adjustments occur when the deferred items are 
recognized. In general, a partner's basis in its partnership interest 
is increased under section 705(a) to account for the partner's share of 
partnership COD income in the taxable year that the COD income is 
realized by the partnership. If a partnership elects to defer its COD 
income under section 108(i), however, a partner's basis in its 
partnership interest is not increased under section 705(a) to account 
for the partner's deferred amount in the taxable year that the COD 
income is realized, but rather is adjusted in the taxable year that the 
partner recognizes the deferred amount. Because a partner does not 
adjust its basis for deferred COD income in the taxable year of a 
reacquisition, a partner could recognize gain under section 731(a) in 
that taxable year if the decrease in the partner's share of partnership 
liabilities exceeds the partner's basis in its partnership interest. 
Congress anticipated this result and created a special deferral rule in 
section 108(i)(6).
    Section 108(i)(6) provides that any decrease in a partner's share 
of partnership liabilities as a result of the discharge shall not be 
taken into account for purposes of section 752 at the time of the 
discharge to the extent it would cause the partner to recognize gain 
under section 731. If a partner were to increase the basis in its 
partnership interest to account for the deferred COD income at the time 
of the reacquisition, the special deferral rule in section 108(i)(6) 
would not be needed. Therefore, consistent with the rule in section 
108(i)(6), Sec.  1.108(i)-2T(b)(2) provides that a partner's basis in 
its partnership interest is not adjusted under section 705(a) to 
account for the partner's share of the partnership's deferred items at 
the time of the reacquisition, but is adjusted when the deferred items 
are recognized, either during the recognition period or as a result of 
an acceleration event. When the partner's share of the partnership's 
deferred items is recognized due to an acceleration event, the partner 
must adjust the basis in its partnership interest under section 705 
immediately prior to the acceleration event to account for the deferred 
items that are recognized.
    Like the basis adjustment rules for partners, an S corporation 
shareholder's stock basis is not adjusted under section 1367 to account 
for the shareholder's share of the S corporation's deferred items at 
the time of the reacquisition, but is adjusted when the deferred items 
are recognized. Moreover, an S corporation's accumulated adjustments 
account (AAA) is not adjusted to account for the deferred items at the 
time of the reacquisition, but is adjusted in the taxable year in which 
the deferred items are recognized.

D. Deferred Section 752 Amount Rules

    Section 2.09 of Rev. Proc. 2009-37 provides general guidelines for 
a partnership to use in determining a partner's deferred section 752 
amount (that is, a decrease in a partner's share of a partnership 
liability under section 752(b) resulting from the reacquisition of an 
applicable debt instrument that is not treated as a current 
distribution of money to the partner under section 752(b) by reason of 
section 108(i)(6)). The temporary regulations include the same general 
rules that are set forth in Rev. Proc. 2009-37 and provide additional 
computational rules for determining a partner's deferred section 752 
amount.
    In computing a partner's deferred section 752 amount, under Sec.  
1.108(i)-2T(b)(3)(ii), the electing partnership must determine the 
amount of gain the partner would recognize in a taxable year of a 
reacquisition under section 731 as a result of the reacquisition absent 
the deferral provided in the second sentence of section 108(i)(6). In 
making this determination, the basis ordering rules in section 705(a) 
apply and the amount of any deemed distribution of money under section 
752(b), resulting from the reacquisition of an applicable debt 
instrument, that is treated as an advance or drawing under Sec.  1.731-
1(a)(1)(ii) is determined as if no COD income resulting from the 
reacquisition is deferred under section 108(i). See Rev. Rul. 94-4, 
1994-1 C.B. 195, and Rev. Rul. 92-97, 1992-2 C.B. 124, for rules 
regarding when a deemed distribution of money under section 752(b) 
resulting from a cancellation of debt is treated as an advance or 
drawing under Sec.  1.731-1(a)(1)(ii).
    If the electing partnership determines that a partner would 
recognize gain under section 731 absent the deferral provided in the 
second sentence of section 108(i)(6) and the partnership makes a 
section 108(i) election to defer COD income from only one applicable 
debt instrument during the taxable year, then any deferred section 752 
amount of the partner relates to that applicable debt instrument. If 
the partnership makes a section 108(i) election to defer COD income 
from more than one applicable debt instrument during the taxable year, 
Sec.  1.108(i)-2T(b)(3)(iii) provides a rule for determining the 
portion of the partner's deferred section 752 amount that relates to 
each such applicable debt instrument.
    Section 4.12(4) of Rev. Proc. 2009-37 provides that the deferred 
section 752 amount for partners in a partnership making a section 
108(i) election is calculated for the electing partnership's direct 
partners. In circumstances where a partnership (upper-tier partnership) 
that is a direct or indirect partner of an electing partnership has a 
deferred section 752 amount with respect to an applicable debt 
instrument of the electing partnership, the upper-tier partnership does 
not need to calculate the deferred section 752 amount of its direct 
partners in the same manner that the electing partnership does. 
Instead, the upper-tier partnership that has a deferred section 752 
amount shall allocate such amount among its direct partners that have a 
deferred amount with respect to the applicable debt instrument in 
proportion to the partners' respective shares of the upper-tier 
partnership's deferred amount. Section 1.108(i)-2T(b)(4)(ii) provides 
that a partner's share of an upper-tier partnership's deferred section 
752 amount may not exceed the partner's deferred amount with respect to 
the

[[Page 49383]]

applicable debt instrument to which the deferred section 752 amount 
relates.
    The temporary regulations contain examples to illustrate how a 
partner's deferred section 752 amount should be computed. One example 
illustrates ordering rules in computing a partner's deferred section 
752 amount if the partnership has both gross income and separately 
stated losses in the year of a reacquisition. Section 1.704-1(d)(2) 
provides rules for computing the adjusted basis of a partner's interest 
for purposes of determining the extent to which a partner's 
distributive share of partnership loss is allowed as a deduction. The 
example illustrates how the deferred section 752 computational rule 
interacts with the rules under section 705(a) and Sec.  1.704-1(d)(2).

