Section 707 Regarding Disguised Sales, Generally, 69291-69300 [2016-23387]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 81, Number 193 (Wednesday, October 5, 2016)]
[Rules and Regulations]
[Pages 69291-69300]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2016-23387]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9787]
RIN 1545-BK29


Section 707 Regarding Disguised Sales, Generally

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations under sections 707 
and 752 of the Internal Revenue Code (Code). The final regulations 
under section 707 provide guidance relating to disguised sales of 
property to or by a partnership and the final regulations under section 
752 provide guidance relating to allocations of excess nonrecourse 
liabilities of a partnership to partners for disguised sale purposes. 
The final regulations affect partnerships and their partners.

DATES: Effective date: These regulations are effective on October 5, 
2016.
    Comment date: Comments will be accepted until January 3, 2017.
    Applicability dates: For dates of applicability, see Sec. Sec.  
1.707-9(a)(1) and 1.752-3(d).

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-122855-15), Room 
5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand-delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to: CC:PA:LPD:PR (REG-
122855-15), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue NW., Washington, DC, or sent electronically, via the Federal 
eRulemaking Portal site at https://www.regulations.gov (indicate IRS and 
REG-122855-15).

FOR FURTHER INFORMATION CONTACT: Deane M. Burke or Caroline E. Hay at 
(202) 317-5279 (not a toll-free number).

SUPPLEMENTARY INFORMATION: In addition to these final regulations, the 
Treasury Department and the IRS are publishing temporary regulations 
concerning a partner's share of partnership liabilities for purposes of 
section 707 (the 707 Temporary Regulations) and the treatment of 
certain payment obligations under section 752 (the 752 Temporary 
Regulations) in the Rules and Regulations section in this issue of the 
Federal Register, and, in the Proposed Rules section in this issue of 
the Federal Register, proposed regulations (REG-122855-15) that 
incorporate the text of the temporary regulations, withdraw a portion 
of a notice of proposed rulemaking (REG-119305-11) to the extent not 
adopted by the final regulations, and contain new proposed regulations 
(the 752 Proposed Regulations) addressing (1) when certain obligations 
to restore a deficit balance in a partner's capital account are 
disregarded under section 704 and (2) when a partnership's liabilities 
are treated as recourse liabilities under section 752.

Paperwork Reduction Act

    The collection of information contained in these final regulations 
has been reviewed in accordance with the Paperwork Reduction Act (44 
U.S.C. 3507) and approved by the Office of Management and Budget under 
control number 1545-0889.
    The collection of information in these final regulations under 
section 707 is in Sec.  1.707-5(a)(7)(ii) (regarding a liability 
incurred within two years prior to a transfer of property) and is 
reported on Form 8275, Disclosure Statement. This information is 
required by the IRS to ensure that section 707(a)(2)(B) of the Code and 
applicable regulations are properly applied to transfers between a 
partner and a partnership.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by section 6103.

Background

1. Overview

    This Treasury decision contains amendments to the Income Tax 
Regulations (26 CFR part 1) under sections 707 and 752 of the Code 
related to a notice of proposed rulemaking published on January 30, 
2014 in the Federal Register (REG-119305-11, 79 FR 4826) to amend 
regulations under sections 707 and 752 (the 2014 Proposed Regulations). 
A public hearing on the 2014 Proposed Regulations was not requested or 
held, but the Treasury Department and the IRS received written 
comments. After full consideration of the comments, the final 
regulations contained in this Treasury decision substantially adopt the 
2014 Proposed Regulations under section 707 with revisions to certain 
proposed rules in response to comments. The revisions to the 2014 
Proposed Regulations under section 707 adopted in these final 
regulations are discussed in the Summary of Comments and Explanation of 
Revisions section of this preamble. In addition, after considering 
comments on the 2014 Proposed Regulations under section 752, this 
Treasury decision adopts as final regulations provisions of the 2014 
Proposed Regulations that amend Sec.  1.752-3, revised in response to 
the comments received. Finally, these final regulations adopt 
provisions of the 2014 Proposed Regulations revising Sec.  1.704-
2(d)(2)(ii) and (m) Example 1, to comport with the provisions in the 
752 Proposed Regulations and the 752 Temporary Regulations relating to 
``bottom dollar payment obligations.''
    However, based on a comment received on the 2014 Proposed 
Regulations requesting that guidance regarding a partner's share of 
partnership liabilities apply solely for disguised sale purposes, the 
Treasury Department and the IRS have reconsidered the rules under Sec.  
1.707-5(a)(2) of the 2014 Proposed Regulations for determining a 
partner's share of partnership liabilities for purposes of section 707. 
Accordingly, in a separate Treasury decision (TD 9788), the Treasury 
Department and the IRS are also publishing the 707 Temporary 
Regulations that require a partner to apply the same percentage used to 
determine the partner's share of excess nonrecourse liabilities under 
Sec.  1.752-3(a)(3) (with certain limitations) in determining the 
partner's share of partnership liabilities for disguised sale purposes. 
That Treasury decision also contains the 752 Temporary Regulations 
providing guidance on the treatment of ``bottom dollar payment 
obligations.'' Cross-referencing proposed regulations providing 
additional opportunity for comment are contained in the related notice 
of proposed rulemaking (REG-122855-15) published in the Proposed Rules 
section in this issue of the Federal Register.
    Finally, after considering comments on the 2014 Proposed 
Regulations under section 752, the Treasury Department

[[Page 69292]]

and the IRS are withdrawing Sec.  1.752-2 of the 2014 Proposed 
Regulations and are publishing the new 752 Proposed Regulations 
contained in the related notice of proposed rulemaking (REG-122855-15) 
published in the Proposed Rules section in this issue of the Federal 
Register.

