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Bulletin No. 1996–7

February 12, 1996

HIGHLIGHTS

OF THIS ISSUE

These synopses are intended only as aids to the reader in

identifying the subject matter covered. They may not be

relied upon as authoritative interpretations.

INCOME TAX

ance Order (TAO) is limited only to the Commissioner,

Deputy Commissioner, or Taxpayer Ombudsman. Del.

Order 232 (Rev. 1) superseded.

PS–2–95, page 50.

Proposed regulations under section 731 relating to the

treatment of a distribution of marketable securities by a

partnership. A public hearing will be held on April 3,

1996.

Del. Order 239 (Rev. 1), page 49.

The Taxpayer Ombudsman is delegated the authority to

issue Taxpayer Assistance Orders (TAO) to intervene on

behalf of taxpayers that make a positive action with

respect to taxpayer cases; to prepare an annual report

of the most significant problems taxpayers face when

conducting business with IRS and suggest solutions

where applicable; and to establish a system to track the

Service’s response to changes suggested in the annual

report. Del. Order 239 amended.

T.D. 8642, page 4.

Final regulations under sections 704 and 737 of the

Code relating to the recognition of gain or loss by

contributing partner on distribution of contributed

property or other property.

ESTATE TAX

Notice 96–10, page 47.

Books and records; imaging systems. This notice

provides a proposed revenue procedure regarding the

use by taxpayers of an imaging system to satisfy the

requirement of section 6001 of the Code to maintain

books and records.

T.D. 8644, page 16.

Final regulations relating to generation-skipping transfer

tax.

ADMINISTRATIVE

Announcement 96–8, page 56.

Publication 595, Tax Guide for Commercial Fishermen,

is corrected.

Del. Order 232 (Rev. 2), page 49.

The authority to modify or rescind a Taxpayer Assist-

Finding Lists begin on page 60.

Announcement of Disbarments and Suspensions begins on page 57.

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Mission of the Service

The purpose of the Internal Revenue Service is to

collect the proper amount of tax revenue at the least

cost; serve the public by continually improving the

quality of our products and services; and perform in a

manner warranting the highest degree of public

confidence in our integrity, efficiency and fairness.

Statement of Principles

of Internal Revenue

Tax Administration

The function of the Internal Revenue Service is to

administer the Internal Revenue Code. Tax policy

for raising revenue is determined by Congress.

With this in mind, it is the duty of the Service to

carry out that policy by correctly applying the laws

enacted by Congress; to determine the reasonable

meaning of various Code provisions in light of the

Congressional purpose in enacting them; and to

perform this work in a fair and impartial manner,

with neither a government nor a taxpayer point of

view.

At the heart of administration is interpretation of the

Code. It is the responsibility of each person in the

Service, charged with the duty of interpreting the

law, to try to find the true meaning of the statutory

provision and not to adopt a strained construction in

the belief that he or she is ‘‘protecting the revenue.’’

The revenue is properly protected only when we ascertain and apply the true meaning of the statute.

The Service also has the responsibility of applying

and administering the law in a reasonable,

practical manner. Issues should only be raised by

examining officers when they have merit, never

arbitrarily or for trading purposes. At the same

time, the examining officer should never hesitate

to raise a meritorious issue. It is also important

that care be exercised not to raise an issue or to

ask a court to adopt a position inconsistent with

an established Service position.

Administration should be both reasonable and

vigorous. It should be conducted with as little

delay as possible and with great courtesy and

considerateness. It should never try to overreach,

and should be reasonable within the bounds of law

and sound administration. It should, however, be

vigorous in requiring compliance with law and it

should be relentless in its attack on unreal tax

devices and fraud.

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Introduction

The Internal Revenue Bulletin is the authoritative

instrument of the Commissioner of Internal Revenue for

announcing official rulings and procedures of the

Internal Revenue Service and for publishing Treasury

Decisions, Executive Orders, Tax Conventions, legislation, court decisions, and other items of general

interest. It is published weekly and may be obtained

from the Superintendent of Documents on a subscription basis. Bulletin contents of a permanent nature are

consolidated semiannually into Cumulative Bulletins,

which are sold on a single-copy basis.

It is the policy of the Service to publish in the Bulletin

all substantive rulings necessary to promote a uniform

application of the tax laws, including all rulings that

supersede, revoke, modify, or amend any of those

previously published in the Bulletin. All published

rulings apply retroactively unless otherwise indicated.

Procedures relating solely to matters of internal

management are not published; however, statements of

internal practices and procedures that affect the rights

and duties of taxpayers are published.

Revenue rulings represent the conclusions of the

Service on the application of the law to the pivotal facts

stated in the revenue ruling. In those based on

positions taken in rulings to taxpayers or technical

advice to Service field offices, identifying details and

information of a confidential nature are deleted to

prevent unwarranted invasions of privacy and to comply

with statutory requirements.

Rulings and procedures reported in the Bulletin do not

have the force and effect of Treasury Department

Regulations, but they may be used as precedents.

Unpublished rulings will not be relied on, used, or cited

as precedents by Service personnel in the disposition of

other cases. In applying published rulings and procedures, the effect of subsequent legislation, regulations,

court decisions, rulings, and procedures must be

considered, and Service personnel and others concerned are cautioned against reaching the same

conclusions in other cases unless the facts and

circumstances are substantially the same.

The Bulletin is divided into four parts as follows:

Part I.—1986 Code.

This part includes rulings and decisions based on

provisions of the Internal Revenue Code of 1986.

Part II.—Treaties and Tax Legislation.

This part is divided into two subparts as follows:

Subpart A, Tax Conventions, and Subpart B, Legislation

and Related Committee Reports.

Part III.—Administrative, Procedural, and Miscellanous.

To the extent practicable, pertinent cross references to

these subjects are contained in the other Parts and

Subparts. Also included in this part are Bank Secrecy

Act Administrative Rulings. Bank Secrecy Act Administrative Rulings are issued by the Department of the

Treasury’s Office of the Assistant Secretary

(Enforcement).

Part IV.—Items of General Interest.

With the exception of the Notice of Proposed Rulemaking and the disbarment and suspension list included in

this part, none of these announcements are consolidated in the Cumulative Bulletins.

The first Bulletin for each month includes an index for

the matters published during the preceding month.

These monthly indexes are cumulated on a quarterly

and semiannual basis, and are published in the first

Bulletin of the succeeding quarterly and semi-annual

period, respectively.

The Bulletin Index-Digest System, a research and

reference service supplementing the Bulletin, may be

obtained from the Superintendent of Documents on a

subscription basis. It consists of four Services: Service

No. 1, Income Tax; Service No. 2, Estate and Gift

Taxes; Service No. 3, Employment Taxes; Service No.

4, Excise Taxes. Each Service consists of a basic

volume and a cumulative supplement that provides (1)

finding lists of items published in the Bulletin, (2)

digests of revenue rulings, revenue procedures, and

other published items, and (3) indexes of Public Laws,

Treasury Decisions, and Tax Conventions.

The contents of this publication are not copyrighted and may be reprinted freely. A citation of the Internal Revenue Bulletin as the source would be appropriate.

For sale by the Superintendent of Documents U.S. Government Printing Office, Washington, D.C. 20402.

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Part I. Rulings and Decisions Under the Internal Revenue Code of 1986

Section 704.—Partner’s Distributive

26 CFR 1.704–4: Distribution on contributed

property.

T.D. 8642

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

Recognition of Gain or Loss by

Contributing Partner on Distribution

of Contributed Property or Other

Property

AGENCY: Internal Revenue Service

(IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains

final regulations relating to the recognition of gain or loss on certain distributions of contributed property by a

partnership under section 704(c)(1)(B)

of the Internal Revenue Code of 1986

(Code). This document also contains

final regulations relating to the recognition of gain on certain distributions to a

contributing partner under section 737.

The final regulations affect partnerships

and their partners and are necessary to

provide guidance for complying with

the applicable tax law.

EFFECTIVE DATE: January 9, 1995.

FOR FURTHER INFORMATION

CONTACT: Stephen J. Coleman, (202)

622-3060 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

The Revenue Reconciliation Act of

1989 added section 704(c)(1)(B) and

section 704(c)(2) to the Internal Revenue Code. Section 704(c)(1)(B) provides that, in the case of a distribution

of contributed property to another

partner within five years of its contribution, the contributing partner must

recognize gain or loss in an amount

equal to the gain or loss the partner

would have been allocated under section 704(c)(1)(A) on a sale of the

property by the partnership at its fair

market value at the time of the distribution. Section 704(c)(2) provides an

exception for distributions of certain

like-kind property.

The Energy Policy Act of 1992

added section 737 to the Code. Section

737 requires a partner who contributes

appreciated property to recognize gain

on a subsequent distribution of other

property to the contributing partner to

the extent of the lesser of (i) the net

precontribution gain on property contributed by the partner, or (ii) the

excess of the value of the distributed

property over the adjusted basis of the

partner’s interest in the partnership.

On January 9, 1995, a notice of proposed rulemaking (PS–76–92; PS–51–

93 [1995–1 C.B. 1001]) under section

704(c)(1)(B) and section 737 was published in the Federal Register (60 FR

2352). Written comments responding to

this notice were received. No public

hearing was held because no hearing

was requested. After consideration of

all comments received, the proposed

regulations under section 704(c)(1)(B)

and section 737 are adopted as revised

by this Treasury decision.

Summary of Significant Comments

and Revisions

The significant comments on the

proposed regulations and the revisions

made in the final regulations are

discussed below.

A. Section 704(c)(1)(B)

Determination of Gain and Loss

The proposed regulations provide

that section 704(c)(1)(B) applies only

to a distribution that is properly characterized as a distribution to a partner

acting in the capacity of a partner

within the meaning of section 731 and

section 737, and not to a transaction or

distribution that is subject to provisions

other than section 731(a) or section

737. Comments requested that the provision be clarified. The final regulations clarify that section 704(c)(1)(B)

applies only to the extent that a transaction is a distribution under section

731. References to transactions and

distributions not subject to section

704(c)(1)(B) have been deleted.

One commentator suggested certain

clarifying revisions to the proposed

regulations’ definition of fair market

value. The definition in the proposed

regulations, however, is identical to the

definition of fair market value in the

704(b) regulations, and distributed

property should have the same fair

market value for purposes of determining gain and loss under section

704(c)(1)(B) and determining capital

account adjustments under section

704(b). The final regulations therefore

adopt the definition in the proposed

regulations without change.

The proposed regulations provide

that the amount of gain or loss

resulting from a distribution of partnership property is determined as if the

distributed property had been sold by

the partnership to the distributee partner. As a result, if built-in loss property

is distributed to a partner that holds

more than a 50 percent interest in

partnership capital or profits, the builtin loss that otherwise would be recognized is disallowed under section

707(b)(1)(A). One commentator suggested that section 704(c)(1)(B) was

intended to address disguised sales

between partners and that, therefore, a

loss should be disallowed on a distribution only if it would be disallowed on a

direct sale between the partners. Section 704(c)(1)(B), however, respects the

form of the transaction as between the

partnership and a partner and does not

recast the transaction as a disguised

sale. See H.R. Rep. No. 247, 101st

Cong., 1st Sess. 406 (1989). The final

regulations therefore adopt the proposed regulations without change.

Several of the provisions in the

proposed regulations refer to distributions that are part of ‘‘the same plan or

arrangement.’’ Commentators requested

clarification of this term. The reference

to distributions that are part of the

same plan or arrangement was intended

to reflect the fact that distributions of

multiple properties to one partner or

distributions of different properties to

more than one partner over a period of

time may be treated as part of the same

distribution under general principles of

taxation, such as the step transaction

doctrine. The final regulations remove

the reference to ‘‘same plan or arrangement’’ and refers to distributions that

are part of the same distribution. This

change is made for simplification only

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and is not intended as a substantive

change to the scope of a distribution

for tax purposes. As under current law,

distributions do not need to be contemporaneous to be part of the same

distribution.

Several comments were received regarding the effect of a partnership

termination under section 708(b)(1)(B).

One comment suggested that it was not

clear whether property that had previously been contributed to the partnership (and was therefore already

subject to a five-year period) was

subject to a new five-year period after

the termination. The final regulations

clarify that a new five-year period does

not begin to the extent of any pretermination gain or loss that would

have been allocated to a contributing

partner under section 704(c)(1)(A) on a

sale of contributed property immediately before the termination.

The legislative history of section

704(c)(1)(B) indicates that a constructive termination does not change

the application of section 704(c) to precontribution gain or loss on property

contributed to the partnership before

termination. One comment read this

legislative history as possibly suggesting that a pro rata distribution is

deemed to occur under section 708(b)(1)(B) for section 704(c)(1)(A) purposes, but a different distribution is

deemed to occur for section 704(c)(1)(B) purposes. The comment expressed

concern about the complexity of such a

system. Section 704(c)(1)(B), however,

does not require or impose such a

‘‘hybrid system.’’ The amount of gain

or loss under section 704(c)(1)(B) is

determined by reference to the amount

of gain or loss that would have been

allocated to the partner under section

704(c)(1)(A) if the property had been

sold. Thus, property of a partnership

that terminates under section

708(b)(1)(B) is deemed to be distributed to the partners in the same

manner for both sections.

Another comment suggested it was

unclear whether section 704(c)(1)(B)

could apply to property that had not

been contributed by a partner to the

partnership prior to the termination.

The final regulations confirm that a

new five-year period begins for all

property that is deemed contributed to

the new partnership after the termination (which would include property not

actually contributed to the partnership),

except to the extent that such built-in

gain or loss would have been allocated

to the contributing partner under section 704(c)(1)(A) on a sale of the

contributed property immediately before the termination.

Commentators also requested guidance on the interaction of section

708(b)(1)(B) and section 704(c) in

general. The IRS and Treasury recognize the need for additional guidance

on this issue, but such guidance is

beyond the scope of these regulations.

The IRS and Treasury are considering a

separate project involving the interaction of section 704(c) and section

708(b)(1)(B) and invite additional comments and suggestions regarding the

project.

Exceptions

The proposed regulations provide

that section 704(c)(1)(B) does not

apply to property contributed to the

partnership on or before October 3,

1989. One commentator requested an

exception for property required to be

contributed under a binding contract

entered into on or before October 3,

1989. The statutory effective date

provisions, however, do not contain a

binding contract exception. Accordingly, the final regulations adopt the

proposed regulations without change.

One commentator suggested an additional exception for distributions of an

undivided interest in property. The

final regulations provide that section

704(c)(1)(B) does not apply to such a

distribution to the extent that the

distributed interest does not exceed the

undivided interest contributed by the

distributee partner.

One commentator also requested an

additional exception for distributions of

fungible property because the partners

may not be able to track the specific

contributed property. The final regulations do not provide such an exception.

Contributed property may be fungible

from an economic perspective, but such

property is generally not fungible for

tax purposes because each contributed

property will have its own individual

tax basis.

The proposed regulations provide an

exception for distributions of section

704(c) property to a noncontributing

partner in liquidation of the partnership

if the contributing partner receives an

interest in the contributed property and

the built-in gain or loss in that property

is equal to or greater than the built-in

gain or loss that would have otherwise

been allocated to the contributing partner. One commentator suggested that

the exception more clearly indicate the

amount of built-in gain or loss that

must be reflected in the property distributed to the contributing partner. The

final regulations clarify that the amount

of the built-in gain or loss must be

equal to the gain or loss that would

have been allocated to the contributing

partner under section 704(c)(1)(A) if

the contributed property had been sold

immediately before the distribution.

One commentator also suggested expanding this exception to apply to the

extent of the built-in gain or loss in the

property distributed to the contributing

partner. This comment is not adopted

in the final regulations. The exception

was intended to apply only in the

limited situation in which a partnership

liquidates and the value of the contributed property exceeds the contributing

partner’s capital account. In that situation, the portion of the contributed

property in excess of the contributing

partner’s capital account would have to

be distributed to another partner,

thereby triggering section 704(c)(1)(B).

The exception allows a partner to avoid

section 704(c)(1)(B) in this situation,

so long as the built-in gain or loss in

the property distributed to the contributing partner is at least equal to the

gain or loss that would have been

allocated to the contributing partner

under section 704(c)(1)(A) if the contributed property had been sold immediately before the distribution.

