Fractions Rule, 84518-84526 [2016-27105]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 81, Number 226 (Wednesday, November 23, 2016)]
[Proposed Rules]
[Pages 84518-84526]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2016-27105]



[[Page 84518]]

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

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-136978-12]
RIN 1545-BL22


Fractions Rule

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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

SUMMARY: This document contains proposed regulations relating to the 
application of section 514(c)(9)(E) of the Internal Revenue Code (Code) 
to partnerships that hold debt-financed real property and have one or 
more (but not all) qualified tax-exempt organization partners within 
the meaning of section 514(c)(9)(C). The proposed regulations amend the 
current regulations under section 514(c)(9)(E) to allow certain 
allocations resulting from specified common business practices to 
comply with the rules under section 514(c)(9)(E). These regulations 
affect partnerships with qualified tax-exempt organization partners and 
their partners.

DATES: Written and electronic comments and requests for a public 
hearing must be received by February 21, 2017.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-136978-12), 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-
136978-12), 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-136978-12).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Caroline E. Hay at (202) 317-5279; concerning the submissions of 
comments and requests for a public hearing, Regina L. Johnson at (202) 
317-6901 (not toll-free numbers).

SUPPLEMENTARY INFORMATION: 

Background

    This document proposes amendments to the Income Tax Regulations (26 
CFR part 1) under section 514(c)(9)(E) regarding the application of the 
fractions rule (as defined in the Background section of this preamble) 
to partnerships that hold debt-financed real property and have one or 
more (but not all) qualified tax-exempt organization partners.
    In general, section 511 imposes a tax on the unrelated business 
taxable income (UBTI) of tax-exempt organizations. Section 514(a) 
defines UBTI to include a specified percentage of the gross income 
derived from debt-financed property described in section 514(b). 
Section 514(c)(9)(A) generally excepts from UBTI income derived from 
debt-financed real property acquired or improved by certain qualified 
organizations (QOs) described in section 514(c)(9)(C). Under section 
514(c)(9)(C), a QO includes an educational organization described in 
section 170(b)(1)(A)(ii) and its affiliated support organizations 
described in section 509(a)(3), any trust which constitutes a qualified 
trust under section 401, an organization described in section 
501(c)(25), and a retirement income account described in section 
403(b)(9).
    Section 514(c)(9)(B)(vi) provides that the exception from UBTI in 
section 514(c)(9)(A) does not apply if a QO owns an interest in a 
partnership that holds debt-financed real property (the partnership 
limitation), unless the partnership meets one of the following 
requirements: (1) all of the partners of the partnership are QOs, (2) 
each allocation to a QO is a qualified allocation (within the meaning 
of section 168(h)(6)), or (3) each partnership allocation has 
substantial economic effect under section 704(b)(2) and satisfies 
section 514(c)(9)(E)(i)(I) (the fractions rule).
    A partnership allocation satisfies the fractions rule if the 
allocation of items to any partner that is a QO does not result in that 
partner having a share of overall partnership income for any taxable 
year greater than that partner's fractions rule percentage (the 
partner's share of overall partnership loss for the taxable year for 
which the partner's loss share is the smallest). Section 1.514(c)-
2(c)(1) describes overall partnership income as the amount by which the 
aggregate items of partnership income and gain for the taxable year 
exceed the aggregate items of partnership loss and deduction for the 
year. Overall partnership loss is the amount by which the aggregate 
items of partnership loss and deduction for the taxable year exceed the 
aggregate items of partnership income and gain for the year.
    Generally, under Sec.  1.514(c)-2(b)(2)(i), a partnership must 
satisfy the fractions rule both on a prospective basis and on an actual 
basis for each taxable year of the partnership, beginning with the 
first taxable year of the partnership in which the partnership holds 
debt-financed real property and has a QO partner. However, certain 
allocations are taken into account for purposes of determining overall 
partnership income or loss only when actually made, and do not create 
an immediate violation of the fractions rule. See Sec.  1.514(c)-
2(b)(2)(i). Certain other allocations are disregarded for purposes of 
making fractions rule calculations. See, for example, Sec.  1.514(c)-
2(d) (reasonable preferred returns and reasonable guaranteed payments), 
Sec.  1.514(c)-2(e) (certain chargebacks and offsets), Sec.  1.514(c)-
2(f) (reasonable partner-specific items of deduction and loss), Sec.  
1.514(c)-2(g) (unlikely losses and deductions), and Sec.  1.514(c)-
2(k)(3) (certain de minimis allocations of losses and deductions). In 
addition, Sec.  1.514(c)-2(k)(1) provides that changes in partnership 
allocations that result from transfers or shifts of partnership 
interests (other than transfers from a QO to another QO) will be 
closely scrutinized, but generally will be taken into account only in 
determining whether the partnership satisfies the fractions rule in the 
taxable year of the change and subsequent taxable years. Section 
1.514(c)-2(m) provides special rules for applying the fractions rule to 
tiered partnerships.
    The Treasury Department and the IRS have received comments 
requesting targeted changes to the existing regulations under section 
514(c)(9)(E) to allow certain allocations resulting from specified 
common business practices to comply with the rules under section 
514(c)(9)(E). Section 514(c)(9)(E)(iii) grants the Secretary authority 
to prescribe regulations as may be necessary to carry out the purposes 
of section 514(c)(9)(E), including regulations that may provide for the 
exclusion or segregation of items. In response to comments and under 
the regulatory authority in section 514(c)(9)(E), these proposed 
regulations provide guidance in determining a partner's share of 
overall partnership income or loss for purposes of the fractions rule, 
including allowing allocations consistent with common arrangements 
involving preferred returns, partner-specific expenditures, unlikely 
losses, and chargebacks of partner-specific expenditures and unlikely 
losses. The proposed regulations also simplify one of the examples 
involving tiered partnerships and provide rules regarding changes to 
partnership allocations as a result of capital commitment defaults and 
later acquisitions of partnership interests. These proposed regulations 
except from applying the fractions rule certain partnerships in which 
all partners other than QOs own five percent or less of the capital or 
profits interests in the

[[Page 84519]]

partnership. Finally, these proposed regulations increase the threshold 
for de minimis allocations away from QO partners.