E. Capital Accounts

    Commenters requested that guidance address how a partnership's 
capital account should be adjusted under Sec.  1.704-1(b)(2)(iv) to 
account for a partner's share of the partnership's deferred items. The 
IRS and the Treasury Department believe that, for capital account 
maintenance purposes, a partnership should treat deferred items as if 
no election under section 108(i) has been made. Accordingly, Sec.  
1.108(i)-2T(b)(2)(ii) provides that a partner's capital account is 
adjusted under Sec.  1.704-1(b)(2)(iv) for the partner's share of the 
partnership's deferred items as if no election under section 108(i) 
were made.

F. Section 465(e) Recapture

    Commenters requested that guidance be provided under section 465 to 
prevent an election under section 108(i) from triggering recapture of 
losses under section 465(e). Under section 465(e)(1)(A), if at the 
close of any taxable year a taxpayer's amount at risk in an activity is 
below zero, the taxpayer generally is required to include the amount of 
the excess in gross income. The amount required to be included in gross 
income, however, is limited to losses allowed in previous years that 
have not already been recaptured. Section 465(e)(1)(B) treats the 
recaptured amount as a deduction attributable to the activity in the 
following taxable year.
    Although the second sentence of section 108(i)(6) provides for 
deferral of a deemed distribution under section 752 to the extent that 
it triggers gain to a partner under section 731, the statute does not 
provide a similar rule that defers any amount at risk in an activity 
required to be recaptured under section 465(e). Thus, if the discharged 
debt for which a section 108(i) election is made has been included in a 
partner's amount at risk in an activity and a portion of that debt is 
discharged, there could be recapture under section 465(e) if the amount 
discharged exceeds the partner's amount at risk in the activity. The 
same issue may arise with respect to shareholders of an S corporation.
    The IRS and the Treasury Department believe that the decrease in a 
partner's or shareholder's amount at risk in an activity that results 
from the discharge of a debt for which a section 108(i) election is 
made by the partnership or S corporation, as the case may be, should 
also be deferred to prevent the partner or shareholder from recognizing 
more recapture income under section 465(e) than the partner or 
shareholder would recognize if the section 108(i) election had not been 
made. Accordingly, Sec.  1.108(i)-2T(d)(3) provides that a decrease in 
a partner's or shareholder's amount at risk in an activity that results 
from a discharge of a debt for which a section 108(i) election is made 
is not taken into account in determining the partner's or shareholder's 
amount at risk in that activity under section 465 in the taxable year 
of the reacquisition. The decrease is taken into account at the same 
time and to the extent remaining in the same amount as the partner or 
shareholder recognizes the deferred COD income.

G. Deferral of Original Issue Discount

    Under section 108(i)(2), if a debt instrument is issued (or treated 
as issued under section 108(e)(4)) in a debt-for-debt exchange 
described in section 108(i)(2)(A) or a deemed debt-for-debt exchange 
described in Sec.  1.108(i)-3T(a) and there is any OID on the debt 
instrument, the issuer of the new debt instrument must defer some or 
all of the deductions for such OID under section 108(i). The temporary 
regulations provide that the aggregate amount of deferred OID is 
allowable as a deduction to the issuer of the debt instrument ratably 
over the inclusion period, or earlier upon the occurrence of an 
acceleration event.
    The OID deferral rule in section 108(i)(2) applies to an issuing 
entity. An issuing entity includes an electing partnership or an 
electing S corporation that issues a debt instrument in a debt-for-debt 
exchange or a deemed debt-for-debt exchange and a partnership or an S 
corporation that is related (within the meaning of section 
108(i)(5)(A)) to an electing entity (an entity that is a taxpayer that 
makes an election under section 108(i)) and that issues a debt 
instrument in a debt-for-debt exchange or a deemed debt-for-debt 
exchange.
    The issuing entity determines whether any OID that accrues on a 
debt instrument in a taxable year during the deferral period is 
required to be deferred. For example, an electing partnership that 
issues a debt instrument with OID in a debt-for-debt exchange described 
in section 108(i)(2)(A) in which the partnership elects to defer $100 
of COD income must defer the first $100 of OID that accrues on such 
debt instrument during the deferral period, even if a partner's share 
of the partnership's deferred OID exceeds the partner's deferred amount 
with respect to the applicable debt instrument.
    The temporary regulations provide rules relating to basis 
adjustments and adjustments to AAA for deferred OID deductions that 
apply to the issuing entity.

H. Acceleration Events

    Section 108(i)(5)(D)(i) provides that deferred items must be taken 
into account upon the occurrence of certain enumerated events 
(acceleration events) with respect to the electing partnership or 
electing S corporation. These events include the liquidation or sale of 
substantially all of the assets of the electing partnership or electing 
S corporation (including in a Title 11 or similar case), the cessation 
of business, or similar circumstances. If any of these events occurs, 
all of the deferred items of the electing partnership or electing S 
corporation are accelerated and must be taken into account by the 
partners and/or shareholders, as the case may be, in the taxable year 
of the electing partnership or electing S corporation in which such 
event occurs.
    Section 108(i)(5)(D)(ii) contains additional acceleration events 
that apply to the partners and/or shareholders of an electing 
partnership or an electing S corporation, as the case may be, and 
includes the sale, exchange, or redemption of an interest in the 
electing partnership or electing S corporation by the holder of such 
interest. If any of these events occurs, the deferred items allocated 
to the partner or S corporation shareholder that sells, exchanges, or 
redeems its interest in the electing partnership or S corporation, as 
the case may be, are accelerated and must be taken into account by such 
partner or shareholder in the taxable year in which the event occurs. 
When an acceleration event occurs under section 108(i)(5)(D)(ii) with 
respect to a particular partner or an S corporation shareholder, it 
does not affect the continued deferral of another partner's or S 
corporation shareholder's

