Determination of Distributive Share When Partner's Interest Changes, 45865-45883 [2015-18816]

Download as PDF Federal Register / Vol. 80, No. 148 / Monday, August 3, 2015 / Rules and Regulations This rule revises subpart 1 to correct citations and office titles. Review Under the Paperwork Reduction Act This direct final rule does not contain any information collection requirements subject to the Paperwork Reduction Act of 1995 (44 U.S.C. 3501 et seq.). Review Under EO 13132 EO 13132, ‘‘Federalism,’’ 64 FR 43255 (August 4, 1999) requires regulations be reviewed for Federalism effects on the institutional interest of states and local governments, and if the effects are sufficiently substantial, preparation of the Federal assessment is required to assist senior policy makers. The amendments will not have any substantial direct effects on state and local governments within the meaning of the EO. Therefore, no Federalism assessment is required. Interagency Relations, Attn: Director, Export Control and Interagency Liaison Division, National Aeronautics and Space Administration, Washington, DC 20546. (3) The NASA Associate Administrator for Human Exploration and Operations is authorized to issue the certification for articles imported into the United States by persons or entities under agreements other than those identified in paragraphs (a)(1) and (a)(2) of this section, including launch services agreements. Requests for certification should be sent to: Human Exploration and Operations Mission Directorate, Attn: Director, International Space Station Office, National Aeronautics and Space Administration, Washington, DC 20546. * * * * * Cheryl E. Parker, NASA Federal Register Liaison Officer. List of Subjects in 14 CFR Part 1217: Custom duties and inspection, space transportation and exploration. Accordingly, under the authority of the National Aeronautics and Space Act, as amended, NASA amends 14 CFR part 1217 as follows: [FR Doc. 2015–17213 Filed 7–31–15; 8:45 am] PART 1217—DUTY-FREE ENTRY OF SPACE ARTICLES 26 CFR Parts 1 and 602 ■ 1. The authority citation for part 1217 is revised as follows: [TD 9728] Authority: 51 U.S.C. 20113; Proclamation No. 6780 of March 23, 1995, 60 FR 15845. RIN 1545–BD71 2. In 1217.103, revise paragraphs (a)(1) through (a)(3) to read as follows: ■ mstockstill on DSK4VPTVN1PROD with RULES § 1217.103 16:06 Jul 31, 2015 Jkt 235001 DEPARTMENT OF THE TREASURY Internal Revenue Service Determination of Distributive Share When Partner’s Interest Changes Internal Revenue Service (IRS), Treasury. ACTION: Final regulations. AGENCY: Authority to certify. (a)* * * (1) The NASA Assistant Administrator for Procurement is authorized to issue the certification for articles imported into the United States which are procured by NASA or by other U.S. Government agencies, or by U.S. Government contractors or subcontractors when title to the articles is or will be vested in the U.S. Government pursuant to the terms of the contract or subcontract. Requests for certification should be sent to: Office of Procurement, Attn: Director, Contract and Grant Policy Division, National Aeronautics and Space Administration, Washington, DC 20546. (2) The NASA Associate Administrator for International and Interagency Relations is authorized to issue the certification for articles imported into the United States pursuant to international agreements. Requests for certification should be sent to: Office of International and VerDate Sep<11>2014 BILLING CODE 7510–13–P This document contains final regulations regarding the determination of a partner’s distributive share of partnership items of income, gain, loss, deduction, and credit when a partner’s interest varies during a partnership taxable year. The final regulations also modify the existing regulations regarding the required taxable year of a partnership. These final regulations affect partnerships and their partners. DATES: Effective date: These regulations are effective on August 3, 2015. Applicability date: For dates of applicability, see §§ 1.706–1(b)(6)(v), 1.706–1(d), 1.706–4(g), and 1.706–5(b). FOR FURTHER INFORMATION CONTACT: Benjamin H. Weaver of the Office of Associate Chief Counsel (Passthroughs and Special Industries) at (202) 317– 6850 (not a toll-free number). SUPPLEMENTARY INFORMATION: SUMMARY: PO 00000 Frm 00025 Fmt 4700 Sfmt 4700 45865 Paperwork Reduction Act The collection of information contained in this Treasury decision has been submitted to the OMB for review in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)). Comments on the collection of information should be sent to the Office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503, with copies to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, Washington, DC 20224. Comments on the collection of information should be received by October 2, 2015. Comments are specifically requested concerning: Whether the proposed collection of information is necessary for the proper performance of the functions of the IRS, including whether the information will have practical utility; The accuracy of the estimated burden associated with the proposed collection of information; and Estimates of capital or start-up costs and costs of operation, maintenance, and purchase of services to provide information. The collections of information in the final regulations are in § 1.706–4(f), which requires partnerships adopting the proration method, adopting the semi-monthly or monthly convention, choosing to perform semi-monthly or monthly interim closings, or selecting an additional class of extraordinary items, to maintain a statement with their books and records. This information will be available to the IRS upon examination to document the partnership’s selection of the method, convention, optional interim closings, or additional class of extraordinary items. The collections of information are required to obtain a benefit. The likely respondents are partnerships. The collections will be reported and collected through the OMB approval number for Form 1065, U.S. Return of Partnership Income, under control number 1545–0123; please see the instructions for Form 1065 for estimates of the burden associated with the collection of information. An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays a valid control number assigned by the OMB. 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, E:\FR\FM\03AUR1.SGM 03AUR1 45866 Federal Register / Vol. 80, No. 148 / Monday, August 3, 2015 / Rules and Regulations tax returns and tax return information are confidential, as required by section 6103. mstockstill on DSK4VPTVN1PROD with RULES Background These final regulations contain amendments to the Income Tax Regulations (26 CFR part 1) under section 706 of the Internal Revenue Code (Code). On April 14, 2009, the Treasury Department and the IRS published a notice of proposed rulemaking (REG–144689–04) (the 2009 proposed regulations) in the Federal Register to provide guidance under section 706(d)(1) and to conform the Income Tax Regulations for certain provisions of section 1246 of the Taxpayer Relief Act of 1997, Public Law 105–34 (111 Stat. 788 (1997)), and section 72 of the Deficit Reduction Act of 1984, Public Law 98–369 (98 Stat. 494 (1984)). The Treasury Department and the IRS did not hold a public hearing because there were no requests to speak at a hearing. However, the Treasury Department and the IRS received comments in response to the 2009 proposed regulations. The comments are discussed in this preamble. The 2009 proposed regulations provided methods for determining partners’ distributive shares of partnership items in any year in which there is a change in a partner’s interest in the partnership, whether by reason of a disposition of the partner’s entire interest or less than the partner’s entire interest, or by reason of a reduction of a partner’s interest due to the entry of a new partner or partners. The 2009 proposed regulations also added proposed § 1.706–1(c)(2)(iii) to provide that a deemed disposition of a partner’s interest pursuant to §§ 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 § 1.1502–1(h)), 1.1362– 3(c)(1) (relating to the termination of the subchapter S election of an S corporation partner), or 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. Finally, the 2009 proposed regulations amended the rules applicable to the determination of the taxable year of a partnership when a partnership interest is held by a ‘‘disregarded foreign partner’’ (as defined in § 1.706–1(b)(6)(i)). After consideration of the comments, the 2009 proposed regulations are adopted as modified by this Treasury decision. VerDate Sep<11>2014 16:06 Jul 31, 2015 Jkt 235001 Explanation of Provisions and Summary of Comments 1. Varying Interests Rule The 2009 proposed regulations under § 1.706–4 provided guidance under section 706(d)(1), which provides that, except as required by section 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 2009 proposed regulations incorporated several of the existing varying interest rules in the regulations under section 706. These final regulations finalize the varying interest rules contained in the 2009 proposed regulations with the modifications described in this Part 1 of the preamble. The Treasury Department and the IRS have decided that these modifications necessitate reorganizing § 1.706–4 for clarity. As finalized by these regulations, § 1.706–4(a)(3) now contains a step-by-step process for making allocations under § 1.706–4. In addition, the remainder of § 1.706–4 has been reorganized into discrete sections addressing the scope of § 1.706–4, exceptions to § 1.706–4, partnership conventions, extraordinary items, and procedures for partnership decisions relating to § 1.706–4. Where possible, this preamble tracks the organization of § 1.706–4 as finalized by these regulations. A. Scope of § 1.706–4 Section 1.706–4 of the final regulations provides rules for determining the partners’ distributive shares of partnership items when a partner’s interest in a partnership varies during the taxable year as a result of the disposition of a partial or entire interest in a partnership as described in § 1.706– 1(c)(2) and (c)(3), or with respect to a partner whose interest in a partnership is reduced as described in § 1.706– 1(c)(3), including by the entry of a new partner (collectively, a ‘‘variation’’). The final regulations further provide that, in all cases, all partnership items for each taxable year must be allocated among the partners, and no items may be duplicated, regardless of the particular provision of section 706 which applies, and regardless of the method or convention adopted by the partnership. The 2009 proposed regulations contained two exceptions for allocations PO 00000 Frm 00026 Fmt 4700 Sfmt 4700 that would otherwise be subject to the rules of § 1.706–4: one exception applies to certain partnerships with contemporaneous partners, and the other exception applies to certain service partnerships. As described below, the final regulations adopt these exceptions with certain modifications. The 2009 proposed regulations did not address the interaction of the allocable cash basis item rules of section 706(d)(2) and the tiered partnership rules of section 706(d)(3) with the rules in § 1.706–4 for determining a partner’s distributive share when a partner’s interest varies. However, the 2009 proposed regulations did request comments on issues that arise with regard to allocable cash basis items and tiered partnerships. In response to comments received, §§ 1.706–2 and 1.706–3 are proposed to be amended as described in a notice of proposed rulemaking issued contemporaneously with these final regulations to address the treatment of allocable cash basis items and tiered partnerships, respectively. The final regulations clarify that § 1.706–4 does not apply to items subject to allocation under other rules, including section 706(d)(2) and section 706(d)(3). i. Permissible Changes Among Contemporaneous Partners The 2009 proposed regulations contained a ‘‘contemporaneous partner exception’’ based on the Tax Court’s opinion in Lipke v. Commissioner, 81 T.C. 689 (1983), and the legislative history of section 706. 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, the Tax Court held that section 706(c)(2)(B) (as in effect prior to 1984) prohibited retroactive allocations of partnership losses when 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 that were members of the partnership for the entire year (contemporaneous partners) if the changes in the allocations did not result from capital contributions. Congress amended section 706 in 1984, 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 replaced the varying E:\FR\FM\03AUR1.SGM 03AUR1 Federal Register / Vol. 80, No. 148 / Monday, August 3, 2015 / Rules and Regulations 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): mstockstill on DSK4VPTVN1PROD with RULES 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). Consistent with this authority, proposed § 1.706–4(b)(1) provided an exception to the rule in proposed § 1.706–4(a)(1) for dispositions of less than a partner’s entire interest in the partnership described in § 1.706–1(c)(3), provided that the variation in the partner’s interest is not attributable to a capital contribution or a partnership distribution to a partner that is a return of capital, and the allocations resulting from the modification otherwise comply with section 704(b) and the regulations promulgated thereunder. Commenters requested guidance on determining when changes in the allocations among partners are attributable to capital contributions to, and distributions from, the partnership, and which requirements of section 704(b) must be met. The final regulations do not address the determination of whether an amended allocation is attributable to a contribution or a distribution to a partner or whether such allocations otherwise satisfy section 704(b) because these comments raise issues beyond the scope of this project and require further consideration. However, the Treasury Department and the IRS may address these issues in future guidance. Commenters also requested that the final regulations expand the scope of the contemporaneous partner exception to include allocations of items attributable solely to a particular segment of a partnership’s year (see § 1.706–4(a)) among partners who are partners of the partnership for that entire segment. The final regulations adopt this recommendation and finalize the contemporaneous partner exception. VerDate Sep<11>2014 16:06 Jul 31, 2015 Jkt 235001 ii. Safe Harbor for Partnerships for Which Capital Is Not a Material IncomeProducing Factor Proposed § 1.706–4(b)(2) provided that a service partnership (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) may choose to determine the partners’ distributive shares of partnership income, gain, loss, deduction, and credit using any reasonable method, provided that the allocations were valid under section 704(b). Commenters recommended the final regulations extend the safe harbor to non-service partnerships that satisfy specific revenue and allocation thresholds (for example, gross receipts of $100 million or less and no partner receives an allocation of an item listed under section 702(a) in excess of $10 million). Another commenter requested that the final regulations provide that the list of service partnerships could be expanded by other published guidance. The Treasury Department and the IRS intend the safe harbor for service partnerships to be limited to partnerships that derive their income from the provision of services and not from capital because, in general, allocations among individual partners in partnerships for which capital is not a material income-producing factor do not raise concerns that may be present in allocations among partners in capitalintensive partnerships. Therefore the final regulations do not provide an exception based upon revenue and allocation thresholds. However, the Treasury Department and the IRS agree that the definition of a service partnership in the proposed regulations was overly narrow. Accordingly, the final regulations apply the service partnership safe harbor to any partnership for which capital is not a material income-producing factor. B. Varying Interest Rule Methods: Interim Closing and Proration The 2009 proposed regulations generally provided that a partnership shall take into account any variation in the partners’ interests in the partnership during the taxable year in determining the distributive share of partnership items under section 702(a) by using either the interim closing method or the proration method. Unless the partners agree to use the proration method, the partnership was required to use the interim closing method and allocate its items among the partners in accordance with their respective partnership interests during each segment of the PO 00000 Frm 00027 Fmt 4700 Sfmt 4700 45867 taxable year. Under the 2009 proposed regulations, if the partners agreed to use the proration method, the partnership was required to allocate the distributive share of partnership items among the partners in accordance with their pro rata shares of the items for the entire taxable year. The 2009 proposed regulations did not, however, allow certain ‘‘extraordinary items’’ to be prorated, and instead required that those items be allocated according to special rules. These regulations finalize the method rules of the 2009 proposed regulations with certain modifications. i . Use of More Than One Method and Convention During the Same Taxable Year Proposed § 1.706–4(a)(1) required the partnership and all of its partners to use the same method for all variations in the partners’ interests occurring within the partnership’s taxable year, whether resulting from a complete or partial termination of a partner’s interest or the entry of a new partner. Commenters recommended that the final regulations allow a partnership to use different methods for separate variations during the partnership’s taxable year, provided that the overall combination of methods is reasonable based on the overall facts and circumstances. Commenters stated that it would be reasonable for a partnership to be allowed to apply the interim closing method to a transfer of a large interest in the partnership, where the partnership or transferee or transferor partner is willing to pay for the additional accounting costs associated with the interim closing method, and in the same year apply the proration method for transfers of small interests (or other large transfers of interests if, for example, the parties are unwilling to bear the costs of closing the books), in order to minimize the costs and administrative burden of accounting for such transfers. The Treasury Department and the IRS agree that partnerships may be more willing to use the interim closing method, which is generally more accurate but more costly, for significant variations if doing so would not require the partnership to use the interim closing method for all variations, regardless of size, that occur throughout the year. Therefore, in response to comments, the final regulations allow a partnership to use different methods for different variations within the partnership’s taxable year, as explained in Part 1.B.iii of this Preamble. Accordingly, a partnership may use the interim closing method with respect to one variation and may choose to use the proration method for another variation in the E:\FR\FM\03AUR1.SGM 03AUR1 45868 Federal Register / Vol. 80, No. 148 / Monday, August 3, 2015 / Rules and Regulations mstockstill on DSK4VPTVN1PROD with RULES same year. However, the final regulations provide that the Commissioner may place restrictions on the ability of a partnership to use different methods during the same taxable year in guidance published in the Internal Revenue Bulletin. ii. Optional Regular Monthly or SemiMonthly Interim Closings The 2009 proposed regulations require partnerships applying the interim closing method to perform the interim closing at the time the variation is deemed to occur, and do not require or permit a partnership to perform an interim closings of its books except at the time of any variation for which the partnership uses the interim closing method. One commenter stated that of the partnerships that close their books at times other than year end, most do so at month end, and some close their books semi-monthly. The commenter stated that most partnerships that currently are subject to the interim closing method do not actually close their books other than at month end as they do not have the resources and systems organized in order to do that. The commenter requested that partnerships using the interim closing method and the calendar day convention be allowed under the final regulations to determine income on a calendar day basis by closing their books at month’s end, and then prorating the last month’s income to the periods of the month before and after the calendar day on which the variation occurred. The Treasury Department and the IRS agree that partnerships should be permitted to perform regular monthly or semi-monthly interim closings, and to prorate items within each month or semi-month, as applicable. Therefore, the final regulations provide that a partnership may, by agreement of the partners, perform regular interim closings of its books on a monthly or semi-monthly basis, regardless of whether any variation occurs. The Treasury Department and the IRS believe that this combination of the use of regular interim closings and the proration method with respect to variations should generally achieve the results sought by the commenter. The final regulations continue to require a partnership using the interim closing method with respect to a variation to perform the interim closing at the time the variation is deemed to occur, and do not require a partnership to perform an interim closings of its books except at the time of any variation for which the partnership uses the interim closing method. VerDate Sep<11>2014 17:58 Jul 31, 2015 Jkt 235001 The final regulations provide guidance on the meaning of the term ‘‘agreement of the partners,’’ including for purposes of the decision to perform regular monthly or semi-monthly interim closings. Because that term applies to several different decisions in § 1.706–4, the discussion of ‘‘agreement of the partners’’ is consolidated into Part 1.E of this preamble. prior proration period and ends at the time of the next variation for which the partnerships uses the proration method. However, each proration period ends no later than the close of the segment. Thus, segments close proration periods. Therefore, the only items subject to proration are the partnership’s items attributable to the segment containing the proration period. iii. Segments and Proration Periods For purposes of accounting for the partners’ varying interests in the partnership, the 2009 proposed regulations required the partnership to maintain, for each partner whose interest changes in the taxable year, segments to account for such changes. Under the 2009 proposed regulations, a segment was a specific portion of a partnership’s taxable year created by a variation, regardless of whether the partnership used the interim closing method or the proration method for that variation. The final regulations continue to rely on the concept of segments; however, because the final regulations now permit partnerships to use both the interim closing method and the proration method in the same taxable year, the final regulations also contain a new concept of proration periods. Under the final regulations, segments are specific periods of the partnership’s taxable year created by interim closings of the partnership’s books, and proration periods are specific portions of a segment created by a variation for which the partnership chooses to apply the proration method. The partnership must divide its year into segments and proration periods, and spread its income among the segments and proration periods according to the rules for the interim closing method and proration method, respectively. Under the final regulations, the first segment commences with the beginning of the taxable year of the partnership and ends at the time of the first interim closing of the partnership’s books. Any additional segment shall commence immediately after the closing of the prior segment and ends at the time of the next interim closing. However, the last segment of the partnership’s taxable year ends no later than the close of the last day of the partnership’s taxable year. If there are no interim closings, the partnership has one segment, which corresponds to its entire taxable year. Under the final regulations, the first proration period in each segment begins at the beginning of the segment, and ends at the time of a variation for which the partnership uses the proration method. The next proration period begins immediately after the close of the a. Rules for Determining the Items in Each Segment Proposed § 1.706–4(a)(2)(i) required that a partnership using the interim closing method treat each segment as though the segment was a separate distributive share period and that therefore a partnership using the interim closing method may compute a capital loss for a segment of a taxable year even though the partnership has a net capital gain for the entire taxable year. Similarly, proposed § 1.706–4(a)(2)(ii) provided that 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 apportioned among the segments using any reasonable method, provided that the total amount of the items apportioned among the segments does not exceed the limitation applicable to the partnership year as a whole. Commenters expressed concern that the examples do not clarify how a partnership accounts for items that are not determined until the end of the taxable year, such as waterfall allocations, minimum gain chargebacks, and certain reserves. Commenters specifically inquired whether these determinations are made at the interim closing dates or at the end of the partnership’s taxable year. Other commenters questioned whether the distributive share periods are treated as separate taxable years for purposes of sections 461(h) (relating to economic performance) and 404(a)(5) (relating to deductions for contributions to employee plans). Finally, other commenters requested guidance on the interaction of sections 168 (relating to the modified accelerated cost recovery system) and 471 (relating to accounting for inventories) with the 2009 proposed regulations. Proposed § 1.706–4(a)(2)(i) and (ii) were intended to demonstrate that yearend determinations and annual limitations are evaluated only at the end of the partnership’s taxable year. The final regulations continue to provide that each segment is generally treated as a separate distributive share period. Additionally, the final regulations PO 00000 Frm 00028 Fmt 4700 Sfmt 4700 E:\FR\FM\03AUR1.SGM 03AUR1 Federal Register / Vol. 80, No. 148 / Monday, August 3, 2015 / Rules and Regulations mstockstill on DSK4VPTVN1PROD with RULES provide that for purposes of determining allocations to segments, any special limitation or requirement relating to the timing or amount of income, gain, loss, deduction, or credit applicable to the entire partnership taxable year will be applied based on the partnership’s satisfaction of the limitation or requirements as of the end of the partnership’s taxable year. For example, the expenses related to the election to expense a section 179 asset must first be calculated (and limited if applicable) based on the partnership’s full taxable year, and then the effect of any limitation must be apportioned among the segments in accordance with the interim closing method or the proration method using any reasonable method. Thus, the segments are not treated as separate taxable years for purposes of sections 461(h) and 404(a)(5). The final regulations do not address inventory accounting under section 471 because those issues are beyond the scope of this project. Moreover, other provisions of the Code providing a convention for making a particular determination still apply. For example, section 168 provides conventions for determining when property is placed in service and when property is disposed of. The convention in section 168 would apply first to determine when the property is placed in service or when the property is disposed of, and section 706 would apply second to determine who was a partner during that segment. The Treasury Department and the IRS are studying issues relating to the interaction of section 706 and the partnership minimum gain provisions in § 1.704–2 and therefore the final regulations do not address these issues. As discussed in Part 1.F of this preamble, the interaction of sections 704 and 706 is generally beyond the scope of these final regulations; accordingly, these final regulations do not address the treatment of waterfall allocations. b. Determining the Items in Each Proration Period Under the 2009 proposed regulations, if the partners agreed to use the proration method, the partnership was required to allocate the distributive share of partnership items among the partners in accordance with their pro rata shares of the items for the entire taxable year. The Treasury Department and the IRS received several comments suggesting various modifications to the proration method. Commenters stated that the 2009 proposed regulations provided less flexibility in accounting for partners’ varying interests under the proration method than the current VerDate Sep<11>2014 16:06 Jul 31, 2015 Jkt 235001 regulations under section 706. Commenters recommended that the final regulations retain the flexibility of the current regulations by allowing partnerships to use any reasonable proration method to determine partners’ distributive shares of partnership items and that the final regulations provide examples of reasonable proration methods. The Treasury Department and the IRS believe that, because the final regulations provide partnerships with flexibility to use either the interim closing method or the proration method for each variation, and because the proration method can be less accurate than the interim closing method, it is appropriate to generally retain the rules applicable to the proration method from the 2009 proposed regulations. Accordingly, the final regulations do not adopt this suggestion. However, because the final regulations permit partnerships to use both the proration method and the interim closing method in the same taxable year, the rules for the proration method are now based upon the items in each segment, rather than the items for the partnership’s entire taxable year. Section 1.706–4(a)(4) of the final regulations contains a detailed example illustrating the interaction of segments and proration periods. Proposed § 1.706–4(d)(1) provided that, for purposes of the proration method, specific items aggregated by the partnership at the end of the year (other than extraordinary items) shall be disregarded, and the aggregate of the items shall be considered to be the partnership item for the year. Commenters questioned whether proposed § 1.706–4(a)(2)(i) and (ii) and (d)(1) were intended to provide the same rules for both the interim closing method and the proration method. These sections address different issues. Proposed § 1.706–4(d)(1) was intended to allow partnerships that have multiple items that are aggregated by the partnership at the end of the year to also treat those items as a single item for purposes of the proration method (for example, capital gains and capital losses). By contrast, proposed § 1.706– 4(a)(2)(i) and (ii) were intended to demonstrate that for purposes of determining allocations to segments, any annual limitation will be disregarded as long as the limitation is satisfied by the end of the partnership’s taxable year. One commenter requested that the final regulations allow publicly traded partnerships (as defined in section 7704(b)) that are treated as partnerships (‘‘PTPs’’) using the proration method and calendar day convention to prorate their annual aggregate tax items by the PO 00000 Frm 00029 Fmt 4700 Sfmt 4700 45869 number of months instead of the number of days. Because the use of the proration method can be less accurate than the interim closing method in certain circumstances, the Treasury Department and the IRS believe that partnerships using the proration method should prorate by the number of days. Therefore, the final regulations do not adopt this recommendation. iv. Agreement of the Partners To Use the Proration Method Consistent with the 2009 proposed regulations, under the final regulations the proration method may be used only by ‘‘agreement of the partners.’’ Commenters requested guidance on the meaning of this term, and the final regulations provide guidance as described in Part 1.E of this preamble. C. Varying Interest Rule Conventions: Calendar Day, Semi-Monthly, and Monthly The 2009 proposed regulations acknowledged that for certain partnerships using the interim closing method, such as partnerships in which interests are frequently transferred, determining the partnership items for each segment could create a significant administrative burden. Accordingly, the 2009 proposed regulations allowed the use of simplifying conventions. Conventions are rules of administrative convenience that determine when each variation is deemed to occur for purposes of § 1.706–4. Because the timing of each variation determines the partnership’s segments and proration periods, which in turn are used to determine the partners’ distributive shares, the convention used by the partnership with respect to a variation will generally affect the allocation of partnership items. However, as discussed in Part 1.D.ii of this preamble, extraordinary items generally must be allocated without regard to the partnership’s convention. The 2009 proposed regulations provided that a partnership using the interim closing method could use either the calendar day convention or the semi-monthly convention to determine the segments of the partnership’s taxable year, and provided that a partnership using the proration method shall use the calendar day convention. The 2009 proposed regulations required the partnership to use the same convention for all variations during a taxable year. The 2009 proposed regulations requested comments with regard to the possible expansion of these rules to include other conventions or other methods. The final regulations generally finalize the rules for E:\FR\FM\03AUR1.SGM 03AUR1 45870 Federal Register / Vol. 80, No. 148 / Monday, August 3, 2015 / Rules and Regulations conventions from the 2009 proposed regulations with the modifications described in this Part 1.C of the preamble. i. Allowance of Monthly Conventions Commenters noted that the legislative history of section 706(d) contemplated that regulations under section 706 would provide a monthly convention for all partnerships. These commenters also argued that the administrative burden and accounting complexity inherent in the interim closing method would be alleviated by a monthly convention. Accordingly, the commenters recommended that the monthly convention be available to all partnerships, regardless of method, provided that the overall allocation of partnership items is reasonable. The legislative history indicates that Congress did consider providing for a statutory election to use a monthly convention: mstockstill on DSK4VPTVN1PROD with RULES [T]o prevent undue complexity, the bill provides, that in any case where there is a disposition of less than an entire interest in the partnership by a partner (including the entry of a new partner), the partnership may elect (on an annual basis) to determine the varying interests of the partners by using a monthly convention that treats any changes in any partner’s interest in the partnership during the taxable year as occurring on the first day of the month. S. Rep. No. 98–169, at 221 (1984). However, this statutory provision was not enacted and the House-Senate Conference Committee report explains that it was omitted because Congress expected the Secretary to provide for a monthly convention by regulation. H.R. Rep. No. 98–861, at 858 (1984). In accordance with this Congressional intent, the final regulations provide that any partnership using the interim closing method (but not partnerships using the proration method) may use a monthly convention to account for partners’ varying interests. Under the monthly convention, in the case of a variation occurring on the first through the 15th day of a calendar month, the variation is deemed to occur for purposes of § 1.706–4 at the end of the last day of the immediately preceding calendar month. And in the case of a variation occurring on the 16th through the last day of a calendar month, the variation is deemed to occur for purposes of § 1.706–4 at the end of the last day of that calendar month. Consistent with the rules for the selection of the proration method, the final regulations provide that the selection of the convention must be made by agreement of the partners by satisfying the provisions of § 1.706–4(f) VerDate Sep<11>2014 16:06 Jul 31, 2015 Jkt 235001 of these final regulations as explained in Part 1.E of this preamble. In the absence of an agreement to use a convention, the partnership will be deemed to have chosen the calendar day convention. ii. Convention for Partnerships Using the Proration Method Commenters also requested that the final regulations allow partnerships using the proration method to allocate extraordinary items under either the calendar day convention or the semimonthly convention to mirror the rules under the interim closing method. As explained in Part 1.D.i of this preamble, the final regulations provide that extraordinary items must generally be allocated based on the date and time on which the extraordinary items arise, without regard to the partnership’s convention or use of the proration method or interim closing method. Thus, under the final regulations the allocation of extraordinary items will generally be the same regardless of the partnership’s selected method or convention. The partnership’s method and convention are generally relevant in determining allocations of nonextraordinary items. The final regulations retain the requirement that partnerships using the proration method must use a calendar day convention. Partnerships using the interim closing method have the option of using a semimonthly or monthly convention in addition to the calendar day convention because of the additional administrative burdens inherent in using the more accurate interim closing method. Although the proration method may impose less administrative burdens on a partnership, it is less accurate than the interim closing method. Thus, the Treasury Department and the IRS believe it is necessary to retain the requirement of a calendar day convention for the proration method. iii. Conventions for PTPs Proposed § 1.706–4(b)(3) provided a safe harbor for PTPs that permitted a PTP using either the interim closing method or the proration method to treat all transfers of its publicly traded units (as described in § 1.7704–1(b)(1)) except for certain block transfers during the 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. Proposed § 1.706– 4(b)(3) also provided that, alternatively, PTPs could use the semi-monthly convention described in proposed § 1.706–4(e)(2). The proposed PTP safe harbor referenced both rules for PO 00000 Frm 00030 Fmt 4700 Sfmt 4700 determining partner status and conventions in the same sentence, which could cause confusion. To eliminate this confusion, the Treasury Department and the IRS have decided to incorporate the rules of the PTP safe harbor from the 2009 proposed regulations, modified in response to comments as described in this section of the preamble, into the portions of the regulations providing rules for partnership conventions and methods. Therefore, the PTP safe harbor from the 2009 proposed regulations is no longer necessary and has been removed from the final regulations. However, as described below, the substantive rules from the PTP safe harbor remain largely unchanged in these final regulations. Commenters on the PTP safe harbor recommended that PTPs should be able to apply their conventions to all transfers of units, not just publicly traded units, including block transfers. The IRS and the Treasury Department agree that the rules from the proposed regulations should be extended to block transfers, but believe that transfers of non-publicly traded units should be accounted for similar to transfers of interests in non-publicly traded partnerships. Accordingly, the final regulations provide that a PTP may, by agreement of the partners, use any of the calendar day, the semi-monthly, or the monthly convention with respect to all variations during the taxable year relating to its publicly-traded units, regardless of whether the PTP uses the proration method with respect to those variations. A PTP must use the same convention for all variations during the taxable year relating to its publicly traded units. The final regulations provide that a PTP must use the calendar day convention with respect to all variations relating to its non-publicly traded units for which the PTP uses the proration method. In addition, consistent with the rules from the PTP safe harbor in the 2009 proposed regulations, the final regulations provide that a PTP using a monthly convention generally may consistently treat all variations occurring during each month as occurring at the end of the last day of that calendar month, if the PTP uses the monthly convention for those variations. The preamble to the 2009 proposed regulations acknowledged that some PTPs use conventions not described in the 2009 proposed regulations and requested comments concerning the use of additional conventions. In response to this request for comments, one commenter on the PTP safe harbor also recommended that the final regulations allow PTPs to use a quarterly E:\FR\FM\03AUR1.SGM 03AUR1 mstockstill on DSK4VPTVN1PROD with RULES Federal Register / Vol. 80, No. 148 / Monday, August 3, 2015 / Rules and Regulations convention. This commenter stated that PTPs generally declare cash distributions quarterly to their unit holders of record on the last day of the quarter to align the distributions with the PTPs’ quarterly financial reporting. The Treasury Department and the IRS believe that a quarterly convention could significantly reduce the accuracy of the allocations of a partnership’s tax items to a particular partner. Accordingly, the final regulations do not permit PTPs to use a quarterly convention. As discussed in Part 1.D.iii.a of this preamble, however, proposed regulations under section 706 (REG–109370–10) are being published concurrently with these final regulations, and, subject to certain exceptions, provide that PTPs may, by agreement of their partners, treat all items of income that are amounts subject to withholding as defined in § 1.1441–2(a) (excluding income effectively connected with the conduct of a trade or business within the United States) or withholdable payments under § 1.1473–1(a) as extraordinary items. If the partners so agree, then for purposes of section 706 such items are treated as occurring at the next time as of which the recipients of a distribution by the PTP are determined, or, to the extent such income items arise between the final time during the taxable year as of which the recipients of a distribution are determined and the end of the taxable year, such items shall be treated as occurring at the final time during the taxable year that the recipients of a distribution by the PTP are determined. This proposed rule does not apply unless the PTP has a regular practice of making at least four distributions (other than de minimis distributions) to its partners during each taxable year. The Treasury Department and the IRS believe that this proposed rule is desirable to link each partner’s distributive share to the related cash distributions, thereby enabling PTPs and their transfer agents to satisfy their withholding obligations under chapter 4 of the Code and under sections 1441 through 1443 from distributions. The convention rules in proposed § 1.706–4(c)(2) and (d)(2) did not apply to existing PTPs (existing PTP exception). Solely for purposes of the 2009 proposed regulations, an existing PTP was a partnership described in section 7704(b) that was formed on a date before the 2009 proposed regulations were published. Commenters noted that an existing PTP that terminates under section 708(b)(1)(B) due to the sale or exchange of 50 percent or more of the total VerDate Sep<11>2014 16:06 Jul 31, 2015 Jkt 235001 interests in partnership capital and profits (a ‘‘technical termination’’) on or after the publication of the 2009 proposed regulations would not receive the benefit of the existing PTP exception. These commenters noted that a technical termination is a tax concept and does not result in any changes to the partnership agreement, including any provisions relating to section 706(d). Commenters also noted that disregarding technical terminations of PTPs would be consistent with other regulation provisions (such as § 1.731– 2(g)(2), which provides that a successor partnership formed as a result of technical termination is disregarded for purposes of applying section 731(c)). The final regulations adopt this recommendation and provide that, for purposes of the effective date provision, the termination of a PTP under section 708(b)(1)(B) is disregarded in determining whether the PTP is an existing PTP. iv. Use of More Than One Convention During a Taxable Year The 2009 proposed regulations required the partnership to use the same convention for all variations during a taxable year. Because the final regulations permit partnerships to use both the proration and interim closing methods during a taxable year, the final regulations provide that the partnership and all of its partners must use the same convention for all variations for which the partnership chooses to use the interim closing method. Furthermore, because PTPs are also permitted to use the semi-monthly and monthly conventions with respect to variations for which the PTP uses the proration method, the final regulations provide that PTPs must use the same convention for all variations during the taxable year. v. Deemed Timing of Variations Under the semi-monthly convention in the 2009 proposed regulations, the first segment of the partnership’s taxable year commenced with the beginning of the partnership’s taxable year, and with respect to a variation in interest occurring on the first through the 15th day of the month, was deemed to close at the end of the last day of the immediately preceding calendar month. Thus, although the 2009 proposed regulations provided that the first segment commences with the beginning of the partnership’s taxable year, they also provided that a variation occurring on the first through the 15th day of the first calendar month of the partnership’s taxable year was deemed to close at the end of the last day of the immediately preceding calendar month, which PO 00000 Frm 00031 Fmt 4700 Sfmt 4700 45871 would be the last day of the prior taxable year. The final regulations provide that all variations within a taxable year are deemed to occur no earlier than the first day of the partnership’s taxable year, and no later than the close of the final day of the partnership’s taxable year. Thus, under the semi-monthly or monthly convention, a variation occurring on January 1st through January 15th for a calendar year partnership will be deemed to occur for purposes of § 1.706–4 at the beginning of the day on January 1. The conventions are not applicable to a sale or exchange of an interest in the partnership that causes a termination of the partnership under section 708(b)(1)(B); instead, such a sale or exchange will be considered to occur when it actually occurred. vi. Exception for Admission to and Exit From the Partnership Within a Convention Period The Treasury Department and the IRS recognize that, while the conventions are rules of administrative convenience that simplify the partnership’s determination of the partners’ distributive shares, the application of the conventions could result in some partners not being allocated any share of partnership items at all. For example, under the monthly convention, if a new partner buys a partnership interest on or after the 16th day of a month, and sells the entire partnership interest on or before the 15th day of the following month, that partner would not be treated as having been a partner at all for purposes of § 1.706–4, even if that partner otherwise is treated as a partner for purposes of other Code and regulations provisions, including section 6031(b) (relating to the partnership’s obligation to furnish each partner a Schedule K–1, ‘‘Partner’s Share of Income, Deductions, Credits, etc.’’) and §§ 1.6012–1(b) and 1.6012– 2(g) (relating to the obligation of certain foreign persons engaged in a U.S. trade or business to file a return). However, the Treasury Department and the IRS believe that the application of the conventions should not cause persons who are admitted to and exit from a partnership during a single convention period to avoid all allocations under § 1.706–4. Accordingly, the final regulations provide that in the case of a partner who becomes a partner during the partnership’s taxable year as a result of a variation, and ceases to be a partner as a result of another variation, and under the application of the partnership’s conventions both such variations would be deemed to occur at the same time, the variations with E:\FR\FM\03AUR1.SGM 03AUR1 45872 Federal Register / Vol. 80, No. 148 / Monday, August 3, 2015 / Rules and Regulations extraordinary items across the segment, and (2) the conventions, which might otherwise inappropriately shift extraordinary items between a transferor and transferee. The final regulations also provide that extraordinary items continue to be subject to any special limitation or requirement relating to the timing or amount of income, gain, loss, deduction, or credit applicable to the entire partnership taxable year (for example, the limitation for section 179 expenses). D. Extraordinary Items Section 1.706–4(d)(3) of the 2009 proposed regulations required 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. Section 1.706–4(d)(3) of the 2009 proposed regulations contained a list of nine enumerated extraordinary items. These final regulations continue to provide special rules for the allocation of extraordinary items; in addition, as discussed in this Part 1.D of the preamble, the final regulations expand the application of the extraordinary item rules to cover partnerships using the interim closing method, modify the list of extraordinary items and the timing of extraordinary item inclusions, and add a small item exception. mstockstill on DSK4VPTVN1PROD with RULES respect to that partner’s interest will instead be treated as occurring when they actually occurred. Thus, in such a case, the partnership must treat the partner as a partner for the entire portion of its taxable year during which the partner actually owned an interest. However, in recognition of the increased administrative difficultly this exception would have for PTPs, this exception does not apply to PTPs with respect to holders of publicly traded units (as described in § 1.7704–1(b) or (c)(1)). ii. Timing of Extraordinary Items Proposed § 1.706–4(d)(3) provided that a partnership must allocate extraordinary items among the partners in proportion to their interests at the beginning of the calendar day on which they are taken into account (beginning of the day rule). One commenter noted that under this rule, if a partnership interest is transferred on a given date and an extraordinary item is recognized by the partnership after the transfer, but still on the transfer date, the 2009 proposed regulations required the item to be allocated to the transferor. This commenter noted that other regulation sections use a ‘‘next day rule’’ (for example, §§ 1.1502–76(b)(1)(ii)(B) and 1.338–1(d)). According to the commenter, under the next day rule, an item would be treated as occurring at the beginning of the day following the day on which the extraordinary item is taken into account by the partnership. Another commenter expressed concern that the beginning of the day rule was incompatible with partnership agreements that provide that partners’ distributive shares are determined on the basis of hurdles, waterfalls, or other income/loss thresholds. The Treasury Department and the IRS agree that extraordinary items should generally be allocated according to the partners’ interests in the item at the time the extraordinary item arose. However, the Treasury Department and the IRS believe that a ‘‘next day’’ rule could result in inappropriate shifts of extraordinary items between a transferor and a transferee in situations in which the extraordinary items arise before, but on the same day as, the transfer of a partnership interest. In addition, the Treasury Department and the IRS believe that allowing allocation of extraordinary items based upon end of year threshold determinations such as hurdles or waterfalls would be inconsistent with the purpose of the varying interest rule and could result in inappropriate shifts in extraordinary items. Therefore, to avoid inappropriate shifts in extraordinary items, the final regulations provide that extraordinary i. Extraordinary Items and the Interim Closing Method The 2009 proposed regulations did not require partnerships using the interim closing method to separately account for extraordinary items. However, the Treasury Department and the IRS are aware (and commenters pointed out) that partnerships using the interim closing method and either the semi-monthly convention or the monthly convention to account for extraordinary items may achieve inappropriate tax consequences by shifting the tax consequences of extraordinary items to partners that were not partners in the partnership when the partnership incurred the extraordinary item. The Treasury Department and the IRS believe that extraordinary items should generally be taken into account by the partners that were partners at the time the partnership incurred the extraordinary item. Therefore, the final regulations provide that the extraordinary item rules also apply to partnerships using the interim closing method. Thus, the final regulations require the allocation of extraordinary items as an exception to (1) the proration method, which would otherwise ratably allocate the VerDate Sep<11>2014 16:06 Jul 31, 2015 Jkt 235001 PO 00000 Frm 00032 Fmt 4700 Sfmt 4700 items must be allocated in accordance with the partners’ interests in the partnership item at the time of day that the extraordinary item occurs, regardless of the method and convention otherwise used by the partnership. Thus, if a partner disposes of its entire interest in a partnership before an extraordinary item occurs (but on the same day), the partnership and all of its partners must allocate the extraordinary item in accordance with the partners’ interests in the partnership item at the time of day on which the extraordinary item occurred; in such a case, the transferor will not be allocated a portion of the extraordinary item, regardless of when the transfer is deemed to occur under the partnership’s convention. However, the final regulations provide that PTPs (as defined in section 7704(b)) may, but are not required to, respect the applicable conventions in determining who held their publicly traded units (as described in § 1.7704–1(b) or 1.7704–1(c)(1)) at the time of the occurrence of an extraordinary item. The Treasury Department and the IRS believe that this exception is necessary for administrative convenience given the frequency of variations experienced by PTPs. Examples 1 through 4 of § 1.706– 4(e)(4) illustrate these timing rules. As discussed in Part 1.B.i of this preamble, proposed § 1.706–4(a)(1) required the partnership and all of its partners to use the same method for all variations in the partners’ interests occurring within the partnership’s taxable year, whether in complete or partial termination of the partners’ interests. Proposed § 1.706–4(d)(3) provided that partnerships using the proration method 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, thus prohibiting the partnership from allocating extraordinary items using the proration method. Commenters stated that proposed § 1.706–4(a)(1) and (d)(3), when read together, could be interpreted to prohibit partnerships with extraordinary items from the using the proration method. These commenters also stated that these provisions could be interpreted to prohibit the use of the so-called ‘‘hybrid method.’’ One commenter explained that under a hybrid method, a partnership separates certain extraordinary items and allocates them to partners based on their interests in the partnership on particular days or periods (for example, the date of sale), effectively using the interim closing E:\FR\FM\03AUR1.SGM 03AUR1 Federal Register / Vol. 80, No. 148 / Monday, August 3, 2015 / Rules and Regulations mstockstill on DSK4VPTVN1PROD with RULES method and a calendar day convention with respect to these extraordinary items. According to this commenter, the partnership then allocates the remaining partnership items in accordance with the proration method. A commenter also requested that the final regulations permit partnerships using the proration method to use the interim closing method and a semi-monthly convention to account for extraordinary items. Under the final regulations, a partnership with extraordinary items may use the proration method. As a result, the final regulations effectively permit the hybrid method described by the commenter. However, the final regulations provide that partnerships must allocate extraordinary items according to the partners’ interests in the partnership item at the time of day that the extraordinary item arose, generally without regard to the method and convention otherwise used by the partnership. iii. List of Extraordinary Items The 2009 proposed regulations defined an extraordinary item as (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 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(a)(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, VerDate Sep<11>2014 16:06 Jul 31, 2015 Jkt 235001 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 2009 proposed regulations requested comments on whether any items should be added to or removed from the definition of extraordinary items. After consideration of the comments received, the Treasury Department and the IRS have decided to generally retain the list of enumerated extraordinary items, subject to changes that are discussed in this Part 1.D.iii of the preamble. a. Two Additional Extraordinary Items and Two Additional Proposed Extraordinary Items In response to comments, the final regulations add two items to the extraordinary item list. First, commenters requested that the final regulations provide partnerships with more flexibility in determining what items are extraordinary items. One commenter argued that the definition of extraordinary item should be tied to the uniqueness of the partnership and materiality of the item. Another commenter recommended the final regulations remove the mandatory treatment of the specifically enumerated items as extraordinary items and instead highlight these specific items as items the partnership may agree to treat as extraordinary. In addition, commenters recommended that the final regulations allow the partners to agree to treat other nonenumerated items as extraordinary items. The commenters noted that this could prevent distortion of the economic deal of the partners in certain circumstances. The final regulations adopt the recommendation to allow a partnership to treat additional nonenumerated items as extraordinary items for a taxable year if, for that taxable year, there is an agreement of the partners (as described in Part 1.E of this preamble) to treat consistently such items as extraordinary items. However, this rule does not apply if treating that additional item as an extraordinary item would result in a substantial distortion of income in any partner’s return. Any additional extraordinary items continue to be subject to any special limitation or requirement relating to the timing or amount of income, gain, loss, deduction, or credit applicable to the entire partnership taxable year (for example, the limitation for section 179 expenses). Second, the final regulations provide that an extraordinary item includes any item identified as an additional class of PO 00000 Frm 00033 Fmt 4700 Sfmt 4700 45873 extraordinary item in guidance published in the Internal Revenue Bulletin. The Treasury Department and the IRS believe that this addition is necessary to provide flexibility and guidance in the event that additional classes of items should be treated as extraordinary items. In addition, proposed regulations under section 706 (REG–109370–10) being published concurrently with these final regulations propose to add two additional extraordinary items. The first proposed additional extraordinary item responds to comments regarding the administrative difficulty PTPs face in satisfying certain withholding obligations if the PTPs are not permitted to use a quarterly convention. As discussed in Part 1.C.iii of this preamble, the final regulations do not permit PTPs to use a quarterly convention. However, the proposed regulations being published concurrently with these final regulations would add an optional extraordinary item for PTPs, which the Treasury Department and the IRS believe is desirable to link each partner’s distributive share to the related cash distributions, thereby enabling PTPs and their transfer agents to satisfy their withholding obligations under Chapter 4 of the Code and sections 1441 through 1443 from distributions. Specifically, the proposed regulations provide that, for PTPs, all items of income that are amounts subject to withholding as defined in § 1.1441–2(a) (excluding income effectively connected with the conduct of a trade or business within the United States) or withholdable payments under § 1.1473–1(a) occurring during a taxable year may be treated as extraordinary items if, for that taxable year, the partners agree to consistently treat all such items as extraordinary items for that taxable year. If the partners so agree, then for purposes of section 706 such items shall be treated as occurring at the next time as of which the recipients of a distribution by the PTP are determined, or, to the extent such income items arise between the final time during the taxable year as of which the recipients of a distribution are determined and the end of the taxable year, such items shall be treated as occurring at the final time during the taxable as of which the recipients of a distribution are determined. This proposed rule does not apply unless the PTP has a regular practice of making at least four distributions (other than de minimis distributions) to its partners during each taxable year. The proposed regulations provide that taxpayers may E:\FR\FM\03AUR1.SGM 03AUR1 45874 Federal Register / Vol. 80, No. 148 / Monday, August 3, 2015 / Rules and Regulations mstockstill on DSK4VPTVN1PROD with RULES rely on this proposed additional extraordinary item for PTPs until final regulations are issued. The second proposed additional extraordinary item addresses partnership deductions attributable to the transfer of partnership equity in connection with the performance of services. Specifically, the proposed regulations being published concurrently with these final regulations would add as an additional extraordinary item any deduction for the transfer of an interest in the partnership in connection with the performance of services and would provide that such deduction is treated as occurring immediately before the transfer or vesting of the partnership interest that results in compensation income for the person who performs the services. Moreover, for such deductions the proposed regulations would ‘‘turn off’’ the exceptions to the extraordinary item rules which would otherwise apply to certain small items and for partnerships for which capital is not a material income-producing factor. The Treasury Department and the IRS believe that this rule is necessary to ensure that, in the case of a transfer of partnership equity in connection with the performance of services, no portion of the deduction for the transfer of a partnership interest in connection with the performance of services will be allocated to the person who performs the services. b. Clarification of Certain Enumerated Items This Part 1.D.iii.b provides additional clarification on five of the extraordinary items from the 2009 proposed regulations. First, the 2009 proposed regulations provided that an extraordinary item includes 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). One commenter requested that the final regulations clarify that gains or losses from the actual or deemed sale of securities by securities partnerships (as defined in § 1.704–3(e)(3)(iii)) are items resulting from the disposition or abandonment of a capital asset (as defined in section 1221) in the ordinary course of business. Without such a rule, the commenter noted that a securities partnership would incur significant administrative and accounting costs to account for each security bought and sold. The Treasury Department and the IRS believe that it is unnecessary to provide a special rule for securities partnerships; if a securities VerDate Sep<11>2014 16:06 Jul 31, 2015 Jkt 235001 partnership is engaged in the trade or business of trading securities then it will generally be true that any gains or losses from the actual or deemed sale of securities are items from the disposition of a capital asset in the ordinary course of the partnership’s business. Accordingly, the final regulations do not modify this extraordinary item. Second, commenters inquired as to whether revaluations of partnership property under § 1.704–1(b)(2)(iv)(e) or (f) are extraordinary items. Section 1.704–1(b)(2)(iv)(e) generally requires that a partner’s capital account be decreased by the fair market value of property distributed by the partnership to such partner. To do so, the partners’ capital accounts are adjusted to reflect the manner in