Guidance Under Section 1061, 49754-49795 [2020-17108]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 85, Number 158 (Friday, August 14, 2020)]
[Proposed Rules]
[Pages 49754-49795]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2020-17108]



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Vol. 85

Friday,

No. 158

August 14, 2020

Part III





Department of the Treasury





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 Internal Revenue Service





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26 CFR Part 1





Guidance Under Section 1061; Proposed Rule

Federal Register / Vol. 85, No. 158 / Friday, August 14, 2020 / 
Proposed Rules

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-107213-18]
RIN 1545-BO81


Guidance Under Section 1061

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed regulations that provide 
guidance under section 1061 of the Internal Revenue Code (Code). 
Section 1061 recharacterizes certain net long-term capital gains of a 
partner that holds one or more applicable partnership interests as 
short-term capital gains. An applicable partnership interest is an 
interest in a partnership that is transferred to or held by a taxpayer, 
directly or indirectly, in connection with the performance of 
substantial services by the taxpayer, or any other related person, in 
any applicable trade or business. These proposed regulations also amend 
existing regulations on holding periods to clarify the holding period 
of a partner's interest in a partnership that includes in whole or in 
part an applicable partnership interest and/or a profits interest. 
These regulations affect taxpayers who directly or indirectly hold 
applicable partnership interests in partnerships and the passthrough 
entities in which the applicable partnership interest is held, directly 
or indirectly.

DATES: Written or electronic comments and requests for a public hearing 
must be received by October 5, 2020, which is 60 days after the date of 
filing for public inspection with the Office of the Federal Register. 
Requests for a public hearing must be submitted as prescribed in the 
``Comments and Requests for a Public Hearing'' section.

ADDRESSES: Commenters are strongly encouraged to submit public comments 
electronically. Submit electronic submissions via the Federal 
eRulemaking Portal at www.regulations.gov (indicate IRS and REG-107213-
18) by following the online instructions for submitting comments. Once 
submitted to the Federal eRulemaking Portal, comments cannot be edited 
or withdrawn. The IRS expects to have limited personnel available to 
process public comments that are submitted on paper through mail. Until 
further notice, any comments submitted on paper will be considered to 
the extent practicable. The Department of the Treasury (Treasury 
Department) and the IRS will publish for public availability any 
comment submitted electronically, and to the extent practicable on 
paper, to its public docket. Send paper submissions to: CC:PA:LPD:PR 
(REG-107213-18), Room 5203, Internal Revenue Service, P.O. Box 7604, 
Ben Franklin Station, Washington, DC 20044.

FOR FURTHER INFORMATION CONTACT: Concerning submissions of comments 
and/or requests for a public hearing, Regina L. Johnson at (202) 317-
5177 (not a toll-free number); Email address: 
[email protected]; concerning the proposed 
regulations, Kara K. Altman or Sonia K. Kothari at (202) 317-6850 (not 
a toll-free number).

SUPPLEMENTARY INFORMATION:

Background and Overview

    This document contains proposed regulations under section 1061 of 
the Code to amend the Income Tax Regulations (26 CFR part 1). Section 
1061 was added to the Code on December 22, 2017, by the enactment of 
section 13309 of Public Law 115-97, 131 Stat. 2054 (2017), commonly 
referred to as the Tax Cuts and Jobs Act (TCJA). Section 1061 applies 
to taxable years beginning after December 31, 2017. Section 1061 
recharacterizes certain net long-term capital gain with respect to 
applicable partnership interests (APIs) as short-term capital gain. 
This Background and Overview section provides an overview of the 
statutory provisions and highlights certain critical concepts and terms 
used in the proposed regulations. The Explanation of Provisions section 
describes the proposed regulations in greater detail.

Section 1061(a): Recharacterization Amount, Owner Taxpayer, and Related 
Concepts

    Section 1061(a) recharacterizes as short-term capital gain the 
difference between a taxpayer's net long-term capital gain with respect 
to one or more APIs and the taxpayer's net long-term capital gain with 
respect to these APIs if paragraphs (3) and (4) of section 1222, which 
define the terms long-term capital gain and long-term capital loss, 
respectively, for purposes of subtitle A of the Code, are applied using 
a three-year holding period instead of a one-year holding period. These 
proposed regulations refer to this difference as the Recharacterization 
Amount.
    The proposed regulations provide that the person who is subject to 
Federal income tax on the Recharacterization Amount is required to 
calculate such amounts and refer to this person as the Owner Taxpayer.
    Although an API can be held directly by an Owner Taxpayer, it also 
may be held indirectly through one or more passthrough entities 
(Passthrough Entities). The proposed regulations provide a framework 
for determining the Recharacterization Amount when an API is held 
through one or more tiers of Passthrough Entities (tiered structure).
    Section 1061(a) applies to a taxpayer's net long-term capital gain 
with respect to one or more APIs held during the taxable year. The 
proposed regulations provide that the determination of a taxpayer's net 
long-term capital gain with respect to the taxpayer's APIs held during 
the taxable year includes the taxpayer's combined net distributive 
share of long-term capital gain or loss from all APIs held during the 
taxable year and the Owner Taxpayer's long-term capital gain and loss 
from the disposition of any APIs during the taxable year. The proposed 
regulations refer to long-term capital gains and losses recognized with 
respect to an API as API Gains and Losses. Unrealized API Gains and 
Losses are capital gains and losses with respect to an API that have 
not yet been realized. In a tiered structure of Passthrough Entities, 
API Gains and Losses and Unrealized API Gains and Losses retain their 
character as API Gains and Losses as they are allocated through the 
tiers.
    The proposed regulations provide that API Gains and Losses do not 
include long-term capital gain determined under sections 1231 and 1256, 
qualified dividends described in section 1(h)(11)(B), and any other 
capital gain that is characterized as long-term or short-term without 
regard to the holding period rules in section 1222, such as capital 
gain characterized under the identified mixed straddle rules described 
in section 1092(b). Additionally, API Gains and Losses do not include 
API Holder Transition Amounts and Capital Interest Gains and Losses. 
API Holder Transition Amounts are allocations to the holder of an API 
(API Holder) of long-term capital gain and loss recognized on the 
disposition of assets held by the partnership for more than three years 
as of January 1, 2018, if the partnership has elected to treat these 
amounts as API Holder Transition Amounts. Capital Interest Gains and 
Losses are long-term capital gains and losses with respect to an API 
Holder's capital investment in a Passthrough Entity.

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Section 1061(c)(1): Definition of an Applicable Partnership Interest

    Section 1061(c)(1) provides that an API is a partnership interest 
held by, or transferred to, a taxpayer, directly or indirectly, in 
connection with the performance of substantial services by the 
taxpayer, or by any other related person, in any applicable trade or 
business (ATB).
    An API is an interest in a partnership's profits that is 
transferred or held in connection with the performance of services. 
There may be one or more tiers of Passthrough Entities between the 
partnership that originally issued the API and the Passthrough Entity 
in which the Owner Taxpayer holds its indirect interest in the API. 
Each Passthrough Entity in the tiered structure is treated as holding 
an API under the proposed regulations, that is, each Passthrough Entity 
is an API Holder. An API Holder may be an individual, partnership, 
trust, estate, S corporation, or a passive foreign investment company 
(PFIC) with respect to which the shareholder has a qualified electing 
fund (QEF) election in effect under section 1295.
    Section 1061(c)(1), similar to section 1061(a), uses the term 
``taxpayer.'' The proposed regulations provide that an Owner Taxpayer 
is the taxpayer for purposes of section 1061(a). However, section 
1061(c)(1) requires that an API be transferred to a taxpayer in 
connection with services performed by the taxpayer or by a related 
person. The proposed regulations provide that the reference to 
``taxpayer'' in section 1061(c)(1) includes not only an Owner Taxpayer, 
but also includes a Passthrough Taxpayer. The proposed regulations 
provide that a Passthrough Taxpayer is a Passthrough Entity that is 
treated as a taxpayer for the purpose of determining the existence of 
an API, regardless of whether the Passthrough Entity itself is subject 
to Federal income tax. Generally, if an interest in a partnership is 
transferred to a Passthrough Taxpayer in connection with the 
performance of its own services, the services of its owners, or the 
services of persons related to either the Passthrough Entity or its 
owners, the interest is an API as to the Passthrough Taxpayer. The 
Passthrough Taxpayer's ultimate owners will be treated as Owner 
Taxpayers, unless otherwise excepted.
    A partnership interest is an API if it is transferred in connection 
with the performance of substantial services. The proposed regulations 
presume that services are substantial with respect to the partnership 
interest transferred in connection with those services. This 
presumption is based on the assumption that the parties have 
economically equated the services performed with the potential value of 
the partnership interest transferred. The proposed regulations provide 
that once a partnership interest is an API, it remains an API and never 
loses that character, unless one of the exceptions to the definition of 
an API applies.

Section 1061(c)(2): Definition of an Applicable Trade or Business

    Under section 1061, for an interest in a partnership to be an API, 
the interest must be held or transferred in connection with the 
performance of services in an ATB. An ATB is defined in section 
1061(c)(2) as any activity conducted on a regular, continuous, and 
substantial basis which consists, in whole or in part, of raising or 
returning capital, and either (i) investing in (or disposing of) 
specified assets (or identifying specified assets for such investing or 
disposition), or (ii) developing specified assets. The proposed 
regulations refer to these actions, respectively, as Raising or 
Returning Capital Actions and Investing or Developing Actions (referred 
to as Specified Actions in the aggregate). The proposed regulations 
provide that an activity is conducted on a regular, continuous, and 
substantial basis if it meets the ATB Activity Test. The ATB Activity 
Test is met if the total level of activity (conducted in one or more 
entities) meets the level of activity required to establish a trade or 
business for purposes of section 162.
    In applying the ATB Activity Test, the proposed regulations provide 
that, in some cases, it is not necessary for both Raising or Returning 
Capital Actions and Investing or Developing Actions to occur in a 
single year for an ATB to exist in that year. Further, Raising or 
Returning Capital Actions and Investing or Developing Actions of 
related persons are aggregated together to determine if the ATB 
Activity Test is met.
    Section 1061(c)(3) provides that specified assets (Specified 
Assets) are securities, as defined in section 475(c)(2) (without regard 
to the last sentence thereof), commodities, as defined in section 
475(e)(2), real estate held for rental or investment, cash or cash 
equivalents, options or derivative contracts with respect to any of the 
foregoing, and an interest in a partnership to the extent of the 
partnership's proportionate interest in any of the foregoing. The 
definition of Specified Assets in the proposed regulations generally 
tracks the statutory language. It also includes an option or derivative 
contract on a partnership interest to the extent that the partnership 
interest represents an interest in other Specified Assets.

Section 1061(c)(4): Exceptions

    Section 1061(c)(4)(A) provides that an API does not include any 
interest in a partnership directly or indirectly held by a corporation. 
In Notice 2018-18 (2018-12 IRB 443, March 19, 2018), the Treasury 
Department and the IRS provided notice that the regulations under 
section 1061 would provide that the term ``corporation'' for purposes 
of section 1061(c)(4)(A) does not include an S corporation. Any timely 
comments received on Notice 2018-18 will be considered as part of the 
Treasury decision adopting these proposed regulations as final 
regulations.
    Section 1061(c)(4)(B) also provides that an API does not include 
certain capital interests. The proposed regulations implement the 
capital interest exception by excepting long-term capital gains and 
losses that represent a return on an API Holder's invested capital in a 
Passthrough Entity from recharacterization under section 1061. The 
proposed regulations refer to these amounts as Capital Interest Gains 
and Losses. Specifically, under the proposed regulations, Capital 
Interest Allocations, Passthrough Interest Capital Allocations and 
Capital Interest Disposition Amounts are treated as Capital Interest 
Gains and Losses.
    Under the proposed regulations, a partner's invested capital in a 
partnership that maintains capital accounts under Sec.  1.704-
1(b)(2)(iv) is the partner's capital account. In the case of a 
Passthrough Entity that is not a partnership (or a partnership that 
does not maintain capital accounts under Sec.  1.704-1(b)(2)(iv)), if 
the Passthrough Entity maintains and determines accounts for its owners 
in a manner similar to that provided in Sec.  1.704-1(b)(2)(iv), those 
accounts will be treated as capital accounts for purposes of the 
proposed regulations. In order for an allocation to be treated as a 
Capital Interest Allocation or a Passthrough Interest Capital 
Allocation, the allocation must be based on an API Holder's relative 
capital account balance in the Passthrough Entity. Although Unrealized 
API Gain or Loss is included in an owner's capital account, the gain or 
loss will be treated as API Gain or Loss and not as Capital Interest 
Gain or Loss when recognized. An allocation of API Gain or Loss from a 
lower-tier entity to an upper-tier entity is always API Gain or Loss 
when further allocated by the upper-tier entity to its direct interest

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holders. Capital Interest Gains and Losses never include API Gains and 
Losses, Unrealized API Gains and Losses, or API Holder Transition 
Amounts.
    If an owner disposes of an interest that is composed of a capital 
interest and an API, the proposed regulations provide a mechanism for 
the owner to determine the portion of long-term capital gain or loss 
recognized on the disposition that is treated as a Capital Interest 
Disposition Amount and thus, a Capital Interest Gain or Loss.

Other Exceptions

    Section 1061(c)(1) provides an exception for certain partnership 
interests held by employees of entities that are not engaged in an ATB. 
The proposed regulations track the statutory language. Also, the 
proposed regulations add an exception for an API that is acquired by a 
bona fide purchaser who (i) does not provide services, (ii) is 
unrelated to any service provider, and (iii) acquired the interest for 
fair market value.
    Section 1061(b) provides regulatory authority to establish an 
exception to section 1061(a) for gain attributable to any assets not 
held for portfolio investment on behalf of third party investors. The 
proposed regulations reserve on the exercise of this authority.

Section 1061(d): Transfer of API to a Related Party

    Section 1061(d) accelerates the recognition of capital gain on a 
direct or indirect transfer that would not otherwise be a taxable event 
and recharacterizes certain long-term capital gain as short-term 
capital gain. Under section 1061(d), if a taxpayer transfers an API to 
a related person described in section 1061(d)(2), then, without regard 
to whether the transfer is otherwise a taxable event, the taxpayer 
includes in gross income, as short-term capital gain, the excess of (A) 
the net built-in long-term capital gain in assets attributable to the 
transferred interest with a holding period of three years or less, over 
(B) the amount of long-term capital gain treated as short term capital 
gain under section 1061(a) on the transfer. The proposed regulations 
provide that the term transfer includes, but is not limited to, 
contributions, distributions, sales and exchanges, and gifts. A related 
person for purposes of section 1061(d)(2) is defined more narrowly than 
a related person for purposes of section 1061(c)(1) and includes only 
members of the taxpayer's family within the meaning of section 
318(a)(1), the taxpayer's colleagues (those who provided services in 
the ATB during certain time periods) and, under the proposed 
regulations, a Passthrough Entity to the extent that a member of the 
taxpayer's family or a colleague is an owner. The proposed regulations 
provide that a contribution under section 721(a) to a partnership is 
not treated as a transfer to a Section 1061(d) Related Person because 
the proposed regulations require that, under the principles of section 
704(c) and Sec. Sec.  1.704-1(b)(2)(iv)(f) and 1.704-3(a)(9), all 
Unrealized API Gains at the time of contribution must be allocated to 
the API Holder contributing the interest when those gains are 
recognized by the partnership.

Section 1061(e): Reporting

    Section 1061(e) provides that the Secretary of the Treasury or his 
delegate (Secretary) shall require such reporting as is necessary to 
carry out the purposes of section 1061. The proposed regulations 
include rules for providing information required to compute the 
Recharacterization Amount when there is a tiered structure.

Regulatory Authority

    The statute requires that the Secretary issue such regulations or 
other guidance as is necessary or appropriate to carry out the purposes 
of section 1061. The legislative history indicates that such guidance 
is to address the prevention of abuse of the purposes of the provision. 
See H.R. Conf. Rep. No. 115-466 at 422 (2017) (Conference Report); see 
also Joint Committee on Taxation, General Explanation of Public Law 
115-97, JCS-1-18, at 203 (2017) (Blue Book). The Conference Report and 
the Blue Book also state that the guidance is to address the 
application of the provision to tiered structures of entities. See id.

Explanation of Provisions

    Section 1.1061-1 provides definitions of the terms used in 
Sec. Sec.  1.1061-1 through 1.1061-6 of these proposed regulations. 
Section 1.1061-2 provides rules and examples regarding APIs and ATBs. 
Section 1.1061-3 provides guidance on the exceptions to an API, 
including the capital interest exception. Section 1.1061-4 provides 
guidance on the computation of the Recharacterization Amount and 
computation examples. Section 1.1061-5 provides guidance regarding the 
application of section 1061(d) to transfers to certain related parties. 
Section 1.1061-6 provides reporting rules. Because the application of 
section 1061 requires a clear determination of the holding period of a 
partnership interest that is, in whole or in part, an API, these 
proposed regulations also provide clarifying amendments to Sec.  
1.1223-3. Additional clarifying amendments to Sec.  1.702-1(a)(2) and 
Sec.  1.704-3(e) are also proposed.

I. Sections 1.1061-1 and 1.1061-2: Definitions, Operational Rules, and 
Examples

    Section 1.1061-1 provides definitions of terms used in Sec. Sec.  
1.1061-1 through 1.1061-6 of these proposed regulations. The 
definitions in Sec.  1.1061-1 combined with the operational rules in 
Sec.  1.1061-2 identify the taxpayer to which section 1061 applies, 
when an interest is an API, what constitutes an ATB, and who is a 
related party. These definitions include terms for identifying 
interests when an API is held through one or more passthrough entities. 
For purposes of these regulations, a Passthrough Entity is defined as a 
partnership, an S corporation, or a PFIC with respect to which the 
shareholder has a QEF election in effect.

A. API, Owner Taxpayer, Passthrough Taxpayer, Indirect API, and 
Passthrough Interest

1. Definitions
    Section 1061(a) refers to a taxpayer in terms of the person whose 
net long-term capital gains from one or more APIs are recharacterized 
as net short-term capital gain under the statute. The proposed 
regulations refer to this amount as the Recharacterization Amount. 
Section 1061(c) also refers to a taxpayer as the person to whom the API 
is transferred or who holds the API in connection with the taxpayer's 
or a related person's services.
    Section 1061(c)(1) defines an API as any interest in a partnership 
which, directly or indirectly, is transferred to (or held by) the 
taxpayer in connection with the performance of substantial services by 
the taxpayer, or by any other related person, in any ATB. These 
proposed regulations also provide that solely for purposes of section 
1061, an interest in a partnership includes any financial instrument or 
contract, the value of which is determined, in whole or in part, by 
reference to the partnership (including the amount of partnership 
distributions, the value of partnership assets, or the results of 
partnership operations).
a. API, Owner Taxpayer, and Passthrough Taxpayer
    Comments and other commentary (collectively referred to as 
comments) considered by the Treasury Department and the IRS highlight 
the importance of the definition of the term ``taxpayer'' for purposes 
of section 1061(a) with respect

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to the determination of the Recharacterization Amount. Additionally, 
the definition of the term ``taxpayer'' for purposes of section 1061(c) 
is important for the determination of whether a partnership interest is 
an API. These comments describe three potential approaches to the 
definition of ``taxpayer.'' These approaches are the aggregate 
approach, the partial entity approach, and the full entity approach. 
Under the aggregate approach, both the existence of the API and the 
Recharacterization Amount are determined solely at the owner level. If 
the Recharacterization Amount is calculated at the owner level, gains 
and losses from multiple APIs held by the owner can be combined and 
netted with each other to determine the Recharacterization Amount. In 
contrast, under the full entity approach, the Recharacterization Amount 
and the existence of an API both are determined at the entity level. 
Additionally, under the full entity approach, the Recharacterization 
Amount would be calculated for each entity and then netted and combined 
at the owner level. Under the partial entity approach, the existence of 
an API is determined at the entity level, but the Recharacterization 
Amount is determined at the owner level.
    The proposed regulations adopt a partial entity approach. To apply 
this approach, the proposed regulations provide for two definitions of 
a taxpayer (Owner Taxpayer and Passthrough Taxpayer) for purposes of 
section 1061. These definitions are provided to define the scope of the 
term ``taxpayer'' for purposes of computing the Recharacterization 
Amount and for purposes of determining whether a partnership interest 
is an API. The proposed regulations define the term Owner Taxpayer as 
the person subject to tax on the net gain with respect to the API. 
Under the proposed regulations, the Recharacterization Amount is 
determined solely by the Owner Taxpayer. For this purpose, the term 
Owner Taxpayer includes individuals, simple and complex trusts, and 
estates. Thus, if an Owner Taxpayer holds one or more APIs indirectly 
(through one or more Passthrough Entities), amounts subject to section 
1061 flow through those entities and are netted at the Owner Taxpayer 
level to determine the Recharacterization Amount.
    The proposed regulations define the term Passthrough Taxpayer as an 
entity that generally does not pay tax itself, notwithstanding that a 
Passthrough Taxpayer could be responsible for paying an imputed 
underpayment calculated based on adjustments to partnership related 
items under section 6225 (Partnership adjustment by the Secretary) or 
that a Passthrough Taxpayer that is an electing 1987 partnership (as 
defined in section 7704(g)(2)) could be responsible for paying the tax 
set forth in section 7704(g)(3). An Owner Taxpayer and a Passthrough 
Taxpayer each are treated as a taxpayer for the purpose of determining 
whether an API exists. In determining whether the elements of an API 
are present, a Passthrough Taxpayer can be (i) the service provider, 
(ii) a person related to the service provider, (iii) engaged in an ATB, 
or (iv) the recipient of an interest in connection with the performance 
of substantial services in an ATB. If a Passthrough Taxpayer is treated 
as the recipient (or holder) of a partnership interest, directly or 
indirectly, for purposes of determining the existence of an API, the 
ultimate owners of the Passthrough Taxpayer are treated as Owner 
Taxpayers for the purpose of determining the Recharacterization Amount. 
Owner Taxpayers do not include owners of a Passthrough Taxpayer who are 
excepted from the application of section 1061 under Sec.  1.1061-3. 
Additionally, Owner Taxpayers to whom a partnership interest is 
directly or indirectly transferred in connection with the Owner 
Taxpayer's or a related party's performance of substantial services in 
an ATB are also treated as taxpayers for purposes of determining the 
existence of an API. Section 1.1061-2 of the proposed regulations 
provides examples of how the existence of an API is determined.
b. Interaction With Revenue Procedures 93-27 and 2001-43
    Revenue Procedure 93-27 (1993-2 C.B. 343) defines a profits 
interest and provides a safe harbor under which the IRS will not treat 
the receipt of a profits interest as a taxable event for the partner or 
the partnership if certain requirements are met. See also Revenue 
Procedure 2001-43 (2001-2 C.B. 191). Section 1061 applies to all 
partnership interests that meet the definition of an API, regardless of 
whether the receipt of the interest is treated as a taxable event under 
Revenue Procedure 93-27. Accordingly, taxpayers should not equate an 
interest that meets the definition of an API with an interest the 
receipt of which would not be treated as a taxable event under Revenue 
Procedure 93-27. For example, Revenue Procedure 93-27 applies to a 
person who receives a profits interest for the provision of services to 
or for the benefit of a partnership in a partner capacity or in 
anticipation of being a partner. Section 1061 applies to partnership 
interests transferred or held in connection with the performance of 
substantial services in an ATB. Further, these proposed regulations 
address only the application of section 1061 and should not be 
interpreted as providing guidance regarding the application of Revenue 
Procedure 93-27 to transactions in which one party provides services 
and another party receives a seemingly associated allocation and 
distribution of partnership income and gain. Lastly, although a 
financial instrument or contract may be treated as an API under section 
1061, a financial instrument or contract is not an interest in a 
partnership for purposes of Revenue Procedure 93-27, unless it is 
otherwise a partnership interest for Federal tax purposes. The Treasury 
Department and the IRS note that arrangements that are not partnership 
interests for Federal tax purposes are not eligible for the safe harbor 
described in Revenue Procedures 93-27 and 2001-43.
c. API Holder
    The proposed regulations include the term API Holder to refer to 
any person who holds an interest in a particular API. An API Holder can 
include either or both a Passthrough Taxpayer and an Owner Taxpayer.
d. Indirect API
    The proposed regulations define an Indirect API as an API that is 
held through one or more Passthrough Entities.
e. Passthrough Interest
    A Passthrough Interest under the proposed regulations is an 
interest in a Passthrough Entity that represents, in whole or in part, 
an API.
f. API Gains and Losses and Unrealized API Gains and Losses
    API Gains and Losses are long-term capital gains and losses 
recognized with respect to an API. The proposed regulations provide 
that API Gains and Losses include long-term capital gain or loss from a 
deemed or actual disposition of the API (including gain and loss 
recognized under section 731(a) and section 752(b)) and the holder's 
distributive share of net long-term capital gain or loss from the 
partnership under sections 702 and 704 with respect to the API. The 
proposed regulations also treat long-term capital gain or loss on the 
disposition of a capital asset distributed from a partnership with 
respect to an API (Distributed API Property) as API Gain or Loss if the 
asset

[[Page 49758]]

is held for more than one year but not more than three years at the 
time the distributee-partner disposes of the property. The holding 
period of the asset in the partner's hands includes the partnership's 
holding period with respect to the asset.
    Unrealized API Gains and Losses include unrealized short-term and 
long-term capital gains and losses that would be allocated to the API 
Holder with respect to its API if the partnership sold all of its 
assets at fair market value and the proceeds were distributed in a 
complete liquidation of the partnership on any relevant date. For 
example, Unrealized API Gains and Losses include all capital gains and 
losses that would be allocated to the API pursuant to a capital account 
revaluation under Sec.  1.704-1(b)(2)(iv)(f) or Sec.  1.704-
1(b)(2)(iv)(s).
    In the case of a Passthrough Entity that contributes property that 
on disposition would generate capital gain or loss subject to section 
1061 to another Passthrough Entity, Unrealized Capital Gains and Losses 
include the appreciation or depreciation in the value of the property 
at the time of the contribution. Accordingly, Unrealized API Gains and 
Losses include the capital gains and losses that would be allocated to 
the API Holder with respect to the API if the property contributed by 
the Passthrough Entity to the lower-tier Passthrough Entity were sold 
immediately before the contribution for the amount that is included in 
the invested capital of the lower-tier Passthrough Entity (i.e., 
included in a partnership's capital account or a similar account 
maintained by another type of Passthrough Entity under Sec.  1.1061-
3(c)(3)(ii) of these proposed regulations) with respect to the 
contributed property.
    In the case of a revaluation of the property of a partnership that 
owns an interest in a tiered structure of partnerships or in the case 
of the contribution of an API to another Passthrough Entity, the 
proposed regulations provide that Unrealized API Gains and Losses 
include capital gains and losses that would be allocated directly or 
indirectly to the API Holder by lower-tier partnerships determined as 
if a taxable disposition of the property of each of the lower-tier 
partnerships also occurred on the date of the revaluation or 
contribution.
    Although the proposed regulations do not require revaluations under 
section 1.704-1(b)(2)(iv)(f), solely to determine and identify 
Unrealized API Gains and Losses for purposes of section 1061 upon the 
occurrence of a revaluation or contribution, these regulations require 
that a revaluation under the principles of Sec.  1.704-1(b)(2)(iv)(f) 
be made through each relevant tier of partnerships. Thus, the proposed 
regulations require revaluations of all the properties held by all 
relevant partnerships in a tiered structure to determine the extent to 
which the partnership has Unrealized API Gains and Losses. If a 
partnership is required to revalue its assets for purposes of section 
1061, such partnership is permitted to revalue its property for 
purposes of section 704 as though an event in Sec.  1.704-
1(b)(2)(iv)(f)(5) had occurred.
    Further, the proposed regulations require that Unrealized API Gains 
and Losses of a partnership be allocated when recognized under 
principles consistent with Sec.  1.704-3(a)(9). Accordingly, if at the 
time an API Holder contributes an interest in a lower-tier partnership 
to an upper-tier partnership, and the lower-tier partnership holds 
property with Unrealized API Gains and Losses that are allocable to the 
API Holder, those gains and losses when recognized by the lower-tier 
partnership must be allocated by the upper-tier partnership to the API 
Holder for purposes of section 1061.
    The Treasury Department and the IRS believe that these rules serve 
two purposes. First, the rules ensure that capital gains and losses 
that would be API Gains and Losses are not converted to Capital 
Interest Gains and Losses by virtue of a revaluation or a contribution. 
Second, these rules also ensure that Unrealized API Gains and Losses of 
a partnership when recognized are properly allocated to the correct API 
Holder in a tiered structure of partnerships. The Treasury Department 
and the IRS request comments on whether such section 1061 revaluations 
are necessary or whether there is another mechanism that would ensure 
that API Gain or Loss is allocated to API Holders when there is a 
revaluation event in one or more of the tiers of entities. Further, 
comments are requested on whether the section 704(b) regulations should 
be amended to specifically include revaluations when such partnership 
revalues its assets for purposes of section 1061 or to address 
revaluations through tiers of partnerships for purposes of section 704 
more generally.
    Unrealized API Gains and Losses that are recognized with respect to 
an asset or API held for more than one year on the date of its 
disposition become API Gains and Losses at the time they are recognized 
and do not lose their character as they are allocated through 
Passthrough Entities in a tiered structure. API Gains and Losses do not 
include any amounts that otherwise are treated as ordinary income under 
any Code section including section 751 and section 1245.
    The Treasury Department and the IRS are aware that taxpayers may 
seek to circumvent section 1061(a) by waiving their rights to gains 
generated from the disposition of a partnership's capital assets held 
for three years or less and substituting for these amounts gains 
generated from capital assets held for more than three years. 
Alternatively, taxpayers may waive their rights to API Gains and 
substitute gains that are not taken into account for purposes of 
determining the Recharacterization Amount. Some arrangements also may 
include the ability for an API Holder to periodically waive its right 
to an allocation of capital gains from all assets in favor of an 
allocation of capital gains from assets held for more than three years 
and/or a priority fill up allocation designed to replicate the 
economics of an arrangement in which the API Holder shares in all 
realized gains over the life of the fund. These arrangements are often 
referred to as carry waivers or carried interest waivers. Taxpayers 
should be aware that these and similar arrangements may not be 
respected and may be challenged under section 707(a)(2)(A), Sec. Sec.  
1.701-2 and 1.704-1(b)(2)(iii), and/or the substance over form or 
economic substance doctrines.
g. Related Persons
    Section 1061(c)(1) provides that an API includes an interest 
transferred to or held by a taxpayer in connection with the performance 
of substantial services by the taxpayer or a related person in an 
applicable trade or business. Section 1061(d) also provides a rule for 
transfers of APIs to certain related persons. Section 1061(d)(2) 
provides a definition of related person that applies solely to 
transfers subject to section 1061(d) and the proposed regulations refer 
to that person as a Section 1061(d) Related Person. However, section 
1061 does not include a definition of related person for the remainder 
of section 1061. Accordingly, in defining Related Person, the proposed 
regulations use the general definition of a person or entity that is 
related under sections 707(b) or 267(b) of the Code.
2. API Operational Rules
a. An API Retains Its Status as an API
    Section 1061 does not contain a provision that would cause an 
interest to cease to be an API unless and until one of the exceptions 
to the definition of API applies. Therefore, the proposed regulations 
clarify that once a

[[Page 49759]]

partnership interest becomes an API, the partnership interest remains 
an API unless and until an exception applies, regardless of whether the 
taxpayer or a Related Person continues to provide services in an ATB. 
Therefore, even after a partner retires and provides no further 
services, if the retired partner continues to hold the partnership 
interest, it remains an API. Similarly, if the partner provides 
services, but the ATB Activity Test (as defined below) is not met in a 
later year, the partnership interest will continue to be an API. 
Further, an API remains an API if it is contributed to another 
Passthrough Entity or a trust or is held by an estate. As discussed 
with respect to the definition of API Gains and Losses and further in 
paragraph I.A.2.b. of this Explanation of Provisions, any unrecognized 
API Gains and Losses included in a capital account upon contribution of 
an API to a Passthrough Entity remain subject to section 1061 when they 
are recognized under the Code.
b. API Gains and Losses and Unrealized API Gains and Losses Retain 
Their Character
    API Gain or Loss retains its character as API Gain or Loss as it is 
allocated through tiered Passthrough Entities. Similarly, Unrealized 
API Gain or Loss retains its character even though it is included in 
the invested capital of a Passthrough Entity (i.e., included in a 
partnership's capital account or a similar account maintained by 
another type of Passthrough Entities under Sec.  1.1061-3(c)(3)(ii)).
c. Substantial Services
    Section 1061(c)(1) provides that an interest in a partnership is an 
API only if the interest is transferred to or held by the taxpayer in 
connection with the performance of substantial services by the 
taxpayer, or by a related person, in an ATB. If a taxpayer provides any 
services in an ATB and an allocation of a partnership's profits is 
transferred to or held by the taxpayer in connection with those 
services, the proposed regulations presume that those services are 
substantial for purposes of Section 1061. The Treasury Department and 
the IRS have concluded that if an interest is granted in connection 
with the performance of services, such services are presumed 
substantial with respect to the interest transferred. This presumption 
is appropriate because the parties to the arrangement have economically 
equated the potential value of the interest granted with the value of 
the services performed. Therefore, the services provided are presumed 
to be substantial with respect to the interest transferred.
    The Treasury Department and the IRS request comments on this 
presumption and the specifics of any arrangements in which 
insubstantial services could be performed in connection with the 
receipt of a profits interest such that the presumption could be 
overcome. Those comments also should address how and why Revenue 
Procedure 93-27 and Revenue Procedure 2001-43 would apply to 
partnership interests received in exchange for such insubstantial 
services.
d. Disregarded Entities
    Entities that are disregarded from their owners (collectively, 
disregarded entities) under any provision of the Code or regulations, 
including grantor trusts and qualified subchapter S subsidiaries, are 
disregarded for purposes of these regulations. Accordingly, if an API 
is held by or transferred to a disregarded entity, the API is treated 
as held by or transferred to the disregarded entity's owner.