[[Page 49384]]

share of the partnership's or S corporation's deferred items.
    Section 108(i)(7) authorizes the Secretary to prescribe such 
regulations as may be necessary or appropriate for purposes of applying 
section 108(i), including rules extending the acceleration provisions 
to other circumstances where appropriate. Therefore, the temporary 
regulations provide additional rules (and exceptions) that apply to the 
acceleration of deferred items under section 108(i)(5)(D).
    The temporary regulations provide that the deferred items allocated 
to the direct and indirect partners of the electing partnership, which 
includes a shareholder of an S corporation that is a direct/indirect 
partner of an electing partnership (S corporation partner), and to the 
shareholder of an electing S corporation are accelerated if the 
electing partnership or the electing S corporation (i) liquidates, (ii) 
sells, exchanges, transfers (including contributions and 
distributions), or gifts substantially all of its assets, (iii) ceases 
doing business, or (iv) files a petition in a Title 11 or similar case. 
In addition, the deferred items of the shareholders of an electing S 
corporation or an S corporation partner are accelerated in the taxable 
year in which the S corporation's or S corporation partner's election 
under section 1362(a) is terminated. Moreover, the acceleration rules 
and exceptions that apply to an electing corporation under Sec.  
1.108(i)-1T(b) also apply to a C corporation partner in the same manner 
as if the C corporation partner were an electing corporation.
    The temporary regulations specify that substantially all of the 
partnership's or S corporation's assets means assets representing at 
least 90 percent of the fair market value of the partnership's or S 
corporation's net assets and at least 70 percent of the fair market 
value of the partnership's or S corporation's gross assets, as measured 
immediately prior to the sale, exchange, transfer, or gift in question. 
If an electing partnership holds only an interest in another 
partnership (lower-tier partnership) and the lower-tier partnership 
sells its assets, the sale by the lower-tier partnership would not 
constitute a sale, exchange, transfer, or gift of the electing 
partnership's assets for purposes of applying the acceleration rules. 
However, the IRS and the Treasury Department believe that if an 
electing partnership, for example, transfers property to a partnership 
(transferee partnership) in a transaction governed all or in part by 
section 721 and the transferee partnership subsequently sells 
substantially all of its assets, it is appropriate to treat the 
electing partnership as having sold, exchanged, transferred, or gifted 
its entire interest in that transferee partnership for purposes of 
applying the acceleration rules. If, in that situation, the electing 
partnership's only asset is its interest in the transferee partnership, 
the electing partnership will be treated as selling substantially all 
of its assets and therefore, its deferred items would be accelerated. 
The principles of the substantially all rules apply to lower-tier 
partnerships of the electing partnership that receive assets of the 
electing partnership from a transferee partnership or another lower-
tier partnership of the electing partnership in a transaction governed 
all or in part by section 721.
    In addition to the electing partnership-level or electing S 
corporation-level events that trigger acceleration under section 
108(i), certain events that occur at the partner or shareholder level 
also trigger acceleration of that partner's or shareholder's share of 
the electing partnership's or electing S corporation's deferred items. 
For instance, the deferred items allocated to a direct or indirect 
partner of an electing partnership are accelerated if: (1) The partner 
dies or liquidates, (2) the partner sells, exchanges (including 
redemptions treated as exchanges under section 302), transfers 
(including contributions and distributions), or gifts (including 
transfers treated as gifts under section 1041) all or a portion of a 
separate interest, (3) the partner's separate interest is redeemed, or 
(4) the partner abandons its separate interest. For this purpose, a 
distribution by a partnership to a partner of property other than a 
separate interest, in a transaction that does not constitute a complete 
redemption of the partner's interest, does not constitute an 
acceleration event, even if, for example, the distribution causes gain 
to be recognized to the partner under section 731(a). Moreover, a 
shareholder's share of an electing S corporation's deferred items is 
accelerated if the shareholder: (1) Dies, (2) sells, exchanges 
(including redemptions treated as exchanges under section 302), 
transfers (including contributions and distributions), or gifts 
(including transfers treated as gifts under section 1041) all or a 
portion of its interest in the electing S corporation, or (3) abandons 
its interest in the electing S corporation. For purposes of the 
temporary regulations, a ``separate interest'' is defined as any direct 
interest in an electing partnership or in a partnership or S 
corporation that is a direct or indirect partner of an electing 
partnership.
    If a partner or shareholder sells, exchanges, transfers, or gifts 
only a portion of its interest in a partnership or an S corporation, 
only a proportionate amount of the partner's or shareholder's share of 
the partnership's or S corporation's deferred items is accelerated. For 
example, if a partner of an electing partnership with a $100 deferred 
amount from the electing partnership sells half of its interest in the 
electing partnership, $50 of the partner's $100 share of the 
partnership's deferred amount is accelerated.
    The temporary regulations address when a partner's separate 
interest is redeemed for purposes of section 108(i). Commenters 
suggested that a non-liquidating distribution of cash or other property 
by a partnership to a partner should not be treated as a redemption 
under section 108(i). The IRS and the Treasury Department agree with 
the commenters. Difficulties in defining a redemption of a partnership 
interest for purposes of section 108(i) arise if non-liquidating 
distributions are treated as redemptions under section 108(i). The IRS 
and the Treasury Department believe that, for purposes of section 
108(i), redemptions should be limited to cases where a partner's 
interest in the partnership is completely liquidated. Therefore, the 
temporary regulations provide that a redemption of a partner's separate 
interest occurs when a partner receives a distribution of cash and/or 
property in complete liquidation of such partner's separate interest.
    The IRS and the Treasury Department believe that certain events 
should not cause a partner's or shareholder's share of the 
partnership's or S corporation's deferred items to be accelerated. For 
instance, if an electing partnership contributes its assets to another 
partnership (transferee partnership) in a transaction governed by 
section 721 (generally a non-recognition event to the electing 
partnership and the transferee partnership), the deferred items of an 
electing partnership can continue to be allocated to its partners under 
principles similar to section 704(c). Therefore, transactions wholly 
governed by section 721 in which a partner's or shareholder's share of 
the partnership's or S corporation's deferred items can continue to be 
allocated to that partner or shareholder are generally not acceleration 
events for purposes of section 108(i). These section 721 non-
acceleration events include contributions by an electing partnership or 
an electing S corporation, contributions of an entire separate interest 
by direct or indirect partners of