which the unrealized income, gain, loss, and deduction inherent in the property would be allocated among the partners if there were a taxable disposition of the property for fair market value on the date of distribution. Section 1.704– 1(b)(2)(iv)(f) provides that a partnership may increase or decrease the capital accounts of the partners to reflect a revaluation of partnership property on the partnership’s books upon the occurrence of certain events. The adjustments to the partners’ capital accounts must reflect the manner in which the unrealized income, gain, loss, or deduction inherent in the property would be allocated among the partners if there were a taxable disposition of the property for fair market value on that date. Under § 1.704–3(a)(6)(i), section 704(c) principles apply to allocations with respect to property for which differences between book value and adjusted tax basis are created when a partnership revalues partnership property pursuant to § 1.704– 1(b)(2)(iv)(f) (reverse section 704(c) allocations). However, partnerships are not generally required to revalue their property on the occurrence of these events. The Treasury Department and the IRS believe that the treatment of an item as an extraordinary item should not depend upon whether the partnership chooses to revalue its assets. Additionally, as discussed in Part 1.F of this preamble, the final regulations generally do not address the interaction of sections 704(b), 704(c), and 706. Accordingly, the final regulations do not include book items from partnership revaluations as extraordinary items. Third, the 2009 proposed regulations provided that an extraordinary item included 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 PO 00000 Frm 00034 Fmt 4700 Sfmt 4700 item is included. One commenter recommended that the final regulations provide that the Commissioner may only treat a nonenumerated item as an extraordinary item where the Commissioner has provided advance notice by notice or regulation of the types of income subject to scrutiny, or where there is evidence that the proration method was chosen with the intent to substantially distort income. However, the Treasury Department and the IRS believe that such a rule would unduly impede the ability of the IRS to correct substantial distortions of income, and accordingly the final regulations do not adopt this suggestion. Fourth, the 2009 proposed regulations provided that an extraordinary item included any section 481(a) adjustment. The Treasury Department and the IRS have determined that the inclusion of section 481(a) adjustments within the meaning of ‘‘extraordinary items’’ for purposes of section 706 may be overbroad. The purpose of the extraordinary items rule is to avoid substantial distortions of income among partners by requiring a partnership to allocate certain significant, nonrecurring items incurred other than in the ordinary course of business among its partners in proportion to their ownership interests in the partnership on the date the extraordinary item was incurred. Section 481 requires a taxpayer that has changed its method of accounting to compute its income by taking into account adjustments necessary to prevent any duplication or omission that would otherwise result from the change. Under certain circumstances, these adjustments may be spread over a period of years, and in all circumstances, the adjustments relate to a change of accounting method by the taxpayer rather than a particular item incurred by the taxpayer. Because the new accounting method that triggers the section 481 adjustment applies to the entire taxable year of the change, the adjustment similarly relates to that entire taxable year rather than any specific date within that taxable year. Therefore, the Treasury Department and the IRS believe that not all section 481 adjustments should be treated as extraordinary items. However, in situations in which the change in accounting method is initiated after the occurrence of a variation, the Treasury Department and the IRS believe it is appropriate to allocate any resulting item attributable to the change among the partners in accordance with their percentage interests at and after the time the method change is initiated. Therefore, the final regulations have E:\FR\FM\03AUR1.SGM 03AUR1 Federal Register / Vol. 80, No. 148 / Monday, August 3, 2015 / Rules and Regulations changed this extraordinary item to include only the effects of any change in accounting method initiated by the filing of the appropriate form after a variation occurs. Fifth, the 2009 proposed regulations provided that an extraordinary item included: 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). mstockstill on DSK4VPTVN1PROD with RULES Section 108(e)(8) and (i) generally require that a partnership allocate discharge of indebtedness income (COD income) to the partners that were partners immediately prior to the transaction giving rise to the COD income. Thus, the rules under section 108(e)(8) and (i) and section 706 could provide conflicting results if items of a partnership subject to section 108(e)(1) or 108(i) were treated as an extraordinary item. This could occur where section 108(e)(8) or 108(i) provides a rule regarding the timing of COD income that is different from the extraordinary item timing rules under section 706. Thus, because section 108(e)(8) and (i) already provide special timing rules, the Treasury Department and the IRS believe it is unnecessary to treat these items as extraordinary items. Accordingly, the final regulations provide a limited exception in the definition of extraordinary items in § 1.706–4(e)(1)(v) for amounts subject to section 108(e)(8) or 108(i). iv. Small Item Exception for Extraordinary Items In addition to receiving comments on the items on the extraordinary item list, the Treasury Department and the IRS received many comments requesting that the final regulations provide a de minimis rule for extraordinary items. One commenter suggested that an extraordinary item would be considered de minimis if, for the partnership’s taxable year: (i) The total of the particular class of extraordinary items is less than five percent of the partnership’s (a) gross income in the case of income or gain items, or (b) gross expenses and losses, including section 705(a)(2)(B) expenditures, in the case of losses and expenses; and (ii) all extraordinary items in total do not exceed $10 million. Another commenter recommended using a dollar amount threshold per item, a cumulative amount (for example, $100,000), or an VerDate Sep<11>2014 16:06 Jul 31, 2015 Jkt 235001 amount that varies depending on the size of the partnership or whether the partnership is a PTP. The Treasury Department and the IRS recognize that accounting for extraordinary items can be burdensome to partnerships. Accordingly, the final regulations adopt the recommendation to include a small item exception. Specifically, the final regulations allow a partnership to treat an otherwise extraordinary item as not extraordinary if, for the partnership’s taxable year: (1) The total of all items in the particular class of extraordinary items (for example, all tort or similar liabilities) is less than five percent of the partnership’s (a) gross income, including tax-exempt income described in section 705(a)(1)(B), in the case of income or gain items, or (b) gross expenses and losses, including section 705(a)(2)(B) expenditures, in the case of losses and expense items; and (2) the total amount of the extraordinary items from all classes of extraordinary items amounting to less than five percent of the partnership’s (a) gross income, including tax-exempt income described in section 705(a)(1)(B), in the case of income or gain items, or (b) gross expenses and losses, including section 705(a)(2)(B) expenditures, in the case of losses and expense items, does not exceed $10 million in the taxable year, determined by treating all such extraordinary items as positive amounts. Examples 5 and 6 of § 1.706–4(e)(4) illustrate the small item exception. E. Agreement of the Partners As discussed in this preamble, the final regulations provide that partnerships may make certain decisions under § 1.706–4 by agreement of the partners. See Part 1.B.ii (agreement to perform regular monthly or semi-monthly interim closings), Part 1.B.iv (selection to use the proration method), Part 1.C.i (choice of convention), and Part 1.D.iii.a (adding extraordinary items). Proposed § 1.706–4(a)(1) provided that a partnership may only use the proration method by agreement of the partners. Proposed § 1.706–4(c)(3) and –(d)(4) provided examples that indicated that the agreement of the partners to use the proration method must be part of the partnership agreement. Commenters requested clarification on the meaning of ‘‘by agreement of the partners’’ and on whether a partnership may delegate the authority to select the proration method. Another commenter suggested that the final regulations adopt different rules for a variation caused by a transaction between the partnership and one or PO 00000 Frm 00035 Fmt 4700 Sfmt 4700 45875 more partners, and for a variation caused by a transaction between partners. One commenter noted that existing partnerships may not be able to amend the partnership agreement within the timeframe prescribed by section 761(c). Section 1.706–4(f) of the final regulations provides guidance on the meaning of ‘‘agreement of the partners.’’ The Treasury Department and the IRS believe that the final regulations should provide the partners with a voice in the choice of methods, conventions, and additional extraordinary items, and should allow the IRS to easily ascertain what the partnership selected, without unduly burdening the partnership. In response to comments, the Treasury Department and the IRS have determined that each of these objectives can be achieved by allowing partnerships to select their method, convention, or additional extraordinary items through a dated, written statement maintained with the partnership’s books and records by the due date, including extensions, of the partnership’s tax return. The final regulations provide that such a statement would include, for example, a selection included in the partnership agreement. The final regulations also permit the selection of the method, convention, or additional extraordinary item to be made by a person authorized to make that selection (including under a grant of general authority provided for by either state law or in the partnership agreement), if that person’s selection is in a dated, written statement maintained with the partnership’s books and records by the due date, including extensions, of the partnership’s tax return. That person’s selection will be binding on the partnership and the partners. F. Interaction of Sections 706(d) and 704 The 2009 proposed regulations did not address the interaction of section 706(d) with the rules under section 704. Section 1.704–1(b)(1) generally provides that, under section 704(b), if a partnership agreement does not provide for the allocation of income, gain, loss, deduction, or credit (or item thereof) to a partner, or if the partnership agreement provides for the allocation of income, gain, loss, deduction, or credit (or item thereof) to a partner but such allocation does not have substantial economic effect, then the partner’s distributive share of such income, gain, loss, deduction, or credit (or item thereof) shall be determined in accordance with such partner’s interest in the partnership (taking into account all facts and circumstances). However, § 1.704–1(b)(1)(iii) provides that the E:\FR\FM\03AUR1.SGM 03AUR1 45876 Federal Register / Vol. 80, No. 148 / Monday, August 3, 2015 / Rules and Regulations mstockstill on DSK4VPTVN1PROD with RULES determination of a partner’s distributive share of income, gain, loss, deduction, or credit (or item thereof) under section 704(b) and the regulations thereunder is not conclusive as to the tax treatment of a partner with respect to such distributive share. Section 1.704– 1(b)(1)(iii) further provides that an allocation that is respected under section 704(b) and the regulations nevertheless may be reallocated under other provisions, such as section 706(d) (and related assignment of income principles). The Treasury Department and the IRS received several comments requesting guidance on the interaction of sections 706(d) and 704. One commenter requested clarification on the effect of a reallocation under section 706(d) on the application of provisions of section 704(b), particularly regarding the capital account maintenance provisions in § 1.704–1(b)(2)(iv). Another commenter indicated that partnership agreements are drafted to apply section 706 to section 704(b) items and allocate tax items in the same manner as the corresponding book items, subject to the application of section 704(c). This commenter asked that the final regulations address whether section 706(d) applies to the allocation of book items rather than tax items. The Treasury Department and the IRS have carefully considered the comments relating to the interaction of sections 706(d) and 704 and believe that the issues require further consideration and are generally outside the scope of these final regulations. However, the Treasury Department and the IRS may consider addressing these issues in future guidance. 2. Deemed Dispositions Proposed § 1.706–1(c)(2)(iii) provided that a deemed disposition of a partner’s interest pursuant to § 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 § 1.1502–1(h)), § 1.1362– 3(c)(1) (relating to the termination of the subchapter S election of an S corporation partner), or § 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. The preamble to the 2009 proposed regulations indicated that this treatment is solely for purposes of section 706. One commenter explained that unless the regulatory language specifically limits the disposition treatment to section 706, taxpayers could deem these transactions to be dispositions for other VerDate Sep<11>2014 16:06 Jul 31, 2015 Jkt 235001 purposes of the Code, thereby achieving unintended results. For example, the commenter stated that, unless clarified, the 2009 proposed regulations could cause unintended consequences under sections 708, 743(b), or 1001 when a member of a consolidated group sells an interest in a partnership that exits the consolidated group after the sale. Consistent with the preamble to the 2009 proposed regulations, the final regulations clarify that deemed dispositions under §§ 1.1502– 76(b)(2)(vi), 1.1362–3(c)(1), or 1.1377– 1(b)(3)(iv) are treated as a disposition of the partner’s entire interest in the partnership solely for purposes of section 706. Effective/Applicability Dates With respect to amendments to §§ 1.706–1 (with the exception of two special rules applicable to § 1.706– 1(b)(6)(iii)), 1.706–4 (with the exception of a special rule applicable to § 1.704– 4(c)(3)), and 1.706–5, these final regulations are applicable to partnership taxable years that begin on or after August 3, 2015. With respect to the final regulations contained in § 1.706–1(b)(6)(iii), the regulations apply to the partnership taxable years that begin on or after August 3, 2015, 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 § 1.706–1(b)(6) unless they have voluntarily chosen to apply them or unless they have undergone a technical termination under section 708(b)(1)(B). The final regulations retain this special rule, such that an existing partnership will not be subject to the modified minority interest rule in § 1.706–1(b)(6)(iii) unless there has been such an election or technical termination of the partnership. Second, because the final regulations modify § 1.706–1(b)(6)(iii) but otherwise leave the rules of § 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 § 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 § 1.706–1(b)(6)(iii) unless they voluntarily elect to be subject to this rule or undergo a technical termination. The final regulations under § 1.706–4 generally apply for partnership taxable years that begin on or after August 3, 2015; however, the rules of § 1.706– 4(c)(3) do not apply to existing PTPs. PO 00000 Frm 00036 Fmt 4700 Sfmt 4700 For purposes of this effective date provision, an existing PTP is a partnership described in section 7704(b) that was formed prior to April 19, 2009. For purposes of this effective date provision, the termination of a PTP under section 708(b)(1)(B) due to the sale or exchange of 50 percent or more of the total interests in partnership capital and profits is disregarded in determining whether the PTP is an existing PTP. Special Analyses It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866, as supplemented by Executive Order 13563. 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 final regulations. It is hereby certified that the collection of information in this Treasury decision will not have a significant economic impact on a substantial number of small entities within the meaning of section 601(6) of the Regulatory Flexibility Act (5 U.S.C. chapter 6). The Treasury Department and the IRS believe that the economic impact on small entities as a result of the collection of information in this Treasury decision will not be significant. The small entities subject to the collection are business entities formed as partnerships that choose to adopt the proration method, the semimonthly or monthly convention, perform semi-monthly or monthly interim closings, or to add an additional class of extraordinary item, in which case the partnership must keep a written statement with its books and records evidencing the decision or delegation. Thus, the collection only applies if the partnership does not wish to accept the default method, convention, and list of extraordinary items provided in these regulations. Furthermore, the information required to be maintained with the partnership’s books and records is simply a short statement evidencing the agreement of the partners. For these reasons, the Treasury Department and the IRS do not believe that the collection of information in this Treasury decision has a significant economic impact. Pursuant to section 7805(f) of the Code, this regulation was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business and no comments were received. E:\FR\FM\03AUR1.SGM 03AUR1 Federal Register / Vol. 80, No. 148 / Monday, August 3, 2015 / Rules and Regulations Drafting Information The principal author of these final regulations is Benjamin H. Weaver, Office of the Associate Chief Counsel (Passthroughs and Special Industries). However, other personnel from the Treasury Department and the IRS participated in their development. List of Subjects 26 CFR Part 1 Income taxes, Reporting and recordkeeping requirements. 26 CFR Part 2 Reporting and recordkeeping requirements. Amendments to the Regulations Accordingly, 26 CFR parts 1 and 602 are 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 * * * Section 1.706–4 also issued under 26 U.S.C. 706(d). * * * Par. 2. Section 1.706–0 is added to read as follows: ■ mstockstill on DSK4VPTVN1PROD with RULES § 1.706–0 Table of contents. This section lists the captions contained in the regulations under section 706. § 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 small item exception. (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. VerDate Sep<11>2014 16:06 Jul 31, 2015 Jkt 235001 (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. § 1.706–2 Certain cash basis items prorated over period to which attributable. [Reserved] § 1.706–2T Temporary regulations; question and answer under the Tax Reform Act of 1984 (temporary). § 1.706–3 Items attributable to interest in lower tier partnership prorated over entire taxable year. [Reserved] § 1.706–4 Determination of distributive share when a partner’s interest varies. (a) General rule. (1) Variations subject to this section. (2) Coordination with section 706(d)(2) and (3). (3) Allocation of items subject to this section. (4) Example. (b) Exceptions. (1) Permissible changes among contemporaneous partners. (2) Safe harbor for partnerships for which capital is not a material income-producing factor. (3) Special rules for publicly traded partnerships. (c) Conventions. PO 00000 Frm 00037 Fmt 4700 Sfmt 4700 45877 (1) In general. (i) Calendar day convention. (ii) Semi-monthly convention. (iii) Monthly convention. (2) Exceptions. (3) Permissible conventions for each variation. (4) Examples. (d)(1) Optional monthly or semimonthly closings. (2) Example. (e) Extraordinary items. (1) General principles. (2) Definition. (3) Small item exception. (4) Examples. (f) Agreement of the partners. (g) Effective/applicability date. § 1.706–5 Taxable year determination. (a) In general. (b) Effective/applicability date. ■ Par. 3. Section 1.706–1 is amended as follows: ■ a. The language ‘‘this paragraph (a)(1)’’ in the first sentence of paragraph (a)(2) is removed and the language ‘‘paragraph (a)(1) of this section’’ is added in its place. ■ b. 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. ■ c. Paragraph (b)(6)(v)(A) is revised. ■ d. The last sentence of paragraph (b)(6)(v)(B) is removed and four new sentences are added in its place. ■ e. Paragraph (b)(6)(v)(C) is revised. ■ f. Add a sentence at the end of paragraph (b)(6)(v)(D). ■ g. Paragraph (c)(2) is revised. ■ h. Paragraph (c)(3) is removed. ■ i. Paragraph (c)(4) is redesignated as paragraph (c)(3) and the last sentence of newly designated paragraph (c)(3) is removed. ■ k. New paragraph (c)(4) is added. ■ l. Paragraph (d) is revised. The revisions and additions read as follows: § 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) apply to partnership taxable years, other than those of an existing partnership, that begin on or after July 23, 2002. The provisions of paragraph (b)(6)(iii) of this section apply to partnership taxable years, other than those of an existing partnership or an interim period partnership, that begin on or after August 3, 2015. For partnership taxable years beginning on or after July 23, E:\FR\FM\03AUR1.SGM 03AUR1 mstockstill on DSK4VPTVN1PROD with RULES 45878 Federal Register / Vol. 80, No. 148 / Monday, August 3, 2015 / Rules and Regulations 2002, and before August 3, 2015, see the provisions of § 1.706–1(b)(6)(iii) as contained in the 26 CFR part 1 on July 31, 2015. For purposes of paragraph (b)(6) of this section, 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 August 3, 2015. (B) * * * An existing partnership that makes such a change prior to August 3, 2015 will generally cease to be exempted from the requirements of this paragraph (b)(6) of this section, and thus will be subject to the requirements of paragraph (b)(6) of this section, except for paragraph (b)(6)(iii) of this section— instead, such partnership will be subject to the provisions of § 1.706–1(b)(6)(iii) as contained in the 26 CFR part 1 on July 31, 2015. An existing partnership that makes such a change on or after August 3, 2015 will cease to be exempted from the requirements of this paragraph (b)(6). 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) of this section. (D) * * * If, in a partnership taxable year beginning on or after August 3, 2015, 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 § 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, liquidation, or sale or exchange of a partner’s entire interest in the partnership, the partner shall include in his taxable income for his VerDate Sep<11>2014 16:06 Jul 31, 2015 Jkt 235001 taxable year within or with which the partner’s interest 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 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 partner 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, 2015. Administration of the estate is completed and the estate, including the partnership interest, is distributed to W as legatee on November 30, 2015. 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, 2015, and H will include in his final return for his final taxable year (January 1, 2015, through March 31, 2015) his distributive share of partnership items for that period under the rules of sections 706(d)(2), 706(d)(3), and § 1.706–4. (iii) Deemed dispositions. A deemed disposition of the partner’s interest pursuant to § 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 §§ 1.1502–1(h)), 1.1362–3(c)(1) (relating to the termination of the subchapter S election of an S corporation partner), or 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 solely for purposes of section 706. * * * * * (4) Determination of distributive shares. See section 706(d)(2), 706(d)(3), and § 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 during the partnership’s taxable year 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 a PO 00000 Frm 00038 Fmt 4700 Sfmt 4700 partner’s entire interest as described in paragraph (c)(3) of this section. * * * * * (d) Effective/applicability date. (1) The rules for paragraphs (a) and (b) of this section apply for partnership taxable years ending on or after May 17, 2002, except for paragraphs (b)(5) and (6) of this section, which generally apply to partnership taxable years beginning on or after July 23, 2002 (however, see paragraphs (b)(5)(iii) and (b)(6)(v) of this section for certain exceptions to and transition relief from the applicability dates of paragraphs (b)(5) and (6) of this section). (2) 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 on or after August 3, 2015. ■ Par. 4. Add reserved § 1.706–2 with the following heading: § 1.706–2 Certain cash basis items allocable. [Reserved] Par. 5. Add reserved § 1.706–3 with the following heading: ■ § 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: ■ § 1.706–4 Determination of distributive share when a partner’s interest varies. (a) General rule—(1) Variations subject to this section. Except as provided in paragraph (a)(2) of this section, this section provides rules for determining the partners’ distributive shares of partnership items when a partner’s interest in a partnership varies during the taxable year as a result of the disposition of a partial or entire interest in a partnership as described in § 1.706– 1(c)(2) and (3), or with respect to a partner whose interest in a partnership is reduced as described in § 1.706– 1(c)(3), including by the entry of a new partner (collectively, a ‘‘variation’’). (2) Coordination with sections 706(d)(2) and 706(d)(3) and other Code sections. Items subject to allocation under other rules, including sections 108(e)(8) and 108(i) (which provide special allocation rules for certain items from the discharge or retirement of indebtedness), section 706(d)(2) (relating to the determination of partners’ distributive shares of allocable cash basis items) and section 706(d)(3) (relating to the determination of partners’ distributive share of any item of an upper tier partnership attributable to a lower tier partnership), are not E:\FR\FM\03AUR1.SGM 03AUR1 mstockstill on DSK4VPTVN1PROD with RULES Federal Register / Vol. 80, No. 148 / Monday, August 3, 2015 / Rules and Regulations subject to the rules of this section. In all cases, all partnership items for each taxable year must be allocated among the partners, and no partnership items may be duplicated, regardless of the particular provision of section 706 (or other Code section) which applies, and regardless of the method or convention adopted by the partnership. (3) Allocation of items subject to this section. In determining the distributive share under section 702(a) of partnership items subject to this section, the partnership shall follow the steps described in this paragraph (a)(3)(i) through (x). (i) First, determine whether either of the exceptions in paragraph (b) of this section (regarding certain changes among contemporaneous partners and partnerships for which capital is not a material income-producing factor) applies. (ii) Second, determine which of its items are subject to allocation under the special rules for extraordinary items in paragraph (e) of this section, and allocate those items accordingly. (iii) Third, determine with respect to each variation whether it will apply the interim closing method or the proration method. Absent an agreement of the partners (within the meaning of paragraph (f) of this section) to use the proration method, the partnership shall use the interim closing method. The partnership may use different methods (interim closing or proration) for different variations within each partnership taxable year; however, the Commissioner may place restrictions on the ability of partnerships to use different methods during the same taxable year in guidance published in the Internal Revenue Bulletin. (iv) Fourth, determine when each variation is deemed to have occurred under the partnership’s selected convention (as described in paragraph (c) of this section). (v) Fifth, determine whether there is an agreement of the partners (within the meaning of paragraph (f) of this section) to perform regular monthly or semimonthly interim closings (as described in paragraph (d) of this section). If so, then the partnership will perform an interim closing of its books at the end of each month (in the case of an agreement to perform monthly closings) or at the end and middle of each month (in the case of an agreement to perform semi-monthly closings), regardless of whether any variation occurs. Absent an agreement of the partners to perform regular monthly or semi-monthly interim closings, the only interim closings during the partnership’s taxable year will be at the deemed time of the VerDate Sep<11>2014 16:06 Jul 31, 2015 Jkt 235001 occurrence of variations for which the partnership uses the interim closing method. (vi) Sixth, determine the partnership’s segments, which are specific periods of the partnership’s taxable year created by interim closings of the partnership’s books. The first segment shall commence with the beginning of the taxable year of the partnership and shall end at the time of the first interim closing. Any additional segment shall commence immediately after the closing of the prior segment and shall end at the time of the next interim closing. However, the last segment of the partnership’s taxable year shall end no later than the close of the last day of the partnership’s taxable year. If there are no interim closings, the partnership has one segment, which corresponds to its entire taxable year. (vii) Seventh, apportion the partnership’s items for the year among its segments. The partnership shall determine the items of income, gain, loss, deduction, and credit of the partnership for each segment. In general, a partnership shall treat each segment as though the segment were a separate distributive share period. For example, a partnership may compute a capital loss for a segment of a taxable year even though the partnership has a net capital gain for the entire taxable year. For purposes of determining allocations to segments, any special limitation or requirement relating to the timing or amount of income, gain, loss, deduction, or credit applicable to the entire partnership taxable year will be applied based upon the partnership’s satisfaction of the limitation or requirement as of the end of the partnership’s taxable year. For example, the expenses related to the election to expense a section 179 asset must first be calculated (and limited if applicable) based on the partnership’s full taxable year, and then the effect of any limitation must be apportioned among the segments in accordance with the interim closing method or the proration method using any reasonable method. (viii) Eighth, determine the partnership’s proration periods, which are specific portions of a segment created by a variation for which the partnership chooses to apply the proration method. The first proration period in each segment begins at the beginning of the segment, and ends at the time of the first variation within the segment for which the partnership selects the proration method. The next proration period begins immediately after the close of the prior proration period and ends at the time of the next variation for which the partnerships PO 00000 Frm 00039 Fmt 4700 Sfmt 4700 45879 selects the proration method. However, each proration period shall end no later than the close of the segment. (ix) Ninth, prorate the items of income, gain, loss, deduction, and credit in each segment among the proration periods within the segment. (x) Tenth, determine the partners’ distributive shares of partnership items under section 702(a) by taking into account the partners’ interests in such items during each segment and proration period. (4) Example. (i) At the beginning of 2015, PRS, a calendar year partnership, has three equal partners, A, B, and C. On April 16, 2015, A sells 50% of its interest in PRS to new partner D. On August 6, 2015, B sells 50% of its interest in PRS to new partner E. During 2015, PRS earned $75,000 of ordinary income, incurred $33,000 of ordinary deductions, earned $12,000 of capital gain in the ordinary course of its business, and sustained $9,000 of capital loss in the ordinary course of its business. Within that year, PRS earned $60,000 of ordinary income, incurred $24,000 of ordinary deductions, earned $12,000 of capital gain, and sustained $6,000 of capital loss between January 1, 2015, and July 31, 2015, and PRS