B. ATB and the ATB Activity Test

1. Relevant Definitions
    The proposed regulations provide that an ATB means any activity for 
which the ATB Activity Test with respect to Specified Actions is met. 
The proposed regulations provide that the ATB Activity Test is met if 
Specified Actions are conducted at a level of activity required for an 
activity to constitute a trade or business under section 162. For 
purposes of determining if the ATB Activity Test is met, all of the 
Specified Actions conducted by Related Persons are combined. If these 
Specified Actions, all taken together, rise to the level of activity 
required to establish a trade or business under section 162, then each 
Related Person is determined to be engaged in the Relevant ATB. A 
Relevant ATB is the ATB in which services were performed in connection 
with which the API was transferred. Multiple Related Persons' actions 
are combined and then attributed to each Related Person. Therefore, a 
single ATB under section 1061 can include the actions taken by multiple 
Related Persons. The definition of an ATB is not the same as the 
definition of activity under section 469 and does not take into account 
any of the grouping rules under section 469. The definition of an ATB 
is solely for purposes of section 1061.
    Specified Actions include both Raising or Returning Capital Actions 
and Investing or Developing Actions. The proposed regulations' 
description of Raising or Returning Capital Actions tracks the 
statutory language of section 1061(c)(2)(A). Similarly, the proposed 
regulations' description of Investing or Developing Actions tracks the 
statutory language of section 1061(c)(2)(B). The proposed regulations 
also include guidance regarding developing Specified Assets from the 
Conference Report. Specifically, the Conference Report states that 
developing specified assets takes place, for example, if it is 
represented to investors, lenders, regulators, or others that the 
value, price, or yield of a portfolio business may be enhanced or 
increased in connection with choices or actions of a service provider 
or of others acting in concert with or at the direction of a service 
provider. However, merely voting shares owned does not amount to 
development; for example, a mutual fund that merely votes proxies 
received with respect to shares of stock it holds is not engaged in 
development. Conference Report at 421. The proposed regulations provide 
that Raising or Returning Capital Actions do not include Investing or 
Developing Actions.
    The definition of Specified Assets in the proposed regulations 
generally tracks the statutory definition of specified assets in 
section 1061(c)(3). Both the statute and the proposed regulations 
provide that a Specified Asset generally includes a security as defined 
in section 475(c)(2). Thus, all corporate stock, regardless of the size 
of the corporation or whether the corporation is publicly traded, is a 
specified asset. Additionally, the proposed regulations, consistent 
with the definition of security in section 475(c)(2), provide that an 
interest in a partnership or a beneficial ownership interest in a trust 
is a Specified Asset if it is a security described in section 
475(c)(2). The proposed regulations follow the statute to provide that 
options or derivative contracts with respect to any of the foregoing 
Specified Assets are also Specified Assets. Further, as provided in 
section 1061(c)(3), an interest in a partnership is also a Specified 
Asset to the extent that the partnership itself holds Specified Assets. 
The Blue Book provides an example in which a hedge fund acquires an 
interest in a partnership that is neither publicly traded nor widely 
held and whose assets consist of stocks, bonds, positions that are 
clearly identified hedges with respect to securities, and commodities. 
The Blue Book provides that the partnership interest is a specified 
asset for purposes of the provision. Blue Book at 203. The proposed 
regulations

[[Page 49760]]

incorporate this concept as illustrated by the Blue Book. Similar to 
the statute's treatment of options or derivative contracts of other 
Specified Assets as Specified Assets, the proposed regulations provide 
that, solely for purposes of section 1061, Specified Assets also 
include a derivative of a partnership interest to the extent not 
otherwise included in the definition of Specified Assets.
2. The ATB Activity Test
a. Actions Taken With Respect to Specified Assets Held by a Partnership
    In the case of a partnership that directly holds Specified Assets, 
actions taken with respect to or on account of these assets, as well as 
a percentage of the actions taken with respect to the partnership 
interest as a whole, will be taken into account for purposes of the ATB 
Activity Test. The percentage of the actions taken with respect to the 
partnership as a whole that are taken into account for the test is the 
ratio of the value of the partnership's Specified Assets over the value 
of all of the partnership's assets. Actions taken to manage working 
capital will not be taken into account for purposes of the ATB Activity 
Test. The Treasury Department and the IRS request comments on the 
application of this rule and how it can be tailored to accomplish the 
purposes of section 1061.
b. Application of the ATB Activity Test
i. Aggregate Actions Taken Into Account
    The proposed regulations provide that the ATB Activity Test takes 
into account the aggregate actions conducted with respect to Raising or 
Returning Capital Actions and Investing or Developing Actions. In other 
words, the ATB Activity Test does not require that Raising or Returning 
Capital Actions and Investing or Developing Actions each individually 
meet the required activity level for the ATB Activity Test to be 
satisfied.
ii. Raising or Returning Capital Actions and Investing or Developing 
Actions Are Not Required To Be Taken Every Year
    The Treasury Department and the IRS recognize that, in some cases, 
once sufficient capital to engage in Investing or Developing Actions 
has been raised, actions involving raising or returning capital may not 
be taken for a period of time. Additionally, at the beginning and the 
end of the activity, actions involving the raising or returning of 
capital may be significant and actions involving investing or 
developing may not be taken. The ATB Activity Test looks at the actions 
taken as a whole. Accordingly, the proposed regulations provide that 
the ATB Activity Test is met if Investing or Developing Actions alone 
satisfy the ATB Activity Test in the current year if Raising or 
Returning Capital Actions have been taken in prior years. Additionally, 
the test is satisfied if Raising or Returning Capital Actions during 
the year satisfy the ATB Activity Test and Investing or Developing 
Actions are anticipated but not yet taken.
iii. Actions of Related Persons Taken Into Account
    The proposed regulations further provide that in applying the ATB 
Activity Test, the actions of one or more Related Persons are taken 
into account, regardless of whether an entity conducts only Raising or 
Returning Capital Actions or only Investing or Developing Actions.
iv. Interests Transferred Prior to Existence of an ATB
    An API arises when an interest in a partnership is transferred or 
held in connection with services in an ATB. The Treasury Department and 
the IRS are aware that interests in a partnership may be issued to a 
service provider in anticipation of the service provider providing 
services to an ATB, but because an ATB does not exist at the time of 
the transfer, the interest is not an API. The Treasury Department and 
the IRS have concluded that once the service provider is providing 
services in an ATB, the interest becomes an API. Once the interest 
becomes an API, its status as an API does not depend on whether the ATB 
continues to meet the ATB Activity Test.

II. Section 1.1061-3: Exceptions to the Definition of API

    Section 1061 includes four exceptions to its application. 
Additionally, these regulations provide an additional exception. First, 
the statutory definition of an API excepts an interest held by a person 
who is employed by another entity that is conducting a trade or 
business (other than an ATB) and provides services only to such other 
entity (non-ATB employee exception). Second, section 1061(c)(4)(A) 
provides that an API does not include any interest in a partnership 
directly or indirectly held by a corporation (corporate exception). 
Third, section 1061(c)(4)(B) provides that an API does not include any 
capital interest in the partnership (Capital Interest Gains and Losses 
exception). Fourth, section 1061(b) provides that to the extent 
provided by the Secretary, section 1061 will not apply to income or 
gain attributable to any asset not held for portfolio investment on 
behalf of third party investors (Section 1061(b) exception). Lastly, 
Sec.  1.1061-3 introduces a fifth exception that applies to an 
unrelated purchaser who is a non-service provider (bona fide unrelated 
purchaser exception).

A. Non-ATB Employee Exception

    Section 1061(c)(1) provides that an API is not held by a person who 
is employed by another entity that is conducting a trade or business 
(other than an ATB) and provides services only to such other entity. 
The proposed regulations track the language of the statute.

B. Corporate Exception

    Section 1061(c)(4)(A) provides that the term API does not include a 
partnership interest directly or indirectly held by a corporation. On 
March 19, 2018, the Treasury Department and the IRS issued Notice 2018-
18, notifying taxpayers that the Treasury Department and the IRS 
intended to issue regulations providing that the term corporation as 
used in section 1061(c)(4)(A) does not include an S corporation. The 
notice informed taxpayers that the regulations under section 1061 would 
provide that this rule is effective for taxable years beginning after 
December 31, 2017 to prevent taxpayers from avoiding the application of 
section 1061 through the use of an S corporation. See section 
7805(b)(3). The Blue Book also provides that the term corporation for 
purposes of section 1061(c)(4)(A) does not include an S corporation. 
Blue Book, page 201. Accordingly, these proposed regulations provide 
that partnership interests held by S corporations are treated as APIs 
if the interest otherwise meets the API definition.
    The Treasury Department and the IRS also have concluded that a 
partnership interest held by a PFIC with respect to which a taxpayer 
has a QEF election in effect is treated as an API if the interest meets 
the API definition. Under section 1291, generally, a U.S. person who 
owns stock of a PFIC is subject to an interest charge regime in which 
interest is charged with respect to certain PFIC distributions and 
dispositions of PFIC shares. However, the shareholder can avoid the 
interest charge regime by making an election under section 1295 to 
treat the PFIC as a QEF. If this election is made, then the holder of 
the stock generally is not subject to the interest charge regime and 
instead includes in income each taxable year its

[[Page 49761]]

pro rata share of the ordinary income and long-term capital gain of the 
QEF. The Treasury Department and the IRS are concerned that, absent 
this rule, taxpayers may use PFICs with respect to which they have made 
QEF elections to avoid the application of section 1061. Such taxpayers 
would have the benefit of passthrough tax treatment without the 
application of section 1061. The Treasury Department and the IRS 
believe it is inappropriate for a PFIC with respect to which the 
shareholder has elected to receive passthrough treatment to be treated 
as a corporation for purposes of section 1061. Therefore, the proposed 
regulations clarify that a PFIC with respect to which the shareholder 
has a QEF election in effect is not treated as corporation for purposes 
of section 1061(c)(4)(A). As a result, a partnership interest held by a 
PFIC with respect to which the shareholder has a QEF election in effect 
will be treated as an API if the interest otherwise meets the API 
definition.
    Section 1061(f) provides that the Secretary has authority to issue 
regulations as are necessary or appropriate to carry out the purposes 
of section 1061. Both the Conference Report and the Blue Book further 
direct the Treasury Department and the IRS to issue regulations to 
address the prevention of abuse of the purposes of the provision. The 
Treasury Department and the IRS have concluded that the grant of 
regulatory authority in section 1061 is sufficient for the government 
to issue regulations providing that the exception in section 
1061(c)(4)(A) does not include S corporations and PFICs with respect to 
which shareholders have QEF elections in effect. The rule that the 
exception in section 1061(c)(4)(A) does not apply to a PFIC with 
respect to which the shareholder has a QEF election in effect applies 
to all taxable years beginning after the date the proposed regulations 
are published in the Federal Register.

C. Capital Interest Gains and Losses Exception

    Section 1061(c)(4)(B) provides that an API does not include a 
capital interest in the partnership that provides a right to share in 
partnership capital commensurate with (i) the amount of capital 
contributed (determined at the time of receipt of such partnership 
interest), or (ii) the value of such interest subject to tax under 
section 83 upon the receipt or vesting of such interest. The statutory 
language creates an exception from recharacterization under section 
1061 for capital gains and losses with respect to a capital interest. 
The Conference Report includes an example in which a partnership 
agreement provides that a partner's share of the partnership's capital 
is commensurate with the amount of capital the partner contributed at 
the time the partnership interest was received compared to the total 
partnership capital. The reference to the amount of capital contributed 
in section 1061(c)(4)(B)(i) and a similar reference in the Conference 
Report indicate that the exception for capital interests should apply 
only to the extent that a service provider's rights with respect to its 
contributed capital matches the rights of other non-service partners 
with respect to their shares of contributed capital. Conference Report 
at 420-21.
    These proposed regulations provide rules for determining if capital 
gains and losses allocated to an API Holder are treated as allocations 
with respect to its capital investment and therefore, excluded from the 
application of section 1061. As discussed in more detail in section 
II.C.1, of this Explanation of Provisions, General Rules Applicable to 
the Determination of Capital Interest Allocations and Passthrough 
Interest Allocations, an allocation must be made in proportion to the 
relative value of the API Holder's capital account (including 
unrealized gains and losses) in the Passthrough Entity in order to be 
an allocation with respect to a capital investment. The proposed 
regulations also provide rules for determining the amount of gain or 
loss recognized on the disposition of a Passthrough Interest that is 
allocable to the capital interest.
    The proposed regulations refer to capital gains and losses with 
respect to a capital interest as Capital Interest Gains and Losses. 
Specifically, the proposed regulations provide that Capital Interest 
Gains and Losses are Capital Interest Allocations, Passthrough Interest 
Capital Allocations and Capital Interest Disposition Amounts.
1. General Rules Applicable to the Determination of Capital Interest 
Allocations and Passthrough Interest Capital Allocations
a. In the Same Manner
    The proposed regulations provide that allocations based on the 
partners' capital account balances that have the same terms, the same 
priority, the same type and level of risk, the same rate of return, the 
same rights to cash or property distributions during partnership 
operations and on liquidation will be treated as made in the same 
manner. The proposed regulations also provide that an allocation to an 
API Holder will not fail to be treated as a Capital Interest Allocation 
solely because it is subordinated to an allocation to Unrelated Non-
service Partners or because it is not reduced by the cost of services 
provided by the API Holder or by a related person.
b. Capital Accounts
    In the case of a partnership that maintains capital accounts under 
Sec.  1.704-1(b)(2)(iv), in order for an allocation to qualify as a 
Capital Interest Allocation or a Passthrough Interest Capital 
Allocation, the allocation must be based on the capital account 
determined under Sec.  1.704-1(b)(2)(iv). In the case of a Passthrough 
Entity that is not a partnership (or a partnership that does not 
maintain capital accounts under Sec.  1.704-1(b)(2)(iv)), if the 
Passthrough Entity maintains and determines accounts for its owners in 
a manner similar to that provided under Sec.  1.704-1(b)(2)(iv), those 
accounts will be treated as capital accounts under the proposed 
regulations. These accounts must be used in order for an allocation to 
qualify as a Capital Interest Allocation or a Passthrough Interest 
Capital Allocation. To qualify to be treated as a capital account for 
this purpose, each owner's account must be increased by the money and 
the net fair market value of property contributed to the Passthrough 
Entity and income and gain allocated to the owner. Each owner's account 
must be decreased by any money and the net fair market value of 
property distributed to the owner and allocations of expenditures, 
loss, and deduction.
    Generally, Passthrough Interest Capital Allocations must be based 
on each owner's share of the Passthrough Entity's capital account in 
the partnership making the Capital Interest Allocations to the 
Passthrough Entity. Passthrough Interest Direct Investment Allocations 
generally must be based on each owner's share of the capital investment 
made by the Passthrough Entity. This amount is equal to the capital 
account of the owner reduced by that owner's share of a capital account 
held directly or indirectly by the Passthrough Entity in a lower-tier 
entity. However, if a Passthrough Entity allocates all Passthrough 
Interest Capital Allocations for the taxable year in the aggregate, 
regardless of whether they are Capital Interest Allocations or 
Passthrough Interest Direct Investment Allocations, the Passthrough 
Entity may allocate those allocations based on each owner's capital 
account in the Passthrough Entity, regardless of whether some or all of 
an owner's

[[Page 49762]]

capital contribution is included in the capital account of a lower-tier 
entity.
    For purposes of section 1061, a capital account does not include 
the contribution of amounts directly or indirectly attributable to any 
loan or other advance made or guaranteed, directly or indirectly, by 
any other partner or the partnership (or any person related to any such 
other partner or the partnership). However, the repayments on the loan 
are included in capital accounts as those amounts are paid (unless the 
repayments are funded with a similar loan from the partners or the 
partnership or any person related to such partners or the partnership).
c. Items That Are Not Treated as Capital Interest Allocations or 
Passthrough Interest Capital Allocations
    Capital Interest Allocations and Passthrough Interest Capital 
Allocations never include any amounts that are treated as API Gains and 
Losses or Unrealized API Gains and Losses that are allocated to the 
Passthrough Entity by a lower-tier Passthrough Entity. Such allocations 
also exclude Partnership Transition Amounts and other items not taken 
into account for purposes of section 1061 as described in section III.E 
of this Explanation of Provisions.
2. Capital Interest Allocations
    Capital Interest Allocations can be made only by a partnership that 
has both API Holders and Unrelated Non-Service Partners. Unrelated Non-
Service Partners are partners who do not (and did not) provide services 
in the Relevant ATB and who are not (and were not) related to an API 
Holder in the partnership or any person who provides services in the 
Relevant ATB. Capital Interest Allocations are allocations of long-term 
capital gain and loss made under the partnership agreement to the API 
Holder and Unrelated Non-Service Partners based on their respective 
capital account balances if: (1) The allocations are made to Unrelated 
Non-Service Partners with a significant aggregate capital account 
balance; (2) the allocations are made in the same manner to the API 
Holder and the Unrelated Non-Service Partners; and (3) the terms of the 
allocations to the API Holder and the Unrelated Non-Service Partners 
are identified both in the partnership agreement and on the 
partnership's books and records and the allocations are clearly 
separate and apart from allocations made with respect to the API.
    These proposed regulations provide that allocations made to 
Unrelated Non-service Partners with an aggregate capital account 
balance of 5 percent or more of the aggregate capital account balance 
at the time the allocation is made by the partnership will be treated 
as significant.
3. Passthrough Interest Capital Allocations
    Passthrough Interest Capital Allocations are long-term capital gain 
and loss allocations made by a Passthrough Entity that holds an API. 
The proposed regulations provide for two types of Passthrough Interest 
Capital Allocations: Passthrough Capital Allocations and Passthrough 
Interest Direct Investment Allocations.
a. Passthrough Capital Allocations
    Passthrough Capital Allocations are Capital Interest Allocations 
made directly or indirectly to the Passthrough Entity from a lower-tier 
entity with respect to its capital account balance in the lower-tier 
entity. Passthrough Capital Allocations must be made by the Passthrough 
Entity to each of its owners in the same manner based on each owner's 
share of the capital account in the lower-tier entity making the 
Capital Interest Allocation to the Passthrough Entity.
b. Passthrough Interest Direct Investment Allocations
    Allocations are treated as Passthrough Interest Direct Investment 
Allocations if the allocations are comprised solely of long-term 
capital gains and losses derived from assets (other than an API) 
directly held by the Passthrough Entity and not through an allocation 
from a lower tier Passthrough Entity. Also, if a Passthrough Entity 
received Distributed API Property from a lower-tier entity and the 
property is no longer Distributed API Property because it has been held 
for more than three years, the property is included in the Passthrough 
Entity's direct investment at that time. Generally, allocations must be 
made in the same manner to each of the owners of the Passthrough Entity 
based on each owner's relative investment in the assets held by the 
Passthrough Entity. An allocation will not fail to qualify to be a 
Passthrough Interest Direct Investment Allocation if the Passthrough 
Entity is a partnership and allocations made to one or more Unrelated 
Non-Service Partners have more beneficial terms than allocations to the 
API Holders if the allocations to the API Holders are made in the same 
manner. For example, if an Unrelated Non-Service Partner receives a 
priority allocation and distribution of 10 percent of net long-term 
capital gain and loss and the other partners, including the API 
Holders, share the remaining 90 percent of the net long-term capital 
gain from the Passthrough Entity's direct investments, allocations to 
the API Holders are Passthrough Interest Direct Investment Allocations. 
Further, allocations made in the same manner to some API Holders by a 
partnership will not fail to qualify to be treated as a Passthrough 
Interest Direct Investment Allocation as to those partners despite 
allocations being made to one or more service providers (or related 
parties) that are treated as APIs issued by the Passthrough Entity. For 
example, if (1) all of the partners of the Passthrough Entity are API 
Holders and one partner manages the Passthrough Entity's direct 
investments and receives a 20 percent interest in the net long-term 
capital gains from those investments that is treated as an API as to 
that partner and (2) the other API Holders share the remaining 80 
percent of gain from those investments based on their relative 
investments in the Passthrough Entity, then (3) the allocation of the 
80 percent of net long-term capital gain is a Passthrough Interest 
Direct Investment Allocation to those partners.
c. Aggregate Passthrough Interest Allocations
    Instead of separately accounting for Passthrough Capital 
Allocations and Passthrough Interest Direct Investment Allocations, 
owners of the Passthrough Entity may prefer to allocate items of 
Capital Interest Gain or Loss without regard to whether these items 
arose from direct investment by the Passthrough Entity or from an 
investment in a lower-tier Passthrough Entity. Therefore, the proposed 
regulations permit an upper-tier Passthrough Entity to allocate its 
Passthrough Capital Allocations and Passthrough Interest Direct 
Investment Allocations in the same manner to all of its partners using 
the partners' capital accounts in such Passthrough Entity unreduced by 
amounts that are included in a capital account of the lower-tier 
entity.
4. Request for Comments Regarding Other Allocations
    The Treasury Department and the IRS understand that the allocations 
in the proposed regulations do not include all allocation arrangements. 
The Treasury Department and the IRS request comments on other 
allocation arrangements that appropriately could be treated as Capital 
Interest Gains and Losses under the regulations without inappropriately 
expanding the capital interest exception, taking into account the 
statutory requirement that the API Holder's right with respect to its 
capital interest be commensurate with other

[[Page 49763]]

partners' rights with respect to their contributed capital.
5. Capital Interest Disposition Amounts
    The proposed regulations provide rules for determining the extent 
to which long-term capital gain or loss recognized on the disposition 
of a Passthrough Interest comprised of both an API and a capital 
interest is excluded from section 1061 because it is treated as Capital 
Interest Gain or Loss. Nothing in section 1061 or these proposed 
regulations overrides existing law regarding the determination of gain 
recognized on the disposition of all or a portion of a Passthrough 
Interest. In particular, in the case of a disposition of a portion of a 
Passthrough Interest, Revenue Ruling 84-53 (1984-1 C.B. 159) applies 
and basis must be equitably apportioned between the portion of the 
interest disposed of and the portion retained. These proposed 
regulations contain amendments to Sec.  1.1223-3 for determining a 
divided holding period when a partnership interest includes an API and/
or a profits interest.
    A commenter requested guidance on whether a capital interest can be 
disposed of separately from an API for purposes of section 1061(a). The 
disposition of a capital interest will be treated as such under section 
1061 and the gain or loss on the disposition is treated as Capital 
Interest Gain or Loss if the interest being disposed of is clearly 
identified as a capital interest. However, nothing in section 1061 or 
these proposed regulations changes the established partnership 
principle that a partner has a unitary basis in its partnership 
interest. See Revenue Ruling 84-53. As noted above, the basis must be 
equitably apportioned to the transferred portion under the principles 
described in Rev. Rul. 84-53 and the holding period of the interest 
would be determined under the rules of Sec.  1.1223-3. Thus, a partner 
may dispose of solely a capital interest or an API, but in either case, 
the partner's basis and holding period (including a split holding 
period) is apportioned between the interest retained and the interest 
transferred.
    The proposed regulations provide that the amount of long-term 
capital gain or loss recognized on a disposition that is treated as a 
Capital Interest Disposition Amount is determined in a multi-step 
process. Amounts that are treated as ordinary income under section 
751(a) or (b) as a result of the disposition are excluded from all 
steps of the calculation. The computation then proceeds as follows. 
First, the amount of gain or loss that would be allocated to the 
Passthrough Interest (or the portion of the Passthrough Interest sold) 
if all of the assets of the Passthrough Entity were sold for their fair 
market value in a fully taxable transaction (deemed liquidation) 
immediately before the disposition is determined (Step One). Second, 
the amount of gain or loss from the deemed liquidation that is 
allocable to the Passthrough Interest as a result of Capital Interest 
Allocations, and Passthrough Interest Capital Allocations is determined 
(Step Two). If a transferor recognizes capital gain under section 
751(b), any amount that constitutes API Gain or Loss is added to any 
API Gain or Loss that results from the disposition of the interest.
    If gain is recognized under the Code on the disposition of a 
Passthrough Interest, and the Capital Interest Allocations, Passthrough 
Interest Capital Allocations, and API Holder Transition Amounts 
determined under Step Two would result in the allocation of a loss, 
then all the gain recognized on the disposition will be treated as API 
Gain. Similarly, if loss is recognized on the disposition of a 
Passthrough Interest, and the Capital Interest Allocations, Passthrough 
Interest Capital Allocations, and API Holder Transition Amounts 
determined under Step Two would result in an allocation of a gain, then 
all of the loss recognized on the disposition will be treated as an API 
Loss.
    If gain is recognized under the Code on the disposition of a 
Passthrough Interest and gain would be recognized with respect to the 
Passthrough Interest under both Step One and Step Two, the API Holder 
must determine the portion of the gain that is attributable to the 
capital interest and the portion of the gain that is attributable to 
the API. To determine these portions, the taxpayer must divide the 
capital gain that would be allocated to the interest pursuant to 
Capital Interest Allocations, Passthrough Interest Capital Allocations, 
and API Holder Transition Amounts on the deemed liquidation of the 
partnership under Step Two by the total amount of gain that would be 
allocated to the interest on the deemed liquidation under Step One. 
This amount, expressed as a percentage, is then multiplied by the total 
amount of gain recognized on the sale to determine the amount of the 
gain that is treated as a Capital Interest Disposition Amount. A 
similar analysis would apply if a loss was recognized on the 
disposition of the interest, and both Steps One and Two resulted in a 
loss. To the extent that the gain or loss is not treated as a Capital 
Interest Disposition Amount, it is API Gain or Loss and subject to 
section 1061.
6. Recapitalizations and Divisions
    The Treasury Department and the IRS are aware that some taxpayers 
have taken the position that a recapitalization or division is a 
capital contribution under section 1061(c)(4)(B) that would allow 
taxpayers to recharacterize what would be API Gains under these 
proposed regulations as Capital Interest Gains. Although a 
recapitalization or a division may be treated as a section 721 
contribution, these transactions would not have the effect of 
recharacterizing API Gains and Losses as Capital Interest Gains and 
Losses under these proposed regulations. The section 1061 statutory 
language does not support this position and the Treasury Department and 
the IRS do not believe it to be a reasonable interpretation of the 
statute.

D. Section 1061(b) Exception

    Section 1061(b) provides that to the extent provided by the 
Secretary, section 1061(a) shall not apply to income or gain 
attributable to any asset not held for portfolio investment on behalf 
of third party investors. The proposed regulations reserve with respect 
to the application of section 1061(b). A third party investor is 
defined in section 1061(c)(5) as a person who holds an interest in the 
partnership which does not constitute property held in connection with 
an applicable ATB; and who does not provide substantial services for 
such partnership or for any applicable trade or business. Comments have 
suggested that the exception is intended to apply to family offices, 
that is, portfolio investments made on behalf of the service providers 
and persons related to the services providers. The Treasury Department 
and the IRS generally agree with these comments and believe that the 
section 1061(b) exception effectively is implemented in the proposed 
regulations with the exception to section 1061 for Passthrough Interest 
Direct Investment Allocations. The Treasury Department and the IRS 
request comments on the application of this provision and whether the 
proposed regulations' exclusion for Passthrough Interest Direct 
Investment Allocations properly implements the exception.

E. Bona Fide Unrelated Purchaser Exception

    The proposed regulations add an exception for unrelated taxpayers 
who purchase an API. The proposed regulations provide that an interest 
in a partnership that would be treated as an API but is purchased by an 
unrelated buyer for the fair market value of the interest is not an API 
with respect to the

[[Page 49764]]

buyer if (1) the buyer does not currently and has never provided 
services in the relevant ATB (or to the Passthrough Entity in which the 
interest is held, if different), (2) does not contemplate providing 
services in the future, and (3) is not related to a person who provides 
services currently or has provided services in the past. However, it 
should be noted that this exception does not apply to an unrelated non-
service provider who becomes a partner by making a contribution to a 
Passthrough Entity that holds an API and in exchange receives an 
interest in the Passthrough Entity's API. In this case, allocations to 
the Unrelated Non-Service Partner with respect to the API are API Gains 
and Losses and retain their character as API Gains and Losses.

III. Section 1.1061-4: Computing the Recharacterization Amount

    As noted in section I of this Explanation of Provisions, under the 
proposed regulations, the amount an Owner Taxpayer must treat as short-
term capital gain under section 1061(a) is called the 
Recharacterization Amount. The Recharacterization Amount is the amount 
by which the Owner Taxpayer's One Year Gain Amount exceeds the Owner 
Taxpayer's Three Year Gain Amount. The Owner Taxpayer's One Year Gain 
Amount is comprised of two components: (1) The Owner Taxpayer's 
combined net API One Year Distributive Share Amount from all APIs held 
during the taxable year; and (2) The Owner Taxpayer's API One Year 
Disposition Amount. The Owner Taxpayer's Three Year Gain Amount is 
comprised of: (1) Its combined net API Three Year Distributive Share 
Amount from all APIs held during the taxable year; and (2) its API 
Three Year Disposition Amount. As noted earlier in this preamble, API 
Gains and Losses retain their character as they flow through each tier 
of Passthrough Entities and are netted at the Owner Taxpayer level to 
determine the Recharacterization Amount.

A. Determination of the API One Year Distributive Share Amount

    Each Passthrough Entity must calculate an API One Year Distributive 
Share Amount for each API Holder that directly holds an interest in the 
Passthrough Entity for the taxable year. Under the proposed 
regulations, all long-term capital gain and loss allocated to the API 
Holder by the Passthrough Entity are API Gains and Losses to the API 
Holder unless an exception applies.
    If the Passthrough Entity is a partnership, the Passthrough Entity 
determines its API One Year Distributive Share Amount in a series of 
steps. First, the partnership determines the long-term capital gains 
and losses that are allocated to the API Holder under the partnership 
agreement under sections 702 and 704. This amount includes long-term 
capital gains and losses from the taxable disposition of Distributed 
API Property by the partnership that was distributed to it from a 
lower-tier entity. Second, the partnership reduces this amount by 
amounts that are not taken into account under these proposed 
regulations for purposes of calculating the Recharacterization Amount. 
As discussed in section III.E of this Explanation of Provisions, 
section 1231 amounts, section 1256 amounts, and qualified dividends are 
excluded from the calculation of the Recharacterization Amount and are 
not included in the API One Year Distributive Share amount. The same is 
true for the API Holder Transition Amount, which is also discussed in 
section III.E of this Explanation of Provisions, and for long-term 
capital gain or loss from the disposition of property that was once 
Distributed API Property but that has ceased to be Distributed API 
property because it was disposed of when the asset had a holding period 
that was more than three years. Third, the partnership reduces the 
amount determined under the second step by any amounts that are treated 
as Capital Interest Gains and Losses under Sec.  1.1061-3(c). The 
resulting amount is the API Holder's One Year Distributive Share Amount 
and the partnership must report this amount to the API Holder as its 
API One Year Distributive Share Amount under Sec.  1.1061-6. 
Additionally, under Sec.  1.1061-6, the partnership must report to the 
API Holder the amount of Capital Interest Gains and Losses and API 
Holder Transition Amounts that have been allocated to the API Holder 
for the calendar year.
    An API One Year Distributive Share Amount must also be calculated 
by an S corporation that holds an API for each direct API Holder in the 
S corporation. In this case, the S corporation must report to each API 
Holder its pro rata share of the API Gains and Losses allocated to the 
S corporation with respect to its API. Such amounts also may be 
calculated and reported by a PFIC with respect to which the shareholder 
has a QEF election in effect.

B. Determination of the API Three Year Distributive Share Amount

    Under the proposed regulations, the API Three Year Distributive 
Share Amount is equal to an API Holder's One Year Distributive Share 
Amount less amounts that would not be treated as long-term capital gain 
and loss if such amount were computed by applying paragraphs (3) and 
(4) of section 1222 and substituting three years for one year in those 
paragraphs. In addition, if the Passthrough Entity sold an API during 
the taxable year and the Lookthrough Rule applies, the API Holder's One 
Year Distributive Share Amount is further reduced by the adjustment 
required by the Lookthrough Rule as described in section III.E of this 
Explanation of Provisions. These amounts must be calculated by the 
Passthrough Entity and reported to the API Holder under Sec.  1.1061-6.