Explanation of Provisions

1. Preferred Returns

    Section 1.514(c)-2(d)(1) and (2) of the existing regulations 
disregard in computing overall partnership income for purposes of the 
fractions rule items of income (including gross income) and gain that 
may be allocated to a partner with respect to a current or cumulative 
reasonable preferred return for capital (including allocations of 
minimum gain attributable to nonrecourse liability (or partner 
nonrecourse debt) proceeds distributed to the partner as a reasonable 
preferred return) if that preferred return is set forth in a binding, 
written partnership agreement. Section 1.514(c)-2(d)(2) of the existing 
regulations also provides that if a partnership agreement provides for 
a reasonable preferred return with an allocation of what would 
otherwise be overall partnership income, items comprising that 
allocation are disregarded in computing overall partnership income for 
purposes of the fractions rule.
    Section 1.514(c)-2(d)(6)(i) of the existing regulations limits the 
amount of income and gain allocated with respect to a preferred return 
that can be disregarded for purposes of the fractions rule to: (A) The 
aggregate of the amount that has been distributed to the partner as a 
reasonable preferred return for the taxable year of the allocation and 
prior taxable years, on or before the due date (not including 
extensions) for filing the partnership's return for the taxable year of 
the allocation; minus (B) the aggregate amount of corresponding income 
and gain (and what would otherwise be overall partnership income) 
allocated to the partner in all prior years. Thus, this rule requires a 
current distribution of preferred returns for the allocations of income 
with respect to those preferred returns to be disregarded.
    The Treasury Department and the IRS have received comments 
requesting that the current distribution requirement be eliminated from 
the regulations because it interferes with normal market practice, 
creates unnecessary complication, and, in some cases, causes economic 
distortions for partnerships with QO partners. The preamble to the 
existing final regulations under section 514(c)(9)(E) responded to 
objections regarding the current distribution requirement by explaining 
that if the requirement were eliminated, partnerships might attempt to 
optimize their overall economics by allocating significant amounts of 
partnership income and gain to QOs in the form of preferred returns. 
The preamble explained that these allocations ``would be a departure 
from the normal commercial practice followed by partnerships in which 
the money partners are generally subject to income tax.'' TD 8539, 59 
FR 24924. A recent commenter explained that the vast majority of 
partnerships holding debt-financed real property (real estate 
partnerships) with preferred returns to investing partners (either the 
QO or the taxable partner) make allocations that match the preferred 
return as it accrues, without regard to whether cash has been 
distributed with respect to the preferred return. Instead of requiring 
distributions equal to the full amount of their preferred returns, 
taxable partners generally negotiate for tax distributions to pay any 
tax liabilities associated with their partnership interest.
    The Treasury Department and the IRS have reconsidered the necessity 
of the current distribution requirement to prevent abuses of the 
fractions rule. So long as the preferred return is required to be 
distributed prior to other distributions (with an exception for certain 
distributions intended to facilitate the payment of taxes) and any 
undistributed amount compounds, the likelihood of abuse is minimized. 
Therefore, the proposed regulations remove the current distribution 
requirement and instead disregard allocations of items of income and 
gain with respect to a preferred return for purposes of the fractions 
rule, but only if the partnership agreement requires that the 
partnership make distributions first to pay any accrued, cumulative, 
and compounding unpaid preferred return to the extent such accrued but 
unpaid preferred return has not otherwise been reversed by an 
allocation of loss prior to such distribution (preferred return 
distribution requirement). The preferred return distribution 
requirement, however, is subject to an exception under the proposed 
regulations that allows distributions intended to facilitate partner 
payment of taxes imposed on the partner's allocable share of 
partnership income or gain, if the distributions are made pursuant to a 
provision in the partnership agreement, are treated as an advance 
against distributions to which the distributee partner would otherwise 
be entitled under the partnership agreement, and do not exceed the 
distributee partner's allocable share of net partnership income and 
gain multiplied by the sum of the highest statutory federal, state, and 
local tax rates applicable to that partner.

2. Partner-Specific Expenditures and Management Fees

    Section 1.514(c)-2(f) of the existing regulations provides a list 
of certain partner- specific expenditures that are disregarded in 
computing overall partnership income or loss for purposes of the 
fractions rule. These expenditures include expenditures attributable to 
a partner for additional record-keeping and accounting costs including 
in connection with the transfer of a partnership interest, additional 
administrative costs from having a foreign partner, and state and local 
taxes. The Treasury Department and the IRS are aware that some real 
estate partnerships allow investing partners to negotiate for 
management and similar fees paid to the general partner that differ 
from fees paid with respect to investments by other partners. These 
fees include the general partner's fees for managing the partnership 
and may include fees paid in connection with the acquisition, 
disposition, or refinancing of an investment. Compliance with the 
fractions rule may preclude a real estate partnership with QO partners 
from allocating deductions attributable to these management expenses in 
a manner that follows the economic fee arrangement because the 
fractions rule limits the ability of the partnership to make 
disproportionate allocations.
    The Treasury Department and the IRS have determined that real 
estate partnerships with QO partners should be permitted to allocate 
management and similar fees among partners to reflect the manner in 
which the partners agreed to bear the expense without causing a 
fractions rule violation. Accordingly, the proposed regulations add 
management (and similar) fees to the current list of excluded partner-
specific expenditures in Sec.  1.514(c)-2(f) of the existing 
regulations to the extent such fees do not, in the aggregate, exceed 
two percent of the partner's aggregate committed capital.
    It has been suggested to the Treasury Department and the IRS that 
similar partner-specific expenditure issues may arise under the new 
partnership audit rules in section 1101 of the Bipartisan Budget Act of 
2015, Public Law 114-74 (the BBA), which was enacted into law on 
November 2, 2015. Section 1101 of the BBA repeals the current rules 
governing partnership audits and replaces them with a new centralized 
partnership audit regime that, in general, assesses and collects tax at 
the

[[Page 84520]]

partnership level as an imputed underpayment. Some have suggested that 
the manner in which an imputed underpayment is borne by partners 
potentially could implicate similar concerns as special allocations of 
partner-specific items. As the Treasury Department and the IRS continue 
to consider how to implement the BBA, the Treasury Department and the 
IRS request comments regarding whether an imputed underpayment should 
be included among the list of partner-specific expenditures.

3. Unlikely Losses

    Similar to Sec.  1.514(c)-2(f), Sec.  1.514(c)-2(g) of the existing 
regulations generally disregards specially allocated unlikely losses or 
deductions (other than items of nonrecourse deduction) in computing 
overall partnership income or loss for purposes of the fractions rule. 
To be disregarded under Sec.  1.514(c)-2(g), a loss or deduction must 
have a low likelihood of occurring, taking into account all relevant 
facts, circumstances, and information available to the partners 
(including bona fide financial projections). Section 1.514(c)-2(g) 
describes types of events that give rise to unlikely losses or 
deductions.
    The Treasury Department and the IRS have received comments 
suggesting that a ``more likely than not'' standard is appropriate for 
determining when a loss or deduction is unlikely to occur. Notice 90-41 
(1990-1 CB 350) (see Sec.  601.601(d)(2)(ii)(b)), which preceded the 
initial proposed regulations under section 514(c)(9)(E), outlined this 
standard. The commenter explained that the ``low likelihood of 
occurring'' standard in the existing regulations is vague and gives 
little comfort to QOs and their taxable partners when drafting 
allocations to reflect legitimate business arrangements (such as, 
drafting allocations to account for cost overruns). The Treasury 
Department and the IRS are considering changing the standard in Sec.  
1.514(c)-2(g) and request further comments explaining why ``more likely 
than not'' is a more appropriate standard than the standard contained 
in the existing regulations, or whether another standard turning upon a 
level of risk that is between ``more likely than not'' and ``low 
likelihood of occurring'' might be more appropriate and what such other 
standard could be.