earned $15,000 of gross ordinary income, incurred $9,000 of gross ordinary deductions, and sustained $3,000 of capital loss between August 1, 2015, and December 31, 2015. None of PRS’s items are extraordinary items within the meaning of paragraph (e)(2) of this section. Capital is a material incomeproducing factor for PRS. For 2015, PRS determines the distributive shares of A, B, C, D, and E as follows. (i) First, PRS determines that none of the exceptions in paragraph (b) of this section apply because capital is a material-income producing factor and no variation is the result of a change in allocations among contemporaneous partners. (ii) Second, PRS determines that none of its items are extraordinary items subject to allocation under paragraph (e) of this section. (iii) Third, the partners of PRS agree (within the meaning of paragraph (f) of this section) to apply the proration method to the April 16, 2015, variation, and PRS accepts the default application of the interim closing method to the August 6, 2015, variation. (iv) Fourth, PRS determines the deemed date of the variations for purposes of this section based upon PRS’s selected convention. Because PRS applied the proration method to the April 16, 2015, variation, PRS must use the calendar day convention with respect to the April 16, 2015, variation pursuant to paragraph (c) of this section. Therefore, the variation that resulted from A’s sale to D on April 16, 2015, is deemed to occur for purposes of this section at the end of the day on April 16, 2015. Further, the partners of PRS agree (within the meaning of paragraph (f) of this section) to apply the semi-monthly convention to the August 6, 2015, variation. Therefore, the August 6, 2015, variation is deemed to occur at the end of the day on July 31, 2015. E:\FR\FM\03AUR1.SGM 03AUR1 mstockstill on DSK4VPTVN1PROD with RULES 45880 Federal Register / Vol. 80, No. 148 / Monday, August 3, 2015 / Rules and Regulations (v) Fifth, the partners of PRS do not agree to perform regular semi-monthly or monthly closings as described in paragraph (d) of this section. Therefore, PRS will have only one interim closing for 2015, occurring at the end of the day on July 31. (vi) Sixth, PRS determines that it has two segments for 2015. The first segment commences January 1, 2015, and ends at the close of the day on July 31, 2015. The second segment commences at the beginning of the day on August 1, 2015, and ends at the close of the day on December 31, 2015. (vii) Seventh, PRS determines that during the first segment of its taxable year (beginning January 1, 2015, and ending July 31, 2015), it had $60,000 of ordinary income, $24,000 of ordinary deductions, $12,000 of capital gain, and $6,000 of capital loss. PRS determines that during the second segment of its taxable year (beginning August 1, 2015, and ending December 31, 2015), it had $15,000 of gross ordinary income, $9,000 of gross ordinary deductions, and $3,000 of capital loss. (viii) Eighth, PRS determines that it has two proration periods. The first proration period begins January 1, 2015, and ends at the close of the day on April 16, 2015; the second proration period begins April 17, 2015, and ends at the close of the day on July 31, 2015. (ix) Ninth, PRS prorates its income from the first segment of its taxable year among the two proration periods. Because each proration period has 106 days, PRS allocates 50% of its items from the first segment to each proration period. Thus, each proration period contains $30,000 gross ordinary income, $12,000 gross ordinary deductions, $6,000 capital gain, and $3,000 capital loss. (x) Tenth, PRS calculates each partner’s distributive share. Because A, B, and C were equal partners during the first proration period, each is allocated one-third of the partnership’s items attributable to that proration period. Thus, A, B, and C are each allocated $10,000 gross ordinary income, $4,000 gross ordinary deductions, $2,000 capital gain, and $1,000 capital loss for the first proration period. For the second proration period, A and D each had a onesixth interest in PRS and B and C each had a one-third interest in PRS. Thus, A and D are each allocated $5,000 gross ordinary income, $2,000 gross ordinary deductions, $1,000 capital gain, and $500 capital loss, and B and C are each allocated $10,000 gross ordinary income, $4,000 gross ordinary deductions, $2,000 capital gain, and $1,000 capital loss for the second proration period. For the second segment of PRS’s taxable year, A, B, D, and E each had a one-sixth interest in PRS and C had a one-third interest in PRS. Thus, A, B, D, and E are each allocated $2,500 gross ordinary income, $1,500 gross ordinary deductions, and $500 capital loss, and C is allocated $5,000 gross ordinary income, $3,000 gross ordinary deductions, and $1,000 capital loss for the second segment. (b) Exceptions—(1) Permissible changes among contemporaneous partners. The general rule of paragraph (a)(3) of this section, with respect to the VerDate Sep<11>2014 16:06 Jul 31, 2015 Jkt 235001 varying interests of a partner described in § 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 (or among contemporaneous partners for a segment if the item is entirely attributable to a segment), 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 partnership or a distribution of money or property by the partnership to a partner; and (ii) The allocations resulting from the modification satisfy the provisions of section 704(b) and the regulations promulgated thereunder. (2) Safe harbor for partnerships for which capital is not a material incomeproducing factor. Notwithstanding paragraph (a)(3) of this section, with respect to any taxable year in which there is a change in any partner’s interest in a partnership for which capital is not a material incomeproducing factor, 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 satisfy the provisions of section 704(b). (c) Conventions—(1) In general. Conventions are rules of administrative convenience that determine when each variation is deemed to occur for purposes of this section. Because the timing of each variation is necessary to determine the partnership’s segments and proration periods, which are used to determine the partners’ distributive shares, the convention used by the partnership with respect to a variation will generally affect the allocation of partnership items. However, see paragraph (e) of this section for special rules regarding extraordinary items, which generally must be allocated without regard to the partnership’s convention. Subject to the limitations set forth in paragraphs (c)(2) and (3) of this section, partnerships may generally choose from the following three conventions: (i) Calendar day convention. Under the calendar day convention, each variation is deemed to occur for purposes of this section at the end of the day on which the variation occurs. (ii) Semi-monthly convention. Under the semi-monthly convention, each variation is deemed to occur for purposes of this section either: PO 00000 Frm 00040 Fmt 4700 Sfmt 4700 (A) In the case of a variation occurring on the 1st through the 15th day of a calendar month, at the end of the last day of the immediately preceding calendar month; or (B) In the case of a variation occurring on the 16th through the last day of a calendar month, at the end of the 15th calendar day of that month. (iii) Monthly convention. Under the monthly convention, each variation is deemed to occur for purposes of this section either: (A) In the case of a variation occurring on the 1st through the 15th day of a calendar month, at the end of the last day of the immediately preceding calendar month; or (B) In the case of a variation occurring on the 16th through the last day of a calendar month, at the end of the last day of that calendar month. (2) Exceptions. (i) Notwithstanding paragraph (c)(1) of this section, all variations within a taxable year shall be deemed to occur no earlier than the first day of the partnership’s taxable year, and no later than the close of the final day of the partnership’s taxable year. Thus, in the case of a calendar year partnership applying either the semimonthly or monthly convention to a variation occurring on January 1st through January 15th, the variation will be deemed to occur for purposes of this section at the beginning of the day on January 1st. (ii) In the case of a partner who becomes a partner during the partnership’s taxable year as a result of a variation, and ceases to be a partner as a result of another variation, if both such variations would be deemed to occur at the same time under the rules of paragraph (c)(1) of this section, then the variations with respect to that partner’s interest will instead be treated as occurring on the dates each variation actually occurred. Thus, the partnership must treat such a partner as a partner for the entire portion of its taxable year during which the partner actually owned an interest. See Example 2 of paragraph (c)(4) of this section. However, this paragraph (c)(2)(ii) does not apply to publicly traded partnerships (as defined in section 7704(b)) that are treated as partnerships with respect to holders of publicly traded units (as described in § 1.7704– 1(b) or 1.7704–1(c)(1)). (iii) Notwithstanding paragraph (c)(1)(iii) of this section, a publicly traded partnership (as defined in section 7704(b)) that is treated as a partnership may consistently treat all variations occurring during each month as occurring at the end of the last day of that calendar month if the publicly E:\FR\FM\03AUR1.SGM 03AUR1 Federal Register / Vol. 80, No. 148 / Monday, August 3, 2015 / Rules and Regulations mstockstill on DSK4VPTVN1PROD with RULES traded partnership uses the monthly convention for those variations. (3) Permissible conventions for each variation—(i) Rules applicable to all partnerships. A partnership generally shall use the calendar day convention for each variation; however, for all variations during a taxable year for which the partnership uses the interim closing method, the partnership may instead use the semi-monthly or monthly convention by agreement of the partners (within the meaning of paragraph (f) of this section). The partnership must use the same convention for all variations for which the partnership uses the interim closing method. (ii) Publicly traded partnerships. A publicly traded partnership (as defined in section 7704(b)) that is treated as a partnership may, by agreement of the partners (within the meaning of paragraph (f) of this section) use any of the calendar day, the semi-monthly, or the monthly conventions with respect to all variations during the taxable year relating to its publicly-traded units (as described in § 1.7704–1(b) or (c)(1)), regardless of whether the publicly traded partnership uses the proration method with respect to those variations. A publicly traded partnership must use the same convention for all variations during the taxable year relating to its publicly traded units. A publicly traded partnership must use the calendar day convention with respect to all variations relating to its non-publicly traded units for which the publicly traded partnership uses the proration method. (4) Examples. The following examples illustrate the principles in this paragraph (c). for both variations. If the partners of PRS agree to use the calendar day convention, the March 11 and October 21 variations will be deemed to occur for purposes of this section at the end of the day on March 11, 2015, and October 21, 2015, respectively. If the partners of PRS agree to use the semi-monthly convention, the March 11 and October 21 variations will be deemed to occur for purposes of this section at the end of the day on February 28, 2015, and October 15, 2015, respectively. If the partners of PRS agree to use the monthly convention, the March 11 and October 21 variations will be deemed to occur for purposes of this section at the end of the day on February 28, 2015, and October 31, 2015, respectively. Pursuant to paragraph (c)(3) of this section PRS must use the calendar day convention with respect to the June 12 variation; thus, the June 12 variation is deemed to occur for purposes of this section at the end of the day on June 12, 2015. Example 2. PRS is a calendar year partnership that uses the interim closing method and monthly convention to account for variations during its taxable year. PRS is not a publicly traded partnership. On January 20, 2015, new partner A purchases an interest in PRS from one of PRS’s existing partners. On February 14, 2015, A sells its entire interest in PRS. These transfers do not result in a termination of PRS under section 708. Under the rules of paragraph (c)(1)(iii) of this section, the January 20, 2015, variation and the February 14, 2015, variation would both be deemed to occur at the same time: the end of the day on January 31, 2015. Therefore, under the exception in paragraph (c)(2)(ii) of this section, the rules of paragraph (c)(1) of this section do not apply, and instead the January 20, 2015, variation and the February 14 variation are considered to occur on January 20, 2015, and February 14, 2015, respectively. PRS must perform a closing of the books on both January 20, 2015, and February 14, 2015, and allocate A a share of PRS’s items attributable to that segment. Example 1. PRS is a calendar year partnership with four equal partners A, B, C, and D. PRS is not a publicly traded partnership. PRS has the following three variations that occur during its 2015 taxable year: on March 11, A sells its entire interest in PRS to new partner E; on June 12, PRS partially redeems B’s interest in PRS with a distribution comprising a partial return of B’s capital; on October 21, C sells part of C’s interest in PRS to new partner E. These transfers do not result in a termination of PRS under section 708. Pursuant to paragraph (a)(3)(iii) of this section, the partners of PRS agree (within the meaning of paragraph (f) of this section) to use the interim closing method with respect to the variations occurring on March 11 and October 21 and agree to use the proration method with respect to the variation occurring on June 12. Pursuant to paragraph (c)(3) of this section, the partners of PRS may agree (within the meaning of paragraph (f) of this section) to use any of the calendar day, semi-monthly, or monthly conventions with respect to the March 11 and October 21 variations, but must use the same convention (d)(1) Optional regular monthly or semi-monthly interim closings. Under the rules of this section, a partnership is not required to perform an interim closing of its books except at the time of any variation for which the partnership uses the interim closing method (taking into account the applicable convention). However, a partnership may, by agreement of the partners (within the meaning of paragraph (f) of this section) perform regular monthly or semi-monthly interim closings of its books, regardless of whether any variation occurs. Regardless of whether the partners agree to perform these regular interim closings, the partnership must continue to apply the interim closing or proration method to its variations according to the rules of this section. (2) Example. The following example illustrates the principles in this paragraph (d). VerDate Sep<11>2014 16:06 Jul 31, 2015 Jkt 235001 PO 00000 Frm 00041 Fmt 4700 Sfmt 4700 45881 Example. (i) PRS is a calendar year partnership with five equal partners A, B, C, D, and E. PRS has the following two variations that occur during its 2015 taxable year: on August 29, A sells its entire interest in PRS to new partner F; on December 27, PRS completely liquidates B’s interest in PRS with a distribution. These variations do not result in a termination of PRS under section 708. (ii) The partners of PRS agree (within the meaning of paragraph (f) of this section) to use the interim closing method and the semimonthly convention with respect to the variation occurring on August 29. Thus, the August variation is deemed to occur for purposes of this section at the end of the day on August 15, 2015. The partners of PRS agree (within the meaning of paragraph (f) of this section) to use the proration method with respect to the December 27 variation. Therefore, PRS must use the calendar day convention with respect to the December variation pursuant to paragraph (c) of this section. Thus, the December variation is deemed to occur for purposes of this section at the end of the day on December 27, 2015. (iii) Pursuant to paragraph (d)(1) of this section, the partners of PRS agree (within the meaning of paragraph (f) of this section) to perform regular monthly interim closings. Therefore, PRS will have twelve interim closings for its 2015 taxable year, one at the end of every month and one at the end of the day on August 15. Therefore, PRS will have thirteen segments for 2015, one corresponding to each month from January through July, one segment from August 1 through August 15, one segment from August 16 through August 31, and one corresponding to each month from September through December. PRS must apportion its items among these segments under the rules of paragraph (a)(3) of this section. (iv) PRS will have two proration periods for 2015, one from December 1 through December 27, and one from December 28 through December 31. Pursuant to the rules of paragraph (a)(3) of this section, PRS will prorate the items in its December segment among these two proration periods. Therefore, PRS will apportion 27/31 of all items in its December segment to the proration period from December 1 through December 27, and 4/31 of all items in its December segment to the proration period from December 28 through December 31. (v) Pursuant to the rules of paragraph (a)(3)(x) of this section, PRS determines the partners’ distributive shares of partnership items under section 702(a) by taking into account the partners’ interests in such items during each of the thirteen segments and two proration periods. Thus, A, B, C, D, and E will each be allocated one-fifth of all items in the following segments: January, February, March, April, May, June, July, and August 1 through August 15. B, C, D, E, and F will each be allocated one-fifth of all items in the following segments: August 16 through August 31, September, October, and November. B, C, D, E, and F will each be allocated one-fifth of all items in the proration period from December 1 through December 27. C, D, E, and F will each be E:\FR\FM\03AUR1.SGM 03AUR1 45882 Federal Register / Vol. 80, No. 148 / Monday, August 3, 2015 / Rules and Regulations mstockstill on DSK4VPTVN1PROD with RULES allocated one-quarter of all items in the proration period from December 28 through December 31. (e) Extraordinary items—(1) General principles. Extraordinary items may not be prorated. The partnership must allocate extraordinary items among the partners in proportion to their interests in the partnership item at the time of day on which the extraordinary item occurred, regardless of the method (interim closing or proration method) and convention (daily, semi-monthly, or monthly) otherwise used by the partnership. These rules require the allocation of extraordinary items as an exception to the proration method, which would otherwise ratably allocate the extraordinary items across the segment, and the conventions, which could otherwise inappropriately shift extraordinary items between a transferor and transferee. However, publicly traded partnerships (as defined in section 7704(b)) that are treated as partnerships may, but are not required to, apply their selected convention in determining who held publicly traded units (as described in § 1.7704–1(b) or (c)(1)) at the time of the occurrence of an extraordinary item. Extraordinary items continue to be subject to any special limitation or requirement relating to the timing or amount of income, gain, loss, deduction, or credit applicable to the entire partnership taxable year (for example, the limitation for section 179 expenses). (2) Definition. Except as provided in paragraph (e)(3) of this section, 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 (other than in the ordinary course of business) of property used in a trade or 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(a)(1), (a)(3), (a)(4), or (a)(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 item resulting from any change in accounting method initiated by the filing of the appropriate form after a variation occurs; VerDate Sep<11>2014 16:06 Jul 31, 2015 Jkt 235001 (vi) Any item from the discharge or retirement of indebtedness (except items subject to section 108(e)(8) or 108(i), which are subject to special allocation rules provided in section 108(e)(8) and 108(i)); (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); (ix) For all partnerships, any additional item if, the partners agree (within the meaning of paragraph (f) of this section) to consistently treat such item as an extraordinary item for that taxable year; however, this rule does not apply if treating that additional item as an extraordinary item would result in a substantial distortion of income in any partner’s return; any additional extraordinary items continue to be subject to any special limitation or requirement relating to the timing or amount of income, gain, loss, deduction, or credit applicable to the entire partnership taxable year (for example, the limitation for section 179 expenses); (x) 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; (xi) Any item identified as an additional class of extraordinary item in guidance published in the Internal Revenue Bulletin. (3) Small item exception. A partnership may treat an item described in paragraph (e)(2) of this section as other than an extraordinary item for purposes of this paragraph (e) if, for the partnership’s taxable year the total of all items in the particular class of extraordinary items (as enumerated in paragraphs (e)(2)(i) through (xi) of this section, for example, all tort or similar liabilities, but in no event counting an extraordinary item more than once) is less than five percent of the partnership’s gross income, including tax-exempt income described in section 705(a)(1)(B), in the case of income or gain items, or gross expenses and losses, including section 705(a)(2)(B) expenditures, in the case of losses and expense items; and the total amount of the extraordinary items from all classes of extraordinary items amounting to less than five percent of the partnership’s gross income, including tax-exempt income described in section 705(a)(1)(B), in the case of income or gain items, or gross expenses and losses, including section 705(a)(2)(B) expenditures, in the case of losses and PO 00000 Frm 00042 Fmt 4700 Sfmt 4700 expense items, does not exceed $10 million in the taxable year, determined by treating all such extraordinary items as positive amounts. (4) Examples. The following examples illustrate the provisions of this paragraph (e). Example 1. PRS, a calendar year partnership, uses the proration method and calendar day convention to account for varying interests of the partners. At 3:15 p.m. on December 7, 2015, PRS recognizes an extraordinary item within the meaning of paragraph (e)(2) of this section. On December 12, 2015, A, a partner in PRS, disposes of its entire interest in PRS. PRS does not experience a termination under section 708 during 2015. PRS has no other extraordinary items for the taxable year, the small item exception of paragraph (e)(3) of this section does not apply, the exceptions in paragraph (b) of this section do not apply, and PRS is not a publicly traded partnership. Pursuant to paragraph (e)(1) of this section, the item of income, gain, loss, deduction, or credit attributable to the extraordinary item will be allocated in accordance with the partners’ interests in the extraordinary item at 3:15 p.m. on December 7, 2015. The remaining partnership items of PRS that are subject to this section must be prorated across the partnership’s taxable year in accordance with paragraph (a)(3) of this section. Example 2. Assume the same facts as in Example 1, except that PRS uses the interim closing method and monthly convention to account for varying interests of the partners. Pursuant to paragraph (c)(1)(iii) of this section, the December 12 variation is deemed to have occurred for purposes of this section at the end of the day on November 30, 2015. Thus, A will not generally be allocated any items of PRS attributable to the segment between December 1, 2015, and December 31, 2015; however, pursuant to paragraph (e)(1) of this section, PRS must allocate the item of income, gain, loss, deduction, or credit attributable to the extraordinary item in accordance with the partners’ interests in the extraordinary item at the time of day on which the extraordinary item occurred, regardless of the convention used by PRS. Thus, because A was a partner in PRS at 3:15 p.m. on December 7, 2015 (ignoring application of PRS’s convention), A must be allocated a share of the extraordinary item. Example 3. Assume the same facts as in Example 2, except that PRS is a publicly traded partnership (within the meaning of section 7704(b)) and A held a publicly traded unit (as described in § 1.7704–1(b) or 1.7704– 1(c)(1)) in PRS. Under PRS’s monthly convention, the December 12 variation is deemed to have occurred for purposes of this section at the end of the day on November 30, 2015. Pursuant to paragraph (e)(1) of this section, a publicly traded partnership (as defined in section 7704(b)) may choose to respect its conventions in determining who held its publicly traded units (as described in § 1.7704–1(b) or § 1.7704–1(c)(1)) at the time of the occurrence of an extraordinary item. Therefore, PRS may choose to treat A as not having been a partner in PRS for purposes of this paragraph (e) at the time the E:\FR\FM\03AUR1.SGM 03AUR1 45883 mstockstill on DSK4VPTVN1PROD with RULES Federal Register / Vol. 80, No. 148 / Monday, August 3, 2015 / Rules and Regulations extraordinary item arose, and thus PRS may choose not to allocate A any share of the extraordinary item. Example 4. A and B each own a 15 percent interest in PRS, a partnership that is not a publicly traded partnership and for which capital is a material income-producing factor. At 9:00 a.m. on April 25, 2015, A sells its entire interest in PRS to new partner D. At 3:00 p.m. on April 25, 2015, PRS incurs an extraordinary item (within the meaning of paragraph (e)(2) of this section). At 5:00 p.m. on April 25, 2015, B sells its entire interest in PRS to new partner E. Under paragraph (e)(1) of this section, PRS must allocate the extraordinary item in accordance with the partners’ interests at 3:00 p.m. on April 25, 2015. Accordingly, a portion of the extraordinary item will be allocated to each of B and D, but no portion will be allocated to A or E. Example 5. PRS, a calendar year partnership that is not a publicly traded partnership, has a variation in a partner’s interest during 2015 and the exceptions in paragraph (b) of this section do not apply. During 2015 PRS has two extraordinary items: PRS recognizes $8 million of gross income on the sale outside the ordinary course of business of an asset described in paragraph (e)(2)(ii) of this section, and PRS also recognizes $12 million of gross income from a tort settlement as described in paragraph (e)(2)(vii) of this section. PRS’s gross income (including the gross income from the extraordinary items) for the taxable year is $200 million. The gain from all items described in paragraph (e)(2)(ii) of this section is less than five percent of PRS’s gross income ($8 million gross income from the asset sale divided by $200 million total gross income, or four percent) and all of the extraordinary items of PRS from classes that are less than five percent of PRS’s gross income ($8 million), in the aggregate, do not exceed $10 million for the taxable year. Thus, the $8 million gain recognized on the asset sale is considered a small item under paragraph (e)(3) of this section and is therefore excepted from the rules of paragraph (e)(1) of this section. Because the gross income attributable to the tort settlement exceeds five percent of PRS’s gross income (six percent), the tort settlement gross income is not considered a small item under paragraph (e)(3) of this section. Therefore, the $12 million gross income attributable to the tort settlement must be allocated according to the rules of paragraph (e)(1) of this section in accordance with PRS’s partners’ interests in the item at the time of the day that the tort settlement income arose. Example 6. Assume the same facts as Example 5, except that during the year, PRS also recognizes two additional extraordinary items: $2 million of gross income from the sale of a capital asset described in paragraph (e)(2)(i) of this section, and $1 million of gross income from discharge of indebtedness described in paragraph (e)(2)(vi) of this section. Although the gain from items described in each of paragraphs (e)(2)(i), (e)(2)(ii), and (e)(2)(vi) of this section is each less than five percent of PRS’s gross income, the extraordinary items of PRS from classes VerDate Sep<11>2014 16:06 Jul 31, 2015 Jkt 235001 that are less than five percent of PRS’s gross income ($11 million), in the aggregate, exceeds $10 million for the taxable year. Thus, none of the items are considered a small item under paragraph (e)(3) of this section. Therefore, the items attributable to the sale of the capital asset, the sale of the trade or business asset, the discharge of indebtedness income, and the tort settlement must each be allocated according to the rules of paragraph (e)(1) of this section in accordance with PRS’s partners’ interests in the item at the time of the day that the items arose. (f) Agreement of the partners. For purposes of paragraphs (a)(3)(iii) (relating to selection of the proration method), (c)(3) (relating to selection of the semi-monthly or monthly convention), (d) (relating to performance of regular monthly or semi-monthly interim closings), and (e)(2)(ix) (relating to selection of additional extraordinary items) of this section, the term agreement of the partners means either an agreement of all the partners to select the method, convention, or extraordinary item in a dated, written statement maintained with the partnership’s books and records, including, for example, a selection that is included in the partnership agreement, or a selection of the method, convention, or extraordinary item made by a person authorized to make that selection, including under a grant of general authority provided for by either state law or in the partnership agreement, if that person’s selection is in a dated, written statement maintained with the partnership’s books and records. In either case, the dated written agreement must be maintained with the partnership’s books and records by the due date, including extension, of the partnership’s tax return. (g) Effective/applicability date. Except with respect to paragraph (c)(3) of this section, this section applies for partnership taxable years that begin on or after August 3, 2015. The rules of paragraph (c)(3) of this section apply for taxable years of partnerships other than existing publicly traded partnerships that begin on or after August 3, 2015. For purposes of the immediately preceding sentence, an existing publicly traded partnership is a partnership described in section 7704(b) that was formed prior to April 19, 2009. For purposes of this effective date provision, the termination of a publicly traded partnership under section 708(b)(1)(B) due to the sale or exchange of 50 percent or more of the total interests in partnership capital and profits is disregarded in determining whether the publicly traded partnership is an existing publicly traded partnership. PO 00000 Frm 00043 Fmt 4700 Sfmt 4700 Par. 7. Section 1.706–5 is added to read as follows: ■ § 1.706–5 Taxable year determination. (a) In general. For purposes of § 1.706–4, the taxable year of a partnership shall be determined without regard to section 706(c)(2)(A) and its regulations. (b) Effective/applicability date. This section applies for partnership taxable years that begin on or after August 3, 2015. PART 602—OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT Par. 8. The authority for part 602 continues to read as follows: ■ Authority: 26 U.S.C. 7805. * * * Par. 9. In § 602.101, paragraph (b) is amended by adding the following entry in numerical order to the table to read as follows: ■ § 602.101 * OMB Control numbers. * * (b) * * * * * CFR Part or section where identified and described * * * 1.706–4(f) ............................. * * * Current OMB control no. * * 1545–0123 * * Karen L. Schiller, Acting Deputy Commissioner for Services and Enforcement. Approved: June 3, 2015. Mark J. Mazur, Assistant Secretary of the Treasury (Tax Policy). [FR Doc. 2015–18816 Filed 7–31–15; 8:45 am] BILLING CODE 4830–01–P DEPARTMENT OF JUSTICE Bureau of Prisons 28 CFR Part 553 [Docket No. BOP–1163] RIN 1120–AB63 Contraband and Inmate Personal Property: Technical Amendment Bureau of Prisons, Justice. Interim rule. AGENCY: ACTION: In this document, the Bureau of Prisons makes a minor technical amendment to its regulations on contraband and inmate personal SUMMARY: E:\FR\FM\03AUR1.SGM 03AUR1