C. Determination of the API One Year Disposition Amount and the API 
Three Year Disposition Amount

    The API One Year Disposition Amount includes the long-term capital 
gains and losses that the Owner Taxpayer recognizes from the direct 
taxable disposition of an API, including gain or loss under sections 
731(a) and 752(b), that has been held for more than one year. The API 
One Year Disposition Amount also includes long-term capital gain or 
loss recognized on the disposition of Distributed API Property by an 
Owner Taxpayer. The API Three Year Disposition Amount includes only the 
long-term capital gain or loss from the direct taxable disposition of 
an API held by the Owner Taxpayer for more than three years. However, 
if the Lookthrough Rule, as described in Sec.  1.1061-4(b)(9) and 
discussed further in section III.E.7 of this Explanation of Provisions, 
applies, the API Three year Disposition Amount is further reduced by 
the adjustment required by the Lookthrough Rule.
    Section 751(b) provides that in the case of certain 
disproportionate distributions, a partner may be treated as engaging in 
a sale or exchange of property with the partnership. To the extent that 
such an exchange results in long-term capital gain with respect to an 
API under section 751(b), it is included in the One Year Disposition 
Amount and additionally, if appropriate, amounts may be included in the 
Three Year Disposition Amount. See Sec.  1.751-1(b)(2).

D. Determination of the One Year Gain Amount and Three Year Gain Amount

    In determining the One Year Gain Amount and Three Year Gain Amount, 
all amounts are netted at the Owner Taxpayer level. If an Owner 
Taxpayer holds more than one API, the Owner Taxpayer combines and nets 
its API Distributive Share Amounts from each API that it held during 
the taxable year

[[Page 49765]]

to determine its combined net API One Year Distributive Share Amount 
and net API Three Year Distributive Share Amount. Additionally, the 
taxpayer must take into account its API One Year Disposition Amount and 
its API Three Year Disposition Amount. If the One Year Gain Amount is 
zero or less than zero, section 1061 does not apply because there is no 
gain to recharacterize. Further, in applying section 1(h) of the Code, 
the Owner Taxpayer determines its net capital gain for the taxable year 
taking into account section 1061. Comments are requested regarding the 
calculation of collectibles gain and loss under section 1(h)(5) and 
unrecaptured section 1250 gain in section 1(h)(6) in cases where 
collectibles gain or unrecaptured section 1250 gain is included in the 
Recharacterization Amount under section 1061(a) and under section 
1061(d).

E. General Calculation Rules

    This section discusses general rules included in the proposed 
regulations for calculating the One Year Gain Amount and Three Year 
Gain Amount.
1. Items Not Taken Into Account for Purposes of Section 1061(a)
    Section 1061(a) applies to assets that produce capital gains or 
losses that are treated as long-term capital gain under paragraphs (3) 
and (4) of section 1222. Section 1231 gains and losses are treated as 
long-term based on the operation of section 1231, and not by reference 
to paragraphs (3) and (4) of section 1222. Similarly, section 1256 
provides for specific character treatment and does not calculate gain 
by reference to section 1222. Accordingly, the proposed regulations 
provide that long-term capital gains determined under section 1231 or 
section 1256 are excluded from both the One Year and Three Year Gain 
Amounts. For similar reasons, amounts treated as qualified dividends 
under section 1(h)(11) and any capital gain that is characterized as 
long term or short term without regard to the holding period rules in 
section 1222, such as capital gains characterized under the identified 
mixed straddle rules described in section 1092(b) and Sec. Sec.  
1.1092(b)-3T, 1.1092(b)-4T, and 1.1092(b)-6, are also excluded.
2. API Holder Transition Amounts
    As described in the discussion of Capital Interest Gains and 
Losses, section 1061(c)(4) provides an exception with respect to 
certain capital interests. Prior to the enactment of section 1061, 
taxpayers had no reason to track what portion of the unrealized 
appreciation in partnership assets was attributable to capital 
interests. Therefore, the Treasury Department and the IRS are aware 
that partnerships may not have information readily available to enable 
them to comply with these regulations with respect to property that the 
partnership held for more than three years as of the effective date of 
section 1061. Accordingly, the proposed regulations provide a 
transition rule for partnership property that was held by the 
partnership for more than three years as of the effective date of 
section 1061. Under these proposed regulations, a partnership that was 
in existence as of January 1, 2018 may irrevocably elect to treat all 
long-term capital gains and losses from the disposition of all assets, 
regardless of whether they would be API Gains or Losses in prior 
periods, that were held by the partnership for more than three years as 
of January 1, 2018 as Partnership Transition Amounts. Partnership 
Transition Amounts that are allocated to the API Holder (API Holder 
Transition Amounts) are not taken into account for purposes of 
determining the Recharacterization Amount. Rather, they are treated as 
long-term capital gains and losses and are not subject to 
recharacterization under section 1061 and these proposed regulations.
    For amounts to be treated as Partnership Transition Amounts, the 
partnership must make a signed and dated election (election statement) 
by the due date, including extensions, of the Form 1065, ``U.S. Return 
of Partnership Income,'' for the first partnership taxable year in 
which it treats amounts as Partnership Transition Amounts. The election 
statement must be identified as an election under Sec.  1.1061-
4(b)(7)(iii) and filed with the IRS as an attachment to the Form 1065 
filed for the partnership's taxable year in which it is making the 
election. By the due date of the election, the partnership must clearly 
and specifically identify all of the assets held by the partnership for 
more than three years as of January 1, 2018 in the partnership's books 
and records. The election applies to the year for which the election is 
made and all subsequent years. Taxpayers may rely on these proposed 
regulations to make the election for taxable years beginning in 2020 or 
in a later year before the final regulations apply.
    As noted above, Partnership Transition Amounts that are allocated 
to the API Holder are called API Holder Transition Amounts under the 
proposed regulations. The API Holder Transition Amount in any year is 
the amount of the Partnership Transition Amount for the year that is 
included in the amount of long-term capital gains and losses allocated 
to the API Holder under sections 702 and 704 with respect to its 
interest in the partnership under the current partnership agreement. 
However, the amount allocated to the API Holder in any taxable year 
under the preceding sentence cannot exceed the amount of the 
Partnership Transition Amount that would have been allocated to the API 
Holder with respect to its partnership interest under the partnership 
agreement for the 2017 taxable year to the extent it was amended on or 
before March 15, 2018. The partnership must retain an executed copy of 
the partnership agreement in effect for the 2017 taxable year to the 
extent amended on or before March 15, 2018 as part of its books and 
records.
    A Passthrough Entity that receives an allocation of API Holder 
Transition Amounts from a lower-tier entity cannot allocate more of the 
Passthrough Entity's API Holder Transition Amount to the Passthrough 
Entity's direct API Holders than the amount of Partnership Transition 
Amounts the API Holders would have been allocated by the Passthrough 
Entity under the Passthrough Entity's governing documents in effect for 
the calendar year ending December 31, 2017 to the extent amended on or 
before March 15, 2018. Further, the amount allocated to the Passthrough 
Entity's direct API Holders cannot exceed the amount of the Passthrough 
Entity's API Holder Transition Amounts the Passthrough Entity was 
allocated by the lower-tier Passthrough Entity.
    Unlike other provisions of the proposed regulations, API Holders 
and Passthrough Entities may elect and treat amounts as Partnership 
Transition Amounts and API Holder Transition Amounts for taxable years 
beginning in 2020 or a later taxable year without following all of the 
provisions of the proposed regulations provided that the partnership 
consistently treats long-term capital gains and losses from identified 
assets as Partnership Transition Amounts and API Holder Transition 
Amounts for the year in which the election is made and all subsequent 
taxable years beginning before the final regulations are published in 
the Federal Register. The Treasury Department and IRS request comments 
on whether a transition rule is needed and whether the Partnership 
Transition Amount Rule is useful or whether another approach would be 
more helpful in easing transition difficulties.
3. Installment Sale Gain
    The proposed regulations provide that the Owner Taxpayer's One Year 
Gain

[[Page 49766]]

Amount and Three Year Gain Amount include gains from installment sales, 
regardless of whether the installment sale occurred before the 
effective date of section 1061. The proposed regulations also make 
clear that the holding period of the asset on the date of its 
disposition is used for purposes of applying section 1061. Accordingly, 
if an API was sold on November 30, 2017 and, at the time of its sale, 
it had a holding period of two years, gain recognized on or after 
January 1, 2018 is subject to section 1061 even though the disposition 
occurred before the effective date of section 1061.
    This rule is consistent with the manner in which installment sales 
are treated under existing law. See, e.g., Snell v. Commissioner, 97 
F.2d 891 (5th Cir. 1938) (the tax laws in effect for the year the 
installment gain is recognized apply to the gain); see also Estate of 
Kearns v. Commissioner, 73 T.C. 1223 (1980); Klein v. Commissioner, 42 
T.C. 1000 (1964); Revenue Ruling 79-22 (1979-1 C.B. 275). The holding 
period of the asset disposed of is the holding period on the date of 
disposition because section 453 defers gain recognition, not gain 
realization, and thus section 1061(a) applies to each year in which 
gain is recognized after 2017, even if the gain is recognized more than 
three years after the date of sale. Estate of Henry H Rodgers v. 
Commissioner, 143 F.2d 695, 696-697 (1944).
4. Regulated Investment Company (RIC) and Real Estate Investment Trust 
(REIT) Capital Gain Dividends
    Section 852(b)(3)(C)(i) provides generally that a RIC capital gain 
dividend is any dividend, or part thereof, which is reported by the RIC 
as a capital gain dividend in written statements furnished to its 
shareholders. Similarly, section 857(b)(3)(B) provides generally that a 
REIT capital gain dividend is any dividend, or part thereof, which is 
designated by the REIT as a capital gain dividend in a written notice 
mailed to its shareholders. The aggregate amount of capital gain 
dividends paid by a RIC or REIT for a taxable year, however, may not 
exceed the net capital gain of the RIC or REIT for that taxable year.
    Section 852(b)(3)(B) provides that a RIC capital gain dividend 
shall be treated by the shareholders as a gain from the sale or 
exchange of a capital asset held for more than one year. Similarly, 
section 857(b)(3)(A) provides that a REIT capital gain dividend shall 
be treated by the shareholders as a gain from the sale or exchange of a 
capital asset held for more than one year.
    The Treasury Department and the IRS are aware that taxpayers are 
concerned that section 1061(a)(2) might be read to prevent RIC and REIT 
capital gain dividends received by partnerships from being treated as 
long-term capital gains by taxpayers that hold APIs in those 
partnerships. Specifically, taxpayers are concerned that these 
dividends may not meet the three-year holding period requirement under 
section 1061(a) because of the specification in sections 852(b)(3)(B) 
and 857(b)(3)(A) that these dividends are treated as a gain from the 
sale or exchange of a capital asset held for more than one year. The 
Treasury Department and the IRS agree that long-term capital gain 
treatment should be available to the extent that the capital gain 
dividend is attributable to capital assets held for more than three 
years or is attributable to assets that are not subject to section 
1061.
    The proposed regulations address this issue by allowing a RIC or 
REIT to disclose two additional amounts for purposes of section 1061. 
The two additional amounts to be disclosed are based on modified 
computations of the RIC's or REIT's net capital gain. First, the RIC or 
REIT may disclose the amount of the capital gain dividend that is 
attributable to the RIC's or REIT's net capital gain excluding any 
amounts not taken into account for purposes of section 1061 under Sec.  
1.1061-4(b)(6) from the computation. Second, the RIC or REIT may 
disclose the amount of the capital gain dividend that is attributable 
to the RIC's or REIT's net capital gain both (1) excluding any amounts 
not taken into account for purposes of section 1061 under Sec.  1.1061-
4(b)(6) from the computation, and (2) substituting three years for one 
year in applying section 1222. The proposed regulations allow a RIC or 
REIT to disclose these two additional amounts in writing to its 
shareholders with its section 852(b)(3)(C)(i) capital gain dividend 
statement or section 857(b)(3)(B) capital gain dividend notice.
    The proposed regulations provide that partnerships that receive 
either or both of these additional capital gain dividend disclosures 
from a RIC or REIT must use each additional disclosed amount in 
calculating API distributive share amounts. The first additional 
disclosed amount is used for the calculation of an API One Year 
Distributive Share Amount. The second additional disclosed amount is 
used for the calculation of an API Three Year Distributive Share 
Amount. However, the proposed regulations provide that the full amount 
of the RIC's or REIT's capital gain dividend must be used for the 
calculation of an API One Year Distributive Share Amount if the first 
additional amount is not disclosed, and no amount of the RIC's or 
REIT's capital gain dividend may be used for the calculation of an API 
Three Year Distributive Share Amount if the second additional amount is 
not disclosed.
    To prevent the avoidance of section 1061, the proposed regulations 
also provide that each of the two additional disclosed amounts provided 
to each shareholder of a RIC or REIT must be proportionate to the share 
of capital gain dividends reported or designated to that shareholder 
for the taxable year. Cf. Section 857(g)(2) and Rev. Rul. 89-81, 1981-1 
C.B. 226.
    Additionally, in accordance with sections 852(b)(4) and 857(b)(8), 
the proposed regulations provide that with respect to any shares of RIC 
or REIT stock with respect to which a partnership receives a capital 
gain dividend distribution and the second additional disclosed amount 
that is used to calculate the API Three Year Distributive Share Amount, 
any loss on the sale or exchange of such shares held for less than six 
months will be treated as capital loss on assets held for more than 
three years to the extent of the second additional disclosed amount 
that is included in the calculation of an API Three Year Distributive 
Share Amount.
5. Distributed API Property
    Generally, the distribution of property with respect to an API does 
not accelerate the recognition of gain under section 1061 or these 
proposed regulations. However, if Distributed API Property is disposed 
of by the distributee-partner when the holding period is three years or 
less (inclusive of the partnership's holding period), gain or loss with 
respect to the disposition is API Gain or Loss. Distributed API 
Property retains its character as it is passed from one tier to the 
next. However, at the time that Distributed API Property is held for 
more than three years, it loses its character and is no longer 
Distributed API Property. If Distributed API Property is distributed 
from one Passthrough Entity to another and the upper-tier entity 
disposes of the property, the long-term capital gain or loss is 
included in the upper-tier entity's long-term capital gain or loss as 
API Gain or Loss. If the property is distributed to an Owner Taxpayer 
and the Owner Taxpayer disposes of the property, the capital gain or 
loss is included in the Owner Taxpayer's API One Year Disposition Gain 
or Loss. This rule is necessary to prevent the avoidance of section 
1061 because,

[[Page 49767]]

absent such a rule, section 1061 could be circumvented by the 
partnership's distribution of an asset to the API Holder prior to the 
sale of the asset in situations in which the asset has been held by the 
partnership for three years or less.
6. Holding Periods Used for Applying Section 1061
    The Treasury Department and the IRS considered different approaches 
to the holding period rules. As one commentator pointed out, there are 
a number of different approaches that can be considered. These 
approaches include: (1) Using the holding period of the owner of the 
asset sold (whether the asset disposed of is the API itself or is an 
underlying capital asset held by the partnership); (2) using the Owner 
Taxpayer's holding period in its interest; (3) using the partnership's 
holding period in its assets; or (4) using the lesser of the holding 
period of the partnership in the assets or the Owner Taxpayer's holding 
period in the interest. If the holding period of the owner of the asset 
applies, then the partnership's holding period in the asset or the 
partner's holding period in the API applies (whichever is disposed of).
    The proposed regulations adopt the approach that the holding period 
of the owner of the asset sold controls. The Treasury Department and 
the IRS have adopted this approach because it is the approach most 
consistent with subchapter K of chapter 1 of the Code and the intended 
application of section 1061. Additionally, this approach is also the 
most administrable for taxpayers and the government.
    To this end, the proposed regulations provide that if a partnership 
disposes of an asset, it is the partnership's holding period in the 
asset that controls. This includes the disposition of an API by the 
partnership. This result is consistent with the application of section 
702(b) and Revenue Ruling 68-79 (1968-1 C.B. 310) which ruled that when 
a partnership sells a capital asset held by the partnership for over 6 
months (the then-required holding period for long-term capital gains), 
a new partner takes into account his distributive share of gain from 
the sale as long-term capital gain notwithstanding that the partner has 
not held its interest in the partnership long enough to qualify for 
long-term capital gain treatment if the partnership interest itself had 
been sold.
    Section 741 provides that gain or loss on the sale of a partnership 
interest is considered as gain or loss from the sale or exchange of a 
capital asset except as otherwise provided in section 751. Therefore, 
the sale of a partnership interest generally follows an entity 
approach, as opposed to an aggregate approach. Following this approach, 
the proposed regulations provide that, except to the extent that the 
Lookthrough Rule described in Sec.  1.1061-4(b)(9) and section III.E.7 
of this Explanation of Provisions, applies, the holding period that an 
API Holder has in an API is the applicable holding period upon the 
disposition of an API.
    The proposed regulations also provide that for purposes of 
computing the Three Year Gain Amount, the relevant holding period of 
either an asset or an API is determined under all provisions of the 
Code or regulations that are relevant to determining whether an asset 
or API has been held for the long-term holding period by applying those 
provisions as if the applicable holding period were three years instead 
of one year.
    These proposed regulations also amend Sec.  1.1223-3 to clarify how 
to calculate the holding period of an API when the API comprises a 
portion of the partnership interest and the partnership interest has a 
divided holding period under Sec.  1.1223-3. This clarification applies 
to the calculation of all profits interests and all APIs. Section 
1.1223-3(a) provides that a partnership has a divided holding period if 
portions of the interest are acquired at different times or the partner 
acquired portions of the partnership interest in exchange for property 
transferred at the same time but resulting in different holding 
periods. The general rule in Sec.  1.1223-3(b)(1) is that the portion 
of the interest to which the holding period relates is determined by 
reference to a fraction, the numerator of which is the fair market 
value of the portion of the partnership interest received in the 
transaction to which the holding period relates, and the denominator of 
which is the fair market value of the entire partnership interest 
determined immediately after the acquisition transaction. In the case 
of the portion of a partnership interest that is comprised in part by 
one or more APIs or profits interests, the proposed regulations clarify 
the timing of this determination as to that portion to the time 
immediately before the disposition (as compared to the acquisition) of 
all or a part of the interest. Accordingly, in the case of a 
partnership interest that has a divided holding period and the 
partnership interest includes a profits interests, the relative fair 
market of the profits interest is determined at the time of the 
interest's disposition (or partial disposition). The holding period of 
the portion of the interest that does not include the profits interest 
continues to be determined under Sec.  1.1223-3(b)(1). No inference is 
intended with respect to the valuation of a profits interest that fails 
to meet the safe harbor under Revenue Procedure 93-27 (as clarified in 
Revenue Procedure 2001-43).
7. Lookthrough Rule on Sale of APIs
    Generally, these proposed regulations do not look through a 
partnership to its assets on the sale of a partnership interest. 
However, the proposed regulations include a limited Lookthrough Rule 
that may apply to the sale of an API with a holding period of more than 
three years for capital gain. In the case of a disposition of a 
directly held API with a holding period of more than three years, the 
Lookthrough Rule applies if the assets of the partnership in which the 
API is held meet the Substantially All Test. In the case of a tiered 
structure in which an API Holder holds its API through one or more 
Passthrough Entities, the Lookthrough Rule applies if the API Holder 
disposes of a Passthrough Interest held for more than three years for a 
gain and either the Passthrough Entity through which the API is 
directly or indirectly held has a holding period in the API that is 
three years or less, or the Passthrough Entity through which the API is 
held has a holding period in the API of more than three years and the 
assets of the partnership in which the API is held meet the 
Substantially All Test. The Lookthrough Rule does not apply to the 
disposition of an API if section 1061(d) applies.
    The Substantially All Test is met if 80 percent or more of the 
assets of the partnership in which the API is held, based on fair 
market value, are assets that would produce capital gain or loss that 
is not described in Sec.  1.1061-4(b)(6) if disposed of by the 
partnership and have a holding period of three years or less. The 
determination of whether the substantially all test is met is made by 
expressing the value of a fraction as a percentage. The numerator of 
the fraction is equal to the aggregate fair market value of the 
partnership's assets that would produce capital gain or loss that is 
not described in Sec.  1.1061-4(b)(6) if disposed of by the partnership 
and that have a holding period of three years or less to the 
partnership as of the date of disposition of the API. The denominator 
is equal to the aggregate fair market value of the partnership's 
assets. Cash, cash equivalents, unrealized receivables under section 
751(c), and inventory items under section 751(d) are not taken into 
account for purposes of the Substantially All Test.

[[Page 49768]]

    In the case of a disposition of an API by an API Holder that is an 
Owner Taxpayer, all of the long-term capital gain recognized on the 
disposition is included in the API One Year Disposition Amount. The 
amount included in the API Three Year Disposition Amount with respect 
to the disposition is the amount included in the API One Year 
Disposition Amount reduced by any adjustment amount required by the 
Lookthrough Rule. In the case of a disposition of an API by an API 
Holder that is a Passthrough Entity to which the Lookthrough Rule 
applies, the long-term capital gain recognized on the sale is included 
in the API One Year Distributive Share Amount calculated for the API 
Holders of the Passthrough Entity. Section 1.1061-4(a)(3) provides that 
the API Three Year Distributive Share Amount is reduced by the 
adjustment amount required by the Lookthrough Rule. The adjustment 
amount required by the Lookthrough Rule is either the capital gain 
recognized on the disposition of the API that is attributable to the 
assets whose fair market value is included in the numerator of the 
fraction used for the Substantially All Test, or, in the case of an API 
indirectly held through a Passthrough Entity for three years or less, 
the gain attributable to the API.

IV. Transfers to Related Parties

A. Recognition and Recharacterization

    Under section 1061(d), if a taxpayer transfers an API to a related 
person described in section 1061(d)(2) in a transfer that would not 
otherwise be a taxable event, the taxpayer must include certain capital 
gain in gross income as short-term capital gain. The amount of gain 
required to be included as short-term capital gain is the excess of the 
net built-in long-term capital gain in assets held for three years or 
less attributable to the transferred interest, over the amount of long-
term capital gain recognized on the transfer that is treated as short 
term capital gain under section 1061(a). If the transfer is otherwise 
taxable, section 1061(d) recharacterizes all or a portion of the 
capital gain otherwise recognized on the transfer as short-term capital 
gain. If the amount of capital gain otherwise recognized by the 
taxpayer on a taxable transfer is less than the amount required to be 
included under section 1061(d), the taxpayer must include the 
difference as short-term capital gain under section 1061(d). The 
proposed regulations refer to a related person described in section 
1061(d)(2) as a Section 1061(d) Related Person.
    One commentator suggested that the Treasury Department and the IRS 
suspend the application of section 1061(d) until Congress clarifies its 
application. The Treasury Department and the IRS do not believe a 
suspension is necessary. Rather, the Treasury Department and the IRS 
interpret section 1061(d)(1) to require that gain equal to the amount 
described in that section be recognized and included in income as 
short-term capital gain on the transfer of an API to a Section 1061(d) 
Related Person even if the transfer is not a transaction in which gain 
is otherwise recognized under the Code. The term transfer under the 
proposed regulations includes, but is not limited to, contributions, 
distributions, sales and exchanges, and gifts.

B. Section 1061(d) Related Person

    Section 1061(d)(2) defines a related person to be a member of the 
taxpayer's family within the meaning of section 318(a)(1) or a person 
who performed a service within the current calendar year or the 
preceding three calendar years in any ATB in which or for which the 
taxpayer performed a service. The Conference Report describes a Section 
1061(d) Related Person as a family member or colleague (or recent 
former colleague). Conference Report at 422. For these purposes, a 
taxpayer is the same taxpayer used for computation purposes (as opposed 
to the taxpayer used for determining whether the elements of an API are 
met), that is, an Owner Taxpayer. The proposed regulations clarify that 
for a service provider to be treated as a Section 1061(d) Related 
Person, the service provider must provide services or have provided 
services in the same ATB to which the transferred API relates, that is, 
in the Relevant ATB. The proposed regulations also include within the 
definition of Section 1061(d) Related Person any Passthrough Entity to 
the extent that a Section 1061(d) Related Person holds an interest. The 
Treasury Department and the IRS request comments on how to calculate 
section 1061(d) gain when a Passthrough Entity is only partially a 
Related Person.
    The proposed regulations provide that a contribution under section 
721(a) to a partnership is not treated as a transfer to a Section 
1061(d) Related Person because the proposed regulations require that 
under the principles of section 704(c) and Sec. Sec.  1.704-
1(b)(2)(iv)(f) and 1.704-3(a)(9) all Unrealized API Gains that would be 
directly or indirectly allocated to the API Holder at the time of 
contribution must be allocated to the API Holder contributing the 
interest when they are recognized. The Treasury Department and the IRS 
request comments on transfers other than section 721(a) contributions 
that satisfy the foregoing standard and that therefore should be 
excluded from section 1061(d).
    The proposed regulations use the term ``person'' as the term is 
generally used under section 7701(a)(1). Section 7701(a)(1) defines 
``person'' to include an individual, trust, estate, partnership, 
association, company, or corporation. Under the section 7701(a)(1) 
definition of person, for example, a management company could qualify 
as a related person under section 1061(d)(2) because the management 
company would have performed a service in the same ATB in which the 
taxpayer had performed a service in the three years preceding the 
transfer.

C. Gain Recharacterized by Section 1061(d)

    Section 1061(d)(1) requires the taxpayer to include as short-term 
capital gain the excess of the taxpayer's long-term capital gain with 
respect to such interest for such taxable year attributable to the sale 
or exchange of any asset held for not more than three years as is 
allocable to such interest over any amount treated as short-term 
capital gain with respect to the transfer of the interest under section 
1061(a).
    The proposed regulations provide that the long-term capital gain 
with respect to the transferred API attributable to the sale or 
exchange of any asset held not more than three years is the long-term 
capital gain that would be allocated to the transferred API if, 
immediately before the transfer, the partnership that issued the API 
had sold all of its assets held for three years or less for fair market 
value in a hypothetical sale. If the result is negative, the result is 
deemed to be zero and section 1061(d) does not apply.
    The proposed regulations provide that if the basis of the 
transferred API in the transferee's hands is determined in whole or in 
part by the basis of the API in the transferor's hands before 
application of section 1061(d), then the basis of the transferred API 
shall be increased (before the application of section 1015(d), if 
applicable) by the capital gain included in gross income by the 
transferor solely by reason of section 1061(d). If an Owner Taxpayer 
transfers only a portion of an API, section 1061(d) applies only to the 
portion transferred.

V. Securities Partnerships

    The proposed regulations include an amendment to Sec.  1.704-
3(e)(3). Section 1.704-3(e)(3)(i) provides that for purposes of making 
reverse section

[[Page 49769]]

704(c) allocations, a securities partnership may aggregate gains and 
losses from financial assets using any reasonable approach that is 
consistent with the purpose of section 704(c). The proposed regulations 
amend Sec.  1.704-3(e)(3) to provide that an approach will not be 
considered reasonable if it fails to take into account the application 
of section 1061. Additionally, the proposed regulations provide that if 
the partnership aggregates gains and losses with respect to capital 
assets held for more than one year, for the partial netting approach in 
Sec.  1.704-3(e)(3)(iv) and the full netting approach in Sec.  1.704-
3(e)(3)(v) to be considered reasonable, the partnership must establish 
separate accounts (1) for taking into account each API Holder's share 
of book API Gains and Losses and book Capital Interest Gains and Losses 
and (2) for determining each API Holder's share of tax API Gains and 
Losses and tax Capital Interest Gains and Losses. The proposed 
regulations do not include rules for dividing existing accounts to 
determine API Gains and Losses and Capital Interest Gains and Losses. 
However, the proposed regulations provide that the manner in which such 
accounts are apportioned must be reasonable. One method that the 
Treasury Department and the IRS have concluded is reasonable is to 
apportion existing accounts based on the relative API Gain or Loss 
amounts and Capital Interest Gain or Loss amounts that would be 
allocated to the API Holder as a result of a deemed liquidation of the 
partnership. The Treasury Department and the IRS request comments on 
whether further guidance on this issue is necessary for securities 
partnerships using the aggregation rules in Sec.  1.704-3(e)(3).

VI. Reporting Requirements

    These proposed regulations provide that an Owner Taxpayer must 
report any information the Commissioner may require in forms, 
instructions or other guidance to evidence the taxpayer's compliance 
with section 1061. Under the proposed regulations, a Passthrough Entity 
in which an Owner Taxpayer holds its interest is required to provide 
the information needed by the Owner Taxpayer to comply with section 
1061 and to determine its Recharacterization Amount. The Passthrough 
Entity is required to provide the Owner Taxpayer with the API One Year 
Distributive Share Amount and the API Three Year Distributive Share 
Amount. Additionally, the Passthrough Entity must provide the Owner 
Taxpayer with the adjustments that must be made to the Owner Taxpayer's 
distributive share of long-term capital gain or loss that would allow 
the Owner Taxpayer to independently calculate its API One Year 
Distributive Share Amount and its API Three Year Distributive Share 
amount. Consistent with Sec.  1.6001-1(a) and (e), if an Owner Taxpayer 
is not furnished its API One Year Distributive Share Amount, the IRS 
will treat the amount of the adjustments necessary to independently 
calculate the API One Year Distributive Share as zero and will also 
treat the API Three Year Distributive Share as zero to the extent 
information is not provided to the Owner Taxpayer and the Owner 
Taxpayer is not able to otherwise substantiate all or a part of those 
amounts to the satisfaction of the Secretary. For example, if the Owner 
Taxpayer is not furnished its API One Year Distributive Share Amount, 
the IRS will not take into account amounts that are excluded from 
section 1061 under Sec.  1.1061-1(b)(6) unless the Owner Taxpayer is 
furnished information regarding this amount or the Owner Taxpayer is 
otherwise able to substantiate this amount. Similarly, if the Owner 
Taxpayer is not furnished its API Three Year Distributive Share Amount, 
to the extent that the Owner Taxpayer is also not furnished information 
regarding items that are not treated as long term capital gain or loss 
if paragraphs (3) and (4) of section 1222 required a three year holding 
period for long-term capital gain treatment, the IRS will treat the API 
Three Year Distributive Share Amount as zero if the taxpayer cannot 
otherwise substantiate this amount. An Owner Taxpayer that takes a 
position that is inconsistent with the information provided to it by a 
Passthrough Entity may have to attach Form 8082, ``Notice of 
Inconsistent Treatment or Administrative Adjustment Request (AAR),'' to 
its federal income tax return.
    A Passthrough Entity that has an API Holder must report information 
to the API Holder to enable the API Holder to comply with the 
regulations under section 1061 as the Commissioner may require in 
forms, instructions, or other guidance. It is contemplated that the 
Passthrough Entity generally will be required to provide this 
information as an attachment to the Schedule K-1 furnished to the API 
Holder for the taxable year. The proposed regulations provide that this 
information includes (i) the API One Year Distributive Share Amount and 
the API Three Year Distributive Share Amount; (ii) long-term capital 
gains and losses allocated to the API Holder that are excluded from 
section 1061 under Sec.  1.1061-4(b)(6); (iii) Capital Interest Gains 
and Losses allocated to the API Holder; (iv) API Holder Transition 
Amounts; and (v) in the case of a disposition by an API Holder of an 
interest in the Passthrough Entity during the taxable year, any 
information required by the API Holder to properly take the disposition 
into account under section 1061, including information regarding the 
application of Lookthrough Rule and information necessary to determine 
its Capital Interest Disposition Amount. Penalties will apply to a 
Passthrough Entity that fails to comply with the reporting rules in 
these proposed regulations and as further required in forms, 
instructions or other guidance. See e.g., section 6698 (Failure to File 
Partnership Returns), section 6699 (Failure to File S Corporation 
Return), section 6722 (Failure to Furnish Correct Payee Statements).
    A Passthrough Entity that holds an interest in a lower-tier entity 
may need information from the lower-tier entity to meet its reporting 
obligations under the proposed regulations. In this case, the 
Passthrough Entity must request information from any lower-tier 
entities in which it owns an interest by the later of the 30th day of 
the close of the calendar year or within 14 days after having received 
a request for information from an API Holder. The lower-tier entity 
must respond by the due date (including extensions) of the Schedule K-1 
for the taxable year. The proposed regulations provide guidance 
regarding an upper-tier Passthrough Entity's reporting requirements if 
the lower-tier Passthrough Entity fails to report the required 
information to the upper-tier Passthrough Entity.

VII. Applicability Date

    The proposed regulations generally provide that the final 
regulations apply to taxable years of Owner Taxpayers and Passthrough 
Entities beginning on or after the date final regulations are published 
in the Federal Register. However, except for the rules in the proposed 
regulations regarding Partnership Transition Amounts and API Holder 
Transition Amounts, Owner Taxpayers and Passthrough Entities may rely 
on the proposed regulations for taxable years beginning before the date 
final regulations are published in the Federal Register provided they 
follow the proposed regulations in their entirety) and in a consistent 
manner. In contrast, taxpayers may rely on the rules in the proposed 
regulations regarding Partnership Transition Amounts and API Holder 
Transition Amounts for taxable years beginning in 2020 and subsequent 
taxable years beginning

[[Page 49770]]

before the date final regulations are published in the Federal 
Register, and may do so without consistently following all of the rules 
provided in Sec. Sec.  1.1061-1 through 1.1061-6 of these proposed 
regulations if the partnership treats capital gains and losses from the 
identified assets as Partnership Transition Amounts and API Holder 
Transition Amounts for the year in which the election is made and all 
subsequent taxable years beginning before the date final regulations 
are published in the Federal Register.
    As indicated in section 4 of Notice 2018-18, proposed Sec.  1.1061-
3(b)(2)(i), which provides that the term corporation does not include 
an S corporation, is proposed to apply to taxable years beginning after 
December 31, 2017. See section 7805(b)(3). Additionally, proposed Sec.  
1.1061-3(b)(2)(ii), which provides that the term corporation does not 
include a PFIC with respect to which the shareholder has a QEF election 
under section 1295 in effect, is proposed to apply for taxable years 
beginning after August 14, 2020.
    With respect to an API in a partnership with a fiscal year ending 
after December 31, 2017, section 706 determines the capital gains and 
losses the Owner Taxpayer includes in income with respect to an API 
after December 31, 2017. Section 706 provides that the taxable income 
of a partner for a taxable year includes amounts required by sections 
702 and section 707(c) with respect to a partnership based on the 
income, gain, loss, deduction, or credit of a partnership for any 
taxable year ending within or with the taxable year of the partner. 
Accordingly, if a calendar year Owner Taxpayer has an API in a fiscal 
year partnership that has a year end after December 31, 2017, section 
1061 applies to the Owner Taxpayer's distributive share of long-term 
capital gain or loss with respect to the API in calendar year 2018 
regardless of whether the partnership disposed of the property giving 
rise to the gains and losses in the period prior to January 1, 2018. 
See Sec.  1.706-1(a)(1).

