Final Regs on Remedial Allocation Method for Contributions to Partnerships

 [4830-01-u]

 ACTION: Final regulations.

 SUMMARY: This document contains final regulations under section 704 of the Internal Revenue Code relating to the remedial allocation method with respect to property contributed by a partner to a partnership and to allocations with respect to securities and similar investments owned by a partnership. Changes to the applicable law were made by the Tax Reform Act of 1984 (the 1984 Act) and the Revenue Reconciliation Act of 1989 (the 1989 Act). The final regulations affect partnerships and their partners and provide guidance needed to comply with the applicable tax law.

 EFFECTIVE DATE: These regulations are effective December 21, 1993.

 FOR FURTHER INFORMATION CONTACT: Deborah Harrington at (202) 622-3050 (not a toll-free number).

 SUPPLEMENTARY INFORMATION:

INTRODUCTION

This document adds sections 1.704-3(d), 1.704-3(e)(3) and 1.704-3(e)(4) to the Income Tax Regulations (26 CFR part 1) under sections 704(c)(1)(A) and 704(c)(3), removes existing sections 1.704-3(e)(2)(iv) and 1.704-3(e)(2)(v), revises existing sections 1.704-1(b)(1)(vi), 1.704-1(b)(2)(iv)(d)(3), 1.704-1(c), 1.704-3(a)(1), 1.704-3(a)(3)(i), and 1.704-3(e)(2)(iii), and removes section 1.704-3T of the Temporary Income Tax Regulations.

BACKGROUND

 On December 22, 1993, final regulations (TD 8500, 58 FR 67676) (the 1993 regulations) under section 704 relating to allocations with respect to property contributed by a partner to a partnership were published in the Federal Register. The 1993 regulations implement section 704(c) as amended by the 1984 Act and the 1989 Act. The portions of the 1993 regulations relating to the remedial allocation method and allocations with respect to securities and similar investments owned by a partnership were reserved. The IRS and Treasury contemporaneously issued temporary regulations (TD 8501, 58 FR 67684) (the temporary regulations) addressing the issues reserved in the final regulations. A notice of proposed rulemaking (58 FR 67744) cross-referencing the temporary regulations was published in the Federal Register on the same day. Comments responding to the notice were received, and a public hearing was held on April 4, 1994. After considering the comments and the statements made at the hearing, the IRS and Treasury adopt the proposed regulations as revised by this Treasury decision and withdraw the temporary regulations. The IRS and Treasury also amend the 1993 regulations as described by this Treasury decision.

EXPLANATION OF PROVISIONS

REMEDIAL ALLOCATION METHOD

 The final regulations generally adopt the provisions of the proposed regulations with respect to the remedial allocation method of making allocations under section 704(c). Accordingly, under the final regulations, a partnership may eliminate ceiling rule distortions by making remedial allocations of income, gain, loss, or deduction to the noncontributing partners equal to the full amount of the limitation caused by the ceiling rule, and offsetting those allocations with remedial allocations of deduction, loss, gain, or income to the contributing partner. In response to comments, the final regulations emphasize that the remedial allocation method involves the creation of notional tax items by the partnership and is not dependent upon the actual tax items recognized by the partnership.

 One comment questioned the Secretary's authority to issue regulations allowing partnerships to create notional tax items in order to make allocations under section 704(c). In enacting section 704(c), Congress gave the Secretary broad authority to permit allocations that correct ceiling rule distortions. See H.R. Rep. No. 98-432 (Part 2), 98th Cong., 2d Sess. 1209 (1984). Offering partnerships a voluntary method of correcting ceiling rule distortions by creating notional tax items is consistent with this congressional grant of authority.

 One comment suggested that the final regulations adopt the remedial allocation method as a safe harbor method for making section 704(c) allocations. Another comment suggested that the remedial allocation method be a baseline for measuring whether the section 704(c) method used by a partnership has the effect of substantially reducing the present value of the aggregate tax liabilities of the partners for purposes of the anti-abuse rule set forth in section 1.704-3(a)(10).

 The IRS and Treasury continue to believe it is appropriate to require that all allocation methods, including the remedial allocation method, be subject to the anti-abuse rule. There may be circumstances under which contributions of property could be made and the remedial allocation method adopted with a view to shifting tax consequences impermissibly. It would be inconsistent with the general scope of these regulations to prescribe a method of allocation that is always reasonable regardless of the facts and circumstances. Furthermore, the IRS and Treasury believe that it would be inappropriate to adopt the remedial allocation method as a baseline for measuring whether the partners' aggregate tax liability has been reduced. Such a baseline would make the remedial allocation method preeminent, undercutting its elective nature.