Special Rules

The proposed regulations provide a

special rule under section 704(c)(2) for

situations in which the partnership

distributes like-kind property to a contributing partner within a specified

period of the distribution of the property contributed by that partner. Under

this rule, the gain or loss that otherwise

would have been recognized on the distribution of the contributed property is

reduced by the amount of the contributing partner’s built-in gain or loss

in the distributed like-kind property.

One commentator criticized this rule as

inconsistent with the statutory

provision.

Section 704(c)(2) provides that

‘‘[u]nder regulations prescribed by the

Secretary, . . . to the extent of the value

of the [like-kind property distributed to

the contributing partner, the calculation

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of the contributing partner’s gain or

loss attributable to the distribution of

the contributed property] shall be [determined] as if the contributing partner

had contributed to the partnership the

[like-kind] property.’’ This provision is

generally intended to treat the contributing partner as if the partner had

exchanged the contributed property for

like-kind property in a nontaxable

exchange outside of the partnership.

This allows the contributing partner to

avoid recognition of gain or loss under

section 704(c)(1)(B) on the distribution

of the contributed property to another

partner because the contributing partner

is treated as having contributed the

like-kind property, not the property that

is actually distributed to the other

partner.

If the contributing partner, however,

had engaged in a like-kind exchange

outside of the partnership, the partner’s

built-in gain or loss in the like-kind

property received would have been the

same as the property that was surrendered. The rule in the proposed regulations reflects this result by limiting the

application of section 704(c)(2) to the

extent that the built-in gain or loss in

the contributed property is not preserved in the like-kind property distributed to the contributing partner. The

IRS and Treasury continue to believe

that the regulations properly implement

Congress’ objective with respect to this

provision. Therefore, the regulations

are finalized without change.

One commentator also suggested a

clarification of the interaction of the

like-kind exception and the disguised

sale rules of 707(a)(2)(B). The proposed regulations provide that the likekind exception reduces any gain that

would have otherwise been recognized

under section 704(c)(1)(B). The proposed regulations also provide that

section 704(c)(1)(B) applies only to a

distribution to a partner within the

meaning of section 731. There is no

suggestion in section 704(c)(2) or the

proposed regulations that the like-kind

exception was intended as an exception

to the disguised sale provisions. The

final regulations confirm that the disguised sale provisions can apply to a

distribution, even if the distribution

would otherwise have qualified for the

section 704(c)(2) like-kind exception.

Anti-Abuse Rule

Commentators made several suggestions for clarifying or modifying the

anti-abuse rule in the proposed regulations. In particular, these commentators

requested clarification of the relationship between this rule and the general

partnership anti-abuse rule in Treas.

Reg. section 1.701–2. The general antiabuse regulation is a rule of general

applicability that provides general principles to be applied in interpreting and

applying all of the provisions of subchapter K. In certain situations, however, more specific anti-abuse rules are

needed to carry out the purpose of a

particular provision. The final regulations therefore adopt the rule in the

proposed regulations without

modification.

B. Section 737

Determination of Gain

The final regulations are clarified to

provide that section 737 applies only to

the extent that a transaction is a

distribution under section 731. In accordance with section 737(d)(2), the

final regulations also provide that section 737 does not apply to the extent

that section 751(b) applies to the

distribution.

Net Precontribution Gain

The proposed regulations provide

that a distributee partner’s net precontribution gain is determined without

regard to the like-kind exception of

section 704(c)(2) in situations in which

the contributed property is not actually

distributed to another partner. One

commentator suggested deleting this

provision as superfluous. The final

regulations adopt the proposed regulations without change. This provision

clarifies that section 737 does not

contain a like-kind exception similar to

the exception in section 704(c)(2).

Section 737 applies even if the property received by the partner is of a

like-kind with the contributed property.

Character of Gain

One commentator suggested that the

proposed regulations fail to clarify

whether there are two groups (ordinary

and capital) for purposes of determining the character of a partner’s net

precontribution gain or whether there

may be an additional section 1231

group or section 1245 and section 1250

groups. The final regulations adopt the

proposed regulations without change.

The proposed regulations provide

that character for purposes of a partner’s net precontribution gain is determined as if the contributed property

were sold to an unrelated third party.

As a result, all of the provisions that

are relevant in determining the character of gain or loss on a sale are

relevant in determining the character of

the net precontribution gain. For example, if the sale of property would have

resulted in part capital gain and part

ordinary income, the character of the

net precontribution gain for that property is part ordinary and part capital.

The same approach applies in determining the allocation of any adjustment

to the partnership’s basis in partnership

property as a result of gain recognized

by the distributee partner. A basis

adjustment attributable to gain treated

as capital gain under section 1231

would be allocated to the property that

entered into the calculation of the

amount of section 1231 gain.

One commentator also suggested that

the proposed regulations do not clarify

whether character is determined at the

partnership or the partner level. This

determination may be important in

situations such as section 1231 where

the character of the gain or loss may

depend on the partner’s particular tax

circumstances. The final regulations

clarify that the character of the gain or

loss is determined at the partnership

level for this purpose.

Exceptions

One commentator suggested adding

an exception for certain divisive transactions in which the contributing partner continued to own an indirect

interest in the contributed property. The

final regulations add a new exception

under which section 737 does not apply

to a transfer of contributed property by

a transferor partnership to a transferee

partnership, followed by a distribution

of an interest in the transferee partnership (and no other property) to the

contributing partner in complete liquidation of the partner’s interest.

This exception is added because the

distributee partner has simply converted

an interest in the transferor partnership

into an interest in a transferee partnership that holds the same contributed

section 704(c) property. The limitations

on this exception ensure that the

partner’s basis in the transferee partnership attributable to the contributed

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property is the same as the partner’s

basis in the transferor partnership attributable to that property. This allows

a partnership to engage in a divisive

split-up transaction, while preventing

any avoidance of section 737 that

might occur as a result of the basis

allocation rules for non-liquidating

distributions.

The proposed regulations provide

that section 737 does not apply to an

incorporation of a partnership other

than an incorporation involving an

actual distribution of partnership property to the partners. One commentator

suggested that this distinction between

methods of incorporation creates an

unnecessary trap for the unwary and

may have a chilling effect on the

conversion of partnerships into S corporations. The final regulations adopt

the proposed regulations without

change. The form of incorporation

chosen by the partners is respected for

Federal tax purposes and, as a result,

the distribution of property in connection with the incorporation is treated as

a distribution for purposes of section

737.

One commentator suggested an additional exception for distributions of an

undivided interest in property similar to

that described with respect to the

regulations under section 704(c)(1)(B).

The final regulations provide a comparable rule under section 737.

Anti-Abuse Rule

Commentators made several suggestions regarding the anti-abuse rule in

the proposed regulations. These suggestions are essentially the same as the

comments regarding the anti-abuse rule

in the section 704(c)(1)(B) regulations,

and thus the comments are discussed

above.

Effective Date

These regulations are effective for

distributions by a partnership to a

partner on or after January 9, 1995.

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 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,

the notice of proposed rulemaking

preceding these regulations was submitted to the Chief Counsel for Advocacy

of the Small Business Administration

for comment on its impact on small

business.

Drafting Information

Several persons from the Office of

Chief Counsel and the Treasury Department participated in the development of these regulations.

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 is amended by adding the

following citation:

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

Section 1.704–4 also issued under 26

U.S.C. 704(c) * * *

Par. 2. Section 1.704–4 is added to

read as follows:

§1.704–4 Distribution of contributed

property.

(a) Determination of gain and loss—

(1) In general. A partner that contributes section 704(c) property to a

partnership must recognize gain or loss

under section 704(c)(1)(B) and this

section on the distribution of such

property to another partner within five

years of its contribution to the partnership in an amount equal to the gain

or loss that would have been allocated

to such partner under section

704(c)(1)(A) and §1.704–3 if the distributed property had been sold by the

partnership to the distributee partner for

its fair market value at the time of the

distribution. See §1.704–3(a)(3)(i) for a

definition of section 704(c) property.

(2) Transactions to which section

704(c)(1)(B) applies. Section 704(c)(1)(B) and this section apply only to

the extent that a distribution by a

partnership is a distribution to a partner

acting in the capacity of a partner

within the meaning of section 731.

(3) Fair market value of property.

The fair market value of the distributed

section 704(c) property is the price at

which the property would change hands

between a willing buyer and a willing

seller at the time of the distribution,

neither being under any compulsion to

buy or sell and both having reasonable

knowledge of the relevant facts. The

fair market value that a partnership

assigns to distributed section 704(c)

property will be regarded as correct,

provided that the value is reasonably

agreed to among the partners in an

arm’s-length negotiation and the partners have sufficiently adverse interests.

(4) Determination of five-year

period—(i) General rule. The five-year

period specified in paragraph (a)(1) of

this section begins on and includes the

date of contribution.

(ii) Section 708(b)(1)(B) terminations. A termination of the partnership

under section 708(b)(1)(B) begins a

new five-year period for each partner

with respect to the built-in gain and

built-in loss property that the partner is

deemed to recontribute to a new

partnership following the termination,

but only to the extent that the pretermination built-in gain or loss, if any,

on such property would not have been

allocated to the contributing partner

under section 704(c)(1)(A) and §1.704–

3 on a sale of the contributed property

to an unrelated party immediately

before the termination. See §1.704–

3(a)(3)(ii) for the definitions of built-in

gain and built-in loss on section 704(c)

property.

(5) Examples. The following examples illustrate the rules of this paragraph (a). Unless otherwise specified,

partnership income equals partnership

expenses (other than depreciation deductions for contributed property) for

each year of the partnership, the fair

market value of partnership property

does not change, all distributions by

the partnership are subject to section

704(c)(1)(B), and all partners are

unrelated.

Example 1. Recognition of gain. (i) On

January 1, 1995, A, B, and C form partnership

ABC as equal partners. A contributes $10,000

cash and Property A, nondepreciable real property with a fair market value of $10,000 and an

adjusted tax basis of $4,000. Thus, there is a

built-in gain of $6,000 on Property A at the time

of contribution. B contributes $10,000 cash and

Property B, nondepreciable real property with a

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fair market value and adjusted tax basis of

$10,000. C contributes $20,000 cash.

(ii) On December 31, 1998, Property A and

Property B are distributed to C in complete

liquidation of C’s interest in the partnership.

(iii) A would have recognized $6,000 of gain

under section 704(c)(1)(A) and §1.704–3 on the

sale of Property A at the time of the distribution

($10,000 fair market value less $4,000 adjusted

tax basis). As a result, A must recognize $6,000

of gain on the distribution of Property A to C. B

would not have recognized any gain or loss

under section 704(c)(1)(A) and §1.704–3 on the

sale of Property B at the time of distribution

because Property B was not section 704(c)

property. As a result, B does not recognize any

gain or loss on the distribution of Property B.

Example 2. Effect of post-contribution depreciation deductions. (i) On January 1, 1995, A,

B, and C form partnership ABC as equal

partners. A contributes Property A, depreciable

property with a fair market value of $30,000 and

an adjusted tax basis of $20,000. Therefore, there

is a built-in gain of $10,000 on Property A. B

and C each contribute $30,000 cash. ABC uses

the traditional method of making section 704(c)

allocations described in §1.704–3(b) with respect

to Property A.

(ii) Property A is depreciated using the

straight-line method over its remaining 10-year

recovery period. The partnership has book

depreciation of $3,000 per year (10 percent of

the $30,000 book basis), and each partner is

allocated $1,000 of book depreciation per year

(one-third of the total annual book depreciation

of $3,000). The partnership has a tax depreciation deduction of $2,000 per year (10 percent of

the $20,000 tax basis in Property A). This $2,000

tax depreciation deduction is allocated equally

between B and C, the noncontributing partners

with respect to Property A.

(iii) At the end of the third year, the book

value of Property A is $21,000 ($30,000 initial

book value less $9,000 aggregate book depreciation) and the adjusted tax basis is $14,000

($20,000 initial tax basis less $6,000 aggregate

tax depreciation). A’s remaining section

704(c)(1)(A) built-in gain with respect to Property A is $7,000 ($21,000 book value less

$14,000 adjusted tax basis).

(iv) On December 31, 1997, Property A is

distributed to B in complete liquidation of B’s

interest in the partnership. If Property A had

been sold for its fair market value at the time of

the distribution, A would have recognized $7,000

of gain under section 704(c)(1)(A) and §1.704–

3(b). Therefore, A recognizes $7,000 of gain on

the distribution of Property A to B.

Example 3. Effect of remedial method. (i) On

January 1, 1995, A, B, and C form partnership

ABC as equal partners. A contributes Property

A1, nondepreciable real property with a fair

market value of $10,000 and an adjusted tax

basis of $5,000, and Property A2, nondepreciable

real property with a fair market value and

adjusted tax basis of $10,000. B and C each

contribute $20,000 cash. ABC uses the remedial

method of making section 704(c) allocations

described in §1.704–3(d) with respect to Property

A1.

(ii) On December 31, 1998, when the fair

market value of Property A1 has decreased to

$7,000, Property A1 is distributed to C in a

current distribution. If Property A1 had been sold

by the partnership at the time of the distribution,

ABC would have recognized the $2,000 of

remaining built-in gain under section

704(c)(1)(A) on the sale (fair market value of

$7,000 less $5,000 adjusted tax basis). All of this

gain would have been allocated to A. ABC

would also have recognized a book loss of

$3,000 ($10,000 original book value less $7,000

current fair market value of the property). Book

loss in the amount of $2,000 would have been

allocated equally between B and C. Under the

remedial method, $2,000 of tax loss would also

have been allocated equally to B and C to match

their share of the book loss. As a result, $2,000

of gain would also have been allocated to A as

an offsetting remedial allocation. A would have

recognized $4,000 of total gain under section

704(c)(1)(A) on the sale of Property A1 ($2,000

of section 704(c) recognized gain plus $2,000

remedial gain). Therefore, A recognizes $4,000

of gain on the distribution of Property A1 to C

under this section.

(b) Character of gain or loss—(1)

General rule. Gain or loss recognized

by the contributing partner under section 704(c)(1)(B) and this section has

the same character as the gain or loss

that would have resulted if the distributed property had been sold by the

partnership to the distributee partner at

the time of the distribution.

(2) Example. The following example

illustrates the rule of this paragraph (b).

Unless otherwise specified, partnership

income equals partnership expenses

(other than depreciation deductions for

contributed property) for each year of

the partnership, the fair market value of

partnership property does not change,

all distributions by the partnership are

subject to section 704(c)(1)(B), and all

partners are unrelated.

Example. Character of gain. (i) On January 1,

1995, A and B form partnership AB. A

contributes $10,000 and Property A, nondepreciable real property with a fair market value of

$10,000 and an adjusted tax basis of $4,000, in

exchange for a 25 percent interest in partnership

capital and profits. B contributes $60,000 cash

for a 75 percent interest in partnership capital

and profits.

(ii) On December 31, 1998, Property A is

distributed to B in a current distribution.

Property A is used in a trade or business of B.

(iii) A would have recognized $6,000 of gain

under section 704(c)(1)(A) on a sale of Property

A at the time of the distribution (the difference

between the fair market value ($10,000) and the

adjusted tax basis ($4,000) of the property at that

time). Because Property A is not a capital asset

in the hands of Partner B and B holds more than

50 percent of partnership capital and profits, the

character of the gain on a sale of Property A to

B would have been ordinary income under

section 707(b)(2). Therefore, the character of the

gain to A on the distribution of Property A to B

is ordinary income.

Section 704(c)(1)(B) and this section

do not apply to property contributed to

the partnership on or before October 3,

1989.

(2) Certain liquidations. Section

704(c)(1)(B) and this section do not

apply to a distribution of an interest in

section 704(c) property to a partner

other than the contributing partner in a

liquidation of the partnership if—

(i) The contributing partner receives

an interest in the section 704(c) property contributed by that partner (and no

other property); and

(ii) The built-in gain or loss in the

interest distributed to the contributing

partner, determined immediately after

the distribution, is equal to or greater

than the built-in gain or loss on the

property that would have been allocated to the contributing partner under

section 704(c)(1)(A) and §1.704–3 on a

sale of the contributed property to an

unrelated party immediately before the

distribution.

(3) Section 708(b)(1)(B) termination.