Agencies

[Federal Register Volume 80, Number 148 (Monday, August 3, 2015)]
[Rules and Regulations]
[Pages 45865-45883]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2015-18816]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 9728]
RIN 1545-BD71


Determination of Distributive Share When Partner's Interest 
Changes

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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

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

DATES: Effective date: These regulations are effective on August 3, 
2015.
    Applicability date: For dates of applicability, see Sec. Sec.  
1.706-1(b)(6)(v), 1.706-1(d), 1.706-4(g), and 1.706-5(b).

FOR FURTHER INFORMATION CONTACT: Benjamin H. Weaver of the Office of 
Associate Chief Counsel (Passthroughs and Special Industries) at (202) 
317-6850 (not a toll-free number).

SUPPLEMENTARY INFORMATION: 

Paperwork Reduction Act

    The collection of information contained in this Treasury decision 
has been submitted to the OMB for review in accordance with the 
Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)). Comments on the 
collection of information should be sent to the Office of Management 
and Budget, Attn: Desk Officer for the Department of the Treasury, 
Office of Information and Regulatory Affairs, Washington, DC 20503, 
with copies to the Internal Revenue Service, Attn: IRS Reports 
Clearance Officer, SE:W:CAR:MP:T:T:SP, Washington, DC 20224. Comments 
on the collection of information should be received by October 2, 2015. 
Comments are specifically requested concerning:
    Whether the proposed collection of information is necessary for the 
proper performance of the functions of the IRS, including whether the 
information will have practical utility;
    The accuracy of the estimated burden associated with the proposed 
collection of information; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of services to provide information.
    The collections of information in the final regulations are in 
Sec.  1.706-4(f), which requires partnerships adopting the proration 
method, adopting the semi-monthly or monthly convention, choosing to 
perform semi-monthly or monthly interim closings, or selecting an 
additional class of extraordinary items, to maintain a statement with 
their books and records. This information will be available to the IRS 
upon examination to document the partnership's selection of the method, 
convention, optional interim closings, or additional class of 
extraordinary items. The collections of information are required to 
obtain a benefit. The likely respondents are partnerships. The 
collections will be reported and collected through the OMB approval 
number for Form 1065, U.S. Return of Partnership Income, under control 
number 1545-0123; please see the instructions for Form 1065 for 
estimates of the burden associated with the collection of information.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the OMB.
    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,

[[Page 45866]]

tax returns and tax return information are confidential, as required by 
section 6103.

Background

    These final regulations contain amendments to the Income Tax 
Regulations (26 CFR part 1) under section 706 of the Internal Revenue 
Code (Code). On April 14, 2009, the Treasury Department and the IRS 
published a notice of proposed rulemaking (REG-144689-04) (the 2009 
proposed regulations) in the Federal Register to provide guidance under 
section 706(d)(1) and to conform the Income Tax Regulations for certain 
provisions of section 1246 of the Taxpayer Relief Act of 1997, Public 
Law 105-34 (111 Stat. 788 (1997)), and section 72 of the Deficit 
Reduction Act of 1984, Public Law 98-369 (98 Stat. 494 (1984)). The 
Treasury Department and the IRS did not hold a public hearing because 
there were no requests to speak at a hearing. However, the Treasury 
Department and the IRS received comments in response to the 2009 
proposed regulations. The comments are discussed in this preamble.
    The 2009 proposed regulations provided methods for determining 
partners' distributive shares of partnership items in any year in which 
there is a change in a partner's interest in the partnership, whether 
by reason of a disposition of the partner's entire interest or less 
than the partner's entire interest, or by reason of a reduction of a 
partner's interest due to the entry of a new partner or partners. The 
2009 proposed regulations also added proposed Sec.  1.706-1(c)(2)(iii) 
to provide that a deemed disposition of a 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), 
or 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. Finally, the 2009 
proposed regulations amended the rules applicable to the determination 
of the taxable year of a partnership when a partnership interest is 
held by a ``disregarded foreign partner'' (as defined in Sec.  1.706-
1(b)(6)(i)).
    After consideration of the comments, the 2009 proposed regulations 
are adopted as modified by this Treasury decision.

Explanation of Provisions and Summary of Comments

1. Varying Interests Rule

    The 2009 proposed regulations under Sec.  1.706-4 provided guidance 
under section 706(d)(1), which provides that, except as required by 
section 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 2009 proposed regulations 
incorporated several of the existing varying interest rules in the 
regulations under section 706. These final regulations finalize the 
varying interest rules contained in the 2009 proposed regulations with 
the modifications described in this Part 1 of the preamble. The 
Treasury Department and the IRS have decided that these modifications 
necessitate reorganizing Sec.  1.706-4 for clarity. As finalized by 
these regulations, Sec.  1.706-4(a)(3) now contains a step-by-step 
process for making allocations under Sec.  1.706-4. In addition, the 
remainder of Sec.  1.706-4 has been reorganized into discrete sections 
addressing the scope of Sec.  1.706-4, exceptions to Sec.  1.706-4, 
partnership conventions, extraordinary items, and procedures for 
partnership decisions relating to Sec.  1.706-4. Where possible, this 
preamble tracks the organization of Sec.  1.706-4 as finalized by these 
regulations.
A. Scope of Sec.  1.706-4
    Section 1.706-4 of the final regulations provides rules for 
determining the partners' distributive shares of partnership items when 
a partner's interest in a partnership varies during the taxable year as 
a result of the disposition of a partial or entire interest in a 
partnership as described in Sec.  1.706-1(c)(2) and (c)(3), or with 
respect to a partner whose interest in a partnership is reduced as 
described in Sec.  1.706-1(c)(3), including by the entry of a new 
partner (collectively, a ``variation''). The final regulations further 
provide that, in all cases, all partnership items for each taxable year 
must be allocated among the partners, and no items may be duplicated, 
regardless of the particular provision of section 706 which applies, 
and regardless of the method or convention adopted by the partnership.
    The 2009 proposed regulations contained two exceptions for 
allocations that would otherwise be subject to the rules of Sec.  
1.706-4: one exception applies to certain partnerships with 
contemporaneous partners, and the other exception applies to certain 
service partnerships. As described below, the final regulations adopt 
these exceptions with certain modifications.
    The 2009 proposed regulations did not address the interaction of 
the allocable cash basis item rules of section 706(d)(2) and the tiered 
partnership rules of section 706(d)(3) with the rules in Sec.  1.706-4 
for determining a partner's distributive share when a partner's 
interest varies. However, the 2009 proposed regulations did request 
comments on issues that arise with regard to allocable cash basis items 
and tiered partnerships. In response to comments received, Sec. Sec.  
1.706-2 and 1.706-3 are proposed to be amended as described in a notice 
of proposed rulemaking issued contemporaneously with these final 
regulations to address the treatment of allocable cash basis items and 
tiered partnerships, respectively. The final regulations clarify that 
Sec.  1.706-4 does not apply to items subject to allocation under other 
rules, including section 706(d)(2) and section 706(d)(3).
i. Permissible Changes Among Contemporaneous Partners
    The 2009 proposed regulations contained a ``contemporaneous partner 
exception'' based on the Tax Court's opinion in Lipke v. Commissioner, 
81 T.C. 689 (1983), and the legislative history of section 706. 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, the Tax Court held that section 
706(c)(2)(B) (as in effect prior to 1984) prohibited retroactive 
allocations of partnership losses when 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 that were members of the 
partnership for the entire year (contemporaneous partners) if the 
changes in the allocations did not result from capital contributions. 
Congress amended section 706 in 1984, 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 replaced the varying

[[Page 45867]]

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).
    Consistent with this authority, proposed Sec.  1.706-4(b)(1) 
provided an exception to the rule in proposed Sec.  1.706-4(a)(1) for 
dispositions of less than a partner's entire interest in the 
partnership described in Sec.  1.706-1(c)(3), provided that the 
variation in the partner's interest is not attributable to a capital 
contribution or a partnership distribution to a partner that is a 
return of capital, and the allocations resulting from the modification 
otherwise comply with section 704(b) and the regulations promulgated 
thereunder.
    Commenters requested guidance on determining when changes in the 
allocations among partners are attributable to capital contributions 
to, and distributions from, the partnership, and which requirements of 
section 704(b) must be met. The final regulations do not address the 
determination of whether an amended allocation is attributable to a 
contribution or a distribution to a partner or whether such allocations 
otherwise satisfy section 704(b) because these comments raise issues 
beyond the scope of this project and require further consideration. 
However, the Treasury Department and the IRS may address these issues 
in future guidance.
    Commenters also requested that the final regulations expand the 
scope of the contemporaneous partner exception to include allocations 
of items attributable solely to a particular segment of a partnership's 
year (see Sec.  1.706-4(a)) among partners who are partners of the 
partnership for that entire segment. The final regulations adopt this 
recommendation and finalize the contemporaneous partner exception.
ii. Safe Harbor for Partnerships for Which Capital Is Not a Material 
Income-Producing Factor
    Proposed Sec.  1.706-4(b)(2) provided that a service partnership (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) may choose 
to determine the partners' distributive shares of partnership income, 
gain, loss, deduction, and credit using any reasonable method, provided 
that the allocations were valid under section 704(b). Commenters 
recommended the final regulations extend the safe harbor to non-service 
partnerships that satisfy specific revenue and allocation thresholds 
(for example, gross receipts of $100 million or less and no partner 
receives an allocation of an item listed under section 702(a) in excess 
of $10 million). Another commenter requested that the final regulations 
provide that the list of service partnerships could be expanded by 
other published guidance.
    The Treasury Department and the IRS intend the safe harbor for 
service partnerships to be limited to partnerships that derive their 
income from the provision of services and not from capital because, in 
general, allocations among individual partners in partnerships for 
which capital is not a material income-producing factor do not raise 
concerns that may be present in allocations among partners in capital-
intensive partnerships. Therefore the final regulations do not provide 
an exception based upon revenue and allocation thresholds. However, the 
Treasury Department and the IRS agree that the definition of a service 
partnership in the proposed regulations was overly narrow. Accordingly, 
the final regulations apply the service partnership safe harbor to any 
partnership for which capital is not a material income-producing 
factor.
B. Varying Interest Rule Methods: Interim Closing and Proration
    The 2009 proposed regulations generally provided that a partnership 
shall take into account any variation in the partners' interests in the 
partnership during the taxable year in determining the distributive 
share of partnership items under section 702(a) by using either the 
interim closing method or the proration method. Unless the partners 
agree to use the proration method, the partnership was required to use 
the interim closing method and allocate its items among the partners in 
accordance with their respective partnership interests during each 
segment of the taxable year. Under the 2009 proposed regulations, if 
the partners agreed to use the proration method, the partnership was 
required to allocate the distributive share of partnership items among 
the partners in accordance with their pro rata shares of the items for 
the entire taxable year. The 2009 proposed regulations did not, 
however, allow certain ``extraordinary items'' to be prorated, and 
instead required that those items be allocated according to special 
rules. These regulations finalize the method rules of the 2009 proposed 
regulations with certain modifications.
i . Use of More Than One Method and Convention During the Same Taxable 
Year
    Proposed Sec.  1.706-4(a)(1) required the partnership and all of 
its partners to use the same method for all variations in the partners' 
interests occurring within the partnership's taxable year, whether 
resulting from a complete or partial termination of a partner's 
interest or the entry of a new partner. Commenters recommended that the 
final regulations allow a partnership to use different methods for 
separate variations during the partnership's taxable year, provided 
that the overall combination of methods is reasonable based on the 
overall facts and circumstances. Commenters stated that it would be 
reasonable for a partnership to be allowed to apply the interim closing 
method to a transfer of a large interest in the partnership, where the 
partnership or transferee or transferor partner is willing to pay for 
the additional accounting costs associated with the interim closing 
method, and in the same year apply the proration method for transfers 
of small interests (or other large transfers of interests if, for 
example, the parties are unwilling to bear the costs of closing the 
books), in order to minimize the costs and administrative burden of 
accounting for such transfers. The Treasury Department and the IRS 
agree that partnerships may be more willing to use the interim closing 
method, which is generally more accurate but more costly, for 
significant variations if doing so would not require the partnership to 
use the interim closing method for all variations, regardless of size, 
that occur throughout the year. Therefore, in response to comments, the 
final regulations allow a partnership to use different methods for 
different variations within the partnership's taxable year, as 
explained in Part 1.B.iii of this Preamble. Accordingly, a partnership 
may use the interim closing method with respect to one variation and 
may choose to use the proration method for another variation in the

[[Page 45868]]

same year. However, the final regulations provide that the Commissioner 
may place restrictions on the ability of a partnership to use different 
methods during the same taxable year in guidance published in the 
Internal Revenue Bulletin.
ii. Optional Regular Monthly or Semi-Monthly Interim Closings
    The 2009 proposed regulations require partnerships applying the 
interim closing method to perform the interim closing at the time the 
variation is deemed to occur, and do not require or permit a 
partnership to perform an interim closings of its books except at the 
time of any variation for which the partnership uses the interim 
closing method. One commenter stated that of the partnerships that 
close their books at times other than year end, most do so at month 
end, and some close their books semi-monthly. The commenter stated that 
most partnerships that currently are subject to the interim closing 
method do not actually close their books other than at month end as 
they do not have the resources and systems organized in order to do 
that. The commenter requested that partnerships using the interim 
closing method and the calendar day convention be allowed under the 
final regulations to determine income on a calendar day basis by 
closing their books at month's end, and then prorating the last month's 
income to the periods of the month before and after the calendar day on 
which the variation occurred.
    The Treasury Department and the IRS agree that partnerships should 
be permitted to perform regular monthly or semi-monthly interim 
closings, and to prorate items within each month or semi-month, as 
applicable. Therefore, the final regulations provide that a partnership 
may, by agreement of the partners, perform regular interim closings of 
its books on a monthly or semi-monthly basis, regardless of whether any 
variation occurs. The Treasury Department and the IRS believe that this 
combination of the use of regular interim closings and the proration 
method with respect to variations should generally achieve the results 
sought by the commenter. The final regulations continue to require a 
partnership using the interim closing method with respect to a 
variation to perform the interim closing at the time the variation is 
deemed to occur, and do not require a partnership to perform an interim 
closings of its books except at the time of any variation for which the 
partnership uses the interim closing method.
    The final regulations provide guidance on the meaning of the term 
``agreement of the partners,'' including for purposes of the decision 
to perform regular monthly or semi-monthly interim closings. Because 
that term applies to several different decisions in Sec.  1.706-4, the 
discussion of ``agreement of the partners'' is consolidated into Part 
1.E of this preamble.
iii. Segments and Proration Periods
    For purposes of accounting for the partners' varying interests in 
the partnership, the 2009 proposed regulations required the partnership 
to maintain, for each partner whose interest changes in the taxable 
year, segments to account for such changes. Under the 2009 proposed 
regulations, a segment was a specific portion of a partnership's 
taxable year created by a variation, regardless of whether the 
partnership used the interim closing method or the proration method for 
that variation. The final regulations continue to rely on the concept 
of segments; however, because the final regulations now permit 
partnerships to use both the interim closing method and the proration 
method in the same taxable year, the final regulations also contain a 
new concept of proration periods. Under the final regulations, segments 
are specific periods of the partnership's taxable year created by 
interim closings of the partnership's books, and proration periods are 
specific portions of a segment created by a variation for which the 
partnership chooses to apply the proration method. The partnership must 
divide its year into segments and proration periods, and spread its 
income among the segments and proration periods according to the rules 
for the interim closing method and proration method, respectively.
    Under the final regulations, the first segment commences with the 
beginning of the taxable year of the partnership and ends at the time 
of the first interim closing of the partnership's books. Any additional 
segment shall commence immediately after the closing of the prior 
segment and ends at the time of the next interim closing. However, the 
last segment of the partnership's taxable year ends no later than the 
close of the last day of the partnership's taxable year. If there are 
no interim closings, the partnership has one segment, which corresponds 
to its entire taxable year.
    Under the final regulations, the first proration period in each 
segment begins at the beginning of the segment, and ends at the time of 
a variation for which the partnership uses the proration method. The 
next proration period begins immediately after the close of the prior 
proration period and ends at the time of the next variation for which 
the partnerships uses the proration method. However, each proration 
period ends no later than the close of the segment. Thus, segments 
close proration periods. Therefore, the only items subject to proration 
are the partnership's items attributable to the segment containing the 
proration period.
a. Rules for Determining the Items in Each Segment
    Proposed Sec.  1.706-4(a)(2)(i) required that a partnership using 
the interim closing method treat each segment as though the segment was 
a separate distributive share period and that therefore a partnership 
using the interim closing method may compute a capital loss for a 
segment of a taxable year even though the partnership has a net capital 
gain for the entire taxable year. Similarly, proposed Sec.  1.706-
4(a)(2)(ii) provided that 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 
apportioned among the segments using any reasonable method, provided 
that the total amount of the items apportioned among the segments does 
not exceed the limitation applicable to the partnership year as a 
whole.
    Commenters expressed concern that the examples do not clarify how a 
partnership accounts for items that are not determined until the end of 
the taxable year, such as waterfall allocations, minimum gain 
chargebacks, and certain reserves. Commenters specifically inquired 
whether these determinations are made at the interim closing dates or 
at the end of the partnership's taxable year. Other commenters 
questioned whether the distributive share periods are treated as 
separate taxable years for purposes of sections 461(h) (relating to 
economic performance) and 404(a)(5) (relating to deductions for 
contributions to employee plans). Finally, other commenters requested 
guidance on the interaction of sections 168 (relating to the modified 
accelerated cost recovery system) and 471 (relating to accounting for 
inventories) with the 2009 proposed regulations.
    Proposed Sec.  1.706-4(a)(2)(i) and (ii) were intended to 
demonstrate that year-end determinations and annual limitations are 
evaluated only at the end of the partnership's taxable year. The final 
regulations continue to provide that each segment is generally treated 
as a separate distributive share period. Additionally, the final 
regulations

[[Page 45869]]

provide that for purposes of determining allocations to segments, any 
special limitation or requirement relating to the timing or amount of 
income, gain, loss, deduction, or credit applicable to the entire 
partnership taxable year will be applied based on the partnership's 
satisfaction of the limitation or requirements as of the end of the 
partnership's taxable year. For example, the expenses related to the 
election to expense a section 179 asset must first be calculated (and 
limited if applicable) based on the partnership's full taxable year, 
and then the effect of any limitation must be apportioned among the 
segments in accordance with the interim closing method or the proration 
method using any reasonable method. Thus, the segments are not treated 
as separate taxable years for purposes of sections 461(h) and 
404(a)(5). The final regulations do not address inventory accounting 
under section 471 because those issues are beyond the scope of this 
project.
    Moreover, other provisions of the Code providing a convention for 
making a particular determination still apply. For example, section 168 
provides conventions for determining when property is placed in service 
and when property is disposed of. The convention in section 168 would 
apply first to determine when the property is placed in service or when 
the property is disposed of, and section 706 would apply second to 
determine who was a partner during that segment. The Treasury 
Department and the IRS are studying issues relating to the interaction 
of section 706 and the partnership minimum gain provisions in Sec.  
1.704-2 and therefore the final regulations do not address these 
issues. As discussed in Part 1.F of this preamble, the interaction of 
sections 704 and 706 is generally beyond the scope of these final 
regulations; accordingly, these final regulations do not address the 
treatment of waterfall allocations.
b. Determining the Items in Each Proration Period
    Under the 2009 proposed regulations, if the partners agreed to use 
the proration method, the partnership was required to allocate the 
distributive share of partnership items among the partners in 
accordance with their pro rata shares of the items for the entire 
taxable year. The Treasury Department and the IRS received several 
comments suggesting various modifications to the proration method. 
Commenters stated that the 2009 proposed regulations provided less 
flexibility in accounting for partners' varying interests under the 
proration method than the current regulations under section 706. 
Commenters recommended that the final regulations retain the 
flexibility of the current regulations by allowing partnerships to use 
any reasonable proration method to determine partners' distributive 
shares of partnership items and that the final regulations provide 
examples of reasonable proration methods. The Treasury Department and 
the IRS believe that, because the final regulations provide 
partnerships with flexibility to use either the interim closing method 
or the proration method for each variation, and because the proration 
method can be less accurate than the interim closing method, it is 
appropriate to generally retain the rules applicable to the proration 
method from the 2009 proposed regulations. Accordingly, the final 
regulations do not adopt this suggestion. However, because the final 
regulations permit partnerships to use both the proration method and 
the interim closing method in the same taxable year, the rules for the 
proration method are now based upon the items in each segment, rather 
than the items for the partnership's entire taxable year. Section 
1.706-4(a)(4) of the final regulations contains a detailed example 
illustrating the interaction of segments and proration periods.
    Proposed Sec.  1.706-4(d)(1) provided that, for purposes of the 
proration method, specific items aggregated by the partnership at the 
end of the year (other than extraordinary items) shall be disregarded, 
and the aggregate of the items shall be considered to be the 
partnership item for the year. Commenters questioned whether proposed 
Sec.  1.706-4(a)(2)(i) and (ii) and (d)(1) were intended to provide the 
same rules for both the interim closing method and the proration 
method. These sections address different issues. Proposed Sec.  1.706-
4(d)(1) was intended to allow partnerships that have multiple items 
that are aggregated by the partnership at the end of the year to also 
treat those items as a single item for purposes of the proration method 
(for example, capital gains and capital losses). By contrast, proposed 
Sec.  1.706-4(a)(2)(i) and (ii) were intended to demonstrate that for 
purposes of determining allocations to segments, any annual limitation 
will be disregarded as long as the limitation is satisfied by the end 
of the partnership's taxable year.
    One commenter requested that the final regulations allow publicly 
traded partnerships (as defined in section 7704(b)) that are treated as 
partnerships (``PTPs'') using the proration method and calendar day 
convention to prorate their annual aggregate tax items by the number of 
months instead of the number of days. Because the use of the proration 
method can be less accurate than the interim closing method in certain 
circumstances, the Treasury Department and the IRS believe that 
partnerships using the proration method should prorate by the number of 
days. Therefore, the final regulations do not adopt this 
recommendation.
iv. Agreement of the Partners To Use the Proration Method
    Consistent with the 2009 proposed regulations, under the final 
regulations the proration method may be used only by ``agreement of the 
partners.'' Commenters requested guidance on the meaning of this term, 
and the final regulations provide guidance as described in Part 1.E of 
this preamble.
C. Varying Interest Rule Conventions: Calendar Day, Semi-Monthly, and 
Monthly
    The 2009 proposed regulations acknowledged that for certain 
partnerships using the interim closing method, such as partnerships in 
which interests are frequently transferred, determining the partnership 
items for each segment could create a significant administrative 
burden. Accordingly, the 2009 proposed regulations allowed the use of 
simplifying conventions. Conventions are rules of administrative 
convenience that determine when each variation is deemed to occur for 
purposes of Sec.  1.706-4. Because the timing of each variation 
determines the partnership's segments and proration periods, which in 
turn are used to determine the partners' distributive shares, the 
convention used by the partnership with respect to a variation will 
generally affect the allocation of partnership items. However, as 
discussed in Part 1.D.ii of this preamble, extraordinary items 
generally must be allocated without regard to the partnership's 
convention.
    The 2009 proposed regulations provided that a partnership using the 
interim closing method could use either the calendar day convention or 
the semi-monthly convention to determine the segments of the 
partnership's taxable year, and provided that a partnership using the 
proration method shall use the calendar day convention. The 2009 
proposed regulations required the partnership to use the same 
convention for all variations during a taxable year. The 2009 proposed 
regulations requested comments with regard to the possible expansion of 
these rules to include other conventions or other methods. The final 
regulations generally finalize the rules for

[[Page 45870]]

conventions from the 2009 proposed regulations with the modifications 
described in this Part 1.C of the preamble.
i. Allowance of Monthly Conventions
    Commenters noted that the legislative history of section 706(d) 
contemplated that regulations under section 706 would provide a monthly 
convention for all partnerships. These commenters also argued that the 
administrative burden and accounting complexity inherent in the interim 
closing method would be alleviated by a monthly convention. 
Accordingly, the commenters recommended that the monthly convention be 
available to all partnerships, regardless of method, provided that the 
overall allocation of partnership items is reasonable.
    The legislative history indicates that Congress did consider 
providing for a statutory election to use a monthly convention:

[T]o prevent undue complexity, the bill provides, that in any case 
where there is a disposition of less than an entire interest in the 
partnership by a partner (including the entry of a new partner), the 
partnership may elect (on an annual basis) to determine the varying 
interests of the partners by using a monthly convention that treats 
any changes in any partner's interest in the partnership during the 
taxable year as occurring on the first day of the month.