 One comment suggested that the regulations require partnerships to elect the remedial allocation method in their partnership agreements. The comment did not specify any reason for imposing this requirement on partnerships.

 The section 704(c) regulations generally allow partnerships to choose a reasonable section 704(c) method. The regulations only require adoption of an allocation method in the partnership agreement for those section 704(c) methods that have a significant potential for abuse. See sections 1.704-3(c)(3)(ii) and 1.704-3(c)(3)(iii)(B) of the 1993 regulations. The use of the remedial allocation method can generally be determined from the partnership's books and records. Therefore, the final regulations do not require that the method be adopted in the partnership agreement.

 The temporary and proposed regulations require that a partnership using the remedial allocation method recover the portion of its book basis in the property equal to its tax basis in the property at the time of contribution in the same manner as the tax basis is recovered. The remainder of the partnership's book basis in the property (the amount by which book basis exceeds adjusted tax basis) is recovered using any applicable recovery period and depreciation (or other cost recovery) method available to the partnership for newly purchased property placed in service at the time of contribution. The final regulations clarify that the recovery period and depreciation (or other cost recovery) method adopted by the partnership for this purpose must be one that is available for newly purchased property of the type contributed, including any applicable first-year conventions.

 Under the temporary and proposed regulations, remedial allocations are reasonable only if they have the same effect on each partner's tax liability as the item limited by the ceiling rule. Some comments requested clarification of this provision.

 In response to these comments, the final regulations provide that the tax attributes of remedial allocations of income, gain, loss, or deduction to noncontributing partners must be the same as the tax attributes of the items limited by the ceiling rule. The tax attributes of offsetting remedial allocations of income, gain, loss, or deduction to the contributing partner are determined by reference to the items limited by the ceiling rule. Thus, for example, if the ceiling rule limited item is loss from the sale of contributed property, the offsetting remedial allocation to the contributing partner must be gain from the sale of that property. If the ceiling rule limited item is depreciation or other cost recovery from the contributed property, the offsetting remedial allocation to the contributing partner must be income of the type produced (directly or indirectly) by that property.

 Any partner level attributes are determined at the partner level. The tax attributes of a remedial allocation at the partner level are determined by treating the remedial allocation as if it were related to the same activity, investment, or business as the item limited by the ceiling rule. For instance, a remedial allocation of depreciation to a noncontributing partner will not be subject to section 469 (passive activity loss) limitations if the noncontributing partner materially participates in the activity in which the contributed property is used. However, the offsetting remedial allocation of income to the contributing partner will be treated as income from a passive activity if the contributing partner does not materially participate in the activity in which the contributed property is used. See section 469.

 Several comments requested that the regulations clarify the effect of remedial allocations on other tax computations, such as the partnership's basis in the section 704(c) property to which the allocation relates and the basis of the partner's partnership interest. The final regulations clarify that remedial allocations have the same effect on a partner's tax liability as other tax items actually recognized by the partnership and have the same effect on the adjusted tax basis of the partner's partnership interest.

 The final regulations also clarify that, because remedial allocations to noncontributing partners and offsetting remedial allocations to the contributing partner net to zero at the partnership level, remedial allocations do not affect the partnership's computation of its taxable income under section 703. Remedial allocations also do not affect the partnership's adjusted tax basis in partnership property (and, consequently, do not affect the aggregate amount of depreciation recapture income recognized by the partnership on the sale of the property).

 Some comments requested that the final regulations address the allocation of gain from section 704(c) property that is treated as ordinary income under sections 1245 or 1250 (depreciation recapture). One comment suggested that the regulations require partnerships to allocate depreciation recapture from section 704(c) property based on the partners' relative shares of depreciation or amortization from the property, rather than on their shares of gain or loss from the property. See sections 1.1245-1(e)(2) and 1.1250-1(f).

 The IRS and Treasury do not believe this issue is appropriately addressed in regulations issued under section 704(c); however, this issue is under review and consideration is being given to amending the regulations under sections 1245 and 1250 to incorporate the rule suggested by these comments. Additional comments on the proper allocation of depreciation recapture income by a partnership, both inside and outside of the section 704(c) context, are welcomed.

 The temporary and proposed regulations provide that the IRS will not require a partnership to use the remedial allocation method described in section 1.704-3T(d). In response to a comment, the final regulations clarify that the IRS may not force a partnership to use any other method involving the creation of notional tax items.