VIII. Request for Comments for Smaller Partnerships

    Comments are requested on whether a simplified method for 
determining and calculating the API gain or loss should be provided for 
smaller partnerships and if so, the criteria that should be used to 
determine which partnerships should be eligible to use the simplified 
method. These comments should include comments and suggestions for a 
simplified method.

Special Analyses

l. Regulatory Planning and Review--Economic Analysis

    Executive Orders 13771, 13563, and 12866 direct agencies to assess 
costs and benefits of available regulatory alternatives and, if 
regulation is necessary, to select regulatory approaches that maximize 
net benefits, including potential economic, environmental, public 
health and safety effects, distributive impacts, and equity. Executive 
Order 13563 emphasizes the importance of quantifying both costs and 
benefits, reducing costs, harmonizing rules, and promoting flexibility. 
The Executive Order 13771 designation for any final rule resulting from 
these proposed regulations will be informed by comments received. The 
preliminary Executive Order 13771 designation for this proposed rule is 
regulatory.
    The proposed regulations have been designated by the Office of 
Information and Regulatory Affairs (OIRA) as subject to review under 
Executive Order 12866 pursuant to the Memorandum of Agreement (MOA, 
April 11, 2018) between the Treasury Department and the Office of 
Management and Budget regarding review of tax regulations. It has been 
determined that the proposed rulemaking is significant under section 
1(b) of the Memorandum of Agreement and thereby subject to review. 
Accordingly, the proposed regulations have been reviewed by OMB.

A. Background

    Section 1061 of the Internal Revenue Code, enacted by the TCJA, 
recharacterizes certain long-term capital gains recognized with respect 
to an API as short-term capital gains. Short-term capital gains are 
taxed at the ordinary income rate whereas long-term capital gains are 
generally taxed at a lower rate.
    Section 1061 defines an API as an interest in a partnership 
transferred to or held by the taxpayer in connection with the 
performance of substantial services by the taxpayer, or any other 
related person, in any ATB. Under section 1061 the term ATB encompasses 
a range of financial service activities. Specifically, an ATB is any 
activity conducted on a regular, continuous, and substantial basis 
which consists, in whole or in part, of raising or returning capital, 
and either (i) investing in (or disposing of) ``specified assets'' (or 
identifying specified assets for such investing or disposition), or 
(ii) developing specified assets. ``Specified assets'' are certain 
securities, certain commodities, real estate held for rental or 
investment, cash or cash equivalents, options or derivative contracts 
with respect to any of the foregoing, and an interest in a partnership 
to the extent of the partnership's proportionate interest in any of the 
foregoing.
    Prior to the TCJA, the Internal Revenue Code made no distinction 
between capital gains allocated to APIs versus other partnership 
interests and partnership assets. Generally, the required holding 
period to obtain the lower long-term capital gains tax rate was one 
year for all partnership interests and partnership assets. Under the 
new provision, the required holding period for an API must be greater 
than three years to obtain long-term capital gains treatment.

B. Overview of the Proposed Regulations

    The proposed regulations provide taxpayers with definitional and 
computational guidance regarding the application of section 1061. In 
particular, the proposed regulations provide a number of important 
definitions, including the term `taxpayer' for the purpose of 
determining the existence of an API. Additionally, the regulations 
clarify the rules for certain exceptions to section 1061, including the 
exception for capital interests, and provide for an additional 
exception for bona fide purchases of APIs by an unrelated party who is 
not a service provider. The proposed regulations also provide rules for 
calculating the recharacterized gain amount and provide for a 
lookthrough rule with respect to the sale of APIs.

C. Economic Analysis

1. Baseline
    The Treasury Department and the IRS have assessed the benefits and 
costs of the proposed regulations relative to a no-action baseline 
reflecting anticipated Federal income tax-related behavior in the 
absence of these proposed regulations.
2. Summary of Economic Effects
    The proposed regulations provide certainty and consistency in the 
application of section 1061 by providing definitions and clarifications 
regarding the statute's terms and rules. An economically efficient tax 
system generally aims to treat income and expense derived from similar 
economic decisions consistently across taxpayers and activities in 
order to reduce incentives for individuals and businesses to make 
choices based on tax rather than market incentives. In the absence of 
the guidance provided in these proposed regulations, taxpayers would 
bear the burden of interpreting

[[Page 49771]]

the statute and the chances that different taxpayers might interpret 
the statute differently would be exacerbated. For example, two 
similarly situated taxpayers might interpret the statutory provisions 
pertaining to the definition of taxpayer or the capital interest 
exception differently, causing one to enter into a partnership that 
another comparable taxpayer might decline because of a different 
interpretation of how the income will be treated under section 1061. 
Thus, lack of certainty may dissuade economically beneficial actions. 
An economic loss may also arise if all taxpayers have identical 
interpretations of the tax treatment of particular income streams under 
the statute but are more conservative (or less conservative) regarding 
the interpretation than Congress intended for these income streams. In 
this case, guidance provides value by bringing economic decisions 
closer in line with the intents and purposes of the statute.
    The Treasury Department and the IRS solicit comments on the 
economic analysis of the proposed regulations. The Treasury Department 
and the IRS particularly solicit comments that provide data, other 
evidence, or models that could enhance the rigor of the analysis.
3. Economic Analysis of Specific Provisions
a. Definition of Taxpayer
    The statute requires taxpayers to make a number of determinations, 
including the determination of the existence of an API, and the 
calculation of the section 1061 amount, or amount of long-term gain 
recharacterized under section 1061. However, the term ``taxpayer'' is 
not defined in either section 1061 or in the Conference Report. 
Comments received by the Treasury Department and IRS highlight the 
importance of the definition of the term taxpayer for purposes of 
section 1061.\1\ Without guidance, taxpayers could use different 
approaches to define ``taxpayer,'' leading otherwise similar taxpayers 
to experience different degrees of complexity, and to report different 
recharacterized amounts.
---------------------------------------------------------------------------

    \1\ See comments from the American Bar Association available at: 
https://www.americanbar.org/content/dam/aba/administrative/taxation/policy/032219comments.pdf.
---------------------------------------------------------------------------

    The proposed regulations include two definitions of taxpayer to 
address the level at which the determination of the existence of an API 
is made and the level at which the calculation of the section 1061 
amount is made. The proposed regulations define the Owner Taxpayer as 
the person generally required to pay tax on the gain or loss with 
respect to the API. Under the proposed regulations, the section 1061 
calculation is only performed by the person (the Owner Taxpayer) who 
must pay tax on the gains and losses recognized with respect to the 
API. The Treasury Department and the IRS estimate that approximately 
22,750 Owner Taxpayers will be required to adjust Schedule D filings. 
There may be others who meet the definition of Owner Taxpayer but face 
no burden because they receive no capital gains allocations in relation 
to their API holdings. The proposed regulations also introduce the term 
Passthrough Taxpayer. A Passthrough Taxpayer is an entity that does not 
itself generally pay tax on capital gains but must determine when an 
API exists and allocate income, gain, deduction and loss to its owners. 
The Treasury Department and the IRS estimate there are approximately 
30,000 Passthrough Taxpayers required to provide information to owner 
taxpayers who hold an API. Both the Owner Taxpayer and the Passthrough 
Taxpayer are treated as taxpayers for the purpose of determining 
whether an API exists.
    The Treasury Department and the IRS considered and rejected two 
alternative approaches to the definition of taxpayer outlined in 
received comments, the ``aggregate approach'' and the ``full entity 
approach.'' Under the aggregate approach, a partnership is not treated 
as a taxpayer for purposes of section 1061. Instead, section 1061 is 
applied solely to the partners that are ultimately subject to tax on 
the partnership's items of capital gain and loss. A concern with using 
this approach for the purpose of determining whether an API exists is 
that it could incentivize partners to use tiered ownership structures 
to avoid section 1061 recharacterization. For example, an upper tier 
partnership may receive an interest in a lower-tier fund in connection 
with the upper-tier partnership's performance of services in an ATB. 
Partners of the upper-tier partnership may contend that they did not 
receive their interest in the upper-tier partnership in connection with 
the services performed by the upper-tier partnership. Stopping such 
avoidance strategies would require complex rules and potentially 
burdensome reporting requirements when tiered ownership structures are 
involved.
    Under the ``full entity approach'', the partnership is treated as a 
taxpayer for purposes of both determining the existence of an API and 
calculating the section 1061 recharacterization amount. Treating the 
partnership as a taxpayer for purposes of calculating the section 1061 
recharacterization amount was found to be more burdensome than the 
approach taken in the proposed regulations for three reasons. First, 
using the full entity approach for determining the section 1061 
recharacterization amount may lead to increased recharacterization of 
gains under section 1061 because individuals would not be able to net 
gains and losses across multiple APIs. Second, the administrative 
burden on both the taxpayer and the IRS would be increased in cases of 
tiered ownership. Under the full entity approach, a separate section 
1061 calculation would be required at each level at which an API is 
held in a tiered partnership structure. Finally, the full entity 
approach may add complexity and burden in cases in which an exception 
to section 1061 applies, such as if a corporation is a direct or 
indirect partner. Because corporations are excluded from section 1061, 
any amount recharacterized at the partnership level would need to be 
tracked as it is allocated to partners to ensure that corporate or 
other excepted partners are not subject to the three year holding 
period under section 1061.
    The Treasury and the IRS have concluded that the chosen 
alternative, incorporating the concepts of Owner Taxpayer and 
Passthrough Taxpayer, is less burdensome than other alternatives and 
provides helpful certainty to taxpayers.
b. Clarification of the Treatment of an API Purchased by an Unrelated 
Party
    The statute states that capital gain or loss recognized by a 
taxpayer on the sale of an API held for more than one year is subject 
to section 1061. The statute also provides guidance for ongoing 
treatment under section 1061 when the API is purchased by, or 
transferred to, a related party or another service provider. However, 
the statute does not provide guidance for the taxpayer who purchases an 
API and is neither a service provider to the relevant ATB, nor related 
to the seller of the API. The proposed regulations add an exception to 
section 1061 and provide that the term API does not include an interest 
in a partnership that would be treated as an API but is held by a bona 
fide purchaser of the interest who does not currently and has never 
provided services in the relevant ATB and who is not related to a 
person who provides services currently or has provided services in the 
past. By clarifying the treatment of an API that is sold at arm's 
length, the proposed regulations reduce uncertainty and compliance 
burdens for

[[Page 49772]]

taxpayers entering into these transactions. The Treasury Department and 
the IRS have determined this exception is consistent with the purpose 
of section 1061, which applies to service providers and persons related 
to service providers and is not meant to apply to bona fide purchasers 
of a partnership interest who do not provide services.
    The Treasury Department and the IRS considered not providing this 
exception. However, it was determined that failure to provide this 
exception would treat unrelated purchasers of an API in an inequitable 
fashion, and that continued treatment of the partnership interest as an 
API is inconsistent with the purpose of section 1061 as unrelated 
purchasers did not receive their interest in connection with the 
performance of substantial services. Relative to the no-action 
baseline, the proposed guidance also provides clarity for taxpayers, 
improving economic efficiency as discussed in the Summary of Economic 
Effects.
c. Capital Interest Exception
    Section 1061(c)(4)(B) provides that the definition of an API does 
not include ``any capital interest in the partnership which provides 
the taxpayer with a right to share in partnership capital commensurate 
with--(i) the amount of capital contributed (determined at the time of 
receipt of such partnership interest) or (ii) the value of the interest 
included in income under section 83 upon the receipt or vesting of such 
interest.'' Comments received by the Treasury Department and the IRS 
identify two sources of ambiguity with regard to this capital interest 
exception (see footnote 1).
    First, there is uncertainty among taxpayers whether unrealized 
capital gains with respect to an API (unrealized API gains) can be 
converted to gains that would qualify for the capital interest 
exception. The proposed regulations clarify that unrealized API gains 
cannot be converted to gains that qualify for the capital interest 
exception. In the absence of this regulation, a significant share of 
taxpayers could potentially avoid section 1061 recharacterization when 
capital gains with respect to an API are realized if the partnership 
revalues assets prior to realization, and unrealized API gains are 
converted to gains that would qualify for the capital interest 
exception. A majority of owner taxpayers could use this avoidance 
strategy if it were available. The availability of this avoidance 
strategy would distort taxpayer behavior, incentivizing complex tiered 
ownership strategies, and distorting decisions to revalue assets. 
Furthermore, allowing this avoidance strategy would be contrary to the 
purposes of section 1061. The statute requires that the Secretary issue 
such regulations or other guidance as is necessary or appropriate to 
carry out the purposes of section 1061. Both the Conference Report and 
the Joint Committee on Taxation's background on 1061, Joint Committee 
on Taxation, General Explanation of Public Law 115-97 (JCS-1-18) at 125 
FN 542 (Dec. 20, 2018), specifically state that the statute requires 
that the Secretary issue regulations or other guidance to address the 
prevention of abuse of the purpose of the provision.
    Second, the statute does not provide guidance on what it means for 
a right to share in partnership capital to be ``commensurate'' with the 
amount of capital contributed. Comments received by the Treasury 
Department and the IRS identify this as a source of confusion among 
taxpayers with respect to section 1061 (see footnote 1). The proposed 
regulations clarify that allocations are deemed commensurate with 
capital contributed if they are made with respect to the taxpayer's 
capital account. The taxpayer's capital account includes realized but 
undistributed gains on contributed capital, and any contributions to 
capital made after the interest was received. In the absence of these 
regulations, taxpayers who have made capital contributions after the 
interest was initially received, or taxpayers who made a capital 
contribution that appreciated in value, might face confusion regarding 
their ability to include the additional contribution when determining 
the value of their capital interest. Further, partners with realized 
gains would be incentivized to engage in a series of inefficient 
transactions, first receiving a distribution reflecting those gains and 
then contributing the distributed amount back into the partnership in 
order to minimize tax.
    The Treasury Department and the IRS considered alternative 
interpretations of ``commensurate with capital contributed,'' including 
a narrow interpretation of the statute to mean only the value of 
capital contributed on the date the interest was initially received. 
However, it was determined that the interpretation presented in the 
proposed regulations is the only viable interpretation that accurately 
reflects the value of capital. Therefore, the proposed regulations 
provide helpful guidance and certainty for taxpayers but are not 
expected to result in any other economic effects.
d. Lookthrough Rule on Sale of APIs
    Section 1061(a) provides that if one or more APIs are held by a 
taxpayer at any time during the taxable year, the excess (if any) of 
(1) the taxpayer's net long-term capital gain with respect to such 
interests for such taxable year, over (2) the taxpayer's net long-term 
capital gain with respect to such interests for that taxable year 
computed by applying paragraphs (3) and (4) of sections 1222 by 
substituting ``3 years'' for ``1 year,'' must be treated as short-term 
capital gain, notwithstanding section 83 or any election in effect 
under section 83(b). The House Report explains that section 1061 
``imposes a three-year holding period (not the generally applicable 
one-year holding period) in the case of long-term capital gain from 
applicable partnership interests.'' Neither section 1061 nor the 
Reports, however, explicitly provides what the relevant holding period 
is for purposes of section 1061(a) for the sale of an API with assets 
of different holding periods. Comments received by the Treasury 
Department and the IRS highlight significant ambiguity, outlining 
multiple interpretations that would result in different amounts of gain 
recharacterized by taxpayers (see footnote 1).
    Pursuant to its regulatory authority to prevent inappropriate 
avoidance of section 1061, the proposed regulations include a limited 
lookthrough rule that is applied to the sale of an API that has been 
held for more than three years at the time of the disposition. The 
Lookthrough Rule only applies if 80 percent or more of the value of the 
assets held by the partnership at the time of the API disposition are 
assets held for three years or less that would produce capital gain or 
loss subject to section 1061 if disposed of by the partnership. If the 
Lookthrough Rule applies, a percentage of the gain or loss on the 
disposition of the API that is included in the one year disposition 
amount is not included in the three year disposition amount.
    The calculations required by the Lookthrough Rule will impose some 
additional compliance burden on individual taxpayers selling an API. 
The rules requiring partnerships to furnish taxpayers with the relevant 
information to perform the calculations will also impose additional 
burden on the relevant partnerships. The Treasury Department and the 
IRS believe only a small fraction of API holders will be affected by 
these requirements in any year. This rule has limited applicability 
because it only applies to taxpayers that sell their interest during 
the taxable year

[[Page 49773]]

and that at the time of the sale have held their API more than three 
years. Additionally, 80 percent of the value of the assets of the 
partnership in which the API being sold is held must have a holding 
period to the partnership that is three years or less. The Treasury 
Department and the IRS have determined that the Lookthrough Rule is 
necessary to prevent inappropriate avoidance of section 1061.
    The Treasury Department and the IRS considered and rejected 
alternative approaches outlined in received comments, including 
applying an interest approach with no Lookthrough Rule, and an 
underlying assets approach. The interest approach with no Lookthrough 
Rule looks solely to the holding period in the API, regardless of the 
holding period of the assets held by the partnership that would produce 
capital gain or loss on disposition. This approach would allow 
taxpayers to avoid section 1061 characterization for long-term capital 
gains on assets that are not held for the more than three years by the 
partnership. This result would encourage distortive behavior in 
investment funds, which might look to create partnerships for different 
investors solely for tax purposes. That is, the partners of that 
investment partnership would not be subject to section 1061 if they had 
owned their APIs for more than three years, irrespective of how long 
the investment partnership had held an asset that it sold.
    Alternatively, the underlying asset, or full Lookthrough, approach 
looks solely to the holding period in the underlying asset (or assets) 
of the partnership, regardless of whether the underlying asset is sold 
by the partnership or the API is sold by its owner. The proposed 
regulations only apply the Lookthough Rule if substantially all of the 
partnership's assets by value are assets held for three years or less 
and that would produce on disposition capital gain or loss not 
described in Sec.  1.1061-4(b)(6). The underlying asset approach would 
be more difficult (and burdensome) for taxpayers to apply as it would 
require a determination of the unrealized gain for each asset held by 
the partnership, even in cases in which a relatively small share of 
assets by value have a holding period of three years or less. We 
anticipate many taxpayers would be able to avoid burdensome valuation 
of assets and identification of holding periods under the limited 
Lookthrough rule but would be required to value each asset under the 
full Lookthrough rule.

II. Paperwork Reduction Act

    The collection of information contained in this notice of proposed 
rulemaking is in Sec.  1.1061-4(b)(7) and Sec.  1.1061-6.

A. Collection of Information Regarding Election To Exclude Partnership 
Transition Amounts in Sec.  1.1061-4(b)(7)

    The collection of information in proposed Sec.  1.1061-4(b)(7) 
requires a partnership that chooses to elect to exclude Partnership 
Transition Amounts from section 1061 to complete a statement making the 
election and to file the election with its federal tax return for the 
first taxable year that it treats amounts as Partnership Transition 
Amounts. It also requires the partnership, by the due date of the 
election, to clearly and specifically identify in its books and records 
the assets held by the partnership for more than three years as of the 
effective date of section 1061. This information is necessary for the 
IRS to determine whether the partnership has made the election and 
whether the partnership is correctly reporting capital gains and losses 
from all of the assets subject to the election.
1. Collection of Information on an Existing Form
    The partnership is required to attach the election statement to the 
Form 1065 filed for the partnership for the first taxable year that the 
partnership treats amounts as partnership transition amounts. For 
purposes of the Paperwork Reduction Act, the reporting burden 
associated with filing the election will be reflected in the Paperwork 
Reduction Act Submissions associated with Form 1065 (OMB 1545-0123).
2. Collection of Information Not on an Existing Form
    A partnership that elects to exclude Partnership Transition Amounts 
must maintain adequate books and records to verify that (i) the 
partnership's list of identified assets properly includes all assets 
that it has held for more than three years as of December 31, 2017; 
(ii) the partnership has treated all capital gains and losses from the 
sale of the identified assets consistent with proposed Sec.  1.1061-
4(b)(7); and, (iii) amounts allocated to API Holders have been 
determined consistent with Sec.  1.1061-4(b)(7). This collection of 
information in Sec.  1.1061-4(b)(7) is mandatory for taxpayers seeking 
to treat certain long-term capital gains as Partnership Transition 
Amounts. Partnerships seeking to rely on the exception from section 
1061 for Partnership Transition Amounts are generally hedge funds and 
private equity funds that would have held one or more capital assets 
more than three years as of December 31, 2017. The making a list of 
assets subject to the election is a one-time requirement. Annually, the 
partnership must maintain sufficient records to demonstrate that long-
term capital gains and losses from the disposition of the identified 
assets have been treated consistent with the requirements of Sec.  
1.1061-4(b)(7) and that API Holder Transition Amounts have been 
determined as provided in Sec.  1.1061-4(b)(7). The information 
required to be maintained will be used by the IRS for tax compliance 
purposes. Estimates with respect to this recordkeeping burden are --
    Estimated total annual reporting burden: 34,375 hours.
    Estimated average annual burden hours per respondent: 2.75.
    Estimated average cost per respondent (in 2017 dollars): $261.31.
    Estimated number of respondents: 12,500.
    Estimated annual frequency of responses: Once.
    Based on these estimates, the annual three-year reporting burden 
for those electing to exclude Partnership Transition Amounts from 
section 1061 is $261.31 (in 2017 dollars).
    These estimates are based on the assumption that only a small 
number of hedge funds would have held assets more than three years as 
of December 31, 2017. We anticipate that the majority of private equity 
funds that were in existence for three years as of December 31, 2017 
will make the election. Private equity funds that were not in existence 
as of December 31, 2017 will not need to make the election. Once the 
election is made, electing funds will have to retain records to 
evidence compliance with Sec.  1.1061-4(b)(7).
    Comments on the collection of information that results from the 
recordkeeping requirement in Sec.  1.1061-4(b)(7) should be sent to the 
Office of Management and Budget, Attn: Desk Officer for the Department 
of Treasury, Office of Information and Regulatory Affairs, Washington, 
DC 20503, with copies to the Internal Revenue Service, Attn: IRS 
Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, Washington, DC 20224. 
Comments on the collection of information should be received by October 
5, 2020.
    Comments are specifically requested concerning:
    Whether the proposed collection of information is necessary for the 
performance of duties of the IRS,

[[Page 49774]]

including whether the information will have practical utility;
    The accuracy of the burden estimate associated with the proposed 
collection of information (including underlying assumptions and 
methodology);
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
    How the burden of complying with the proposed collection of 
information may be minimized, including through the application of 
automated collection techniques or other forms of information 
technology; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance and purchase of services to provide information.

B. Collection of Information in Sec.  1.1061-6(a) on the Owner Taxpayer 
Is on Existing Forms

    The collection of information in proposed Sec.  1.1061-6(a) 
requires an Owner Taxpayer to file such information with the IRS as the 
Commissioner may require in forms, instructions and other published 
guidance as is necessary for the IRS to determine that the taxpayer has 
properly complied with section 1061 and Sec. Sec.  1.1061-1 through 
1.1061-5 of the proposed regulations. This information is necessary for 
the IRS to determine that the Owner Taxpayer has properly complied with 
section 1061. In general, the Owner Taxpayer is an individual and the 
Owner Taxpayer's Recharacterization Amount will be required to be 
reported to the IRS as short term capital gain on Schedule D, ``Capital 
Gains and Losses,'' of the Form 1040, ``U.S. Individual Income Tax 
Return.'' Less frequently, the Owner Taxpayer is a trust and the Owner 
Taxpayer's Recharacterization Amount will be required to be reported to 
the IRS as short term capital gain on Schedule D, ``Capital Gains and 
Losses,'' of the Form 1041, ``U.S. Income Tax Return for Estates and 
Trusts.''
    The current status of the Paperwork Reduction Action submission 
related to Sec.  1.1061-6(a) is provided in the following table. The 
burdens associated with the collection of information from the Owner 
Taxpayer to comply with section 1061 will be included in the aggregate 
burden estimates for Form 1040 under OMB control number 1545-0074 and 
Form 1041 under OMB control number 1545-0092. The overall burden 
estimates provided in OMB Control Number 1545-0074 represents a total 
estimated burden time, including all other related forms and schedules 
for individuals, of 1.784 billion hours and total estimated monetized 
costs of $31.74 billion (in 2017 dollars). The overall burden estimates 
provided in OMB Control Number 1545-0092 represents a total estimated 
burden time, including all other forms and schedules for trusts and 
estates of 307.8 million hours and total estimated monetized costs of 
$9.95 billion (in 2016 dollars). These amounts are aggregate amounts 
that relate to all information collections associated with the 
applicable OMB control numbers, and will in the future include, but not 
isolate, the estimated burden of Owner Taxpayers as a result of the 
information collections in the proposed regulations. No burden 
estimates specific to the proposed regulations are currently available. 
The Treasury Department and IRS have not estimated the burden, 
including that of any new information collections, related to the 
requirements under the proposed regulations. Those estimates would 
capture both changes made by the TCJA and those that arise out of 
discretionary authority exercised in the proposed regulations. The 
Treasury Department and the IRS request comments on all aspects of 
information collection burdens related to the collection of information 
applicable to the Owner Taxpayer in the proposed regulations. In 
addition, when available, drafts of IRS forms are posted for comment at 
www.irs.gov/draftforms.

----------------------------------------------------------------------------------------------------------------
                 Form                         Type of filer          OMB No(s).                Status
----------------------------------------------------------------------------------------------------------------
Form 1040 (Including Schedule D)......  Individual (NEW Model)...       1545-0074  Published in the Federal
                                                                                    Register on 9/30/19. Comment
                                                                                    period closed on 11/29/19.
                                                                                    84 FR 51712. Thirty-day
                                                                                    notice published on 12/18/
                                                                                    19. 84 FR 69458. Approved by
                                                                                    OIRA on 1/30/20.
Form 1041 (Including Schedule D)......  Trusts and Estates              1545-0092  Published in the Federal
                                         (Legacy Model).                            Register on 4/4/2018. 83 FR
                                                                                    14552. Public comment period
                                                                                    closed 6/4/2018. Thirty-day
                                                                                    notice published on 9/27/18.
                                                                                    83 FR 48894. Approved by
                                                                                    OIRA on 5/8/19.
----------------------------------------------------------------------------------------------------------------

C. Collection of Information on Passthrough Entities in Sec.  1.1061-
6(b) and (c) on Existing forms

1. Passthrough Entities
    The collection of information in proposed Sec.  1.1061-6(b) 
requires a Passthrough Entity that has issued an API to furnish to the 
API Holder, including the Owner Taxpayer, such information at such time 
and in such manner as the Commissioner may require in forms, 
instructions, and other published guidance as is necessary to determine 
the One Year Gain amount and the Three Year Gain Amount with respect to 
an Owner Taxpayer. This includes: (i) The API One Year Distributive 
Share Amount and the API Three Year Distributive Share Amount (as 
determined under Sec.  1.1061-4); (ii) Capital gains and losses 
allocated to the API Holder that are excluded from section 1061 under 
Sec.  1.1061-4(b)(6); (iii) Capital Interest Gains and Losses allocated 
to the API Holder (as determined under Sec.  1.1061-3(c)); (iv) In the 
case of a disposition by the API Holder of an interest in the 
Passthrough Entity during the taxable year, any information required by 
the API Holder to properly take the disposition into account under 
section 1061, including information to apply the Lookthrough Rule and 
to determine its Capital Interest Disposition Amount. The proposed 
regulations seek to minimize the information that a Passthrough Entity 
is required to automatically furnish annually. In some cases, an upper 
tier Passthrough Entity may be an API Holder in a lower tier 
Passthrough Entity, and the information furnished by the lower tier 
Passthrough Entity to the upper tier Passthrough Entity may not be 
sufficient for the upper tier Passthrough Entity to meet its reporting 
obligations under the regulations. In this case, the proposed 
regulations require the lower tier Passthrough Entity to furnish 
information to the upper tier Passthrough Entity if requested. Thus, if 
an upper tier Passthrough Entity in a tiered entity structure holds an 
interest in a lower tier Passthrough Entity and it needs information 
from the lower tier Passthrough Entity to comply with its obligation to 
furnish information under the proposed regulations, it must request 
information from the lower tier entity and the lower tier entity must 
furnish the requested information. This passing of information upon 
request

[[Page 49775]]

between the tiers of entities is necessary to minimize the quantity of 
information required to be annually furnished by a Passthrough Entity 
and because each Passthrough Entity in a tiered entity arrangement is 
the only entity that has access to the information that is required to 
be furnished. The collection of information in the proposed regulations 
is necessary to ensure that the Owner Taxpayer receives information 
sufficient to correctly calculate its Recharacterization Amount under 
section 1061.
2. RICs and REITs
    Section 1.1061-6(c) permits a RIC or a REIT that reports or 
designates all or a part of a dividend as a capital gain dividend, to 
disclose additional information to their shareholders for purposes of 
section 1061. The furnishing of this information may allow a 
Passthrough Entity to include a portion of the capital gain dividend in 
the API Three Year Distributive Share amount furnished to API Holders 
and may ultimately enable an Owner Taxpayer to reduce its 
Recharacterization Amount under the proposed regulations.
3. Table for Collections of Information in Sec.  1.1061-6(b) and (c)
    The collection of information with respect to Sec.  1.1061-6(b) and 
(c) is provided in the following table. In the case of a Passthrough 
Entity that is a partnership, the information will be required to be 
furnished as an attachment to the Schedule K-1, ``Partner's Share of 
Income, Deduction, Credit, Etc.'' of Form 1065, ``U.S. Return of 
Partnership Income.'' In the case of a Passthrough Entity that is an S 
corporation, the information will be required to be furnished as an 
attachment to the Schedule K-1, ``Shareholder's Share of Income, 
Deductions, Credit, Etc.,'' of Form 1120-S, ``U.S. Income Tax Return 
for an S Corporation.'' The burdens associated with the collection of 
information from the Passthrough Entities will be included in the 
aggregate burden estimates for the Form 1065 and the Form 1120S under 
OMB control number 1545-0123. The overall burden estimates provided in 
OMB Control Number 1545-0123 represents a total estimated burden time, 
including all others related forms and schedules, of 3.157 billion 
hours and total estimated monetized costs of $58.148 billion (in 2017 
dollars). The burden estimates provided in OMB Control Number 1545-0123 
are aggregate amounts that relate to all information collections 
associated with the applicable OMB control number, and will in the 
future include, but not isolate, the Passthrough Entities' estimated 
burden as a result of the information collections in the proposed 
regulations.
    In the case of RICs and REITs the information will be furnished in 
connection with the Form 1099-DIV, ``Dividends and Distributions.'' The 
burden estimates associated with the collection of information from 
RICs and REITs will be included in the aggregate burden estimated for 
the Form 1099-DIV under OMB Control Number 1545-0110. The overall 
burden estimates provided in OMB Control Number 1545-0110 represents a 
total estimated burden time of 32,119,195 hours and total estimated 
monetized costs of $1.64 billion (in 2016 dollars). The burden 
estimates provided in OMB Control Number 1545-0110 relate to all 
information collections associated with the applicable OMB Control 
Number, and will in the future include, but not isolate, the RIC and 
REIT estimated burden as a result of the information collections in the 
proposed regulations.
    With the exception of the burden estimate provided with respect to 
the recordkeeping requirement related to the Partnership Transition 
amount election in Sec.  1.1061-4(b)(7), no burden estimates specific 
to the proposed regulations are currently available. The Treasury 
Department and IRS have not estimated the burden, including that of any 
new information collections, related to the requirements under the 
proposed regulations. Those estimates would capture both changes made 
by the TCJA and those that arise out of the discretionary authority 
exercised in the proposed regulations. The Treasury Department and the 
IRS request comments on all aspects of information collection burdens 
related to the collection of information applicable to the Passthrough 
Entities in the proposed regulations. In addition, when available, 
drafts of IRS Forms and the applicable instructions are posted for 
comment at https://www.irs.gov/pub/irs-dft/.