4. Chargebacks of Partner-Specific Expenditures and Unlikely Losses

    Because allocations of partner-specific expenditures in Sec.  
1.514(c)-2(f) and unlikely losses in Sec.  1.514(c)-2(g) are 
disregarded in computing overall partnership income or loss, 
allocations of items of income or gain or net income to reverse the 
prior partner-specific expenditure or unlikely loss could cause a 
violation of the fractions rule. For example, a QO may contribute 
capital to a partnership to pay a specific expenditure with the 
understanding that it will receive a special allocation of income to 
reverse the prior expenditure once the partnership earns certain 
profits. If the allocation of income is greater than the QO's fractions 
rule percentage, the allocation will cause a fractions rule violation.
    Section 1.514(c)-2(e)(1) of the existing regulations generally 
disregards certain allocations of income or loss made to chargeback 
previous allocations of income or loss in computing overall partnership 
income or loss for purposes of the fractions rule. Specifically, Sec.  
1.514(c)-2(e)(1)(i) disregards allocations of what would otherwise be 
overall partnership income that chargeback (that is, reverse) prior 
disproportionately large allocations of overall partnership loss (or 
part of the overall partnership loss) to a QO (the chargeback 
exception). The chargeback exception applies to a chargeback of an 
allocation of part of the overall partnership income or loss only if 
that part consists of a pro rata portion of each item of partnership 
income, gain, loss, and deduction (other than nonrecourse deductions, 
as well as partner nonrecourse deductions and compensating allocations) 
that is included in computing overall partnership income or loss.
    The Treasury Department and the IRS understand that often a real 
estate partnership with QO partners may seek to reverse a special 
allocation of unlikely losses or partner-specific items with net 
profits of the partnership, which could result in allocations that 
would violate the fractions rule. Such allocations of net income to 
reverse special allocations of unlikely losses or partner-specific 
items that were disregarded in computing overall partnership income or 
loss for purposes of the fractions rule under Sec.  1.514(c)-2(f) or 
(g), respectively, do not violate the purpose of the fractions rule. 
Accordingly, the proposed regulations modify the chargeback exception 
to disregard in computing overall partnership income or loss for 
purposes of the fractions rule an allocation of what would otherwise 
have been an allocation of overall partnership income to chargeback 
(that is, reverse) a special allocation of a partner-specific 
expenditure under Sec.  1.514(c)-2(f) or a special allocation of an 
unlikely loss under Sec.  1.514(c)-2(g). Notwithstanding the rule in 
the proposed regulations, an allocation of an unlikely loss or a 
partner-specific expenditure that is disregarded when allocated, but is 
taken into account for purposes of determining the partners' economic 
entitlement to a chargeback of such loss or expense may, in certain 
circumstances, give rise to complexities in determining applicable 
percentages for purposes of fractions rule compliance. Accordingly, the 
Treasury Department and the IRS request comments regarding the 
interaction of disregarded partner-specific expenditures and unlikely 
losses with chargebacks of such items with overall partnership income.

5. Acquisition of Partnership Interests After Initial Formation of 
Partnership

    Section 1.514(c)-2(k)(1) of the existing regulations provides 
special rules regarding changes in partnership allocations arising from 
a change in partners' interests. Specifically, Sec.  1.514(c)-2(k)(1) 
provides that changes in partnership allocations that result from 
transfers or shifts of partnership interests (other than transfers from 
a QO to another QO) will be closely scrutinized (to determine whether 
the transfer or shift stems from a prior agreement, understanding, or 
plan or could otherwise be expected given the structure of the 
transaction), but generally will be taken into account only in 
determining whether the partnership satisfies the fractions rule in the 
taxable year of the change and subsequent taxable years. Section 
1.514(c)-2(k)(4) of the existing regulations provides that Sec.  
1.514(c)-2 may not be applied in a manner inconsistent with the purpose 
of the fractions rule, which is to prevent tax avoidance by limiting 
the permanent or temporary transfer of tax benefits from tax-exempt 
partners to taxable partners.
    The Treasury Department and the IRS have received comments 
requesting guidance in applying the fractions rule when additional 
partners are admitted to a partnership after the initial formation of 
the partnership. The commenter explained that many real estate 
partnerships with QO partners admit new partners in a number of rounds 
of closings, but treat the partners as having entered at the same time 
for purposes of sharing in profits and losses (staged closings). A 
number of commercial arrangements are used to effect staged closings. 
For example, the initial operations of the partnership may be funded 
entirely through debt financing, with all partners contributing their 
committed capital at a later date. Alternatively, later entering 
partners may contribute capital and an interest

[[Page 84521]]

factor, some or both of which is then distributed to the earlier 
admitted partners to compensate them for the time value of their 
earlier contributions.
    Under existing regulations, staged closings could cause violations 
of the fractions rule in two ways. First, when new partners are 
admitted to a partnership, shifts of partnership interests occur. 
Changes in allocations that result from shifts of partnership interests 
are closely scrutinized under Sec.  1.514(c)-2(k)(1) of the existing 
regulations if pursuant to a prior agreement and could be determined to 
violate the fractions rule. Second, after admitting new partners, 
partnerships may disproportionately allocate income or loss to the 
partners to adjust the partners' capital accounts as a result of the 
staged closings. These disproportionate allocations could cause 
fractions rule violations if one of the partners is a QO.
    The Treasury Department and the IRS have determined that changes in 
allocations and disproportionate allocations resulting from common 
commercial staged closings should not violate the fractions rule if 
they are not inconsistent with the purpose of the fractions rule under 
Sec.  1.514(c)-2(k)(4) and certain conditions are satisfied. The 
conditions include the following: (A) The new partner acquires the 
partnership interest no later than 18 months following the formation of 
the partnership (applicable period); (B) the partnership agreement and 
other relevant documents anticipate the new partners acquiring the 
partnership interests during the applicable period, set forth the time 
frame in which the new partners will acquire the partnership interests, 
and provide for the amount of capital the partnership intends to raise; 
(C) the partnership agreement and any other relevant documents 
specifically set forth the method of determining any applicable 
interest factor and for allocating income, loss, or deduction to the 
partners to adjust partners' capital accounts after the new partner 
acquires the partnership interest; and (D) the interest rate for any 
applicable interest factor is not greater than 150 percent of the 
highest applicable Federal rate, at the appropriate compounding period 
or periods, at the time the partnership was formed.
    Under the proposed regulations, if those conditions are satisfied, 
the IRS will not closely scrutinize changes in allocations resulting 
from staged closings under Sec.  1.514(c)-2(k)(1) and will disregard in 
computing overall partnership income or loss for purposes of the 
fractions rule disproportionate allocations of income, loss, or 
deduction made to adjust the capital accounts when a new partner 
acquires its partnership interest after the partnership's formation.

