Application of Section 514(c)(9)(E) of the Internal Revenue Code to Partnerships in Which One or More (but not all) of the Partners Are Qualified Organizations Within the Meaning of Section 514(c)(9)(C)

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8539]

RIN 1545-A078

Application of Section 514(c)(9)(E) of the Internal Revenue Code

to Partnerships in Which One or More (but not all) of the Partners Are

Qualified Organizations Within the Meaning of Section 514(c)(9)(C)

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the

application of section 514(c)(9)(E) of the Internal Revenue Code to

partnerships in which one or more (but not all) of the partners are

qualified tax-exempt organizations within the meaning of section

514(c)(9)(C). These organizations include educational organizations

described in section 170(b)(1)(A)(ii) and their affiliated support

organizations, and qualified trusts described in section 401. The final

regulations provide rules governing the application of section

514(c)(9)(E) of the Internal Revenue Code (Code). Section 514(c)(9)(E)

was added to the Code by the Omnibus Budget Reconciliation Act of 1987,

and was amended by the Technical and Miscellaneous Revenue Act of 1988.

The final regulations are necessary to provide affected partnerships

and their partners with the guidance they need to comply with the

applicable tax law.

EFFECTIVE DATE: May 13, 1994.

For dates of applicability of these regulations, see ``Effective

dates'' under SUPPLEMENTARY INFORMATION in the preamble.

FOR FURTHER INFORMATION CONTACT: Deane M. Burke at (202) 622-3080 (not

a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

This document amends 26 CFR part 1, which provides rules governing

the application of section 514(c)(9)(E) of the Internal Revenue Code of

1986 (Code), as amended. Section 514(c)(9)(E) was added to the Code by

section 10214 of the Omnibus Budget Reconciliation Act of 1987, Pub. L.

100-203, and was amended by section 2004(h) of the Technical and

Miscellaneous Revenue Act of 1988, Pub. L. 100-647.

On June 25, 1990, Notice 90-41, 1990-1 C.B. 350, was published in

the Internal Revenue Bulletin to provide interim guidance regarding the

application of section 514(c)(9)(E) of the Code and to request

comments. On December 30, 1992, the IRS published a notice of proposed

rulemaking in the Federal Register (57 FR 62266) (the proposed

regulations) regarding section 514(c)(9)(E). The preamble to that

notice contains an explanation to the proposed rules.

The IRS received written comments on the proposed regulations, but

cancelled a public hearing scheduled for March 31, 1993, because no one

requested to testify. After consideration of all the public comments on

the proposed regulations, the regulations are adopted as revised by

this Treasury decision.

Explanation of Provisions

I. Statutory Provisions

Section 511 of the Code provides that tax-exempt organizations are

generally taxable on their unrelated business taxable income. Section

514(a) provides that unrelated business taxable income includes a

specified percentage of the gross income derived from debt-financed

property described in section 514(b). Section 514(c)(9) provides an

exception for income derived from certain debt-financed investments in

real property by qualified organizations. Under section 514(c)(9)(C),

qualified organizations include educational organizations described in

section 170(b)(1)(A)(ii) and their affiliated support organizations,

and qualified trusts described in section 401.

If a qualified organization (QO) invests in debt-financed real

property through a partnership in which one or more (but not all) of

the partners are qualified organizations, the QO is eligible for the

exception provided in section 514(c)(9) only if the partnership

satisfies an additional requirement. Either each allocation to a

partner that is a qualified organization must be a qualified allocation

within the meaning of section 168(h)(6), or the partnership must

satisfy the requirements of section 514(c)(9)(E). These regulations

provide rules governing the application of section 514(c)(9)(E).

II. Overview of the Regulations

To satisfy the requirements of section 514(c)(9)(E), a partnership

must establish that the allocation of items to any partner that is a QO

cannot result in that partner having a percentage share of overall

partnership income for any taxable year greater than that partner's

percentage share of overall partnership loss for the taxable year for

which that partner's percentage loss share will be the smallest (that

partner's fractions rule percentage). This requirement, commonly

referred to as the fractions rule, must be satisfied both on a

prospective basis and on an actual basis for each taxable year of the

partnership.

The fractions rule is applied on an overall partnership basis.

Therefore, if partnership allocations to one QO partner fail to satisfy

the requirements of the fractions rule, that partner, and other QO

partners in the partnership, are subject to the debt-financed property

rules, even if the allocations to those other QO partners would

otherwise have complied with the requirements of the fractions rule.

A second requirement under section 514(c)(9)(E) is that each

partnership allocation must either have substantial economic effect or

(in the case of certain allocations that cannot have economic effect)

otherwise appropriately comply with the requirements of the regulations

under section 704(b).

For purposes of the fractions rule, overall partnership income is

the amount by which the aggregate items of partnership income and gain

for the taxable year exceed the aggregate items of partnership loss and

deduction for the year. Overall partnership loss is the amount by which

the aggregate items of partnership loss and deduction for the taxable

year exceed the aggregate items of partnership income and gain for the

year. In general, all items of partnership income, gain, loss, and

deduction that increase or decrease the partners' capital accounts

under Sec. 1.704-1(b)(2)(iv) are taken into account in computing

overall partnership income or loss.

The proposed regulations exclude allocations of certain items--

generally by disregarding those items in computing overall partnership

income or loss and the partners' allocable shares of overall

partnership income or loss. In some situations, however, items are

disregarded only until an allocation is actually made. The purpose of

the exclusions is to allow ordinary economic business allocations (such

as preferred returns), to avoid technical violations arising due to the

requirements of section 704(b), and to avoid foot-faults.