 Several comments requested that the final regulations clarify the interaction between the remedial allocation method and other Code provisions, notably sections 743, 752, and 754. The IRS and Treasury have determined that these issues would be better addressed in other guidance. To give the IRS and Treasury flexibility in addressing these issues in the future, the final regulations provide that the Commissioner may, by published guidance, prescribe adjustments to the remedial allocation method as necessary or appropriate. This guidance may, for example, prescribe adjustments to the remedial allocation method to prevent the duplication or omission of items of income or deduction or to reflect more clearly the partners' income or the income of a transferee of a partner.

SECURITIES AGGREGATION

 The frequency of capital account restatements under section 1.704-1(b)(2)(iv)(f) and the number of partnership assets may make it impractical for certain securities partnerships to make reverse section 704(c) allocations on an asset-by-asset basis. Therefore, the temporary and proposed regulations permit certain securities partnerships to aggregate gains and losses from securities or similar instruments when making reverse section 704(c) allocations. The temporary and proposed regulations define a securities partnership as one that: (1) is diversified as defined in section 851(b)(4), (2) has at least 90 percent of its non-cash assets in stock, securities, commodities, options, warrants, futures, or similar investments that are readily tradeable on an established securities market, (3) either is registered as a management company with the Securities and Exchange Commission under the Investment Company Act of 1940, as amended (15 U.S.C. 80a) (the 1940 Act), or does not have 50 percent or more of its capital interests held at any time during the current partnership year by five or fewer unrelated persons, and (4) makes all of its allocations in proportion to the partners' relative book capital accounts (except for reasonable special allocations to a partner that provides management services).

 The IRS and Treasury requested and received comments suggesting other definitions of securities partnerships. After considering these comments, the IRS and Treasury have determined that a more flexible definition of securities partnership should be adopted. Accordingly, under the final regulations, a securities partnership is a partnership that is either a management company or an investment partnership, and that makes all of its book allocations in proportion to the partners' relative book capital accounts (except for reasonable special allocations to a partner providing management services or investment advisory services). The final regulations define a management company as a partnership that is registered as a management company under the 1940 Act. The final regulations define an investment partnership as a partnership that, on the date of each capital account restatement, holds qualified financial assets constituting at least 90 percent of the fair market value of its non- cash assets and that reasonably expects, as of the end of the first taxable year in which the partnership adopts an aggregate approach for reverse section 704(c) allocations, to make revaluations of its qualified financial assets at least annually.

 Some comments suggested that the regulations allow a securities partnership to aggregate gains and losses from all of its assets. The IRS and Treasury believe that it is not generally appropriate to allow a partnership to aggregate gains and losses from financial assets with gains and losses from other types of assets. The IRS and Treasury also believe that aggregation should generally be limited to financial assets that are easily valued.

 Nevertheless, the IRS and Treasury recognize that some financial assets that are not readily tradeable on an established securities market may be easily valued. These financial assets are included in section 1.1092(d)-1 (defining actively traded property for purposes of the straddle rules). Accordingly, the final regulations permit securities partnerships to aggregate gains and losses from qualified financial assets, defined as any personal property (including stock) that is actively traded as defined in section 1.1092(d)-1, even if it is not readily tradeable on an established securities market.

 There is less reason to limit aggregation to easily valued assets when the partnership is registered as a management company under the 1940 Act, because a management company's valuation of its assets is closely regulated by the Securities and Exchange Commission. Accordingly, the final regulations allow partnerships registered as management companies to aggregate gains and losses from stock, evidences of indebtedness, notional principal contracts, derivative financial instruments, options, forward or futures contracts, short positions, and similar financial instruments, whether or not actively traded.

 In response to comments, the final regulations also clarify the treatment of tiered partnerships. Under the final regulations, a partnership interest is not a qualified financial asset. However, if a partnership (upper-tier partnership) holds an interest in a securities partnership (lower-tier partnership), the upper-tier partnership must treat its proportionate share of the lower-tier partnership's assets as assets of the upper-tier partnership in determining whether the upper-tier partnership qualifies as an investment partnership. The final regulations also provide that, if the upper-tier partnership adopts an aggregate approach under the special rule for securities partnerships, the upper-tier partnership must aggregate the gains and losses from its directly held qualified financial assets with its distributive share of the gains and losses from the qualified financial assets of the lower-tier partnership.

 The temporary and proposed regulations require that a securities partnership aggregate its gains separately from its losses. In response to comments, this requirement has been eliminated in the final regulations. Under the final regulations, partnerships may net book gains with book losses and may also net tax gains with tax losses when making reverse section 704(c) allocations so long as the partnership's aggregate approach is reasonable and does not violate the anti-abuse rule set forth in section 1.704-3(a)(10). This rule accords more with the overall flexibility of the section 704(c) regulations than does an outright prohibition of netting.