2. Summary of Applicable Law

A. Section 707
    Section 707 provides rules concerning ``disguised sales'' of 
property to or by a partnership. Section 707(a)(2)(B) generally 
provides that, under regulations prescribed by the Secretary, related 
transfers to and by a partnership that, when viewed together, are more 
properly characterized as a sale or exchange of property, will be 
treated either as a transaction between the partnership and one who is 
not a partner or between two or more partners acting other than in 
their capacity as partners. Generally under Sec.  1.707-3, a transfer 
of property by a partner to a partnership followed by a transfer of 
money or other consideration from the partnership to the partner will 
be treated as a sale of property by the partner to the partnership (a 
disguised sale), if based on all the facts and circumstances, the 
transfer of money or other consideration would not have been made but 
for the transfer of property and, for non-simultaneous transfers, the 
subsequent transfer is not dependent on the entrepreneurial risks of 
the partnership.
    The existing regulations under section 707, however, provide 
several exceptions. One exception is in Sec.  1.707-4(d) for 
reimbursements of capital expenditures. Section 1.707-4(d) excepts 
transfers of money or other consideration from a partnership to 
reimburse a partner for certain capital expenditures and costs incurred 
by the partner from being treated as part of a disguised sale of 
property under Sec.  1.707-3 (exception for preformation capital 
expenditures). The exception for preformation capital expenditures 
generally applies only to the extent that the reimbursed capital 
expenditures do not exceed 20 percent of the fair market value of the 
property transferred by the partner to the partnership (the 20-percent 
limitation). The 20-percent limitation, however, does not apply if the 
fair market value of the transferred property does not exceed 120 
percent of the partner's adjusted basis in the property at the time of 
the transfer (the 120-percent test).
    Another exception is in Sec.  1.707-5(b), which generally provides 
that if a partner transfers property to a partnership, the partnership 
incurs a liability and all or a portion of the proceeds of that 
liability are traceable to a transfer of money or other consideration 
to the partner, the transfer of money or other consideration is taken 
into account for purposes of Sec.  1.707-3 only to the extent that the 
amount of money or the fair market value of other consideration exceeds 
the partner's allocable share of the partnership liability (the debt-
financed distribution exception).
    In addition to the exception for preformation capital expenditures 
and the debt-financed distribution exception, the disguised sale rules 
generally exclude certain types of liabilities from disguised sale 
treatment. Generally under Sec.  1.707-5(a)(5), a partnership's 
assumption of a qualified liability, or a partnership's taking property 
subject to a qualified liability, in connection with a transfer of 
property by a partner to the partnership is not treated as part of a 
disguised sale. Section 1.707-5(a)(6) of the existing regulations 
defines four types of liabilities that are qualified liabilities. One 
type of qualified liability is a liability that is allocable under the 
rules of Sec.  1.163-8T to capital expenditures with respect to the 
property transferred to the partnership. Another type is one incurred 
in the ordinary course of the trade or business in which property 
transferred to the partnership was used or held, but only if all of the 
assets that are material to that trade or business are transferred to 
the partnership. The other two types of qualified liabilities are 
liabilities incurred more than two years before the transfer of 
property to the partnership and liabilities incurred within two years 
of the transfer of the property to the partnership, but not in 
anticipation of transfer to the partnership. In order to qualify as one 
of these types of liabilities, it is required that the liability 
encumber the transferred property.
B. Determining a Partner's Share of Liability for Disguised Sale 
Purposes
    In determining a partner's share of a partnership liability for 
disguised sale purposes, the existing regulations under section 707 
prescribe separate rules for a partnership's recourse liability and a 
partnership's nonrecourse liability. Under Sec.  1.707-5(a)(2)(i), a 
partner's share of a partnership's recourse liability equals the 
partner's share of the liability under section 752 and the regulations 
thereunder. A partnership liability is a recourse liability under 
section 707 to the extent that the obligation is a recourse liability 
under Sec.  1.752-1(a)(1). Under Sec.  1.707-5(a)(2)(ii), a partner's 
share of a partnership's nonrecourse liability is determined by 
applying the same percentage used to determine the partner's share of 
the excess nonrecourse liabilities under Sec.  1.752-3(a)(3). 
Generally, a partner's share of excess nonrecourse liabilities is 
determined in accordance with the partner's share of partnership 
profits taking into account all facts and circumstances relating to the 
economic arrangement of the partners. A partnership liability is a 
nonrecourse liability under section 707 to the extent that the 
obligation is a nonrecourse liability under Sec.  1.752-1(a)(2). Also 
for purposes of the rules under section 707, a partner's share of a 
liability assumed or taken subject to by a partnership is determined by 
taking into account certain subsequent reductions in the partner's 
share of the liability under an anticipated reduction rule.
C. Section 752 Allocation of Excess Nonrecourse Liabilities
    Section 1.752-3(a)(3) provides various methods to determine a 
partner's share of excess nonrecourse liabilities. Under one method, a 
partner's share of excess nonrecourse liabilities of the partnership is 
determined in accordance with the partner's share of partnership 
profits, which takes into account all facts and circumstances relating 
to the economic arrangement of the partners. For this purpose, the 
partnership agreement may specify the partners' interests in 
partnership profits so long as the interests so specified are 
reasonably consistent with allocations (that have substantial economic 
effect under the section 704(b) regulations) of some other significant 
item of partnership income or gain (the significant item method). 
Alternatively, excess nonrecourse liabilities may be allocated among 
partners in a manner that deductions attributable to those liabilities 
are reasonably expected to be allocated (alternative method). 
Additionally, the partnership may first allocate an excess nonrecourse 
liability to a partner up to the amount of built-in gain that is 
allocable to the partner on section 704(c) property (as defined under 
Sec.  1.704-3(a)(3)(ii)) or property for which reverse section 704(c) 
allocations are applicable (as described in Sec.  1.704-3(a)(6)(i)) 
where such property is subject to the nonrecourse liability, to the 
extent that such built-in gain exceeds the gain described in Sec.  
1.752-3(a)(2) with respect to such property (additional method). This 
additional method does not apply in determining a partner's share of a 
liability for disguised sale purposes.

[[Page 69293]]

3. The 2014 Proposed Regulations
    As discussed in greater detail in the Summary of Comments and 
Explanation of Provisions section of this preamble, the 2014 Proposed 
Regulations, as they pertained to section 707, were intended to address 
certain deficiencies and ambiguities under existing regulations 
Sec. Sec.  1.707-3, 1.707-4, and 1.707-5. The 2014 Proposed 
Regulations, among other things, provided rules that (1) clarified that 
in the case of multiple property contributions to a partnership, the 
exception for preformation capital expenditures applies on a property-
by-property basis, (2) clarified the definition of capital expenditures 
for the purpose of the exception for preformation capital expenditures, 
(3) coordinated the exception for preformation capital expenditures and 
the rules regarding liabilities traceable to capital expenditures, (4) 
added a new type of qualified liability, (5) prescribed an ordering 
rule for applying the debt-financed distribution exception where other 
exceptions also potentially applied, (6) specified that a reduction 
that is subject to the entrepreneurial risks of the partnership is not 
an anticipated reduction for purposes of the rule taking into account 
an anticipated reduction in a partner's share of a liability, (7) 
clarified, with respect to tiered partnerships, the application of the 
debt-financed distribution exception and the application of the rules 
for qualified liabilities, and (8) extended the principles of Sec.  
1.752-1(f) providing for netting of increases and decreases in a 
partner's share of liabilities resulting from a single transaction to 
the disguised sale rules.

Summary of Comments and Explanation of Revisions

1. Preformation Capital Expenditures

    As explained above, Sec.  1.707-4(d) excepts transfers of money or 
other consideration from a partnership to reimburse a partner for 
certain capital expenditures and costs incurred by the partner from 
being treated as part of a disguised sale of property under Sec.  
1.707-3, subject to the 20 percent limitation and the 120 percent test.
    The 2014 Proposed Regulations under section 707 provided that the 
determination of whether the 20 percent limitation and the 120 percent 
test apply to reimbursements of capital expenditures is made, in the 
case of multiple property transfers, separately for each property that 
qualifies for the exception (property-by-property rule). Commenters 
generally supported the property-by-property rule but noted that in 
some circumstances the approach may be burdensome and recommended 
limited aggregation of certain property. After considering the 
comments, the Treasury Department and the IRS have determined that 
limited aggregation of property is warranted in certain cases to reduce 
the burden of separately accounting for each property under the 
property-by-property rule. Thus, the final regulations adopt the 
proposed rule but permit aggregation to the extent: (i) The total fair 
market value of the aggregated property (of which no single property's 
fair market value exceeds 1 percent of the total fair market value of 
such aggregated property) is not greater than the lesser of 10 percent 
of the total fair market value of all property, excluding money and 
marketable securities (as defined under section 731(c)), transferred by 
the partner to the partnership, or $1,000,000; (ii) the partner uses a 
reasonable aggregation method that is consistently applied; and (iii) 
the aggregation of property is not part of a plan a principal purpose 
of which is to avoid Sec. Sec.  1.707-3 through 1.707-5. Additionally, 
the final regulations add an example to illustrate the application of 
the property-by-property rule when a partner transfers both tangible 
and intangible property to a partnership.
    In addition to the property-by-property rule, the 2014 Proposed 
Regulations provided a rule coordinating the exception for preformation 
capital expenditures with a rule regarding one type of qualified 
liability (within the meaning of Sec.  1.707-5(a)(6)) under Sec.  
1.707-5(a)(6)(i)(C). Under Sec.  1.707-5(a)(6)(i)(C), a liability that 
is allocable under the rules of Sec.  1.163-8T to capital expenditures 
with respect to the property transferred to the partnership by the 
partner is a qualified liability (capital expenditure qualified 
liability). Generally under Sec.  1.707-5(a)(5), a partnership's 
assumption of a qualified liability, or a partnership's taking property 
subject to a qualified liability, in connection with a transfer of 
property by a partner to the partnership is not treated as part of a 
disguised sale. To coordinate the exception for preformation capital 
expenditures and the capital expenditure qualified liability rule under 
Sec.  1.707-5(a)(6)(i)(C), the 2014 Proposed Regulations provided that 
to the extent a partner funded a capital expenditure through a capital 
expenditure qualified liability and economic responsibility for that 
borrowing shifts to another partner, the exception for preformation 
capital expenditures would not apply because there is no outlay by the 
partner to reimburse.
    A commenter suggested that the final regulations broaden this 
proposed rule to include any qualified liability under Sec.  1.707-
5(a)(6) used to fund capital expenditures, not just a capital 
expenditure qualified liability under Sec.  1.707-5(a)(6)(i)(C). The 
final regulations adopt the suggestion and provide that to the extent 
any qualified liability under Sec.  1.707-5(a)(6) is used by a partner 
to fund capital expenditures and economic responsibility for that 
borrowing shifts to another partner, the exception for preformation 
capital expenditures does not apply. Under the final regulations, 
capital expenditures are treated as funded by the proceeds of a 
qualified liability to the extent the proceeds are either traceable to 
the capital expenditures under Sec.  1.163-8T or are actually used to 
fund the capital expenditures, irrespective of the tracing requirements 
under Sec.  1.163-8T. However, under an anti-abuse provision, if 
capital expenditures and a qualified liability are incurred under a 
plan a principal purpose of which is to avoid the requirements of this 
coordinating rule, the capital expenditures are deemed funded by the 
qualified liability.
    Finally, it has come to the attention of the Treasury Department 
and the IRS that some partners have taken the position that the 
disclosure requirements of Sec.  1.707-3(c)(2) are not applicable to 
situations in which the partners believe that one or more of the 
exceptions for disguised sale treatment are applicable, including the 
exception for preformation capital expenditures. The Treasury 
Department and the IRS remind taxpayers that disclosure is required 
whenever money or other consideration is transferred by a partnership 
to a partner within two years of the transfer of property by the 
partner to the partnership, except in the limited situations described 
in Sec.  1.707-3(c)(2)(iii).
    Notwithstanding the final regulations, the Treasury Department and 
the IRS continue to study the appropriateness of the exception for 
preformation capital expenditures. Specifically, because the receipt of 
``boot'' in the context of other nonrecognition transactions, for 
example, transfers of property to corporations in section 351 
transactions, is generally taxable to the transferor, the Treasury 
Department and the IRS are considering whether the exception for 
preformation capital expenditures is appropriate and request comments 
on whether the regulations should continue to include the exception, 
including any policy justifications for keeping the

