Temporary Regs Provide Remedial Allocation Method for Contributions to Partnerships

 [4830-01-u]

 ACTION: Temporary regulations.

 SUMMARY: This document contains temporary 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 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 and the Revenue Reconciliation Act of 1989. The temporary regulations affect partnerships and their partners and are necessary to provide guidance needed to comply with the applicable tax law.

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

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

SUPPLEMENTARY INFORMATION:

INTRODUCTION

This document contains amendments to the Income Tax Regulations (26 CFR part 1) under section 704(c)(1)(A) and 704(c)(3) of the Internal Revenue Code (Code).

BACKGROUND

 Contributions to and distributions from partnerships are generally tax free under sections 721 and 731, respectively. Section 704(c) requires that income, gain, loss, and deduction with respect to property contributed to a partnership by a partner be shared among the partners so as to take account of the variation between the basis of the property to the partnership and its fair market value at the time of contribution. Similar principles apply to partnerships restating their capital accounts under section 1.704-1(b)(4)(i).

 Final regulations under section 704(c)(1)(A) and 704(c)(3) were filed with the Federal Register on December 21, 1993. The final regulations reserve two sections: 1) the remedial allocation method, and 2) aggregation of securities and similar investments by securities partnerships for purposes of section 704(b) and (c). These temporary regulations address those issues.

EXPLANATION OF PROVISIONS

REMEDIAL ALLOCATION METHOD

 The proposed regulations published by the IRS in the Federal Register on December 24, 1992 (FR 61345) (the original proposed regulations) included the deferred sale method as a reasonable allocation method. The IRS and Treasury included the deferred sale method in the original proposed regulations because it provided a method to eliminate the distortions created by the ceiling rule. In essence, the deferred sale method provided additional cost recovery deductions for the noncontributing partners, which were offset by deferred gain to the contributing partner. In addition, the method prevented the ceiling rule from creating distortions upon the sale of the contributed property due to post-contribution changes in value.

 After considering the many comments received concerning the deferred sale method and upon further review by the IRS and Treasury, it was determined that the results of the deferred sale method in the original proposed regulations could be achieved using a less complex method. Therefore, the IRS and Treasury have included a revised deferred sale method referred to as the remedial allocation method in these temporary regulations. The remedial allocation method is being issued by temporary regulation because the IRS and Treasury believe that taxpayers should be permitted to use the remedial allocation method during the comment period. Use of the remedial allocation method is subject to the anti-abuse rule contained in the final regulations.

 The remedial allocation method contained in these temporary regulations permits the use of remedial allocations to achieve results substantially similar to the results under the deferred sale method contained in the original proposed regulations without the complexity of that method. Remedial allocations are tax allocations of income or gain created by the partnership that are offset by tax allocations of loss or deduction created by the partnership. Remedial allocations are in addition to other allocations made by a partnership and have no effect on the partnership book capital accounts. Under the remedial allocation method of these temporary regulations, if the ceiling rule results in a book allocation to a noncontributing partner different from the corresponding tax allocation, the partnership makes a remedial allocation of income, gain, loss, or deduction to the noncontributing partner equal to the full amount of the limitation caused by the ceiling rule, and a simultaneous, offsetting remedial allocation of deduction, loss, gain, or income to the contributing partner.

 The amount of book items allocated to each partner is determined in the same manner as under the deferred sale method of the original proposed regulations. Therefore, the ceiling rule amount is determined differently under the remedial allocation method of these temporary regulations than under the other allocation methods contained in the final regulations (which must use the rules of section 1.704-1(b)(2)(iv)(g)(3) to determine book cost recovery). Under the remedial allocation method, the portion of book basis in the property equal to the tax basis in the property at the time of contribution is recovered in the same manner as the tax basis (generally over the property's remaining recovery period under section 168(i)(7) or other applicable section of the Code). 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.

 A remedial allocation is reasonable only to the extent it equals the amount necessary to offset the effect of the ceiling rule for that taxable year and only if it has the same effect on each partner's tax liability as the item limited by the ceiling rule. Thus, if the item limited by the ceiling rule is depreciation or other cost recovery, the offsetting remedial allocation of income to the contributing partner must consist of the same type of income that the contributed property produces. Similarly, if the item limited by the ceiling rule is capital loss from the sale of contributed property, the offsetting remedial allocation to the contributing partner must be capital gain from the sale of that property.