III. Public Comments and Clarifying Changes

A. Manner in Which the Fractions Rule Is Applied

One commentator requested clarification regarding the prospective

application of the fractions rule, especially with respect to

allocations that are taken into account only when an allocation is

made. The final regulations clarify that a partnership generally does

not qualify for the fractions rule exception for any taxable year of

its existence unless it satisfies the fractions rule--both on a

prospective and actual basis--for every year. The regulations also

clarify that if the partnership violates the fractions rule by reason

of an allocation that the regulations provide is ``disregarded'' or

``not taken into account'' until an actual allocation is made, the

partnership is treated (subject to the anti-abuse rule) as violating

the fractions rule only for the taxable year of that actual allocation

and subsequent taxable years. The final regulations also add an example

illustrating this wait-and-see approach.

B. Section 704(c) Allocations

The proposed regulations provide that tax items allocable under

section 704(c) (or Sec. 1.704-1(b)(2)(iv)(f)(4)), are not included in

computing overall partnership income or loss. The final regulations

clarify that those types of tax allocations may nonetheless be relevant

in determining if the partnership violates the anti-abuse rule.

C. Exclusion of Reasonable Preferred Returns and Guaranteed Payments

Under the exception for reasonable preferred returns, items of

income and gain allocated with respect to a reasonable preferred return

for capital are disregarded in computing overall partnership income or

loss for purposes of the fractions rule. Reasonable guaranteed payments

for capital or services also are disregarded. However, to qualify for

the exception, the income allocation (or the deduction of the

guaranteed payment) generally must not precede the making of the

related cash payment.

The final regulations adopt a commentator's recommendation that the

exception for reasonable preferred returns should apply not only to

allocations effected with items of income or gain, but also to

allocations effected with overall partnership income. In implementing

this change, the regulations refer to ``an allocation of what would

otherwise be overall partnership income.'' (This technical refinement

also was made to several parts of the regulation that previously

referred to allocations of overall partnership income.) This is

necessary because the exclusion of an allocated item from the

computation of overall partnership income or loss for purposes of the

fractions rule means that the item is not overall partnership income or

overall partnership loss.

Although the exception for reasonable preferred returns contained

in the proposed regulations applies only to those allocations made to a

QO, the final regulations apply the exception to all partners. Without

this change, a partnership that paid a reasonable preferred return to

both its QO and taxable partners arguably could disregard the

allocations to its QO partners in computing overall partnership income

or loss, but at the same time, take the corresponding allocations to

its taxable partners into account in computing overall partnership

income or loss. Although the anti-abuse rule of the proposed

regulations does not permit the excessive allocation of income or gain

to the QO partners that would result if this argument were accepted,

the final regulations clarify this issue. A similar change was not

called for with respect to guaranteed payments because guaranteed

payments to taxable partners automatically are excluded from overall

partnership income or loss.

The proposed regulations generally provide that a material

distribution is a return of capital if it is not attributable to the

partnership's cash flow from its business operations. Concern was

expressed that under this rule certain returns on capital might

inappropriately be characterized as a return of capital. There also was

a separate concern that this rule inappropriately implied that

distributions of operating cash flow would generally not be respected

as a return of capital.

To address these concerns and to reflect that capital may be

returned from a number of different sources, the final regulations

provide that a designation of distributions in a written partnership

agreement generally will be respected in determining a partner's

unreturned capital so long as the designation is economically

reasonable. Although the regulations do not specify when the

designation must be made, timing may be relevant in determining whether

the designation is reasonable.

Some commentators characterized the cash payment requirement as a

significant limitation on the exception for preferred returns and

guaranteed payments. The principal objection voiced on this point is

that requiring a cash payment may prevent partners from achieving their

economic deal. Since real estate partnerships often lack free cash in

their early years, the money partners are forced to rely on the

partnership having sufficient income in subsequent years to ultimately

provide them with their preferred return.

The IRS and Treasury Department are concerned that if the

requirement were eliminated, partnerships might attempt to optimize

their overall economics by allocating significant amounts of

partnership income and gain to QOs in the form of preferred returns and

guaranteed payments. It is believed that in many instances this would

be a departure from the normal commercial practice followed by

partnerships in which the money partners are generally subject to

income tax. Taxable partners generally are not willing to bear the tax

burden attributable to income allocations that precede the

corresponding distribution of cash by many years. A suggestion that

partnerships be required to compound allocated but unpaid amounts could

exacerbate the problem. Compounding would increase the amount of

undistributed income or gain allocated to the tax-exempt partners.

The final regulations retain the cash payment requirement. However,

the regulations also provide more explicitly that the normal rules of

accrual accounting are overridden with respect to the deduction of

reasonable guaranteed payments. The deduction is delayed until the

partnership taxable year in which the payment is made in cash.

(Similarly, the inclusion of the guaranteed payment in the QO's income

is delayed because the regulation does not change the existing rule

under Sec. 1.707-1(c) that a guaranteed payment is included in income

in the same taxable year it is deducted by the partnership.) For

partnerships that are concerned about the availability of sufficient

future income to ensure the payment of a preferred return, this

clarification may help them use guaranteed payments to achieve greater

assurance that the partnership ultimately will pay a return on capital.

D. Chargebacks and Offsets

The final regulations continue to provide exceptions for four types

of chargebacks and offsets: (1) Allocations that charge back prior

disproportionately large allocations (i.e., in excess of a qualified

organization's fractions rule percentage) of overall partnership loss

to a qualified organization, or prior disproportionately small

allocations of overall partnership income to a qualified organization;

(2) minimum gain chargebacks of nonrecourse deductions; (3) chargebacks

of partner nonrecourse deductions (and of compensating allocations of

recourse deductions to another partner); and (4) qualified income

offsets. The final regulations also continue to provide that

allocations of minimum gain that may be made with respect to

distributions of proceeds of nonrecourse liabilities are taken into

account only to the extent an allocation is actually made (to avoid

technical violations of the fractions rule that would otherwise arise

from including a minimum gain chargeback provision in a partnership

agreement). In addition, a limited new chargeback exception (described

in greater detail below) applies to allocations of minimum gain

attributable to certain distributions of proceeds of nonrecourse

liabilities.