----------------------------------------------------------------------------------------------------------------
                 Form                         Type of filer          OMB No(s).                Status
----------------------------------------------------------------------------------------------------------------
Form 1065 (including Schedule K-1)....  Business (NEW Model).....       1545-0123  Sixty-day notice published in
                                                                                    the Federal Register on 9/30/
                                                                                    19. Public Comment period
                                                                                    closed on 11/29/19. 84 FR
                                                                                    51718. Thirty-day notice
                                                                                    published in the Federal
                                                                                    Register on 12/19/19. Public
                                                                                    Comment period closed on 1/
                                                                                    21/20. 84 FR 69825. Approved
                                                                                    by OIRA on 1/30/20.
Form 1120S (Including Schedule K-1)...  Business (New Model).....       1545-0123  Sixty-day notice published in
                                                                                    the Federal Register on 9/30/
                                                                                    19. Public Comment period
                                                                                    closed on 11/29/19.
                                                                                   84 FR 51718. Thirty-day
                                                                                    notice published in the
                                                                                    Federal Register on 12/19/
                                                                                    19. Public Comment period
                                                                                    closed on 1/21/20. 84 FR
                                                                                    69825. Approved by OIRA on 1/
                                                                                    30/20.
Form 1099-DIV.........................  (Legacy Model)...........       1545-0110  Sixty-day notice published in
                                                                                    the Federal Register on 9/19/
                                                                                    19. Public comment period
                                                                                    closed 11/18/19.
                                                                                   84 FR 49379. Thirty-day
                                                                                    notice published in the
                                                                                    Federal Register on 12/20/
                                                                                    19. 84 FR 70269.
                                       -------------------------------------------------------------------------
                                        Link: https://www.FederalRegister.gov/documents/2018/05/23/2018-10981/proposed-collection-comment-request-for-form-1099-div.
----------------------------------------------------------------------------------------------------------------

D. Chart Showing Number of Respondents Regarding Existing Forms

    The following chart shows the estimated number of returns that are 
expected to have attachments providing additional information with 
respect to section 1061. As noted above, Owner Taxpayers will be 
required to provide section 1061 information on an attachment to 
Schedules D for Forms 1040 and 1041. Passthrough Taxpayers will be 
required to report section 1061 on Forms 1065 and 1120S to the IRS and 
to furnish information to their API Holders on attachments to the 
respective K-1s. RICs and REITs may voluntarily report additional 
information at an attachment to Form 1099-DIV.

 
 
 
Schedule D Form 1040.......................................       20,475

[[Page 49776]]

 
Schedule D Form 1041.......................................        2,275
Schedule K Form 1065.......................................       28,500
Schedule K-1s Form 1065....................................       57,000
Schedule K Form 1120S......................................        1,500
Schedule K-1s Form 1120....................................        1,000
Form 1099-DIV filed by REITs...............................          836
Form 1099-DIV filed by RICs................................        3,880
 

E. Voluntary Collection of Information in Sec.  1.1061-6(d) on PFIC 
Shareholder Will Be Added to Existing OMB Control Number for PFIC 
Information Retention

    Section 1.1061-6(d) permits a PFIC with respect to which the 
shareholder is an API Holder who has a QEF election is in effect for 
the taxable year to provide additional information to the shareholder 
to determine the amount of the shareholder's inclusion that would be 
included in the API One Year Distributive Share Amount and the API 
Three Year Distributive Share Amount. If the PFIC furnishes this 
information to the shareholder, the shareholder must retain a copy of 
this information along with the other information required to be 
retained under Sec.  1.1295-1(f)(2)(ii). The burden associated with 
retaining this additional information will be included in the aggregate 
burden estimates for Sec.  1.1295-1(f) under OMB Control Number 1545-
1555. 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 and records related to the 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 26 U.S.C. 6103.

III. Regulatory Flexibility Act

    It is hereby certified that these regulations will not have a 
significant economic impact on a substantial number of small entities 
within the meaning of section 601(6) of the Regulatory Flexibility Act 
(5 U.S.C. chapter 6). These regulations generally only impact 
investment funds that have capital gains and losses that derive from 
the disposition of assets that have a holding period of more than one 
year but not more than three years.
    Investment funds are considered small business if they have annual 
average receipts of $41.5 million or less (13 CFR 121). The rule may 
affect a substantial number of small entities, but data are not readily 
available to assess how many entities will be affected.
    Even if a substantial number of small entities are affected, the 
economic impact of these regulations on small entities is not likely to 
be significant. The proposed regulations provide taxpayers with 
definitional and computational guidance regarding the application of 
section 1061. The impact of the regulations is to impose an additional 
reporting obligation that applies only with respect to the sale of 
assets held for more than one year but not more than three years. The 
Treasury Department and the IRS recognize that this reporting 
obligation may increase, at least to some extent, the tax preparation 
burden for affected taxpayers beyond that imposed by the statute. This 
reporting obligation generally will only apply to a minority of the 
asset dispositions by an entity. The entity will also have a reporting 
obligation in certain circumstances regarding the disposition of an 
API, but the extent of the reporting obligation depends on the number 
of assets held by the entity and their holding periods. The information 
reported is readily available to taxpayers and reported on forms 
already in use beginning with the 2019 tax year. Finally, some 
taxpayers may find they need an initial investment of time to read and 
understand these regulations at an approximate cost of $95/hour and an 
estimated time of ten hours.
    Notwithstanding this certification, the Treasury Department and the 
IRS invite comments on any impact this rule would have on small 
entities.

IV. Unfunded Mandates Reform Act

    Section 202 of the Unfunded Mandates Reform Act of 1995 requires 
that agencies assess anticipated costs and benefits and take certain 
other actions before issuing a final rule that includes any Federal 
mandate that may result in expenditures in any one year by a state, 
local, or tribal government, in the aggregate, or by the private 
sector, of $100 million in 1995 dollars, updated annually for 
inflation. This rule does not include any Federal mandate that may 
result in expenditures by state, local, or tribal governments, or by 
the private sector in excess of that threshold.

V. Executive Order 13132: Federalism

    Executive Order 13132 (entitled ``Federalism'') prohibits an agency 
from publishing any rule that has federalism implications if the rule 
either imposes substantial, direct compliance costs on state and local 
governments, and is not required by statute, or preempts state law, 
unless the agency meets the consultation and funding requirements of 
section 6 of the Executive Order. This rule does not have federalism 
implications and does not impose substantial direct compliance costs on 
state and local governments or preempt state law within the meaning of 
the Executive Order.

Statement of Availability of IRS Documents

    Notice 2018-18, 2018-2 I.R.B. 443 (in addition to any other revenue 
procedures or revenue rulings, etc. cited in this preamble) is 
published in the Internal Revenue Bulletin (or Cumulative Bulletin) and 
is available from the Superintendent of Documents, U.S. Government 
Publishing Office, Washington, DC 20402, or by visiting the IRS website 
at https://www.irs.gov.

Comments and Requests for a Public Hearing

    Before these proposed amendments to the regulations are adopted as 
final regulations, consideration will be given to comments that are 
submitted timely to the IRS as prescribed in the preamble under the 
ADDRESSES section. The Treasury Department and the IRS request comments 
on all aspects of the proposed regulations. Any electronic comments 
submitted, and to the extent practicable any paper comments submitted, 
will be made available at www.regulations.gov or upon request.
    A public hearing will be scheduled if requested in writing by any 
person who timely submits electronic or written comments. Requests for 
a public hearing are also encouraged to be made electronically. If a 
public hearing is scheduled, notice of the date and time for the public 
hearing will be published in the Federal Register. Announcement 2020-4, 
2020-17 IRB 1, provides that until further notice, public hearings 
conducted by the IRS will be held telephonically. Any telephonic 
hearing will be made accessible to people with disabilities.

Drafting Information

    The principal author of these proposed regulations is Kara Altman 
of the Office of 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.

Proposed Amendment to the Regulations

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

[[Page 49777]]

PART 1--INCOME TAXES

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

    Authority:  26 U.S.C. 7805 * * *
    Sections 1.1061-0 through 1.1061-6 are added under 26 U.S.C. 
1061(f). * * *

0
Par. 2. Section 1.702-1 is amended by adding a sentence at the end of 
paragraph (a)(2) and adding paragraph (g) to read as follows.


Sec.  1.702-1   Income and credits of partner.

    (a) * * *
    (2) * * * Each partner subject to section 1061 shall take into 
account gains and losses from sales of capital assets held for more 
than one year as provided in that section and Sec. Sec.  1.1061-0 
through 1.1061-6.
* * * * *
    (g) Applicability date. The last sentence of paragraph (a)(2) of 
this section applies for the taxable years beginning on or after [DATE 
OF PUBLICATION OF THE FINAL RULE IN THE FEDERAL REGISTER].
0
Par. 3. Section 1.704-3 is amended by:
0
1. Redesignating paragraphs (e)(3)(vii), (viii), and (ix) as paragraphs 
(e)(3)(viii), (ix), and (x), respectively;
0
2. Adding new paragraph (e)(3)(vii);
0
3. Revising the subject heading and first sentence of paragraph (f) and 
adding a sentence to the end of paragraph (f).
    The additions and revisions read as follows:


Sec.  1.704-3   Contributed property.

* * * * *
    (e) * * *
    (3) * * *
    (vii) Application of section 1061--(A) In general. A partnership 
that is combining gains and losses from qualified financial assets 
under this paragraph (e)(3) will not be considered to be using a 
reasonable method if that method fails to take into account the 
application of section 1061 in an appropriate manner. If a partnership 
uses the partial netting approach described in paragraph (e)(3)(iv) of 
this section or the full netting approach described in paragraph 
(e)(3)(v) of this section (or another otherwise reasonable approach), 
the approach will not be considered reasonable if it does not 
appropriately take into account the application of section 1061 to any 
person who directly or indirectly holds an applicable partnership 
interest (API) (as defined in Sec.  1.1061-1(a)). To this end, if a 
partnership uses the partial or full netting approach, the partnership 
must establish appropriate accounts for the purpose of taking into 
account its book Unrealized API Gains and Losses and API Gains and 
Losses (as defined in Sec.  1.1061-1(a)) separate from the book Capital 
Interest Gains and Losses (as defined in Sec.  1.1061-1(a)) of an API 
Holder (as defined in Sec.  1.1061-1(a)) and determining the API 
Holder's share of taxable gains and losses that are API Gains and 
Losses and Capital Interest Gains and Losses.
    (B) Transition rule. If an API Holder holds an interest in a 
partnership as of January 1, 2018, the partnership may use any 
reasonable method to apportion existing accounts for the purpose of 
determining an API Holder's share of book Unrealized API Gains and 
Losses, API Gains and Losses, and book Capital Interest Gains and 
Losses and for determining an API Holder's share of tax API Gains and 
Losses and tax Capital Interest Gains and Losses.
* * * * *
    (f) Applicability dates. With the exception of paragraphs (a)(1), 
(a)(8)(ii) and (iii), (a)(10) and (11), and (e)(3)(vii) of this 
section, and of the last sentence of paragraph (d)(2) of this section, 
this section applies to properties contributed to a partnership and to 
restatements pursuant to Sec.  1.704-1(b)(2)(iv)(f) on or after 
December 21, 1993. * * * Paragraph (e)(3)(vii) of this section applies 
to taxable years beginning on or after [DATE OF PUBLICATION OF THE 
FINAL RULE IN THE FEDERAL REGISTER].
0
Par. 4. Sections 1.1061-0 through 1.1061-6 are added before the 
undesignated center heading ``Changes to Effectuate F.C.C. Policy'' to 
read as follows:
Sec.
* * * * *
1.1061-0 Table of contents.
1.1061-1 Section 1061 Definitions.
1.1061-2 Applicable partnership interests and applicable trades or 
businesses.
1.1061-3 Exceptions to the definition of an API.
1.1061-4 Section 1061 computations.
1.1061-5 Section 1061(d) transfers to related persons.
1.1061-6 Reporting rules.
* * * * *


Sec.  1.1061-0  Table of contents.

    This section lists the captions that appear in Sec. Sec.  1.1061-1 
through 1.1061-6.

Sec.  1.1061-1 Section 1061 Definitions.

    (a) Definitions.
    (b) Applicability date.

Sec.  1.1061-2 Applicable partnership interests and applicable 
trades or businesses.

    (a) API rules and examples.
    (1) Rules.
    (i) An API remains as an API.
    (ii) Unrealized API Gains and Losses.
    (A) Long-term Unrealized API Gains and Losses become API Gains 
and Losses.
    (B) Requirement to determine Unrealized API Gains and Losses.
    (iii) API Gains and Losses retain their character.
    (iv) Substantial services by the Owner Taxpayer, Passthrough 
Taxpayer or any Related Person.
    (v) Grantor trusts and entities disregarded as separate from 
their owners.
    (2) Examples.
    (b) Application of the ATB Activity Test.
    (1) In general.
    (i) Rules for applying the ATB Activity Test.
    (A) Aggregate Specified Actions taken into account.
    (B) Raising or Returning Capital Actions and Investing or 
Developing Actions are not both required to be taken each year.
    (C) Combined conduct by multiple related entities taken into 
account.
    (ii) Developing Specified Assets.
    (iii) Partnerships.
    (2) Examples.
    (c) Applicability date.

Sec.  1.1061-3 Exceptions to the definition of an API.

    (a) A partnership interest held by an employee of another entity 
not conducting an ATB.
    (b) Partnership interest held by a corporation.
    (1) In general.
    (2) Treatment of interests held by an S corporation or a 
qualified electing fund.
    (c) Capital Interest Gains and Losses.
    (1) In general.
    (2) Capital Interest Gains and Losses Defined.
    (3) General rules for determining Capital Interest Allocations 
and Passthrough Interest Capital Allocations.
    (i) Allocations made in the same manner.
    (ii) Capital accounts.
    (A) In general.
    (B) Tiers.
    (C) Proceeds of partnership or partner loans not included in 
capital account.
    (iii) Items that are not included in Capital Interest 
Allocations or Passthrough Interest Capital Allocations.
    (4) Capital Interest Allocations.
    (5) Passthrough Interest Capital Allocations.
    (i) In general.
    (ii) Passthrough Capital Allocations.
    (iii) Passthrough Interest Direct Investment Allocations.
    (6) Capital Interest Disposition Amounts.
    (i) In general.
    (ii) Determination of the Capital Interest Disposition Amount.
    (7) Examples.
    (d) Partnership interest acquired by purchase by an unrelated 
taxpayer.
    (1) Taxpayer is not a Related Person.
    (2) Section 1061(d) not applicable.
    (3) Taxpayer not a service provider.
    (e) [Reserved]
    (f) Applicability date.

[[Page 49778]]

    (1) General rule.
    (2) Section 1.1061-3(b)(2)(i) exception.
    (3) Section 1.1061-3(b)(2)(ii) exception.

Sec.  1.1061-4 Section 1061 computations.

    (a) Computations.
    (1) Recharacterization Amount.
    (2) One Year Gain Amount and Three Year Gain Amount.
    (i) One Year Gain Amount.
    (ii) Three Year Gain Amount.
    (3) API One Year Distributive Share Amount and Three Year 
Distributive Share Amount.
    (i) API One Year Distributive Share Amount.
    (ii) API Three Year Distributive Share Amount.
    (4) API One Year Disposition Amount and Three Year Disposition 
Amount.
    (i) API One Year Disposition Amount.
    (ii) API Three Year Disposition Amount.
    (b) Special rules for calculating the One Year Gain Amount and 
the Three Year Gain Amount.
    (1) One Year Gain Amount equals zero or less.
    (2) Three Year Gain Amount equals zero or less.
    (3) Installment sale gain.
    (4) Special rules for capital gain dividends from regulated 
investment companies (RICs) and real estate investment trusts 
(REITs).
    (i) API One Year Distributive Share Amount.
    (ii) API Three Year Distributive Share Amount.
    (iii) Loss on sale or exchange of stock.
    (5) Pro rata share of qualified electing fund (QEF) net capital 
gain.
    (i) One year QEF net capital gain.
    (ii) Three year QEF net capital gain.
    (6) Items not taken into account for purposes of section 1061.
    (7) API Holder Transition Amounts not taken into account.
    (i) In general.
    (ii) API Holder Transition Amount.
    (iii) Partnership Transition Amounts and Partnership Transition 
Amount Election.
    (8) Holding period determination.
    (i) Determination of holding period for purposes of Three Year 
Gain Amount.
    (ii) Relevant holding period.
    (9) Lookthrough Rule for certain API dispositions.
    (i) Determination that the Lookthrough Rule Applies.
    (ii) Application of the Lookthrough Rule.
    (10) Section 83.
    (c) Examples.
    (1) Computation examples.
    (2) Special rules examples.
    (d) Applicability date.

Sec.  1.1061-5 Section 1061(d) transfers to related persons.

    (a) In general.
    (b) Transfer.
    (c) Application of paragraph (a) of this section.
    (1) Determination of amounts included in paragraph (a)(1) of 
this section.
    (2) Application to an otherwise taxable transfer.
    (d) Basis of interest increased by additional gain recognized.
    (e) Section 1061(d) Related Person.
    (1) In general.
    (2) Exception.
    (f) Examples.
    (g) Applicability date.

Sec.  1.1061-6 Reporting rules.

    (a) Owner Taxpayer Filing Requirements.
    (b) Passthrough Entity Filing Requirements and Reporting.
    (1) Requirement to file information with the IRS and to furnish 
information to API Holder.
    (2) Requirement to request, furnish, and file information in 
tiered structures.
    (i) Requirement to request information.
    (ii) Requirement to furnish and file information.
    (iii) Timing of requesting and furnishing information.
    (iv) Manner of requesting information.
    (v) Recordkeeping requirement.
    (vi) Passthrough Entity is not Furnished Information to meet its 
Reporting Obligations under paragraph (b)(1) of this section.
    (vii) Penalties.
    (c) Regulated investment company (RIC) and real estate 
investment trust (REIT) reporting.
    (1) Section 1061 disclosures.
    (i) One Year Amounts Disclosure.
    (ii) Three Year Amounts Disclosure.
    (2) Pro rata disclosures.
    (3) Report to shareholders.
    (d) Qualified electing fund (QEF) reporting.
    (e) Applicability date.


Sec.  1.1061-1  Section 1061 Definitions.

    (a) Definitions. The following definitions apply solely for 
purposes of this section and Sec. Sec.  1.1061-2 through 1.1061-6.
    Applicable Partnership Interest (API) means any interest in a 
partnership which, directly or indirectly, is transferred to (or is 
held by) an Owner Taxpayer or Passthrough Taxpayer in connection with 
the performance of substantial services by the Owner Taxpayer or by a 
Passthrough Taxpayer, or by any Related Person, including services 
performed as an employee, in any ATB unless an exception in Sec.  
1.1061-3 applies. For purposes of defining an API under this section 
and section 1061 of the Internal Revenue Code, an interest in a 
partnership also includes any financial instrument or contract, the 
value of which is determined in whole or in part by reference to the 
partnership (including the amount of partnership distributions, the 
value of partnership assets, or the results of partnership operations). 
An Owner Taxpayer and a Passthrough Taxpayer can hold an API directly 
or indirectly through one or more Passthrough Entities.
    API Gains and Losses are any long-term capital gains and capital 
losses with respect to an API and include:
    (i) The API One Year Distributive Share Amount as defined in Sec.  
1.1061-4(a)(3)(i);
    (ii) The API Three Year Distributive Share Amount as defined in 
Sec.  1.1061-4(a)(3)(ii);
    (iii) The API One Year Disposition Amount as defined in Sec.  
1.1061-4(a)(4)(i);
    (iv) The API Three Year Disposition Amount as defined in Sec.  
1.1061-4(a)(4)(ii); and
    (v) Capital gains or losses from the disposition of Distributed API 
Property.
    API Holder is a person who holds an API.
    API Holder Transition Amount has the meaning provided in Sec.  
1.1061-4(b)(7)(ii).
    Applicable Trade or Business (ATB) means any activity for which the 
ATB Activity Test with respect to Specified Actions is met, and 
includes all Specified Actions taken by Related Persons, including 
combining activities occurring in separate partnership tiers or 
entities as one ATB.
    ATB Activity Test has the meaning provided in Sec.  1.1061-2(b)(1).
    Capital Interest Allocations has the meaning provided in Sec.  
1.1061-3(c)(4).
    Capital Interest Disposition Amount has the meaning provided in 
Sec.  1.1061-3(c)(6).
    Capital Interest Gains and Losses has the meaning provided in Sec.  
1.1061-3(c)(2).
    Distributed API Property means property distributed by a 
Passthrough Entity to an API Holder with respect to an API if the 
holding period, as determined under sections 735 and 1223, in the API 
Holder's hands is three years or less at the time of disposition of the 
property by the API Holder.
    Indirect API means an API that is held through one or more 
Passthrough Entities.
    Investing or Developing Actions means actions involving either--
    (i) Investing in (or disposing of) Specified Assets (or identifying 
Specified Assets for such investing or disposition), or
    (ii) Developing Specified Assets (see Sec.  1.1061-2(b)(1)(ii)).
    Lookthrough Rule has the meaning provided in Sec.  1.1061-4(b)(9).
    One Year Gain Amount has the meaning provided in Sec.  1.1061-
4(a)(2)(i).
    Owner Taxpayer means the person subject to Federal income tax on 
net gain with respect to an API or an Indirect API during the taxable 
year, including an owner of a Passthrough Taxpayer unless the owner of 
the Passthrough Taxpayer is a Passthrough Entity itself or is excepted 
under Sec.  1.1061-3(a), (b), or (d).

[[Page 49779]]

    Partnership Transition Amount has the meaning provided in Sec.  
1.1061-4(b)(7)(iii).
    Passthrough Capital Allocations has the meaning provided in Sec.  
1.1061-3(c)(5)(ii).
    Passthrough Entity means a partnership, an S corporation described 
in Sec.  1.1061-3(b)(2)(i), or passive foreign investment company 
described in Sec.  1.1061-3(b)(2)(ii).
    Passthrough Interest means an interest in a Passthrough Entity that 
represents in whole or in part an API.
    Passthrough Interest Capital Allocations has the meaning provided 
in Sec.  1.1061-3(c)(5)(i).
    Passthrough Interest Direct Investment Allocations has the meaning 
provided in Sec.  1.1061-3(c)(5)(iii).
    Passthrough Taxpayer means a Passthrough Entity that is treated as 
a taxpayer for the purpose of determining the existence of an API.
    Raising or Returning Capital Actions means actions involving 
raising or returning capital but does not include Investing or 
Developing Actions.
    Recharacterization Amount has the meaning provided in Sec.  1.1061-
4(a)(1).
    Related Person means a person or entity who is treated as related 
to another person or entity under sections 707(b) or 267(b).
    Relevant ATB means the ATB in which services were provided and in 
connection with which an API is held or was transferred.
    Section 1061(d) Related Person has the meaning provided in Sec.  
1.1061-5(e).
    Specified Actions means Raising or Returning Capital Actions and 
Investing or Developing Actions.
    Specified Assets means--
    (i) Securities, including interests in partnerships qualifying as 
securities (as defined in section 475(c)(2) without regard to the last 
sentence thereof);
    (ii) Commodities (as defined in section 475(e)(2));
    (iii) Real estate held for rental or investment;
    (iv) Cash or cash equivalents; and
    (v) An interest in a partnership to the extent that the partnership 
holds Specified Assets. See Sec.  1.1061-2(b)(1)(iii).
    (vi) Specified Assets include options or derivative contracts with 
respect to any of the foregoing.
    Substantially All Test has the meaning provided in Sec.  1.1061-
4(b)(9)(i)(C).
    Three Year Gain Amount has the meaning provided in Sec.  1.1061-
4(a)(2)(ii).
    Unrealized API Gains and Losses means all unrealized capital gains 
and losses, (including both short-term and long-term), that would be 
allocated to an API Holder with respect to its API, if all relevant 
assets were disposed of for fair market value in a taxable transaction 
on the relevant date. Unrealized API Gains and Losses include--
    (i) Unrealized capital gains and losses that are allocated to the 
API Holder with respect to the API pursuant to a capital account 
revaluation under Sec.  1.704-1(b)(2)(iv)(f) or Sec.  1.704-
1(b)(2)(iv)(s);
    (ii) In the case of a Passthrough Entity that contributes property 
to another Passthrough Entity, unrealized capital gains and losses that 
would be allocated to the API Holder with respect to the API if the 
property contributed by the upper-tier Passthrough Entity to the lower-
tier Passthrough Entity were sold immediately before the contribution 
for the amount that is included in the lower-tier partnership's capital 
account or, in the case of another type of lower-tier Passthrough 
Entity, a similar account maintained under Sec.  1.1061-3(c)(3)(ii) 
with respect to the contributed property; and
    (iii) In the case of a revaluation of the property of a partnership 
that is the owner of a tiered structure of partnerships or in the case 
of the contribution of an API to another Passthrough Entity, an API 
Holder's Unrealized API Gains or Losses at the time of the revaluation 
or contribution include those capital gains or losses that would be 
allocated directly or indirectly to the API Holder by the lower-tier 
partnerships as if a taxable disposition of the property of each of the 
lower-tier partnerships also occurred on the date of the revaluation or 
contribution under the principles of Sec.  1.704-1(b)(2)(iv)(f). See 
Sec.  1.1061-2(a)(1)(ii)(B).
    Unrelated Non-Service Partners mean partners who do not (and did 
not) provide services in the Relevant ATB and who are not (and were 
not) related to any API Holder in the partnership or any person who 
provides or has provided services in the Relevant ATB.
    (b) Applicability date. The provisions of this section apply to 
taxable years of Owner Taxpayers and Passthrough Entities beginning on 
or after [DATE OF PUBLICATION OF THE FINAL RULE IN THE FEDERAL 
REGISTER].


Sec.  1.1061-2   Applicable partnership interests and applicable trades 
or businesses.

    (a) API rules and examples--(1) Rules--(i) An API remains as an 
API. Once a partnership interest qualifies as an API, the partnership 
interest remains an API unless and until the requirements of one of the 
exceptions to qualification of a partnership interest as an API, set 
forth in Sec.  1.1061-3, are satisfied.
    (ii) Unrealized API Gains and Losses-(A) Long-term Unrealized API 
Gains and Losses become API Gains and Losses. Long-term Unrealized API 
Gains and Losses are API Gains and Losses subject to section 1061 when 
the gains and losses are realized and recognized. Unrealized API Gains 
and Losses do not lose their character as such until they are 
recognized.
    (B) Requirement to determine Unrealized API Gains and Losses. In 
the case of a revaluation of the property of a partnership that owns a 
tiered structure of partnerships, or in the case of the contribution of 
an API to another Passthrough Entity, Unrealized API Gains and Losses 
included in the fair market value of the property held by all relevant 
partnerships in the tiered structure as of the date of the revaluation 
or contribution that are directly or indirectly allocable to the API 
Holder must be determined under principles similar to Sec.  1.704-
1(b)(2)(iv)(f). If a partnership is required to revalue its assets for 
purposes of section 1061 under this paragraph, such partnership is 
permitted to revalue its property for purposes of section 704 as though 
an event in Sec.  1.704-1(b)(2)(iv)(f)(5) had occurred. Unrealized API 
Gains and Losses of a partnership that become API Gains and Losses 
under paragraph (a)(1)(ii)(A) of this section must be allocated to the 
API Holder under principles similar to Sec.  1.704-3(a)(9).
    (iii) API Gains and Losses retain their character. API Gains and 
Losses retain their character as API Gains and Losses as they are 
allocated from one Passthrough Entity to another Passthrough Entity and 
then to the Owner Taxpayer.
    (iv) Substantial services by an Owner Taxpayer, Passthrough 
Taxpayer, or any Related Person. If an interest in a partnership is 
transferred to or held by an Owner Taxpayer, Passthrough Taxpayer, or 
any Related Person in connection with the performance of services, the 
Owner Taxpayer, the Passthrough Taxpayer, or the Related Person is 
presumed to have provided substantial services.
    (v) Grantor trusts and entities disregarded as separate from their 
owners. A trust wholly described in subpart E, part I, subchapter J, 
chapter 1 of the Code (that is, a grantor trust), a qualified 
subchapter S subsidiary described in section 1361(b)(3), and an entity 
with a single owner that is treated as disregarded as an entity 
separate from its owner under any provision of the Code or any part of 
26 CFR (including

[[Page 49780]]

Sec.  301.7701-3 of this chapter) are disregarded for purposes of 
Sec. Sec.  1.1061-1 through 1.1061-6.
    (2) Examples. The following examples illustrate the provisions of 
this paragraph (a).
    (i) Example 1. API. (A) A is the general partner of PRS, a 
partnership, and provides services to PRS. A is engaged in an ATB as 
defined in Sec.  1.1061-1(a). PRS transfers an interest in the net 
profits of PRS to A in connection with A's performance of services in 
A's ATB and with respect to PRS. A's interest in PRS is an API.
    (B) After 6 years, A retires and is no longer engaged in an ATB and 
does not perform any services with respect to its ATB and with respect 
to PRS. However, A retains the API in PRS. PRS continues to acquire new 
capital assets and to allocate gain to A from the disposition of those 
assets. A's interest in PRS remains an API after A retires.
    (ii) Example 2. Contribution of an API to a partnership. 
Individuals A, B, and C each directly hold APIs in PRS, a partnership. 
A and B form a new partnership, GP, and contribute their APIs in PRS to 
GP. Following the contribution, A and B each hold an Indirect API 
because A and B now indirectly hold their APIs in PRS through GP, a 
Passthrough Entity. Each of A's and B's interests in GP is a 
Passthrough Interest because each of A's and B's interests in GP 
represents an indirect interest in an API. See Sec.  1.1061-5 regarding 
the potential application of section 1061(d) to this example.
    (iii) Example 3. Passthrough Interest, Indirect API, Passthrough 
Taxpayer. A, B, and C each provide services to and are equal partners 
of GP. GP is the general partner of PRS. GP is engaged in an ATB, as 
defined in Sec.  1.1061-1(a), and provides management services to PRS. 
In connection with GP's performance of services in an ATB, an interest 
in the net profits of PRS is transferred to GP. Because its interest in 
PRS's net profits was transferred to GP in connection with GP's 
services in an ATB, GP is a Passthrough Taxpayer. Therefore, GP's 
interest in PRS is an API. Because A, B, and C are partners in GP, they 
each hold a Passthrough Interest in GP and an Indirect API in PRS as a 
result of GP's API in PRS. A, B, and C are treated as the Owner 
Taxpayers because they are partners in GP, a Passthrough Taxpayer, and 
also because they indirectly hold an API in PRS in connection with the 
performance of their services to GP's ATB.
    (iv) Example 4. S corporation, Passthrough Interest, Indirect API, 
and Passthrough Taxpayer. A owns all of the stock of S Corp, an S 
corporation. S Corp is engaged in an ATB, as defined in Sec.  1.1061-
1(a). S Corp provides substantial management services to PRS, a 
partnership. Additionally, S Corp is the general partner of PRS. A 
provides substantial services in S Corp's ATB. In connection with S 
Corp's performance of services to PRS, an interest in the net profits 
of PRS is transferred to S Corp. S Corp's interest in PRS is its only 
asset. Because its interest in PRS's net profits was transferred to S 
Corp in connection with substantial services in an ATB, S Corp is a 
Passthrough Taxpayer and its interest in PRS is an API. Because A is a 
shareholder in S Corp, A holds a Passthrough Interest in S Corp and an 
Indirect API in PRS as a result of S Corp's API in PRS. A is treated as 
an Owner Taxpayer because A holds an interest in S Corp, a Passthrough 
Taxpayer, and also indirectly holds an API in PRS in connection with 
A's services in S Corp's ATB.
    (v) Example 5. Indirect API, Related Party and Passthrough 
Taxpayer. A, B, and C are equal partners of GP, a partnership. GP is 
the general partner of PRS. GP's Specified Actions by themselves do not 
satisfy the ATB Activity Test under Sec.  1.1061-1(a) and as a result, 
GP's actions do not establish an ATB. GP is required under PRS's 
partnership agreement to provide management services to PRS, either by 
itself or through a delegate. GP enters into an agreement with 
Management Company, a partnership, to provide services to PRS, and 
Management Company is paid reasonable compensation for such services. 
Management Company is related to GP within the meaning of sections 
267(b) and 707(b). Management Company provides management services on 
behalf of GP to PRS and is engaged in an ATB. GP also is in an ATB 
because Management Company's actions are attributed to GP as GP's 
delegate. An interest in the net profits of PRS is transferred to GP in 
connection with Management Company's services to PRS. Because its 
interest in the net profits of PRS is transferred to GP in connection 
with services provided by Management Company, a Related Person, GP is a 
Passthrough Taxpayer and its interest in PRS is an API. Unless an 
exception described in Sec.  1.1061-3 applies, because A, B, and C are 
partners in GP, they each hold a Passthrough Interest in GP and an 
Indirect API in PRS. A, B, and C are treated as Owner Taxpayers because 
they hold an interest in GP, a Passthrough Taxpayer. See also 
Sec. Sec.  1.1061-2(b)(1)(i)(C)(2) and 1.1061-2(b)(2)(v), Example 5.
    (b) Application of the ATB Activity Test--(1) In general. The ATB 
Activity Test is satisfied if Specified Actions are conducted by one or 
more Related Persons and the total level of activity, including the 
combined activities of all Related Persons, satisfies the level of 
activity that would be required to establish a trade or business under 
section 162.
    (i) Rules for applying the ATB Activity Test--(A) Aggregate 
Specified Actions taken into account. The determination of whether the 
ATB Activity Test is satisfied is based on the combined activities 
conducted that qualify as either Raising or Returning Capital Actions 
and Investing or Developing Actions. The fact that either Raising or 
Returning Capital Actions or Investing or Developing Actions are only 
infrequently taken does not preclude the test from being satisfied if 
the combined Specified Actions meet the test.
    (B) Raising or Returning Capital Actions and Investing or 
Developing Actions are not both required to be taken in each taxable 
year. Raising or Returning Capital Actions and Investing or Developing 
Actions are not both required to be taken in each taxable year in order 
to satisfy the ATB Activity Test. For example, the ATB Activity Test 
will be satisfied if Investing or Developing Actions are not taken in 
the current taxable year, but sufficient Raising or Returning Capital 
Actions are taken in anticipation of future Investing or Developing 
Actions. Additionally, the ATB Activity Test will be satisfied if no 
Raising or Returning Capital Actions are taken in the current taxable 
year, but have been taken in a prior taxable year (regardless of 
whether the ATB Activity Test was met in the prior year), and 
sufficient Investing or Developing Actions are undertaken by the 
taxpayer in the current taxable year.
    (C) Combined conduct by multiple related entities taken into 
account--(1) Related Entities. If a Related Person(s) (within the 
meaning of Sec.  1.1061-1(a)) solely or primarily performs Raising or 
Returning Capital Actions and one or more other Related Person(s) 
solely or primarily performs Investing or Developing Actions, the 
combination of the activities performed by these Related Persons will 
be taken into account in determining whether the ATB Activity Test is 
satisfied.
    (2) Actions taken by an agent or delegate. Specified Actions taken 
by an agent or a delegate in its capacity as an agent or a delegate of 
a principal will be taken into account by the principal in determining 
whether the ATB Activity