Section 704(c)(1)(B) and this section

do not apply to a deemed distribution

of property caused by a termination of

the partnership under section 708(b)(1)(B). See paragraph (a)(4)(ii) of this

section for a special rule regarding a

new five-year period for certain property deemed contributed to a new

partnership following a termination of

the partnership under section

708(b)(1)(B). See also §1.737–2(a) for

a similar rule in the context of section

737.

(4) Complete transfer to another

partnership. Section 704(c)(1)(B) and

this section do not apply to a transfer

by a partnership (transferor partnership)

of all of its assets and liabilities to a

second partnership (transferee partnership) in an exchange described in

section 721, followed by a distribution

of the interest in the transferee partnership in liquidation of the transferor

partnership as part of the same plan or

arrangement. A subsequent distribution

of section 704(c) property by the

transferee partnership to a partner of

the transferee partnership is subject to

section 704(c)(1)(B) to the same extent

that a distribution by the transferor

partnership would have been subject to

section 704(c)(1)(B). See §1.737–2(b)

for a similar rule in the context of

section 737.

(5) Incorporation of a partnership.

Section 704(c)(1)(B) and this section

do not apply to an incorporation of a

partnership by any method of incor-

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poration (other than a method involving

an actual distribution of partnership

property to the partners followed by a

contribution of that property to a

corporation), provided that the partnership is liquidated as part of the

incorporation transaction. See §1.737–

2(c) for a similar rule in the context of

section 737.

(6) Undivided interests. Section

704(c)(1)(B) and this section do not

apply to a distribution of an undivided

interest in property to the extent that

the undivided interest does not exceed

the undivided interest, if any, contributed by the distributee partner in the

same property. See §1.737–2(d)(4) for

the application of section 737 in a

similar context. The portion of the

undivided interest in property retained

by the partnership after the distribution,

if any, that is treated as contributed by

the distributee partner, is reduced to the

extent of the undivided interest distributed to the distributee partner.

(7) Example. The following example

illustrates the rule of paragraph (c)(2)

of this section. Unless otherwise specified, partnership income equals partnership expenses (other than depreciation deductions for contributed

property) for each year of the partnership, the fair market value of

partnership property does not change,

all distributions by the partnership are

subject to section 704(c)(1)(B), and all

partners are unrelated.

Example. (i) On January 1, 1995, A and B

form partnership AB, as equal partners. A

contributes Property A, nondepreciable real

property with a fair market value and adjusted

tax basis of $20,000. B contributes Property B,

nondepreciable real property with a fair market

value of $20,000 and an adjusted tax basis of

$10,000. Property B therefore has a built-in gain

of $10,000 at the time of contribution.

(ii) On December 31, 1998, the partnership

liquidates when the fair market value of Property

A has not changed, but the fair market value of

Property B has increased to $40,000.

(iii) In the liquidation, A receives Property A

and a 25 percent interest in Property B. This

interest in Property B has a fair market value of

$10,000 to A, reflecting the fact that A was

entitled to 50 percent of the $20,000 postcontribution appreciation in Property B. The

partnership distributes to B a 75 percent interest

in Property B with a fair market value of

$30,000. B’s basis in this portion of Property B

is $10,000 under section 732(b). As a result, B

has a built-in gain of $20,000 in this portion of

Property B immediately after the distribution

($30,000 fair market value less $10,000 adjusted

tax basis). This built-in gain is greater than the

$10,000 of built-in gain in Property B at the time

of contribution to the partnership. B therefore

does not recognize any gain on the distribution

of a portion of Property B to A under this

section.

(d) Special rules—(1) Nonrecognition transactions. Property received by

the partnership in exchange for section

704(c) property in a nonrecognition

transaction is treated as the section

704(c) property for purposes of section

704(c)(1)(B) and this section to the

extent that the property received is

treated as section 704(c) property under

§1.704–3(a)(8). See §1.737–2(d)(3) for

a similar rule in the context of section

737.

(2) Transfers of a partnership interest. The transferee of all or a portion of

the partnership interest of a contributing partner is treated as the contributing partner for purposes of section

704(c)(1)(B) and this section to the

extent of the share of built-in gain or

loss allocated to the transferee partner.

See §1.704–3(a)(7).

(3) Distributions of like-kind property. If section 704(c) property is

distributed to a partner other than the

contributing partner and like-kind property (within the meaning of section

1031) is distributed to the contributing

partner no later than the earlier of (i)

180 days following the date of the

distribution to the non-contributing

partner, or (ii) the due date (determined

with regard to extensions) of the

contributing partner’s income tax return

for the taxable year of the distribution

to the noncontributing partner, the

amount of gain or loss, if any, that the

contributing partner would otherwise

have recognized under section 704(c)(1)(B) and this section is reduced by

the amount of built-in gain or loss in

the distributed like-kind property in the

hands of the contributing partner immediately after the distribution. The contributing partner’s basis in the distributed like-kind property is

determined as if the like-kind property

were distributed in an unrelated distribution prior to the distribution of any

other property distributed as part of the

same distribution and is determined

without regard to the increase in the

contributing partner’s adjusted tax basis

in the partnership interest under section

704(c)(1)(B) and this section. See

§1.707–3 for provisions treating the

distribution of the like-kind property to

the contributing partner as a disguised

sale in certain situations.

(4) Example. The following example

illustrates the rules of this paragraph

(d). Unless otherwise specified, partnership income equals partnership expenses (other than depreciation deductions for contributed property) for each

year of the partnership, the fair market

value of partnership property does not

change, all distributions by the partnership are subject to section

704(c)(1)(B), and all partners are

unrelated.

Example. Distribution of like-kind property. (i)

On January 1, 1995, A, B, and C form

partnership ABC as equal partners. A contributes

Property A, nondepreciable real property with a

fair market value of $20,000 and an adjusted tax

basis of $10,000. B and C each contribute

$20,000 cash. The partnership subsequently buys

Property X, nondepreciable real property of a

like-kind to Property A with a fair market value

and adjusted tax basis of $8,000. The fair market

value of Property X subsequently increases to

$10,000.

(ii) On December 31, 1998, Property A is

distributed to B in a current distribution. At the

same time, Property X is distributed to A in a

current distribution. The distribution of Property

X does not result in the contribution of Property

A being properly characterized as a disguised

sale to the partnership under §1.707–3. A’s basis

in Property X is $8,000 under section 732(a)(1).

A therefore has $2,000 of built-in gain in

Property X ($10,000 fair market value less

$8,000 adjusted tax basis).

(iii) A would generally recognize $10,000 of

gain under section 704(c)(1)(B) on the distribution of Property A, the difference between the

fair market value ($20,000) of the property and

its adjusted tax basis ($10,000). This gain is

reduced, however, by the amount of the built-in

gain of Property X in the hands of A. As a

result, A recognizes only $8,000 of gain on the

distribution of Property A to B under section

704(c)(1)(B) and this section.

(e) Basis adjustments—(1) Contributing partner’s basis in the partnership

interest. The basis of the contributing

partner’s interest in the partnership is

increased by the amount of the gain, or

decreased by the amount of the loss,

recognized by the partner under section

704(c)(1)(B) and this section. This

increase or decrease is taken into

account in determining (i) the contributing partner’s adjusted tax basis under

section 732 for any property distributed

to the partner in a distribution that is

part of the same distribution as the

distribution of the contributed property,

other than like-kind property described

in paragraph (d)(3) of this section

(pertaining to the special rule for

distributions of like-kind property), and

(ii) the amount of the gain recognized

by the contributing partner under section 731 or section 737, if any, on a

distribution of money or property to the

contributing partner that is part of the

same distribution as the distribution of

the contributed property. For a determination of basis in a distribution

subject to section 737, see §1.737–3(a).

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(2) Partnership’s basis in partnership property. The partnership’s

adjusted tax basis in the distributed

section 704(c) property is increased or

decreased immediately before the distribution by the amount of gain or loss

recognized by the contributing partner

under section 704(c)(1)(B) and this

section. Any increase or decrease in

basis is therefore taken into account in

determining the distributee partner’s

adjusted tax basis in the distributed

property under section 732. For a

determination of basis in a distribution

subject to section 737, see §1.737–3(b).

(3) Section 754 adjustments. The

basis adjustments to partnership property made pursuant to paragraph (e)(2)

of this section are not elective and

must be made regardless of whether the

partnership has an election in effect

under section 754. Any adjustments to

the bases of partnership property (including the distributed section 704(c)

property) under section 734(b) pursuant

to a section 754 election must be made

after (and must take into account) the

adjustments to basis made under paragraph (e)(2) of this section. See

§1.737–3(c)(4) for a similar rule in the

context of section 737.

(4) Example. The following example

illustrates the rules of this paragraph

(e). Unless otherwise specified, partnership income equals partnership expenses (other than depreciation deductions for contributed property) for each

year of the partnership, the fair market

value of partnership property does not

change, all distributions by the partnership are subject to section 704(c)(1)(B), and all partners are unrelated.

Example. Basis adjustment. (i) On January 1,

1995, A, B, and C form partnership ABC as

equal partners. A contributes $10,000 cash and

Property A, nondepreciable real property with a

fair market value of $10,000 and an adjusted tax

basis of $4,000. B and C each contribute $20,000

cash.

(ii) On December 31, 1998, Property A is

distributed to B in a current distribution.

(iii) Under paragraph (a) of this section, A

recognizes $6,000 of gain on the distribution of

Property A because that is the amount of gain

that would have been allocated to A under

section 704(c)(1)(A) and §1.704–3 on a sale of

Property A for its fair market value at the time

of the distribution (fair market value of Property

A ($10,000) less its adjusted tax basis at the time

of distribution ($4,000)). The adjusted tax basis

of A’s partnership interest is increased from

$14,000 to $20,000 to reflect this gain. The

partnership’s adjusted tax basis in Property A is

increased from $4,000 to $10,000 immediately

prior to its distribution to B. B’s adjusted tax

basis in Property A is therefore $10,000 under

section 732(a)(1).

(f) Anti-abuse rule—(1) In general.

The rules of section 704(c)(1)(B) and

this section must be applied in a

manner consistent with the purpose of

section 704(c)(1)(B). Accordingly, if a

principal purpose of a transaction is to

achieve a tax result that is inconsistent

with the purpose of section 704(c)(1)(B), the Commissioner can recast the

transaction for federal tax purposes as

appropriate to achieve tax results that

are consistent with the purpose of

section 704(c)(1)(B) and this section.

Whether a tax result is inconsistent

with the purpose of section 704(c)(1)(B) and this section must be determined based on all the facts and

circumstances. See §1.737–4 for an

anti-abuse rule and examples in the

context of section 737.

(2) Examples. The following examples illustrate the anti-abuse rule of this

paragraph (f). The examples set forth

below do not delineate the boundaries

of either permissible or impermissible

types of transactions. Further, the addition of any facts or circumstances that

are not specifically set forth in an

example (or the deletion of any facts or

circumstances) may alter the outcome

of the transaction described in the

example. Unless otherwise specified,

partnership income equals partnership

expenses (other than depreciation deductions for contributed property) for

each year of the partnership, the fair

market value of partnership property

does not change, all distributions by

the partnership are subject to section

704(c)(1)(B), and all partners are unrelated.

Example 1. Distribution in substance made

within five-year period; results inconsistent with

the purpose of section 704(c)(1)(B). (i) On

January 1, 1995, A, B, and C form partnership

ABC as equal partners. A contributes Property

A, nondepreciable real property with a fair

market value of $10,000 and an adjusted tax

basis of $1,000. B and C each contributes

$10,000 cash.

(ii) On December 31, 1998, the partners desire

to distribute Property A to B in complete

liquidation of B’s interest in the partnership. If

Property A were distributed at that time,

however, A would recognize $9,000 of gain

under section 704(c)(1)(B), the difference between the $10,000 fair market value and the

$1,000 adjusted tax basis of Property A, because

Property A was contributed to the partnership

less than five years before December 31, 1998.

On becoming aware of this potential gain

recognition, and with a principal purpose of

avoiding such gain, the partners amend the

partnership agreement on December 31, 1998,

and take any other steps necessary to provide

that substantially all of the economic risks and

benefits of Property A are borne by B as of

December 31, 1998, and that substantially all of

the economic risks and benefits of all other

partnership property are borne by A and C. The

partnership holds Property A until January 5,

2000, at which time it is distributed to B in

complete liquidation of B’s interest in the

partnership.

(iii) The actual distribution of Property A

occurred more than five years after the contribution of the property to the partnership. The steps

taken by the partnership on December 31, 1998,

however, are the functional equivalent of an

actual distribution of Property A to B in

complete liquidation of B’s interest in the

partnership as of that date. Section 704(c)(1)(B)

requires recognition of gain when contributed

section 704(c) property is in substance distributed to another partner within five years of its

contribution to the partnership. Allowing a

contributing partner to avoid section 704(c)(1)(B)

through arrangements such as those in this

Example 1 that have the effect of a distribution

of property within five years of the date of its

contribution to the partnership would effectively

undermine the purpose of section 704(c)(1)(B)

and this section. As a result, the steps taken by

the partnership on December 31, 1998, are

treated as causing a distribution of Property A to

B for purposes of section 704(c)(1)(B) on that

date, and A recognizes gain of $9,000 under

section 704(c)(1)(B) and this section at that time.

(iv) Alternatively, if on becoming aware of

the potential gain recognition to A on a

distribution of Property A on December 31,

1998, the partners had instead agreed that B

would continue as a partner with no changes to

the partnership agreement or to B’s economic

interest in partnership operations, the distribution

of Property A to B on January 5, 2000, would

not have been inconsistent with the purpose of

section 704(c)(1)(B) and this section. In that

situation, Property A would not have been distributed until after the expiration of the five-year

period specified in section 704(c)(1)(B) and this

section. Deferring the distribution of Property A

until the end of the five-year period for a

principal purpose of avoiding the recognition of

gain under section 704(c)(1)(B) and this section

is not inconsistent with the purpose of section

704(c)(1)(B). Therefore, A would not have

recognized gain on the distribution of Property A

in that case.

Example 2. Suspension of five-year period in

manner consistent with the purpose of section

704(c)(1)(B). (i) A, B, and C form partnership

ABC on January 1, 1995, to conduct bona fide

business activities. A contributes Property A,

nondepreciable real property with a fair market

value of $10,000 and an adjusted tax basis of

$1,000, in exchange for a 49.5 percent interest in

partnership capital and profits. B contributes

$10,000 in cash for a 49.5 percent interest in

partnership capital and profits. C contributes cash

for a 1 percent interest in partnership capital and

profits. A and B are wholly owned subsidiaries

of the same affiliated group and continue to

control the management of Property A by virtue

of their controlling interests in the partnership.

The partnership is formed pursuant to a plan a

principal purpose of which is to minimize the

period of time that A would have to remain a

partner with a potential acquiror of Property A.

(ii) On December 31, 1997, D is admitted as a

partner to the partnership in exchange for

$10,000 cash.

(iii) On January 5, 2000, Property A is

distributed to D in complete liquidation of D’s

interest in the partnership.

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(iv) The distribution of Property A to D

occurred more than five years after the contribution of the property to the partnership. On these

facts, however, a principal purpose of the

transaction was to minimize the period of time

that A would have to remain partners with a

potential acquiror of Property A, and treating the

five-year period of section 704(c)(1)(B) as

running during a time when Property A was still

effectively owned through the partnership by

members of the contributing affiliated group of

which A is a member is inconsistent with the

purpose of section 704(c)(1)(B). Prior to the

admission of D as a partner, the pooling of assets

between A and B, on the one hand, and C, on

the other hand, although sufficient to constitute

ABC as a valid partnership for federal income

tax purposes, is not a sufficient pooling of assets

for purposes of running the five-year period with

respect to the distribution of Property A to D.

Allowing a contributing partner to avoid section

704(c)(1)(B) through arrangements such as those

in this Example 2 would have the effect of

substantially nullifying the five-year requirement

of section 704(c)(1)(B) and this section and

elevating the form of the transaction over its

substance. As a result, with respect to the

distribution of Property A to D, the five-year

period of section 704(c)(1)(B) is tolled until the

admission of D as a partner on December 31,

1997. Therefore, the distribution of Property A

occurred before the end of the five-year period

of section 704(c)(1)(B), and A recognizes gain of

$9,000 under section 704(c)(1)(B) on the

distribution.