S. Rep. No. 98-169, at 221 (1984). However, this statutory provision 
was not enacted and the House-Senate Conference Committee report 
explains that it was omitted because Congress expected the Secretary to 
provide for a monthly convention by regulation. H.R. Rep. No. 98-861, 
at 858 (1984). In accordance with this Congressional intent, the final 
regulations provide that any partnership using the interim closing 
method (but not partnerships using the proration method) may use a 
monthly convention to account for partners' varying interests. Under 
the monthly convention, in the case of a variation occurring on the 
first through the 15th day of a calendar month, the variation is deemed 
to occur for purposes of Sec.  1.706-4 at the end of the last day of 
the immediately preceding calendar month. And in the case of a 
variation occurring on the 16th through the last day of a calendar 
month, the variation is deemed to occur for purposes of Sec.  1.706-4 
at the end of the last day of that calendar month.
    Consistent with the rules for the selection of the proration 
method, the final regulations provide that the selection of the 
convention must be made by agreement of the partners by satisfying the 
provisions of Sec.  1.706-4(f) of these final regulations as explained 
in Part 1.E of this preamble. In the absence of an agreement to use a 
convention, the partnership will be deemed to have chosen the calendar 
day convention.
ii. Convention for Partnerships Using the Proration Method
    Commenters also requested that the final regulations allow 
partnerships using the proration method to allocate extraordinary items 
under either the calendar day convention or the semi-monthly convention 
to mirror the rules under the interim closing method. As explained in 
Part 1.D.i of this preamble, the final regulations provide that 
extraordinary items must generally be allocated based on the date and 
time on which the extraordinary items arise, without regard to the 
partnership's convention or use of the proration method or interim 
closing method. Thus, under the final regulations the allocation of 
extraordinary items will generally be the same regardless of the 
partnership's selected method or convention.
    The partnership's method and convention are generally relevant in 
determining allocations of non-extraordinary items. The final 
regulations retain the requirement that partnerships using the 
proration method must use a calendar day convention. Partnerships using 
the interim closing method have the option of using a semi-monthly or 
monthly convention in addition to the calendar day convention because 
of the additional administrative burdens inherent in using the more 
accurate interim closing method. Although the proration method may 
impose less administrative burdens on a partnership, it is less 
accurate than the interim closing method. Thus, the Treasury Department 
and the IRS believe it is necessary to retain the requirement of a 
calendar day convention for the proration method.
iii. Conventions for PTPs
    Proposed Sec.  1.706-4(b)(3) provided a safe harbor for PTPs that 
permitted a PTP using either the interim closing method or the 
proration method to treat all transfers of its publicly traded units 
(as described in Sec.  1.7704-1(b)(1)) except for certain block 
transfers during the 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. Proposed Sec.  
1.706-4(b)(3) also provided that, alternatively, PTPs could use the 
semi-monthly convention described in proposed Sec.  1.706-4(e)(2). The 
proposed PTP safe harbor referenced both rules for determining partner 
status and conventions in the same sentence, which could cause 
confusion. To eliminate this confusion, the Treasury Department and the 
IRS have decided to incorporate the rules of the PTP safe harbor from 
the 2009 proposed regulations, modified in response to comments as 
described in this section of the preamble, into the portions of the 
regulations providing rules for partnership conventions and methods. 
Therefore, the PTP safe harbor from the 2009 proposed regulations is no 
longer necessary and has been removed from the final regulations. 
However, as described below, the substantive rules from the PTP safe 
harbor remain largely unchanged in these final regulations.
    Commenters on the PTP safe harbor recommended that PTPs should be 
able to apply their conventions to all transfers of units, not just 
publicly traded units, including block transfers. The IRS and the 
Treasury Department agree that the rules from the proposed regulations 
should be extended to block transfers, but believe that transfers of 
non-publicly traded units should be accounted for similar to transfers 
of interests in non-publicly traded partnerships. Accordingly, the 
final regulations provide that a PTP may, by agreement of the partners, 
use any of the calendar day, the semi-monthly, or the monthly 
convention with respect to all variations during the taxable year 
relating to its publicly-traded units, regardless of whether the PTP 
uses the proration method with respect to those variations. A PTP must 
use the same convention for all variations during the taxable year 
relating to its publicly traded units. The final regulations provide 
that a PTP must use the calendar day convention with respect to all 
variations relating to its non-publicly traded units for which the PTP 
uses the proration method. In addition, consistent with the rules from 
the PTP safe harbor in the 2009 proposed regulations, the final 
regulations provide that a PTP using a monthly convention generally may 
consistently treat all variations occurring during each month as 
occurring at the end of the last day of that calendar month, if the PTP 
uses the monthly convention for those variations.
    The preamble to the 2009 proposed regulations acknowledged that 
some PTPs use conventions not described in the 2009 proposed 
regulations and requested comments concerning the use of additional 
conventions. In response to this request for comments, one commenter on 
the PTP safe harbor also recommended that the final regulations allow 
PTPs to use a quarterly

[[Page 45871]]

convention. This commenter stated that PTPs generally declare cash 
distributions quarterly to their unit holders of record on the last day 
of the quarter to align the distributions with the PTPs' quarterly 
financial reporting. The Treasury Department and the IRS believe that a 
quarterly convention could significantly reduce the accuracy of the 
allocations of a partnership's tax items to a particular partner. 
Accordingly, the final regulations do not permit PTPs to use a 
quarterly convention. As discussed in Part 1.D.iii.a of this preamble, 
however, proposed regulations under section 706 (REG-109370-10) are 
being published concurrently with these final regulations, and, subject 
to certain exceptions, provide that PTPs may, by agreement of their 
partners, treat all items of income that are amounts subject to 
withholding as defined in Sec.  1.1441-2(a) (excluding income 
effectively connected with the conduct of a trade or business within 
the United States) or withholdable payments under Sec.  1.1473-1(a) as 
extraordinary items. If the partners so agree, then for purposes of 
section 706 such items are treated as occurring at the next time as of 
which the recipients of a distribution by the PTP are determined, or, 
to the extent such income items arise between the final time during the 
taxable year as of which the recipients of a distribution are 
determined and the end of the taxable year, such items shall be treated 
as occurring at the final time during the taxable year that the 
recipients of a distribution by the PTP are determined. This proposed 
rule does not apply unless the PTP has a regular practice of making at 
least four distributions (other than de minimis distributions) to its 
partners during each taxable year. The Treasury Department and the IRS 
believe that this proposed rule is desirable to link each partner's 
distributive share to the related cash distributions, thereby enabling 
PTPs and their transfer agents to satisfy their withholding obligations 
under chapter 4 of the Code and under sections 1441 through 1443 from 
distributions.
    The convention rules in proposed Sec.  1.706-4(c)(2) and (d)(2) did 
not apply to existing PTPs (existing PTP exception). Solely for 
purposes of the 2009 proposed regulations, an existing PTP was a 
partnership described in section 7704(b) that was formed on a date 
before the 2009 proposed regulations were published. Commenters noted 
that an existing PTP that terminates under section 708(b)(1)(B) due to 
the sale or exchange of 50 percent or more of the total interests in 
partnership capital and profits (a ``technical termination'') on or 
after the publication of the 2009 proposed regulations would not 
receive the benefit of the existing PTP exception. These commenters 
noted that a technical termination is a tax concept and does not result 
in any changes to the partnership agreement, including any provisions 
relating to section 706(d). Commenters also noted that disregarding 
technical terminations of PTPs would be consistent with other 
regulation provisions (such as Sec.  1.731-2(g)(2), which provides that 
a successor partnership formed as a result of technical termination is 
disregarded for purposes of applying section 731(c)). The final 
regulations adopt this recommendation and provide that, for purposes of 
the effective date provision, the termination of a PTP under section 
708(b)(1)(B) is disregarded in determining whether the PTP is an 
existing PTP.
iv. Use of More Than One Convention During a Taxable Year
    The 2009 proposed regulations required the partnership to use the 
same convention for all variations during a taxable year. Because the 
final regulations permit partnerships to use both the proration and 
interim closing methods during a taxable year, the final regulations 
provide that the partnership and all of its partners must use the same 
convention for all variations for which the partnership chooses to use 
the interim closing method. Furthermore, because PTPs are also 
permitted to use the semi-monthly and monthly conventions with respect 
to variations for which the PTP uses the proration method, the final 
regulations provide that PTPs must use the same convention for all 
variations during the taxable year.
v. Deemed Timing of Variations
    Under the semi-monthly convention in the 2009 proposed regulations, 
the first segment of the partnership's taxable year commenced with the 
beginning of the partnership's taxable year, and with respect to a 
variation in interest occurring on the first through the 15th day of 
the month, was deemed to close at the end of the last day of the 
immediately preceding calendar month. Thus, although the 2009 proposed 
regulations provided that the first segment commences with the 
beginning of the partnership's taxable year, they also provided that a 
variation occurring on the first through the 15th day of the first 
calendar month of the partnership's taxable year was deemed to close at 
the end of the last day of the immediately preceding calendar month, 
which would be the last day of the prior taxable year. The final 
regulations provide that all variations within a taxable year are 
deemed to occur no earlier than the first day of the partnership's 
taxable year, and no later than the close of the final day of the 
partnership's taxable year. Thus, under the semi-monthly or monthly 
convention, a variation occurring on January 1st through January 15th 
for a calendar year partnership will be deemed to occur for purposes of 
Sec.  1.706-4 at the beginning of the day on January 1. The conventions 
are not applicable to a sale or exchange of an interest in the 
partnership that causes a termination of the partnership under section 
708(b)(1)(B); instead, such a sale or exchange will be considered to 
occur when it actually occurred.
vi. Exception for Admission to and Exit From the Partnership Within a 
Convention Period
    The Treasury Department and the IRS recognize that, while the 
conventions are rules of administrative convenience that simplify the 
partnership's determination of the partners' distributive shares, the 
application of the conventions could result in some partners not being 
allocated any share of partnership items at all. For example, under the 
monthly convention, if a new partner buys a partnership interest on or 
after the 16th day of a month, and sells the entire partnership 
interest on or before the 15th day of the following month, that partner 
would not be treated as having been a partner at all for purposes of 
Sec.  1.706-4, even if that partner otherwise is treated as a partner 
for purposes of other Code and regulations provisions, including 
section 6031(b) (relating to the partnership's obligation to furnish 
each partner a Schedule K-1, ``Partner's Share of Income, Deductions, 
Credits, etc.'') and Sec. Sec.  1.6012-1(b) and 1.6012-2(g) (relating 
to the obligation of certain foreign persons engaged in a U.S. trade or 
business to file a return). However, the Treasury Department and the 
IRS believe that the application of the conventions should not cause 
persons who are admitted to and exit from a partnership during a single 
convention period to avoid all allocations under Sec.  1.706-4. 
Accordingly, the final regulations provide that in the case of a 
partner who becomes a partner during the partnership's taxable year as 
a result of a variation, and ceases to be a partner as a result of 
another variation, and under the application of the partnership's 
conventions both such variations would be deemed to occur at the same 
time, the variations with

[[Page 45872]]

respect to that partner's interest will instead be treated as occurring 
when they actually occurred. Thus, in such a case, the partnership must 
treat the partner as a partner for the entire portion of its taxable 
year during which the partner actually owned an interest. However, in 
recognition of the increased administrative difficultly this exception 
would have for PTPs, this exception does not apply to PTPs with respect 
to holders of publicly traded units (as described in Sec.  1.7704-1(b) 
or (c)(1)).
D. Extraordinary Items
    Section 1.706-4(d)(3) of the 2009 proposed regulations required 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. Section 1.706-4(d)(3) of 
the 2009 proposed regulations contained a list of nine enumerated 
extraordinary items. These final regulations continue to provide 
special rules for the allocation of extraordinary items; in addition, 
as discussed in this Part 1.D of the preamble, the final regulations 
expand the application of the extraordinary item rules to cover 
partnerships using the interim closing method, modify the list of 
extraordinary items and the timing of extraordinary item inclusions, 
and add a small item exception.
i. Extraordinary Items and the Interim Closing Method
    The 2009 proposed regulations did not require partnerships using 
the interim closing method to separately account for extraordinary 
items. However, the Treasury Department and the IRS are aware (and 
commenters pointed out) that partnerships using the interim closing 
method and either the semi-monthly convention or the monthly convention 
to account for extraordinary items may achieve inappropriate tax 
consequences by shifting the tax consequences of extraordinary items to 
partners that were not partners in the partnership when the partnership 
incurred the extraordinary item. The Treasury Department and the IRS 
believe that extraordinary items should generally be taken into account 
by the partners that were partners at the time the partnership incurred 
the extraordinary item. Therefore, the final regulations provide that 
the extraordinary item rules also apply to partnerships using the 
interim closing method. Thus, the final regulations require the 
allocation of extraordinary items as an exception to (1) the proration 
method, which would otherwise ratably allocate the extraordinary items 
across the segment, and (2) the conventions, which might otherwise 
inappropriately shift extraordinary items between a transferor and 
transferee. The final regulations also provide that extraordinary items 
continue to be subject to any special limitation or requirement 
relating to the timing or amount of income, gain, loss, deduction, or 
credit applicable to the entire partnership taxable year (for example, 
the limitation for section 179 expenses).
ii. Timing of Extraordinary Items
    Proposed Sec.  1.706-4(d)(3) provided that a partnership must 
allocate extraordinary items among the partners in proportion to their 
interests at the beginning of the calendar day on which they are taken 
into account (beginning of the day rule). One commenter noted that 
under this rule, if a partnership interest is transferred on a given 
date and an extraordinary item is recognized by the partnership after 
the transfer, but still on the transfer date, the 2009 proposed 
regulations required the item to be allocated to the transferor. This 
commenter noted that other regulation sections use a ``next day rule'' 
(for example, Sec. Sec.  1.1502-76(b)(1)(ii)(B) and 1.338-1(d)). 
According to the commenter, under the next day rule, an item would be 
treated as occurring at the beginning of the day following the day on 
which the extraordinary item is taken into account by the partnership. 
Another commenter expressed concern that the beginning of the day rule 
was incompatible with partnership agreements that provide that 
partners' distributive shares are determined on the basis of hurdles, 
waterfalls, or other income/loss thresholds.
    The Treasury Department and the IRS agree that extraordinary items 
should generally be allocated according to the partners' interests in 
the item at the time the extraordinary item arose. However, the 
Treasury Department and the IRS believe that a ``next day'' rule could 
result in inappropriate shifts of extraordinary items between a 
transferor and a transferee in situations in which the extraordinary 
items arise before, but on the same day as, the transfer of a 
partnership interest. In addition, the Treasury Department and the IRS 
believe that allowing allocation of extraordinary items based upon end 
of year threshold determinations such as hurdles or waterfalls would be 
inconsistent with the purpose of the varying interest rule and could 
result in inappropriate shifts in extraordinary items. Therefore, to 
avoid inappropriate shifts in extraordinary items, the final 
regulations provide that extraordinary items must be allocated in 
accordance with the partners' interests in the partnership item at the 
time of day that the extraordinary item occurs, regardless of the 
method and convention otherwise used by the partnership. Thus, if a 
partner disposes of its entire interest in a partnership before an 
extraordinary item occurs (but on the same day), the partnership and 
all of its partners must allocate the extraordinary item in accordance 
with the partners' interests in the partnership item at the time of day 
on which the extraordinary item occurred; in such a case, the 
transferor will not be allocated a portion of the extraordinary item, 
regardless of when the transfer is deemed to occur under the 
partnership's convention. However, the final regulations provide that 
PTPs (as defined in section 7704(b)) may, but are not required to, 
respect the applicable conventions in determining who held their 
publicly traded units (as described in Sec.  1.7704-1(b) or 1.7704-
1(c)(1)) at the time of the occurrence of an extraordinary item. The 
Treasury Department and the IRS believe that this exception is 
necessary for administrative convenience given the frequency of 
variations experienced by PTPs. Examples 1 through 4 of Sec.  1.706-
4(e)(4) illustrate these timing rules.
    As discussed in Part 1.B.i of this preamble, proposed Sec.  1.706-
4(a)(1) required the partnership and all of its partners to use the 
same method for all variations in the partners' interests occurring 
within the partnership's taxable year, whether in complete or partial 
termination of the partners' interests. Proposed Sec.  1.706-4(d)(3) 
provided that partnerships using the proration method 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, thus prohibiting the partnership from allocating 
extraordinary items using the proration method. Commenters stated that 
proposed Sec.  1.706-4(a)(1) and (d)(3), when read together, could be 
interpreted to prohibit partnerships with extraordinary items from the 
using the proration method. These commenters also stated that these 
provisions could be interpreted to prohibit the use of the so-called 
``hybrid method.'' One commenter explained that under a hybrid method, 
a partnership separates certain extraordinary items and allocates them 
to partners based on their interests in the partnership on particular 
days or periods (for example, the date of sale), effectively using the 
interim closing

[[Page 45873]]

method and a calendar day convention with respect to these 
extraordinary items. According to this commenter, the partnership then 
allocates the remaining partnership items in accordance with the 
proration method. A commenter also requested that the final regulations 
permit partnerships using the proration method to use the interim 
closing method and a semi-monthly convention to account for 
extraordinary items. Under the final regulations, a partnership with 
extraordinary items may use the proration method. As a result, the 
final regulations effectively permit the hybrid method described by the 
commenter. However, the final regulations provide that partnerships 
must allocate extraordinary items according to the partners' interests 
in the partnership item at the time of day that the extraordinary item 
arose, generally without regard to the method and convention otherwise 
used by the partnership.
iii. List of Extraordinary Items
    The 2009 proposed regulations defined an extraordinary item as (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 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(a)(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 2009 proposed regulations requested comments on whether any 
items should be added to or removed from the definition of 
extraordinary items. After consideration of the comments received, the 
Treasury Department and the IRS have decided to generally retain the 
list of enumerated extraordinary items, subject to changes that are 
discussed in this Part 1.D.iii of the preamble.
a. Two Additional Extraordinary Items and Two Additional Proposed 
Extraordinary Items
    In response to comments, the final regulations add two items to the 
extraordinary item list. First, commenters requested that the final 
regulations provide partnerships with more flexibility in determining 
what items are extraordinary items. One commenter argued that the 
definition of extraordinary item should be tied to the uniqueness of 
the partnership and materiality of the item. Another commenter 
recommended the final regulations remove the mandatory treatment of the 
specifically enumerated items as extraordinary items and instead 
highlight these specific items as items the partnership may agree to 
treat as extraordinary. In addition, commenters recommended that the 
final regulations allow the partners to agree to treat other 
nonenumerated items as extraordinary items. The commenters noted that 
this could prevent distortion of the economic deal of the partners in 
certain circumstances. The final regulations adopt the recommendation 
to allow a partnership to treat additional nonenumerated items as 
extraordinary items for a taxable year if, for that taxable year, there 
is an agreement of the partners (as described in Part 1.E of this 
preamble) to treat consistently such items as extraordinary items. 
However, this rule does not apply if treating that additional item as 
an extraordinary item would result in a substantial distortion of 
income in any partner's return. Any additional extraordinary items 
continue to be subject to any special limitation or requirement 
relating to the timing or amount of income, gain, loss, deduction, or 
credit applicable to the entire partnership taxable year (for example, 
the limitation for section 179 expenses).
    Second, the final regulations provide that an extraordinary item 
includes any item identified as an additional class of extraordinary 
item in guidance published in the Internal Revenue Bulletin. The 
Treasury Department and the IRS believe that this addition is necessary 
to provide flexibility and guidance in the event that additional 
classes of items should be treated as extraordinary items.
    In addition, proposed regulations under section 706 (REG-109370-10) 
being published concurrently with these final regulations propose to 
add two additional extraordinary items. The first proposed additional 
extraordinary item responds to comments regarding the administrative 
difficulty PTPs face in satisfying certain withholding obligations if 
the PTPs are not permitted to use a quarterly convention. As discussed 
in Part 1.C.iii of this preamble, the final regulations do not permit 
PTPs to use a quarterly convention. However, the proposed regulations 
being published concurrently with these final regulations would add an 
optional extraordinary item for PTPs, which the Treasury Department and 
the IRS believe is desirable to link each partner's distributive share 
to the related cash distributions, thereby enabling PTPs and their 
transfer agents to satisfy their withholding obligations under Chapter 
4 of the Code and sections 1441 through 1443 from distributions. 
Specifically, the proposed regulations provide that, for PTPs, all 
items of income that are amounts subject to withholding as defined in 
Sec.  1.1441-2(a) (excluding income effectively connected with the 
conduct of a trade or business within the United States) or 
withholdable payments under Sec.  1.1473-1(a) occurring during a 
taxable year may be treated as extraordinary items if, for that taxable 
year, the partners agree to consistently treat all such items as 
extraordinary items for that taxable year. If the partners so agree, 
then for purposes of section 706 such items shall be treated as 
occurring at the next time as of which the recipients of a distribution 
by the PTP are determined, or, to the extent such income items arise 
between the final time during the taxable year as of which the 
recipients of a distribution are determined and the end of the taxable 
year, such items shall be treated as occurring at the final time during 
the taxable as of which the recipients of a distribution are 
determined. This proposed rule does not apply unless the PTP has a 
regular practice of making at least four distributions (other than de 
minimis distributions) to its partners during each taxable year. The 
proposed regulations provide that taxpayers may

[[Page 45874]]

rely on this proposed additional extraordinary item for PTPs until 
final regulations are issued.
    The second proposed additional extraordinary item addresses 
partnership deductions attributable to the transfer of partnership 
equity in connection with the performance of services. Specifically, 
the proposed regulations being published concurrently with these final 
regulations would add as an additional extraordinary item any deduction 
for the transfer of an interest in the partnership in connection with 
the performance of services and would provide that such deduction is 
treated as occurring immediately before the transfer or vesting of the 
partnership interest that results in compensation income for the person 
who performs the services. Moreover, for such deductions the proposed 
regulations would ``turn off'' the exceptions to the extraordinary item 
rules which would otherwise apply to certain small items and for 
partnerships for which capital is not a material income-producing 
factor. The Treasury Department and the IRS believe that this rule is 
necessary to ensure that, in the case of a transfer of partnership 
equity in connection with the performance of services, no portion of 
the deduction for the transfer of a partnership interest in connection 
with the performance of services will be allocated to the person who 
performs the services.
b. Clarification of Certain Enumerated Items
    This Part 1.D.iii.b provides additional clarification on five of 
the extraordinary items from the 2009 proposed regulations.
    First, the 2009 proposed regulations provided that an extraordinary 
item includes 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). One commenter requested that the final regulations clarify that 
gains or losses from the actual or deemed sale of securities by 
securities partnerships (as defined in Sec.  1.704-3(e)(3)(iii)) are 
items resulting from the disposition or abandonment of a capital asset 
(as defined in section 1221) in the ordinary course of business. 
Without such a rule, the commenter noted that a securities partnership 
would incur significant administrative and accounting costs to account 
for each security bought and sold. The Treasury Department and the IRS 
believe that it is unnecessary to provide a special rule for securities 
partnerships; if a securities partnership is engaged in the trade or 
business of trading securities then it will generally be true that any 
gains or losses from the actual or deemed sale of securities are items 
from the disposition of a capital asset in the ordinary course of the 
partnership's business. Accordingly, the final regulations do not 
modify this extraordinary item.
    Second, commenters inquired as to whether revaluations of 
partnership property under Sec.  1.704-1(b)(2)(iv)(e) or (f) are 
extraordinary items. Section 1.704-1(b)(2)(iv)(e) generally requires 
that a partner's capital account be decreased by the fair market value 
of property distributed by the partnership to such partner. To do so, 
the partners' capital accounts are adjusted to reflect the manner in 
which the unrealized income, gain, loss, and deduction inherent in the 
property would be allocated among the partners if there were a taxable 
disposition of the property for fair market value on the date of 
distribution. Section 1.704-1(b)(2)(iv)(f) provides that a partnership 
may increase or decrease the capital accounts of the partners to 
reflect a revaluation of partnership property on the partnership's 
books upon the occurrence of certain events. The adjustments to the 
partners' capital accounts must reflect the manner in which the 
unrealized income, gain, loss, or deduction inherent in the property 
would be allocated among the partners if there were a taxable 
disposition of the property for fair market value on that date. Under 
Sec.  1.704-3(a)(6)(i), section 704(c) principles apply to allocations 
with respect to property for which differences between book value and 
adjusted tax basis are created when a partnership revalues partnership 
property pursuant to Sec.  1.704-1(b)(2)(iv)(f) (reverse section 704(c) 
allocations). However, partnerships are not generally required to 
revalue their property on the occurrence of these events. The Treasury 
Department and the IRS believe that the treatment of an item as an 
extraordinary item should not depend upon whether the partnership 
chooses to revalue its assets. Additionally, as discussed in Part 1.F 
of this preamble, the final regulations generally do not address the 
interaction of sections 704(b), 704(c), and 706. Accordingly, the final 
regulations do not include book items from partnership revaluations as 
extraordinary items.
    Third, the 2009 proposed regulations provided that an extraordinary 
item included 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. One commenter recommended that the final regulations 
provide that the Commissioner may only treat a nonenumerated item as an 
extraordinary item where the Commissioner has provided advance notice 
by notice or regulation of the types of income subject to scrutiny, or 
where there is evidence that the proration method was chosen with the 
intent to substantially distort income. However, the Treasury 
Department and the IRS believe that such a rule would unduly impede the 
ability of the IRS to correct substantial distortions of income, and 
accordingly the final regulations do not adopt this suggestion.
    Fourth, the 2009 proposed regulations provided that an 
extraordinary item included any section 481(a) adjustment. The Treasury 
Department and the IRS have determined that the inclusion of section 
481(a) adjustments within the meaning of ``extraordinary items'' for 
purposes of section 706 may be overbroad. The purpose of the 
extraordinary items rule is to avoid substantial distortions of income 
among partners by requiring a partnership to allocate certain 
significant, nonrecurring items incurred other than in the ordinary 
course of business among its partners in proportion to their ownership 
interests in the partnership on the date the extraordinary item was 
incurred. Section 481 requires a taxpayer that has changed its method 
of accounting to compute its income by taking into account adjustments 
necessary to prevent any duplication or omission that would otherwise 
result from the change. Under certain circumstances, these adjustments 
may be spread over a period of years, and in all circumstances, the 
adjustments relate to a change of accounting method by the taxpayer 
rather than a particular item incurred by the taxpayer. Because the new 
accounting method that triggers the section 481 adjustment applies to 
the entire taxable year of the change, the adjustment similarly relates 
to that entire taxable year rather than any specific date within that 
taxable year. Therefore, the Treasury Department and the IRS believe 
that not all section 481 adjustments should be treated as extraordinary 
items. However, in situations in which the change in accounting method 
is initiated after the occurrence of a variation, the Treasury 
Department and the IRS believe it is appropriate to allocate any 
resulting item attributable to the change among the partners in 
accordance with their percentage interests at and after the time the 
method change is initiated. Therefore, the final regulations have

[[Page 45875]]

changed this extraordinary item to include only the effects of any 
change in accounting method initiated by the filing of the appropriate 
form after a variation occurs.
    Fifth, the 2009 proposed regulations provided that an extraordinary 
item included:

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).