[[Page 49781]]

Test is satisfied with respect to the principal. These Specified 
Actions are also taken into account in determining whether the ATB 
Activity test is satisfied by the agent or the delegate.
    (ii) Developing Specified Assets. Developing Specified Assets takes 
place if it is represented to investors, lenders, regulators, or other 
interested parties that the value, price, or yield of a portfolio 
business may be enhanced or increased in connection with choices or 
actions of a service provider. Merely exercising voting rights with 
respect to shares owned or similar activities do not amount to 
developing Specified Assets.
    (iii) Partnerships. Investing or Developing Actions directly 
conducted with respect to Specified Assets held by a partnership are 
counted towards the ATB Activity Test. Additionally, a portion of the 
Investing or Developing Actions conducted with respect to the interests 
in a partnership that holds Specified Assets is counted towards the ATB 
Activity Test. This portion is the value of the partnership's Specified 
Assets over the value of all of the partnership's assets. Actions taken 
to manage a partnership's working capital will not be taken into 
account in determining the portion of Investing or Developing Actions 
conducted with respect to the interests in the partnership.
    (2) Examples. The following examples illustrate the application of 
the ATB Activity Test described in paragraph (b)(1) of this section.
    (i) Example 1. Combined activities of Raising or Returning Capital 
Actions and Investing or Developing Actions. During the taxable year, B 
takes a small number of actions to raise capital for new investments. B 
takes numerous actions to develop Specified Assets. B's actions with 
respect to raising capital and B's actions with respect to developing 
Specified Assets are combined for the purpose of determining whether 
the ATB Activity Test is satisfied.
    (ii) Example 2. Combining Specified Actions in multiple entities. 
GP, a partnership, conducts Raising or Returning Capital Actions. 
Management Company, a partnership that is a Related Party to GP, 
conducts Investing or Developing Actions. When GP's and Management 
Company's activities are combined, the ATB Activity Test is satisfied. 
Accordingly, both GP and Management Company are engaged in an ATB, and 
services performed by either GP or Management Company are performed in 
an ATB.
    (iii) Example 3. Investing or Developing Actions taken after 
Raising or Returning Capital Actions that do not meet the ATB Activity 
Test. In year 1, PRS engaged in Raising or Returning Capital Actions to 
fund PRS's investment in Specified Assets. However, PRS' Specified 
Actions during year 1 did not satisfy the ATB Activity Test because 
they did not satisfy the level of activity required to establish a 
trade or business under section 162. Therefore, PRS was not in engaged 
in an ATB in year 1. In year 2, PRS engaged in significant Investing or 
Developing Actions but did not engage in any Raising or Returning 
Capital Actions. In year 2, PRS's Investing or Developing Actions alone 
satisfy the ATB Activity Test. Therefore, PRS is engaged in an ATB in 
year 2.
    (iv) Example 4. Raising or Returning Capital Actions taken in 
anticipation of Investing or Developing Actions. In year 1, A spent all 
of A's time on Raising or Returning Capital Actions. A's Raising or 
Returning Capital Actions were undertaken to raise capital to invest in 
Specified Assets with the goal of increasing their value through 
Investing or Developing Actions. A did not take Investing or Developing 
actions during the taxable year. A's Raising or Returning Capital 
Actions alone satisfy the ATB Activity Test. Therefore, the ATB 
Activity Test is satisfied, and A is engaged in an ATB in year 1.
    (v) Example 5. Attribution of delegate's actions. GP is the general 
partner of PRS. GP is responsible for providing management services to 
PRS. GP contracts with Management Company to provide management 
services on GP's behalf to PRS. GP and Management Company are not 
Related Persons. The Specified Actions taken by Management Company on 
behalf of GP are attributed to GP for purposes of the ATB Activity Test 
because the Management Company is operating as a delegate of the GP. 
Additionally, those Specified Actions are taken into account by 
Management Company for purposes of the ATB Activity Test and whether it 
is engaged in an ATB.
    (vi) Example 6. ATB Activity Test not satisfied. A is the manager 
of a hardware store. Partnership owns the hardware store, including the 
building in which the hardware business is conducted. In connection 
with A's services as the manager of the hardware store, a profits 
interest in Partnership is transferred to A. Partnership's business 
involves buying hardware from wholesale suppliers and selling it to 
customers. The hardware is not a Specified Asset. Although real estate 
is a Specified Asset if it is held for rental or investment purposes, 
Partnership holds the building for the purpose of conducting its 
hardware business and not for rental or investment purposes. Therefore, 
the building is not a Specified Asset as to Partnership. Partnership 
also maintains and manages a certain amount of working capital for its 
business, but actions with respect to working capital are not taken 
into account for the purpose of determining whether the ATB Activity 
Test is met. Partnership is not a Related Person with respect to any 
person who takes Specified Actions. Partnership is not engaged in an 
ATB because the ATB Activity Test is not satisfied. Although 
Partnership raises capital, its Raising or Returning Capital Actions 
alone do not satisfy the ATB Activity Test. Further, Partnership takes 
no Investing or Developing Actions because it holds no Specified Assets 
other than working capital. Partnership is not in an ATB and the 
profits interest transferred to A is not an API.
    (c) Applicability date. The provisions of this section apply to 
taxable years of Owner Taxpayers and Passthrough Entities beginning on 
or after [DATE OF PUBLICATION OF THE FINAL RULE IN THE FEDERAL 
REGISTER].


Sec.  1.1061-3   Exceptions to the definition of an API.

    (a) A partnership interest held by an employee of another entity 
not conducting an ATB. An API does not include any interest transferred 
to a person in connection with the performance of substantial services 
by that person as an employee of another entity that is conducting a 
trade or business (other than an ATB) and the person provides services 
only to such other entity.
    (b) Partnership interest held by a corporation--(1) In general. 
Except as provided in paragraph (b)(2) of this section, an API does not 
include any interest directly or indirectly held by a corporation.
    (2) Treatment of interests held by an S corporation or a qualified 
electing fund. For purposes of this section, a corporation does not 
include an entity for which an election was made to treat the entity as 
a Passthrough Entity. Thus, the following entities are not treated as 
corporations for purposes of section 1061--
    (i) An S corporation for which an election under section 1362(a) is 
in effect; and
    (ii) A passive foreign investment company (PFIC) with respect to 
which the shareholder has a qualified electing fund (QEF) election 
under section 1295 in effect.
    (c) Capital Interest Gains and Losses--(1) In general. Capital 
Interest Gains and Losses are not subject to section 1061 and, 
therefore, are not

[[Page 49782]]

included in calculating an Owner Taxpayer's Recharacterization Amount.
    (2) Capital Interest Gains and Losses Defined. For purposes of 
paragraph (c)(1) of this section, Capital Interest Gains and Losses are 
Capital Interest Allocations that meet the requirements of paragraph 
(c)(4) of this section, Passthrough Interest Capital Allocations that 
meet the requirements of paragraph (c)(5) of this section, and Capital 
Interest Disposition Amounts that meet the requirements of paragraph 
(c)(6) of this section.
    (3) General rules for determining Capital Interest Allocations and 
Passthrough Interest Capital Allocations--(i) Allocations made in the 
same manner. Only allocations that are made in the same manner to all 
partners can be Capital Interest Allocations or Passthrough Interest 
Capital Allocations. In general, allocations will be considered to be 
made in the same manner if, under the partnership agreement, the 
allocations are based on the relative capital accounts of the partners 
(or owners in the case of a Passthrough Entity that is not a 
partnership) receiving the allocation and the terms, priority, type and 
level of risk, rate of return, and rights to cash or property 
distributions during the partnership's operations and on liquidation 
are the same. An allocation to an API Holder will not fail to qualify 
solely because the allocation is subordinated to allocations made to 
Unrelated Non-Service Partners. Further, an allocation to an API Holder 
will not fail to qualify because it is not reduced by the cost of 
services provided by the API Holder or a Related Person to the 
partnership.
    (ii) Capital accounts--(A) In general. Capital Interest Allocations 
and Passthrough Interest Capital Allocations must be based on an API 
Holder's relative capital account balance in a Passthrough Entity. In 
the case of a partnership that maintains capital accounts under Sec.  
1.704-1(b)(2)(iv), the allocation must be tested under paragraph 
(c)(3)(i) of this section based on that capital account. In the case of 
a Passthrough Entity that is not a partnership (or a partnership that 
does not maintain capital accounts under Sec.  1.704-1(b)(2)(iv)), if 
the Passthrough Entity maintains and determines accounts for its owners 
using principles similar to those provided under Sec.  1.704-
1(b)(2)(iv), the account will be treated as a capital account for 
purposes of this paragraph (c) and an allocation must be tested under 
paragraph (c)(3)(i) of this section based on those accounts.
    (B) Tiers--(1) Passthrough Capital Allocations. Generally, 
Passthrough Capital Allocations must be based on each owner's share of 
the Passthrough Entity's capital account in the entity making the 
Capital Interest Allocations described under paragraph (c)(4) of this 
section to the Passthrough Entity unless the exception in paragraph 
(c)(3)(ii)(B)(3) of this section applies.
    (2) Passthrough Interest Direct Investment Allocations. Generally, 
Passthrough Interest Direct Investment Allocations must be based on 
each Owner Taxpayer's or Passthrough Taxpayer's relative capital 
account balance in the Passthrough Entity holding the investments, 
reduced by that owner's share of a capital account held directly or 
indirectly by the Passthrough Entity in a lower-tier entity unless the 
exception in paragraph (c)(3)(ii)(B)(3) of this section applies.
    (3) Aggregate Allocation of Passthrough Interest Capital 
Allocations. A Passthrough Entity that allocates all Passthrough 
Interest Capital Allocations for the taxable year in the aggregate 
regardless of whether they are Passthrough Capital Allocations or 
Passthrough Interest Direct Investment Allocations may make those 
allocations based on each Owner Taxpayer's or Passthrough Taxpayer's 
relative capital account balance in the Passthrough Entity rather than 
under paragraph (c)(3)(ii)(B)(1) and (2) of this section.
    (C) Proceeds of partnership or partner loans not included in 
capital account. For purposes of Sec. Sec.  1.1061-1 through 1.1061-6, 
a capital account does not include the contribution of amounts directly 
or indirectly attributable to any loan or other advance made or 
guaranteed, directly or indirectly, by any other partner or the 
partnership (or any Related Person with respect to any such other 
partner or the partnership). However, the repayments on the loan are 
included in capital accounts as those amounts are paid by the partner, 
provided that the loan is not repaid with the proceeds of another loan 
described in this paragraph.
    (iii) Items that are not included in Capital Interest Allocations 
or Passthrough Interest Capital Allocations. Capital Interest 
Allocations and Passthrough Interest Capital Allocations do not 
include--
    (A) Amounts that are treated as API Gains and Losses and Unrealized 
API Gains and Losses;
    (B) Partnership Transition Amounts described in Sec.  1.1061-
4(b)(7)(iii); or
    (C) Items that are not taken into account for purposes of section 
1061 under Sec.  1.1061-4(b)(6).
    (4) Capital Interest Allocations. Capital Interest Allocations are 
allocations of long-term capital gain or loss made under the 
partnership agreement to an API Holder and to Unrelated Non-Service 
Partners based on their respective capital account balances that meet 
the requirements in paragraphs (c)(4)(i), (ii), and (iii) of this 
section.
    (i) Allocations are made in the same manner to API Holders and 
Unrelated Non-Service Partners;
    (ii) The allocations are made to Unrelated Non-Service Partners 
with a significant aggregate capital account balance. An aggregate 
capital account balance equal to 5 percent or more of the aggregate 
capital account balance of the partnership at the time the allocations 
are made will be treated as significant. Allocations to more than one 
Unrelated Non-Service Partner may be aggregated for determining 
significance if such allocations are made in the same manner to each of 
the Unrelated Non-Service Partners; and
    (iii) The allocations to the API Holder and the Unrelated Non-
Service Partners are clearly identified both under the partnership 
agreement and on the partnership's books and records as separate and 
apart from allocations made to the API Holder with respect to its API, 
and both the partnership agreement and the partnership's books and 
records clearly demonstrate that the requirements of paragraphs (c)(3) 
and (4) of this section have been met.
    (5) Passthrough Interest Capital Allocations--(i) In general. 
Passthrough Interest Capital Allocations are made by Passthrough 
Entities that hold an API in a lower-tier Passthrough Entity. 
Passthrough Interest Capital Allocations can be either Passthrough 
Capital Allocations as determined under paragraph (c)(5)(ii) of this 
section or Passthrough Interest Direct Investment Allocations as 
determined under paragraph (c)(5)(iii) of this section.
    (ii) Passthrough Capital Allocations. Passthrough Capital 
Allocations are Capital Interest Allocations that are made directly or 
indirectly to the Passthrough Entity by a lower-tier entity and that 
are allocated by the Passthrough Entity among its direct owners in the 
same manner (as provided in paragraph (c)(3)(i) of this section) with 
respect to each owner's capital account as determined under paragraph 
(c)(3)(ii) of this section.
    (iii) Passthrough Interest Direct Investment Allocations. 
Allocations are treated as Passthrough Interest Direct Investment 
Allocations if--
    (A) The allocations solely are comprised of long-term capital gain 
and loss derived from assets (other than an API) directly held by the 
Passthrough Entity; and

[[Page 49783]]

    (B) Allocations are made in the same manner (as provided in 
paragraph (c)(3)(i) of this section) based on each direct owner's 
capital account as determined under paragraph (c)(3)(ii) of this 
section.
    (6) Capital Interest Disposition Amounts--(i) In general. The term 
Capital Interest Disposition Amount means the amount of long-term 
capital gain and loss recognized on the sale or disposition of all or a 
portion of a Passthrough Interest that may be treated as Capital 
Interest Gain or Loss. The amount of long-term capital gain or loss 
that is recognized on the sale or disposition is determined under 
federal tax law (see, for example, sections 741 and 751, and Sec.  
1.61-6) and the holding period of the Passthrough Interest is 
determined as provided in Sec.  1.1061-4(b)(8). In general, long-term 
capital gain or loss recognized on the sale or disposition of a 
Passthrough Interest is deemed to be API Gain or Loss unless it is 
determined under these rules to be a Capital Interest Disposition 
Amount.
    (ii) Determination of the Capital Interest Disposition Amount. If a 
Passthrough Interest that includes a right to allocations of Capital 
Interest Gains and Losses is disposed of, the amount of long-term 
capital gain or loss that is treated as a Capital Interest Disposition 
Amount is determined under the rules provided in this paragraph.
    (A) First, determine the amount of long-term capital gain or loss 
that would be allocated to the Passthrough Interest (or the portion of 
the Passthrough Interest sold) if all the assets of the Passthrough 
Entity were sold for their fair market value in a fully taxable 
transaction (deemed liquidation) immediately before the disposition of 
the Passthrough Interest. To calculate this in tiered entities, 
determine the long-term capital gain or loss from a lower-tier 
Passthrough Entity.
    (B) Second, determine the sum of the amount of Capital Interest 
Gain or Loss from the deemed liquidation that is allocated to the 
Passthrough Interest (or the portion of the Passthrough Interest sold) 
as Capital Interest Allocations under paragraph (c)(4) of this section 
and Passthrough Interest Capital Allocations under paragraph (c)(5) of 
this section. To calculate this in tiered entities, determine the 
capital gain or loss from a lower-tier Passthrough Entity.
    (C) If the transferor recognized long-term capital gain upon 
disposition of the Passthrough Interest and only capital losses are 
allocated to the Passthrough Interest under paragraph (c)(6)(ii)(B) of 
this section from the deemed liquidation, then all of the long-term 
capital gain is API Gain. If the transferor recognized long-term 
capital loss on the disposition of the Passthrough Interest and only 
capital gain is allocated to the Passthrough Interest under paragraph 
(c)(6)(ii)(B) of this section, then all the long-term capital loss is 
API Loss.
    (D) If paragraph (c)(6)(ii)(C) of this section does not apply, the 
amount of long-term capital gain that the transferor of the Passthrough 
Interest recognizes that is treated as a Capital Interest Disposition 
Amount is determined by multiplying long-term capital gain recognized 
on the disposition of the Passthrough Interest by a fraction, the 
numerator of which is the amount of long-term capital gain determined 
under paragraph (c)(6)(ii)(B) of this section, and the denominator of 
which is the amount of long-term capital gain determined under 
paragraph (c)(6)(ii)(A) of this section. Alternatively, if long-term 
capital loss is recognized on the disposition of the Passthrough 
Interest, the amount of long-term capital loss treated as a Capital 
Interest Disposition Amount is determined by multiplying the 
transferor's capital loss by a fraction, the numerator of which is the 
amount of long-term capital loss determined under paragraph 
(c)(6)(ii)(B) of this section, and the denominator of which is the 
amount of long-term capital loss determined under paragraph 
(c)(6)(ii)(A) of this section.
    (E) In applying these rules, allocations of amounts that are not 
included in determining the amount of long-term capital gain or loss 
recognized on the sale or disposition of the Passthrough Interest are 
not included. See, for example, section 751(a).
    (7) Examples. The rules of this paragraph (c) are illustrated by 
the following examples. For purposes of these examples, unless stated 
otherwise, A, B, and C are equal partners of GP, a partnership. GP is 
the general partner of PRS, a partnership. The other partners of PRS 
are Unrelated Non-Service Partners. GP's and PRS's partnership 
agreements both require that the partnership determine and maintain 
capital accounts under Sec.  1.704-1(b)(2)(iv). GP holds an API in PRS 
that entitles GP to 20 percent of PRS's net profits. GP's API in PRS is 
an Indirect API as to each of A, B, and C. In addition, A, B, and C 
contributed $100 each to GP in exchange for their interests in GP.
    (i) Example 1. Capital Interest Allocations--(A) Facts. GP 
contributed the $300 of capital contributed by A, B and C to PRS. GP's 
$300 contribution equals 2% of the contributed capital made by all of 
PRS's partners. PRS's partnership agreement allocates 20% of its net 
profits to GP with respect to its API (20% API allocation). The 
partnership agreement allocates the 80% of net profits remaining after 
the 20% API allocation to the partners pro rata (including GP) based on 
their relative capital account balances (Investment Allocations). Under 
PRS's partnership agreement, Investment Allocations to the partners, 
both to GP and to the Unrelated Non-service Partners, have the same 
priority, type and level of risk, and rate of return. Additionally, all 
of the partners have the same rights to cash or property distributions 
with respect to the Investment Allocations during the partnership's 
operations and on liquidation. GP's capital account balance comprises 
2% of PRS's total capital account balance and the capital accounts of 
the Unrelated Non-service Partners receiving the Investment Allocations 
comprise the other 98% of PRS's total capital account balance. During 
the taxable year, PRS has $10,000 of net capital gain. It allocates 
$2,000 of net capital gain to GP based on its API allocation providing 
for a 20% interest in net profits ($10,000 x 20%). Additionally, GP 
receives a 2% Investment Allocation from PRS, or $160 of net capital 
gain ($8,000 ($10,000 - $2,000) x 2%). In total, PRS allocates $2,160 
of net capital gain to GP for the taxable year. GP allocates $720 
($2,160/3) of this net capital gain to each of A, B, and C. The 
allocation received by GP from PRS is allocated among the partners of 
GP pro rata based on their share of the capital account that GP has in 
PRS.
    (B) Capital Interest Allocations Analysis. GP's 2% Investment 
Allocation of $160 of net capital gain is a Capital Interest 
Allocation. Other than GP, PRS's partners are Unrelated Non-Service 
Providers. GP is an API Holder. Under PRS's partnership agreement, the 
Investment Allocation is made pro rata to GP (an API Holder) and each 
of the Unrelated Non-Service Partners based on their relative capital 
account balances and the allocations are made in the same manner. 
Further, because allocations are made in the same manner with respect 
to each Unrelated Non-Service Partner's capital account, the capital 
account balances of the Unrelated Non-service Partners can be 
aggregated to determine if the allocations to the Unrelated Non-Service 
Partners are significant. The capital accounts of the Unrelated Non-
Service Partners are significant because they equal 98% of the 
aggregate capital

[[Page 49784]]

account balance of PRS at the time the allocations are made. 
Accordingly, the Investment Allocation to GP, the API Holder, is 
treated as a Capital Interest Allocation. GP's API allocation of $2,000 
of net capital gain is not a Capital Interest Allocation because it is 
made irrespective of the balance of GP's capital account. Therefore, 
the API allocation is not made in the same manner as any allocation to 
an Unrelated Non-Service Partner.
    (C) Passthrough Interest Capital Allocation Analysis. GP is 
allocated $160 of Capital Interest Allocations by PRS. This amount is 
allocated to A, B, and C pro rata and in the same manner based on their 
shares of GP's capital account in PRS. As such, they qualify as 
Passthrough Capital Allocations by GP. In addition, GP holds an API in 
PRS and is allocated $2,000 gain from PRS with respect to its API. This 
gain is API Gain when allocated by GP to its partners and cannot be 
treated as a Passthrough Capital Allocation by GP. In summary, A, B, 
and C are each allocated $720 of long-term capital gain from PRS 
($2,160/3). Of this amount, $667 is API Gain ($2,000/3) and $53 is a 
Passthrough Interest Capital Allocation ($160/3).
    (ii) Example 2. Passthrough Interest Direct Investment Allocation--
(A) Facts. The facts are the same as in Example 1, except that GP does 
not contribute any of the $300 contributed to GP by A, B, and C to PRS. 
Thus, GP's capital account in PRS is $0. Each of A, B, and C have a 
$100 capital account balance in GP. GP invests the contributed $300 in 
assets held directly by GP. Under the terms of GP's partnership 
agreement, long-term capital gains and losses from assets (other than 
an API) held directly by GP are allocated in the same manner to the 
partners of GP based on their relative capital accounts in GP less 
amounts that are included in the capital account of a lower-tier 
Passthrough Entity in which GP holds an interest. For the taxable year, 
GP receives an allocation of $2,000 of net capital gain with respect to 
the API GP holds in PRS. Additionally, GP earns $30 on the assets it 
holds directly. GP allocates $677 to each of A, B, and C for the 
taxable year.
    (B) Analysis. Of the $677 allocated to each of A, B, and C, $667 is 
an allocation of API Gain because it is an allocation of gain received 
with respect to GP's API in PRS. The remaining $10 allocated to A, B, 
and C was earned from assets which GP, a Passthrough Entity, holds 
directly. The $30 was allocated in the same manner, based on the 
respective capital account balances of A, B, and C in GP, as determined 
under paragraph (c)(3)(ii) of this section. Thus, the $10 allocated to 
each of A, B, and C is treated as a Passthrough Interest Direct 
Investment Allocation.
    (iii) Example 3. Aggregate Allocation of Passthrough Interest 
Capital Allocations--(A) Facts. The facts are the same as in Example 2, 
except that C is not a partner. A and B each contribute $100 to GP. GP 
contributes the $200 contributed by A and B to PRS, which entitles GP 
to a 1.5% Investment Allocation in PRS. One month later, C contributes 
$100 to GP for a one-third interest in GP. GP does not contribute the 
$100 contributed by C to PRS but instead invests the $100 directly. 
GP's partnership agreement allocates all items to the partners pro 
rata, based on their percentage interests, as represented by their 
capital account balances in GP. For the taxable year, GP receives an 
allocation of $2,000 of net capital gain with respect to the API GP 
holds in PRS. Additionally, GP receives an Investment Allocation from 
PRS of $120 of net capital gain. In sum, GP is allocated $2,120 of net 
capital gain from PRS. GP earns $30 on the assets it holds directly.
    (B) Analysis. GP allocates $667 of the API Gain to each of A, B, 
and C, which remains an allocation of API Gain. GP allocates $150 ($120 
Capital Interest Allocation which GP received from PRS, plus the $30 GP 
earned on its investment made with C's capital contribution) to each of 
A, B, and C, based on their percentage interests as represented by 
their capital accounts in GP. Thus, of the $150 of net capital gain 
that did not arise from GP's API in PRS, GP allocates to each of A, B, 
and C $50. Because GP allocates all Passthrough Interest Capital 
Allocations in the aggregate pro rata based on its partners' capital 
accounts in GP, the $50 allocated to each of A, B, and C is a 
Passthrough Interest Capital Allocation.
    (iv) Example 4. Sale of a Passthrough Interest. A, B, and C form GP 
in Year 1 and contribute $100 each. GP invests the $300 in Asset X in 
Year 1. In Year 3, A sells A's interest in GP to an unrelated third 
party for $800 and recognizes $700 of capital gain on the sale. GP does 
not have a capital account in PRS and is not entitled to Capital 
Interest Allocations from PRS. GP is entitled to allocations of API 
Gain and Loss in PRS. If PRS had sold its assets in a taxable 
transaction for their fair market value and liquidated immediately 
before A transferred its interest in GP, GP would have been allocated 
$1,800 of long-term capital gain with respect to GP's API in PRS. Of 
this $1,800, GP would have allocated $600 to A. If GP sold all of its 
assets for fair market value immediately before A's sale of the 
interest in GP and liquidated, A would have received a Passthrough 
Interest Direct Investment Allocation of $100. Accordingly, total gain 
allocable to A as a result of the hypothetical liquidation would be 
$700. The percentage of the total gain of $700 that is comprised of a 
Passthrough Interest Direct Investment Allocation is $100/$700 or 
approximately 14.286%. Accordingly, 14.286% of A's $700 gain, or $100, 
is A's Capital Interest Disposition Amount, and not subject to section 
1061.
    (v) Example 5. Sale of a portion of a Passthrough Interest--(A) 
Facts. A, B, and C each hold a one-third interest in GP's profits and 
capital. PRS's ownership interests are divided into two classes, Class 
A and Class B. The PRS partnership agreement provides for 10 Class A 
units which each represent a 2% interest in the net profits of PRS, for 
a total of 20% of the total net profits. Additionally, the PRS 
partnership agreement provides for 100 Class B units. Each Class B unit 
represents a 1% interest in the capital and a 0.8% interest in the 
profits of PRS, for a total of 80% of the total net profits. PRS does 
not have any outstanding indebtedness. In Year 1, PRS transferred the 
10 Class A units to GP in connection with GP's performance of 
substantial services to PRS. GP is engaged in an ATB. Additionally, on 
the same date, PRS transferred 2 Class B units in exchange for GP's 
capital contribution of $2,000 to PRS. The balance of the Class B units 
were issued to Unrelated Non-Service Partners for contributions of 
$1,000 per unit. In Year 3, when the fair market value of the Class A 
units is $7,000, GP sells its Class B units to an Unrelated Non-Service 
Partner for $3,000. At the time of the sale, GP's basis in its 
partnership interest in PRS is $2,000. Additionally, if all of the 
assets of PRS were sold in a taxable transaction immediately before the 
Class B units were sold, GP would be allocated $1,000 of capital gain 
with respect to GP's Class B units.
    (B) Treatment of the Class A and Class B Units under Section 1061. 
GP's class A units represent an API as to GP because they were 
transferred to GP in connection with the performance of substantial 
services in an ATB. Class A units do not provide for allocations that 
meet the requirements to be treated as either Capital Interest 
Allocations or Passthrough Interest Capital Allocations. GP's Class B 
units entitle GP to Capital Interest Allocations. Allocations of gain 
made by PRS with respect to the Class B units are treated as Capital 
Interest Allocations because the allocations are made to GP as a

[[Page 49785]]

holder of an API with respect to GP's capital account in the same 
manner as allocations are made to Unrelated Non-Service Partners with 
respect to their capital accounts. Additionally, 98% of the Class B 
units representing 98% of the capital account balance in PRS are held 
by Unrelated Non-Service Partners. Thus, their interest in PRS is 
significant.
    (C) Calculation of GP's gain on the sale of the Class B Units. 
Although GP's interest in PRS is represented by units of different 
classes and some of those units may constitute a right to API Gains and 
Losses and other units may constitute a right to Capital Interest 
Allocations, under the provisions of subchapter K, chapter 1 of the 
Code, GP has a single partnership interest in PRS and a single tax 
basis and section 704(b) book capital account in that partnership 
interest. GP's basis in its partnership interest is $2,000. To 
determine GP's gain on the disposition of the Class B units, GP's tax 
basis in its partnership interest must be equitably apportioned between 
GP's Class A and Class B units. See Sec.  1.61-6(a). At the time of the 
sale, the fair market value of the Class A Units is $7,000 and the fair 
market value of the Class B Units is $3,000. GP's overall fair market 
value in its interest in PRS is equal to $10,000. Of this amount, the 
value of the Class B Units is $3,000, or 30%, of the fair market value 
of the entire interest. Accordingly, GP apportions 30% of its tax basis 
to the Class B units. This amount is $600 (30% x $2,000). Accordingly, 
GP's long-term capital gain on the sale of the Class B units is $2,400 
($3,000 less $600).
    (D) Determination of Capital Interest Disposition Amount. To 
determine the percentage of the long-term capital gain that is treated 
as a Capital Interest Disposition Amount, GP determines the amount of 
long-term capital gain that would be allocated to the portion of GP's 
interest sold if PRS sold all of its assets for fair market value and 
liquidated immediately before the disposition. Because Class B units 
are only entitled to allocations that are Capital Interest Allocations 
and are not entitled to allocations of API Gain or Loss, all of the 
$2,400 long-term capital gain is Capital Interest Disposition Gain.
    (vi) Example 6. Contribution of an API to a Passthrough Entity with 
an Unrelated Non-Service Partner. A and B form partnership GP and are 
equal partners in GP. A contributes an API in PRS with a fair market 
value of $200 and a tax basis of $0 to GP. B, an Unrelated Non-Service 
Partner, contributes $200 cash to GP. GP invests the $200 cash 
contributed by B in assets held for investment by GP. Because A 
contributes an API in PRS to GP, PRS revalues its assets to determine 
the Unrealized API Gains and Losses that are allocable to A's interest 
in PRS at the time A contributes its interest in A to GP. See Sec.  
1.1061-2(a)(1)(ii)(B). At the time of the contribution of the API to 
GP, PRS holds two assets each with $100 of Unrealized API Gains that 
are allocable to the API. PRS sells one of its assets and allocates 
long-term capital gain of $100 to GP with respect to the API 
contributed to GP by A. This gain is API Gain and is first allocated to 
GP and then solely to A as required under Sec.  1.1061-2(a)(1)(ii)(B). 
The Unrealized API Gain included in A's capital account in GP retains 
its character as Unrealized API Gain and is not converted to Capital 
Interest Gain or Loss because it is included A's capital account in GP. 
Thus, this gain is API Gain as to A when recognized.
    (d) Partnership interest acquired by purchase by an unrelated 
taxpayer. If a taxpayer acquires an interest in a partnership (target 
partnership) by taxable purchase for fair market value that, but for 
the exception set forth in this paragraph (d), would be an API, the 
taxpayer will not be treated as acquiring an API if, immediately before 
the purchase--
    (1) Taxpayer not a Related Person. The taxpayer is not a Related 
Person (within the meaning of Sec.  1.1061-1(a)) with respect to--
    (i) Any person who provides services in the Relevant ATB, or
    (ii) Any service providers who provide services to or for the 
benefit of the target partnership or a lower-tier partnership in which 
the target partnership holds an interest, directly or indirectly.
    (2) Section 1061(d) not applicable. Section 1061(d) does not apply 
to the transaction (as provided in Sec.  1.1061-5); and
    (3) Taxpayer not a service provider. The taxpayer did not and does 
not now provide services, and does not anticipate providing services in 
the future, to or for the benefit of the target partnership, directly 
or indirectly, or any lower-tier partnership in which the target 
partnership directly or indirectly holds an interest.
    (e) [Reserved]
    (f) Applicability date--(1) General rule. Except as provided in 
paragraphs (f)(2) and (f)(3) of this section, the provisions of this 
section apply to taxable years of Owner Taxpayers and Passthrough 
Entities beginning on or after [DATE OF PUBLICATION OF THE FINAL RULE 
IN THE FEDERAL REGISTER].
    (2) Section 1.1061-3(b)(2)(i) exception. Section 1.1061-3(b)(2)(i), 
which provides that the exception under section 1061(c)(1) to the 
definition of an API does not apply to a partnership interest held by 
an S corporation with an election under section 1362(a) in effect, is 
applicable for taxable years beginning after December 31, 2017.
    (3) Section 1.1061-3(b)(2)(ii) exception. Section 1.1061-
3(b)(2)(ii) which provides that the exception under section 1061(c)(1) 
to the definition of an API does not apply to a partnership interest 
held by a PFIC with respect to which the shareholder has a QEF election 
in effect under section 1295 is applicable to taxable years of an Owner 
Taxpayer and Passthrough Entity beginning after August 14, 2020.