 Two examples of aggregate approaches have been added to the regulations for purposes of illustrating the operation of the aggregation rules. Other aggregate approaches were suggested. Although those approaches may be reasonable in appropriate situations, they are not specifically described in the final regulations because they appear to be less common than those aggregate approaches that are described in the regulations.

 Under the final regulations, the character and other tax attributes of gain or loss allocated to the partners must: (1) preserve the tax attributes of each item of gain or loss realized by the partnership; (2) be determined under an approach that is consistently applied; and (3) not be determined with a view to reducing substantially the present value of the partners' aggregate tax liability.

 In response to a comment, the IRS and Treasury have added in the final regulations a transitional rule that allows securities partnerships to use any reasonable approach to coordinate revaluations occurring on or after the effective date of these regulations with revaluations occurring before the effective date of these regulations. This provision allows securities partnerships to net book gains and book losses from revaluations occurring before the effective date of these regulations with book gains and book losses from revaluations occurring on or after the effective date of these regulations in making allocations under these regulations.

 The IRS and Treasury recognize that a partnership may, at some point, no longer qualify as a securities partnership. The final regulations make it clear that a securities partnership that adopts an aggregate approach and subsequently fails to qualify as a securities partnership is not required to disaggregate the book gain or book loss from qualified asset revaluations before the date of disqualification when making reverse section 704(c) allocations on or after the date of disqualification. Additional guidance relating to this issue may be issued in the future. The final regulations authorize the Commissioner to permit, by published guidance or by letter ruling, aggregation of gain and loss from qualified financial assets by partnerships not qualifying as securities partnerships. The IRS and Treasury welcome comments on whether and under what circumstances waivers of the qualification requirements should be granted.

AGGREGATION OF SECTION 704(c) AND REVERSE SECTION 704(c) ALLOCATIONS

 Several comments requested that the final regulations allow partnerships that restate capital accounts pursuant to section 1.704-1(b)(2)(iv)(f) to aggregate their built-in gains and losses from contributed property with their built-in gains and losses from capital account restatements. Because this type of aggregation could lead to substantial distortions in the character and timing of the income or loss recognized by contributing partners, the final regulations do not specifically authorize this type of aggregation. The IRS and Treasury recognize, however, that there may be instances in which the likelihood of character and timing distortions is minimal and the burden of making section 704(c) allocations separate from reverse section 704(c) allocations is great. Accordingly, the final regulations authorize the Commissioner to permit, by letter ruling or in published guidance, aggregation of section 704(c) gains and losses with reverse section 704(c) gains and losses.

 In response to another comment, the final regulations also authorize the Commissioner to permit, by letter ruling or in published guidance, aggregation of section 704(c) gains and losses from properties other than those specifically authorized in the regulations or from properties contributed by more than one partner.

EFFECTIVE DATE

 The provisions added by this Treasury decision apply to property contributed to a partnership and to restatements pursuant to section 1.704-1(b)(2)(iv)(f) on or after December 21, 1993. However, taxpayers may rely on the provisions of section 1.704-3T when making allocations with respect to properties contributed to a partnership and to restatements pursuant to section 1.704-1(b)(2)(iv)(f) on or after December 21, 1993 and before December 28, 1994.

 General tax principles continue to apply to all transactions involving section 704(c) entered into before and after the effective date of the regulations under section 704(c). The IRS and Treasury are aware of certain transactions entered into after the proposed section 704(c) regulations were issued under section 1.704-3, but before the regulations were finalized, that were similar to the anti- abuse examples contained in the proposed regulations and that would violate the anti-abuse rule contained in the final section 704(c) regulations under section 1.704-3(a)(10) but for the effective date of those regulations. The IRS and Treasury believe that the validity of these transactions is subject to challenge under general tax principles and will apply these principles in reviewing such transactions.

SPECIAL ANALYSES

 It has been determined that this Treasury decision is not a significant regulatory action as defined in EO 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking preceding these regulations was submitted to the Small Business Administration for comment on its impact on small business.

DRAFTING INFORMATION

 The principal author of these final regulations is Deborah Harrington of the Office of the Assistant Chief Counsel (Passthroughs and Special Industries). However, other personnel from the IRS and Treasury participated in their development.

LIST OF SUBJECTS IN 26 CFR PART 1

 Income taxes, Reporting and recordkeeping requirements.

Treasury Decision 8585

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR part 1 is amended as follows:

PART 1 -- INCOME TAXES

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

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

Section 1.704-3 also issued under 26 U.S.C. 704(c). * * *

Par. 2. Section 1.704-1 is amended as follows:

1. Paragraph (b)(1)(vi) is amended by removing the reference "section 1.704-3T(d)(2)" and adding "section 1.704-3(d)(2)" in its place.