(g) Effective date. This section applies to distributions by a partnership to

a partner on or after January 9, 1995.

Par. 3. Sections 1.737–1, 1.737–2,

1.737–3, 1.737–4, and 1.737–5 are

added to read as follows:

§1.737–1 Recognition of

precontribution gain.

(a) Determination of gain—(1) In

general. A partner that receives a

distribution of property (other than

money) must recognize gain under

section 737 and this section in an

amount equal to the lesser of the

excess distribution (as defined in paragraph (b) of this section) or the

partner’s net precontribution gain (as

defined in paragraph (c) of this section). Gain recognized under section

737 and this section is in addition to

any gain recognized under section 731.

(2) Transactions to which section

737 applies. Section 737 and this

section apply only to the extent that a

distribution by a partnership is a

distribution to a partner acting in the

capacity of a partner within the meaning of section 731, except that section

737 and this section do not apply to the

extent that section 751(b) applies to the

distribution.

(b) Excess distribution—(1) Definition. The excess distribution is the

amount (if any) by which the fair

market value of the distributed property

(other than money) exceeds the distributee partner’s adjusted tax basis in

the partner’s partnership interest.

(2) Fair market value of property.

The fair market value of the distributed

property is the price at which the

property would change hands between

a willing buyer and a willing seller at

the time of the distribution, neither

being under any compulsion to buy or

sell and both having reasonable knowledge of the relevant facts. The fair

market value that a partnership assigns

to distributed property will be regarded

as correct, provided that the value is

reasonably agreed to among the partners in an arm’s-length negotiation and

the partners have sufficiently adverse

interests.

(3) Distributee partner’s adjusted

tax basis—(i) General rule. In determining the amount of the excess

distribution, the distributee partner’s

adjusted tax basis in the partnership

interest includes any basis adjustment

resulting from the distribution that is

subject to section 737 (for example,

adjustments required under section 752)

and from any other distribution or

transaction that is part of the same

distribution, except for—

(A) The increase required under section 737(c)(1) for the gain recognized

by the partner under section 737; and

(B) The decrease required under section 733(2) for any property distributed

to the partner other than property

previously contributed to the partnership by the distributee partner. See

§1.704–4(e)(1) for a rule in the context

of section 704(c)(1)(B). See also

§1.737–3(b)(2) for a special rule for

determining a partner’s adjusted tax

basis in distributed property previously

contributed by the partner to the

partnership.

(ii) Advances or drawings. The distributee partner’s adjusted tax basis in

the partnership interest is determined as

of the last day of the partnership’s

taxable year if the distribution to which

section 737 applies is properly characterized as an advance or drawing

against the partner’s distributive share

of income. See §1.731–1(a)(1)(ii).

General rule. The distributee partner’s

net precontribution gain is the net gain

(if any) that would have been recog-

nized by the distributee partner under

section 704(c)(1)(B) and §1.704–4 if

all property that had been contributed

to the partnership by the distributee

partner within five years of the distribution and is held by the partnership

immediately before the distribution had

been distributed by the partnership to

another partner other than a partner

who owns, directly or indirectly, more

than 50 percent of the capital or profits

interest in the partnership. See §1.704–

4 for provisions determining a contributing partner’s gain or loss under

section 704(c)(1)(B) on an actual distribution of contributed section 704(c)

property to another partner.

(2) Special rules—(i) Property contributed on or before October 3, 1989.

Property contributed to the partnership

on or before October 3, 1989, is not

taken into account in determining a

partner’s net precontribution gain. See

§1.704–4(c)(1) for a similar rule in the

context of section 704(c)(1)(B).

(ii) Section 734(b)(1)(A) adjustments. For distributions to a distributee

partner of money by a partnership with

a section 754 election in effect that are

part of the same distribution as the

distribution of property subject to section 737, for purposes of paragraph (a)

and (c)(1) of this section the distributee

partner’s net precontribution gain is

reduced by the basis adjustments (if

any) made to section 704(c) property

contributed by the distributee partner

under section 734(b)(1)(A). See

§1.737–3(c)(4) for rules regarding basis

adjustments for partnerships with a

section 754 election in effect.

(iii) Transfers of a partnership interest. The transferee of all or a portion of

a contributing partner’s partnership interest succeeds to the transferor’s net

precontribution gain, if any, in an

amount proportionate to the interest

transferred. See §1.704–3(a)(7) and

§1.704–4(d)(2) for similar provisions in

the context of section 704(c)(1)(A) and

section 704(c)(1)(B).

(iv) Section 704(c)(1)(B) gain recognized in related distribution. A distributee partner’s net precontribution

gain is determined after taking into

account any gain or loss recognized by

the partner under section 704(c)(1)(B)

and §1.704–4 (or that would have been

recognized by the partner except for

the like-kind exception in section

704(c)(2) and §1.704–4(d)(3)) on an

actual distribution to another partner of

section 704(c) property contributed by

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the distributee partner that is part of the

same distribution as the distribution to

the distributee partner.

(v) Section 704(c)(2) disregarded. A

distributee partner’s net precontribution

gain is determined without regard to

the provisions of section 704(c)(2) and

§1.704–4(d)(3) in situations in which

the property contributed by the distributee partner is not actually distributed to another partner in a distribution related to the section 737

distribution.

(d) Character of gain. The character

of the gain recognized by the distributee partner under section 737 and

this section is determined by, and is

proportionate to, the character of the

partner’s net precontribution gain. For

this purpose, all gains and losses on

section 704(c) property taken into

account in determining the partner’s net

precontribution gain are netted according to their character. Character is

determined at the partnership level for

this purpose, and any character with a

net negative amount is disregarded. The

character of the partner’s gain under

section 737 is the same as, and in

proportion to, any character with a net

positive amount. Character for this

purpose is determined as if the section

704(c) property had been sold by the

partnership to an unrelated third party

at the time of the distribution and

includes any item that would have been

taken into account separately by the

contributing partner under section

702(a) and §1.702–1(a).

(e) Examples. The following examples illustrate the provisions of this

section. Unless otherwise specified,

partnership income equals partnership

expenses (other than depreciation deductions for contributed property) for

each year of the partnership, the fair

market value of partnership property

does not change, all distributions by

the partnership are subject to section

737, and all partners are unrelated.

Example 1. Calculation of excess distribution

and net precontribution gain. (i) On January 1,

1995, A, B, and C form partnership ABC as

equal partners. A contributes Property A, depreciable real property with a fair market value of

$30,000 and an adjusted tax basis of $20,000. B

contributes Property B, nondepreciable real property with a fair market value and adjusted tax

basis of $30,000. C contributes $30,000 cash.

(ii) Property A has 10 years remaining on its

cost recovery schedule and is depreciated using

the straight-line method. The partnership uses the

traditional method for allocating items under

section 704(c) described in §1.704–3(b)(1) for

Property A. The partnership has book deprecia-

tion of $3,000 per year (10 percent of the

$30,000 book basis in Property A) and each

partner is allocated $1,000 of book depreciation

per year (one-third of the total annual book

depreciation of $3,000). The partnership also has

tax depreciation of $2,000 per year (10 percent

of the $20,000 adjusted tax basis in Property A).

This $2,000 tax depreciation is allocated equally

between B and C, the noncontributing partners

with respect to Property A.

(iii) At the end of 1997, the book value of

Property A is $21,000 ($30,000 initial book

value less $9,000 aggregate book depreciation)

and its adjusted tax basis is $14,000 ($20,000

initial tax basis less $6,000 aggregate tax

depreciation).

(iv) On December 31, 1997, Property B is

distributed to A in complete liquidation of A’s

partnership interest. The adjusted tax basis of

A’s partnership interest at that time is $20,000.

The amount of the excess distribution is $10,000,

the difference between the fair market value of

the distributed Property B ($30,000) and A’s

adjusted tax basis in A’s partnership interest

($20,000). A’s net precontribution gain is $7,000,

the difference between the book value of

Property A ($21,000) and its adjusted tax basis at

the time of the distribution ($14,000). A

recognizes gain of $7,000 on the distribution, the

lesser of the excess distribution and the net

precontribution gain.

Example 2. Determination of distributee partner’s basis. (i) On January 1, 1995, A, B, and C

form general partnership ABC as equal partners.

A contributes Property A, nondepreciable real

property with a fair market value of $10,000 and

an adjusted tax basis of $4,000. B and C each

contributes $10,000 cash.

(ii) The partnership purchases Property B,

nondepreciable real property with a fair market

value of $9,000, subject to a $9,000 nonrecourse

liability. This nonrecourse liability is allocated

equally among the partners under section 752,

increasing A’s adjusted tax basis in A’s partnership interest from $4,000 to $7,000.

(iii) On December 31, 1998, A receives

$2,000 cash and Property B, subject to the

$9,000 liability, in a current distribution.

(iv) In determining the amount of the excess

distribution, the adjusted tax basis of A’s

partnership interest is adjusted to take into

account the distribution of money and the shift in

liabilities. A’s adjusted tax basis is therefore

increased to $11,000 for this purpose ($7,000

initial adjusted tax basis, less $2,000 distribution

of money, less $3,000 (decrease in A’s share of

the $9,000 partnership liability), plus $9,000

(increase in A’s individual liabilities)). As a

result of this basis adjustment, the adjusted tax

basis of A’s partnership interest ($11,000) is

greater than the fair market value of the

distributed property ($9,000) and therefore, there

is no excess distribution. A recognizes no gain

under section 737.

Example 3. Net precontribution gain reduced

for gain recognized under section 704(c)(1)(B).

(i) On January 1, 1995, A, B, and C form

partnership ABC as equal partners. A contributes

Properties A1 and A2, nondepreciable real

properties located in the United States each with

a fair market value of $10,000 and an adjusted

tax basis of $6,000. B contributes Property B,

nondepreciable real property located outside the

United States, with a fair market value and

adjusted tax basis of $20,000. C contributes

$20,000 cash.

(ii) On December 31, 1998, Property B is

distributed to A in complete liquidation of A’s

interest and, as part of the same distribution,

Property A1 is distributed to B in a current

distribution.

(iii) A’s net precontribution gain before the

distribution is $8,000 ($20,000 fair market value

of Properties A1 and A2 less $12,000 adjusted

tax basis of such properties). A recognizes

$4,000 of gain under section 704(c)(1)(B) and

§1.704–4 on the distribution of Property A1 to B

($10,000 fair market value of Property A1 less

$6,000 adjusted tax basis of Property A1). This

gain is taken into account in determining A’s

excess distribution and net precontribution gain.

As a result, A’s net precontribution gain is

reduced from $8,000 to $4,000, and the adjusted

tax basis in A’s partnership interest is increased

by $4,000 to $16,000.

(iv) A recognizes gain of $4,000 on the

receipt of Property B under section 737, an

amount equal to the lesser of the excess

distribution of $4,000 ($20,000 fair market value

of Property B less $16,000 adjusted tax basis of

A’s interest in the partnership) and A’s remaining net precontribution gain of $4,000.

Example 4. Character of gain. (i) On January

1, 1995, A, B, and C form partnership ABC as

equal partners. A contributes the following

nondepreciable property to the partnership:

Property A1

Property A2

Property A3

Fair Market

Value

Adjusted Tax

Basis

$30,000

30,000

10,000

$20,000

38,000

9,000

(ii) The character of gain or loss on Property

A1 and Property A2 is long-term, U.S.-source

capital gain or loss. The character of gain on

Property A3 is long-term, foreign-source capital

gain. B contributes Property B, nondepreciable

real property with a fair market value and

adjusted tax basis of $70,000. C contributes

$70,000 cash.

(iii) On December 31, 1998, Property B is

distributed to A in complete liquidation of A’s

interest in the partnership. A recognizes $3,000

of gain under section 737, an amount equal to

the excess distribution of $3,000 ($70,000 fair

market value of Property B less $67,000 adjusted

tax basis in A’s partnership interest) and A’s net

precontribution gain of $3,000 ($70,000 aggregate fair market value of properties contributed

by A less $67,000 aggregate adjusted tax basis of

such properties).

(iv) In determining the character of A’s gain,

all gains and losses on property taken into

account in determining A’s net precontribution

gain are netted according to their character and

allocated to A’s recognized gain under section

737 based on the relative proportions of the net

positive amounts. U.S.-source and foreign-source

gains must be netted separately because A would

have been required to take such gains into

account separately under section 702. As a result,

A’s net precontribution gain of $3,000 consists

of $2,000 of net long-term, U.S.-source capital

gain ($10,000 gain on Property A1 and $8,000

loss on Property A2) and $1,000 of net longterm, foreign-source capital gain ($1,000 gain on

Property A3).

(v) The character of A’s gain under paragraph

(d) of this section is therefore $2,000 long-term,

U.S.-source capital gain ($3,000 gain recognized

under section 737 3 $2,000 net long-term, U.S.-

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source capital gain/$3,000 total net precontribution gain) and $1,000 long-term, foreign-source

capital gain ($3,000 gain recognized under

section 737 3 $1,000 net long-term, foreignsource capital gain/$3,000 total net precontribution gain).

§1.737–2 Exceptions and special

rules.

(a) Section 708(b)(1)(B) terminations. Section 737 and this section do

not apply to a deemed distribution of

property caused by a termination of the

partnership under section 708(b)(1)(B).

See §1.704–4(c)(3) for a similar rule in

the context of section 704(c)(1)(B).

(b) Transfers to another partnership—(1) Complete transfer. Section

737 and this section do not apply to a

transfer by a partnership (transferor

partnership) of all of its assets and

liabilities to a second partnership

(transferee partnership) in an exchange

described in section 721, followed by a

distribution of the interest in the

transferee partnership in liquidation of

the transferor partnership as part of the

same plan or arrangement. See §1.704–

4(c)(4) for a similar rule in the context

of section 704(c)(1)(B).

(2) Certain divisive transactions.

Section 737 and this section do not

apply to a transfer by a partnership

(transferor partnership) of all of the

section 704(c) property contributed by

a partner to a second partnership

(transferee partnership) in an exchange

described in section 721, followed by a

distribution as part of the same plan or

arrangement of an interest in the

transferee partnership (and no other

property) in complete liquidation of the

interest of the partner that originally

contributed the section 704(c) property

to the transferor partnership.

(3) Subsequent distributions. A subsequent distribution of property by the

transferee partnership to a partner of

the transferee partnership that was

formerly a partner of the transferor

partnership is subject to section 737 to

the same extent that a distribution from

the transferor partnership would have

been subject to section 737.

Section 737 and this section do not

apply to an incorporation of a partnership by any method of incorporation

(other than a method involving an

actual distribution of partnership property to the partners followed by a

contribution of that property to a

corporation), provided that the part-

nership is liquidated as part of the

incorporation transaction. See §1.704–

4(c)(5) for a similar rule in the context

of section 704(c)(1)(B).

(d) Distribution of previously contributed property—(1) General rule.

Any portion of the distributed property

that consists of property previously

contributed by the distributee partner

(including property treated as contributed by the partner in connection with

a termination of the partnership under

section 708(b)(1)(B)) (previously contributed property) is not taken into

account in determining the amount of

the excess distribution or the partner’s

net precontribution gain. See §1.737–

3(b)(2) for a special rule for determining the basis of previously contributed

property in the hands of a distributee

partner who contributed the property to

the partnership.

(2) Limitation for distribution of

previously contributed interest in an

entity. An interest in an entity previously contributed to the partnership is

not treated as previously contributed

property to the extent that the value of

the interest is attributable to property

contributed to the entity after the

interest was contributed to the partnership. The preceding sentence does

not apply to the extent that the property

contributed to the entity was contributed to the partnership by the partner

that also contributed the interest in the

entity to the partnership.

(3) Nonrecognition transactions.

Property received by the partnership in

exchange for contributed section 704(c)

property in a nonrecognition transaction

is treated as the contributed property

with regard to the contributing partner

for purposes of section 737 to the

extent that the property received is

treated as section 704(c) property under

§1.704–3(a)(8). See §1.704–4(d)(1) for

a similar rule in the context of section

704(c)(1)(B).

(4) Undivided interests. The distribution of an undivided interest in property is treated as the distribution of

previously contributed property to the

extent that the undivided interest does

not exceed the undivided interest, if

any, contributed by the distributee

partner in the same property. See

§1.704–4(c)(6) for the application of

section 704(c)(1)(B) in a similar context. The portion of the undivided

interest in property retained by the

partnership after the distribution, if

any, that is treated as contributed by

the distributee partner, is reduced to the

extent of the undivided interest distributed to the distributee partner.