6. Capital Commitment Defaults or Reductions

    The Treasury Department and the IRS received comments requesting 
guidance with respect to calculations of overall partnership income and 
loss when allocations change as a result of capital commitment defaults 
or reductions. The commenter indicated that, in the typical real estate 
partnership, a limited partner generally will not contribute its entire 
investment upon being admitted as a partner. Rather, that limited 
partner will commit to contribute a certain dollar amount over a fixed 
period of time, and the general partner will then ``call'' on that 
committed, but uncontributed, capital as needed. These calls will be 
made in proportion to the partners' commitments to the partnership.
    The commenter identified certain remedies that partnership 
agreements provide if a partner fails to contribute a portion (or all) 
of its committed capital. These remedies commonly include: (i) Allowing 
the non-defaulting partner(s) to contribute additional capital in 
return for a preferred return on that additional capital; (ii) causing 
the defaulting partner to forfeit all or a portion of its interest in 
the partnership; (iii) forcing the defaulting partner to sell its 
interest in the partnership, or (iv) excluding the defaulting partner 
from making future capital contributions. Alternatively, the agreement 
may allow partners to reduce their commitment amounts, reducing 
allocations of income and loss as well. The commenter noted that, 
depending on the facts, any of these partnership agreement provisions 
could raise fractions rule concerns.
    There is little guidance in the existing regulations regarding 
changes to allocations of a partner's share of income and losses from 
defaulted capital calls and reductions in capital commitments. Section 
1.514(c)-2(k)(1) applies to changes in allocations resulting from a 
default if there is a ``transfer or shift'' of partnership interests. 
The Treasury Department and the IRS have determined that changes in 
allocations resulting from unanticipated defaults or reductions do not 
run afoul of the purpose of the fractions rule if such changes are 
provided for in the partnership agreement. Therefore, the proposed 
regulations provide that, if the partnership agreement provides for 
changes to allocations due to an unanticipated partner default on a 
capital contribution commitment or an unanticipated reduction in a 
partner's capital contribution commitment, and those changes in 
allocations are not inconsistent with the purpose of the fractions rule 
under Sec.  1.514(c)-2(k)(4), then: (A) Changes to partnership 
allocations provided in the agreement will not be closely scrutinized 
under Sec.  1.514(c)-2(k)(1) and (B) partnership allocations of income, 
loss, or deduction (including allocations to adjust partners' capital 
accounts to be consistent with the partners' adjusted capital 
commitments) to partners to adjust the partners' capital accounts as a 
result of unanticipated capital contribution defaults or reductions 
will be disregarded in computing overall partnership income or loss for 
purposes of the fractions rule.

7. Applying the Fractions Rule to Tiered Partnerships

    Section 1.514(c)-2(m)(1) of the existing regulations provides that 
if a QO holds an indirect interest in real property through one or more 
tiers of partnerships (a chain), the fractions rule is satisfied if: 
(i) The avoidance of tax is not a principal purpose for using the 
tiered-ownership structure; and (ii) the relevant partnerships can 
demonstrate under ``any reasonable method'' that the relevant chains 
satisfy the requirements of Sec.  1.514(c)-2(b)(2) through (k). Section 
1.514(c)-2(m)(2) of the existing regulations provides examples that 
illustrate three different ``reasonable methods:'' the collapsing 
approach, the entity-by-entity approach, and the independent chain 
approach.
    The Treasury Department and the IRS have received comments 
requesting guidance with respect to tiered partnerships and the 
application of the independent chain approach. Under the independent 
chain approach in Sec.  1.514(c)-2(m)(2) Example 3 of the existing 
regulations, different lower-tiered partnership chains (one or more 
tiers of partnerships) are examined independently of each other, even 
if these lower-tiered partnerships are owned by a common upper-tier 
partnership. The example provides, however, that chains are examined 
independently only if the upper-tier partnership allocates the items of 
each lower-tier partnership separately from the items of another lower-
tier partnership.
    The comment noted that in practice, a real estate partnership 
generally invests in a significant number of properties, often through 
joint ventures with other partners. A typical real estate partnership 
will not make separate allocations to its partners of lower-tier 
partnership items. Accordingly, the

[[Page 84522]]

proposed regulations amend Sec.  1.514(c)-2(m)(2) Example 3 to remove 
the requirement that a partnership allocate items from lower-tier 
partnerships separately from one another. Partnership provisions 
require that partnership items such as items that would give rise to 
UBTI be separately stated. See Sec.  1.702-1(a)(8)(ii). That 
requirement suffices to separate the tiers of partnerships, and, thus, 
the proposed regulations do not require the upper-tier partnership to 
separately allocate partnership items from separate lower-tier 
partnerships. The proposed regulations also revise Sec.  1.514(c)-
2(m)(1)(ii) to remove the discussion of minimum gain chargebacks that 
refers to language that has been deleted from the example.