2. Paragraph (b)(2)(iv)(d)(3) is amended by removing the reference "section 1.704-3T(d)(2)" and adding "section 1.704-3(d)(2)" in its place.

3. Paragraph (c) is amended by removing the reference "See sections 1.704-3 and 1.704-3T" and adding "See section 1.704-3" in its place.

Par. 3. Section 1.704-3 is amended as follows:

1. Paragraph (a)(1) is amended by removing the reference "section 1.704-3T(d)" and adding "section 1.704-3(d)" in its place.

2. Paragraph (a)(3)(i) is amended by removing the reference "section 1.704-3T(d)(2)" and adding "section 1.704-3(d)(2)" in its place.

3. Paragraph (d) is revised.

4. Paragraph (e)(2)(iii) is revised.

5. Paragraphs (e)(2)(iv) and (e)(2)(v) are removed.

6. Paragraph (e)(3) is revised and paragraph (e)(4) is added.

7. The additions and revisions read as follows:

SECTION 1.704-3 CONTRIBUTED PROPERTY.

* * * * *

(d) REMEDIAL ALLOCATION METHOD -- (1) IN GENERAL. A partnership may adopt the remedial allocation method described in this paragraph to eliminate distortions caused by the ceiling rule. A partnership adopting the remedial allocation method eliminates those distortions by creating remedial items and allocating those items to its partners. Under the remedial allocation method, the partnership first determines the amount of book items under paragraph (d)(2) of this section and the partners' distributive shares of these items under section 704(b). The partnership then allocates the corresponding tax items recognized by the partnership, if any, using the traditional method described in paragraph (b)(1) of this section. If the ceiling rule (as defined in paragraph (b)(1) of this section) causes the book allocation of an item to a noncontributing partner to differ from the tax allocation of the same item to the noncontributing partner, the partnership creates a remedial item of income, gain, loss, or deduction equal to the full amount of the difference and allocates it to the noncontributing partner. The partnership simultaneously creates an offsetting remedial item in an identical amount and allocates it to the contributing partner.

(2) DETERMINING THE AMOUNT OF BOOK ITEMS. Under the remedial allocation method, a partnership determines the amount of book items attributable to contributed property in the following manner rather than under the rules of section 1.704-1(b)(2)(iv)(g)(3). The portion of the partnership's book basis in the property equal to the adjusted tax basis in the property at the time of contribution is recovered in the same manner as the adjusted tax basis in the property is recovered (generally, over the property's remaining recovery period under section 168(i)(7) or other applicable Internal Revenue Code section). The remainder of the partnership's book basis in the property (the amount by which book basis exceeds adjusted tax basis) is recovered using any recovery period and depreciation (or other cost recovery) method (including first-year conventions) available to the partnership for newly purchased property (of the same type as the contributed property) that is placed in service at the time of contribution.

(3) TYPE. Remedial allocations of income, gain, loss, or deduction to the noncontributing partner have the same tax attributes as the tax item limited by the ceiling rule. The tax attributes of offsetting remedial allocations of income, gain, loss, or deduction to the contributing partner are determined by reference to the item limited by the ceiling rule. Thus, for example, if the ceiling rule limited item is loss from the sale of contributed property, the offsetting remedial allocation to the contributing partner must be gain from the sale of that property. Conversely, if the ceiling rule limited item is gain from the sale of contributed property, the offsetting remedial allocation to the contributing partner must be loss from the sale of that property. If the ceiling rule limited item is depreciation or other cost recovery from the contributed property, the offsetting remedial allocation to the contributing partner must be income of the type produced (directly or indirectly) by that property. Any partner level tax attributes are determined at the partner level. For example, if the ceiling rule limited item is depreciation from property used in a rental activity, the remedial allocation to the noncontributing partner is depreciation from property used in a rental activity and the offsetting remedial allocation to the contributing partner is ordinary income from that rental activity. Each partner then applies section 469 to the allocations as appropriate.

(4) EFFECT OF REMEDIAL ITEMS -- (i) EFFECT ON PARTNERSHIP. Remedial items do not affect the partnership's computation of its taxable income under section 703 and do not affect the partnership's adjusted tax basis in partnership property.

(ii) EFFECT ON PARTNERS. Remedial items are notional tax items created by the partnership solely for tax purposes and do not affect the partners' book capital accounts. Remedial items have the same effect as actual tax items on a partner's tax liability and on the partner's adjusted tax basis in the partnership interest.