(e) Examples. The following examples illustrate the rules of this section.

Unless otherwise specified, partnership

income equals partnership expenses

(other than depreciation deductions for

contributed property) for each year of

the partnership, the fair market value of

partnership property does not change,

all distributions by the partnership are

subject to section 737, and all partners

are unrelated.

Example 1. Distribution of previously contributed property. (i) On January 1, 1995, A, B, and

C form partnership ABC as equal partners. A

contributes the following nondepreciable real

property to the partnership:

Property A1

Property A2

Fair Market

Value

Adjusted Tax

Basis

$20,000

10,000

$10,000

6,000

(ii) A’s total net precontribution gain on the

contributed property is $14,000 ($10,000 on

Property A1 plus $4,000 on Property A2). B

contributes $10,000 cash and Property B, nondepreciable real property with a fair market value

and adjusted tax basis of $20,000. C contributes

$30,000 cash.

(iii) On December 31, 1998, Property A2 and

Property B are distributed to A in complete

liquidation of A’s interest in the partnership.

Property A2 was previously contributed by A

and is therefore not taken into account in

determining the amount of the excess distribution

or A’s net precontribution gain. The adjusted tax

basis of Property A2 in the hands of A is also

determined under section 732 as if that property

were the only property distributed to A.

(iv) As a result of excluding Property A2 from

these determinations, the amount of the excess

distribution is $10,000 ($20,000 fair market

value of distributed Property B less $10,000

adjusted tax basis in A’s partnership interest).

A’s net precontribution gain is also $10,000

($14,000 total net precontribution gain less

$4,000 gain with respect to previously contributed Property A2). A therefore recognizes

$10,000 of gain on the distribution, the lesser of

the excess distribution and the net precontribution gain.

Example 2. Distribution of a previously contributed interest in an entity. (i) On January 1,

1995, A, B, and C form partnership ABC as

equal partners. A contributes Property A, nondepreciable real property with a fair market value

of $10,000 and an adjusted tax basis of $5,000,

and all of the stock of Corporation X with a fair

market value and adjusted tax basis of $500. B

contributes $500 cash and Property B, nondepreciable real property with a fair market value and

adjusted tax basis of $10,000. Partner C contributes $10,500 cash. On December 31, 1996, ABC

contributes Property B to Corporation X in a

nonrecognition transaction under section 351.

(ii) On December 31, 1998, all of the stock of

Corporation X is distributed to A in complete

liquidation of A’s interest in the partnership. The

stock is treated as previously contributed property with respect to A only to the extent of the

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$500 fair market value of the Corporation X

stock contributed by A. The fair market value of

the distributed stock for purposes of determining

the amount of the excess distribution is therefore

$10,000 ($10,500 total fair market value of

Corporation X stock less $500 portion treated as

previously contributed property). The $500 fair

market value and adjusted tax basis of the

Corporation X stock is also not taken into

account in determining the amount of the excess

distribution and the net precontribution gain.

(iii) A recognizes $5,000 of gain under section

737, the amount of the excess distribution

($10,000 fair market value of distributed property less $5,000 adjusted tax basis in A’s

partnership interest) and A’s net precontribution

gain ($10,000 fair market value of Property A

less $5,000 adjusted tax basis in Property A).

Example 3. Distribution of undivided interest

in property. (i) On January 1, 1995, A and B

form partnership AB as equal partners. A

contributes $500 cash and an undivided one-half

interest in Property X. B contributes $500 cash

and an undivided one-half interest in Property X.

(ii) On December 31, 1998, an undivided onehalf interest in Property X is distributed to A in

a current distribution. The distribution of the

undivided one-half interest in Property X is

treated as a distribution of previously contributed

property because A contributed an undivided

one-half interest in Property X. As a result, A

does not recognize any gain under section 737 on

the distribution.

§1.737–3 Basis adjustments; Recovery

rules.

(a) Distributee partner’s adjusted

tax basis in the partnership interest.

The distributee partner’s adjusted tax

basis in the partnership interest is

increased by the amount of gain

recognized by the distributee partner

under section 737 and this section. This

increase is not taken into account in

determining the amount of gain recognized by the partner under section

737(a)(1) and this section or in determining the amount of gain recognized

by the partner under section 731(a) on

the distribution of money in the same

distribution or any related distribution.

See §1.704–4(e)(1) for a determination

of the distributee partner’s adjusted tax

basis in a distribution subject to section

704(c)(1)(B).

(b) Distributee partner’s adjusted

tax basis in distributed property—(1)

In general. The distributee partner’s

adjusted tax basis in the distributed

property is determined under section

732(a) or (b) as applicable. The increase in the distributee partner’s adjusted tax basis in the partnership

interest under paragraph (a) of this

section is taken into account in determining the distributee partner’s adjusted tax basis in the distributed

property other than property previously

contributed by the partner. See §1.704–

4(e)(2) for a determination of basis in a

distribution subject to section

704(c)(1)(B).

(2) Previously contributed property.

The distributee partner’s adjusted tax

basis in distributed property that the

partner previously contributed to the

partnership is determined as if it were

distributed in a separate and independent distribution prior to the distribution

that is subject to section 737 and

§1.737–1.

in partnership property—(1) Increase in

basis. The partnership’s adjusted tax

basis in eligible property is increased by

the amount of gain recognized by the

distributee partner under section 737.

(2) Eligible property. Eligible property is property that—

(i) Entered into the calculation of

the distributee partner’s net precontribution gain;

(ii) Has an adjusted tax basis to the

partnership less than the property’s fair

market value at the time of the

distribution;

(iii) Would have the same character

of gain on a sale by the partnership to

an unrelated party as the character of

any of the gain recognized by the distributee partner under section 737; and

(iv) Was not distributed to another

partner in a distribution subject to

section 704(c)(1)(B) and §1.704–4 that

was part of the same distribution as the

distribution subject to section 737.

(3) Method of adjustment. For the

purpose of allocating the basis increase

under paragraph (c)(2) of this section

among the eligible property, all eligible

property of the same character is

treated as a single group. Character for

this purpose is determined in the same

manner as the character of the recognized gain is determined under §1.737–

1(d). The basis increase is allocated

among the separate groups of eligible

property in proportion to the character

of the gain recognized under section

737. The basis increase is then allocated among property within each

group in the order in which the

property was contributed to the partnership by the partner, starting with the

property contributed first, in an amount

equal to the difference between the

property’s fair market value and its

adjusted tax basis to the partnership at

the time of the distribution. For property that has the same character and

was contributed in the same (or a

related) transaction, the basis increase

is allocated based on the respective

amounts of unrealized appreciation in

such properties at the time of the

distribution.

(4) Section 754 adjustments. The

basis adjustments to partnership property made pursuant to paragraph (c)(1)

of this section are not elective and

must be made regardless of whether the

partnership has an election in effect

under section 754. Any adjustments to

the bases of partnership property (including eligible property as defined in

paragraph (c)(2) of this section) under

section 734(b) pursuant to a section

754 election (other than basis adjustments under section 734(b)(1)(A) described in the following sentence) must

be made after (and must take into

account) the adjustments to basis made

under paragraph (a) and paragraph

(c)(1) of this section. Basis adjustments

under section 734(b)(1)(A) that are

attributable to distributions of money to

the distributee partner that are part of

the same distribution as the distribution

of property subject to section 737 are

made before the adjustments to basis

under paragraph (a) and paragraph

(c)(1) of this section. See §1.737–

1(c)(2)(ii) for the effect, if any, of basis

adjustments under section 734(b)(1)(A)

on a partner’s net precontribution gain.

See also §1.704–4(e)(3) for a similar

rule regarding basis adjustments pursuant to a section 754 election in the

context of section 704(c)(1)(B).

(d) Recovery of increase to adjusted

tax basis. Any increase to the adjusted

tax basis of partnership property under

paragraph (c)(1) of this section is

recovered using any applicable recovery period and depreciation (or other

cost recovery) method (including firstyear conventions) available to the

partnership for newly purchased property (of the type adjusted) placed in

service at the time of the distribution.

(e) Examples. The following examples illustrate the rules of this section.

Unless otherwise specified, partnership

income equals partnership expenses

(other than depreciation deductions for

contributed property) for each year of

the partnership, the fair market value of

partnership property does not change,

all distributions by the partnership are

subject to section 737, and all partners

are unrelated.

Example 1. Partner’s basis in distributed

property. (i) On January 1, 1995, A, B, and C

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form partnership ABC as equal partners. A

contributes Property A, nondepreciable real

property with a fair market value of $10,000 and

an adjusted tax basis of $5,000. B contributes

Property B, nondepreciable real property with a

fair market value and adjusted tax basis of

$10,000. C contributes $10,000 cash.

(ii) On December 31, 1998, Property B is

distributed to A in complete liquidation of A’s

interest in the partnership. A recognizes $5,000

of gain under section 737, an amount equal to

the excess distribution of $5,000 ($10,000 fair

market value of Property B less $5,000 adjusted

tax basis in A’s partnership interest) and A’s net

precontribution gain of $5,000 ($10,000 fair

market value of Property A less $5,000 adjusted

tax basis of such property).

(iii) A’s adjusted tax basis in A’s partnership

interest is increased by the $5,000 of gain

recognized under section 737. This increase is

taken into account in determining A’s basis in

the distributed property. Therefore, A’s adjusted

tax basis in distributed Property B is $10,000

under section 732(b).

Example 2. Partner’s basis in distributed

property in connection with gain recognized

under section 704(c)(1)(B). (i) On January 1,

1995, A, B, and C form partnership ABC as

equal partners. A contributes the following

nondepreciable real property to the partnership:

Property A1

Property A2

Fair Market

Value

Adjusted Tax

Basis

$10,000

10,000

$5,000

2,000

(ii) B contributes $10,000 cash and Property

B, nondepreciable real property, with a fair

market value and adjusted tax basis of $10,000.

C contributes $20,000 cash.

(iii) On December 31, 1998, Property B is

distributed to A in a current distribution and

Property A1 is distributed to B in a current

distribution. A recognizes $5,000 of gain under

section 704(c)(1)(B) and §1.704–4 on the distribution of Property A1 to B, the difference

between the fair market value of such property

($10,000) and the adjusted tax basis in distributed Property A1 ($5,000). The adjusted tax

basis of A’s partnership interest is increased by

this $5,000 of gain under section 704(c)(1)(B)

and §1.704–4(e)(1).

(iv) The increase in the adjusted tax basis of

A’s partnership interest is taken into account in

determining the amount of the excess distribution. As a result, there is no excess distribution

because the fair market value of Property B

($10,000) is less than the adjusted tax basis of

A’s interest in the partnership at the time of

distribution ($12,000). A therefore recognizes no

gain under section 737 on the receipt of Property

B. A’s adjusted tax basis in Property B is

$10,000 under section 732(a)(1). The adjusted

tax basis of A’s partnership interest is reduced

from $12,000 to $2,000 under section 733. See

Example 3 of §1.737–1(e).

Example 3. Partnership’s basis in partnership

property after a distribution with section 737

gain. (i) On January 31, 1995, A, B, and C form

partnership ABC as equal partners. A contributes

the following nondepreciable property to the

partnership:

Property A1

Property A2

Property A3

Property A4

Fair Market

Value

Adjusted Tax

Basis

$1,000

4,000

6,000

$ 500

1,500

6,000

4,000

(ii) The character of gain or loss on Properties

A1, A2, and A3 is long-term, U.S.-source capital

gain or loss. The character of gain on Property

A4 is long-term, foreign-source capital gain. B

contributes Property B, nondepreciable real property with a fair market value and adjusted tax

basis of $15,000. C contributes $15,000 cash.

(iii) On December 31, 1998, Property B is

distributed to A in complete liquidation of A’s

interest in the partnership. A recognizes gain of

$3,000 under section 737, an amount equal to the

excess distribution of $3,000 ($15,000 fair

market value of Property B less $12,000 adjusted

tax basis in A’s partnership interest) and A’s net

precontribution gain of $3,000 ($15,000 aggregate fair market value of the property contributed

by A less $12,000 aggregate adjusted tax basis of

such property).

(iv) $2,000 of A’s gain is long-term, foreignsource capital gain ($3,000 total gain under

section 737 3 $2,000 net long-term, foreignsource capital gain/$3,000 total net precontribution gain). $1,000 of A’s gain is long-term, U.S.source capital gain ($3,000 total gain under

section 737 3 $1,000 net long-term, U.S.-source

capital gain/$3,000 total net precontribution

gain).

(v) The partnership must increase the adjusted

tax basis of the property contributed by A by

$3,000. All property contributed by A is eligible

property. Properties A1, A2, and A3 have the

same character and are grouped into a single

group for purposes of allocating this basis

increase. Property A4 is in a separate character

group.

(vi) $2,000 of the basis increase must be

allocated to long-term, foreign-source capital

assets because $2,000 of the gain recognized by

A was long-term, foreign-source capital gain.

The adjusted tax basis of Property A4 is

therefore increased from $4,000 to $6,000.

$1,000 of the increase must be allocated to

Properties A1 and A2 because $1,000 of the gain

recognized by A is long-term, U.S.-source capital

gain. No basis increase is allocated to Property

A3 because its fair market value is less than its

adjusted tax basis. The $1,000 basis increase is

allocated between Properties A1 and A2 based

on the unrealized appreciation in each asset

before such basis adjustment. As a result, the

adjusted tax basis of Property A1 is increased by

$167 ($1,000 3 $500/$3,000) and the adjusted

tax basis of Property A2 is increased by $833

($1,000 3 $2,500/3,000).

§1.737–4 Anti-abuse rule.

(a) In general. The rules of section

737 and §§1.737–1, 1.737–2, and

1.737–3 must be applied in a manner

consistent with the purpose of section

737. Accordingly, if a principal purpose of a transaction is to achieve a tax

result that is inconsistent with the

purpose of section 737, the Commissioner can recast the transaction for

federal tax purposes as appropriate to

achieve tax results that are consistent

with the purpose of section 737.

Whether a tax result is inconsistent

with the purpose of section 737 must

be determined based on all the facts

and circumstances. See §1.704–4(f) for

an anti-abuse rule and examples in the

context of section 704(c)(1)(B). The

anti-abuse rule and examples under

section 704(c)(1)(B) and §1.704–4(f)

are relevant to section 737 and

§§1.737–1, 1.737–2, and 1.737–3 to the

extent that the net precontribution gain

for purposes of section 737 is determined by reference to section

704(c)(1)(B).

(b) Examples. The following examples illustrate the rules of this section.

The examples set forth below do not

delineate the boundaries of either permissible or impermissible types of

transactions. Further, the addition of

any facts or circumstances that are not

specifically set forth in an example (or

the deletion of any facts or circumstances) may alter the outcome of the

transaction described in the example.

Unless otherwise specified, partnership

income equals partnership expenses

(other than depreciation deductions for

contributed property) for each year of

the partnership, the fair market value of

partnership property does not change,

all distributions by the partnership are

subject to section 737, and all partners

are unrelated.

Example 1. Increase in distributee partner’s

basis by temporary contribution; results inconsistent with the purpose of section 737. (i) On

January 1, 1995, A, B, and C form partnership

ABC as equal partners. A contributes Property

A1, nondepreciable real property with a fair

market value of $10,000 and an adjusted tax

basis of $1,000. B contributes Property B,

nondepreciable real property with a fair market

value of $10,000 and an adjusted tax basis of

$10,000. C contributes $10,000 cash.

(ii) On January 1, 1999, pursuant to a plan a

principal purpose of which is to avoid gain under

section 737, A transfers to the partnership

Property A2, nondepreciable real property with a

fair market value and adjusted tax basis of

$9,000. A treats the transfer as a contribution to

the partnership pursuant to section 721 and

increases the adjusted tax basis of A’s partnership interest from $1,000 to $10,000. On

January 1, 1999, the partnership agreement is

amended and all other necessary steps are taken

so that substantially all of the economic risks and

benefits of Property A2 are retained by A. On

February 1, 1999, Property B is distributed to A

in a current distribution. If the contribution of

Property A2 is treated as a contribution to the

partnership for purposes of section 737, there is

no excess distribution because the fair market

value of distributed Property B ($10,000) does

not exceed the adjusted tax basis of A’s interest

in the partnership ($10,000), and therefore

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section 737 does not apply. A’s adjusted tax

basis in distributed Property B is $10,000 under

section 732(a)(1) and the adjusted tax basis of

A’s partnership interest is reduced to zero under

section 733.