[[Page 49385]]

an electing partnership, and section 708(b)(2)(A) mergers or 
consolidations of an electing partnership or a partnership that is a 
direct or indirect partner of an electing partnership.
    In any of the events listed above, the general acceleration rules 
apply to any part of the transaction to which section 721(a) does not 
apply. For example, if an electing partnership merges with another 
partnership and one of the partners of the electing partnership elects 
to apply the partner buy-out rule of Sec.  1.708-1(c)(4), such 
partner's share of the electing partnership's deferred items is 
accelerated because such partner is treated as selling its interest in 
the electing partnership immediately before the merger. The other 
partners' shares of deferred items of the electing partnership are not 
accelerated as a result of the merger.
    In addition to the section 721 non-acceleration events, like-kind 
exchanges of property by an electing partnership or an electing S 
corporation pursuant to section 1031(a) are generally not acceleration 
events. As in a transaction governed by section 721, a transaction 
governed by section 1031(a) is generally a non-recognition event. The 
electing partnership or electing S corporation that transfers property 
in the like-kind exchange can continue to allocate the partners' or 
shareholders' shares of the partnership's or S corporation's deferred 
items as if no exchange occurred. To the extent money or property which 
does not meet the requirements of section 1031(a) (boot) is received in 
the exchange, however, a portion of the transferred property will be 
treated as sold. Under Sec.  1.108(i)-2T(b)(6)(iii)(B) and Sec.  
1.108(i)-2T(c)(3)(iii)(B), the portion of the transferred property that 
is treated as sold is based on the ratio of the boot to the total 
consideration received in the exchange. For example, if an electing 
partnership exchanges property with a value of $100 and a basis of $30 
for $80 of like-kind property and $20 of non-like kind property, the 
electing partnership is treated as if it sold 20 percent of the 
property transferred in the exchange. In such a case, if the portion 
sold constitutes substantially all of the electing partnership's 
assets, the electing partnership's deferred items would be accelerated 
under Sec.  1.108(i)-2T(b)(6)(i)(A)(2).
    In addition to the section 721 and section 1031 non-acceleration 
events, a technical termination of an electing partnership or a 
partnership that is a direct or indirect partner of an electing 
partnership under section 708(b)(1)(B) is not an acceleration event for 
purposes of section 108(i). Section 708(b)(1)(B) provides that a 
partnership is considered as terminated if within a twelve-month period 
there is a sale or exchange of 50 percent or more of the total interest 
in partnership capital and profits. Under Sec.  1.708-1(b)(4), the 
terminated partnership is deemed to contribute its assets and 
liabilities to a new partnership in exchange for an interest in the new 
partnership and, immediately thereafter, the terminated partnership is 
deemed to distribute interests in the new partnership to its partners 
in liquidation of their interests. As in a transaction governed by 
section 721, the deferred items of the terminated partnership's 
partners can continue to be allocated to those partners by the new 
partnership. The terminated partnership's business continues in the new 
partnership and the non-selling partners of the terminated partnership 
remain partners in the new partnership. The terminated partnership's 
section 108(i) election remains in effect for the new partnership. 
Therefore, a technical termination of a partnership under section 
708(b)(1)(B) is not an acceleration event for purposes of section 
108(i). The transfer that causes a technical termination, however, may 
be an acceleration event for the transferring partner.
    In addition to the section 721, section 1031, and section 
708(b)(1)(B) non-acceleration events, certain distributions of separate 
interests by a partnership (upper-tier partnership) that is a direct or 
indirect partner of an electing partnership are not acceleration events 
for purposes of section 108(i). If an upper-tier partnership 
distributes its entire separate interest (distributed separate 
interest) to one or more of its partners (distributee partners) that 
have a share of the electing partnership's deferred items from upper-
tier partnership's distributed separate interest, the partnership, the 
interest in which was distributed, can continue to allocate the 
deferred items of any distributee partner with respect to the 
distributed separate interest. As a result, the distributee partner's 
share of the electing partnership's deferred items associated with the 
distributed separate interest are not accelerated, even if such 
distribution is in complete liquidation of that partner's interest in 
the upper-tier partnership. However, because the upper-tier partnership 
no longer holds the separate interest, the upper-tier partnership's 
share of the electing partnership's deferred items associated with that 
separate interest will be accelerated for the non-distributee partners. 
Further, if the distributee's partnership interest is redeemed by the 
upper-tier partnership, any other share of an electing partnership's 
deferred items associated with the redeemed separate interest in the 
upper-tier partnership will be accelerated and must be taken into 
account by the distributee partner.
    Certain non-acceleration events that apply to an electing 
corporation also apply to C corporation partners. The exception in 
Sec.  1.108(i)-1T(b)(2)(ii)(B) relating to transactions governed by 
section 381 applies to C corporation partners. Section 1.108(i)-
2T(b)(6)(iii)(G) contains special rules for certain intercompany 
transfers made by C corporation partners.
    The above acceleration events only apply to deferred items 
allocated to direct or indirect partners of an electing partnership or 
to the shareholders of an electing S corporation. A direct or indirect 
partner's share of a related partnership's deferred OID deduction or a 
shareholder's share of a related S corporation's deferred OID deduction 
is only accelerated to the extent the deferred COD income attributable 
to the related partnership's or related S corporation's deferred OID 
deduction is taken into account by the electing entity or its owners.