(5) LIMITATIONS ON USE OF METHODS INVOLVING REMEDIAL ALLOCATIONS -- (i) LIMITATION ON TAXPAYERS. In the absence of published guidance, the remedial allocation method described in this paragraph (d) is the only reasonable section 704(c) method permitting the creation of notional tax items.

(ii) LIMITATION ON INTERNAL REVENUE SERVICE. In exercising its authority under paragraph (a)(10) of this section to make adjustments if a partnership's allocation method is not reasonable, the Internal Revenue Service will not require a partnership to use the remedial allocation method described in this paragraph (d) or any other method involving the creation of notional tax items.

(6) ADJUSTMENTS TO APPLICATION OF METHOD. The Commissioner may, by published guidance, prescribe adjustments to the remedial allocation method under this paragraph (d) as necessary or appropriate. This guidance may, for example, prescribe adjustments to the remedial allocation method to prevent the duplication or omission of items of income or deduction or to reflect more clearly the partners' income or the income of a transferee of a partner.

(7) EXAMPLES. The following examples illustrate the principles of this paragraph (d).

EXAMPLE 1. REMEDIAL ALLOCATION METHOD -- (i) FACTS. On January 1, L and M form partnership LM and agree that each will be allocated a 50 percent share of all partnership items. The partnership agreement provides that LM will make allocations under section 704(c) using the remedial allocation method under this paragraph (d) and that the straight-line method will be used to recover excess book basis. L contributes depreciable property with an adjusted tax basis of $4,000 and a fair market value of $10,000. The property is depreciated using the straight-line method with a 10-year recovery period and has 4 years remaining on its recovery period. M contributes $10,000, which the partnership uses to purchase land. Except for the depreciation deductions, LM's expenses equal its income in each year of the 10 years commencing with the year the partnership is formed.

(ii) YEARS 1 THROUGH 4. Under the remedial allocation method of this paragraph (d), LM has book depreciation for each of its first 4 years of $1,600 [$1,000 ($4,000 adjusted tax basis divided by the 4-year remaining recovery period) plus $600 ($6,000 excess of book value over tax basis, divided by the NEW 10-year recovery period)]. (For the purpose of simplifying the example, the partnership's book depreciation is determined without regard to any first-year depreciation conventions.) Under the partnership agreement, L and M are each allocated 50 percent ($800) of the book depreciation. M is allocated $800 of tax depreciation and L is allocated the remaining $200 of tax depreciation ($1,000 - $800). See paragraph (d)(1) of this section. No remedial allocations are made because the ceiling rule does not result in a book allocation of depreciation to M different from the tax allocation. The allocations result in capital accounts at the end of LM's first 4 years as follows:

 L                       M

 L                       M

 L                       M

 L                       M

 N                       P

 N                       P

 N                       P

 N                       P

(2) * * *

(iii) INVENTORY. For partnerships that do not use a specific identification method of accounting, each item of inventory, other than qualified financial assets (as defined in paragraph (e)(3)(ii) of this section).

(3) SPECIAL AGGREGATION RULE FOR SECURITIES PARTNERSHIPS -- (i) GENERAL RULE. For purposes of making reverse section 704(c) allocations, a securities partnership may aggregate gains and losses from qualified financial assets using any reasonable approach that is consistent with the purpose of section 704(c). Notwithstanding paragraphs (a)(2) and (a)(6)(i) of this section, once a partnership adopts an aggregate approach, that partnership must apply the same aggregate approach to all of its qualified financial assets for all taxable years in which the partnership qualifies as a securities partnership. Paragraphs (e)(3)(iv) and (e)(3)(v) of this section describe approaches for aggregating reverse section 704(c) gains and losses that are generally reasonable. Other approaches may be reasonable in appropriate circumstances. See, however, paragraph (a)(10) of this section, which describes the circumstances under which section 704(c) methods, including the aggregate approaches described in this paragraph (e)(3), are not reasonable. A partnership using an aggregate approach must separately account for any built-in gain or loss from contributed property.

(ii) QUALIFIED FINANCIAL ASSETS -- (A) IN GENERAL. A qualified financial asset is any personal property (including stock) that is actively traded. Actively traded means actively traded as defined in section 1.1092(d)-1 (defining actively traded property for purposes of the straddle rules).

(B) MANAGEMENT COMPANIES. For a management company, qualified financial assets also include the following, even if not actively traded: shares of stock in a corporation; notes, bonds, debentures, or other evidences of indebtedness; interest rate, currency, or equity notional principal contracts; evidences of an interest in, or derivative financial instruments in, any security, currency, or commodity, including any option, forward or futures contract, or short position; or any similar financial instrument.