A suggestion that all chargebacks be permitted without regard to

whether the initial allocation was ``disproportionate'' was carefully

considered and rejected. A principal consideration in rejecting the

proposal was that it would represent a significant departure from the

mechanical approach contained in the proposed regulations, which,

overall, is relatively simple for taxpayers to apply and for the IRS to

administer and enforce. Accordingly, the final regulations retain the

basic approach of the proposed regulations, but add a number of

technical and clarifying changes. In addition, two examples have been

added to further clarify the operation of these provisions.

The final regulations clarify that disproportionate allocations

need not be reversed in full, but may also be reversed in part. In

addition, the provision requiring that an initial allocation of less

than the entire overall partnership income or loss consist of a pro

rata portion of each item of partnership income, gain, loss, or

deduction now excepts from the pro rata requirement nonrecourse

deductions and certain other allocations relating to nonrecourse debt.

Absent this change, the disproportionate chargeback provisions might

have overly limited applicability, because real estate partnerships

typically have borrowed on a nonrecourse basis.

One commentator accurately noted that the exception for allocations

of overall partnership loss (or, more precisely, what would otherwise

be overall partnership loss) that charge back disproportionately small

allocations of overall partnership income to a QO partner is somewhat

confusing and counterintuitive. Part of the confusion arises because

the Code refers to chargebacks of disproportionately large income

allocations to taxable partners. However, the equivalent approach taken

in the regulations is desirable because it avoids the need to determine

the analog of a fractions rule percentage for taxable partners and

because it is simpler to apply to partnerships with more than one QO

partner. Accordingly, an example has been added to the final

regulations, as requested by the commentator, to illustrate a

qualifying allocation of overall partnership loss that charges back a

disproportionately small allocation of overall partnership income to a

QO partner.

The final regulations revise the formula approach in the proposed

regulations for determining the extent to which a minimum gain

chargeback is attributable to nonrecourse deductions (or partner

nonrecourse deductions) to properly interact with the Sec. 1.704-2

regulations governing partnership minimum gain and partner nonrecourse

debt minimum gain. The Sec. 1.704-2 regulations effect minimum gain

chargebacks on the basis of the partners' percentage shares of minimum

gain. Accordingly, the final regulations require partnerships to

determine--in a reasonable and consistent manner--the extent to which a

partner's percentage share of the partnership minimum gain is

attributable to nonrecourse deductions. The final regulations also

provide, by way of example, a formula for determining in certain

circumstances the extent to which a partner's percentage share of

minimum gain is attributable to nonrecourse deductions. Although the

final regulations do not explicitly so provide, a partnership that

computes the extent to which minimum gain is attributable to

nonrecourse deductions, also computes, by default, the extent to which

minimum gain is attributable to prior distributions of proceeds of

nonrecourse liabilities.

There is a limited new chargeback exception that applies if QO

partners initially contribute capital used to purchase depreciable real

property and are allocated the resulting depreciation deductions. If

the partnership later borrows money on a nonrecourse basis (using that

depreciable real property as security) and distributes the proceeds to

the QO partners as a return of capital, the resulting minimum gain

chargeback is permanently disregarded in computing overall partnership

income or loss for purposes of the fractions rule. Without a special

rule, the distribution of nonrecourse proceeds and the resulting

minimum gain chargeback might cause a violation of the fractions rule

in the year the minimum gain is triggered. In effect, the new exception

allows the partnership to apply the general chargeback rule for

nonrecourse deductions (rather than the general chargeback rule for

nonrecourse distributions) even though the initial depreciation

deductions allocated to the QO partners were not nonrecourse.

This new rule is narrow. It provides complete relief to

partnerships only to the extent the amount of the partnership

depreciation deduction for the property for the year does not exceed

the overall partnership loss for the year. The reason for making this

rule narrow is that chargebacks attributable to distributions of

proceeds of nonrecourse liabilities may provide greater potential for

manipulation than other chargebacks. Nonetheless, the new provision

should provide significant relief from a problem that may be fairly

common.

E. Exclusion of Partner-Specific Items of Deduction

The final regulations continue to exclude from the computation of

overall partnership income or loss, certain expenditures allocated to

the partners to whom they are attributable. Furthermore, in partial

response to a commentator's request that certain other exceptions be

added, the final regulations expand the exception for expenditures

incurred in computing section 743(b) basis adjustments to generally

encompass additional record-keeping and accounting expenditures

incurred in connection with transfers of partnership interests. To

allow proper consideration of other items that might be excepted, the

final regulations also permit the list of qualifying expenditures to be

expanded in the future by revenue ruling, revenue procedure, or private

letter ruling.

F. Unlikely Losses and Deductions

The requirement that a loss or expenditure not be reasonably

foreseeable to qualify as unlikely has been revised in response to

concerns that were voiced. To qualify as ``unlikely'' under the final

regulations, a loss or deduction must have a low likelihood of

occurring, taking into account the relevant facts and circumstances.

In addition, the final regulations clarify that the types of events

described in the regulations are not per se unlikely. They merely

illustrate possible situations giving rise to allocations to which the

exception for unlikely losses and deductions applies (if they have a

low likelihood of occurring taking into account the relevant facts and

circumstances). In response to a comment, the discovery of

environmental conditions that require remediation has been added to the

illustrative list of potential relevant events.