(iii) On March 1, 2000, A receives Property

A2 from the partnership in complete liquidation

of A’s interest in the partnership. A recognizes

no gain on the distribution of Property A2

because the property was previously contributed

property. See §1.737–2(d).

(iv) Although A has treated the transfer of

Property A2 as a contribution to the partnership

that increased the adjusted tax basis of A’s

interest in the partnership, it would be inconsistent with the purpose of section 737 to recognize

the transfer as a contribution to the partnership.

Section 737 requires recognition of gain when

the value of distributed property exceeds the

distributee partner’s adjusted tax basis in the

partnership interest. Section 737 assumes that

any contribution or other transaction that affects

a partner’s adjusted tax basis in the partnership

interest is a contribution or transaction in

substance and is not engaged in with a principal

purpose of avoiding recognition of gain under

section 737. Because the transfer of Property A2

to the partnership was not a contribution in

substance and was made with a principal purpose

of avoiding recognition of gain under section

737, the Commissioner can disregard the contribution of Property A2 for this purpose. As a

result, A recognizes gain of $9,000 under section

737 on the receipt of Property B, an amount

equal to the lesser of the excess distribution of

$9,000 ($10,000 fair market value of distributed

Property B less the $1,000 adjusted tax basis of

A’s partnership interest, determined without

regard to the transitory contribution of Property

A2) or A’s net precontribution gain of $9,000 on

Property A1.

Example 2. Increase in distributee partner’s

basis; section 752 liability shift; results consistent

with the purpose of section 737. (i) On January 1,

1995, A and B form general partnership AB as

equal partners. A contributes Property A, nondepreciable real property with a fair market value

of $10,000 and an adjusted tax basis of $1,000. B

contributes Property B, nondepreciable real property with a fair market value and adjusted tax

basis of $10,000. The partnership also borrows

$10,000 on a recourse basis and purchases

Property C. The $10,000 liability is allocated

equally between A and B under section 752,

thereby increasing the adjusted tax basis in A’s

partnership interest to $6,000.

(ii) On December 31, 1998, the partners agree

that A is to receive Property B in a current

distribution. If A were to receive Property B at

that time, A would recognize $4,000 of gain

under section 737, an amount equal to the lesser

of the excess distribution of $4,000 ($10,000 fair

market value of Property B less $6,000 adjusted

tax basis in A’s partnership interest) or A’s net

precontribution gain of $9,000 ($10,000 fair

market value of Property A less $1,000 adjusted

tax basis of Property A).

(iii) With a principal purpose of avoiding such

gain, A and B agree that A will be solely liable

for the repayment of the $10,000 partnership

liability and take the steps necessary so that the

entire amount of the liability is allocated to A

under section 752. The adjusted tax basis in A’s

partnership interest is thereby increased from

$6,000 to $11,000 to reflect A’s share of the

$5,000 of liability previously allocated to B. As

a result of this increase in A’s adjusted tax basis,

there is no excess distribution because the fair

market value of distributed Property B ($10,000)

is less than the adjusted tax basis of A’s

partnership interest. Recognizing A’s increased

adjusted tax basis as a result of the shift in

liabilities is consistent with the purpose of

section 737 and this section. Section 737 requires

recognition of gain only when the value of the

distributed property exceeds the distributee partner’s adjusted tax basis in the partnership

interest. The $10,000 recourse liability is a bona

fide liability of the partnership that was undertaken for a substantial business purpose and A’s

and B’s agreement that A will assume responsibility for repayment of that debt has substance.

Therefore, the increase in A’s adjusted tax basis

in A’s interest in the partnership due to the shift

in partnership liabilities under section 752 is

respected, and A recognizes no gain under

section 737.

§1.737–5 Effective date.

Dated December 13, 1995.

Margaret Milner Richardson,

Commissioner of

Internal Revenue.

Approved:

Leslie Samuels,

Assistant Secretary of

the Treasury.

(Filed by the Office of the Federal Register on

December 22, 1995, 8:45 a.m., and published

in the issue of the Federal Register for

December 26, 1995, 60 F.R. 66727)

Section 2601.—Tax Imposed

26 CFR 26.2601–1: Effective dates.

T.D. 8644

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 26, 301 and 602

Generation-Skipping Transfer Tax

AGENCY: Internal Revenue Service,

Treasury

Final

and

temporary

SUMMARY: This document contains

final generation-skipping transfer

(GST) tax regulations under chapter 13

of the Internal Revenue Code (Code),

DATES: These regulations are effective

December 27, 1995.

FOR FURTHER INFORMATION

CONTACT: James F. Hogan, (202)

622-3090 (not a toll free number).

SUPPLEMENTARY INFORMATION:

Sections 1.737–1, 1.737–2, 1.737–3,

and 1.737–4 apply to distributions by a

partnership to a partner on or after

January 9, 1995.

ACTION:

regulations

as added by section 1431 of the Tax

Reform Act of 1986. Changes to the

applicable law were made by the Tax

Reform Act of 1986, the Technical and

Miscellaneous Revenue Act of 1988,

and the Revenue Reconciliation Act of

1989. The regulations are necessary to

provide guidance to taxpayers so that

they may comply with chapter 13 of

the Code.

Paperwork Reduction Act

The collection of information requirements contained in these final

regulations have been reviewed and

approved by the Office of Management

and Budget in accordance with the

Paperwork Reduction Act (44 U.S.C.

3507) under control numbers 1545–

0985 (relating to §§26.2601–1 and

26.2662–2) and 1545–1358 (relating to

§§26.2632–1, 26.2642–1, 26.2642–2,

26.2642–3, 26.2642–4 and 26.2652–2).

All of these paperwork requirements

will be consolidated under control

number 1545–0985. Responses to this

collection of information are required

to ensure the proper collection of the

generation-skipping transfer tax.

An agency may not conduct or

sponsor, and a person is not required to

respond to, a collection unless the

collection of information displays a

valid control number.

The estimated burden per respondent is

1 hour under control number 1545–0985.

The time estimates for the reporting and

recordkeeping requirements under control

number 1545–1358 are included in the

estimates of burden applicable to Forms

706, 706NA, 706GS(T), 706GS(D),

706GS(D–1), and 709.

Comments concerning the accuracy

of this burden estimate and suggestions

for reducing this burden should be

directed to the Internal Revenue Service, Attn: IRS Reports Clearance Officer T:FP, Washington, DC 20224, and

to the Office of Management and

Budget, Attn: Desk Officer for the

Department of Treasury, Office of

Information and Regulatory Affairs,

Washington, DC 20503.

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Books or records relating to this

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.

Background

On March 15, 1988, the IRS published in the Federal Register a notice

of proposed rulemaking (53 FR 8469)

by cross reference to Temporary Regulations published on the same date in

the Federal Register (53 FR 8441)

under §§2601 and 2662. Subsequently,

on December 24, 1992, the IRS published a second notice of proposed

rulemaking (57 FR 61353) amending

the prior notice. Also, on December 24,

1992, the IRS published a notice of

proposed rulemaking in the Federal

proposed regulations under §§2611,

2612, 2613, 2632, 2641, 2642, 2652,

2653, 2654, and 2663. The IRS received written and oral comments on

the proposed regulations and, on April

21, 1993, a public hearing was held.

These documents adopt final regulations with respect to these notices of

proposed rulemaking.

The following is a discussion of the

more significant revisions that were

made.

Section 2601—Transitional Rules

Transfers after September 25, 1985

and before October 23, 1986

Section 26.2601–1(a)(2)(i), relating

to inter vivos transfers made after

September 25, 1985, and before October 23, 1986, clarifies that chapter 13

applies to inter vivos transfers that are

subject to chapter 12 even though a gift

tax is not actually paid because of, for

example, the marital deduction or the

unified credit.

Section 26.2601–1(a)(2)(ii) (which

treats inter vivos transfers made after

September 25, 1985, and before October 23, 1986, as if made on October

23, 1986) clarifies that the value of the

transferred property for purposes of

chapter 13 is determined as of the

actual transfer date rather than as of the

deemed transfer date of October 23,

1986.

Section 26.2601–1(a)(4) adds an example illustrating that §26.2601–1(a)(2)

does not apply to transfers made under

a revocable trust that becomes irrevocable by reason of the grantor’s death

after September 25, 1985, but before

October 23, 1986. Those transfers are

not subject to chapter 13 because they

are in the nature of testamentary

transfers that occurred prior to October

23, 1986.

Section 26.2601–1(b)(1)(ii)(C) clarifies that incidents of ownership in an

insurance policy that are relinquished

before September 25, 1985, are not to

be taken into account in determining

whether a trust is irrevocable for

purposes of §26.2601–1(b)(1), which

exempts trusts that were irrevocable on

September 25, 1985, from the provisions of chapter 13.

Under §26.2601–1(b)(1)(iii)(A), a

qualified terminable interest property

(QTIP) trust that is grandfathered under

§26.2601–1(b)(1) is treated as if the

reverse QTIP election had been made

under section 2652(a)(3). Example 1 in

§26.2601–1(b)(1)(iii)(B) has been revised to illustrate that the initial QTIP

election under section 2523(f) need not

be made before September 25, 1985,

provided that the trust was irrevocable

on that date. Further, §26.2601–1(b)(1)(v)(C) has been revised to provide that

in the case of a trust with respect to

which a reverse QTIP election is

deemed to have been made, the failure

to exercise the right of reimbursement

under section 2207A will not be treated

as a constructive addition to the trust.

This conforms the treatment of trusts

that are irrevocable on September 25,

1985, with the rule provided in

§26.2652–1(a)(3) which applies to

trusts created after September 25, 1985.

In §26.2601–1(b)(2)(iv)(B), the

phrase ‘‘or to a generation-skipping

trust’’ has been added to eliminate any

implication that the provision is limited

to situations involving direct skips. The

provision applies to all generationskipping transfers.

Section 26.2601–1(b)(3)(iii) applies

the transitional rules where the decedent was under a mental disability but

had not been adjudged a mental incompetent. This section has been clarified

to provide that any evidence submitted

to establish the decedent’s state of

incompetency is not conclusive and is

subject to examination. In addition, an

example has been added to illustrate

the transitional rules applicable in the

case of mental incompetency.

Uniform statutory rule against

perpetuities

The notice of proposed rulemaking

published on December 24, 1992, (57

FR 61353) contained a proposed modification to §26.2601–1(b)(1)(v)(B)(2).

Section 26.2601–1(b)(1)(v)(B)(2)

provided that the exercise of a nongeneral power of appointment will not

be treated as an addition to a grandfathered GST trust if the power is

exercised in a manner that may not

postpone or suspend the vesting, absolute ownership, or power of alienation

of a interest in property for a period,

measured from the date of creation of

the trust, extending beyond any life in

being at the date of creation of the trust

plus a period of 21 years (perpetuities

period).

The proposed modification to

§26.2601–1(b)(1)(v)(B)(2), which is finalized in this document, provides that

the exercise of a nongeneral power of

appointment that validly postpones or

suspends the vesting, absolute ownership, or power of alienation of an

interest in property for a term of years

that will not exceed 90 years (measured

from the date of creation of the trust)

will not be considered an exercise that

postpones vesting, etc., beyond the

perpetuities period. The modification

takes into account the fact that many

states have adopted the Uniform Statutory Rule Against Perpetuities

(USRAP) which allows either a 90 year

perpetuities period or the common law

perpetuities period. Under §26.2601–

1(b)(1)(v)(B)(2), as modified, the nongeneral power may not be exercised in

a manner that postpones vesting, etc.,

for the longer of 90 years or the

common law period (lives in being plus

21 years).

The discussion in the preamble published on December 24, 1992, indicates

that USRAP has a ‘‘wait and see’’

aspect that is not appropriate for GST

purposes because it will be necessary

to determine the GST tax consequences

of distributions and terminations at the

time they occur. Thus, the preamble

stated that, in order to comply with the

regulation and avoid a constructive

addition, it must be clear at the time

the nongeneral power is exercised that

the exercise may not postpone or

suspend vesting, etc., beyond either

lives in being plus 21 years or 90 years

(but not the longer of the two periods).

A commentator has pointed out that the

USRAP invalidates any attempt to

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exercise a power for the longer of the

two periods. Under the USRAP, it will

be clear at the time the nongeneral

power is exercised that the exercise

may not postpone or suspend vesting,

etc., beyond one of the two periods

(but not both). Under the USRAP, the

common law period (lives in being plus

21 years) is imposed in the event that

the power holder exercises the power

in a manner that attempts to suspend or

postpone vesting, etc., for the longer of

the two periods. Although the preamble

published on December 24, 1992, may

have been misleading in referring to a

‘‘wait and see’’ aspect of USRAP, the

modification to §26.2601–1(b)(1)(v)(B)(2) is not affected.

Section 2611 et. seq.—GST

substantive rules

Definition of generation-skipping

transfers

Section 26.2611–1 has been revised

to clarify that, in determining whether

an event is subject to the GST tax,

reference must be made to the most

recent transfer that was subject to

Federal estate or gift tax. This is

because the most recent transfer that

was subject to estate or gift tax

establishes the identity of the transferor, which in turn determines the

identity of the skip persons and nonskip persons.

Definitions

Section 26.2612–1(a)(2)(i) of the

proposed regulations provides generally

that, for purposes of determining

whether a transfer constitutes a direct

skip, the generation assignment of a

person who would otherwise be a skip

person is redetermined by disregarding

the intervening generation, if certain

individuals have died prior to the

transfer (e.g., a predeceased child of

the transferor). The section has been

modified to provide that, if an individual who is a member of the intervening

generation dies no later than 90 days

after the transfer, the deceased individual is treated as having predeceased the

transferor, if the governing instrument

or applicable state law provides for

such treatment.

Section 26.2612–1(a)(2)(ii) has been

added to provide that, if a transferor

makes an addition to an existing trust

after the death of an individual de-

scribed in paragraph (a)(2)(i) of that

section (i.e., an individual in the

intervening generation), the additional

property is treated as being held in a

separate trust for purposes of chapter

13.

Section 2612(a)(1) defines the term

taxable termination to mean the termination of an interest in property held in

trust unless, among other things, at no

time after such termination may a distribution (including distributions on

termination) be made from the trust to

a skip person. Section 26.2612–1(b)(1)(iii), as proposed, has been revised to

provide that, for purposes of applying

this rule, potential distributions to skip

persons are to be disregarded if the

probability of occurrence is so remote

as to be negligible. A similar rule has

been applied to §26.2612–1(d)(2), regarding when a trust is considered a

skip person. The probability that a

distribution will occur is so remote as

to be negligible only if it can be

ascertained by actuarial standards that

there is less than a 5 percent probability that the distribution will occur.

Section 26.2612–1(c)(2) has been

added to clarify that the look-through

rule in section 2651(e)(2) does not

apply for purposes of determining

whether a transfer from one trust to

another trust is a taxable distribution.

Thus, the transfer is treated as having

been made to the recipient trust rather

than to the beneficiaries of that trust.

Accordingly, a transfer is a taxable

distribution only if the recipient trust

itself is a skip person.

Section 26.2612–1(e)(3) has been

added to provide that, in determining

whether a trust is a skip person, trust

interests disclaimed pursuant to a

qualified disclaimer described in section 2518 are not taken into account.

Example 3 has been added to

§26.2612–1(f) to illustrate that a transfer to a trust pursuant to which a

beneficiary who is a skip person has a

withdrawal power is not a direct skip

unless the trust is a skip person.

Example 9 has been added to

§26.2612–1(f) to illustrate that a taxable termination may occur upon the

distribution of the entire trust property

(less amounts retained to pay a resulting GST tax and administration

expenses).

Example 14 contained in §26.2612–

1(f) of the proposed regulations illustrates that an individual is not treated

as having an interest in a trust for

purposes of Chapter 13, if the individual’s support obligation could be satisfied at the discretion of the trustee.