Section 108(e)(8) and (i) generally require that a partnership allocate 
discharge of indebtedness income (COD income) to the partners that were 
partners immediately prior to the transaction giving rise to the COD 
income. Thus, the rules under section 108(e)(8) and (i) and section 706 
could provide conflicting results if items of a partnership subject to 
section 108(e)(1) or 108(i) were treated as an extraordinary item. This 
could occur where section 108(e)(8) or 108(i) provides a rule regarding 
the timing of COD income that is different from the extraordinary item 
timing rules under section 706. Thus, because section 108(e)(8) and (i) 
already provide special timing rules, the Treasury Department and the 
IRS believe it is unnecessary to treat these items as extraordinary 
items. Accordingly, the final regulations provide a limited exception 
in the definition of extraordinary items in Sec.  1.706-4(e)(1)(v) for 
amounts subject to section 108(e)(8) or 108(i).
iv. Small Item Exception for Extraordinary Items
    In addition to receiving comments on the items on the extraordinary 
item list, the Treasury Department and the IRS received many comments 
requesting that the final regulations provide a de minimis rule for 
extraordinary items. One commenter suggested that an extraordinary item 
would be considered de minimis if, for the partnership's taxable year: 
(i) The total of the particular class of extraordinary items is less 
than five percent of the partnership's (a) gross income in the case of 
income or gain items, or (b) gross expenses and losses, including 
section 705(a)(2)(B) expenditures, in the case of losses and expenses; 
and (ii) all extraordinary items in total do not exceed $10 million. 
Another commenter recommended using a dollar amount threshold per item, 
a cumulative amount (for example, $100,000), or an amount that varies 
depending on the size of the partnership or whether the partnership is 
a PTP.
    The Treasury Department and the IRS recognize that accounting for 
extraordinary items can be burdensome to partnerships. Accordingly, the 
final regulations adopt the recommendation to include a small item 
exception. Specifically, the final regulations allow a partnership to 
treat an otherwise extraordinary item as not extraordinary if, for the 
partnership's taxable year: (1) The total of all items in the 
particular class of extraordinary items (for example, all tort or 
similar liabilities) is less than five percent of the partnership's (a) 
gross income, including tax-exempt income described in section 
705(a)(1)(B), in the case of income or gain items, or (b) gross 
expenses and losses, including section 705(a)(2)(B) expenditures, in 
the case of losses and expense items; and (2) the total amount of the 
extraordinary items from all classes of extraordinary items amounting 
to less than five percent of the partnership's (a) gross income, 
including tax-exempt income described in section 705(a)(1)(B), in the 
case of income or gain items, or (b) gross expenses and losses, 
including section 705(a)(2)(B) expenditures, in the case of losses and 
expense items, does not exceed $10 million in the taxable year, 
determined by treating all such extraordinary items as positive 
amounts. Examples 5 and 6 of Sec.  1.706-4(e)(4) illustrate the small 
item exception.
E. Agreement of the Partners
    As discussed in this preamble, the final regulations provide that 
partnerships may make certain decisions under Sec.  1.706-4 by 
agreement of the partners. See Part 1.B.ii (agreement to perform 
regular monthly or semi-monthly interim closings), Part 1.B.iv 
(selection to use the proration method), Part 1.C.i (choice of 
convention), and Part 1.D.iii.a (adding extraordinary items).
    Proposed Sec.  1.706-4(a)(1) provided that a partnership may only 
use the proration method by agreement of the partners. Proposed Sec.  
1.706-4(c)(3) and -(d)(4) provided examples that indicated that the 
agreement of the partners to use the proration method must be part of 
the partnership agreement. Commenters requested clarification on the 
meaning of ``by agreement of the partners'' and on whether a 
partnership may delegate the authority to select the proration method. 
Another commenter suggested that the final regulations adopt different 
rules for a variation caused by a transaction between the partnership 
and one or more partners, and for a variation caused by a transaction 
between partners. One commenter noted that existing partnerships may 
not be able to amend the partnership agreement within the timeframe 
prescribed by section 761(c). Section 1.706-4(f) of the final 
regulations provides guidance on the meaning of ``agreement of the 
partners.''
    The Treasury Department and the IRS believe that the final 
regulations should provide the partners with a voice in the choice of 
methods, conventions, and additional extraordinary items, and should 
allow the IRS to easily ascertain what the partnership selected, 
without unduly burdening the partnership. In response to comments, the 
Treasury Department and the IRS have determined that each of these 
objectives can be achieved by allowing partnerships to select their 
method, convention, or additional extraordinary items through a dated, 
written statement maintained with the partnership's books and records 
by the due date, including extensions, of the partnership's tax return. 
The final regulations provide that such a statement would include, for 
example, a selection included in the partnership agreement. The final 
regulations also permit the selection of the method, convention, or 
additional extraordinary item to be made by a person authorized to make 
that selection (including under a grant of general authority provided 
for by either state law or in the partnership agreement), if that 
person's selection is in a dated, written statement maintained with the 
partnership's books and records by the due date, including extensions, 
of the partnership's tax return. That person's selection will be 
binding on the partnership and the partners.
F. Interaction of Sections 706(d) and 704
    The 2009 proposed regulations did not address the interaction of 
section 706(d) with the rules under section 704. Section 1.704-1(b)(1) 
generally provides that, under section 704(b), if a partnership 
agreement does not provide for the allocation of income, gain, loss, 
deduction, or credit (or item thereof) to a partner, or if the 
partnership agreement provides for the allocation of income, gain, 
loss, deduction, or credit (or item thereof) to a partner but such 
allocation does not have substantial economic effect, then the 
partner's distributive share of such income, gain, loss, deduction, or 
credit (or item thereof) shall be determined in accordance with such 
partner's interest in the partnership (taking into account all facts 
and circumstances). However, Sec.  1.704-1(b)(1)(iii) provides that the

[[Page 45876]]

determination of a partner's distributive share of income, gain, loss, 
deduction, or credit (or item thereof) under section 704(b) and the 
regulations thereunder is not conclusive as to the tax treatment of a 
partner with respect to such distributive share. Section 1.704-
1(b)(1)(iii) further provides that an allocation that is respected 
under section 704(b) and the regulations nevertheless may be 
reallocated under other provisions, such as section 706(d) (and related 
assignment of income principles).
    The Treasury Department and the IRS received several comments 
requesting guidance on the interaction of sections 706(d) and 704. One 
commenter requested clarification on the effect of a reallocation under 
section 706(d) on the application of provisions of section 704(b), 
particularly regarding the capital account maintenance provisions in 
Sec.  1.704-1(b)(2)(iv). Another commenter indicated that partnership 
agreements are drafted to apply section 706 to section 704(b) items and 
allocate tax items in the same manner as the corresponding book items, 
subject to the application of section 704(c). This commenter asked that 
the final regulations address whether section 706(d) applies to the 
allocation of book items rather than tax items.
    The Treasury Department and the IRS have carefully considered the 
comments relating to the interaction of sections 706(d) and 704 and 
believe that the issues require further consideration and are generally 
outside the scope of these final regulations. However, the Treasury 
Department and the IRS may consider addressing these issues in future 
guidance.

2. Deemed Dispositions

    Proposed Sec.  1.706-1(c)(2)(iii) provided that a deemed 
disposition of a partner's interest pursuant to 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)), Sec.  1.1362-3(c)(1) (relating to the termination of the 
subchapter S election of an S corporation partner), or Sec.  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. The preamble to the 2009 
proposed regulations indicated that this treatment is solely for 
purposes of section 706. One commenter explained that unless the 
regulatory language specifically limits the disposition treatment to 
section 706, taxpayers could deem these transactions to be dispositions 
for other purposes of the Code, thereby achieving unintended results. 
For example, the commenter stated that, unless clarified, the 2009 
proposed regulations could cause unintended consequences under sections 
708, 743(b), or 1001 when a member of a consolidated group sells an 
interest in a partnership that exits the consolidated group after the 
sale. Consistent with the preamble to the 2009 proposed regulations, 
the final regulations clarify that deemed dispositions under Sec. Sec.  
1.1502-76(b)(2)(vi), 1.1362-3(c)(1), or 1.1377-1(b)(3)(iv) are treated 
as a disposition of the partner's entire interest in the partnership 
solely for purposes of section 706.

Effective/Applicability Dates

    With respect to amendments to Sec. Sec.  1.706-1 (with the 
exception of two special rules applicable to Sec.  1.706-1(b)(6)(iii)), 
1.706-4 (with the exception of a special rule applicable to Sec.  
1.704-4(c)(3)), and 1.706-5, these final regulations are applicable to 
partnership taxable years that begin on or after August 3, 2015.
    With respect to the final regulations contained in Sec.  1.706-
1(b)(6)(iii), the regulations apply to the partnership taxable years 
that begin on or after August 3, 2015, 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 chosen to 
apply them or unless they have undergone a technical termination under 
section 708(b)(1)(B). The final regulations retain this special rule, 
such that an existing partnership will not be subject to the modified 
minority interest rule in Sec.  1.706-1(b)(6)(iii) unless there has 
been such an election or technical termination of the partnership. 
Second, because the final regulations 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 Sec.  1.706-1(b)(6)(iii) unless 
they voluntarily elect to be subject to this rule or undergo a 
technical termination.
    The final regulations under Sec.  1.706-4 generally apply for 
partnership taxable years that begin on or after August 3, 2015; 
however, the rules of Sec.  1.706-4(c)(3) do not apply to existing 
PTPs. For purposes of this effective date provision, an existing PTP is 
a partnership described in section 7704(b) that was formed prior to 
April 19, 2009. For purposes of this effective date provision, the 
termination of a PTP under section 708(b)(1)(B) due to the sale or 
exchange of 50 percent or more of the total interests in partnership 
capital and profits is disregarded in determining whether the PTP is an 
existing PTP.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866, as 
supplemented by Executive Order 13563. 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 final regulations. It is hereby certified that the 
collection of information in this Treasury decision will not have a 
significant economic impact on a substantial number of small entities 
within the meaning of section 601(6) of the Regulatory Flexibility Act 
(5 U.S.C. chapter 6). The Treasury Department and the IRS believe that 
the economic impact on small entities as a result of the collection of 
information in this Treasury decision will not be significant. The 
small entities subject to the collection are business entities formed 
as partnerships that choose to adopt the proration method, the semi-
monthly or monthly convention, perform semi-monthly or monthly interim 
closings, or to add an additional class of extraordinary item, in which 
case the partnership must keep a written statement with its books and 
records evidencing the decision or delegation. Thus, the collection 
only applies if the partnership does not wish to accept the default 
method, convention, and list of extraordinary items provided in these 
regulations. Furthermore, the information required to be maintained 
with the partnership's books and records is simply a short statement 
evidencing the agreement of the partners. For these reasons, the 
Treasury Department and the IRS do not believe that the collection of 
information in this Treasury decision has a significant economic 
impact.
    Pursuant to section 7805(f) of the Code, this regulation was 
submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business and no 
comments were received.

[[Page 45877]]

Drafting Information

    The principal author of these final regulations is Benjamin H. 
Weaver, Office of the Associate Chief Counsel (Passthroughs and Special 
Industries). However, other personnel from the Treasury Department and 
the IRS participated in their development.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 2

    Reporting and recordkeeping requirements.

Amendments to the Regulations

    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 a 
new entry in numerical order to read as follows:

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

    Section 1.706-4 also issued under 26 U.S.C. 706(d). * * *


0
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 small item exception.
    (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.  1.706-2T Temporary regulations; question and answer under the Tax 
Reform Act of 1984 (temporary).
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) Variations subject to this section.
    (2) Coordination with section 706(d)(2) and (3).
    (3) Allocation of items subject to this section.
    (4) Example.
    (b) Exceptions.
    (1) Permissible changes among contemporaneous partners.
    (2) Safe harbor for partnerships for which capital is not a 
material income-producing factor.
    (3) Special rules for publicly traded partnerships.
    (c) Conventions.
    (1) In general.
    (i) Calendar day convention.
    (ii) Semi-monthly convention.
    (iii) Monthly convention.
    (2) Exceptions.
    (3) Permissible conventions for each variation.
    (4) Examples.
    (d)(1) Optional monthly or semi-monthly closings.
    (2) Example.
    (e) Extraordinary items.
    (1) General principles.
    (2) Definition.
    (3) Small item exception.
    (4) Examples.
    (f) Agreement of the partners.
    (g) Effective/applicability date.
Sec.  1.706-5 Taxable year determination.
(a) In general.
(b) Effective/applicability date.

0
Par. 3. Section 1.706-1 is amended as follows:
0
a. The language ``this paragraph (a)(1)'' in the first sentence of 
paragraph (a)(2) is removed and the language ``paragraph (a)(1) of this 
section'' is added in its place.
0
b. 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.
0
c. Paragraph (b)(6)(v)(A) is revised.
0
d. The last sentence of paragraph (b)(6)(v)(B) is removed and four new 
sentences are added in its place.
0
e. Paragraph (b)(6)(v)(C) is revised.
0
f. Add a sentence at the end of paragraph (b)(6)(v)(D).
0
g. Paragraph (c)(2) is revised.
0
h. Paragraph (c)(3) is removed.
0
i. Paragraph (c)(4) is redesignated as paragraph (c)(3) and the last 
sentence of newly designated paragraph (c)(3) is removed.
0
k. New paragraph (c)(4) is added.
0
l. Paragraph (d) is revised.
    The revisions and additions 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) apply to partnership taxable 
years, other than those of an existing partnership, that begin on or 
after July 23, 2002. The provisions of paragraph (b)(6)(iii) of this 
section apply to partnership taxable years, other than those of an 
existing partnership or an interim period partnership, that begin on or 
after August 3, 2015. For partnership taxable years beginning on or 
after July 23,

[[Page 45878]]

2002, and before August 3, 2015, see the provisions of Sec.  1.706-
1(b)(6)(iii) as contained in the 26 CFR part 1 on July 31, 2015. For 
purposes of paragraph (b)(6) of this section, 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 August 3, 2015.
    (B) * * * An existing partnership that makes such a change prior to 
August 3, 2015 will generally cease to be exempted from the 
requirements of this paragraph (b)(6) of this section, and thus will be 
subject to the requirements of paragraph (b)(6) of this section, except 
for paragraph (b)(6)(iii) of this section--instead, such partnership 
will be subject to the provisions of Sec.  1.706-1(b)(6)(iii) as 
contained in the 26 CFR part 1 on July 31, 2015. An existing 
partnership that makes such a change on or after August 3, 2015 will 
cease to be exempted from the requirements of this paragraph (b)(6). 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) of 
this section.
    (D) * * * If, in a partnership taxable year beginning on or after 
August 3, 2015, 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, 
liquidation, or sale or 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 interest 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 
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 partner 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, 2015. 
Administration of the estate is completed and the estate, including 
the partnership interest, is distributed to W as legatee on November 
30, 2015. 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, 2015, and H will include 
in his final return for his final taxable year (January 1, 2015, 
through March 31, 2015) his distributive share of partnership items 
for that period under the rules of sections 706(d)(2), 706(d)(3), 
and Sec.  1.706-4.

    (iii) Deemed dispositions. A deemed disposition of the partner's 
interest pursuant to 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. Sec.  1.1502-1(h)), 1.1362-3(c)(1) (relating 
to the termination of the subchapter S election of an S corporation 
partner), or 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 solely 
for purposes of section 706.
* * * * *
    (4) Determination of distributive shares. See section 706(d)(2), 
706(d)(3), and 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 during the 
partnership's taxable year 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 a partner's 
entire interest as described in paragraph (c)(3) of this section.
* * * * *
    (d) Effective/applicability date. (1) The rules for paragraphs (a) 
and (b) of this section apply for partnership taxable years ending on 
or after May 17, 2002, except for paragraphs (b)(5) and (6) of this 
section, which generally apply to partnership taxable years beginning 
on or after July 23, 2002 (however, see paragraphs (b)(5)(iii) and 
(b)(6)(v) of this section for certain exceptions to and transition 
relief from the applicability dates of paragraphs (b)(5) and (6) of 
this section).
    (2) 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 on or after August 3, 2015.

0
Par. 4. Add reserved Sec.  1.706-2 with the following heading:


Sec.  1.706-2  Certain cash basis items allocable. [Reserved]

0
Par. 5. Add reserved Sec.  1.706-3 with the following heading:


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

0
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) Variations subject to this section. Except as 
provided in paragraph (a)(2) of this section, this section provides 
rules for determining the partners' distributive shares of partnership 
items when a partner's interest in a partnership varies during the 
taxable year as a result of the disposition of a partial or entire 
interest in a partnership as described in Sec.  1.706-1(c)(2) and (3), 
or with respect to a partner whose interest in a partnership is reduced 
as described in Sec.  1.706-1(c)(3), including by the entry of a new 
partner (collectively, a ``variation'').
    (2) Coordination with sections 706(d)(2) and 706(d)(3) and other 
Code sections. Items subject to allocation under other rules, including 
sections 108(e)(8) and 108(i) (which provide special allocation rules 
for certain items from the discharge or retirement of indebtedness), 
section 706(d)(2) (relating to the determination of partners' 
distributive shares of allocable cash basis items) and section 
706(d)(3) (relating to the determination of partners' distributive 
share of any item of an upper tier partnership attributable to a lower 
tier partnership), are not

[[Page 45879]]

subject to the rules of this section. In all cases, all partnership 
items for each taxable year must be allocated among the partners, and 
no partnership items may be duplicated, regardless of the particular 
provision of section 706 (or other Code section) which applies, and 
regardless of the method or convention adopted by the partnership.
    (3) Allocation of items subject to this section. In determining the 
distributive share under section 702(a) of partnership items subject to 
this section, the partnership shall follow the steps described in this 
paragraph (a)(3)(i) through (x).
    (i) First, determine whether either of the exceptions in paragraph 
(b) of this section (regarding certain changes among contemporaneous 
partners and partnerships for which capital is not a material income-
producing factor) applies.
    (ii) Second, determine which of its items are subject to allocation 
under the special rules for extraordinary items in paragraph (e) of 
this section, and allocate those items accordingly.
    (iii) Third, determine with respect to each variation whether it 
will apply the interim closing method or the proration method. Absent 
an agreement of the partners (within the meaning of paragraph (f) of 
this section) to use the proration method, the partnership shall use 
the interim closing method. The partnership may use different methods 
(interim closing or proration) for different variations within each 
partnership taxable year; however, the Commissioner may place 
restrictions on the ability of partnerships to use different methods 
during the same taxable year in guidance published in the Internal 
Revenue Bulletin.
    (iv) Fourth, determine when each variation is deemed to have 
occurred under the partnership's selected convention (as described in 
paragraph (c) of this section).
    (v) Fifth, determine whether there is an agreement of the partners 
(within the meaning of paragraph (f) of this section) to perform 
regular monthly or semi-monthly interim closings (as described in 
paragraph (d) of this section). If so, then the partnership will 
perform an interim closing of its books at the end of each month (in 
the case of an agreement to perform monthly closings) or at the end and 
middle of each month (in the case of an agreement to perform semi-
monthly closings), regardless of whether any variation occurs. Absent 
an agreement of the partners to perform regular monthly or semi-monthly 
interim closings, the only interim closings during the partnership's 
taxable year will be at the deemed time of the occurrence of variations 
for which the partnership uses the interim closing method.
    (vi) Sixth, determine the partnership's segments, which are 
specific periods of the partnership's taxable year created by interim 
closings of the partnership's books. The first segment shall commence 
with the beginning of the taxable year of the partnership and shall end 
at the time of the first interim closing. Any additional segment shall 
commence immediately after the closing of the prior segment and shall 
end at the time of the next interim closing. However, the last segment 
of the partnership's taxable year shall end no later than the close of 
the last day of the partnership's taxable year. If there are no interim 
closings, the partnership has one segment, which corresponds to its 
entire taxable year.
    (vii) Seventh, apportion the partnership's items for the year among 
its segments. The partnership shall determine the items of income, 
gain, loss, deduction, and credit of the partnership for each segment. 
In general, a partnership shall treat each segment as though the 
segment were a separate distributive share period. For example, a 
partnership may compute a capital loss for a segment of a taxable year 
even though the partnership has a net capital gain for the entire 
taxable year. For purposes of determining allocations to segments, any 
special limitation or requirement relating to the timing or amount of 
income, gain, loss, deduction, or credit applicable to the entire 
partnership taxable year will be applied based upon the partnership's 
satisfaction of the limitation or requirement as of the end of the 
partnership's taxable year. For example, the expenses related to the 
election to expense a section 179 asset must first be calculated (and 
limited if applicable) based on the partnership's full taxable year, 
and then the effect of any limitation must be apportioned among the 
segments in accordance with the interim closing method or the proration 
method using any reasonable method.
    (viii) Eighth, determine the partnership's proration periods, which 
are specific portions of a segment created by a variation for which the 
partnership chooses to apply the proration method. The first proration 
period in each segment begins at the beginning of the segment, and ends 
at the time of the first variation within the segment for which the 
partnership selects the proration method. The next proration period 
begins immediately after the close of the prior proration period and 
ends at the time of the next variation for which the partnerships 
selects the proration method. However, each proration period shall end 
no later than the close of the segment.
    (ix) Ninth, prorate the items of income, gain, loss, deduction, and 
credit in each segment among the proration periods within the segment.
    (x) Tenth, determine the partners' distributive shares of 
partnership items under section 702(a) by taking into account the 
partners' interests in such items during each segment and proration 
period.

    (4) Example. (i) At the beginning of 2015, PRS, a calendar year 
partnership, has three equal partners, A, B, and C. On April 16, 
2015, A sells 50% of its interest in PRS to new partner D. On August 
6, 2015, B sells 50% of its interest in PRS to new partner E. During 
2015, PRS earned $75,000 of ordinary income, incurred $33,000 of 
ordinary deductions, earned $12,000 of capital gain in the ordinary 
course of its business, and sustained $9,000 of capital loss in the 
ordinary course of its business. Within that year, PRS earned 
$60,000 of ordinary income, incurred $24,000 of ordinary deductions, 
earned $12,000 of capital gain, and sustained $6,000 of capital loss 
between January 1, 2015, and July 31, 2015, and PRS earned $15,000 
of gross ordinary income, incurred $9,000 of gross ordinary 
deductions, and sustained $3,000 of capital loss between August 1, 
2015, and December 31, 2015. None of PRS's items are extraordinary 
items within the meaning of paragraph (e)(2) of this section. 
Capital is a material income-producing factor for PRS. For 2015, PRS 
determines the distributive shares of A, B, C, D, and E as follows.
    (i) First, PRS determines that none of the exceptions in 
paragraph (b) of this section apply because capital is a material-
income producing factor and no variation is the result of a change 
in allocations among contemporaneous partners.
    (ii) Second, PRS determines that none of its items are 
extraordinary items subject to allocation under paragraph (e) of 
this section.
    (iii) Third, the partners of PRS agree (within the meaning of 
paragraph (f) of this section) to apply the proration method to the 
April 16, 2015, variation, and PRS accepts the default application 
of the interim closing method to the August 6, 2015, variation.
    (iv) Fourth, PRS determines the deemed date of the variations 
for purposes of this section based upon PRS's selected convention. 
Because PRS applied the proration method to the April 16, 2015, 
variation, PRS must use the calendar day convention with respect to 
the April 16, 2015, variation pursuant to paragraph (c) of this 
section. Therefore, the variation that resulted from A's sale to D 
on April 16, 2015, is deemed to occur for purposes of this section 
at the end of the day on April 16, 2015. Further, the partners of 
PRS agree (within the meaning of paragraph (f) of this section) to 
apply the semi-monthly convention to the August 6, 2015, variation. 
Therefore, the August 6, 2015, variation is deemed to occur at the 
end of the day on July 31, 2015.