Contrary to a commentator's request, the final regulations do not

sanction pre-funding of a loss or deduction. Generally, pre-funding is

incompatible with a conclusion that a loss or deduction is unlikely.

G. Changes in Partnership Allocations

The final regulations retain the rule that changes in partnership

allocations resulting from transfers or shifts in partnership interests

will be closely scrutinized, but generally will be relevant only on a

prospective basis. However, the final regulations provide taxpayers

with more specific guidance. The scope of the scrutiny relates to the

determination of whether the transfers or shifts stem from a prior

agreement, understanding, or plan, or could otherwise be expected given

the structure of the transaction (e.g., a situation where the structure

and economics is such that it could well be anticipated that a sale of

an interest would occur at some particular phase of the partnership's

(or transaction's) life). This approach bears some similarity to the

approach of Sec. 1.704-1(b)(4)(vi) (relating to the scrutiny given to

amendments to partnership agreements).

H. De Minimis Exceptions

In response to comments, changes were also made to the two de

minimis rules. One commentator asked for clarification on the exception

for de minimis interests. In response, the rule has been slightly

clarified and an example has been added to illustrate the rule's

application.

The nature of the comments received with respect to the de minimis

allocation exception indicated that the exception was viewed

differently than had been intended. The intent of this exception was to

provide relief for what would otherwise be minor inadvertent violations

of the fractions rule. One example would be a plumber's bill that is

paid directly by a taxable partner, or that is paid by the partnership

but is overlooked until after the partnership's allocations have been

computed and then is allocated entirely to the taxable partner. It was

not intended that this provision be used routinely by partnerships to

allocate some of the partnership's losses and deductions. Consistent

with the intent underlying this provision, the final regulations limit

the total amount (rather than the amount allocated to the QO partner)

to which the exception applies to the lesser of $50,000 and one percent

of the partnership's total losses and deductions.

I. Anti-Abuse Rule

At least one commentator suggested that the anti-abuse rule in the

proposed regulations was vague. To address this concern, the final

regulations provide a more complete statement of the purpose of the

fractions rule, which largely tracks the wording of the Conference

Committee Report accompanying the enactment of the Revenue Act of 1987.

See H.R. Conf. Rep. No. 495, 100th Cong., 1st Sess. 957 (1987).

J. Tiered Partnerships

The rules regarding tiered partnerships were well received and

remain largely the same as in the proposed regulations. However, some

changes were made. First, the final regulations clarify that the

relevant partnerships (as opposed to individual QOs) must demonstrate

that the relevant chains satisfy the requirements of the regulations

under any reasonable method. Also, although the same three basic

examples contained in the proposed regulations continue to illustrate

the application of this rule, a number of changes were made to those

examples. Most of the changes to the examples are stylistic or

clarifying.

One clarification is that tiered partnerships may not simply be

used to achieve results that could not be achieved in the absence of a

tiered-partnership structure. For example, the facts in the second

tiered-partnership example (relating to the entity-by-entity approach)

now state that each of the upper-tier partnerships has been established

for the purpose of investing in numerous real estate properties

independently of the other upper-tier partnership and its partners.

Thus, the tiered-partnership rules may not be used simply to apply the

fractions rule on a QO-by-QO basis instead of the regulation's

generally applicable overall partnership basis.

The facts in the second example also now contain a statement that

neither of the upper-tier partnerships have outstanding debt. The

reason for that statement is that in some cases, debt might be used to

attempt to achieve allocations that would not satisfy the fractions

rule if, for example, the lower-tier partnership had incurred the debt.

The inclusion of this added fact should not be viewed as flatly

precluding the existence of debt at any level other than the lower-tier

partnership. The absence of debt was added as a fact to obviate the

need to complicate the example by addressing the precise effect of

debt, in what likely would have been a fact pattern that would have

been of limited value in analyzing other debt arrangements.

Accordingly, the existence of debt at a level other than the lower-tier

partnership should be viewed as something to be taken into

consideration in determining whether a partnership can demonstrate that

the requirements of the regulations have been satisfied. It should also

be noted that the existence of debt at the partner level might also be

relevant in situations where tiered partnerships are not used.

One clarifying change and one technical change were made with

respect to the third example in the tiered-partnership rules (relating

to the independent chain approach). The clarifying change was to state

that the upper-tier partnership separately allocates to its upper-tier

partners the items allocated to the upper-tier partnership by the

lower-tier partnerships. This change emphasizes that, as a practical

matter, partnerships would not otherwise be able to demonstrate that

the requirements of the fractions rule are complied with.

The technical change, which is related, is to provide that for

purposes of applying Sec. 1.704-2(k) under the independent chain

approach, minimum gain chargebacks are taken into account on an if-and-

when basis. Absent this change, no tiered-partnership structure in

which a lower-tier partnership incurred nonrecourse debt would be able

to comply with the fractions rule. This is because Sec. 1.704-2(k)

would be treated on a prospective basis as giving rise to: (1) an

allocation of a decrease in minimum gain to the upper-tier partnership

(and, in turn, an upper-tier QO partner) from one lower-tier

partnership lacking sufficient income and gain to effect a minimum gain

chargeback; and (2) a corresponding minimum gain chargeback by the

upper-tier partnership using income and gain allocated to the upper-

tier partnership by the other lower-tier partnership.

K. Effective Date

The final regulations retain December 30, 1992, as their general

effective date, i.e., the date the proposed regulations were published

in the Federal Register. However, the final regulations also permit

reliance on the proposed regulations during the window period beginning

December 30, 1992, and ending on May 13, 1994. The regulations provide

transition rules for partnerships commencing after October 13, 1987,

property acquired by partnerships after October 13, 1987, and

partnership interests acquired by qualified organizations after October

13, 1987.