8. De Minimis Exceptions From Application of the Fractions Rule

    Section 1.514(c)-2(k)(2) of the existing regulations provides that 
the partnership limitation in section 514(c)(9)(B)(vi) does not apply 
to a partnership if all QOs hold a de minimis interest in the 
partnership, defined as no more than five percent in the capital or 
profits of the partnership, and taxable partners own substantial 
interests in the partnership through which they participate in the 
partnership on substantially the same terms as the QO partners. If the 
partnership limitation in section 514(c)(9)(B)(vi) does not apply to 
the partnership, the fractions rule does not apply to the partnership. 
Because the fractions rule does not apply to a partnership if all QOs 
are de minimis interest holders in the partnership, the Treasury 
Department and the IRS considered whether the inverse fact pattern, in 
which all non-QO partners are de minimis partners, implicates the 
purpose of the fractions rule. See Sec.  1.514(c)-2(k)(4) (providing 
that the purpose of the fractions rule is to ``prevent tax avoidance by 
limiting the permanent or temporary transfer of tax benefits from tax-
exempt partners to taxable partners, whether by directing income or 
gain to tax-exempt partners, by directing losses, deductions or credits 
to taxable partners, or by some similar manner.'').
    The Treasury Department and the IRS have determined that the 
purpose of the fractions rule is similarly not violated if all non-QO 
partners hold a de minimis interest. Therefore, the proposed 
regulations provide that the fractions rule does not apply to a 
partnership in which non-QO partners do not hold (directly or 
indirectly through a partnership), in the aggregate, interests of 
greater than five percent in the capital or profits of the partnership, 
so long as the partnership's allocations have substantial economic 
effect. For purposes of the proposed rule, the determination of whether 
an allocation has substantial economic effect is made without 
application of the special rules in Sec.  1.704-1(b)(2)(iii)(c)(2) 
(regarding the presumption that there is a reasonable possibility that 
allocations will affect substantially the dollar amounts to be received 
by the partners from the partnership if there is a strong likelihood 
that offsetting allocations will not be made in five years, and the 
presumption that the adjusted tax basis (or book value) of partnership 
property is equal to the fair market value of such property).
    The existing regulations also provide for a de minimis exception 
for allocations away from QO partners. Section 1.514(c)-2(k)(3) of the 
existing regulations provides that a QO's fractions rule percentage of 
the partnership's items of loss and deduction, other than nonrecourse 
and partner nonrecourse deductions, that are allocated away from the QO 
and to other partners in any taxable year, are treated as having been 
allocated to the QO for purposes of the fractions rule if: (i) The 
allocation was neither planned nor motivated by tax avoidance; and (ii) 
the total amount of those items of partnership loss or deduction is 
less than both one percent of the partnership's aggregate items of 
gross loss and deduction for the taxable year and $50,000. The preamble 
to the existing final regulations under section 514(c)(9)(E) explained 
that the de minimis allocation exception was ``to provide relief for 
what would otherwise be minor inadvertent violations of the fractions 
rule.'' TD 8539, 59 FR 24924. The exception was ``not intended . . . 
[to] be used routinely by partnerships to allocate some of the 
partnership's losses and deductions.'' Id. To that end, the final 
regulations limited the exception to $50,000. As an example of a de 
minimis allocation intended to meet this exception, the preamble 
described a scenario in which a plumber's bill is paid by the 
partnership but overlooked until after the partner's allocations have 
been computed and then is allocated entirely to the taxable partner. 
Id.
    In current business practices, a $50,000 threshold does not provide 
sufficient relief for de minimis allocations away from the QO partner. 
The proposed regulations still require that allocations not exceed one 
percent of the partnership's aggregate items of gross loss and 
deduction for the taxable year, but raise the threshold from $50,000 to 
$1,000,000.

Proposed Applicability Date

    The regulations under section 514(c)(9)(E) are proposed to apply to 
taxable years ending on or after the date these regulations are 
published as final regulations in the Federal Register. However, a 
partnership and its partners may apply all the rules in these proposed 
regulations for taxable years ending on or after November 23, 2016.

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. Because these proposed regulations do not impose a 
collection of information on small entities, the Regulatory Flexibility 
Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of 
the Code, this notice of proposed rulemaking has been submitted to the 
Chief Counsel for Advocacy of the Small Business Administration for 
comment on its impact on small business.

Comments and Requests for a Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any comments that are submitted timely 
to the IRS as prescribed in this preamble under the ``Addresses'' 
heading. The Treasury Department and the IRS request comments on all 
aspects of the proposed rules. All comments will be available at 
www.regulations.gov or upon request. A public hearing will be scheduled 
if requested in writing by any person that timely submits written 
comments. If a public hearing is scheduled, notice of the date, time, 
and place for the public hearing will be published in the Federal 
Register.

Drafting Information

    The principal author of these proposed regulations is Caroline E. 
Hay, 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 in 26 CFR Part 1

    Income Taxes, Reporting and recordkeeping requirements.

[[Page 84523]]

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

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

    Authority:  26 U.S.C. 7805 * * *
    Section 1.514(c)-2 also issued under 26 U.S.C. 
514(c)(9)(E)(iii).

0
Par. 2. Section 1.514(c)-2 is amended by:
0
1. In paragraph (a), adding entries for (d)(2)(i) through (iii), adding 
entries for (d)(3)(i) and (ii), revising the entry for (d)(6), removing 
entries for (d)(6)(i) and (ii), and (d)(7), adding entries for 
(k)(1)(i) through (iv), revising the entries for (k)(2)(i) and (ii), 
adding an entry for (k)(2)(iii), and revising the entry for (n).
0
2. Revising paragraphs (d)(2) and (3).
0
3. Removing paragraph (d)(6).
0
4. Redesignating paragraph (d)(7) as paragraph (d)(6).
0
5. Revising newly redesignated paragraph (d)(6) Example 1 paragraph (i) 
and adding paragraph (iv).
0
6. Removing the language ``(i.e., reverse)'' in paragraph (e)(1)(i) and 
adding the language ``(that is, reverse)'' in its place.
0
7. Removing the language ``other partners; and'' at the end of 
paragraph (e)(1)(iii) and adding the language ``other partners;'' in 
its place.
0
8. Removing the language ``of Sec.  1.704-1(b)(2)(ii)(d).'' at the end 
of paragraph (e)(1)(iv) and adding the language ``of Sec.  1.704-
1(b)(2)(ii)(d);'' in its place.
0
9. Removing the language ``the regulations thereunder.'' at the end of 
paragraph (e)(1)(v) and adding the language ``the regulations 
thereunder;'' in its place.
0
10. Adding new paragraphs (e)(1)(vi) and (vii).
0
11. Adding Example 5 to paragraph (e)(5).
0
12. Removing the word ``and'' at the end of paragraph (f)(3).
0
13. Redesignating paragraph (f)(4) as paragraph (f)(5) and adding new 
paragraph (f)(4).
0
14. Revising paragraph (k)(1).
0
15. Revising the subject heading for paragraph (k)(2)(i).
0
16. Revising paragraph (k)(2)(i)(A).
0
17. Redesignating paragraph (k)(2)(ii) as paragraph (k)(2)(iii) and 
adding new paragraph (k)(2)(ii).
0
18. Revising paragraph (k)(3)(ii)(B).
0
19. Removing the second sentence in paragraph (m)(1)(ii).
0
20. Revising Example 3(ii) of paragraph (m)(2).
0
21. Revising the subject heading for paragraph (n).
0
22. Adding a sentence to the end of paragraph (n)(2).
    The revisions and additions read as follows:


Sec.  1.514(c)-2.  Permitted allocations under section 514(c)(9)(E).