This example has been renumbered as

Example 15 and has been clarified to

provide that an individual will have an

interest in the trust if the trustee is

required to make distributions for the

beneficiary’s support, in satisfaction of

the individual’s support obligation.

Allocation of GST exemption

Under §26.2632–1(b)(2)(ii)(A) of the

proposed regulations, a late allocation

of GST exemption is effective on the

date the Form 709 reporting the allocation is filed, and is deemed to precede

in point of time any taxable event

occurring on that date. This section has

been revised to specify that the Form

709 is treated as filed on the date it is

mailed to the appropriate IRS Service

Center. Further, the late allocation may

be made on a timely filed Form 709

reporting another transfer.

Section 26.2632–1(b)(2)(ii)(B) has

been added to clarify how the GST

exemption allocated on a Federal gift

tax return (Form 709) is to be apportioned in the event that the amount

allocated on the return exceeds the

value of the transfers reported on the

return.

Example 4 of §26.2632–1(b)(2)(iii)

of the proposed regulations has been

revised to better illustrate the effective

date of a late allocation of GST

exemption.

Example 5 of §26.2632–1(b)(2)(iii)

has been added to illustrate the automatic allocation of GST exemption to

inter vivos direct skips in situations

where split gift treatment is elected on

an initial gift tax return filed after its

due date.

Section 26.2632–1(d)(1) has been revised to provide that a late allocation

of GST exemption made by an executor with respect to an inter vivos

transfer not included in the gross

estate, is effective as of the date the

allocation is filed. This rule does not

apply to any automatic allocation under

section 2632(b)(1). This revision conforms the regulation to section

2642(b)(3).

Estate tax inclusion period

As proposed, §26.2632–1(c)(2)(ii)

provided that an estate tax inclusion

period (ETIP) exists during the period

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in which the transferred property would

have been includible in the transferor’s

gross estate had the transferor retained

an interest held by the transferor’s

spouse, but only to the extent the

spouse acquired the interest from the

transferor in an inter vivos transfer that

was not included in the transferor’s

taxable gifts or for which a deduction

was allowed under section 2523. Commentators stated that there was no

support in the statute for this spousal

rule, and any such rule would require a

legislative change. The final regulations

eliminate this spousal rule and Example

5 of §26.2632–1(c)(5).

Section 26.2632–1(c)(2)(ii)(A) has

been added to provide that the ETIP

rules do not apply when the possibility

that the property will be included in the

gross estate of the transferor (or the

transferor’s spouse) is so remote as to

be negligible. Further, §26.2632–1(c)(2)(ii)(B) has been added to provide

that transferred property will not be

treated as being subject to inclusion in

the transferor’s spouse’s gross estate,

and thus, subject to an ETIP, where the

only power possessed by the spouse is

a right to withdraw no more than the

greater of 5 percent or $5,000 of the

trust’s corpus and the withdrawal right

terminates within 60 days of the

transfer to the trust.

Section 26.2632–1(c)(5) Example 3,

of the proposed regulations illustrates

that if a transferor’s spouse elects giftsplitting treatment with respect to the

transferor’s gift that is subject to an

ETIP, the spouse is treated as the

transferor of one-half of the gift. The

example has been expanded to illustrate

that, since the spouse’s deemed transfer

is subject to an ETIP, if the spouse dies

prior to the termination of the trust, the

spouse’s executor may allocate GST

exemption to the trust. However, the

allocation will not be effective until the

ETIP terminates on the transferor’s

death.

Erroneous allocations

Under the proposed regulations, allocations in excess of the amount of

the property transferred are void. This

treatment has been expanded under the

final regulations. Thus, any allocation

to a trust that has no GST potential at

the time of the allocation, with respect

to the transferor for whom the allocation is made, is also void. This provision is intended to prevent the

wasting of GST exemption because of

an erroneous allocation with respect to

a testamentary or inter vivos transfer.

A trust will have no GST potential only

if there is no possibility that a GST

will be made from the trust with

respect to the transferor.

Determination of applicable fraction

Section 26.2642–1(b)(2) of the proposed regulations provided rules for

determining the inclusion ratio with

respect to a trust subject to an ETIP

where GSTs are made from the trust

during the ETIP. Comments were received that the rules were unclear

regarding whether an ineffective allocation, i.e., an allocation made prior to

any distributions or terminations, would

apply in determining the amount of the

transferor’s unused GST exemption, or

whether such an allocation could be

modified prior to an ETIP termination.

In response to the comments,

§26.2632–1(c)(1) (providing rules for

the allocation of exemption with respect to a trust subject to an ETIP) and

§26.2642–1(b)(2) clarify that an allocation made to a trust subject to an ETIP

prior to any distribution or termination

is not subject to modification or

revocation. However, the allocation

will not be effective, i.e., the allocation

does not operate to fix the inclusion

ratio of the trust, at the time it is made.

Rather, the allocation becomes effective as of the date of a subsequent

distribution or termination. Section

26.2632–1(c)(5) Example 2, illustrates

this point.

Section 26.2642–2 of the proposed

regulations provides valuation rules for

determining the denominator of the

applicable fraction under section 2642.

Section 26.2642–2(a)(1) of the final

regulations specifies that, in the case of

a timely allocation of GST exemption

with respect to an inter vivos transfer,

the denominator of the applicable fraction is the fair market value of the

transferred property, as finally determined for gift tax purposes.

Section 26.2642–2(b)(1) of the proposed regulations provides special rules

for determining the denominator of the

applicable fraction in situations involving property subject to the special

valuation rules contained in section

2032A. Under the proposed regulations,

the special use value of the property

could only be used in determining the

applicable fraction if the property was

transferred in a direct skip. Thus, a

generation-skipping trust to which section 2032A property was transferred in

a transfer that was not a direct skip

would not receive the benefit of the

favorable valuation rules of section

2032A in determining the applicable

fraction with respect to the trust.

Comments stated that the proposed

regulation was inconsistent with section

2642(b), which provides that the chapter 11 value must be used to determine

the applicable fraction in the case of a

testamentary transfer. Under the final

regulations, the section 2032A value of

property is to be used to determine the

applicable fraction for a direct skip

transfer and for a generation-skipping

trust created in a transfer other than a

direct skip.

In the event that additional estate tax

is imposed under section 2032A(c)

with respect to the property, then the

applicable fraction is redetermined as

of the transferor’s date of death. Thus,

the GST tax liability with respect to

any direct skip, taxable termination, or

taxable distribution occurring prior to

the recapture event would be recomputed based on the redetermined applicable fraction, and an additional GST

tax would be due. The taxation of any

future GST transfers would also be

based on the redetermined applicable

fraction.

Sections 26.2642–2(b)(2) and (3) of

the proposed regulations contain special

rules for determining the denominator

of the applicable fraction in situations

involving residuary and pecuniary payments. Generally, in the case of a

residual GST after the payment of a

pecuniary amount, the denominator of

the applicable fraction will be the

estate tax value of the total assets

available to satisfy the pecuniary payment less the amount of the pecuniary

payment, provided the pecuniary payment carries ‘‘appropriate interest’’ as

defined in §26.2642–2(b)(4). Under

§26.2642–2(b)(4)(ii), the payment need

not carry appropriate interest if, inter

alia, the payment is irrevocably ‘‘set

aside’’ within 15 months of the transferor’s death. The final regulations

clarify that this exception to the appropriate interest requirement applies only

if the entire payment is set aside.

Further, the payment is treated as set

aside if the amount is segregated and

held in a separate account pending

distribution. Finally, under the proposed regulation, the appropriate inter-

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est requirement can be satisfied if a pro

rata share of estate income is allocated

to the pecuniary bequest. The final

regulations clarify that the payment of

income may be allocated pursuant to

the terms of the governing instrument

or applicable local law.

Section 26.2642–4(a)(3) of the proposed regulations addresses a situation

where a lifetime allocation is made

with respect to a trust when the trust

was not subject to an ETIP, and the

trust is subsequently included in the

transferor’s gross estate. The regulation

has been revised to provide that, if

additional GST exemption is allocated

to the trust, the nontax portion of the

trust is determined immediately after

the date of the transferor’s death. Also,

if additional GST exemption is not

allocated to the trust by the transferor’s

executor, the applicable fraction does

not change, if the trust was not

otherwise subject to an ETIP at the

time the previous allocation of GST

exemption was made. Further, where

such property is included in the gross

estate, the denominator of the applicable fraction is reduced to reflect any

federal or state estate or inheritance tax

paid by the trust.

Definition of transferor

Section 26.2652–1(a)(1) of the proposed regulations, defining transferor,

has been revised to specify that a

surviving spouse is treated as the

transferor of a qualified domestic trust

(QDOT) described in section 2056A

that is included in the surviving

spouse’s gross estate for federal estate

tax purposes, assuming the trust is not

subject to a reverse QTIP election

under section 2652(a)(3). The surviving

spouse is also the transferor of any

QDOT created by the surviving spouse

under section 2056(d)(2)(B).

Section 26.2652–1(a)(4), as proposed, provided that the creator of a

special power of appointment will be

treated as making a transfer subject to

estate or gift tax (and thus be considered a transferor) if the holder of the

power exercised the power in a manner

that may postpone vesting, etc., of the

property subject to the power beyond

the permissible perpetuities period.

This result is inconsistent with section

2041(a)(3), which treats the holder of

the power as making a transfer under

these circumstances. Accordingly, the

regulation has been revised to provide

that the holder of the power will be

treated as making a taxable transfer, if

the holder exercises the power in the

manner prescribed.

Section 26.2652–1(a)(5) has been

added to specify that where a donor’s

spouse consents to have the donor’s

gift treated as made one-half by the

spouse, then for purposes of chapter

13, the spouse is treated as the

transferor of one-half of the property

transferred by the donor. Thus, if a

donor transfers property to a trust and

retains a qualified interest as defined in

section 2702(b), with the remainder to

a grandchild, a consenting spouse

would be treated as the transferor of

one-half the entire property. It was

suggested that the spouse should only

be treated as the transferor of that

portion of the trust corresponding to

one-half of the actuarial value of the

interest passing to the grandchild, since

under section 2513, only one-half the

gift to the grandchild may be treated as

made by the consenting spouse. However, treating the consenting spouse as

the transferor of one-half of the entire

trust is consistent with the general

treatment accorded other split-interest

transfers. For example, if a transferor

transferred property in trust retaining

an interest that qualified under section

2702(b), with the remainder to the

transferor’s grandchild, the transferor

would be considered the transferor of

the entire trust for purposes of chapter

13, notwithstanding that, from a technical standpoint, only the actuarial value

of the gift to the grandchild is subject

to gift tax at the time of the transfer.

Example 8 in §26.2652–1(a)(6) has

been added illustrating that a surviving

spouse will not be treated as making a

contribution to a QTIP trust that is

included in the spouse’s gross estate

and is subject to a reverse QTIP

election, where the spouse directs in

the will that the estate tax generated by

the inclusion of the trust is to be paid

from the spouse’s probate estate.

Separate shares treated as separate

trusts

Section 26.2654–1 of the proposed

regulations provides rules under which

‘‘separate shares’’ of a single trust that

satisfy the requirements of the regulations will be recognized as separate

trusts for GST purposes.

Under the proposed regulations, a

mandatory payment of a pecuniary

amount is treated as a separate share of

a trust (and thus, a separate trust for

GST purposes) if certain conditions are

satisfied. The section is clarified to

specify that a mandatory payment is a

payment that is nondiscretionary and

noncontingent; i.e., the payment must

be made in all events.

A sentence was added to Example 3,

now contained in §26.2654–1(a)(5), to

clarify that, where a decedent’s probate

estate pours over to a revocable trust,

and then amounts are distributed pursuant to the terms of the trust, the

distributions will be treated as separate

shares for purposes of chapter 13.

Example 4, now contained in

§26.2654–1(a)(5), has been revised to

specify that the bequest of a pecuniary

amount payable in kind is not treated

as a separate share of the trust, since,

under the facts presented, neither the

trust nor local law requires that the

assets distributed in satisfaction of the

bequest fairly reflect net appreciation

and depreciation. This is the result

regardless of whether the assets are

distributed within 15 months of the

transferor’s death.

Comments received suggested that

the regulations should allow separate

trust treatment whenever a single inter

vivos trust was recognized as separate

trusts under local law. For example, an

inter vivos trust provides income to

child for life, but when each grandchild

reaches age 35, a separate trust is to be

established for the child, the grandchild, and the grandchild’s issue. Comments suggested that the Service should

recognize each trust established when a

grandchild reaches age 35 as a separate

trust, and allow a late allocation of

GST exemption specifically to that

trust when severance occurs.

This suggestion was rejected. Generally, the adoption of this approach

would effectively allow the allocation

of GST exemption to specific distributions from a GST trust, rather than to

the entire trust. This result would be

contrary to the clear language of the

statute. See, e.g., sections 2642(a)(1)(A) and (a)(2).

Division of a single trust into

separate trusts

Under §26.2654–1(c) of the proposed

regulations, a testamentary trust could

be severed into several parts, provided

the severance was commenced prior to

the filing of the estate tax return.

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Further, the new trusts created pursuant

to the severance had to be identical to

the old trusts. For example, a testamentary trust providing for income to

spouse, remainder to be divided equally

between child and grandchild could

only be severed into two trusts both

providing income to spouse with the

remainder to be divided between child

and grandchild. Finally, an inter vivos

trust could not be severed unless it

consisted of separate shares, or different transferors had contributed to the

trust.

The regulation has been clarified to

specify that the division of a single

trust that is included in the transferor’s

gross estate will be recognized if

either: (1) the single trust consists of

separate shares and is thus, treated as

separate trusts; or (2) the single trust,

although not consisting of separate

shares, is severed into separate trusts

pursuant to a direction in the governing

instrument providing that the trust is to

be divided into separate trusts on the

transferor’s death; or (3) the governing

instrument does not require or direct

severance but the trust is severed

pursuant to the discretionary authority

of the trustee granted under the governing instrument or local law.

The final regulations provide that the

trusts resulting from the severance of a

single testamentary trust need not be

identical. Thus, if the trust provides

income to spouse, remainder to child

and grandchild, the trust may be

severed to create two trusts, one with

income to spouse, remainder to child

and a second with income to spouse

remainder to grandchild. This result

could be achieved through proper estate

planning in any event. However, the

regulations make it clear that the

resulting trusts must provide for the

same succession of interests as

provided for under the original trusts.

Thus, a trust providing for an income

interest to a child, with remainder to a

grandchild, could not be divided into

one trust for the child (equal in value

to the child’s income interest) and

another for the grandchild.

The proposed regulations provided

that the new trusts must be funded with

a fractional share of each and every

asset held by the original single trust.

The provision has been revised to

provide that the new trusts may also be

funded on a nonpro rata basis, based on

the fair market value of the assets

selected on the date of severance. Thus,

the executor or trustee may select the

assets with which to fund each trust,

and need not fractionalize each asset.

An example has been added to illustrate that, if a revocable trust included

in the transferor’s gross estate is, under

the terms of the trust, divided into

multiple trusts on the transferor’s

death, then each trust established will

be treated as a separate trust for GST

purposes.

Due date of return

New §26.2662–1(d)(2) has been

added to provide that the due date of

the return with respect to a taxable

termination subject to an election under

section 2624(c) (relating to alternate

valuation in accordance with section

2032) is April 15th of the following

year in which the taxable termination

occurred or on or before the 15th day

of the tenth month following the month

in which the death that resulted in the

taxable termination occurred, whichever is later.

Application of chapter 13 to

nonresident aliens

Section 2663(2) requires that the

Commissioner prescribe regulations,

consistent with the provisions of chapters 11 and 12, providing for the

application of the GST tax to a

nonresident alien (NRA). In general,

under §26.2663–2(b) as proposed, the

GST tax applied to inter vivos and

testamentary direct skip transfers by a

NRA, to the extent that the transferred

property was U.S. situs property such

that the transfer was subject to a gift

tax (in the case of inter vivos transfers)

or an estate tax (in the case of testamentary transfers). Similarly, in the

case of transfers in trust, chapter 13

applied to taxable terminations and

distributions to the extent the initial

transfer to the trust (whether inter vivos

or testamentary) consisted of U.S. situs

property, such that the initial transfer

was subject to the gift or estate tax.

This was the case regardless of the

situs of the property at the time of the

actual distribution or termination and

regardless of the residency or citizenship of the skip person receiving the

beneficial interest or property.