 In determining whether a remedial allocation of income has the same effect on each partner's tax liability as the item limited by the ceiling rule, all of the provisions of the Code apply as if the remedial allocation had actually been realized by the partnership. For example, assume a partner contributes to a partnership appreciated nondepreciable property that, if sold, would generate capital gain. The property thereafter declines in value so that the ceiling rule limits the amount of capital gain allocable to the contributing partner on a subsequent sale. The partnership must make a remedial allocation of capital gain to the contributing partner, and an equal offsetting remedial allocation of capital loss to the noncontributing partner. These allocations would be subject to all the rules normally applicable to capital gains and capital losses, as if the amounts had actually been realized by the partnership. As a further illustration of this principle, if the item limited by the ceiling rule is loss from the sale of stock of a controlled foreign corporation (CFC), section 1248 applies to the remedial allocation of income to the contributing partner as if it were gain from the sale of that property (provided that the requirements of section 1248 are otherwise satisfied). If a remedial allocation of gain to the contributing partner is characterized as dividend income pursuant to section 1248, other provisions of the Code apply. Further guidance may be published detailing the application of these rules to such transactions.

 As noted above, remedial allocations are subject to the general anti-abuse rule of section 1.704-3(a)(10). For example, assume that a partnership holding contributed stock of a CFC causes the CFC to distribute dividends prior to the disposition of the CFC stock by the partnership, and the dividend income is properly allocated among the partners under section 704(b). If the contributing partner would have received a section 704(c) allocation of dividend income pursuant to section 1248 absent the dividend distribution but, as a result of the distribution, the contributing partner would receive a remedial allocation of capital gain, the anti-abuse rule will apply if the contribution of CFC stock, the dividend distribution, and the remedial allocation are made with a view to reducing substantially the present value of the partners' aggregate tax liability.

 In response to comments received on the original proposed regulations, the IRS will not require a partnership to use the remedial allocation method described in these temporary regulations if a partnership's allocation method is not reasonable. In the absence of specific published guidance, the method described in these temporary regulations is the only reasonable section 704(c) method using remedial allocations.

SECURITIES AGGREGATION

 In general, the final regulations under section 1.704-3(e)(2) provide that property may not be aggregated for purposes of making allocations under section 704(c). However, aggregation is permitted for certain specifically defined types of property. In addition, the final regulations state that the IRS and Treasury may provide in guidance published in the Internal Revenue Bulletin that other classes of items may be aggregated for purposes of section 704(c). Aggregation may also be permitted by letter ruling.

 Reverse section 704(c) allocations are required with respect to property for which differences between book value and adjusted tax basis are created when a partnership revalues property pursuant to section 1.704-1(b)(2)(iv)(f). The IRS has received comments that the frequency of capital account restatements under section 1.704-1(b)(4)(i) and the number of partnership assets may make it impractical for securities partnerships to make reverse section 704(c) allocations on an asset-by-asset basis. The comments also maintain that permitting aggregation of securities when making reverse section 704(c) allocations does not significantly increase the potential of abusive allocations. After studying the issue, the IRS and Treasury agree that aggregation of securities should be permitted for certain securities partnerships when making reverse section 704(c) allocations. The temporary regulations provide only for aggregation of securities and similar investments for certain specifically defined partnerships. The IRS and Treasury will consider expanding the types of partnerships that are permitted to aggregate securities and similar investments after receiving comments from taxpayers, and will also consider expanding the type of property interests eligible for aggregation by those partnerships.

 The temporary regulations provide that when making reverse section 704(c) allocations, it is generally reasonable for a securities partnership consistently to aggregate all gains and all losses from securities and similar investments. Gains must be aggregated separately from losses. Securities partnerships

 The temporary regulations provide that for purposes of securities aggregation, a securities partnership is one that: (1) is diversified as defined by section 851(b)(4), (2) has at least 90 percent of its non-cash assets in securities or similar investment interests described in section 1.704-1(b)(2)(iv)(f)(5)(iii) (consisting of stock, securities, commodities, options, warrants, futures, or similar investments that are readily tradable on an established securities market), (3) either is registered with the Securities and Exchange Commission under the Investment Company Act of 1940, as amended (15 U.S.C. 80a-1 to 80b-2), as a Management Company, 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 persons, determined in accordance with section 707(b)(3), 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 to the partnership).

 The IRS and Treasury recognize that there are other ways to define a securities partnership. For example, it is possible to define these partnerships in terms of the number of accounting entries that would be needed on an asset-by-asset method. The IRS and Treasury welcome comments on how to define a securities partnership.

EFFECTIVE DATE

 These temporary regulations apply to contributions of property to a partnership and revaluations of securities and similar investments made on or after December 21, 1993.

SPECIAL ANALYSES

 It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. It has also 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, these regulations will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

DRAFTING INFORMATION

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

LIST OF SUBJECTS IN 26 CFR PART 1

 Income taxes, Reporting and recordkeeping requirements.