(C) PARTNERSHIP INTERESTS. An interest in a partnership is not a qualified financial asset for purposes of this paragraph (e)(3)(ii). However, for purposes of this paragraph (e)(3), a partnership (upper- tier partnership) that holds an interest in a securities partnership (lower-tier partnership) must take into account the lower-tier partnership's assets and qualified financial assets as follows:

(1) In determining whether the upper-tier partnership qualifies as an investment partnership, the upper-tier partnership must treat its proportionate share of the lower-tier securities partnership's assets as assets of the upper-tier partnership; and

(2) If the upper-tier partnership adopts an aggregate approach under this paragraph (e)(3), the upper-tier partnership must aggregate the gains and losses from its directly held qualified financial assets with its distributive share of the gains and losses from the qualified financial assets of the lower-tier securities partnership.

(iii) SECURITIES PARTNERSHIP -- (A) IN GENERAL. A partnership is a securities partnership if the partnership is either a management company or an investment partnership, and the partnership makes all of its book allocations in proportion to the partners' relative book capital accounts (except for reasonable special allocations to a partner that provides management services or investment advisory services to the partnership).

(B) DEFINITIONS -- (1) MANAGEMENT COMPANY. A partnership is a management company if it is registered with the Securities and Exchange Commission as a management company under the Investment Company Act of 1940, as amended (15 U.S.C. 80a).

(2) INVESTMENT PARTNERSHIP. A partnership is an investment partnership if:

(i) On the date of each capital account restatement, the partnership holds qualified financial assets that constitute at least 90 percent of the fair market value of the partnership's non-cash assets; and

(ii) The partnership reasonably expects, as of the end of the first taxable year in which the partnership adopts an aggregate approach under this paragraph (e)(3), to make revaluations at least annually.

(iv) PARTIAL NETTING APPROACH. This paragraph (e)(3)(iv) describes the partial netting approach of making reverse section 704(c) allocations. See Example 1 of paragraph (e)(3)(ix) of this section for an illustration of the partial netting approach. To use the partial netting approach, the partnership must establish appropriate accounts for each partner for the purpose of taking into account each partner's share of the book gains and losses and determining each partner's share of the tax gains and losses. Under the partial netting approach, on the date of each capital account restatement, the partnership:

(A) Nets its book gains and book losses from qualified financial assets since the last capital account restatement and allocates the net amount to its partners;

(B) Separately aggregates all tax gains and all tax losses from qualified financial assets since the last capital account restatement; and

(C) Separately allocates the aggregate tax gain and aggregate tax loss to the partners in a manner that reduces the disparity between the book capital account balances and the tax capital account balances (book-tax disparities) of the individual partners.

(v) FULL NETTING APPROACH. This paragraph (e)(3)(v) describes the full netting approach of making reverse section 704(c) allocations on an aggregate basis. See Example 2 of paragraph (e)(3)(ix) of this section for an illustration of the full netting approach. To use the full netting approach, the partnership must establish appropriate accounts for each partner for the purpose of taking into account each partner's share of the book gains and losses and determining each partner's share of the tax gains and losses. Under the full netting approach, on the date of each capital account restatement, the partnership:

(A) Nets its book gains and book losses from qualified financial assets since the last capital account restatement and allocates the net amount to its partners;

(B) Nets tax gains and tax losses from qualified financial assets since the last capital account restatement; and

(C) Allocates the net tax gain (or net tax loss) to the partners in a manner that reduces the book-tax disparities of the individual partners.

(vi) TYPE OF TAX GAIN OR LOSS. The character and other tax attributes of gain or loss allocated to the partners under this paragraph (e)(3) must:

(A) Preserve the tax attributes of each item of gain or loss realized by the partnership;

(B) Be determined under an approach that is consistently applied; and

(C) Not be determined with a view to reducing substantially the present value of the partners' aggregate tax liability.

(vii) DISQUALIFIED SECURITIES PARTNERSHIPS. A securities partnership that adopts an aggregate approach under this paragraph (e)(3) and subsequently fails to qualify as a securities partnership must make reverse section 704(c) allocations on an asset-by-asset basis after the date of disqualification. The partnership, however, is not required to disaggregate the book gain or book loss from qualified asset revaluations before the date of disqualification when making reverse section 704(c) allocations on or after the date of disqualification.

(viii) TRANSITIONAL RULE FOR QUALIFIED FINANCIAL ASSETS REVALUED AFTER EFFECTIVE DATE. A securities partnership revaluing its qualified financial assets pursuant to section 1.704-1(b)(2)(iv)(f) on or after the effective date of this section may use any reasonable approach to coordinate with revaluations that occurred prior to the effective date of this section.

(ix) EXAMPLES. The following examples illustrate the principles of this paragraph (e)(3).