[[Page 69294]]

exception, and on the effects that removing the exception may have. In 
addition, the Treasury Department and the IRS are concerned that 
partners and partnerships may be attempting to apply the exception in 
an unintended manner such that the exception may be subject to 
potential abuses in certain circumstances that could effectively 
refresh expenditures not incurred within the two-year period preceding 
a contribution to a partnership (for example, where an entity treats as 
a capital expenditure an issuance of its own interest in exchange for 
property contributed to it in a nonrecognition transaction). Also, the 
Treasury Department and the IRS are aware that a contribution to a 
partnership of an intangible such as goodwill, may, in certain 
circumstances, give rise to an unintended benefit under the exception. 
The Treasury Department and the IRS are studying the potential for 
abuse under the exception for preformation capital expenditures, 
including any unintended benefits with respect to intangibles, for 
which the final regulations reserve a section under the exception.

2. Partner's Share of Partnership Liabilities

    As is discussed in the preamble to the 707 Temporary Regulations, 
after considering the comments on the 2014 Proposed Regulations under 
both sections 707 and 752, the Treasury Department and the IRS have 
determined that, for disguised sale purposes only, it is appropriate 
for partners to determine their share of any liability, whether 
recourse or nonrecourse, in the manner in which excess nonrecourse 
liabilities are allocated under Sec.  1.752-3(a)(3). Accordingly, under 
the 707 Temporary Regulations a partner's share of any partnership 
liability for disguised sale purposes is determined using the same 
percentage used to determine the partner's share of the partnership's 
excess nonrecourse liabilities under Sec.  1.752-3(a)(3) based on the 
partner's share of partnership profits. Thus, the 707 Temporary 
Regulations treat all partnership liabilities, whether recourse or 
nonrecourse, as nonrecourse liabilities solely for disguised sale 
purposes under section 707. These final regulations, however, provide 
limitations on the available allocation methods under Sec.  1.752-
3(a)(3), applicable solely for disguised sale purposes under section 
707, for determining a partner's share of excess nonrecourse 
liabilities.
    For purposes of allocating excess nonrecourse liabilities under 
Sec.  1.752-3(a)(3), proposed Sec.  1.752-3(a)(3) removed the 
significant item method and the alternative method, but provided a new 
approach based on a partner's liquidation value percentage. Under the 
2014 Proposed Regulations, a partner's liquidation value percentage was 
a ratio (expressed as a percentage) of the liquidation value of the 
partner's interest in the partnership to the liquidation value of all 
of the partners' interests in the partnership. The liquidation value of 
a partner's interest in a partnership was defined as the amount of cash 
the partner would receive with respect to the interest if, immediately 
after formation of the partnership or the occurrence of an event 
described in Sec.  1.704-1(b)(2)(iv)(f)(5), as the case may be, the 
partnership sold all of its assets for cash equal to the fair market 
value of such property (taking into account section 7701(g)), satisfied 
all of its liabilities (other than those described in Sec.  1.752-7), 
paid an unrelated third party to assume all of its Sec.  1.752-7 
liabilities in a fully taxable transaction, and then liquidated.
    Commenters expressed concerns with the scope of changes to Sec.  
1.752-3(a)(3) in the 2014 Proposed Regulations and suggested that such 
changes should be adopted, if at all, for disguised sale purposes only. 
Additionally, one commenter noted that in all but the simplest of 
partnerships the liquidation value percentage may have little or no 
relationship to the partners' share of profits and therefore is 
inconsistent with the general rule for allocating excess nonrecourse 
liabilities. Another commenter thought the liquidation value percentage 
approach could be subject to manipulation. Partially in response to 
commenters' concerns about both the liquidation value percentage and 
the relationship between the methods and certain rules under Sec.  
1.704-2, the final regulations under Sec.  1.752-3 retain the 
significant item method and the alternative method, but do not adopt 
the liquidation value percentage approach for determining partners' 
interests in partnership profits. However, the Treasury Department and 
the IRS have concluded that the allocation of excess nonrecourse 
liabilities in accordance with the significant item method and the 
alternative method has been abused by partnerships and their partners 
for disguised sale purposes under section 707. Therefore, as suggested 
by some commenters, the final regulations under Sec.  1.752-3 provide 
that, along with the additional method, the significant item method and 
the alternative method do not apply for purposes of determining a 
partner's share of a partnership liability for disguised sale purposes.
    In addition to the changes to Sec.  1.752-3, the final regulations 
revise Example 1 under Sec.  1.707-5(f) and Example 2 under Sec.  
1.707-6(d) to update some of the cross references to the liability 
allocation rule in the 707 Temporary Regulations. The final regulations 
also revise Examples 5 and 6 under Sec.  1.707-5(f) and Examples 10 and 
12 under proposed Sec.  1.707-5(f) to remove the assumption that the 
liability is a recourse liability.
    Finally, because, under the 707 Temporary Regulations, a partner's 
share of a partnership liability for disguised sale purposes is based 
on the partner's share of partnership profits, a partner cannot be 
allocated 100 percent of the liabilities for purposes of section 707. 
As a result, some amount of the liabilities, both qualified liabilities 
and nonqualified liabilities, may shift among partners. The shifting of 
even a minimal amount of a nonqualified liability that triggers a 
disguised sale can cause a portion of the qualified liability to be 
treated as consideration under Sec.  1.707-5(a)(5). Section 1.707-
5(a)(5) provides a special rule when a partnership's assumption of, or 
taking property subject to, a qualified liability is treated as a 
transfer of consideration made pursuant to a sale due solely to the 
partnership's assumption of, or taking property subject to, a liability 
other than a qualified liability. To mitigate the effect of the 
allocation method for disguised sales, the final regulations include a 
rule under Sec.  1.707-5(a)(5) that does not take into account 
qualified liabilities as consideration in transfers of property treated 
as a sale when the total amount of all liabilities other than qualified 
liabilities that the partnership assumes or takes subject to is the 
lesser of 10 percent of the total amount of all qualified liabilities 
the partnership assumes or takes subject to, or $1,000,000.