[[Page 45880]]

    (v) Fifth, the partners of PRS do not agree to perform regular 
semi-monthly or monthly closings as described in paragraph (d) of 
this section. Therefore, PRS will have only one interim closing for 
2015, occurring at the end of the day on July 31.
    (vi) Sixth, PRS determines that it has two segments for 2015. 
The first segment commences January 1, 2015, and ends at the close 
of the day on July 31, 2015. The second segment commences at the 
beginning of the day on August 1, 2015, and ends at the close of the 
day on December 31, 2015.
    (vii) Seventh, PRS determines that during the first segment of 
its taxable year (beginning January 1, 2015, and ending July 31, 
2015), it had $60,000 of ordinary income, $24,000 of ordinary 
deductions, $12,000 of capital gain, and $6,000 of capital loss. PRS 
determines that during the second segment of its taxable year 
(beginning August 1, 2015, and ending December 31, 2015), it had 
$15,000 of gross ordinary income, $9,000 of gross ordinary 
deductions, and $3,000 of capital loss.
    (viii) Eighth, PRS determines that it has two proration periods. 
The first proration period begins January 1, 2015, and ends at the 
close of the day on April 16, 2015; the second proration period 
begins April 17, 2015, and ends at the close of the day on July 31, 
2015.
    (ix) Ninth, PRS prorates its income from the first segment of 
its taxable year among the two proration periods. Because each 
proration period has 106 days, PRS allocates 50% of its items from 
the first segment to each proration period. Thus, each proration 
period contains $30,000 gross ordinary income, $12,000 gross 
ordinary deductions, $6,000 capital gain, and $3,000 capital loss.
    (x) Tenth, PRS calculates each partner's distributive share. 
Because A, B, and C were equal partners during the first proration 
period, each is allocated one-third of the partnership's items 
attributable to that proration period. Thus, A, B, and C are each 
allocated $10,000 gross ordinary income, $4,000 gross ordinary 
deductions, $2,000 capital gain, and $1,000 capital loss for the 
first proration period. For the second proration period, A and D 
each had a one-sixth interest in PRS and B and C each had a one-
third interest in PRS. Thus, A and D are each allocated $5,000 gross 
ordinary income, $2,000 gross ordinary deductions, $1,000 capital 
gain, and $500 capital loss, and B and C are each allocated $10,000 
gross ordinary income, $4,000 gross ordinary deductions, $2,000 
capital gain, and $1,000 capital loss for the second proration 
period. For the second segment of PRS's taxable year, A, B, D, and E 
each had a one-sixth interest in PRS and C had a one-third interest 
in PRS. Thus, A, B, D, and E are each allocated $2,500 gross 
ordinary income, $1,500 gross ordinary deductions, and $500 capital 
loss, and C is allocated $5,000 gross ordinary income, $3,000 gross 
ordinary deductions, and $1,000 capital loss for the second segment.

    (b) Exceptions--(1) Permissible changes among contemporaneous 
partners. The general rule of paragraph (a)(3) 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 (or 
among contemporaneous partners for a segment if the item is entirely 
attributable to a segment), 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 partnership or a 
distribution of money or property by the partnership to a partner; and
    (ii) The allocations resulting from the modification satisfy the 
provisions of section 704(b) and the regulations promulgated 
thereunder.
    (2) Safe harbor for partnerships for which capital is not a 
material income-producing factor. Notwithstanding paragraph (a)(3) of 
this section, with respect to any taxable year in which there is a 
change in any partner's interest in a partnership for which capital is 
not a material income-producing factor, 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 satisfy the provisions of section 704(b).
    (c) Conventions--(1) In general. Conventions are rules of 
administrative convenience that determine when each variation is deemed 
to occur for purposes of this section. Because the timing of each 
variation is necessary to determine the partnership's segments and 
proration periods, which are used to determine the partners' 
distributive shares, the convention used by the partnership with 
respect to a variation will generally affect the allocation of 
partnership items. However, see paragraph (e) of this section for 
special rules regarding extraordinary items, which generally must be 
allocated without regard to the partnership's convention. Subject to 
the limitations set forth in paragraphs (c)(2) and (3) of this section, 
partnerships may generally choose from the following three conventions:
    (i) Calendar day convention. Under the calendar day convention, 
each variation is deemed to occur for purposes of this section at the 
end of the day on which the variation occurs.
    (ii) Semi-monthly convention. Under the semi-monthly convention, 
each variation is deemed to occur for purposes of this section either:
    (A) In the case of a variation occurring on the 1st through the 
15th day of a calendar month, at the end of the last day of the 
immediately preceding calendar month; or
    (B) In the case of a variation occurring on the 16th through the 
last day of a calendar month, at the end of the 15th calendar day of 
that month.
    (iii) Monthly convention. Under the monthly convention, each 
variation is deemed to occur for purposes of this section either:
    (A) In the case of a variation occurring on the 1st through the 
15th day of a calendar month, at the end of the last day of the 
immediately preceding calendar month; or
    (B) In the case of a variation occurring on the 16th through the 
last day of a calendar month, at the end of the last day of that 
calendar month.
    (2) Exceptions. (i) Notwithstanding paragraph (c)(1) of this 
section, all variations within a taxable year shall be deemed to occur 
no earlier than the first day of the partnership's taxable year, and no 
later than the close of the final day of the partnership's taxable 
year. Thus, in the case of a calendar year partnership applying either 
the semi-monthly or monthly convention to a variation occurring on 
January 1st through January 15th, the variation will be deemed to occur 
for purposes of this section at the beginning of the day on January 
1st.
    (ii) In the case of a partner who becomes a partner during the 
partnership's taxable year as a result of a variation, and ceases to be 
a partner as a result of another variation, if both such variations 
would be deemed to occur at the same time under the rules of paragraph 
(c)(1) of this section, then the variations with respect to that 
partner's interest will instead be treated as occurring on the dates 
each variation actually occurred. Thus, the partnership must treat such 
a partner as a partner for the entire portion of its taxable year 
during which the partner actually owned an interest. See Example 2 of 
paragraph (c)(4) of this section. However, this paragraph (c)(2)(ii) 
does not apply to publicly traded partnerships (as defined in section 
7704(b)) that are treated as partnerships with respect to holders of 
publicly traded units (as described in Sec.  1.7704-1(b) or 1.7704-
1(c)(1)).
    (iii) Notwithstanding paragraph (c)(1)(iii) of this section, a 
publicly traded partnership (as defined in section 7704(b)) that is 
treated as a partnership may consistently treat all variations 
occurring during each month as occurring at the end of the last day of 
that calendar month if the publicly

[[Page 45881]]

traded partnership uses the monthly convention for those variations.
    (3) Permissible conventions for each variation--(i) Rules 
applicable to all partnerships. A partnership generally shall use the 
calendar day convention for each variation; however, for all variations 
during a taxable year for which the partnership uses the interim 
closing method, the partnership may instead use the semi-monthly or 
monthly convention by agreement of the partners (within the meaning of 
paragraph (f) of this section). The partnership must use the same 
convention for all variations for which the partnership uses the 
interim closing method.
    (ii) Publicly traded partnerships. A publicly traded partnership 
(as defined in section 7704(b)) that is treated as a partnership may, 
by agreement of the partners (within the meaning of paragraph (f) of 
this section) use any of the calendar day, the semi-monthly, or the 
monthly conventions with respect to all variations during the taxable 
year relating to its publicly-traded units (as described in Sec.  
1.7704-1(b) or (c)(1)), regardless of whether the publicly traded 
partnership uses the proration method with respect to those variations. 
A publicly traded partnership must use the same convention for all 
variations during the taxable year relating to its publicly traded 
units. A publicly traded partnership must use the calendar day 
convention with respect to all variations relating to its non-publicly 
traded units for which the publicly traded partnership uses the 
proration method.
    (4) Examples. The following examples illustrate the principles in 
this paragraph (c).
    Example 1.  PRS is a calendar year partnership with four equal 
partners A, B, C, and D. PRS is not a publicly traded partnership. 
PRS has the following three variations that occur during its 2015 
taxable year: on March 11, A sells its entire interest in PRS to new 
partner E; on June 12, PRS partially redeems B's interest in PRS 
with a distribution comprising a partial return of B's capital; on 
October 21, C sells part of C's interest in PRS to new partner E. 
These transfers do not result in a termination of PRS under section 
708. Pursuant to paragraph (a)(3)(iii) of this section, the partners 
of PRS agree (within the meaning of paragraph (f) of this section) 
to use the interim closing method with respect to the variations 
occurring on March 11 and October 21 and agree to use the proration 
method with respect to the variation occurring on June 12. Pursuant 
to paragraph (c)(3) of this section, the partners of PRS may agree 
(within the meaning of paragraph (f) of this section) to use any of 
the calendar day, semi-monthly, or monthly conventions with respect 
to the March 11 and October 21 variations, but must use the same 
convention for both variations. If the partners of PRS agree to use 
the calendar day convention, the March 11 and October 21 variations 
will be deemed to occur for purposes of this section at the end of 
the day on March 11, 2015, and October 21, 2015, respectively. If 
the partners of PRS agree to use the semi-monthly convention, the 
March 11 and October 21 variations will be deemed to occur for 
purposes of this section at the end of the day on February 28, 2015, 
and October 15, 2015, respectively. If the partners of PRS agree to 
use the monthly convention, the March 11 and October 21 variations 
will be deemed to occur for purposes of this section at the end of 
the day on February 28, 2015, and October 31, 2015, respectively. 
Pursuant to paragraph (c)(3) of this section PRS must use the 
calendar day convention with respect to the June 12 variation; thus, 
the June 12 variation is deemed to occur for purposes of this 
section at the end of the day on June 12, 2015.
    Example 2. PRS is a calendar year partnership that uses the 
interim closing method and monthly convention to account for 
variations during its taxable year. PRS is not a publicly traded 
partnership. On January 20, 2015, new partner A purchases an 
interest in PRS from one of PRS's existing partners. On February 14, 
2015, A sells its entire interest in PRS. These transfers do not 
result in a termination of PRS under section 708. Under the rules of 
paragraph (c)(1)(iii) of this section, the January 20, 2015, 
variation and the February 14, 2015, variation would both be deemed 
to occur at the same time: the end of the day on January 31, 2015. 
Therefore, under the exception in paragraph (c)(2)(ii) of this 
section, the rules of paragraph (c)(1) of this section do not apply, 
and instead the January 20, 2015, variation and the February 14 
variation are considered to occur on January 20, 2015, and February 
14, 2015, respectively. PRS must perform a closing of the books on 
both January 20, 2015, and February 14, 2015, and allocate A a share 
of PRS's items attributable to that segment.

    (d)(1) Optional regular monthly or semi-monthly interim closings. 
Under the rules of this section, a partnership is not required to 
perform an interim closing of its books except at the time of any 
variation for which the partnership uses the interim closing method 
(taking into account the applicable convention). However, a partnership 
may, by agreement of the partners (within the meaning of paragraph (f) 
of this section) perform regular monthly or semi-monthly interim 
closings of its books, regardless of whether any variation occurs. 
Regardless of whether the partners agree to perform these regular 
interim closings, the partnership must continue to apply the interim 
closing or proration method to its variations according to the rules of 
this section.
    (2) Example. The following example illustrates the principles in 
this paragraph (d).

    Example.  (i) PRS is a calendar year partnership with five equal 
partners A, B, C, D, and E. PRS has the following two variations 
that occur during its 2015 taxable year: on August 29, A sells its 
entire interest in PRS to new partner F; on December 27, PRS 
completely liquidates B's interest in PRS with a distribution. These 
variations do not result in a termination of PRS under section 708.
    (ii) The partners of PRS agree (within the meaning of paragraph 
(f) of this section) to use the interim closing method and the semi-
monthly convention with respect to the variation occurring on August 
29. Thus, the August variation is deemed to occur for purposes of 
this section at the end of the day on August 15, 2015. The partners 
of PRS agree (within the meaning of paragraph (f) of this section) 
to use the proration method with respect to the December 27 
variation. Therefore, PRS must use the calendar day convention with 
respect to the December variation pursuant to paragraph (c) of this 
section. Thus, the December variation is deemed to occur for 
purposes of this section at the end of the day on December 27, 2015.
    (iii) Pursuant to paragraph (d)(1) of this section, the partners 
of PRS agree (within the meaning of paragraph (f) of this section) 
to perform regular monthly interim closings. Therefore, PRS will 
have twelve interim closings for its 2015 taxable year, one at the 
end of every month and one at the end of the day on August 15. 
Therefore, PRS will have thirteen segments for 2015, one 
corresponding to each month from January through July, one segment 
from August 1 through August 15, one segment from August 16 through 
August 31, and one corresponding to each month from September 
through December. PRS must apportion its items among these segments 
under the rules of paragraph (a)(3) of this section.
    (iv) PRS will have two proration periods for 2015, one from 
December 1 through December 27, and one from December 28 through 
December 31. Pursuant to the rules of paragraph (a)(3) of this 
section, PRS will prorate the items in its December segment among 
these two proration periods. Therefore, PRS will apportion 27/31 of 
all items in its December segment to the proration period from 
December 1 through December 27, and 4/31 of all items in its 
December segment to the proration period from December 28 through 
December 31.
    (v) Pursuant to the rules of paragraph (a)(3)(x) of this 
section, PRS determines the partners' distributive shares of 
partnership items under section 702(a) by taking into account the 
partners' interests in such items during each of the thirteen 
segments and two proration periods. Thus, A, B, C, D, and E will 
each be allocated one-fifth of all items in the following segments: 
January, February, March, April, May, June, July, and August 1 
through August 15. B, C, D, E, and F will each be allocated one-
fifth of all items in the following segments: August 16 through 
August 31, September, October, and November. B, C, D, E, and F will 
each be allocated one-fifth of all items in the proration period 
from December 1 through December 27. C, D, E, and F will each be

[[Page 45882]]

allocated one-quarter of all items in the proration period from 
December 28 through December 31.

    (e) Extraordinary items--(1) General principles. Extraordinary 
items may not be prorated. The partnership must allocate extraordinary 
items among the partners in proportion to their interests in the 
partnership item at the time of day on which the extraordinary item 
occurred, regardless of the method (interim closing or proration 
method) and convention (daily, semi-monthly, or monthly) otherwise used 
by the partnership. These rules require the allocation of extraordinary 
items as an exception to the proration method, which would otherwise 
ratably allocate the extraordinary items across the segment, and the 
conventions, which could otherwise inappropriately shift extraordinary 
items between a transferor and transferee. However, publicly traded 
partnerships (as defined in section 7704(b)) that are treated as 
partnerships may, but are not required to, apply their selected 
convention in determining who held publicly traded units (as described 
in Sec.  1.7704-1(b) or (c)(1)) at the time of the occurrence of an 
extraordinary item. Extraordinary items continue to be subject to any 
special limitation or requirement relating to the timing or amount of 
income, gain, loss, deduction, or credit applicable to the entire 
partnership taxable year (for example, the limitation for section 179 
expenses).
    (2) Definition. Except as provided in paragraph (e)(3) of this 
section, 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 (other than in 
the ordinary course of business) of property used in a trade or 
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(a)(1), (a)(3), (a)(4), or (a)(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 item resulting from any change in accounting method 
initiated by the filing of the appropriate form after a variation 
occurs;
    (vi) Any item from the discharge or retirement of indebtedness 
(except items subject to section 108(e)(8) or 108(i), which are subject 
to special allocation rules provided in section 108(e)(8) and 108(i));
    (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);
    (ix) For all partnerships, any additional item if, the partners 
agree (within the meaning of paragraph (f) of this section) to 
consistently treat such item as an extraordinary item for that taxable 
year; however, this rule does not apply if treating that additional 
item as an extraordinary item would result in a substantial distortion 
of income in any partner's return; any additional extraordinary items 
continue to be subject to any special limitation or requirement 
relating to the timing or amount of income, gain, loss, deduction, or 
credit applicable to the entire partnership taxable year (for example, 
the limitation for section 179 expenses);
    (x) 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;
    (xi) Any item identified as an additional class of extraordinary 
item in guidance published in the Internal Revenue Bulletin.
    (3) Small item exception. A partnership may treat an item described 
in paragraph (e)(2) of this section as other than an extraordinary item 
for purposes of this paragraph (e) if, for the partnership's taxable 
year the total of all items in the particular class of extraordinary 
items (as enumerated in paragraphs (e)(2)(i) through (xi) of this 
section, for example, all tort or similar liabilities, but in no event 
counting an extraordinary item more than once) is less than five 
percent of the partnership's gross income, including tax-exempt income 
described in section 705(a)(1)(B), in the case of income or gain items, 
or gross expenses and losses, including section 705(a)(2)(B) 
expenditures, in the case of losses and expense items; and the total 
amount of the extraordinary items from all classes of extraordinary 
items amounting to less than five percent of the partnership's gross 
income, including tax-exempt income described in section 705(a)(1)(B), 
in the case of income or gain items, or gross expenses and losses, 
including section 705(a)(2)(B) expenditures, in the case of losses and 
expense items, does not exceed $10 million in the taxable year, 
determined by treating all such extraordinary items as positive 
amounts.
    (4) Examples. The following examples illustrate the provisions of 
this paragraph (e).

    Example 1.  PRS, a calendar year partnership, uses the proration 
method and calendar day convention to account for varying interests 
of the partners. At 3:15 p.m. on December 7, 2015, PRS recognizes an 
extraordinary item within the meaning of paragraph (e)(2) of this 
section. On December 12, 2015, A, a partner in PRS, disposes of its 
entire interest in PRS. PRS does not experience a termination under 
section 708 during 2015. PRS has no other extraordinary items for 
the taxable year, the small item exception of paragraph (e)(3) of 
this section does not apply, the exceptions in paragraph (b) of this 
section do not apply, and PRS is not a publicly traded partnership. 
Pursuant to paragraph (e)(1) of this section, the item of income, 
gain, loss, deduction, or credit attributable to the extraordinary 
item will be allocated in accordance with the partners' interests in 
the extraordinary item at 3:15 p.m. on December 7, 2015. The 
remaining partnership items of PRS that are subject to this section 
must be prorated across the partnership's taxable year in accordance 
with paragraph (a)(3) of this section.
    Example 2.  Assume the same facts as in Example 1, except that 
PRS uses the interim closing method and monthly convention to 
account for varying interests of the partners. Pursuant to paragraph 
(c)(1)(iii) of this section, the December 12 variation is deemed to 
have occurred for purposes of this section at the end of the day on 
November 30, 2015. Thus, A will not generally be allocated any items 
of PRS attributable to the segment between December 1, 2015, and 
December 31, 2015; however, pursuant to paragraph (e)(1) of this 
section, PRS must allocate the item of income, gain, loss, 
deduction, or credit attributable to the extraordinary item in 
accordance with the partners' interests in the extraordinary item at 
the time of day on which the extraordinary item occurred, regardless 
of the convention used by PRS. Thus, because A was a partner in PRS 
at 3:15 p.m. on December 7, 2015 (ignoring application of PRS's 
convention), A must be allocated a share of the extraordinary item.
    Example 3.  Assume the same facts as in Example 2, except that 
PRS is a publicly traded partnership (within the meaning of section 
7704(b)) and A held a publicly traded unit (as described in Sec.  
1.7704-1(b) or 1.7704-1(c)(1)) in PRS. Under PRS's monthly 
convention, the December 12 variation is deemed to have occurred for 
purposes of this section at the end of the day on November 30, 2015. 
Pursuant to paragraph (e)(1) of this section, a publicly traded 
partnership (as defined in section 7704(b)) may choose to respect 
its conventions in determining who held its publicly traded units 
(as described in Sec.  1.7704-1(b) or Sec.  1.7704-1(c)(1)) at the 
time of the occurrence of an extraordinary item. Therefore, PRS may 
choose to treat A as not having been a partner in PRS for purposes 
of this paragraph (e) at the time the

[[Page 45883]]

extraordinary item arose, and thus PRS may choose not to allocate A 
any share of the extraordinary item.
    Example 4.  A and B each own a 15 percent interest in PRS, a 
partnership that is not a publicly traded partnership and for which 
capital is a material income-producing factor. At 9:00 a.m. on April 
25, 2015, A sells its entire interest in PRS to new partner D. At 
3:00 p.m. on April 25, 2015, PRS incurs an extraordinary item 
(within the meaning of paragraph (e)(2) of this section). At 5:00 
p.m. on April 25, 2015, B sells its entire interest in PRS to new 
partner E. Under paragraph (e)(1) of this section, PRS must allocate 
the extraordinary item in accordance with the partners' interests at 
3:00 p.m. on April 25, 2015. Accordingly, a portion of the 
extraordinary item will be allocated to each of B and D, but no 
portion will be allocated to A or E.
    Example 5.  PRS, a calendar year partnership that is not a 
publicly traded partnership, has a variation in a partner's interest 
during 2015 and the exceptions in paragraph (b) of this section do 
not apply. During 2015 PRS has two extraordinary items: PRS 
recognizes $8 million of gross income on the sale outside the 
ordinary course of business of an asset described in paragraph 
(e)(2)(ii) of this section, and PRS also recognizes $12 million of 
gross income from a tort settlement as described in paragraph 
(e)(2)(vii) of this section. PRS's gross income (including the gross 
income from the extraordinary items) for the taxable year is $200 
million. The gain from all items described in paragraph (e)(2)(ii) 
of this section is less than five percent of PRS's gross income ($8 
million gross income from the asset sale divided by $200 million 
total gross income, or four percent) and all of the extraordinary 
items of PRS from classes that are less than five percent of PRS's 
gross income ($8 million), in the aggregate, do not exceed $10 
million for the taxable year. Thus, the $8 million gain recognized 
on the asset sale is considered a small item under paragraph (e)(3) 
of this section and is therefore excepted from the rules of 
paragraph (e)(1) of this section. Because the gross income 
attributable to the tort settlement exceeds five percent of PRS's 
gross income (six percent), the tort settlement gross income is not 
considered a small item under paragraph (e)(3) of this section. 
Therefore, the $12 million gross income attributable to the tort 
settlement must be allocated according to the rules of paragraph 
(e)(1) of this section in accordance with PRS's partners' interests 
in the item at the time of the day that the tort settlement income 
arose.
    Example 6.  Assume the same facts as Example 5, except that 
during the year, PRS also recognizes two additional extraordinary 
items: $2 million of gross income from the sale of a capital asset 
described in paragraph (e)(2)(i) of this section, and $1 million of 
gross income from discharge of indebtedness described in paragraph 
(e)(2)(vi) of this section. Although the gain from items described 
in each of paragraphs (e)(2)(i), (e)(2)(ii), and (e)(2)(vi) of this 
section is each less than five percent of PRS's gross income, the 
extraordinary items of PRS from classes that are less than five 
percent of PRS's gross income ($11 million), in the aggregate, 
exceeds $10 million for the taxable year. Thus, none of the items 
are considered a small item under paragraph (e)(3) of this section. 
Therefore, the items attributable to the sale of the capital asset, 
the sale of the trade or business asset, the discharge of 
indebtedness income, and the tort settlement must each be allocated 
according to the rules of paragraph (e)(1) of this section in 
accordance with PRS's partners' interests in the item at the time of 
the day that the items arose.

    (f) Agreement of the partners. For purposes of paragraphs 
(a)(3)(iii) (relating to selection of the proration method), (c)(3) 
(relating to selection of the semi-monthly or monthly convention), (d) 
(relating to performance of regular monthly or semi-monthly interim 
closings), and (e)(2)(ix) (relating to selection of additional 
extraordinary items) of this section, the term agreement of the 
partners means either an agreement of all the partners to select the 
method, convention, or extraordinary item in a dated, written statement 
maintained with the partnership's books and records, including, for 
example, a selection that is included in the partnership agreement, or 
a selection of the method, convention, or extraordinary item made by a 
person authorized to make that selection, including under a grant of 
general authority provided for by either state law or in the 
partnership agreement, if that person's selection is in a dated, 
written statement maintained with the partnership's books and records. 
In either case, the dated written agreement must be maintained with the 
partnership's books and records by the due date, including extension, 
of the partnership's tax return.
    (g) Effective/applicability date. Except with respect to paragraph 
(c)(3) of this section, this section applies for partnership taxable 
years that begin on or after August 3, 2015. The rules of paragraph 
(c)(3) of this section apply for taxable years of partnerships other 
than existing publicly traded partnerships that begin on or after 
August 3, 2015. For purposes of the immediately preceding sentence, an 
existing publicly traded partnership is a partnership described in 
section 7704(b) that was formed prior to April 19, 2009. For purposes 
of this effective date provision, the termination of a publicly traded 
partnership under section 708(b)(1)(B) due to the sale or exchange of 
50 percent or more of the total interests in partnership capital and 
profits is disregarded in determining whether the publicly traded 
partnership is an existing publicly traded partnership.

0
Par. 7. Section 1.706-5 is added to read as follows:


Sec.  1.706-5  Taxable year determination.

    (a) In general. For purposes of Sec.  1.706-4, the taxable year of 
a partnership shall be determined without regard to section 
706(c)(2)(A) and its regulations.
    (b) Effective/applicability date. This section applies for 
partnership taxable years that begin on or after August 3, 2015.

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

0
Par. 8. The authority for part 602 continues to read as follows:

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

0
Par. 9. In Sec.  602.101, paragraph (b) is amended by adding the 
following entry in numerical order to the table to read as follows:


Sec.  602.101  OMB Control numbers.

* * * * *
    (b) * * *

------------------------------------------------------------------------
                                                            Current OMB
   CFR Part or section where identified and described       control no.
------------------------------------------------------------------------
 
                                * * * * *
1.706-4(f)..............................................       1545-0123
 
                                * * * * *
------------------------------------------------------------------------


Karen L. Schiller,
Acting Deputy Commissioner for Services and Enforcement.

    Approved: June 3, 2015.
Mark J. Mazur,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2015-18816 Filed 7-31-15; 8:45 am]
 BILLING CODE 4830-01-P