Special Analyses

It has been determined that this Treasury decision is not a

significant regulatory action as defined in EO 12866. Therefore, a

regulatory assessment is not required. It also has been determined that

section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)

and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to

these regulations, and, therefore, a Regulatory Flexibility Analysis is

not required. Pursuant to section 7805(f) of the Internal Revenue Code,

the notice of proposed rulemaking preceding these regulations was

submitted to the Small Business Administration for comment on its

impact on small business.

Drafting Information

The principal author of these regulations is Deane M. Burke, Office

of Assistant Chief Counsel (Passthroughs and Special Industries),

Internal Revenue Service. However, other personnel from the IRS and

Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

Income Taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

Paragraph 1. The authority citation for part 1 is amended by adding

an entry in numerical order to read as follows:

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

Section 1.514(c)-2 also issued under 26 U.S.C.

514(c)(9)(E)(iii). * * *

Par. 2. Section 1.514(c)-2 is added to read as follows:

Sec. 1.514(c)-2. Permitted allocations under section 514(c)(9)(E).

(a) Table of contents. This paragraph contains a listing of the

major headings of this Sec. 1.514(c)-2.

(a) Table of contents.

(b) Application of section 514(c)(9)(E), relating to debt-financed

real property held by partnerships.

(1) In general.

(i) The fractions rule.

(ii) Substantial economic effect.

(2) Manner in which fractions rule is applied.

(i) In general.

(ii) Subsequent changes.

(c) General definitions.

(1) Overall partnership income and loss.

(i) Items taken into account in determining overall partnership

income and loss.

(ii) Guaranteed payments to qualified organizations.

(2) Fractions rule percentage.

(3) Definitions of certain terms by cross reference to

partnership regulations.

(4) Example.

(d) Exclusion of reasonable preferred returns and guaranteed

payments.

(1) Overview.

(2) Preferred returns.

(3) Guaranteed payments.

(4) Reasonable amount.

(i) In general.

(ii) Safe harbor.

(5) Unreturned capital.

(i) In general.

(ii) Return of capital.

(6) Timing rules.

(i) Limitation on allocations of income with respect to

reasonable preferred returns for capital.

(ii) Reasonable guaranteed payments may be deducted only when

paid in cash.

(7) Examples.

(e) Chargebacks and offsets.

(1) In general.

(2) Disproportionate allocations.

(i) In general.

(ii) Limitation on chargebacks of partial allocations.

(3) Minimum gain chargebacks attributable to nonrecourse

deductions.

(4) Minimum gain chargebacks attributable to distribution of

nonrecourse debt proceeds.

(i) Chargebacks disregarded until allocations made.

(ii) Certain minimum gain chargebacks related to returns of

capital.

(5) Examples.

(f) Exclusion of reasonable partner-specific items of deduction or

loss.

(g) Exclusion of unlikely losses and deductions.

(h) Provisions preventing deficit capital account balances.

(i) [Reserved].

(j) Exception for partner nonrecourse deductions.

(1) Partner nonrecourse deductions disregarded until actually

allocated.

(2) Disproportionate allocation of partner nonrecourse

deductions to a qualified organization.

(k) Special rules.

(1) Changes in partnership allocations arising from a change in

the partners' interests.

(2) De minimis interest rule.

(i) In general.

(ii) Example.

(3) De minimis allocations disregarded.

(4) Anti-abuse rule.

(l) [Reserved].

(m) Tiered partnerships.

(1) In general.

(2) Examples.

(n) Effective date.

(1) In general.

(2) General effective date of the regulations.

(3) Periods after June 24, 1990, and prior to December 30, 1992.

(4) Periods prior to the issuance of Notice 90-41.

(5) Material modifications to partnership agreements.

(b) Application of section 514(c)(9)(E), relating to debt-financed

real property held by partnerships--(1) In general. This Sec. 1.514(c)-

2 provides rules governing the application of section 514(c)(9)(E). To

comply with section 514(c)(9)(E), the following two requirements must

be met:

(i) The fractions rule. The allocation of items to a partner that

is a qualified organization cannot result in that partner having a

percentage share of overall partnership income for any partnership

taxable year greater than that partner's fractions rule percentage (as

defined in paragraph (c)(2) of this section).

(ii) Substantial economic effect. Each partnership allocation must

have substantial economic effect. However, allocations that cannot have

economic effect must be deemed to be in accordance with the partners'

interests in the partnership pursuant to Sec. 1.704-1(b)(4), or (if

Sec. 1.704-1(b)(4) does not provide a method for deeming the

allocations to be in accordance with the partners' interests in the

partnership) must otherwise comply with the requirements of Sec. 1.704-

1(b)(4). Allocations attributable to nonrecourse liabilities or partner

nonrecourse debt must comply with the requirements of Sec. 1.704-2(e)

or Sec. 1.704-2(i).

(2) Manner in which fractions rule is applied--(i) In general. A

partnership must satisfy the fractions rule both on a prospective basis

and on an actual basis for each taxable year of the partnership,

commencing with the first taxable year of the partnership in which the

partnership holds debt-financed real property and has a qualified

organization as a partner. Generally, a partnership does not qualify

for the unrelated business income tax exception provided by section

514(c)(9)(A) for any taxable year of its existence unless it satisfies

the fractions rule for every year the fractions rule applies. However,

if an actual allocation described in paragraph (e)(4), (h), (j)(2), or

(m)(1)(ii) of this section (regarding certain allocations that are

disregarded or not taken into account for purposes of the fractions

rule until an actual allocation is made) causes the partnership to

violate the fractions rule, the partnership ordinarily is treated as

violating the fractions rule only for the taxable year of the actual

allocation and subsequent taxable years. For purposes of applying the

fractions rule, the term partnership agreement is defined in accordance

with Sec. 1.704-1(b)(2)(ii)(h), and informal understandings are

considered part of the partnership agreement in appropriate

circumstances. See paragraph (k) of this section for rules relating to

changes in the partners' interests and de minimis exceptions to the

fractions rule.