3. Step-in-the-Shoes Rule Regarding Preformation Capital Expenditures 
and Liabilities Incurred by Another Person

    For purposes of applying the exception for preformation capital 
expenditures and determining whether a liability is a qualified 
liability under Sec.  1.707-5(a)(6), commenters suggested that the 
final regulations clarify how the rules under Sec. Sec.  1.707-4(d) and 
1.707-5 apply if the transferor partner acquired the transferred 
property in a nonrecognition transaction, assumed a liability in a 
nonrecognition transaction, or took property subject to a liability in 
a nonrecognition transaction from a

[[Page 69295]]

person who incurred the preformation capital expenditures or the 
liability. Commenters noted that Rev. Rul. 2000-44 (2000-2 CB 336) 
allowed ``step-in-the-shoes'' treatment when a corporation that 
acquires assets in a transaction described in section 381(a) succeeds 
to the status of the transferor corporation for purposes of applying 
the exception for preformation capital expenditures and determining 
whether a liability is a qualified liability under Sec.  1.707-5(a)(6). 
Similar to a corporation that acquires assets in a section 381(a) 
transaction, a partner that acquires property, assumes a liability, or 
takes property subject to a liability from another person in connection 
with certain other nonrecognition transactions should succeed to the 
status of the other person for purposes of applying the exception for 
preformation capital expenditures and determining whether a liability 
is a qualified liability under Sec.  1.707-5(a)(6). Thus, the final 
regulations provide a ``step-in-the-shoes'' rule for applying the 
exception for preformation capital expenditures and for determining 
whether a liability is a qualified liability under Sec.  1.707-5(a)(6) 
when a partner acquires property, assumes a liability, or takes 
property subject to a liability from another person in connection with 
a nonrecognition transaction under section 351, 381(a), 721, or 731. As 
a result, Rev. Rul. 2000-44, relating to preformation capital 
expenditures and qualified liabilities involved in a transaction 
described in section 381(a), is superseded by these final regulations.

4. Anticipated Reduction

    Under the existing regulations, for purposes of the rules under 
section 707, a partner's share of a liability assumed or taken subject 
to by a partnership is determined by taking into account certain 
subsequent reductions in the partner's share of the liability. See 
Sec.  1.707-5(a)(3) and (b)(2)(iii). The 2014 Proposed Regulations 
provided that if, within two years of the partnership assuming, taking 
property subject to, or incurring a liability, a partner's share of the 
liability is reduced due to a decrease in the partner's or a related 
person's net value, then the reduction will be presumed to be 
anticipated and must be disclosed under Sec.  1.707-8, unless the facts 
and circumstances clearly establish that the decrease in the net value 
was not anticipated. Because the 707 Temporary Regulations provide that 
a partner's share of any liability for disguised sale purposes is 
determined in accordance with the partner's interest in partnership 
profits under Sec.  1.752-3(a)(3), net value is not relevant in 
determining a partner's share of partnership liabilities for disguised 
sale purposes. Accordingly, the final regulations do not retain the net 
value component of the anticipated reduction of share of liabilities 
rule.

5. Tiered Partnerships

    The existing regulations in Sec.  1.707-5(e), and Sec.  1.707-6(b) 
by applying rules similar to Sec.  1.707-5(e), provide only a limited 
tiered-partnership rule for cases in which a partnership succeeds to a 
liability of another partnership. The 2014 Proposed Regulations added 
additional rules regarding tiered partnerships. One rule related to the 
characterization of liabilities attributable to a contributed 
partnership interest. Under that proposed rule, a contributing 
partner's share of a liability from a lower-tier partnership is treated 
as a qualified liability to the extent the liability would be a 
qualified liability had the liability been assumed or taken subject to 
by the upper-tier partnership in connection with a transfer of all of 
the lower-tier partnership's property to the upper-tier partnership by 
the lower-tier partnership. The final regulations retain this proposed 
rule but, in response to comments, address whose intent, the partner's 
or the lower-tier partnership's, is relevant when applying the 
anticipated transfer of property rule in Sec.  1.707-5(a)(6) for 
purposes of determining whether a liability constitutes a qualified 
liability. The comments suggested that it should be the intent of the 
partner as to whether the partner anticipated transferring its interest 
in the lower-tier partnership to the upper-tier partnership at the time 
the lower-tier partnership incurred the liability.
    The Treasury Department and the IRS agree that the intent of the 
partner is the appropriate inquiry in applying the anticipated transfer 
of property rule under Sec.  1.707-5(a)(6) in the context of 
contributions of a partnership interest. Thus, the final regulations 
provide that in determining whether a liability would be a qualified 
liability under Sec.  1.707-5(a)(6)(i)(B) or (E), the determination of 
whether the liability was incurred in anticipation of the transfer of 
property to the upper-tier partnership is based on whether the partner 
in the lower-tier partnership anticipated transferring the partner's 
interest in the lower-tier partnership to the upper-tier partnership at 
the time the liability was incurred by the lower-tier partnership.
    Commenters also requested that the final regulations allow for the 
application of the exception for preformation capital expenditures when 
a person incurs capital expenditures with respect to property, 
transfers the property to a partnership (lower-tier partnership), and 
then transfers an interest in the lower-tier partnership to another 
partnership (upper-tier partnership) within the two-year period in 
which the person incurred the capital expenditures. The Treasury 
Department and the IRS have determined that such a rule is warranted, 
subject to certain limitations. Therefore, the final regulations 
provide that, in such circumstances, and provided such expenditures are 
not otherwise reimbursed to the person, the upper-tier partnership 
``steps in the shoes'' of the person with respect to the property for 
which the capital expenditures were incurred and may be reimbursed for 
the capital expenditures by the lower-tier partnership to the same 
extent that the person could have been reimbursed by the lower-tier 
partnership. In addition, the person is deemed to have transferred the 
property, rather than the partnership interest, to the upper-tier 
partnership for purposes of the exception for preformation capital 
expenditures and, accordingly, may be reimbursed by the upper-tier 
partnership to the extent the person could have been previously 
reimbursed by the lower-tier partnership. The aggregate reimbursements 
for capital expenditures under this rule cannot exceed the amount that 
the person could have been reimbursed for such capital expenditures 
under Sec.  1.707-4(d)(1).

6. Treatment of Liabilities in Assets-Over Merger

    The 2014 Proposed Regulations extended the netting principles of 
Sec.  1.752-1(f) in a provision for determining the effect of an 
assets-over merger or consolidation under the disguised sale rules. 
Although comments were generally favorable, they did request 
clarification on the specific rule provided.
    Upon further consideration of the area, the Treasury Department and 
the IRS have determined that no rule on the treatment of liabilities in 
an assets-over merger is needed in Sec.  1.707-5. In many instances, 
liabilities involved in such a merger will constitute qualified 
liabilities, especially given that the final regulations adopt a 
``step-in-the-shoes'' rule for liabilities acquired by a partner from 
another person in certain nonrecognition transactions. In cases in 
which liabilities involved in an assets-over merger do not constitute 
qualified liabilities, the facts and circumstances test in Sec.  1.707-
3 should reach the proper result. Thus, the final regulations do not 
retain the proposed rule for

[[Page 69296]]

partnership assets-over mergers or consolidations.

7. Disguised Sales of Property by a Partnership to a Partner

    Under Sec.  1.707-6, rules similar to those provided in Sec.  
1.707-3 apply in determining whether a transfer of property by a 
partnership to a partner and one or more transfers of money or other 
consideration by that partner to the partnership are treated as a 
disguised sale of property, in whole or in part, to the partner. The 
Treasury Department and the IRS requested in the preamble to the 2014 
Proposed Regulations comments on whether, for purposes of Sec.  1.707-
6, it is inappropriate to take into account a transferee partner's 
share of a partnership liability immediately prior to a distribution if 
the transferee partner did not have economic exposure with respect to 
the partnership liability for a meaningful period of time before 
appreciated property is distributed to that partner subject to the 
liability. Commenters suggested that Sec.  1.707-6 should be amended to 
take into account the transitory nature of a partner's share of 
nonqualified liabilities.
    Because under the 707 Temporary Regulations a partner's share of 
all liabilities is determined for disguised sale purposes in accordance 
with the partner's interest in partnership profits under Sec.  1.752-
3(a)(3), the transitory nature of a partner's share of nonqualified 
liabilities is no longer an issue. Under that allocation method, an 
allocation of a 100 percent share of a liability to a partner 
immediately before a transfer of property by the partnership to the 
partner in which the transferee partner assumes the liability will not 
be taken into account. Therefore, the final regulations do not make any 
changes to the rules under Sec.  1.707-6, other than revising Example 2 
under Sec.  1.707-6(d) to update a cross reference to the liability 
allocation rule in the 707 Temporary Regulations.