EXAMPLE 1. OPERATION OF THE PARTIAL NETTING APPROACH -- (i) FACTS. Two regulated investment companies, X and Y, each contribute $150,000 in cash to form PRS, a partnership that registers as a management company. The partnership agreement provides that book items will be allocated in accordance with the partners' relative book capital accounts, that book capital accounts will be adjusted to reflect daily revaluations of property pursuant to section 1.704-1(b)(2)(iv)(f)(5)(iii), and that reverse section 704(c) allocations will be made using the partial netting approach described in paragraph (e)(3)(iv) of this section. X and Y each have an initial book capital account of $150,000. In addition, the partnership establishes for each of X and Y a revaluation account with a beginning balance of $0. On Day 1, PRS buys Stock 1, Stock 2, and Stock 3 for $100,000 each. On Day 2, Stock 1 increases in value from $100,000 to $102,000, Stock 2 increases in value from $100,000 to $105,000, and Stock 3 declines in value from $100,000 to $98,000. At the end of Day 2, Z, a regulated investment company, joins PRS by contributing $152,500 in cash for a one-third interest in the partnership [$152,500 divided by $300,000 (initial values of stock) + $5,000 (net gain at end of Day 2) + $152,500]. PRS uses this cash to purchase Stock 4. PRS establishes a revaluation account for Z with a $0 beginning balance. As of the close of Day 3, Stock 1 increases in value from $102,000 to $105,000, and Stocks 2, 3, and 4 decrease in value from $105,000 to $102,000, from $98,000 to $96,000, and from $152,500 to $151,500, respectively. At the end of Day 3, PRS sells Stocks 2 and 3.

(ii) BOOK ALLOCATIONS -- DAY 2. At the end of Day 2, PRS revalues the partnership's qualified financial assets and increases X's and Y's book capital accounts by each partner's 50 percent share of the $5,000 ($2,000 + $5,000 - $2,000) net increase in the value of the partnership's assets during Day 2. PRS increases X's and Y's respective revaluation account balances by $2,500 each to reflect the amount by which each partner's book capital account increased on Day 2. Z's capital account is not affected because Z did not join PRS until the end of Day 2. At the beginning of Day 3, the partnership's accounts are as follows:

 Stock 1     Stock 2     Stock 3   Stock  4

 Stock 1     Stock 2     Stock 3    Stock 4

(ii) BOOK ALLOCATIONS -- DAYS 2 AND 3. PRS allocates its book gains and losses in the manner described in paragraphs (ii) and (iii) of Example 1 (the partial netting approach). Thus, at the end of Day 2, PRS increases the book capital accounts of X and Y by $2,500 to reflect the appreciation in the partnership's assets from the close of Day 1 to the close of Day 2 and records that increase in the revaluation account created for each partner. At the end of Day 3, PRS decreases the book capital accounts of X, Y, and Z by $1,000 to reflect each partner's share of the decline in value of the partnership's assets from Day 2 to Day 3 and reduces each partner's revaluation account by a corresponding amount.

(iii) TAX ALLOCATIONS -- DAY 3. After making the book adjustments described in the previous paragraph, PRS allocates its net tax gain (or net tax loss) from its sales of qualified financial assets during Day 3. To do so, PRS first determines its net tax gain (or net tax loss) recognized from its sales of qualified financial assets for the day. There is a $2,000 net tax loss ($2,000 gain from the sale of Stock 2 less $4,000 loss from the sale of Stock 3) on the sale of PRS's qualified financial assets. Because Z is the only partner with a negative revaluation account balance, the partnership's net tax loss is allocated first to Z to the extent of Z's ($1,000) revaluation account balance. The remaining net tax loss is allocated among the partners in accordance with their distributive shares of loss. Thus, PRS allocates $333.33 of the $2,000 net tax loss to each of X and Y. PRS also allocates an additional $333.33 of the net tax loss to Z, so that the total net tax loss allocation to Z is $1,333.33. PRS then increases each partner's revaluation account balance by the amount of net tax loss allocated to that partner. At the beginning of Day 4, the partnership's accounts are as follows:

 Stock 1     Stock 2     Stock 3    Stock 4

(i) Aggregation of properties other than those described in paragraphs (e)(2) and (e)(3) of this section;

(ii) Partnerships and partners not described in paragraph (e)(3) of this section to aggregate gain and loss from qualified financial assets; and

(iii) Aggregation of qualified financial assets for purposes of making section 704(c) allocations in the same manner as that described in paragraph (e)(3) of this section.

* * * * *

Section 1.704-3T [Removed]

Par. 4. Section 1.704-3T is removed.