    (a) Table of contents. * * *
    (d) * * *
    (2) * * *
    (i) In general.
    (ii) Limitation.
    (iii) Distributions disregarded.
    (3) * * *
    (i) In general.
    (ii) Reasonable guaranteed payments may be deducted only when 
paid in cash.
* * * * *
    (6) Examples.
* * * * *
    (k) * * *
    (1) * * *
    (i) In general.
    (ii) Acquisition of partnership interests after initial 
formation of partnership.
    (iii) Capital commitment defaults or reductions.
    (iv) Examples.
    (2) * * *
    (i) Qualified organizations.
    (ii) Non-qualified organizations.
    (iii) Example.
* * * * *
    (n) Effective/applicability dates.
* * * * *

    (d) * * *
    (2) Preferred returns--(i) In general. Items of income (including 
gross income) and gain that may be allocated to a partner with respect 
to a current or cumulative reasonable preferred return for capital 
(including allocations of minimum gain attributable to nonrecourse 
liability (or partner nonrecourse debt) proceeds distributed to the 
partner as a reasonable preferred return) are disregarded in computing 
overall partnership income or loss for purposes of the fractions rule. 
Similarly, if a partnership agreement effects a reasonable preferred 
return with an allocation of what would otherwise be overall 
partnership income, those items comprising that allocation are 
disregarded in computing overall partnership income for purposes of the 
fractions rule.
    (ii) Limitation. Except as otherwise provided in paragraph 
(d)(2)(iii) of this section, items of income and gain (or part of what 
would otherwise be overall partnership income) that may be allocated to 
a partner in a taxable year with respect to a reasonable preferred 
return for capital are disregarded under paragraph (d)(2)(i) of this 
section for purposes of the fractions rule only if the partnership 
agreement requires the partnership to make distributions first to pay 
any accrued, cumulative, and compounding unpaid preferred return to the 
extent such accrued but unpaid preferred return has not otherwise been 
reversed by an allocation of loss prior to such distribution.
    (iii) Distributions disregarded. A distribution is disregarded for 
purposes of paragraph (d)(2)(ii) of this section if the distribution--
    (A) Is made pursuant to a provision in the partnership agreement 
intended to facilitate the partners' payment of taxes imposed on their 
allocable shares of partnership income or gain;
    (B) Is treated as an advance against distributions to which the 
distributee partner would otherwise be entitled under the partnership 
agreement; and
    (C) Does not exceed the distributee partner's allocable share of 
net partnership income and gain multiplied by the sum of the highest 
statutory federal, state, and local tax rates applicable to such 
partner.
    (3) Guaranteed payments--(i) In general. A current or cumulative 
reasonable guaranteed payment to a qualified organization for capital 
or services is treated as an item of deduction in computing overall 
partnership income or loss, and the income that the qualified 
organization may receive or accrue from the current or cumulative 
reasonable guaranteed payment is not treated as an allocable share of 
overall partnership income or loss. The treatment of a guaranteed 
payment as reasonable for purposes of section 514(c)(9)(E) does not 
affect its possible characterization as unrelated business taxable 
income under other provisions of the Internal Revenue Code.
    (ii) Reasonable guaranteed payments may be deducted only when paid 
in cash. If a partnership that avails itself of paragraph (d)(3)(i) of 
this section would otherwise be required (by virtue of its method of 
accounting) to deduct a reasonable guaranteed payment to a qualified 
organization earlier than the taxable year in which it is paid in cash, 
the partnership must delay the deduction of the guaranteed payment 
until the taxable year it is paid in cash. For purposes of this 
paragraph (d)(3)(ii), a guaranteed payment that is paid in cash on or 
before the due date (not including extensions) for filing the 
partnership's return for a taxable year may be treated as paid in that 
prior taxable year.
* * * * *
    (6) * * *

    Example 1.  * * *
    (i) The partnership agreement provides QO a 10 percent preferred 
return on its

[[Page 84524]]

unreturned capital. The partnership agreement provides that the 
preferred return may be compounded (at 10 percent) and may be paid 
in future years and requires that when distributions are made, they 
must be made first to pay any accrued, cumulative, and compounding 
unpaid preferred return not previously reversed by a loss 
allocation. The partnership agreement also allows distributions to 
be made to facilitate a partner's payment of federal, state, and 
local taxes. Under the partnership agreement, any such distribution 
is treated as an advance against distributions to which the 
distributee partner would otherwise be entitled and must not exceed 
the partner's allocable share of net partnership income or gain for 
that taxable year multiplied by the sum of the highest statutory 
federal, state, and local tax rates applicable to the partner. The 
partnership agreement first allocates gross income and gain 100 
percent to QO, to the extent of the preferred return. All remaining 
income or loss is allocated 50 percent to QO and 50 percent to TP.
* * * * *
    (iv) The facts are the same as in paragraph (i) of this Example 
1, except the partnership makes a distribution to TP of an amount 
computed by a formula in the partnership agreement equal to TP's 
allocable share of net income and gain multiplied by the sum of the 
highest statutory federal, state, and local tax rates applicable to 
TP. The partnership satisfies the fractions rule. The distribution 
to TP is disregarded for purposes of paragraph (d)(2)(ii) of this 
section because the distribution is made pursuant to a provision in 
the partnership agreement that provides that the distribution is 
treated as an advance against distributions to which TP would 
otherwise be entitled and the distribution did not exceed TP's 
allocable share of net partnership income or gain for that taxable 
year multiplied by the sum of the highest statutory federal, state, 
and local tax rates applicable to TP. The income and gain that is 
specially allocated to QO with respect to its preferred return is 
disregarded in computing overall partnership income or loss for 
purposes of the fractions rule because the requirements of paragraph 
(d) of this section are satisfied. After disregarding those 
allocations, QO's fractions rule percentage is 50 percent (see 
paragraph (c)(2) of this section), and, under the partnership 
agreement, QO may not be allocated more than 50 percent of overall 
partnership income in any taxable year.