I. Foreign Partners of Electing Partnership

    Section 1446 and the regulations thereunder provide, in general, 
that if a domestic or foreign partnership has effectively connected 
taxable income allocable under section 704 to a foreign partner, then 
the partnership must withhold tax under section 1446 (section 1446 tax) 
at the time and in the manner prescribed in Sec. Sec.  1.1446-1 through 
1.1446-6. Section 1.1446-5 provides rules under section 1446 for 
tiered-partnership structures. These regulations provide a cross 
reference to the regulations under section 1446 to signal to 
partnerships, including tiered partnerships, that they may have an 
obligation to pay a section 1446 tax when income deferred under section 
108(i) is recognized (either ratably over the inclusion period or as a 
result of an acceleration event).

J. Effective Date

    These regulations apply to reacquisitions of applicable debt 
instruments in taxable years ending after December 31, 2008.

Availability of IRS Documents

    The IRS revenue procedure cited in this preamble is published in 
the Internal Revenue Bulletin and is available at: https://www.IRS.gov.

[[Page 49386]]

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. For applicability 
of the Regulatory Flexibility Act (5 U.S.C. chapter 6), refer to the 
Special Analyses section of the preamble to the cross-reference notice 
of proposed rulemaking published in the Proposed Rules section in this 
issue of the Federal Register. Pursuant to section 7805(f) of the Code, 
these regulations have been submitted to the Chief Counsel for Advocacy 
of the Small Business Administration for comment on its impact on small 
business.
    Section 108(i) applies to the reacquisition of an applicable debt 
instrument during the brief election period, January 1, 2009 through 
December 31, 2010. These temporary regulations provide necessary 
guidance regarding the application of this new section 108(i) in order 
for partnerships and S corporations to timely file their tax returns. 
For this reason, it has been determined pursuant to 5 U.S.C. 
553(b)(3)(B), that prior notice and public procedure are impracticable 
and contrary to the public interest. For the same reason, it has been 
determined pursuant to 5 U.S.C. 553(d)(3) that good cause exists for 
not delaying the effective date of these temporary regulations.

Drafting Information

    The principal authors of these regulations are Megan A. Stoner and 
Joseph R. Worst of the 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

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Amendments to the Regulations

0
Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 is amended by adding an 
entry in numerical order to read in part as follows:

    Authority:  26 U.S.C. 7805 * * *
    Section 1.108(i)-2T also issued under 26 U.S.C. 108(i)(7). * * *

0
Par. 2. Section 1.108(i)-2T is added to read as follows:


Sec.  1.108(i)-2T  Application of section 108(i) to partnerships and S 
corporations (temporary).

    (a) Overview. Under section 108(i), a partnership or an S 
corporation may elect to defer COD income arising in connection with a 
reacquisition of an applicable debt instrument for the deferral period. 
COD income deferred under section 108(i) is included in gross income 
ratably over the inclusion period, or earlier upon the occurrence of 
any acceleration event described in paragraph (b)(6) or (c)(3) of this 
section. If a debt instrument is issued (or treated as issued under 
section 108(e)(4)) in a debt-for-debt exchange described in section 
108(i)(2)(A) or a deemed debt-for-debt exchange described in Sec.  
1.108(i)-3T(a), some or all of the deductions for OID with respect to 
such debt instrument must be deferred during the deferral period. The 
aggregate amount of OID deductions deferred during the deferral period 
is generally allowed as a deduction ratably over the inclusion period, 
or earlier upon the occurrence of any acceleration event described in 
paragraph (b)(6) or (c)(3) of this section. Paragraph (b) of this 
section provides rules that apply to partnerships. Paragraph (c) of 
this section provides rules that apply to S corporations. Paragraph (d) 
of this section provides general rules that apply to partnerships and S 
corporations. Paragraph (e) of this section provides election 
procedures and reporting requirements. Paragraph (f) of this section 
contains the effective/applicability date. See Sec.  1.108(i)-0T(a) for 
definitions that apply to this section.
    (b) Specific rules applicable to partnerships--(1) Allocation of 
COD income and partner's deferred amounts. An electing partnership that 
defers any portion of COD income realized from a reacquisition of an 
applicable debt instrument under section 108(i) must allocate all of 
the COD income with respect to the applicable debt instrument to its 
direct partners that are partners in the electing partnership 
immediately before the reacquisition in the manner in which the income 
would be included in the distributive shares of the partners under 
section 704 and the regulations under section 704, including Sec.  
1.704-1(b)(2)(iii), without regard to section 108(i). The electing 
partnership may determine, in any manner, the portion, if any, of a 
partner's COD income amount with respect to an applicable debt 
instrument that is the deferred amount, and the portion, if any, that 
is the included amount. However, no partner's deferred amount with 
respect to an applicable debt instrument may exceed that partner's COD 
income amount with respect to such applicable debt instrument, and the 
aggregate amount of the partners' COD income amounts and deferred 
amounts with respect to each applicable debt instrument must equal the 
electing partnership's COD income amount and deferred amount, 
respectively, with respect to each such applicable debt instrument.
    (2) Basis adjustments and capital account maintenance--(i) Basis 
adjustments. The adjusted basis of a partner's interest in a 
partnership is not increased under section 705(a)(1) by the partner's 
deferred amount in the taxable year of the reacquisition. The adjusted 
basis of a partner's interest in a partnership is not decreased under 
section 705(a)(2) by the partner's share of any deferred OID deduction 
in the taxable year in which the deferred OID accrues. The adjusted 
basis of a partner's interest in a partnership is adjusted under 
section 705(a) by the partner's share of the electing partnership's 
deferred items for the taxable year in which the partner takes into 
account such deferred items under this section.
    (ii) Capital account maintenance. For purposes of maintaining a 
partner's capital account under Sec.  1.704-1(b)(2)(iv) and 
notwithstanding Sec.  1.704-1(b)(2)(iv)(n), the capital account of a 
partner of a partnership is adjusted under Sec.  1.704-1(b)(2)(iv) for 
a partner's share of an electing partnership's deferred items as if no 
election under section 108(i) were made.
    (3) Deferred section 752 amount--(i) In general. An electing 
partnership shall determine, for each of its direct partners with a 
deferred amount, the partner's deferred section 752 amount, if any, 
with respect to an applicable debt instrument. A partner's deferred 
section 752 amount with respect to an applicable debt instrument equals 
the decrease in the partner's share of a partnership liability under 
section 752(b) resulting from the reacquisition of the applicable debt 
instrument that is not treated as a current distribution of money under 
section 752(b) by reason of section 108(i)(6) (deferred section 752 
amount). A partner's deferred section 752 amount is treated as a 
distribution of money by the partnership to the partner under section 
752(b), at the same time and to the extent remaining in the same 
amount, as the partner recognizes the deferred amount with

