# SEQ 0224 JOB A29-001-005 PAGE-0003 COVER

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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Order 232 (Rev. 1) superseded.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.

2

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
Share
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.

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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

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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.

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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

7

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.

(c) Exceptions—(1) Property contributed on or before October 3, 1989.
Section 704(c)(1)(B) and this section

8

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

9

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

10

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).
(c) Net precontribution gain—(1)
General rule. The distributee partner’s
net precontribution gain is the net gain
(if any) that would have been recog-

11

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.

12

(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.
(c) Incorporation of a partnership.
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

13

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.
(c) Partnership’s adjusted tax basis
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

14

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
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

15

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),

16

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
Register (57 FR 61356) containing
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.

17

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 w

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/agency%3Airs%3A332ad8863e06dbc0. Public record. Not legal advice.