Effective/Applicability Dates

    With respect to amendments to Sec. Sec.  1.707-3 through 1.707-6, 
the final regulations under section 707 apply to any transaction with 
respect to which all transfers occur on or after October 5, 2016.
    With respect to amendments to Sec.  1.752-3, the final regulations 
under section 752 apply to liabilities that are incurred by a 
partnership, that a partnership takes property subject to, or that are 
assumed by a partnership on or after October 5, 2016, other than 
liabilities incurred by a partnership, that a partnership takes 
property subject to, or that are assumed by a partnership pursuant to a 
written binding contract in effect prior to that date.

Effect on Other Documents

    The following publication is superseded on October 5, 2016: Rev. 
Rul. 2000-44 (2000-2 CB 336).

Special Analyses

    Certain IRS regulations, including this one, are exempt from the 
requirements of Executive Order 12866, as supplemented and reaffirmed 
by Executive Order 13563. Therefore, a regulatory impact assessment is 
not required. It also has been determined that section 553(b) of the 
Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to 
these regulations. It is hereby certified that the collection of 
information in these regulations will not have a significant economic 
impact on a substantial number of small entities. This certification is 
based on the fact that the amount of time necessary to report the 
required information will be minimal in that it requires partners to 
provide information they already maintain or can easily obtain to the 
IRS. Moreover, it should take a partner no more than 1 hour to satisfy 
the information requirement in these regulations. Accordingly, a 
Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 
U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the 
Code, the notice of proposed rulemaking preceding these regulations was 
submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business.

Drafting Information

    The principal authors of these regulations are Deane M. Burke and 
Caroline E. Hay of the Office of the Associate Chief Counsel 
(Passthroughs & Special Industries), IRS. However, other personnel from 
the Treasury Department and the IRS participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

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

    Authority:  26 U.S.C. 7805 * * *
    Sections 1.707-2 through 1.707-9 also issued under 26 U.S.C. 
707(a)(2)(B).


Sec.  1.704-2  [Amended]

0
Par. 2. Section 1.704-2 is amended by:
0
1. Removing the language ``and (vii)'' in paragraph (d)(2)(ii).
0
2. Removing the language ``Example (1)(viii) and (ix)'' in paragraph 
(i)(2) and adding the language ``Example (1)(vii) and (viii)'' in its 
place.
0
3. Removing the language ``Example (1)(viii)'' in paragraph (i)(5) and 
adding the language ``Example (1)(vii)'' in its place.
0
4. Removing Example (1)(vii) in paragraph (m) and redesignating 
Examples (1)(viii) and (ix) as Examples (1)(vii) and (viii) 
respectively.
0
5. Removing the language ``Example (1)(viii)'' in newly redesignated 
Example (1)(viii) in paragraph (m) and adding the language ``Example 
(1)(vii)'' in its place.

0
Par. 3. Section 1.707-0 is amended by:
0
1. Adding entries for Sec. Sec.  1.707-4(d)(1), (d)(2) through (4), 
(d)(4)(i) and (ii), (d)(5) and (6), and (f).
0
2. Adding entries for Sec. Sec.  1.707-5(a)(8) and (b)(3).
    The additions read as follows:


Sec.  1.707-0  Table of contents.

* * * * *


Sec.  1.707-4   Disguised sales of property to partnership; special 
rules applicable to guaranteed payments, preferred returns, operating 
cash flow distributions, and reimbursements of preformation 
expenditures.

* * * * *
    (d) * * *
    (1) In general.
    (2) Capital expenditures incurred by another person.
    (3) Contribution of a partnership interest with capital 
expenditures property.
    (4) Special rule for qualified liabilities.
    (i) In general.
    (ii) Anti-abuse rule.
    (5) Scope of capital expenditures.
    (6) Example.
* * * * *
    (f) Ordering rule cross reference.
* * * * *


Sec.  1.707-5  Disguised sales of property to partnership; special 
rules relating to liabilities.

    (a) * * *
    (8) Liability incurred by another person.
    (b) * * *
    (3) Ordering rule.
* * * * *

[[Page 69297]]


0
Par. 4. Section 1.707-4 is amended by:
0
1. Redesignating the text of paragraph (d) introductory text after its 
subject heading as paragraph (d)(1) and adding a paragraph (d)(1) 
subject heading.
0
2. Redesignating paragraph (d)(1) as paragraph (d)(1)(i).
0
3. Redesignating paragraph (d)(2) introductory text as paragraph 
(d)(1)(ii).
0
4. Redesignating paragraph (d)(2)(i) as paragraph (d)(1)(ii)(A).
0
5. Redesignating paragraph (d)(2)(ii) as paragraph (d)(1)(ii)(B) and 
revising it.
0
6. Adding reserved paragraph (d)(1)(ii)(C) and paragraphs (d)(2) 
through (6) and (f).
    The additions and revisions read as follows:


Sec.  1.707-4  Disguised sales of property to partnership; special 
rules applicable to guaranteed payments, preferred returns, operating 
cash flow distributions, and reimbursements of preformation 
expenditures.

* * * * *
    (d) * * *
    (1) In general. * * *
    (ii) * * *
    (B) Property transferred to the partnership by the partner, but 
only to the extent the reimbursed capital expenditures do not exceed 20 
percent of the fair market value of such property at the time of the 
transfer (the 20-percent limitation). However, the 20-percent 
limitation of this paragraph (d)(1)(ii)(B) does not apply if the fair 
market value of the transferred property does not exceed 120 percent of 
the partner's adjusted basis in the transferred property at the time of 
the transfer (the 120-percent test). This paragraph (d)(1)(ii)(B) shall 
be applied on a property-by-property basis, except that a partner may 
aggregate any of the transferred property under this paragraph (d)(1) 
to the extent--
    (1) The total fair market value of such aggregated property (of 
which no single property's fair market value exceeds 1 percent of the 
total fair market value of such aggregated property) is not greater 
than the lesser of 10 percent of the total fair market value of all 
property, excluding money and marketable securities (as defined under 
section 731(c)), transferred by the partner to the partnership, or 
$1,000,000;
    (2) The partner uses a reasonable aggregation method that is 
consistently applied; and
    (3) Such aggregation of property is not part of a plan a principal 
purpose of which is to avoid Sec. Sec.  1.707-3 through 1.707-5.
    (C) [Reserved].
    (2) Capital expenditures incurred by another person. For purposes 
of paragraph (d)(1) of this section, a partner steps in the shoes of a 
person (to the extent the person was not previously reimbursed under 
paragraph (d)(1) of this section) with respect to capital expenditures 
the person incurred with respect to property transferred to the 
partnership by the partner to the extent the partner acquired the 
property from the person in a nonrecognition transaction described in 
section 351, 381(a), 721, or 731.
    (3) Contribution of a partnership interest with capital 
expenditures property. If a person transfers property with respect to 
which the person incurred capital expenditures (capital expenditures 
property) to a partnership (lower-tier partnership) and, within the 
two-year period beginning on the date upon which the person incurred 
the capital expenditures, transfers an interest in the lower-tier 
partnership to another partnership (upper-tier partnership) in a 
nonrecognition transaction under section 721, the upper-tier 
partnership steps in the shoes of the person who transferred the 
capital expenditures property to the lower-tier partnership with 
respect to the capital expenditures that are not otherwise reimbursed 
to the person. The upper-tier partnership may be reimbursed by the 
lower-tier partnership under paragraph (d)(1) of this section to the 
extent the person could have been reimbursed for the capital 
expenditures by the lower-tier partnership under paragraph (d)(1) of 
this section. In addition, for purposes of paragraph (d)(1) of this 
section, the person is deemed to have transferred the capital 
expenditures property to the upper-tier partnership and may be 
reimbursed by the upper-tier partnership under paragraph (d)(1) of this 
section to the extent the person could have been reimbursed for the 
capital expenditures by the lower-tier partnership under paragraph 
(d)(1) of this section and has not otherwise been previously 
reimbursed. The aggregate reimbursements for capital expenditures under 
this paragraph (d)(3) shall not exceed the amount that the person could 
have been reimbursed for such capital expenditures under paragraph 
(d)(1) of this section.
    (4) Special rule for qualified liabilities--(i) In general. For 
purposes of paragraph (d)(1) of this section, if capital expenditures 
were funded by the proceeds of a qualified liability defined in Sec.  
1.707-5(a)(6)(i) that a partnership assumes or takes property subject 
to in connection with a transfer of property to the partnership by a 
partner, a transfer of money or other consideration by the partnership 
to the partner is not treated as made to reimburse the partner for such 
capital expenditures to the extent the transfer of money or other 
consideration by the partnership to the partner exceeds the partner's 
share of the qualified liability (as determined under Sec.  1.707-
5(a)(2), (3), and (4)). Capital expenditures are treated as funded by 
the proceeds of a qualified liability to the extent the proceeds are 
either traceable to the capital expenditures under Sec.  1.163-8T or 
were actually used to fund the capital expenditures, irrespective of 
the tracing requirements under Sec.  1.163-8T.
    (ii) Anti-abuse rule. If capital expenditures and a qualified 
liability are incurred under a plan a principal purpose of which is to 
avoid the requirements of paragraph (d)(4)(i) of this section, the 
capital expenditures are deemed funded by the qualified liability.
    (5) Scope of capital expenditures. For purposes of this section and 
Sec.  1.707-5, the term capital expenditures has the same meaning as 
the term capital expenditures has under the Internal Revenue Code and 
applicable regulations, except that it includes capital expenditures 
taxpayers elect to deduct, and does not include deductible expenses 
taxpayers elect to treat as capital expenditures.
    (6) Example. The following example illustrates the application of 
paragraph (d) of this section:

    Example.  Intangible treated as separate property. (i) Z 
transfers to a partnership a business the material assets of which 
include a tangible asset and goodwill from the reputation of the 
business. At the time Z transfers the business to the partnership, 
the tangible asset has a fair market value of $550,000 and an 
adjusted basis of $450,000. The goodwill is a section 197 intangible 
with a fair market value of $100,000 and an adjusted basis of $0. Z 
incurred $130,000 of capital expenditures with respect to 
improvements to the tangible asset (which amount is reflected in its 
adjusted basis) one year preceding the transfer. Z would like to be 
reimbursed by the partnership for the capital expenditures with an 
amount that qualifies for the exception for reimbursement of 
preformation expenditures under paragraph (d)(1) of this section.
    (ii) Under paragraph (d)(1)(ii)(B) of this section, the 20-
percent limitation on reimbursed capital expenditures applies on a 
property-by-property basis. The 120-percent test also applies on a 
property-by-property basis. Accordingly, the tangible asset and the 
goodwill each constitutes a separate property. Z incurred the 
capital expenditures with respect to the tangible asset only. The 
$550,000 fair market value of the tangible asset exceeds 120 percent 
of Z's $450,000 adjusted basis in the asset at the time of the 
transfer (120 percent x $450,000 = $540,000). Thus, the 20-percent 
limitation applies so that the reimbursement of Z's $130,000 of

[[Page 69298]]

capital expenditures is limited to 20 percent of the fair market 
value of the tangible asset, or $110,000 (20 percent x $550,000).
* * * * *
    (f) Ordering rule cross reference. For payments or transfers by a 
partnership to a partner to which the rules under this section and 
Sec.  1.707-5(b) apply, see the ordering rule under Sec.  1.707-
5(b)(3).

0
Par. 5. Section 1.707-5 is amended by:
0
1. Revising paragraph (a)(3).
0
2. Adding paragraph (a)(5)(iii).
0
3. Revising paragraph (a)(6)(i)(C).
0
4. Removing ``and'' at the end of paragraph (a)(6)(i)(D) and adding 
``or'' in its place.
0
5. Adding paragraph (a)(6)(i)(E).
0
6. Revising paragraph (a)(7)(ii).
0
7. Adding paragraph (a)(8).
0
8. Adding a sentence at the end of paragraph (b)(1).
0
9. Removing the word ``property'' in paragraph (b)(2)(i)(A) and adding 
the word ``consideration'' in its place.
0
10. Revising paragraph (b)(2)(iii).
0
11. Adding paragraph (b)(3).
0
12. Designating the text of paragraph (e) after its subject heading as 
paragraph (e)(1) and adding paragraph (e)(2).
0
13. Revising Examples 1, 5, 6, and 10 in paragraph (f).
0
14. Redesignating Example 11 in paragraph (f) as Example 13 and adding 
new Examples 11 and 12.
    The additions and revisions read as follows:


Sec.  1.707-5  Disguised sales of property to partnership; special 
rules relating to liabilities.

    (a) * * *
    (3) Reduction of partner's share of liability. For purposes of this 
section, a partner's share of a liability, immediately after a 
partnership assumes or takes property subject to the liability, is 
determined by taking into account a subsequent reduction in the 
partner's share if--
    (i) At the time that the partnership assumes or takes property 
subject to the liability, it is anticipated that the transferring 
partner's share of the liability will be subsequently reduced;
    (ii) The anticipated reduction is not subject to the 
entrepreneurial risks of partnership operations; and
    (iii) The reduction of the partner's share of the liability is part 
of a plan that has as one of its principal purposes minimizing the 
extent to which the assumption of or taking property subject to the 
liability is treated as part of a sale under Sec.  1.707-3.
* * * * *
    (5) * * *
    (iii) Notwithstanding paragraph (a)(5)(i) of this section, in 
connection with a transfer of property by a partner to a partnership 
that is treated as a sale due solely to the partnership's assumption of 
or taking property subject to a liability other than a qualified 
liability, the partnership's assumption of or taking property subject 
to a qualified liability is not treated as a transfer of consideration 
made pursuant to the sale if the total amount of all liabilities other 
than qualified liabilities that the partnership assumes or takes 
subject to is the lesser of 10 percent of the total amount of all 
qualified liabilities the partnership assumes or takes subject to, or 
$1,000,000.
    (6) * * *
    (i) * * *
    (C) A liability that is allocable under the rules of Sec.  1.163-8T 
to capital expenditures (as described under Sec.  1.707-4(d)(5)) with 
respect to the property;
* * * * *
    (E) A liability that was not incurred in anticipation of the 
transfer of the property to a partnership, but that was incurred in 
connection with a trade or business in which property transferred to 
the partnership was used or held but only if all the assets related to 
that trade or business are transferred other than assets that are not 
material to a continuation of the trade or business (see paragraph 
(a)(7) of this section for further rules regarding a liability incurred 
within two years of a transfer presumed to be in anticipation of the 
transfer); and
* * * * *
    (7) * * *
    (ii) Disclosure of transfers of property subject to liabilities 
incurred within two years of the transfer. A partner that treats a 
liability assumed or taken subject to by a partnership in connection 
with a transfer of property as a qualified liability under paragraph 
(a)(6)(i)(B) of this section or under paragraph (a)(6)(i)(E) of this 
section (if the liability was incurred by the partner within the two-
year period prior to the earlier of the date the partner agrees in 
writing to transfer the property or the date the partner transfers the 
property to the partnership) must disclose such treatment to the 
Internal Revenue Service in accordance with Sec.  1.707-8.
    (8) Liability incurred by another person. Except as provided in 
paragraph (e)(2) of this section, a partner steps in the shoes of a 
person for purposes of paragraph (a) of this section with respect to a 
liability the person incurred or assumed to the extent the partner 
assumed or took property subject to the liability from the person in a 
nonrecognition transaction described in section 351, 381(a), 721, or 
731.
    (b) * * *
    (1) * * * For purposes of paragraph (b) of this section, an upper-
tier partnership's share of the liability of a lower-tier partnership 
as described under Sec.  1.707-5(a)(2) that is treated as a liability 
of the upper-tier partnership under Sec.  1.752-4(a) shall be treated 
as a liability of the upper-tier partnership incurred on the same day 
the liability was incurred by the lower-tier partnership.
    (2) * * *
    (iii) Reduction of partner's share of liability. For purposes of 
paragraph (b)(2) of this section, a partner's share of a liability 
immediately after a partnership incurs the liability is determined by 
taking into account a subsequent reduction in the partner's share if--
    (A) At the time that the partnership incurs the liability, it is 
anticipated that the partner's share of the liability that is allocable 
to a transfer of money or other consideration to the partner will be 
reduced subsequent to the transfer;
    (B) The anticipated reduction is not subject to the entrepreneurial 
risks of partnership operations; and
    (C) The reduction of the partner's share of the liability is part 
of a plan that has as one of its principal purposes minimizing the 
extent to which the partnership's distribution of the proceeds of the 
borrowing is treated as part of a sale.
    (3) Ordering rule. The treatment of a transfer of money or other 
consideration under paragraph (b) of this section is determined before 
applying the rules under Sec.  1.707-4.
* * * * *
    (e) * * *
    (2) If an interest in a partnership that has one or more 
liabilities (the lower-tier partnership) is transferred to another 
partnership (the upper-tier partnership), the upper-tier partnership's 
share of any liability of the lower-tier partnership that is treated as 
a liability of the upper-tier partnership under Sec.  1.752-4(a) is 
treated as a qualified liability under paragraph (a)(6)(i) of this 
section to the extent the liability would be a qualified liability 
under paragraph (a)(6)(i) of this section had the liability been 
assumed or taken subject to by the upper-tier partnership in connection 
with a transfer of all of the lower-tier partnership's property to the 
upper-tier partnership by the lower-tier partnership. For purposes of 
determining whether the liability constitutes a qualified liability 
under paragraphs (a)(6)(i)(B) and (E) of this