    (e) * * *
    (1) * * *
    (vi) Allocations of what would otherwise be overall partnership 
income that may be made to chargeback (that is, reverse) prior 
allocations of partner-specific expenditures that were disregarded in 
computing overall partnership income or loss for purposes of the 
fractions rule under paragraph (f) of this section; and
    (vii) Allocations of what would otherwise be overall partnership 
income that may be made to chargeback (that is, reverse) prior 
allocations of unlikely losses and deductions that were disregarded in 
computing overall partnership income or loss for purposes of the 
fractions rule under paragraph (g) of this section.
* * * * *
    (5) * * *

    Example 5.  Chargeback of prior allocations of unlikely losses 
and deductions. (i) Qualified organization (QO) and taxable 
corporation (TP) are equal partners in a partnership that holds 
encumbered real property. The partnership agreement generally 
provides that QO and TP share partnership income and deductions 
equally. QO contributes land to the partnership, and the partnership 
agreement provides that QO bears the burden of any environmental 
remediation required for that land, and, as such, the partnership 
will allocate 100 percent of the expense attributable to the 
environmental remediation to QO. In the unlikely event of the 
discovery of environmental conditions that require remediation, the 
partnership agreement provides that, to the extent its cumulative 
net income (without regard to the remediation expense) for the 
taxable year the partnership incurs the remediation expense and for 
subsequent taxable years exceeds $500x, after allocation of the 
$500x of cumulative net income, net income will first be allocated 
to QO to offset any prior allocation of the environmental 
remediation expense deduction. On January 1 of Year 3, the 
partnership incurs a $100x expense for the environmental remediation 
of the land. In that year, the partnership had gross income of $60x 
and other expenses of $30x for total net income of $30x without 
regard to the expense associated with the environmental remediation. 
The partnership allocated $15x of income to each of QO and TP and 
$100x of remediation expense to QO.
    (ii) The partnership satisfies the fractions rule. The 
allocation of the expense attributable to the remediation of the 
land is disregarded under paragraph (g) of this section. QO's share 
of overall partnership income is 50 percent, which equals QO's share 
of overall partnership loss.
    (iii) In Year 8, when the partnership's cumulative net income 
(without regard to the remediation expense) for the taxable year the 
partnership incurred the remediation expense and subsequent taxable 
years is $480x (the $30x from Year 3, plus $450x of cumulative net 
income for Years 4-7), the partnership has gross income of $170x and 
expenses of $50x, for total net income of $120x. The partnership's 
cumulative net income for all years from Year 3 to Year 8 is $600x 
($480x for Years 3-7 and $120x for Year 8). Pursuant to the 
partnership agreement, the first $20x of net income for Year 8 is 
allocated equally between QO and TP because the partnership must 
first earn cumulative net income in excess of $500x before making 
the offset allocation to QO. The remaining $100x of net income for 
Year 8 is allocated to QO to offset the environmental remediation 
expense allocated to QO in Year 3.
    (iv) Pursuant to paragraph (e)(1)(vii) of this section, the 
partnership's allocation of $100x of net income to QO in Year 8 to 
offset the prior environmental remediation expense is disregarded in 
computing overall partnership income or loss for purposes of the 
fractions rule. The allocation does not cause the partnership to 
violate the fractions rule.

    (f) * * *
    (4) Expenditures for management and similar fees, if such fees in 
the aggregate for the taxable year are not more than 2 percent of the 
partner's capital commitments; and * * *
* * * * *
    (k) Special rules--(1) Changes in partnership allocations arising 
from a change in the partners' interests--(i) In general. A qualified 
organization that acquires a partnership interest from another 
qualified organization is treated as a continuation of the prior 
qualified organization partner (to the extent of that acquired 
interest) for purposes of applying the fractions rule. Changes in 
partnership allocations that result from other transfers or shifts of 
partnership interests will be closely scrutinized (to determine whether 
the transfer or shift stems from a prior agreement, understanding, or 
plan or could otherwise be expected given the structure of the 
transaction), but generally will be taken into account only in 
determining whether the partnership satisfies the fractions rule in the 
taxable year of the change and subsequent taxable years.
    (ii) Acquisition of partnership interests after initial formation 
of partnership. Changes in partnership allocations due to an 
acquisition of a partnership interest by a partner (new partner) after 
the initial formation of a partnership will not be closely scrutinized 
under paragraph (k)(1)(i) of this section, but will be taken into 
account only in determining whether the partnership satisfies the 
fractions rule in the taxable year of the change and subsequent taxable 
years, and disproportionate allocations of income, loss, or deduction 
to the partners to adjust the partners' capital accounts as a result 
of, and to reflect, the new partner acquiring the partnership interest 
and the resulting changes to the other partners' interests will be 
disregarded in computing overall partnership income or loss for 
purposes of the fractions rule if such changes and disproportionate 
allocations are not inconsistent with the purpose of the fractions rule 
under paragraph (k)(4) of this section and--
    (A) The new partner acquires the partnership interest no later than 
18 months following the formation of the partnership (applicable 
period);
    (B) The partnership agreement and other relevant documents 
anticipate the

[[Page 84525]]

new partners acquiring the partnership interest during the applicable 
period, set forth the time frame in which the new partners will acquire 
the partnership interests, and provide for the amount of capital the 
partnership intends to raise;
    (C) The partnership agreement and other relevant documents 
specifically set forth the method for determining any applicable 
interest factor and for allocating income, loss, or deduction to the 
partners to account for the economics of the arrangement in the 
partners' capital accounts after the new partner acquires the 
partnership interest; and
    (D) The interest rate for any applicable interest factor is not 
greater than 150 percent of the highest applicable Federal rate, at the 
appropriate compounding period or periods, at the time the partnership 
was formed.
    (iii) Capital commitment defaults or reductions. Changes in 
partnership allocations that result from an unanticipated partner 
default on a capital contribution commitment or an unanticipated 
reduction in a partner's capital contribution commitment, that are 
effected pursuant to provisions prescribing the treatment of such 
events in the partnership agreement, and that are not inconsistent with 
the purpose of the fractions rule under paragraph (k)(4) of this 
section, will not be closely scrutinized under paragraph (k)(1)(i) of 
this section, but will be taken into account only in determining 
whether the partnership satisfies the fractions rule in the taxable 
year of the change and subsequent taxable years. In addition, 
partnership allocations of income, loss, or deduction to partners made 
pursuant to the partnership agreement to adjust partners' capital 
accounts as a result of unanticipated capital contribution defaults or 
reductions will be disregarded in computing overall partnership income 
or loss for purposes of the fractions rule. The adjustments may include 
allocations to adjust partners' capital accounts to be consistent with 
the partners' adjusted capital commitments.
    (iv) Examples. The following examples illustrate the provisions of 
paragraph (k)(1) of this section.