Sec.  1.1061-4   Section 1061 computations.

    (a) Computations--(1) Recharacterization Amount. The 
Recharacterization Amount is the amount that an Owner Taxpayer must 
treat as short-term capital gain and not as long-term capital gain 
under section 1061(a). The Recharacterization Amount equals--
    (i) The Owner Taxpayer's One Year Gain Amount, less
    (ii) The Owner Taxpayer's Three Year Gain Amount.
    (2) One Year Gain Amount and Three Year Gain Amount--(i) One Year 
Gain Amount. The Owner Taxpayer's One Year Gain Amount is the sum of--
    (A) The Owner Taxpayer's combined net API One Year Distributive 
Share Amount from all APIs held during the taxable year; and
    (B) The Owner Taxpayer's API One Year Disposition Amount.
    (ii) Three Year Gain Amount. An Owner Taxpayer's Three Year Gain 
Amount is equal to--
    (A) The Owner Taxpayer's combined net API Three Year Distributive 
Share Amount from all APIs held during the taxable year; and
    (B) The Owner Taxpayer's API Three Year Disposition Amount.
    (3) API One Year Distributive Share Amount and Three Year 
Distributive Share Amount--(i) API One Year Distributive Share Amount. 
The API One Year Distributive Share Amount equals--
    (A) The API Holder's distributive share of net long-term capital 
gain from the partnership for the taxable year, including capital gain 
or loss on the disposition of all or a part of an API, with respect to 
the partnership interest held by the API Holder calculated without the 
application of section 1061, less
    (B) To the extent included in the amount determined under paragraph

[[Page 49786]]

(a)(3)(i)(A) of this section, the aggregate of--
    (1) Amounts that are excluded from section 1061 under paragraph 
(b)(6) of this section;
    (2) The API Holder's Transition Amount for the taxable year; and
    (3) Capital Interest Gains and Losses as determined under Sec.  
1.1061-3(c)(2).
    (ii) API Three Year Distributive Share Amount. The API Three Year 
Distributive Share Amount equals--
    (A) The API One Year Distributive Share Amount; less
    (B) Items included in paragraph (a)(3)(ii)(A) of this section that 
would not be treated as a long-term gain or loss if three years is 
substituted for one year in paragraphs (3) and (4) of section 1222, 
and, if the Lookthrough Rule applies to the disposition of all or a 
part of an API, the adjustment required under paragraphs (b)(9)(ii)(B) 
and (C) of this section.
    (4) API One Year Disposition Amount and API Three Year Disposition 
Amount--(i) API One Year Disposition Amount. The API One Year 
Disposition Amount is the combined net amount of--
    (A) Long-term capital gains and losses recognized during the 
taxable year by an Owner Taxpayer, including long-term capital gain 
computed under the installment method that is taken into account for 
the taxable year, on the disposition of all or a portion of an API that 
had been held for more than one year, including a disposition to which 
the Lookthrough Rule applies;
    (B) Long-term capital gain and loss recognized on a distribution 
with respect to an API during the taxable year that is treated under 
sections 731(a) (and 752(b) if applicable) as gain or loss from the 
sale or exchange of a partnership interest held for more than one year;
    (C) Long-term capital gains and losses recognized on the 
disposition of Distributed API Property during the taxable year that 
has a holding period of more than one year but not more than three 
years to the distributee Owner Taxpayer on the date of disposition; and
    (D) Long-term capital gain or losses recognized as a result of the 
application of section 751(b).
    (ii) API Three Year Disposition Amount. The API Three Year 
Disposition Amount is the combined net amount of--
    (A) Long-term capital gains and losses recognized during the 
taxable year by an Owner Taxpayer, including long-term capital gain 
computed under the installment method that is taken into account for 
the taxable year, on the disposition of all or a portion of an API that 
had been held for more than three years and to which the Lookthrough 
Rule does not apply;
    (B) Long-term capital gains and losses recognized by an Owner 
Taxpayer on the disposition during the taxable year of all or a portion 
of an API that has been held for more than three years less any 
adjustments required under the Lookthrough Rule in paragraphs 
(b)(9)(ii)(B) and (C) of this section.
    (C) Long-term capital gains and losses recognized on a distribution 
with respect to an API during the taxable year that is treated under 
sections 731(a) (and section 752(b) if applicable) as gain or loss from 
the sale or exchange of a partnership interest held for more than three 
years; and
    (D) Long-term capital gains and losses recognized as a result of 
the application of section 751(b) that is treated as derived from an 
asset held for more than three years.
    (b) Special rules for calculating the One Year Gain Amount and the 
Three Year Gain Amount--(1) One Year Gain Amount equals zero or less. 
If an Owner Taxpayer's One Year Gain Amount is zero or results in a 
loss, the Recharacterization Amount for the taxable year is zero and 
section 1061(a) does not apply.
    (2) Three Year Gain Amount equals zero or less. If an Owner 
Taxpayer's Three Year Gain Amount is zero or results in a loss, the 
Three Year Gain Amount shall be zero for purposes of calculating the 
Recharacterization Amount.
    (3) Installment sale gain. The One Year Gain Amount under paragraph 
(a)(2)(i) of this section, and the Three Year Gain Amount, as 
determined under paragraph (a)(2)(ii) of this section, include long-
term capital gains from installment sales. This includes long-term 
capital gain or loss recognized with respect to an API after December 
31, 2017, with respect to an installment sale that occurred on or 
before December 31, 2017. The holding period of the asset upon the date 
of disposition is used for purposes of determining whether capital gain 
is included in the taxpayer's One Year Gain Amount or the Three Year 
Gain Amount. See paragraph (b)(8) of this section for rules governing 
the holding period of APIs.
    (4) Special rules for capital gain dividends from regulated 
investment companies (RICs) and real estate investment trusts (REITs)--
(i) API One Year Distributive Share Amount. If a RIC or REIT reports or 
designates a dividend as a capital gain dividend and provides the One 
Year Amounts Disclosure as defined in Sec.  1.1061-6(c)(1)(i), the 
amount provided in the One Year Amounts Disclosure is included in the 
calculation of an API One Year Distributive Share Amount. If the RIC or 
REIT does not provide the One Year Amounts Disclosure, the full amount 
of the RIC's or REIT's capital gain dividend must be included in the 
calculation of an API One Year Distributive Share Amount.
    (ii) API Three Year Distributive Share Amount. If a RIC or REIT 
reports or designates a dividend as a capital gain dividend and 
provides the Three Year Amounts Disclosure as defined in Sec.  1.1061-
6(c)(1)(ii), the amount provided in the Three Year Amounts Disclosure 
is used for the calculation of an API Three Year Distributive Share 
amount. If the RIC or REIT does not provide the Three Year Amounts 
Disclosure, no amount of the RIC's or REIT's capital gain dividend may 
be used for the calculation of an API Three Year Distributive Share 
Amount.
    (iii) Loss on sale or exchange of stock. If a RIC or REIT provides 
the Three Year Amounts Disclosure as provided in paragraph (b)(4)(ii) 
of this section, any loss on the sale or exchange of shares of a RIC or 
REIT held for six months or less is treated as a capital loss on an 
asset held for more than three years, to the extent of the amount of 
the Three Year Amounts Disclosure from that RIC or REIT.
    (5) Pro rata share of qualified electing fund (QEF) net capital 
gain--(i) One-year QEF net capital gain. The calculation of an API One 
Year Distributive Share Amount includes an Owner Taxpayer's share of an 
inclusion under section 1293(a)(1) of a pro rata share of the net 
capital gain (as defined in Sec.  1.1293-1(a)(2)) of a passive foreign 
investment company (as defined in section 1297(a)) for which a QEF 
election (as described in section 1295(a)) is in effect for the taxable 
year. The amount of the inclusion may be reduced by the amount of long-
term capital gain that is not taken into account for purposes of 
section 1061 as provided in paragraph (b)(6) of this section. See Sec.  
1.1061-6 for reporting rules.
    (ii) Three year QEF net capital gain. The calculation of an API 
Three Year Distributive Share Amount includes an Owner Taxpayer's share 
of an inclusion under section 1293(a)(1) of a pro rata share of the net 
long-term capital gain (as defined in Sec.  1.1293-1(a)(2)) of a QEF 
determined for purposes of paragraph (b)(5)(i) of this section if the 
QEF provides information to determine the amount of the inclusion that 
would constitute net long-term capital gain (as defined in Sec.  
1.1293-1(a)(2)) if the QEF's net capital gain for the taxable year were

[[Page 49787]]

calculated under section 1222(11) applying paragraphs (3) and (4) of 
section 1222 by substituting three years for one year. See Sec.  
1.1061-6 for reporting rules.
    (6) Items not taken into account for purposes of section 1061. The 
following items of long-term capital gain and loss are excluded from 
the calculation of the API One Year Distributive Share Amount in 
paragraph (a)(3)(i) of this section and the API Three Year Distributive 
Share Amount in paragraph (a)(3)(ii) of this section:
    (i) Long-term capital gain and long-term capital loss determined 
under section 1231;
    (ii) Long-term capital gain and long-term capital loss determined 
under section 1256;
    (iii) Qualified dividends included in net capital gain for purposes 
of section 1(h)(11)(B); and
    (iv) Capital gains and losses that are characterized as long-term 
or short-term without regard to the holding period rules in section 
1222, such as certain capital gains and losses characterized under the 
mixed straddle rules described in section 1092(b) and Sec. Sec.  
1.1092(b)-3T, 1.1092(b)-4T, and 1.1092(b)-6.
    (7) API Holder Transition Amounts not taken into account--(i) In 
General. An API Holder Transition Amount is not taken into account for 
purposes of determining the Recharacterization Amount.
    (ii) API Holder Transition Amount. An API Holder Transition Amount 
is the amount of long-term gain or loss that is treated as a 
Partnership Transition Amount and that is included in the allocation of 
long-term capital gains and losses under sections 702 and 704 to the 
API Holder for the taxable year with respect to the API Holder's 
interest in the Passthrough Entity. The API Holder Transition Amount 
for any taxable year cannot exceed the amount of Partnership Transition 
Amount that would have been allocated to the API Holder with respect to 
its interest in the partnership under the partnership agreement in 
effect on March 15, 2018, with respect to the calendar year ending 
December 31, 2017.
    (iii) Partnership Transition Amounts and Partnership Transition 
Amount Election. A partnership that was in existence as of January 1, 
2018, may irrevocably elect to treat all long-term capital gains and 
losses recognized from the disposition of all assets held by the 
partnership for more than three years as of January 1, 2018, as 
Partnership Transition Amounts. To treat amounts as Partnership 
Transition Amounts--
    (A) The partnership must attach a signed and dated copy of a 
statement that the partnership is making an election in accordance with 
this paragraph (b)(7)(iii)(A) to the timely filed return (including 
extensions) filed by the partnership with the IRS under section 6031(a) 
for the first taxable year the partnership treats amounts as 
Partnership Transition Amounts;
    (B) The partnership must maintain a copy of the election made under 
paragraph (b)(7)(iii)(A) of this section and by the due date of the 
election must clearly and specifically identify the assets held for 
more than three years as of January 1, 2018, in the partnership's books 
and records;
    (C) The partnership must keep sufficient books and records to 
demonstrate to the satisfaction of the Secretary of the Treasury or his 
delegate that the identified assets had been held by the partnership 
for more than three years as of January 1, 2018, and that long-term 
capital gain or loss on the disposition of each asset has been treated 
as a Partnership Transition Amounts; and
    (D) The partnership must keep an executed copy of its partnership 
agreement in effect as of March 15, 2018, and must have sufficient 
books and records to demonstrate that the API Holder Transition Amounts 
allocated to an API Holder in any taxable year do not exceed the 
amounts that would have been allocated to the API Holder with respect 
to its API under the partnership agreement in effect as of March 15, 
2018, for the year ending December 31, 2017.
    (8) Holding period determination--(i) Determination of holding 
period for purposes of the Three Year Gain Amount. For purposes of 
computing the Three Year Gain Amount, the relevant holding period of 
either an asset or an API is determined under all provisions of the 
Code or regulations that are relevant to determining whether the asset 
or the API has been held for the long-term capital gain holding period 
by applying those provisions as if the holding period were three years 
instead of one year.
    (ii) Relevant Holding Period. The relevant holding period is the 
direct owner's holding period in the asset sold. Accordingly, for 
purposes of determining an API Holder's Taxpayer's API One Year 
Distributive Share Amount and API Three Year Distributive Share Amount 
for the taxable year under paragraph (a)(3) of this section, the 
partnership's holding period in the asset being sold or disposed of 
(whether a directly held asset or a partnership interest) is the 
relevant holding period for purposes of section 1061.
    (9) Lookthrough Rule for certain API dispositions--(i) 
Determination that the Lookthrough Rule applies-(A) Directly held API. 
The Lookthrough Rule applies if an API Holder disposes of a directly 
held API in a taxable transaction to which section 1061(d) does not 
apply and recognizes capital gain, the API Holder's holding period in 
the API is more than three years, and the assets of the partnership 
meet the Substantially All Test described in paragraph (b)(9)(i)(C) of 
this section.
    (B) Indirectly held API. In the case of a tiered structure in which 
the API Holder holds its API through one or more Passthrough Entities, 
the Lookthrough Rule applies if an API Holder disposes of a Passthrough 
Interest held for more than three years in a taxable transaction to 
which section 1061(d) does not apply and recognizes capital gain, and 
either--
    (1) The Passthrough Entity, through which the API is directly or 
indirectly held, has a holding period in the API of three years or 
less; or
    (2) The Passthrough Entity, through which the API is directly or 
indirectly held, has a holding period in the API of more than three 
years and the assets of the partnership in which the API is held meet 
the Substantially All Test described paragraph (b)(9)(i)(C) of this 
section.
    (C) Substantially All Test--(1) In general. The Substantially All 
Test is met if 80 percent or more of the assets of the partnership in 
which the API is held are assets that would produce capital gain or 
loss that is not described in paragraph (b)(6) of this section if 
disposed of by the partnership and have a holding period of three years 
or less to the partnership. The determination of whether this test is 
met is based on fair market value and is made by dividing the amount 
determined under paragraph (b)(9)(i)(C)(1)(i) of this section (the 
numerator) by the amount determined under paragraph (b)(9)(i)(C)(1)(ii) 
of this section (the denominator) and expressing the result as a 
percentage. Cash, cash equivalents, unrealized receivables under 
section 751(c), and inventory items under section 751(d) are not taken 
into account for purposes of determining the numerator or the 
denominator.
    (i) Numerator. For purposes of determining the fraction described 
in paragraph (b)(9)(i)(C)(1) of this section, the numerator is equal to 
the aggregate fair market value of the partnership's assets that would 
produce capital gain or loss that is not described in paragraph (b)(6) 
of this section if

[[Page 49788]]

disposed of by the partnership as of the date of disposition of the API 
and that have a holding period of three years or less.
    (ii) Denominator. For purposes of determining the fraction 
described in paragraph (b)(9)(i)(C)(1) of this section, the denominator 
is equal to the aggregate fair market value of all of the partnership's 
assets as of the date of disposition of the API.
    (2) Applying the Substantially All Test in tiered arrangements. In 
applying the Substantially All Test, if a partnership has held an 
interest in a lower-tier Passthrough Entity for more than three years, 
the partnership must increase the amount calculated for the numerator 
under paragraph (b)(9)(i)(C)(1)(i) of this section by the partnership's 
share of the value of the assets held by the lower-tier Passthrough 
Entity that would be included in the numerator under paragraph 
(b)(9)(i)(C)(1)(i) of this section by the lower-tier Passthrough 
Entity, if the lower-tier Passthrough Entity was calculating the 
numerator under paragraph (b)(9)(i)(C)(1)(i) of this section.
    (ii) Application of the Lookthrough Rule. If the Lookthrough Rule 
applies--
    (A) The Owner Taxpayer must include the entire amount of capital 
gain recognized on the sale of the API in the API One Year Disposition 
Amount (see paragraph (a)(4)(i)(A) of this section) and in the case of 
an API Holder that is a Passthrough Entity and not an Owner Taxpayer, 
the entire amount of the capital gain recognized on the sale is 
included in the One Year Distributive Share Amount determined with 
respect to the API Holders of the Passthrough Entity (see paragraph 
(a)(3)(i)(A) of this section); and
    (B) The Owner Taxpayer must include the amount of gain included in 
the API One Year Disposition Amount with respect to the disposition of 
the API reduced by the adjustment determined under paragraph 
(b)(9)(ii)(C) of this section (see paragraph (a)(4)(ii)(B) of this 
section) in the API Three Year Disposition Amount, and in the case of 
an API Holder that is a Passthrough Entity and not an Owner Taxpayer, 
the API Three Year Distributive Share Amount is reduced by the 
adjustment determined under paragraph (b)(9)(ii)(C) of this section as 
provided in paragraph (a)(3)(ii)(B) of this section.
    (C) Adjustment required by the Lookthrough Rule. The adjustment 
required by the Lookthough Rule equals--
    (1) If the Lookthrough Rule applies under paragraph (b)(9)(i)(A) or 
paragraph (b)(9)(i)(B)(2) of this section, the adjustment is equal to 
the capital gain recognized on the disposition of the API that is 
attributable to assets included in the numerator under paragraph 
(b)(9)(i)(C)(1)(i) of this section. This amount is calculated by 
multiplying the capital gain recognized on the sale of the API by a 
fraction, expressed as a percentage. The numerator of the fraction is 
equal to the total net capital gain the partnership would recognize if 
the partnership disposed of the assets the value of which was included 
in the numerator under paragraph (b)(9)(i)(C)(1)(i) of this section for 
fair market value immediately before the disposition of the API. The 
denominator is equal to the total net capital gain the partnership 
would recognize if the partnership disposed of the assets the value of 
which was included in the denominator under paragraph 
(b)(9)(i)(C)(1)(ii) of this section for fair market value immediately 
prior to the disposition of the API. If the numerator is zero or less, 
the adjustment in this paragraph (b)(9)(ii)(C) is zero. If the 
numerator is greater than zero and the denominator is zero or less, the 
adjustment is the entire amount of gain recognized on the sale of the 
API.
    (2) If the Lookthrough Rule applies under paragraph (b)(9)(i)(B)(1) 
of this section, the adjustment is equal to the gain attributable to 
the API directly or indirectly held by the Passthrough Entity.
    (10) Section 83. Except with respect to any portion of the interest 
that is a capital interest under Sec.  1.1061-3(c), this section 
applies regardless of whether an Owner Taxpayer has made an election 
under section 83(b) or included amounts in gross income under section 
83.
    (c) Examples--(1) Computation examples. The rules of paragraph (a) 
of this section are illustrated by the following examples. Unless 
otherwise stated, none of the long-term capital gain or loss in this 
section is capital gain or loss not taken into account for purposes of 
section 1061, as provided in paragraph (b)(6) of this section.
    (i) Example 1. Calculation of the API One Year Distributive Share 
Amount and the API Three Year Distributive Share Amount--(A) Facts. A 
holds an API in PRS. A does not have a capital account in PRS for 
purposes of Sec.  1.1061-3(c)(3)(ii). During the taxable year, A is 
allocated $20 of long-term capital gain recognized by PRS on the sale 
of capital asset X held by PRS for two years. A is allocated $40 of 
long-term capital gain from the sale of capital asset Y held by PRS for 
five years. Assume A has no other items of long-term capital gain or 
loss with respect to its interest in PRS during the taxable year. 
Accordingly, A is allocated $60 of long-term capital gain from PRS 
under Sec.  1.702-1(a)(2) for the taxable year. A has no other long-
term capital gains or losses with respect to an API during the taxable 
year.
    (B) Calculation of A's API One Year Distributive Share Amount. A 
has an API One Year Distributive Share Amount for PRS of $60 of long-
term capital gain. This amount is equal to A's $60 distributive share 
from PRS under Sec.  1.702-1(a)(2) because no items that are described 
in paragraph (b)(6) or (7) of this section reduce that amount.
    (C) Calculation of A's API Three Year Distributive Share Amount. A 
has an API Three Year Distributive Share Amount of $40 of long-term 
capital gain. A calculates this amount by subtracting the $20 allocated 
to A from the sale of capital asset X from the API One Year 
Distributive Share Amount of $60 calculated in paragraph (B) of this 
Example 1. A subtracts the gain allocated to A as a result of the sale 
of capital asset X because PRS had only held capital asset X for two 
years prior to its disposition and this gain would not be treated as 
long-term capital gain if three years were substituted for one year in 
paragraphs (3) and (4) of section 1222. Only the $40 gain allocated to 
A on the sale of capital asset Y which was held by PRS for five years 
prior to its disposition is included in A's API Three Year Distributive 
Share Amount.
    (D) Calculation of A's Recharacterization Amount. A's One Year Gain 
amount equals $60 (A's API One Year Distributive Share Amount, plus an 
API One Year Disposition Amount of $0). A's Three Year Gain Amount 
equals $40 (A's API Three Year Distributive Share Amount, plus an API 
Three Year Disposition Amount of $0). A's Recharacterization Amount is 
$20, the difference between A's One Year Gain Amount of $60, and A's 
Three Year Gain Amount of $40.
    (ii) Example 2. Calculation of the API One Year Distributive Share 
amount when Capital Interest Allocations are present--(A) Facts. A 
holds a Passthrough Interest in PRS. A holds an API in PRS and, under 
the terms of the partnership agreement, is entitled to Capital Interest 
Allocations from PRS. During the taxable year, A receives a $130 
allocation of long-term capital gain under Sec.  1.702-1(a)(2) with 
respect to its interest in PRS as a result of the sale of asset X that 
PRS had held for 5 years. Of this amount, $50 is treated as a Capital 
Interest Allocation described in Sec.  1.1061-3(c)(4). A has no other 
long-term capital gains and losses with

[[Page 49789]]

respect to an API during the taxable year.
    (B) Calculation. A's distributive share of long-term capital gain 
from PRS is $130. A's API One Year Distributive Share Amount is $80. 
This is calculated by subtracting A's $50 Capital Interest Allocation 
from A's distributive share of long-term capital gain determined for 
purposes of Sec.  1.702-1(a)(2). A's API Three Year Distributive Share 
Amount is also $80 because the $80 would be treated as long-term 
capital gain if three years were substituted for one year in paragraphs 
(3) and (4) of section 1222.
    (C) Recharacterization Amount. A has a One Year Gain Amount of $80 
(A's $80 API One Year Distributive Share Amount, plus a One Year 
Disposition Amount of $0). A has a Three Year Gain Amount of $80 (A's 
$80 API Three Year Distributive Share Amount, plus a Three Year 
Disposition Amount of $0). Accordingly, A's Recharacterization Amount 
is $0, the difference between A's One Year Gain Amount and Three Year 
Gain Amount.
    (iii) Example 3. API One Year Disposition Amount--(A) Facts. During 
the taxable year, A disposes of an API that A has held for four years 
as of the date of disposition for a $100 gain. The Lookthrough Rule is 
not applicable to the sale. Additionally, A sells Distributed API 
Property at a $300 gain when such property had a two year holding 
period in A's hands. A has no other items of long-term capital gain or 
loss with respect to an API in that year.
    (B) Calculation of A's API One Year Disposition Amount. A's API One 
Year Disposition Amount is $400. This amount equals A's $300 long-term 
capital gain on A's disposition of its Distributed API Property and 
$100 long-term capital gain on the disposition of A's API. A's Three 
Year Disposition Amount is $100, the amount of long-term capital gain A 
recognized upon disposition of A's API held for more than three years.
    (C) Calculation of A's Recharacterization Amount. A's One Year Gain 
Amount is $400. A's Three Year Gain Amount is $100. A's 
Recharacterization Amount is $300, the difference between A's One Year 
Gain Amount and Three Year Gain Amount.
    (iv) Example 4. Calculation of One Year Gain Amount, Three Year 
Gain Amount, and Recharacterization Amount--(A) Facts. During the 
taxable year, A held an API in PRS1 and an API in PRS2 for the entire 
year. With respect to PRS1, A's API One Year Distributive Share Amount 
is $100 of long-term capital gain and A's API Three Year Distributive 
Share Amount is ($200) of long-term capital loss. With respect to PRS2, 
A's API One Year Distributive Share Amount is $600 of long-term capital 
gain and A's API Three Year Distributive Share Amount is $300 of long-
term capital gain. For the taxable year, A also has an API One Year 
Disposition Amount of $200 of gain. A has no other items of long-term 
capital gain or loss with respect to an API for the taxable year.
    (B) Calculation of A's One Year Gain Amount. A's One Year Gain 
Amount is $900. This amount is calculated by combining A's $100 API One 
Year Distributive Share Gain from PRS1, the $600 API One Year 
Distributive Share from PRS2 (for a combined net API One Year 
Distributive Share Amount of $700 of long-term capital gain), and the 
$200 API One Year Disposition Amount.
    (C) Calculation of A's Three Year Gain Amount. A's Three Year Gain 
Amount is $100. This amount is calculated by first determining A's 
combined net API Three Year Distributive Share Amount for the taxable 
year. This amount is arrived at by combining and netting A's $200 API 
Three Year Distributive Share Amount loss from PRS1 with A's API Three 
Year Distributive Share Amount Gain of $300 from PRS2. A's combined net 
Three Year Distributive Share Amount is $100 of long-term capital gain. 
Because A does not have an API Three Year Disposition Amount, the Three 
Year Gain Amount is equal to A's API Three Year Distributive Share 
Amount of $100 of gain.
    (D) Calculation of A's Recharacterization Amount. A's 
Recharacterization Amount is $800, which is the amount by which A's One 
Year Gain Amount of $900 exceeds A's Three Year Gain Amount of $100.
    (2) Special rules examples. The principles of paragraph (b) of this 
section are illustrated by the following examples.
    (i) Example 1. Lookthrough rule--(A) Facts. A is a partner in GP. 
GP is a partnership and holds an API in PRS, which GP has held for 2 
years. A's interest in GP includes both an indirect interest in GP's 
API in PRS and a capital account in GP that entitles A to Capital 
Interest Gains and Losses from GP. A has held its interest in GP for 4 
years. During the taxable year, A sold its interest in GP for a $200 
gain in a transaction to which section 1061(d) did not apply. After the 
application of Sec.  1.1061-3(c)(6), A determined that $100 of A's 
capital gain on the disposition of its interest in GP is a Capital 
Interest Disposition Amount and $100 of A's capital gain is API Gain.
    (B) Determination of Whether the Lookthrough Rule Applies. A's 
disposition of an interest in GP is a disposition of a Passthrough 
Interest held for more than three years with respect to which A 
recognized capital gain. GP is the Passthrough Entity in which A holds 
its Passthrough Interest and GP has a two year holding period in its 
API in PRS. Thus, under paragraph (b)(9)(i)(B)(1) of this section, the 
Lookthrough Rule applies to A's disposition of A's Indirect API.
    (C) Effect of the Application of the Lookthrough Rule. A is an 
Owner Taxpayer. Under paragraph (b)(9)(ii)(A) of this section, A must 
include the $100 of API Gain in A's One Year Disposition Amount. Under 
paragraph (b)(9)(ii)(B) of this section, the amount A includes in the 
Three Year Disposition Amount is the amount A included in the One Year 
Disposition Amount, reduced by the adjustment required under paragraph 
(b)(9)(ii)(C)(2) of this section. This amount is A's gain attributable 
to the sale of its Indirect API, or $100. Therefore, A includes none of 
the $100 of API Gain from the sale of A's Indirect API in A's Three 
Year Disposition Amount.
    (ii) Example 2. Lookthrough Rule-(A) Facts. Assume the same facts 
as Example 1 except that GP has held its API in PRS for 4 years and all 
of the assets of PRS are securities that are subject to an election 
under section 475.
    (B) Determination of whether the Lookthrough Rule applies. A's 
disposition of an interest in GP is a disposition of a Passthrough 
Interest held for more than three years with respect to which A 
recognized capital gain. GP is the Passthrough Entity in which A holds 
its Passthrough Interest and GP has a four year holding period in its 
API. Thus, under paragraph (b)(9)(i)(B)(2) of this section, the 
Lookthrough Rule will apply if the assets of PRS meet the Substantially 
All Test in paragraph (b)(9)(i)(C) of this section. The determination 
of whether the test is met is made by dividing the aggregate fair 
market value of the assets of PRS that would produce capital gain or 
loss not described in paragraph (b)(6) of this section if disposed of 
by PRS as of the date of disposition of the API and that have a holding 
period of three years or less (the numerator as determined under 
paragraph (b)(9)(i)(C)(1)(i) of this section); by, the aggregate fair 
market value of all of the partnerships assets as of the date of 
disposition (the denominator as determined under paragraph 
(b)(9)(i)(C)(1)(ii) of this section). Because all of the assets of the 
partnership are assets subject to an election under section 475 and 
thus would produce ordinary income or loss on disposition, the 
numerator as

[[Page 49790]]

determined under paragraph (b)(9)(i)(C)(1)(i) of this section is 0. As 
a result, the Substantially All Test is not met, and the Lookthrough 
Rule does not apply.
    (iii) Example 3.--(A) Facts. Assume that same facts in Example 2, 
except that GP disposed of its API in PRS for a capital gain of $480. 
GP's API entitles it to 20% of PRS' net profits. A is allocated $120 of 
gain from the sale. At the time of GP's disposition of its interest in 
PRS, PRS held the following assets--
    (1) $1,000 cash;
    (2) Asset X, an asset that would produce capital gain or loss that 
is not described in paragraph (b)(6) of this section if disposed of by 
PRS, which has a fair market value of $100, a basis of $100, and a 
holding period of 4 years;
    (3) Asset Y, an asset that would produce capital gain or loss that 
is not described in paragraph (b)(6) of this section if disposed of by 
PRS, which has a fair market value of $1,600, a basis of $1,000, and a 
holding period of 2 years;
    (4) Asset Z, an asset that would produce capital gain or loss that 
is described in paragraph (b)(6) of this section if disposed of by PRS, 
which has a value of $300, a basis of $100, and a holding period of 2 
years; and
    (5) A 20% interest in the profits and capital of partnership PRS2. 
The total fair market value of PRS2 is $10,000. The interest PRS holds 
in PRS 2 has a fair market value of $2,000, a basis of $400, and a 
holding period of 4 years.
    (6) PRS2 holds two assets that would produce capital gain or loss 
that is not described in paragraph (b)(6) of this section if disposed 
of by PRS2, Asset S and Asset T. Asset S has a fair market value of 
$8,000, a basis of $1,000, and a holding period of 2 years. Asset T has 
a fair market value of $2,000, a basis of $1,000, and a holding period 
of 4 years.
    (B) Determination of Whether the Lookthrough Rule Applies--(1) In 
general. Because GP recognized capital gain on the disposition of an 
API that GP held directly that had a holding period of more than three 
years, paragraph (b)(9)(i)(A) of this section governs whether the 
Lookthrough Rule applies. To determine whether the Lookthrough Rule 
applies under paragraph (b)(9)(i)(A) of this section, it must be 
determined whether the assets of PRS meet the Substantially All Test in 
paragraph (b)(9)(i)(C) of this section. To make this determination, the 
numerator under paragraph (b)(9)(i)(C)(1)(i) of this section and the 
denominator under paragraph (b)(9)(i)(C)(1)(ii) of this section of the 
fraction described in paragraph (b)(9)(i)(C)(1) of this section must be 
determined. The value of cash, cash equivalents, unrealized receivables 
described in section 751(c), and inventory items described in section 
751(d) is excluded from this determination.
    (2) Calculation of the denominator under paragraph 
(b)(9)(i)(C)(1)(ii) of this section. The denominator under paragraph 
(b)(9)(i)(C)(1)(ii) of this section is equal to the aggregate fair 
market value of the assets of PRS on the date of disposition of the API 
and is $4,000 ($100 (Asset X) + $1,600 (Asset Y) + $300 (Asset Z) + 
$2,000 (PRS2)).
    (3) Calculation of the numerator under paragraph (b)(9)(i)(C)(1)(i) 
of this section. The numerator in paragraph (b)(9)(i)(C)(1)(i) of this 
section equals the aggregate fair market value of assets of PRS that 
would produce capital gain or loss that is not described in paragraph 
(b)(6) of this section if disposed of by PRS as of the date GP disposes 
of its API in PRS and that have a holding period of three years or less 
to PRS. Based on the following, this amount is equal to $3,200 (the 
value of Asset Y ($1,600) and PRS's share of the value of Asset S 
($1,600) held by PRS2).
    (i) The $1000 of cash is not taken into account for purposes of the 
Substantially All Test.
    (ii) The fair market value of Asset X is excluded from the 
calculation of the numerator under paragraph (b)(9)(i)(C)(i)(1) of this 
section because it has a 4 year holding period to PRS.
    (iii) Asset Y would produce capital gain or loss that is not 
described in paragraph (b)(6) of this section if disposed of by PRS and 
Asset Y has a holding period of 2 years. Accordingly, the $1,600 fair 
market value of asset Y is included in calculating the numerator under 
the paragraph (b)(9)(i)(C)(1)(i) of this section.
    (iv) Although Asset Z has a holding period of 2 years to GP, 
capital gain or loss on the disposition of Asset Z is described 
paragraph (b)(6) of this section so its value is not included in 
calculating the numerator under paragraph (b)(9)(i)(C)(1)(i) of this 
section.
    (v) PRS holds a 20% capital and profits interest in PRS2 and has a 
holding period of 4 years in its interest. Under paragraph 
(b)(9)(i)(C)(2) of this section, PRS's share of the fair market value 
of the assets held by PRS2 for three years or less is included in the 
GP's calculation of the amount under paragraph (b)(9)(i)(C)(1)(i) of 
this section. Asset S has a holding period of 2 years and a value of 
$8,000. PRS's share of the $8,000 is $1,600 ($8,000 x 20% = $1,600). 
Asset T has a holding period of more than 3 years and is not included 
in the amount determined under paragraph (b)(9)(i)(C)(1)(i) of this 
section. The amount included in the calculation under paragraph 
(b)(9)(i)(C)(2) of this section with respect to the interest PRS holds 
in PRS2 is $1,600, PRS' share of the fair market value of Asset S.
    (4) Fraction. Because $3,200 (the amount calculated under paragraph 
(b)(9)(i)(C)(1)(i) of this section) divided by $4,000, expressed as a 
percentage, is equal to 80%, the Lookthrough Rule applies.
    (C) Effect of application of the Lookthrough Rule--(1) In general. 
The API Holder is GP, which is a Passthrough Entity and not an Owner 
Taxpayer. Thus, the application of the Lookthrough Rule affects the 
calculation of the API One Year Distributive Share Amount and API Three 
Year Distributive Share Amounts of GP's API Holders.
    (2) Calculation of the API One Year Distributive Share Amount. All 
of GP's gain is API Gain and GP must include the entire $480 of GP's 
long-term capital gain in the API One Year Distributive Share Amount of 
its API Holders. For A, this amount is $120.
    (3) Calculation of the adjustment to the API Three Year 
Distributive Share Amount--(i) Adjustment calculation. To determine the 
amount by which the API Three Year Distributive Share Amount calculated 
under paragraph (a)(3)(ii)(B) of this section is reduced as a result of 
the application of the Lookthrough Rule, the adjustment described in 
paragraph (b)(9)(ii)(C) of this section must be determined. The 
adjustment is equal to the capital gain recognized on the disposition 
of the API in PRS by GP that is attributable to assets included in the 
numerator under paragraph (b)(9)(i)(C)(1)(i) of this section. This 
amount is calculated by multiplying the capital gain recognized on the 
sale by a fraction, expressed as a percentage. The numerator of the 
fraction is equal to total net capital gain that would be generated by 
the assets included in calculating the numerator under paragraph 
(b)(9)(C)(1)(i) of this section if PRS disposed of the assets for fair 
market immediately before the disposition of the API. The denominator 
of the fraction is equal to the total net capital gain that would be 
attributable to the assets included in the denominator under paragraph 
(b)(9)(C)(1)(ii) of this section if PRS disposed of all of its assets 
for fair market value immediately before the disposition of the API.
    (ii) Total net gain that would be recognized on a hypothetical sale 
of the assets included in the denominator under paragraph 
(b)(9)(i)(C)(1)(ii) of this