[[Page 49387]]

respect to the applicable debt instrument.
    (ii) Electing partnership's computation of a partner's deferred 
section 752 amount. To compute a partner's deferred section 752 amount, 
the electing partnership must first determine the amount of gain that 
its direct partner would recognize in the taxable year of a 
reacquisition under section 731 as a result of the reacquisition of one 
or more applicable debt instruments during the taxable year absent the 
deferral provided in the second sentence of section 108(i)(6) (the 
section 108(i)(6) deferral). If a direct partner of an electing 
partnership would not recognize any gain under section 731 as a result 
of the reacquisition of one or more applicable debt instruments during 
the taxable year absent the section 108(i)(6) deferral, the partner 
will not have a deferred section 752 amount with respect to any 
applicable debt instrument that is reacquired during the taxable year. 
If a direct partner of an electing partnership would recognize gain 
under section 731 as a result of the reacquisition of one or more 
applicable debt instruments during the taxable year absent the section 
108(i)(6) deferral, the partner's deferred section 752 amount for all 
applicable debt instruments that are reacquired during the taxable year 
is equal to the lesser of the partner's aggregate deferred amounts from 
the electing partnership for all applicable debt instruments reacquired 
during the taxable year, or the gain that the partner would recognize 
in the taxable year of the reacquisitions under section 731 as a result 
of the reacquisitions absent the section 108(i)(6) deferral. In 
determining the amount of gain that the direct partner would recognize 
in the taxable year of a reacquisition under section 731 as a result of 
the reacquisition of one or more applicable debt instruments during the 
taxable year absent the section 108(i)(6) deferral, the rule under 
Sec.  1.731-1(a)(1)(ii) applies to any deemed distribution of money 
under section 752(b) resulting from a decrease in the partner's share 
of a reacquired applicable debt instrument that is treated as an 
advance or drawing of money. The amount of any deemed distribution of 
money under section 752(b) resulting from a decrease in the partner's 
share of a reacquired applicable debt instrument that is treated as an 
advance or drawing of money under Sec.  1.731-1(a)(1)(ii) is determined 
as if no COD income resulting from the reacquisition of the applicable 
debt instrument is deferred under section 108(i).
    (iii) Multiple section 108(i) elections. If a direct partner of an 
electing partnership has a deferred section 752 amount under paragraph 
(b)(3)(ii) of this section for the taxable year of a reacquisition and 
the partner has a deferred amount with respect to more than one 
applicable debt instrument from the electing partnership for which a 
section 108(i) election is made in that taxable year, the partner's 
deferred section 752 amount with respect to each such applicable debt 
instrument equals the partner's deferred section 752 amount as 
determined under paragraph (b)(3)(ii) of this section, multiplied by a 
ratio, the numerator of which is the partner's deferred amount with 
respect to such applicable debt instrument, and the denominator of 
which is the partner's aggregate deferred amounts from the electing 
partnership for all applicable debt instruments reacquired during the 
taxable year.
    (iv) Electing partnership's request for information. At the request 
of an electing partnership, each direct partner of the electing 
partnership that has a deferred amount with respect to such partnership 
must provide to the electing partnership a written statement containing 
information requested by the partnership that is necessary to determine 
the partner's deferred section 752 amount (such as the partner's 
adjusted basis in the partner's interest in the electing partnership). 
The written statement must be signed under penalties of perjury and 
provided to the requesting partnership within 30 days of the date of 
the request by the electing partnership.
    (v) Examples. The following examples illustrate the rules under 
paragraph (b)(3) of this section:

    Example 1. (i) A and B each hold a 50 percent interest in 
Partnership, a calendar-year partnership. As of January 1, 2009, A 
and B each have an adjusted basis of $50 in their partnership 
interests. Partnership has two applicable debt instruments 
outstanding, debt one of $300 and debt two of $200. On March 1, 
2009, debt one is cancelled and Partnership realizes $300 of COD 
income. On December 1, 2009, debt two is cancelled and Partnership 
realizes $200 of COD income. The Partnership has no other income or 
loss items for 2009. A and B are each allocated $150 of COD income 
from debt one and $100 of COD income from debt two. Partnership 
makes an election under section 108(i) to defer $225 of the $300 of 
COD income realized from the reacquisition of debt one, $150 of 
which is A's deferred amount, and $75 of which is B's deferred 
amount. Partnership also makes an election under section 108(i) to 
defer $125 of the $200 of COD income realized from the reacquisition 
of debt two, $100 of which is A's deferred amount, and $25 of which 
is B's deferred amount. A has no included amount for either debt. B 
has an included amount of $75 with respect to debt one and an 
included amount of $75 with respect to debt two for 2009.
    (ii) Under paragraph (b)(3)(ii) of this section, the amount of 
gain that A would recognize under section 731 as a result of the 
reacquisitions absent the section 108(i)(6) deferral is $200. Thus, 
A's deferred section 752 amount with respect to debt one and debt 
two equals $200 (the lesser of A's aggregate deferred amounts with 
respect to debt one and debt two of $250, or gain that A would 
recognize under section 731 in 2009, as a result of the 
reacquisitions absent the section 108(i)(6) deferral, of $200). 
Under paragraph (b)(3)(iii) of this section, $120 of A's $200 
deferred section 752 amount relates to debt one ($200 x $150/$250) 
and $80 relates to debt two ($200 x $100/$250).
    (iii) Under paragraph (b)(3)(ii) of this section, the amount of 
gain that B would recognize under section 731 as a result of the 
reacquisitions absent the section 108(i)(6) deferral is $50. Thus, 
B's deferred section 752 amount with respect to debt one and debt 
two equals $50 (the lesser of B's aggregate deferred amounts with 
respect to debt one and debt two of $100, or gain that B would 
recognize under section 731 in 2009, as a result of the 
reacquisitions absent the section 108(i)(6) deferral, of $50). Under 
paragraph (b)(3)(iii) of this section, $37.50 of B's $50 deferred 
section 752 amount relates to debt one ($50 x $75/$100) and $12.50 
relates to debt two ($50 x $25/$100).
    Example 2.  (i) The facts are the same as in Example 1, except 
that Partnership has gross income for the year (including the $500 
of COD income) of $700 and other separately stated losses of $500. 
A's and B's distributive share of each item is 50 percent.
    (ii) In determining the amount of gain that A would recognize 
under section 731 as a result of the reacquisitions absent the 
section 108(i)(6) deferral, Partnership first increases A's $50 
adjusted basis in his interest in Partnership by A's distributive 
share of Partnership income (other than the deferred amounts 
relating to debt one and debt two) of $100, and then decreases A's 
adjusted basis in Partnership by deemed distributions under section 
752(b) of $250 and, thereafter, by A's distributive share of 
Partnership losses of $250, but only to the extent that A's basis is 
not reduced below zero. Under paragraph (b)(3)(ii) of this section, 
the amount of gain that A would recognize under section 731 as a 
result of the reacquisitions absent section 108(i)(6) deferral is 
$100. Thus, A's deferred section 752 amount with respect to debt one 
and debt two equals $100 (the lesser of A's aggregate deferred 
amounts with respect to debt one and debt two of $250, or gain that 
A would recognize under section 731 as a result of the 
reacquisitions absent the deferral section 108(i)(6) deferral of 
$100). Under paragraph (b)(3)(iii) of this section, A's deferred 
section 752 amount with respect to debt one is $60 ($100 x $150/
$250), and A's deferred section 752 amount with respect to debt two 
is $40 ($100 x $100/$250). A's $250 of Partnership losses are 
suspended under section 704(d).
    (iii) In determining the amount of gain that B would recognize 
under section 731 as a result of the reacquisitions absent the 
section

[[Page 49388]]

108(i)(6) deferral, Partnership first increases B's $50 adjusted 
basis in his interest in Partnership by B's distributive share of 
Partnership income (other than the deferred amounts relating to debt 
one and debt two) of $250 ($100 other income plus $150 included 
amount with respect to debt one and debt two), and then decreases 
B's adjusted basis in Partnership by deemed distributions under 
section 752(b) of $250 and, thereafter, by B's distributive share of 
Partnership losses of $250, but only to the extent that B's basis is 
not reduced below zero. Under paragraph (b)(3)(ii) of this section, 
B would not recognize any gain under section 731 as a result of the 
reacquisitions absent the section 108(i)(6) deferral. Thus, B has no 
deferred section 752 amount with respect to either debt one or debt 
two. B may deduct his distributive share of Partnership losses to 
the extent of $50, with the remaining $200 suspended under section 
704(d).