(ii) Subsequent changes. A subsequent change to a partnership

agreement that causes the partnership to violate the fractions rule

ordinarily causes the partnership's income to fail the exception

provided by section 514(c)(9)(A) only for the taxable year of the

change and subsequent taxable years.

(c) General definitions--(1) Overall partnership income and loss.

Overall partnership income is the amount by which the aggregate items

of partnership income and gain for the taxable year exceed the

aggregate items of partnership loss and deduction for the year. Overall

partnership loss is the amount by which the aggregate items of

partnership loss and deduction for the taxable year exceed the

aggregate items of partnership income and gain for the year.

(i) Items taken into account in determining overall partnership

income and loss. Except as otherwise provided in this section, the

partnership items that are included in computing overall partnership

income or loss are those items of income, gain, loss, and deduction

(including expenditures described in section 705(a)(2)(B)) that

increase or decrease the partners' capital accounts under Sec. 1.704-

1(b)(2)(iv). Tax items allocable pursuant to section 704(c) or

Sec. 1.704-1(b)(2)(iv)(f)(4) are not included in computing overall

partnership income or loss. Nonetheless, allocations pursuant to

section 704(c) or Sec. 1.704-1(b)(2)(iv)(f)(4) may be relevant in

determining that this section is being applied in a manner that is

inconsistent with the fractions rule. See paragraph (k)(4) of this

section.

(ii) Guaranteed payments to qualified organizations. Except to the

extent otherwise provided in paragraph (d) of this section--

(A) A guaranteed payment to a qualified organization is not treated

as an item of partnership loss or deduction in computing overall

partnership income or loss; and

(B) Income that a qualified organization may receive or accrue with

respect to a guaranteed payment is treated as an allocable share of

overall partnership income or loss for purposes of the fractions rule.

(2) Fractions rule percentage. A qualified organization's fractions

rule percentage is that partner's percentage share of overall

partnership loss for the partnership taxable year for which that

partner's percentage share of overall partnership loss will be the

smallest.

(3) Definitions of certain terms by cross reference to partnership

regulations. Minimum gain chargeback, nonrecourse deduction,

nonrecourse liability, partner nonrecourse debt, partner nonrecourse

debt minimum gain, partner nonrecourse debt minimum gain chargeback,

partner nonrecourse deduction, and partnership minimum gain have the

meanings provided in Sec. 1.704-2.

(4) Example. The following example illustrates the provisions of

this paragraph (c).

Example. Computation of overall partnership income and loss for

a taxable year. (i) Taxable corporation TP and qualified

organization QO form a partnership to own and operate encumbered

real property. Under the partnership agreement, all items of income,

gain, loss, deduction, and credit are allocated 50 percent to TP and

50 percent to QO. Neither partner is entitled to a preferred return.

However, the partnership agreement provides for a $900 guaranteed

payment for services to QO in each of the partnership's first two

taxable years. No part of the guaranteed payments qualify as a

reasonable guaranteed payment under paragraph (d) of this section.

(ii) The partnership violates the fractions rule. Due to the

existence of the guaranteed payment, QO's percentage share of any

overall partnership income in the first two years will exceed QO's

fractions rule percentage. For example, the partnership might have

bottom-line net income of $5,100 in its first taxable year that is

comprised of $10,000 of rental income, $4,000 of salary expense, and

the $900 guaranteed payment to QO. The guaranteed payment would not

be treated as an item of deduction in computing overall partnership

income or loss because it does not qualify as a reasonable

guaranteed payment. See paragraph (c)(1)(ii)(A) of this section.

Accordingly, overall partnership income for the year would be

$6,000, which would consist of $10,000 of rental income less $4,000

of salary expense. See paragraph (c)(1)(i) of this section. The $900

QO would include in income with respect to the guaranteed payment

would be treated as an allocable share of the $6,000 of overall

partnership income. See paragraph (c)(1)(ii)(B) of this section.

Therefore, QO's allocable share of the overall partnership income

for the year would be $3,450, which would be comprised of the $900

of income pertaining to QO's guaranteed payment, plus QO's $2,550

allocable share of the partnership's net income for the year (50

percent of $5,100). QO's $3,450 allocable share of overall

partnership income would equal 58 percent of the $6,000 of overall

partnership income and would exceed QO's fractions rule percentage,

which is less than 50 percent. (If there were no guaranteed payment,

QO's fractions rule percentage would be 50 percent. However, the

existence of the guaranteed payment to QO that is not disregarded

for purposes of the fractions rule pursuant to paragraph (d) of this

section means that QO's fractions rule percentage is less than 50

percent.)

(d) Exclusion of reasonable preferred returns and guaranteed

payments--(1) Overview. This paragraph (d) sets forth requirements for

disregarding reasonable preferred returns for capital and reasonable

guaranteed payments for capital or services for purposes of the

fractions rule. To qualify, the preferred return or guaranteed payment

must be set forth in a binding, written partnership agreement.

(2) Preferred returns. Items of income (including gross income) and

gain that may be allocated to a partner with respect to a current or

cumulative reasonable preferred return for capital (including

allocations of minimum gain attributable to nonrecourse liability (or

partner nonrecourse debt) proceeds distributed to the partner as a

reasonable preferred return) are disregarded in computing overall

partnership income or loss for purposes of the fractions rule.