[[Page 69299]]

section, a determination that the liability was not incurred in 
anticipation of the transfer of property to the upper-tier partnership 
is based on whether the partner in the lower-tier partnership 
anticipated transferring its interest in the lower-tier partnership to 
the upper-tier partnership at the time the liability was incurred by 
the lower-tier partnership.
    (f) * * *

    Example 1. Partnership's assumption of nonrecourse liability 
encumbering transferred property. (i) A and B form partnership AB, 
which will engage in renting office space. A transfers $500,000 in 
cash to the partnership, and B transfers an office building to the 
partnership. At the time it is transferred to the partnership, the 
office building has a fair market value of $1,000,000, has an 
adjusted basis of $400,000, and is encumbered by a $500,000 
nonrecourse liability, which B incurred 12 months earlier to finance 
the acquisition of other property and which the partnership assumed. 
No facts rebut the presumption that the liability was incurred in 
anticipation of the transfer of the property to the partnership. 
Assume that this liability is a nonrecourse liability of the 
partnership within the meaning of section 752 and the regulations 
thereunder. The partnership agreement provides that partnership 
items will be allocated equally between A and B, including excess 
nonrecourse liabilities under Sec.  1.752-3(a)(3). The partnership 
agreement complies with the requirements of Sec.  1.704-
1(b)(2)(ii)(b).
    (ii) The nonrecourse liability secured by the office building is 
not a qualified liability within the meaning of paragraph (a)(6) of 
this section. B would be allocated 50 percent of the excess 
nonrecourse liability under the partnership agreement. Accordingly, 
immediately after the partnership's assumption of that liability, 
B's share of the liability as determined under paragraph (a)(2) of 
this section is $250,000 (B's 50 percent share of the partnership's 
excess nonrecourse liability as determined in accordance with B's 
share of partnership profits under Sec.  1.752-3(a)(3)).
    (iii) The partnership's assumption of the liability encumbering 
the office building is treated as a transfer of $250,000 of 
consideration to B (the amount by which the liability ($500,000) 
exceeds B's share of that liability immediately after the 
partnership's assumption of the liability ($250,000)). B is treated 
as having sold $250,000 of the fair market value of the office 
building to the partnership in exchange for the partnership's 
assumption of a $250,000 liability. This results in a gain of 
$150,000 ($250,000 minus ($250,000/$1,000,000 multiplied by 
$400,000)).
* * * * *
    Example 5. Partnership's assumption of a qualified liability as 
sole consideration. (i) F purchases property Z in 2012. In 2016, F 
transfers property Z to a partnership. At the time of its transfer 
to the partnership, property Z has a fair market value of $165,000 
and an adjusted tax basis of $75,000. Also, at the time of the 
transfer, property Z is subject to a $75,000 nonrecourse liability 
that F incurred more than two years before transferring property Z 
to the partnership. The liability has been secured by property Z 
since it was incurred by F. Upon the transfer of property Z to the 
partnership, the partnership assumed the liability encumbering that 
property. The partnership made no other transfers to F in 
consideration for the transfer of property Z to the partnership. 
Assume that immediately after the partnership's assumption of the 
liability encumbering property Z, F's share of that liability for 
disguised sale purposes is $25,000 in accordance with Sec.  1.707-
5(a)(2).
    (ii) The $75,000 liability secured by property Z is a qualified 
liability of F because F incurred the liability more than two years 
prior to the partnership's assumption of the liability and the 
liability has encumbered property Z for more than two years prior to 
F's transfer. See paragraph (a)(6) of this section. Therefore, since 
no other transfer to F was made as consideration for the transfer of 
property Z, under paragraph (a)(5) of this section, the 
partnership's assumption of the qualified liability of F encumbering 
property Z is not treated as part of a sale.
    Example 6. Partnership's assumption of a qualified liability in 
addition to other consideration. (i) The facts are the same as in 
Example 5, except that the partnership makes a transfer to F of 
$30,000 in money that is consideration for F's transfer of property 
Z to the partnership under Sec.  1.707-3.
    (ii) As in Example 5, the $75,000 liability secured by property 
Z is a qualified liability of F. Since the partnership transferred 
$30,000 to F in addition to assuming the qualified liability under 
paragraph (a)(5) of this section, assuming no other exception to 
disguised sale treatment applies to the transfer of the $30,000, the 
partnership's assumption of this qualified liability is treated as a 
transfer of additional consideration to F to the extent of the 
lesser of--
    (A) The amount that the partnership would be treated as 
transferring to F if the liability were not a qualified liability 
($50,000 (that is, the excess of the $75,000 qualified liability 
over F's $25,000 share of that liability)); or
    (B) The amount obtained by multiplying the qualified liability 
($75,000) by F's net equity percentage with respect to property Z 
(one-third).
    (iii) F's net equity percentage with respect to property Z 
equals the fraction determined by dividing--
    (A) The aggregate amount of money or other consideration (other 
than the qualified liability) transferred to F and treated as part 
of a sale of property Z under Sec.  1.707-3(a) ($30,000 transfer of 
money); by
    (B) F's net equity in property Z ($90,000 (that is, the excess 
of the $165,000 fair market value over the $75,000 qualified 
liability)).
    (iv) Accordingly, the partnership's assumption of the qualified 
liability of F encumbering property Z is treated as a transfer of 
$25,000 (one-third of $75,000) of consideration to F pursuant to a 
sale. Therefore, F is treated as having sold $55,000 of the fair 
market value of property Z to the partnership in exchange for 
$30,000 in money and the partnership's assumption of $25,000 of the 
qualified liability. Accordingly, F must recognize $30,000 of gain 
on the sale (the excess of the $55,000 amount realized over $25,000 
of F's adjusted basis for property Z (that is, one-third of F's 
adjusted basis for the property, because F is treated as having sold 
one-third of the property to the partnership)).
* * * * *
    Example 10. Treatment of debt-financed transfers of 
consideration by partnership. (i) K transfers property Z to 
partnership KL in exchange for a 50 percent interest therein on 
April 9, 2016. On September 13, 2016, the partnership incurs a 
nonrecourse liability of $20,000. On November 17, 2016, the 
partnership transfers $20,000 to K, and $10,000 of this transfer is 
allocable under the rules of Sec.  1.163-8T to proceeds of the 
partnership liability incurred on September 13, 2016. The remaining 
$10,000 is paid from other partnership funds. Assume that on 
November 17, 2016, for disguised sale purposes, K's share of the 
$20,000 liability incurred on September 13, 2016, is $10,000 in 
accordance with Sec.  1.707-5(a)(2).
    (ii) Because a portion of the transfer made to K on November 17, 
2016, is allocable under Sec.  1.163-8T to proceeds of a partnership 
liability that was incurred by the partnership within 90 days of 
that transfer, K is required to take the transfer into account in 
applying the rules of this section and Sec.  1.707-3 only to the 
extent that the amount of the transfer exceeds K's allocable share 
of the liability used to fund the transfer. K's allocable share of 
the $20,000 liability used to fund $10,000 of the transfer to K is 
$5,000 (K's share of the liability ($10,000) multiplied by the 
fraction obtained by dividing--
    (A) The amount of the liability that is allocable to the 
distribution to K ($10,000); by
    (B) The total amount of such liability ($20,000)).
    (iii) Therefore, K is required to take into account $15,000 of 
the $20,000 partnership transfer to K for purposes of this section 
and Sec.  1.707-3. Under these facts, assuming no other exception 
applies and the within-two-year presumption is not rebutted, this 
$15,000 transfer will be treated under the rule in Sec.  1.707-3 as 
part of a sale by K of property Z to the partnership.
    Example 11. Treatment of debt-financed transfers of 
consideration and transfers characterized as guaranteed payments by 
a partnership. (i) The facts are the same as in Example 10, except 
that the entire $20,000 transfer to K is allocable under the rules 
of Sec.  1.163-8T to proceeds of the partnership liability incurred 
on September 13, 2016. In addition, the partnership agreement 
provides that K is to receive a guaranteed payment for the use of 
K's capital in the amount of $10,000 in each of the three years 
following the transfer of property Z. Ten thousand dollars of the 
transfer made to K on November 17, 2016, is pursuant to this 
provision of the partnership agreement. Assume that the guaranteed 
payment to K constitutes a reasonable guaranteed payment within the 
meaning of Sec.  1.707-4(a)(3).
    (ii) Under these facts, the rules under both Sec.  1.707-4(a) 
and Sec.  1.707-5(b) apply to the