    (4) Tiered partnerships--(i) In general. If a partnership (upper-
tier partnership) is a direct or indirect partner of an electing 
partnership and directly or indirectly receives an allocation of a COD 
income amount from the electing partnership, all or a portion of which 
is deferred under section 108(i), the upper-tier partnership must 
allocate its COD income amount to its partners that are partners in the 
upper-tier partnership immediately before the reacquisition in the 
manner in which the income would be included in the distributive shares 
of the partners under section 704 and the regulations under section 
704, including Sec.  1.704-1(b)(2)(iii), without regard to section 
108(i). The upper-tier partnership may determine, in any manner, the 
portion, if any, of a partner's COD income amount with respect to an 
applicable debt instrument that is the deferred amount, and the 
portion, if any, that is the included amount. However, no partner's 
deferred amount with respect to an applicable debt instrument may 
exceed that partner's COD income amount with respect to such applicable 
debt instrument, and the aggregate amount of the partners' COD income 
amounts and deferred amounts with respect to each applicable debt 
instrument must equal the upper-tier partnership's COD income amount 
and deferred amount, respectively, with respect to each such applicable 
debt instrument.
    (ii) Deferred section 752 amount. The computation of a partner's 
deferred section 752 amount, as described in paragraph (b)(3)(ii) of 
this section, is calculated only for direct partners of the electing 
partnership. An upper-tier partnership's deferred section 752 amount 
with respect to an applicable debt instrument of the electing 
partnership is allocated only to those partners of the upper-tier 
partnership that have a deferred amount with respect to that applicable 
debt instrument, and in proportion to such partners' share of the 
upper-tier partnership's deferred amount with respect to that 
applicable debt instrument. A partner's share of the upper-tier 
partnership's deferred section 752 amount with respect to an applicable 
debt instrument must not exceed that partner's share of the upper-tier 
partnership's deferred amount with respect to the applicable debt 
instrument to which the deferred section 752 amount relates. The 
deferred section 752 amount of a partner of an upper-tier partnership 
is treated as a distribution of money by the upper-tier partnership to 
the partner under section 752(b), at the same time and to the extent 
remaining in the same amount, as the partner recognizes the deferred 
amount with respect to the applicable debt instrument.
    (iii) Examples. The following examples illustrate the rules under 
paragraph (b)(4) of this section:

    Example 1.  (i) PRS, a calendar-year partnership, has two equal 
partners, A, an individual, and XYZ, a partnership. As of January 1, 
2009, A and XYZ each have an adjusted basis of $50 in their 
partnership interests. PRS has a $500 applicable debt instrument 
outstanding. On June 1, 2009, the creditor agrees to cancel the $500 
indebtedness. PRS realizes $500 of COD income as a result of the 
reacquisition. PRS has no other income or loss items for 2009. PRS 
makes an election under section 108(i) to defer $200 of the $500 of 
COD income. PRS allocates the $500 of COD income equally between its 
partners ($250 each). PRS determines that, for each partner, $100 of 
the COD income amount is the deferred amount, and $150 is the 
included amount. For 2009, each of A's and XYZ's share of the 
decrease in PRS's reacquired applicable debt instrument is $250.
    (ii) XYZ has two equal partners, individuals X and Y. X and Y 
share equally in XYZ's liabilities. XYZ allocates the $250 COD 
income amount from PRS equally between X and Y ($125 each). XYZ 
determines that X has a deferred amount of $100 and an included 
amount of $25. All $125 of Y's COD income amount is Y's included 
amount. For 2009, each of X's and Y's share of XYZ's $250 decrease 
in liability with respect to the reacquired applicable debt 
instrument of PRS is $125.
    (iii) Under paragraph (b)(3)(ii) of this section, PRS determines 
that XYZ has a deferred section 752 amount of $50. Therefore, for 
2009, of XYZ's $250 share of the decrease in PRS's reacquired 
applicable debt instrument, $200 is treated as a deemed distribution 
under section 752(b) and $50 is the deferred section 752 amount.
    (iv) Under paragraph (b)(4)(ii) of this section, none of XYZ's 
$50 deferred section 752 amount is allocated to Y because Y does not 
have a deferred amount with respect to the reacquired applicable 
debt interest. XYZ's entire $50 of deferred section 752 amount is 
allocated to X. Therefore, of X's $125 share of the XYZ's decrease 
in liability with respect to the reacquired applicable debt 
instrument of PRS, $75 is treated as a deemed distribution under 
section 752(b) and $50 is X's deferred section 752 amount. Y's $125 
share of XYZ's decrease in liability with respect to the reacquired 
applicable debt instrument of PRS is treated as a deemed 
distribution under section 752(b) and none is a deferred section 752 
amount.
    Example 2.  (i) The facts are the same as in Example 1, except 
for the following: XYZ has three partners, X, Y, and Z. The profits 
and losses of XYZ are shared 25 percent by X, 25 percent by Y, and 
50 percent by Z. XYZ allocates its $250 COD income amount from PRS 
$62.50 to each of X and Y, and $125 to Z. XYZ determines that X has 
a deferred amount of $50 and an included amount of $12.50, Y has a 
deferred amount of $0 and an included amount of $62.50, and Z has a 
deferred amount of $50 and an included amount of $75 with respect to 
the applicable debt instrument. X's, Y's, and Z's share of XYZ's 
decrease in liability with respect to the reacquired applicable debt 
instrument of PRS is $62.50, $62.50 and $125, respectively.
    (ii) Under paragraph (b)(4)(ii) of this section, none of XYZ's 
$50 deferred section 752 amount is allocated to Y because Y does not 
have a deferred amount with respect to the reacquired applicable 
debt instrument. XYZ's $50 deferred section 752 amount is allocated 
to X and Z in proportion to X's and Z's share of XYZ's deferred 
amount, or $25 each ($50 x ($50/$100)). Therefore, of X's $62.50 
share of XYZ's decrease in liability with respect to the reacquired 
applicable debt instrument, $37.50 is treated as a deemed 
distribution under section 752(b) and $25 is X's deferred section 
752 amount. All of Y's $62.50 share of XYZ's decrease in liability 
with respect to the reacquired applicable debt instrument is treated 
as a deemed distribution under section 752(b). Of Z's $125 share of 
XYZ's decrease in liability with respect to the reacquired 
applicable debt instrument, $100 is treated as a deemed distribution 
under section 752(b) and $25 is Z's deferred section 752 amount.

    (5) S corporation partner--(i) In general. If an S corporation 
partner has a deferred amount with respect to an applicable debt 
instrument of an electing partnership, such deferred amount is shared 
pro rata only among those shareholders that are shareholders of the S 
corporation partner immediately before the reacquisition of the 
applicable debt instrument.
    (ii) Basis adjustments. T