[[Page 49791]]

section. The total amount of capital gain that would be recognized on a 
hypothetical disposition of the assets that were included in the 
denominator under paragraph (b)(9)(i)(C)(1)(ii) of this section is 
$2,400 ($0 gain on Asset X + $600 gain on Asset Y + $200 gain on Asset 
Z and $1,600 gain on the interest in PRS2).
    (iii) Total net gain that would be recognized on a hypothetical 
sale of the assets included in the numerator under paragraph 
(b)(9)(i)(C)(1)(i) of this section. The full fair market value of Asset 
Y and PRS's 20% share of the fair market value Asset S held by PRS2 
were included in the amount determined under paragraph (b)(9)(C)(1)(i) 
of this section. Asset Y has been held for 2 years and would produce 
$600 of gain if sold immediately before GP's disposition of its API in 
PRS. If Asset S were disposed of immediately before GP disposed of its 
interest in PRS, GP would be allocated gain of $1,400 ($8,000 fair 
market value less $1,000 basis equals gain of $7,000 and 20% of $7,000 
equals $1,400). Accordingly, the amount of gain that would be 
recognized on the disposition of the assets included in paragraph 
(b)(9)(i)(C)(1)(i) of this section is $2,000.
    (iv) Adjustment. The amount of the adjustment is calculated by 
multiplying $480, the amount of gain recognized on the disposition of 
the API by a fraction, expressed as a percentage. The numerator of the 
fraction is $2,000, the amount of gain attributable to assets included 
in the computation under paragraph (b)(9)(i)(C)(1)(i) of this section. 
The denominator of the fraction is equal to $2,400, the amount of gain 
that would be recognized on the hypothetical sale of PRS's assets 
included in the denominator under paragraph (b)(9)(ii)(C)(1)(ii) of 
this section. The fraction is equal to $2000 divided by $2,400, 
expressed as a percentage, or 83.3 percent. The capital gain recognized 
by GP on the sale, $480 is multiplied by 83.3 percent to arrive at the 
gain attributable to the assets included in paragraph 
(b)(9)(i)(C)(1)(i) of this section or $399.84. A's share of the gain is 
$99.96. To compute A's API Three Year Distributive Share Amount, A's 
API Three Year Distributive Share Amount calculated under paragraph 
(a)(3)(ii) of this section is reduced by $99.96 as a result of the 
application of the Lookthrough Rule.
    (iv) Example 4. Installment sale gain. On December 22, 2017, A 
disposed of A's API in an installment sale. At the time of the 
disposition, A had held its API for two years. A received a payment 
with respect to the installment sale during A's 2018 taxable year 
causing A to recognize $200 of long-term capital gain. The $200 long-
term capital gain recognized in 2018 is subject to section 1061 because 
it is recognized after December 31, 2017. Accordingly, the $200 of 
long-term capital gain recognized by A in 2018 is included in A's API 
One Year Disposition Amount. The $200 of long-term capital gain is not 
in A's API Three Year Disposition Amount because the API was not held 
for more than three years at the time of its disposition.
    (v) Example 5. Partnership Transition Amounts and API Holder 
Transition Amounts--(A) Facts. A and B formed GP on January 1, 2012, by 
contributing $150 each. GP contributed the $300 to PRS. GP has a 
calendar taxable year. GP's capital contribution to PRS is equal to 10% 
of the aggregate capital account balance of GP which is $3,000. In 
2012, PRS also issued GP an API in PRS. Under the terms of the 
partnership agreement, GP is allocated 20% of all net capital gain or 
loss earned by PRS with respect to its API. GP also earns a pro rata 
allocation of the remaining 80% of net capital gain or loss. In 2012, 
PRS acquired Asset X and Asset Y for $1,500 each. Following a 
revaluation event, PRS increased the capital accounts of A and B to 
reflect a revaluation of the partnership property as of that date under 
Sec.  1.704-1(b)(2)(iv)(f). As of January 1, 2018, PRS continued to 
hold Asset X and Asset Y. PRS also purchases Asset U for $1,000 on 
December 31, 2019. GP's capital account balance continues to equal 10% 
of the aggregate capital account balance of PRS. As of the due date of 
PRS's federal income tax return for the 2021 taxable year, the first 
year PRS treats amounts as Partnership Transition Amounts, PRS elected 
to treat the long-term capital gain or loss recognized on the 
disposition of all of PRS's assets held for more than three years as of 
January 1, 2018, as Partnership Transition Amounts. PRS identified 
Asset X and Asset Y as assets held for more than three years as of 
January 1, 2018, and subject to the election. PRS retained sufficient 
records to demonstrate that Asset X and Asset Y had been held for more 
than three years as of January 1, 2018.
    (B) Calculation of Partnership Transition Amounts. On December 31, 
2021, when its holding period in Asset U was two years, PRS disposed of 
Asset U for a gain of $2,000. PRS also disposed of Asset X for a gain 
of $2,000 and Asset Y for a gain of $3,000 on the same date. PRS did 
not dispose of any other assets during the calendar year. Thus, PRS 
recognized a total of $7,000 of net long-term capital gain from the 
sale of Asset U, Asset X, and Asset Y ($2,000 + $2,000 + $3,000). 
Because Asset X and Asset Y are assets identified by PRS as having been 
held for three years as of January 1, 2018, the long-term gain from the 
disposition of these assets is treated as a Partnership Transition 
Amount by PRS pursuant to its election. Based on its API, GP is 
entitled to 20% of the total net long-term capital gain of $7,000, or 
$1,400. The remainder of the gain, $5,600, is split between the 
partners according to their partnership interests. GP is entitled to 
10% of the $5,600. GP's distributive share of long-term capital gain 
for 2019 from PRS is $1,960 ((20% x $7,000) + (10% x $5,600)). Of this 
amount, $1,400 is attributable to gain from Asset X ((20% x $2,000) + 
(10% x $1,600)) and Asset Y ((20% x $3,000) + (10% x $2,400)), and is 
treated as an API Holder Transition Amount as to GP. After the $1,960 
allocated to GP is reduced by the $1,400, $560 of the original 
distributive share of long-term capital gain to GP remains. Of this 
amount, $160 is a Capital Interest Allocation from PRS to GP with 
respect to the capital account GP holds in PRS. This amount is also 
subtracted from the amount of the original distributive share, leaving 
a $400 API One Year Distributive Share Amount for the taxable year. 
Because PRS has only held Asset U for two years, the API Three Year 
Distributive Share Amount for the taxable year is 0. GP, in allocating 
the API Holder Transition Amounts allocated to GP by PRS to A and B, 
must allocate those amounts to A and B consistently with the 
partnership agreement in effect for GP as of March 15, 2018, for the 
year ending December 31, 2017. Because A and B have always been 50% 
partners, 50% of the API Holder Transition Amount allocated to GP by 
PRS can be allocated by GP to each A and B.
    (vi) Example 6. REIT capital gain dividend. During the taxable 
year, A holds an API in PRS. PRS holds an interest in REIT. During the 
taxable year, REIT designates a $1,000 capital gain dividend to PRS of 
which 50% is allocable to A's API. Part of the capital gain dividend 
for the year results from section 1231 gain. In accordance with Sec.  
1.1061-6(c)(1)(i), REIT discloses to PRS the One Year Amounts 
Disclosure of $400 which is the $1000 capital gain dividend reduced by 
the $600 of section 1231 capital gain dividend included in that amount. 
Part of the One Year Amounts Disclosure for the year results from gain 
from property held for less than three years. In accordance with Sec.  
1.1061-6(c)(1)(ii), REIT also discloses

[[Page 49792]]

the Three Year Amounts Disclosure of $150, which is the $400 One Year 
Amounts Disclosure reduced by the $250 of gain attributable to property 
held for less than three years. PRS includes a $200 gain in determining 
A's API One Year Distributive Share Amount and a $75 gain in 
determining A's API Three Year Distributive Share Amount. See paragraph 
(b)(4)(i) and (ii) of this section.
    (d) Applicability date. The provisions of this section apply to 
taxable years of Owner Taxpayers and Passthrough Entities beginning on 
or after [DATE OF PUBLICATION OF THE FINAL RULE IN THE FEDERAL 
REGISTER].


Sec.  1.1061-5   Section 1061(d) transfers to related persons.

    (a) In general. If an Owner Taxpayer transfers any API, or any 
Distributed API Property, directly or indirectly, or if a Passthrough 
Entity in which an Owner Taxpayer holds an interest, directly or 
indirectly, transfers an API to a Section 1061(d) Related Person, as 
defined in paragraph (e) of this section, regardless of whether gain is 
otherwise recognized on the transfer under the Internal Revenue Code, 
the Owner Taxpayer shall include in gross income as short-term capital 
gain, the excess (if any) of--
    (1) The Owner Taxpayer's net long-term capital gain with respect to 
such interest for such taxable year determined as provided in paragraph 
(c) of this section, over
    (2) Any amount treated as short-term capital gain under Sec.  
1.1061-4 with respect to the transfer of such interest (that is, any 
amount included in the Owner Taxpayer's API One Year Disposition Gain 
Amount and not in the Owner Taxpayer's Three Year Disposition Gain 
Amount with respect to the transferred interest).
    (b) Transfer. For purposes of section 1061(d), the term transfer 
includes, but is not limited to, contributions, distributions, sales 
and exchanges, and gifts.
    (c) Application of paragraph (a) of this section--(1) Determination 
of amounts included in paragraph (a)(1) of this section.--(A) In 
general. An Owner Taxpayer's net long-term capital gain with respect to 
a transferred API for the taxable year for the purpose of paragraph 
(a)(1) of this section is the amount of net long-term capital gain from 
assets held for three years or less (including any remedial allocations 
under Sec.  1.704-3(d)) that would have been allocated to the partner 
(to the extent attributable to the transferred API) if the partnership 
had sold all of its property in a fully taxable transaction for cash in 
an amount equal to the fair market value of such property (taking into 
account section 7701(g)) immediately prior to the partner's transfer of 
the API. If the amount calculated pursuant to this paragraph (c) is 
negative or zero, then the amount calculated under paragraph (a) of 
this section shall be zero, and section 1061(d) shall not apply. If 
only a portion of a partnership interest is so transferred, then only 
the portion of gain attributable to the transferred interest shall be 
included in gross income.
    (B) Tiered entities. If the Owner Taxpayer transfers an Indirect 
API and is subject to this section, the computation described in 
paragraph (c)(1) of this section must be applied at the level of any 
lower-tier Passthrough Entities.
    (2) Application to an otherwise taxable transfer. In the case of a 
transfer that is otherwise a taxable event, paragraph (a) of this 
section characterizes the capital gain recognized on the transfer as 
short-term capital gain to the extent that the gain is required to be 
included in gross income as short-term capital gain under paragraph (a) 
of this section. If the amount of capital gain otherwise recognized on 
the transfer is less than the amount that is required to be included 
under paragraph (a) of this section, the Owner Taxpayer must include in 
gross income the difference between the amount of gain otherwise 
recognized and the gain required to be included under paragraph (a) of 
this section as short term capital gain.
    (d) Basis of transferred interest increased by additional gain 
recognized. If the basis of a transferred API or, in the case of a 
transfer of an Indirect API, the basis of a transferred Passthrough 
Interest in the transferee's hands is determined, in whole or in part, 
by reference to the basis of the transferred API or Passthrough 
Interest in the transferor's hands before application of this section, 
and capital gain is required to be recognized because of the 
application of this section, then, immediately before the transfer, the 
basis of the API or Passthrough Interest shall (before any increase 
permitted under section 1015(d), if applicable) be increased by the 
capital gain the transferor included in gross income solely by reason 
of this section.
    (e) Section 1061(d) Related Person--(1) In general. For purposes of 
this section, the term Section 1061(d) Related Person means--
    (i) A person that is a member of the taxpayer's family within the 
meaning of section 318(a)(1);
    (ii) A person that performed a service within the current calendar 
year or the preceding three calendar years in a Relevant ATB to the API 
transferred by taxpayer; or
    (iii) A Passthrough Entity to the extent that a person described in 
paragraph (e)(1)(i) or (ii) of this section owns an interest, directly 
or indirectly.
    (2) Exception. A contribution under section 721(a) to a partnership 
is not a transfer to a Section 1061(d) Related Person under this 
paragraph (e) because, as provided in Sec.  1.1061-2(a)(1)(ii)(B), for 
purposes of section 1061 the principles of section 704(c) and 
Sec. Sec.  1.704-1(b)(2)(iv)(f) and 1.704-3(a)(9) apply to allocate all 
applicable Unrealized API Gains and Losses subject to section 1061(a) 
at the time of transfer to the API Holder contributing the interest.
    (f) Examples. The following examples illustrate the rules of this 
section.
    (1) Example 1. Transfer to child by gift. A, an individual, 
performs services in an ATB and has held an API in connection with 
those services for 10 years. The API has a fair market value of $1,000 
and a tax basis of $0. A transfers all of the API to A's daughter as a 
gift. A's daughter is a Section 1061(d) Related Person. Immediately 
before the gift, if the partnership that issued the API had sold all of 
its assets for fair market value, A would have been allocated $700 of 
net long-term capital gain from assets held by the partnership for 
three years or less. Therefore, the amount described in (a)(1) of this 
section is $700. A did not recognize any gain on the transfer for 
federal income tax purposes before application of this section, which 
means that the amount described in (a)(2) of this section is $0. A 
includes the difference between the amounts described in (a)(1) and 
(a)(2) of this section, or $700 and $0, in gross income as short-term 
capital gain. A includes $700 in gross income as short-term capital 
gain. A's daughter increases her basis in the API by the $700 of gain 
recognized by A on the transfer under paragraph (d) of this section.
    (2) Example 2. Taxable transfer to child for fair market value. The 
facts are the same as in Example 1, except that A sells the API to A's 
daughter for $1,000, the API's fair market value and recognizes $1,000 
of capital gain. A's API One Year Disposition Amount and API Three Year 
Disposition Amount are both $1,000. Therefore, the amount described in 
(a)(2) of this section is $0. The amount described in (a)(1) is $700. 
The difference between the amount described in (a)(1) of this section 
($700) and the amount described in (a)(2) of this section ($0) is $700. 
Because A

[[Page 49793]]

recognized gain greater than the amount required under paragraph (a) of 
this section, there is no gain to accelerate and up to $700 of A's 
long-term capital gain will be recharacterized as short-term gain. 
Three hundred dollars of A's gain is not recharacterized under section 
1061(d). The balance of $700 of long-term capital gain is entirely 
recharacterized as short-term capital gain. Accordingly, A includes 
$300 of gain in gross income as long-term capital gain and $700 as 
short-term capital gain. Because A's daughter does not determine her 
basis in the API by reference to A's basis, paragraph (d) of this 
section does not apply.
    (3) Example 3. Contribution of an API to a Passthrough Entity owned 
by Section 1061(d) Related Persons--(i) Facts. A, B, and C are equal 
partners in GP. GP holds only one asset, an API in PRS1 which is an 
indirect API as to each A, B, and C. A, B, and C each provide services 
in the ATB in connection with which GP was transferred its API in PRS1. 
A and B contribute their interests in GP to PRS2 in exchange for 
interests in PRS2. Under the terms of the partnership agreement of 
PRS2, all Unrealized API Gain or Loss allocable to A and B in the 
property held by GP and PRS1 as of the date of the contribution by A 
and B when recognized will continue to be allocated to each A and B by 
PRS2. As provided in Sec.  1.1061-2(a)(1)(ii)(B), as a result of the 
contribution by A and B of their interests in GP to PRS2, PRS1 and GP 
must revalue their assets under the principles of Sec.  1.704-
1(b)(2)(iv)(f).
    (ii) Application of section 1061(d). The contribution by A and B of 
their interest in GP to PRS2 is a potential transfer to a Section 
1061(d) Related Person as to both A and B under paragraph (e)(1)(iii) 
of this section to the extent that the other is an owner of PRS2. 
However, because paragraph (e)(2) of this section provides that a 
contribution under section 721(a) to a partnership is not a transfer to 
a Section 1061(d) Related Person for purposes of this section, section 
1061(d) does not apply to A and B's contribution.
    (g) Applicability date. The provisions of this section apply to 
taxable years of Owner Taxpayers and Passthrough Entities beginning on 
or after [DATE OF PUBLICATION OF THE FINAL RULE IN THE FEDERAL 
REGISTER].


Sec.  1.1061-6   Reporting rules.

    (a) Owner Taxpayer Filing Requirements-(1) In general. An Owner 
Taxpayer must file such information with the IRS as the Commissioner 
may require in forms, instructions, or other guidance as is necessary 
for the Commissioner to determine that the Owner Taxpayer has properly 
complied with section 1061 and Sec. Sec.  1.1061-1 through 1.1061-6.
    (2) Failure to obtain information. Paragraph (b)(1) of this section 
requires Passthrough Entities to furnish an Owner Taxpayer with certain 
amounts necessary to determine its Recharacterization Amount and meet 
its reporting requirements under paragraph (a)(1) of this section. To 
the extent that an Owner Taxpayer is not furnished the information 
required to be furnished under paragraph (b)(1) of this section in such 
time and in such manner as required by the Commissioner and the Owner 
Taxpayer is not otherwise able to substantiate all or a part of these 
amounts to the satisfaction of the Secretary of the Treasury or his 
delegate (Secretary), then--
    (i) With respect to the determination of the API One Year 
Distributive Share Amount under Sec.  1.1061-4(a)(3)(i) if not 
furnished, the amount calculated under Sec.  1.1061-4(a)(3)(i)(B) does 
not include--
    (A) Amounts excluded from section 1061 under Sec.  1.1061-4(b)(6);
    (B) API Holder Transition Amounts; and
    (C) Capital Interest Gains and Losses as determined under Sec.  
1.1061-3(c)(2).
    (ii) With respect to the determination of the API Three Year 
Distributive Share Amount determined under Sec.  1.1061-4(a)(3)(ii) if 
not furnished, items included in the API One Year Distributive Share 
amount are treated as items that would not be treated as long-term 
capital gain or loss, if three years is substituted for one year in 
paragraphs (3) and (4) of section 1222.
    (b) Passthrough Entity Filing Requirements and Reporting--(1) 
Requirement to file information with the IRS and to furnish information 
to API Holder. A Passthrough Entity must file such information with the 
IRS as the Commissioner may require in forms, instructions, or other 
guidance as is necessary for the Commissioner to determine that it and 
its partners have complied with the section 1061 and Sec. Sec.  1.1061-
1 through 1.1061-6. A Passthrough Entity that has issued an API must 
furnish to the API Holder, including an Owner Taxpayer, such 
information at such time and in such manner as the Commissioner may 
require in forms, instructions or other guidance as is necessary to 
determine the One Year Gain Amount and the Three Year Gain Amount with 
respect to an Owner Taxpayer that directly or indirectly holds the API. 
A Passthrough Entity that has furnished information to the API Holder 
must file such information with the IRS, at such time and in such 
manner as the Commissioner may require in forms, instructions or other 
guidance. This information includes:
    (i) The API One Year Distributive Share Amount and the API Three 
Year Distributive Share Amount (as determined under Sec.  1.1061-4);
    (ii) Capital gains and losses allocated to the API Holder that are 
excluded from section 1061 under Sec.  1.1061-4(b)(6);
    (iii) Capital Interest Gains and Losses allocated to the API Holder 
(as determined under Sec.  1.1061-3(c));
    (iv) API Holder Transition Amounts (as determined under Sec.  
1.1061-4(b)(7)); and
    (v) In the case of a disposition by an API Holder of an interest in 
the Passthrough Entity during the taxable year, any information 
required by the API Holder to properly take the disposition into 
account under section 1061, including information to apply the 
Lookthrough Rule and to determine its Capital Interest Disposition 
Amount.
    (2) Requirement to request, furnish, and file information in tiered 
structures--(i) Requirement to request information. If Passthrough 
Entity requires information to meet its reporting and filing 
requirements under this Sec.  1.1061-6 (in addition to any information 
required to be furnished to the Passthrough Entity under paragraph 
(b)(1) of this section) from a lower tier entity in which it holds an 
interest, the Passthrough Entity must request such information from 
that entity.
    (ii) Requirement to furnish and file information. If information is 
requested of a Passthrough Entity under paragraph (b)(2)(i) of this 
section, the Passthrough Entity must furnish the requested information 
to the person making the request. If the person requesting the 
information is an API Holder in the Passthrough Entity, the information 
is furnished under paragraph (b)(1) of this section. If the Passthrough 
Entity requesting the information is not an API Holder, the Passthrough 
Entity must furnish the information to the requesting Passthrough 
Entity as required by the Commissioner in forms, instructions, or other 
guidance. Additionally, the Passthrough Entity must file the requested 
information with the IRS as the Commissioner may require in forms, 
instructions, or other guidance.
    (iii) Timing of requesting and furnishing information--(A) 
Requesting information. A Passthrough Entity described in paragraph 
(b)(2)(i) of this section must request information under paragraph 
(b)(2)(i) of this section by the later of the 30th day after the close 
of

[[Page 49794]]

the taxable year to which the information request relates or 14 days 
after the date of a request for information from an upper tier 
Passthrough Entity.
    (B) Furnishing information--(1) In general. Except as provided in 
paragraph (b)(2)(iii)(B)(2) of this section, requested information must 
be furnished by the date on which the entity is required to furnish 
information under section 6031(b) or under section 6037(b), as 
applicable.
    (2) Late requests. Information with respect to a taxable year that 
is requested by an upper tier Passthrough Entity after the date that is 
14 days prior to the due date for a lower tier Passthrough Entity to 
furnish and file information under section 6031(b) or section 6037(b), 
as applicable, must be furnished and filed in the time and manner 
prescribed by forms, instructions and other guidance.
    (iv) Manner of requesting information. Information may be requested 
electronically or in any manner that is agreed to by the parties.
    (v) Recordkeeping Requirement. Any Passthrough Entity receiving a 
request for information must retain a copy of the request and the date 
received in its books and records.
    (vi) Passthrough Entity is not Furnished Information to meet its 
Reporting Obligations under paragraph (b)(1) of this section. If an 
upper-tier Passthrough Entity holds an interest in a lower-tier 
Passthrough Entity and it is not furnished the information described in 
paragraph (b)(1) of this section, or, alternatively, if it has not been 
furnished information after having properly requested the information 
under this paragraph (b)(2), the upper-tier Passthrough Entity must 
take actions to otherwise determine and substantiate the missing 
information. To the extent that the upper-tier Passthrough Entity is 
not able to otherwise substantiate and determine the missing 
information to the satisfaction of the Secretary, the upper-tier 
Passthrough Entity must treat these amounts as provided under paragraph 
(a)(2) of this section. The upper-tier Passthrough Entity must provide 
notice to the API Holder and the IRS regarding the application of this 
paragraph (b)(2) to the information being reported as required in 
forms, instructions, and other guidance.
    (vii) Penalties. In addition to the requirement to section 1061(e), 
the information required to be furnished under this paragraph (b) is 
also required to be furnished under sections 6031(b) and 6037(b), and 
failure to report as required under this paragraph (b) will be subject 
to penalties under section 6722.
    (c) Regulated investment company (RIC) and real estate investment 
trust (REIT) reporting--(1) Section 1061 disclosures. A RIC or REIT 
that reports or designates a dividend, or part thereof, as a capital 
gain dividend, may, in addition to the information otherwise required 
to be furnished to a shareholder, disclose two amounts for purposes of 
section 1061--
    (i) One Year Amounts Disclosure. The One Year Amounts Disclosure of 
a RIC or REIT is a disclosure by the RIC or REIT of an amount that is 
attributable to a computation of the RIC's or REIT's net capital gain 
excluding capital gain and capital loss not taken into account for 
purposes of section 1061 under Sec.  1.1061-4(b)(6). The aggregate 
amounts provided in the One Year Amounts Disclosures with respect to a 
taxable year of a RIC or REIT must equal the lesser of the RIC's or 
REIT's net capital gain, excluding any capital gains and capital losses 
not taken into account for purposes of section 1061 under Sec.  1.1061-
4(b)(6), for the taxable year or the RIC's or REIT's aggregate capital 
gain dividends for the taxable year.
    (ii) Three Year Amounts Disclosure. The Three Year Amounts 
Disclosure of a RIC or REIT is a disclosure by the RIC or REIT of an 
amount that is attributable to a computation of the RIC's or REIT's One 
Year Amounts Disclosure substituting ``three years'' for ``one year'' 
in applying section 1222. The aggregate amounts provided in the Three 
Year Amounts Disclosures with respect to a taxable year of a RIC or 
REIT must equal the lesser of the aggregate amounts provided in the 
RIC's or REIT's One Year Amounts Disclosures substituting ``three 
years'' for ``one year'' in applying section 1222 for the taxable year 
or the RIC's or REIT's aggregate capital gain dividends for the taxable 
year.
    (2) Pro rata disclosures. The One Year Amounts Disclosure and Three 
Year Amounts Disclosure made to each shareholder of a RIC or REIT must 
be proportionate to the share of capital gain dividends reported or 
designated to that shareholder for the taxable year.
    (3) Report to shareholders. A RIC or REIT that provides the section 
1061 disclosures described in paragraphs (c)(1)(i) and (ii) of this 
section must provide those section 1061 disclosures in writing to its 
shareholders with the statement described in section 852(b)(3)(C)(i) or 
the notice described in section 857(b)(3)(B) in which the capital gain 
dividend is reported or designated.
    (d) Qualified electing fund (QEF) reporting. A passive foreign 
investment company with respect to which the shareholder has a QEF 
election (as described in section 1295(a)) in effect for the taxable 
year that determines net capital gain as provided in Sec.  1.1293-
1(a)(2)(A) may provide additional information to its shareholders to 
enable API Holders to determine the amount of their inclusion under 
section 1293(a)(1) that would be included in the API One Year 
Distributive Share Amounts and API Three Year Distributive Share 
Amounts. If such information is not provided, an API Holder must 
include all amounts of long-term capital gain from the QEF in its API 
One Year Distributive Share Amounts and no amounts in its API Three 
Year Distributive Share Amount. An API Holder who receives the 
additional information described in this paragraph (d) must retain such 
information as required by Sec.  1.1295-1(f)(2)(ii).
    (e) Applicability date. The provisions of this section apply to 
taxable years of Owner Taxpayers and Passthrough Entities beginning on 
or after [DATE OF PUBLICATION OF THE FINAL RULE IN THE FEDERAL 
REGISTER].
0
Par. 5. Section 1.1223-3 is amended by:
0
1. Redesignating paragraph (b)(5) as paragraph (b)(6);
0
2. Adding new paragraph (b)(5);
0
3. Designating Example 1 through Example 8 of paragraph (f) as 
paragraphs (f)(1) through (f)(8);
0
4. Adding paragraphs (f)(9) and (10); and
0
5. Adding a sentence at the end of paragraph (g).
    The additions read as follows:


Sec.  1.1223-3   Rules relating to the holding periods of partnership 
interests.

* * * * *
    (b) * * *
    (5) Divided holding period if partnership interest comprises in 
whole or in part one or more profits interests--(i) In general. If a 
partnership interest is comprised in whole or in part of one or more 
profits interests (as defined in paragraph (b)(5)(ii) of this section), 
then, for purposes of applying paragraph (b)(1) of this section, the 
portion of the holding period to which a profits interest relates is 
determined based on the fair market value of the profits interest upon 
the disposition of all, or part, of the interest (and not at the time 
that the profits interest is acquired). Paragraph (b)(1) of this 
section continues to apply to the extent that a partner acquires 
portions of a partnership interest that are not comprised of a profits 
interest and the value of the profits interest is not included for 
purposes of determining

[[Page 49795]]

the value of the entire partnership interest under that paragraph.
    (ii) Definition of profits interest. For purposes of this paragraph 
(b)(5), a profits interest is a partnership interest other than a 
capital interest. A capital interest is an interest that would give the 
holder a share of the proceeds if the partnership's assets were sold at 
fair market value at the time the interest was received and then the 
proceeds were distributed in a complete liquidation of the partnership. 
A profits interest, for purposes of this paragraph (b)(5), is received 
in connection with the performance of services to or for the benefit of 
a partnership in a partner capacity or in anticipation of being a 
partner, and the receipt of the interest is not treated as a taxable 
event for the partner or the partnership under applicable federal 
income tax guidance.
* * * * *
    (f) * * *
    (9) Example 9. On June 1, 2020, GP contributes $10,000 to PRS for a 
partnership interest in PRS. On June 30, 2023, GP received a 20% 
interest in the profits of PRS that is an applicable partnership 
interest (API), as defined in Sec.  1.1061-1, in PRS. On June 30, 2025, 
GP sells its interest in PRS for $30,000. At the time of GP's sale of 
its interest, the API has a fair market value of $15,000. GP has a 
divided holding period in its interest in PRS; 50% of the partnership 
interest has a holding period beginning on June 1, 2020, and 50% has a 
holding period that begins on June 30, 2023.
    (10) Example 10. Assume the same facts as in Example 9, except that 
on June 30, 2024, GP contributes an additional $5,000 cash to GP prior 
to GP's sale of its interest in 2025. Immediately after the 
contribution of the $5,000 on June 23, 2024, GP's interest in PRS has a 
value of $15,000, not taking into account the value of GP's profits 
interest in PRS. GP calculates its holding period in the portions not 
comprised by the profits interest and two-thirds of its holding period 
runs from June 30, 2020, and one-third runs from June 30, 2024. On June 
30, 2025, GP sells its interest for $30,000 and the API has a fair 
market value of $15,000. Accordingly, on the date of disposition, one-
third of GP's interest has a five year holding period from its interest 
received in 2020 for its $10,000 contribution, one-half of GP's 
interest has a two year holding period from the profits interest issued 
on June 30, 2023, and one-sixth of GP's interest has a one year holding 
period from the contribution of the $5,000.
    (g) * * * Paragraph (b)(5), (f)(9), and (f)(10) of this section 
apply to taxable years beginning on or after [DATE OF PUBLICATION OF 
THE FINAL RULE IN THE FEDERAL REGISTER].

Sunita Lough,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 2020-17108 Filed 8-6-20; 4:15 pm]
BILLING CODE 4830-01-P