AMENDMENTS TO THE REGULATIONS

Accordingly, the amendments to 26 CFR part 1 are 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 1.704-3T also issued under 26 U.S.C. 704(c). * * *

Par. 2. Section 1.704-3T, is added to read as follows:

SECTION 1.704-3T CONTRIBUTED PROPERTY (TEMPORARY).

(a) through (c) [Reserved]

(d) REMEDIAL ALLOCATION METHOD -- (1) IN GENERAL. For contributions of property to a partnership and restatements pursuant to section 1.704-1(b)(2)(iv)(f) on or after December 21, 1993, a partnership may adopt the remedial allocation method described in this paragraph by making reasonable remedial allocations to eliminate ceiling rule disparities between tax items of noncontributing partners and corresponding book items (as computed under paragraph (d)(2) of this section). Remedial allocations are tax allocations of income or gain that are offset by tax allocations of loss or deduction. These tax allocations are created by the partnership and have no effect on the partnership's book capital accounts. Under this method the partnership determines the amount of book items under paragraph (d)(2) of this section and determines the distributive share of these items under section 704(b). The partnership then makes tax allocations using the methodology set forth in section 1.704-3(b)(1) to avoid shifting the tax consequences of built-in gain or loss. If the ceiling rule (as defined in section 1.704-3(b)(1)) results in a book allocation to a noncontributing partner different from the corresponding tax allocation, the partnership makes a remedial allocation of income, gain, loss, or deduction to the noncontributing partner equal to the full amount of the limitation caused by the ceiling rule, and a simultaneous, offsetting remedial allocation of deduction, loss, gain, or income to the contributing partner. In the absence of specific published guidance, the method described in this paragraph is the only reasonable section 704(c) method using remedial allocations.

(2) DETERMINING THE AMOUNT OF BOOK ITEMS. Under the remedial allocation method, for purposes of subchapter K the partnership determines the amount of book items 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 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.

(3) TYPE. Remedial allocations of income, gain, loss, or deduction must have the same effect on each partner's tax liability as the tax item limited by the ceiling rule. This means that, when relevant, such attributes as the source, character, or (e.g., under section 469) nature of the item limited by the ceiling rule must be taken into account. Thus, if the item limited by the ceiling rule is loss from the sale of contributed property, the offsetting remedial allocation to the contributing partner must be gain from the sale of the property. If the item limited by the ceiling rule is depreciation or other cost recovery, the offsetting remedial allocation of income to the contributing partner must be of the same type of income that the contributed property produces.

(4) LIMITATION ON ADJUSTMENTS BY THE INTERNAL REVENUE SERVICE. In exercising its authority under section 1.704-3 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).

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

EXAMPLE 1. REMEDIAL ALLOCATION METHOD -- (i) FACTS. 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 paragraph (d) of this section 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 depreciable 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 paragraph (d) of this section, LM has book depreciation for each of its first 4 years of $1,600 [$1,000 ($4,000 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 ten-year recovery period)]. 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

(3) SPECIAL AGGREGATION RULE FOR SECURITIES PARTNERSHIPS -- (i) GENERAL RULE. The frequency of capital account restatements under section 1.704-1(b)(4)(i) and the number of partnership assets may make it impractical for securities partnerships to make reverse section 704(c) allocations on an asset-by-asset basis. Therefore, when making reverse section 704(c) allocations with respect to restatements made on or after December 21, 1993, it is generally reasonable for a securities partnership consistently to aggregate all gains and all losses from securities and similar investments (as defined in section 1.704-1(b)(2)(iv)(f)(5)(iii)). Gains must be aggregated separately from losses.

(ii) SECURITIES PARTNERSHIP. For purposes of paragraph (e)(3)(i) of this section, a securities partnership is one that--

(A) If it were a domestic corporation would satisfy the requirements of section 851(b)(4);

(B) On each revaluation date, holds assets described in section 1.704-1(b)(2)(iv)(f)(5)(iii) that constitute at least 90 percent of the fair market value of its non-cash assets;

(C) Either is registered with the Securities and Exchange Commission under the Investment Company Act of 1940, as amended (15 U.S.C. 80a-1 to 80b-2), as a Management Company, or does not have 50 percent or more of its capital interests held at any time during the current partnership taxable year by five or fewer persons, determined in accordance with section 707(b)(3); and

(D) Makes all of its book allocations in proportion to the partners' relative book capital accounts (except that the partnership may make reasonable special allocations to a partner that provides management services to the partnership).

(iii) LETTER RULINGS. The Commissioner may, by letter ruling, permit partnerships not meeting the requirements of this paragraph (e)(3) to aggregate assets when making reverse section 704(c) allocations.