Similarly, if a partnership agreement effects a reasonable preferred

return with an allocation of what would otherwise be overall

partnership income, those items comprising that allocation are

disregarded in computing overall partnership income for purposes of the

fractions rule.

(3) Guaranteed payments. A current or cumulative reasonable

guaranteed payment to a qualified organization for capital or services

is treated as an item of deduction in computing overall partnership

income or loss, and the income that the qualified organization may

receive or accrue from the current or cumulative reasonable guaranteed

payment is not treated as an allocable share of overall partnership

income or loss. The treatment of a guaranteed payment as reasonable for

purposes of section 514(c)(9)(E) does not affect its possible

characterization as unrelated business taxable income under other

provisions of the Internal Revenue Code.

(4) Reasonable amount--(i) In general. A guaranteed payment for

services is reasonable only to the extent the amount of the payment is

reasonable under Sec. 1.162-7 (relating to the deduction of

compensation for personal services). A preferred return or guaranteed

payment for capital is reasonable only to the extent it is computed,

with respect to unreturned capital, at a rate that is commercially

reasonable based on the relevant facts and circumstances.

(ii) Safe harbor. For purposes of this paragraph (d)(4), a rate is

deemed to be commercially reasonable if it is no greater than four

percentage points more than, or if it is no greater than 150 percent

of, the highest long-term applicable federal rate (AFR) within the

meaning of section 1274(d), for the month the partner's right to a

preferred return or guaranteed payment is first established or for any

month in the partnership taxable year for which the return or payment

on capital is computed. A rate in excess of the rates described in the

preceding sentence may be commercially reasonable, based on the

relevant facts and circumstances.

(5) Unreturned capital--(i) In general. Unreturned capital is

computed on a weighted-average basis and equals the excess of--

(A) The amount of money and the fair market value of property

contributed by the partner to the partnership (net of liabilities

assumed, or taken subject to, by the partnership); over

(B) The amount of money and the fair market value of property (net

of liabilities assumed, or taken subject to, by the partner)

distributed by the partnership to the partner as a return of capital.

(ii) Return of capital. In determining whether a distribution

constitutes a return of capital, all relevant facts and circumstances

are taken into account. However, the designation of distributions in a

written partnership agreement generally will be respected in

determining whether a distribution constitutes a return of capital, so

long as the designation is economically reasonable.

(6) Timing rules--(i) Limitation on allocations of income with

respect to reasonable preferred returns for capital. Items of income

and gain (or part of what would otherwise be overall partnership

income) that may be allocated to a partner in a taxable year with

respect to a reasonable preferred return for capital are disregarded

for purposes of the fractions rule only to the extent the allocable

amount will not exceed--

(A) The aggregate of the amount that has been distributed to the

partner as a reasonable preferred return for the taxable year of the

allocation and prior taxable years, on or before the due date (not

including extensions) for filing the partnership's return for the

taxable year of the allocation; minus

(B) The aggregate amount of corresponding income and gain (and what

would otherwise be overall partnership income) allocated to the partner

in all prior years.

(ii) Reasonable guaranteed payments may be deducted only when paid

in cash. If a partnership that avails itself of paragraph (d)(3) of

this section would otherwise be required (by virtue of its method of

accounting) to deduct a reasonable guaranteed payment to a qualified

organization earlier than the taxable year in which it is paid in cash,

the partnership must delay the deduction of the guaranteed payment

until the taxable year it is paid in cash. For purposes of this

paragraph (d)(6)(ii), a guaranteed payment that is paid in cash on or

before the due date (not including extensions) for filing the

partnership's return for a taxable year may be treated as paid in that

prior taxable year.

(7) Examples. The following examples illustrate the provisions of

this paragraph (d).

Facts. Qualified organization QO and taxable corporation TP form

a partnership. QO contributes $9,000 to the partnership and TP

contributes $1,000. The partnership borrows $50,000 from a third

party lender and purchases an office building for $55,000. At all

relevant times the safe harbor rate described in paragraph

(d)(4)(ii) of this section equals 10 percent.

Example 1. Allocations made with respect to preferred returns.

(i) The partnership agreement provides that in each taxable year the

partnership's distributable cash is first to be distributed to QO as

a 10 percent preferred return on its unreturned capital. To the

extent the partnership has insufficient cash to pay QO its preferred

return in any taxable year, the preferred return is compounded (at

10 percent) and is to be paid in future years to the extent the

partnership has distributable cash. The partnership agreement first

allocates gross income and gain 100 percent to QO, to the extent

cash has been distributed to QO as a preferred return. All remaining

profit or loss is allocated 50 percent to QO and 50 percent to TP.

(ii) The partnership satisfies the fractions rule. Items of

income and gain that may be specially allocated to QO with respect

to its preferred return are disregarded in computing overall

partnership income or loss for purposes of the fractions rule

because the requirements of paragraph (d) of this section are

satisfied. After disregarding those allocations, QO's fractions rule

percentage is 50 percent (see paragraph (c)(2) of this section), and

under the partnership agreement QO may not be allocated more than 50

percent of overall partnership income in any taxable year.

(iii) The facts are the same as in paragraph (i) of this Example

1, except that QO's preferred return is computed on unreturned

capital at a rate that exceeds a commercially reasonable rate. The

partnership violates the fractions rule. The income and gain that

may be specially allocated to QO with respect to the preferred

return is not disregarded in computing overall partnership income or

loss to the extent it exceeds a commercially reasonable rate. See

paragraph (d) of this section. As a result, QO's fractions rule

percentage is less than 50 percent (see paragraph (c)(2) of this

section), and allocations of income and gain to QO with respect to

its preferred return could result in QO being allocated more than 50

percent of the overall partnership income in a taxable year.