Under §26.2663–2(c) as proposed, if

the property involved in a generationskipping transfer was not situated in

the U.S. at the time of the initial

transfer, the generation-skipping trans-

fer was still subject to the GST tax if:

(1) at the time of the direct skip,

taxable termination or distribution, the

property passes to a skip person who is

a U.S. resident or citizen; and (2) at the

time of the initial transfer to the skip

person or trust, a lineal descendant of

the transferor, who is a lineal ancestor

of the skip person, was a resident or

citizen of the U.S. This rule applied

regardless of the situs of the property

at the time of the actual distribution or

termination. Section 26.2663–2(f) of

the proposed regulations provided for

the automatic allocation of a NRA’s

$1,000,000 GST exemption regardless

of whether the transfer was a direct

skip.

Thus, the proposed regulations subjected non-U.S. situs property to the

GST tax based on the status of the skip

person/recipient of the property at the

time the property was received, and the

status of the generation that was

skipped at the time of the initial

transfer to the trust or skip person.

Many comments were critical of this

approach. In general, these comments

emphasized that the estate and gift tax

provisions subject transfers by NRAs to

transfer tax based on the situs of the

property, not the status of the recipient.

Therefore, the proposed regulations

conflict with section 2663, which

provides that the regulations should be

consistent with the principles of chapters 11 and 12 of the Internal Revenue

Code (Code). Further, the commentators argued that treating a NRA who

transfers non-U.S. situs property as a

transferor for GST tax purposes would

conflict with the definition of transferor under section 2652, since the

transfer would not be subject to estate

or gift tax. Under section 2652, an

individual is a transferor only to the

extent the transfer is subject to U.S.

gift tax or estate tax.

The proposed regulations have been

revised to address these concerns.

Thus, the rules in the proposed regulations applying chapter 13 to transfers

of property that were not subject to

estate or gift tax have been eliminated.

Under the final regulations, the application of the GST tax will be limited to

situations where an estate or gift tax is

imposed on the property. Thus, the

GST tax will apply to inter vivos and

testamentary direct skip transfers by a

NRA transferor to the extent a gift tax

is imposed on the transfer (in the case

of an inter vivos transfer) or the

transferred property is included in the

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transferor’s gross estate (in the case of

a testamentary direct skip). In the case

of taxable terminations and taxable

distributions, chapter 13 will apply to

the extent a gift tax was imposed on

the initial transfer to the trust, or the

property was included in the transferor’s gross estate. Accordingly, under

the final regulations (in the absence of

a situation involving an ETIP), the

application of Chapter 13 is generally

dependent on the situs of the property

at the time of the initial transfer. The

regulations contain special rules for

determining the applicable fraction and

inclusion ratio where a trust is funded

with both U.S. and foreign situs

property.

In general, the rules of §26.2632–1

apply with respect to the allocation of

the exemption. However, the ETIP rule

provided in §26.2632–1(c) applies only

if the property transferred by the NRA

is subsequently included in the transferor’s gross estate. The final regulations provide transitional relief with

respect to NRA’s who made GST

transfers and relied on the automatic

allocation rules in the proposed

regulations.

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 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,

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 regulations is James F. Hogan, Office of the

Chief Counsel, IRS. Other personnel

from the IRS and Treasury Department

participated in their development.

Adoption of Amendments to the

Regulations

Accordingly, 26 CFR parts 26, 301,

and 602 are amended as follows:

Paragraph 1. Part 26 is revised to

read as follows:

PART 26—GENERATION-SKIPPING

TRANSFER TAX REGULATIONS

UNDER THE TAX REFORM ACT

OF 1986

26.2600–1 Table of contents.

26.2601–1 Effective dates.

26.2611–1 Generation-skipping transfer

defined.

26.2612–1 Definitions.

26.2613–1 Skip person.

26.2632–1 Allocation of GST

exemption.

26.2641–1 Applicable rate of tax.

26.2642–1 Inclusion ratio.

26.2642–2 Valuation.

26.2642–3 Special rule for charitable

lead annuity trusts.

26.2642–4 Redetermination of applicable fraction.

26.2642–5 Finality of inclusion ratio.

26.2652–1 Transferor defined; other

definitions.

26.2652–2 Special election for

qualified terminable interest property.

26.2653–1 Taxation of multiple skips.

26.2654–1 Certain trusts treated as

separate trusts.

26.2662–1 Generation-skipping transfer

tax return requirements.

26.2663–1 Recapture tax under section

2032A.

26.2663–2 Application of chapter 13 to

transfers by nonresidents not citizens of

the United States.

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

U.S.C. 2663.

Section 26.2632–1 also issued under 26

U.S.C. 2632 and 2663.

Section 26.2642–4 also issued under 26

U.S.C. 2632 and 2663.

Section 26.2662–1 also issued under 26

U.S.C. 2662.

Section 26.2663–2 also issued under 26

U.S.C. 2632 and 2663.

§26.2600–1 Table of contents.

§26.2601–1 Effective dates.

(a) Transfers subject to the

generation-skipping transfer

tax.

(1) In general.

(2) Certain transfers treated as

if made after October 22,

1986.

(3) Certain trust events treated

as if occurring after October 22, 1986.

(4) Example.

(b) Exceptions.

(1) Irrevocable trusts.

(2) Transition rule for wills or

revocable trusts executed

before October 22, 1986.

(3) Transition rule in the case

of mental incompetency.

(4) Exceptions to additions

rule.

§26.2611–1 Generation-skipping

transfer defined.

§26.2612–1 Definitions.

(a) Direct skip.

(1) In general.

(2) Special rule for certain lineal descendants.

(b) Taxable termination.

(1) In general.

(2) Partial termination.

(1) In general.

(2) Look-through rule not to

apply.

(d) Skip person.

(e) Interest in trust.

(1) In general.

(2) Exceptions.

(f) Examples.

§26.2613–1 Skip person.

§26.2632–1 Allocation of GST

exemption.

(a) General rule.

(b) Lifetime allocations.

(1) Automatic allocation to direct skips.

(2) A l l o c a t i o n t o o t h e r

transfers.

tax inclusion period.

(1) In general.

(2) Estate tax inclusion period

defined.

(3) Termination of an ETIP.

(4) Treatment of direct skips.

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(5) Examples.

(d) Allocations after the transferor’s death.

(1) Allocation by executor.

(2) Automatic allocation after

death.

§26.2641–1 Applicable rate of tax.

§26.2642–1 Inclusion ratio.

(a) In general.

(b) Numerator of applicable

fraction.

(1) In general.

(2) GSTs occurring during an

ETIP.

fraction.

(1) In general.

(2) Zero denominator.

(3) Nontaxable gifts.

(d) Examples.

§26.2642–2 Valuation.

(a) Lifetime transfers.

(1) In general.

(2) Special rule for late allocations during life.

(b) Transfers at death.

(1) In general.

(2) Special rule for pecuniary

payments.

(3) Special rule for residual

transfers after payment of a

pecuniary payment.

(4) Appropriate interest.

§26.2642–3 Special rule for

charitable lead annuity trusts.

(a) In general.

(b) Adjusted GST exemption

defined.

§26.2642–4 Redetermination of

applicable fraction.

(a) In general.

(1) Multiple transfers to a single trust.

(2) Consolidation of separate

trusts.

(3) Property included in transferor’s gross estate.

(4) Imposition of recapture tax

under section 2032A.

(b) Examples.

§26.2642–5 Finality of inclusion

ratio.

(a) Direct skips.

(b) Other GSTs.

§26.2652–1 Transferor defined; other

definitions.

(a) Transferor defined.

(1) In general.

(2) Transfers subject to Federal

estate or gift tax.

(3) Special rule for certain

QTIP trusts.

(4) Exercise of certain nongeneral powers of appointment.

(5) Split-gift transfers.

(6) Examples.

(b) Trust defined.

(1) In general.

(2) Examples.

(d) Executor defined.

(e) Interest in trust.

§26.2652–2 Special election for

qualified terminable interest property.

(a) In general.

(b) Time and manner of making

election.

(d) Examples.

§26.2653–1 Taxation of multiple

skips.

(a) General rule.

(b) Examples.

§26.2654–1 Certain trusts treated as

separate trusts.

(a) Single trust treated as separate

trusts.

(1) Substantially separate and

independent shares.

(2) Multiple transferors with

respect to a single trust.

(3) Severance of a single trust.

(4) Allocation of exemption.

(5) Examples.

(b) Division of a trust included in

the gross estate.

(1) In general.

(2) Special rule.

(3) Allocation of exemption.

(4) Example.

§26.2662–1 Generation-skipping

transfer tax return requirements.

(a) In general.

(b) Form of return.

(1) Taxable distributions.

(2) Taxable terminations.

(3) Direct skip.

(1) In general.

(2) Special rule for direct skips

occurring at death with respect to property held in

trust arrangements.

(3) Limitation on personal liability of trustee.

(4) Exceptions.

(d) Time and manner of filing

return.

(1) In general.

(2) Exceptions.

(e) Place for filing returns.

(f) Lien on property.

§26.2663–1 Recapture tax under

section 2032A.

§26.2663–2 Application of chapter 13

to transfers by nonresidents not

citizens of the United States.

(a) In general.

(b) Transfers subject to Chapter

13.

(1) Direct skips.

(2) Taxable distributions and

taxable terminations.

property subject to Chapter 13

and in part with property not

subject to Chapter 13.

(1) In general.

(2) Nontax portion of the trust.

(3) Special rule with respect to

estate tax inclusion period.

(d) Examples.

(e) Transitional rule for allocations

for transfers made before December 27, 1995.

26.2601–1 Effective dates.

(a) Transfers subject to the

generation-skipping transfer tax—(1)

In general. Except as otherwise provided in this section, the provisions of

chapter 13 of the Internal Revenue

Code of 1986 (Code) apply to any

generation-skipping transfer (as defined

in section 2611) made after October 22,

1986.

(2) Certain transfers treated as if

made after October 22, 1986. Solely

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for purposes of chapter 13, an inter

vivos transfer is treated as if it were

made on October 23, 1986, if it was—

(i) Subject to chapter 12 (regardless

of whether a tax was actually incurred

or paid); and

(ii) Made after September 25, 1985,

but before October 23, 1986. For

purposes of this paragraph, the value of

the property transferred shall be the

value of the property on the date the

property was transferred.

(3) Certain trust events treated as if

occurring after October 22, 1986. For

purposes of chapter 13, if an inter

vivos transfer is made to a trust after

September 25, 1985, but before October 23, 1986, any subsequent distribution from the trust or termination of an

interest in the trust that occurred before

October 23, 1986, is treated as occurring immediately after the deemed

transfer on October 23, 1986. If more

than one distribution or termination

occurs with respect to a trust, the

events are treated as if they occurred

on October 23, 1986, in the same order

as they occurred. See paragraph (b)(1)(iv)(B) of this section for rules determining the portion of distributions and

terminations subject to tax under chapter 13. This paragraph (a)(3) does not

apply to transfers to trusts not subject

to chapter 13 by reason of the transition rules in paragraphs (b)(2) and (3)

of this section. The provisions of this

paragraph (a)(3) do not apply in

determining the value of the property

under chapter 13.

(4) Example. The following example

illustrates the principle that paragraph

(a)(2) of this section is not applicable

to transfers under a revocable trust that

became irrevocable by reason of the

transferor’s death after September 25,

1985, but before October 23, 1986:

Example. T created a revocable trust on

September 30, 1985, that became irrevocable

when T died on October 10, 1986. Although the

trust terminated in favor of a grandchild of T, the

transfer to the grandchild is not treated as

occurring on October 23, 1986, pursuant to

paragraph (a)(2) of this section because it is not

an inter vivos transfer subject to chapter 12. The

transfer is not subject to chapter 13 because it is

in the nature of a testamentary transfer that

occurred prior to October 23, 1986.

(b) Exceptions—(1) Irrevocable

trusts—(i) In general. The provisions

of chapter 13 do not apply to any

generation-skipping transfer under a

trust (as defined in section 2652(b))

that was irrevocable on September 25,

1985. The rule of the preceding sentence does not apply to a pro rata

portion of any generation-skipping

transfer under an irrevocable trust if

additions are made to the trust after

September 25, 1985. See paragraph (b)(1)(iv) of this section for rules for

determining the portion of the trust that

is subject to the provisions of chapter

13.

(ii) Irrevocable trust defined—(A) In

general. Unless otherwise provided in

either paragraph (b)(1)(ii)(B) or (C) of

this section, any trust (as defined in

section 2652(b)) in existence on September 25, 1985, is considered an

irrevocable trust.

(B) Property includible in the gross

estate under section 2038. For purposes

of this chapter a trust is not an irrevocable trust to the extent that, on

September 25, 1985, the settlor held a

power with respect to such trust that

would have caused the value of the

trust to be included in the settlor’s

gross estate for Federal estate tax

purposes by reason of section 2038

(without regard to powers relinquished

before September 25, 1985) if the

settlor had died on September 25,

1985. A trust is considered subject to a

power on September 25, 1985, even

though the exercise of the power was

subject to the precedent giving of

notice, or even though the exercise

could take effect only on the expiration

of a stated period, whether or not on or

before September 25, 1985, notice had

been given or the power had been

exercised. A trust is not considered

subject to a power if the power is, by

its terms, exercisable only on the

occurrence of an event or contingency

not subject to the settlor’s control

(other than the death of the settlor) and

if the event or contingency had not in

fact taken place on September 25,

1985.

estate under section 2042. A policy of

insurance on an individual’s life that is

treated as a trust under section 2652(b)

is not considered an irrevocable trust to

the extent that, on September 25, 1985,

the insured possessed any incident of

ownership (as defined in §20.2042–1(c)

of this chapter, and without regard to

any incidents of ownership relinquished

before September 25, 1985), that would

have caused the value of the trust, (i.e.,

the insurance proceeds) to be included

in the insured’s gross estate for Federal

estate tax purposes by reason of section

2042, if the insured had died on

September 25, 1985.

(D) Examples. The following examples illustrate the application of this

paragraph (b)(1):

Example 1. Section 2038 applicable. On

September 25, 1985, T, the settlor of a trust that

was created before September 25, 1985, held a

testamentary power to add new beneficiaries to

the trust. T held no other powers over any

portion of the trust. The testamentary power held

by T would have caused the trust to be included

in T’s gross estate under section 2038 if T had

died on September 25, 1985. Therefore, the trust

is not an irrevocable trust for purposes of this

section.

Example 2. Section 2038 not applicable when

power held by a person other than settlor. On

September 25, 1985, S, the spouse of the settlor

of a trust in existence on that date, had an annual

right to withdraw a portion of the principal of

the trust. The trust was otherwise irrevocable on

that date. Because the power was not held by the

settlor of the trust, it is not a power described in

section 2038. Thus, the trust is considered an

irrevocable trust for purposes of this section.

Example 3. Section 2038 not applicable. In

1984, T created a trust and retained the right to

expand the class of remaindermen to include any

of T’s afterborn grandchildren. As of September

25, 1985, all of T’s grandchildren were named

remaindermen of the trust. Since the exercise of

T’s power was dependent on there being

afterborn grandchildren who were not members

of the class of remaindermen, a contingency that

did not exist on September 25, 1985, the trust is

not considered subject to the power on September 25, 1985, and is an irrevocable trust for

purposes of this section. The result is not

changed even if grandchildren are born after

September 25, 1985, whether or not T exercises

the power to expand the class of remaindermen.

Example 4. Section 2042 applicable. On

September 25, 1985, T purchased an insurance

policy on T’s own life and designated child, C,

and grandchild, GC, as the beneficiaries. T

retained the power to obtain from the insurer a

loan against the surrender value of the policy.

T’s insurance policy is a trust (as defined in

section 2652(b)) for chapter 13 purposes. The

trust is not considered an irrevocable trust

because, on September 25, 1985, T possessed an

incident of ownership that would have caused the

value of the policy to be included in T’s gross

estate under section 2042 if T had died on that

date.

Example 5. Trust partially irrevocable. In

1984, T created a trust naming T’s grandchildren

as the income and remainder beneficiaries. T

retained the power to revoke the trust as to onehalf of the principal at any time prior to T’s

death. T retained no other powers over the trust

principal. T did

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