    Example 1.  Staged closing. (i) On July 1 of Year 1, two taxable 
partners (TP1 and TP2) form a partnership that will invest in debt-
financed real property. The partnership agreement provides that, 
within an 18-month period, partners will be added so that an 
additional $1000x of capital can be raised. The partnership 
agreement sets forth the method for determining the applicable 
interest factor that complies with paragraph (k)(1)(ii)(D) of this 
section and for allocating income, loss, or deduction to the 
partners to account for the economics of the arrangement in the 
partners' capital accounts. During the partnership's Year 1 taxable 
year, partnership had $150x of net income. TP1 and TP2, each, is 
allocated $75x of net income.
    (ii) On January 1 of Year 2, qualified organization (QO) joins 
the partnership. The partnership agreement provides that TP1, TP2, 
and QO will be treated as if they had been equal partners from July 
1 of Year 1. Assume that the interest factor is treated as a 
reasonable guaranteed payment to TP1 and TP2, the expense from which 
is taken into account in the partnership's net income of $150x for 
Year 2. To balance capital accounts, the partnership allocates $100x 
of the income to QO ($50x, or the amount of one-third of Year 1 
income that QO was not allocated during the partnership's first 
taxable year, plus $50x, or one-third of the partnership's income 
for Year 2) and the remaining income equally to TP1 and TP2. Thus, 
the partnership allocates $100x to QO and $25x to TP1 and TP2, each.
    (iii) The partnership's allocation to QO would violate the 
fractions rule because QO's overall percentage of partnership income 
for Year 2 of 66.7 percent is greater than QO's fractions rule 
percentage of 33.3 percent. However, the special allocation of $100x 
to QO for Year 2 is disregarded in determining QO's percentage of 
overall partnership income for purposes of the fractions rule 
because the requirements in paragraph (k)(1)(ii) of this section are 
satisfied.
    Example 2.  Capital call default. (i) On January 1 of Year 1, 
two taxable partners, (TP1 and TP2) and a qualified organization 
(QO) form a partnership that will hold encumbered real property and 
agree to share partnership profits and losses, 60 percent, 10 
percent, and 30 percent, respectively. TP1 agreed to a capital 
commitment of $120x, TP2 agreed to a capital commitment of $20x, and 
QO agreed to a capital commitment of $60x. The partners met half of 
their commitments upon formation of the partnership. The partnership 
agreement requires a partner's interest to be reduced if the partner 
defaults on a capital call. The agreement also allows the non-
defaulting partners to make the contribution and to increase their 
own interests in the partnership. Following a capital call default, 
the partnership agreement requires allocations to adjust capital 
accounts to reflect the change in partnership interests as though 
the funded commitments represented the partner's interests from the 
partnership's inception.
    (ii) In Year 1, partnership had income of $100x, which was 
allocated to the partners $60x to TP1, $10x to TP2, and $30x to QO.
    (iii) In Year 2, partnership required each partner to contribute 
the remainder of its capital commitment, $60x from TP1, $10x from 
TP2, and $30x from QO. TP1 could not make its required capital 
contribution, and QO contributed $90x, its own capital commitment, 
in addition to TP1's. TP1's default was not anticipated. As a result 
and pursuant to the partnership agreement, TP1's interest was 
reduced to 30 percent and QO's interest was increased to 60 percent. 
Partnership had income of $60x and losses of $120x in Year 2, for a 
net loss of $60x. Partnership allocated to TP1 $48x of loss (special 
allocation of $30x of gross items of loss to adjust capital accounts 
and $18x of net loss (30 percent of $60x net loss)), TP2 $6x of net 
loss (10 percent of $60x net loss), and QO $6x of loss (special 
allocation of $30x of gross items of income to adjust capital 
accounts--$36x of net loss (60 percent of $60x net loss)). At the 
end of Year 2, TP1's capital account equals $72x (capital 
contribution of $60x + $60x income from Year 1--$48x loss from Year 
2); TP2's capital account equals $24x (capital contributions of $20x 
+ $10x income from Year 1--$6x loss from Year 2); and QO's capital 
account equals $144x (capital contributions of $120x ($30x + $90x) + 
$30x income from Year 1--$6x loss from Year 2).
    (iv) The changes in partnership allocations to TP1 and QO due to 
TP1's unanticipated default on its capital contribution commitment 
were effected pursuant to provisions prescribing the treatment of 
such events in the partnership agreement. Therefore these changes in 
allocations will not be closely scrutinized under paragraph 
(k)(1)(i) of this section, but will be taken into account only in 
determining whether the partnership satisfies the fractions rule in 
the taxable year of the change and subsequent taxable years. In 
addition, pursuant to paragraph (k)(1)(iii) of this section, the 
special allocations of $30x additional loss to TP1 and $30x 
additional income to QO to adjust their capital accounts to reflect 
their new interests in the partnership are disregarded when 
calculating QO's percentage of overall partnership income and loss 
for purposes of the fractions rule.

    (2) * * *
    (i) Qualified organizations. * * *
    (A) Qualified organizations do not hold (directly or indirectly 
through a partnership), in the aggregate, interests of greater than 
five percent in the capital or profits of the partnership; and
* * * * *
    (ii) Non-qualified organizations. Section 514(c)(9)(B)(vi) does not 
apply to a partnership otherwise subject to that section if--
    (A) All partners other than qualified organizations do not hold 
(directly or indirectly through a partnership), in the aggregate, 
interests of greater than five percent in the capital or profits of the 
partnership; and
    (B) Allocations have substantial economic effect without 
application of the special rules in Sec.  1.704-1(b)(2)(iii)(c) 
(regarding the presumption that there is a reasonable possibility that 
allocations will affect substantially the dollar amounts to be received 
by the partners from the partnership if there is a strong likelihood 
that offsetting allocations will not be made in five years, and the 
presumption that the adjusted tax basis (or book value) of partnership 
property

[[Page 84526]]

is equal to the fair market value of such property).
* * * * *
    (3) * * *
    (ii) * * *
    (B) $1,000,000.
* * * * *
    (m) * * *
    (2) * * *
    Example 3.  * * *
    (ii) P2 satisfies the fractions rule with respect to the P2/P1A 
chain. See Sec.  1.702-1(a)(8)(ii) (for rules regarding separately 
stating partnership items). P2 does not satisfy the fractions rule 
with respect to the P2/P1B chain.

    (n) Effective/applicability dates. * * *
    (2) * * * However, paragraphs (d)(2)(ii) and (iii), (d)(6) Example 
1 (i) and (iv), (e)(1)(vi) and (vii), (e)(5) Example 5, (f)(4), 
(k)(1)(ii) through (iv), (k)(2)(i)(A), (k)(2)(ii), (k)(3)(ii)(B), 
(m)(1)(ii), and (m)(2) Example 3 (ii) of this section apply to taxable 
years ending on or after the date these regulations are published as 
final regulations in the Federal Register.
* * * * *

John Dalrymple,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 2016-27105 Filed 11-22-16; 8:45 am]
 BILLING CODE 4830-01-P