[[Page 69300]]

November 17, 2016 transfer to K by the partnership. Thus, the 
ordering rule in Sec.  1.707-5(b)(3) requires that the Sec.  1.707-
5(b) debt-financed distribution rules apply first to determine the 
treatment of the $20,000 transfer. Because the entire transfer made 
to K on November 17, 2016, is allocable under Sec.  1.163-8T to 
proceeds of a partnership liability that was incurred by the 
partnership within 90 days of that transfer, K is required to take 
the transfer into account in applying the rules of this section and 
Sec.  1.707-3 only to the extent that the amount of the transfer 
exceeds K's allocable share of the liability used to fund the 
transfer. K's allocable share of the $20,000 liability used to fund 
the transfer to K is $10,000 (K's share of the liability ($10,000) 
multiplied by the fraction obtained by dividing--
    (A) The amount of the liability that is allocable to the 
distribution to K ($20,000); by
    (B) The total amount of such liability ($20,000)).
    (iii) The remaining $10,000 amount of the transfer to K that 
exceeds K's allocable share of the liability is tested to determine 
whether an exception under Sec.  1.707-4 applies. Because $10,000 of 
the payment to K is a reasonable guaranteed payment for capital 
under Sec.  1.707-4(a)(1)(ii), the $10,000 transfer will not be 
treated as part of a sale by K of property Z to the partnership 
under Sec.  1.707-3.
    Example 12. Treatment of debt-financed transfers of 
consideration by partnership made pursuant to plan. (i) O transfers 
property X, and P transfers property Y, to partnership OP in 
exchange for equal interests therein on June 1, 2016. On October 1, 
2016, the partnership incurs two nonrecourse liabilities: Liability 
1 of $8,000 and Liability 2 of $4,000. On December 15, 2016, the 
partnership transfers $2,000 to each of O and P pursuant to a plan. 
The transfers made to O and P on December 15, 2016 are allocable 
under Sec.  1.163-8T to the proceeds of either Liability 1 or 
Liability 2. Assume that under Sec.  1.707-5(a)(2), O's and P's 
share of Liability 1 is $4,000 each and of Liability 2 is $2,000 
each on December 15, 2016.
    (ii) Because the partnership transferred pursuant to a plan a 
portion of the proceeds of the two liabilities to O and P, paragraph 
(b)(1) of this section is applied by treating Liability 1 and 
Liability 2 as a single $12,000 liability. Pursuant to paragraph 
(b)(2)(ii)(A) of this section, each partner's allocable share of the 
$12,000 liability equals the amount obtained by multiplying the sum 
of the partner's share of Liability 1 and Liability 2 ($6,000) 
($4,000 for Liability 1 plus $2,000 for Liability 2) by the fraction 
obtained by dividing--
    (A) The amount of the liability that is allocable to the 
distribution to O and P pursuant to the plan ($4,000); by
    (B) The total amount of such liability ($12,000).
    (iii) Therefore, O's and P's allocable share of the $12,000 
liability is $2,000 each. Accordingly, because a portion of the 
proceeds of the $12,000 liability are allocable under Sec.  1.163-8T 
to the $2,000 transfer made to each of O and P within 90 days of 
incurring the liability, and the $2,000 transfer does not exceed O's 
or P's $2,000 allocable share of that liability, each is required to 
take into account $0 of the $2,000 transfer for purposes of this 
section and Sec.  1.707-3. Under these facts, no part of the 
transfers to O and P will be treated as part of a sale of property X 
by O or of property Y by P.
* * * * *

0
Par. 6. Section 1.707-6 is amended by revising Example 2(i) in 
paragraph (d) to read as follows:


Sec.  1.707-6   Disguised sales of property by partnership to partner; 
general rules.

* * * * *
    (d) * * *
    Example 2. Assumption of liability by partner. (i) B is a member 
of an existing partnership. The partnership transfers property Y to 
B. On the date of the transfer, property Y has a fair market value 
of $1,000,000 and is encumbered by a nonrecourse liability of 
$600,000. B takes the property subject to the liability. The 
partnership incurred the nonrecourse liability six months prior to 
the transfer of property Y to B and used the proceeds to purchase an 
unrelated asset. Assume that under Sec.  1.707-5(a)(2), B's share of 
the nonrecourse liability immediately before the transfer of 
property Y was $100,000.
* * * * *

0
Par. 7. Section 1.707-9 is amended by revising paragraph (a)(1) to read 
as follows:


Sec.  1.707-9  Effective dates and transitional rules.

    (a) * * *
    (1) In general. Except as otherwise provided in this paragraph (a), 
Sec. Sec.  1.707-3 through 1.707-6 apply to any transaction with 
respect to which all transfers occur on or after October 5, 2016. For 
any transaction with respect to which all transfers that are part of a 
sale of an item of property occur after April 24, 1991, but before 
October 5, 2016, Sec. Sec.  1.707-3 through 1.707-6 as contained in 26 
CFR part 1 revised as of April 1, 2016, apply.
* * * * *

0
Par. 8. Section 1.752-3 is amended by:
0
 1. Revising the third, fourth, fifth, and sixth sentences in paragraph 
(a)(3).
0
 2. Adding paragraph (d).
    The revisions and addition read as follows:


Sec.  1.752-3  Partner's share of nonrecourse liabilities.

    (a) * * *
    (3) * * * The partnership agreement may specify the partners' 
interests in partnership profits for purposes of allocating excess 
nonrecourse liabilities provided the interests so specified are 
reasonably consistent with allocations (that have substantial economic 
effect under the section 704(b) regulations) of some other significant 
item of partnership income or gain (significant item method). 
Alternatively, excess nonrecourse liabilities may be allocated among 
the partners in accordance with the manner in which it is reasonably 
expected that the deductions attributable to those nonrecourse 
liabilities will be allocated (alternative method). Additionally, the 
partnership may first allocate an excess nonrecourse liability to a 
partner up to the amount of built-in gain that is allocable to the 
partner on section 704(c) property (as defined under Sec.  1.704-
3(a)(3)(ii)) or property for which reverse section 704(c) allocations 
are applicable (as described in Sec.  1.704-3(a)(6)(i)) where such 
property is subject to the nonrecourse liability to the extent that 
such built-in gain exceeds the gain described in paragraph (a)(2) of 
this section with respect to such property (additional method). The 
significant item method, alternative method, and additional method do 
not apply for purposes of Sec.  1.707-5(a)(2). * * *
* * * * *
    (d) Effective/applicability dates. The third, fourth, fifth, and 
sixth sentences of paragraph (a)(3) of this section apply to 
liabilities that are incurred, taken subject to, or assumed by a 
partnership on or after October 5, 2016, other than liabilities 
incurred, taken subject to, or assumed by a partnership pursuant to a 
written binding contract in effect prior to October 5, 2016. For 
liabilities that are incurred, taken subject to, or assumed by a 
partnership before October 5, 2016, the third, fourth, fifth, and sixth 
sentences of paragraph (a)(3) of this section as contained in 26 CFR 
part 1 revised as of April 1, 2016, apply.

John Dalrymple,
Deputy Commissioner for Services and Enforcement.
    Approved: August 29, 2016.
Mark M. Mazur,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2016-23387 Filed 10-4-16; 8:45 am]
BILLING CODE 4830-01-P