Example 2. Guaranteed payments and the computation of overall

partnership income or loss. (i) The partnership agreement allocates

all bottom-line partnership income and loss 50 percent to QO and 50

percent to TP throughout the life of the partnership. The

partnership agreement provides that QO is entitled each year to a 10

percent guaranteed payment on unreturned capital. To the extent the

partnership is unable to make a guaranteed payment in any taxable

year, the unpaid amount is compounded at 10 percent and is to be

paid in future years.

(ii) Assuming the requirements of paragraph (d)(6)(ii) of this

section are met, the partnership satisfies the fractions rule. The

guaranteed payment is disregarded for purposes of the fractions rule

because it is computed with respect to unreturned capital at the

safe harbor rate described in paragraph (d)(4)(ii) of this section.

Therefore, the guaranteed payment is treated as an item of deduction

in computing overall partnership income or loss, and the

corresponding income that QO may receive or accrue with respect to

the guaranteed payment is not treated as an allocable share of

overall partnership income or loss. See paragraph (d)(3) of this

section. Accordingly, QO's fractions rule percentage is 50 percent

(see paragraph (c)(2) of this section), and under the partnership

agreement QO may not be allocated more than 50 percent of overall

partnership income in any taxable year.

(e) Chargebacks and offsets--(1) In general. The following

allocations are disregarded in computing overall partnership income or

loss for purposes of the fractions rule--

(i) Allocations of what would otherwise be overall partnership

income that may be made to chargeback (i.e., reverse) prior

disproportionately large allocations of overall partnership loss (or

part of the overall partnership loss) to a qualified organization, and

allocations of what would otherwise be overall partnership loss that

may be made to chargeback prior disproportionately small allocations of

overall partnership income (or part of the overall partnership income)

to a qualified organization;

(ii) Allocations of income or gain that may be made to a partner

pursuant to a minimum gain chargeback attributable to prior allocations

of nonrecourse deductions to the partner;

(iii) Allocations of income or gain that may be made to a partner

pursuant to a minimum gain chargeback attributable to prior allocations

of partner nonrecourse deductions to the partner and allocations of

income or gain that may be made to other partners to chargeback

compensating allocations of other losses, deductions, or section

705(a)(2)(B) expenditures to the other partners; and

(iv) Allocations of items of income or gain that may be made to a

partner pursuant to a qualified income offset, within the meaning of

Sec. 1.704-1(b)(2)(ii)(d).

(2) Disproportionate allocations--(i) In general. To qualify under

paragraph (e)(1)(i) of this section, prior disproportionate allocations

may be reversed in full or in part, and in any order, but must be

reversed in the same ratio as originally made. A prior allocation is

disproportionately large if the qualified organization's percentage

share of that allocation exceeds its fractions rule percentage. A prior

allocation is disproportionately small if the qualified organization's

percentage share of that allocation is less than its fractions rule

percentage. However, a prior allocation (or allocations) is not

considered disproportionate unless the balance of the overall

partnership income or loss for the taxable year of the allocation is

allocated in a manner that would independently satisfy the fractions

rule.

(ii) Limitation on chargebacks of partial allocations. Except in

the case of a chargeback allocation pursuant to paragraph (e)(4) of

this section, and except as otherwise provided by the Internal Revenue

Service by revenue ruling, revenue procedure, or, on a case-by-case

basis, by letter ruling, paragraph (e)(1)(i) of this section applies to

a chargeback of an allocation of part of the overall partnership income

or loss only if that part consists of a pro rata portion of each item

of partnership income, gain, loss, and deduction (other than

nonrecourse deductions, as well as partner nonrecourse deductions and

compensating allocations) that is included in computing overall

partnership income or loss.

(3) Minimum gain chargebacks attributable to nonrecourse

deductions. Commencing with the first taxable year of the partnership

in which a minimum gain chargeback (or partner nonrecourse debt minimum

gain chargeback) occurs, a chargeback to a partner is attributable to

nonrecourse deductions (or separately, on a debt-by-debt basis, to

partner nonrecourse deductions) in the same proportion that the

partner's percentage share of the partnership minimum gain (or

separately, on a debt-by-debt basis, the partner nonrecourse debt

minimum gain) at the end of the immediately preceding taxable year is

attributable to nonrecourse deductions (or partner nonrecourse

deductions). The partnership must determine the extent to which a

partner's percentage share of the partnership minimum gain (or partner

nonrecourse debt minimum gain) is attributable to deductions in a

reasonable and consistent manner. For example, in those cases in which

none of the exceptions contained in Sec. 1.704-2(f) (2) through (5) are

relevant, a partner's percentage share of the partnership minimum gain

generally is attributable to nonrecourse deductions in the same ratio

that--

(i) The aggregate amount of the nonrecourse deductions previously

allocated to the partner but not charged back in prior taxable years;

bears to

(ii) The sum of the amount described in paragraph (e)(3)(i) of this

section, plus the aggregate amount of distributions previously made to

the partner of proceeds of a nonrecourse liability allocable to an

increase in partnership minimum gain but not charged back in prior

taxable years.

(4) Minimum gain chargebacks attributable to distribution of

nonrecourse debt proceeds--(i) Chargebacks disregarded until

allocations made. Allocations of items of income and gain that may be

made pursuant to a provision in the partnership agreement that charges

back minimum gain attributable to the distribution of proceeds of a

nonrecourse liability (or a partner nonrecourse debt) are taken into

account for purposes of the fractions rule only to the extent an

allocation is made. (See paragraph (d)(2) of this section, pursuant to

which there is permanently excluded chargeback allocations of minimum

gain that are attributable to proceeds distributed as a reasonable

preferred return.)

(ii) Certain minimum gain chargebacks related to returns of

capital. Allocations of items of income or gain that (in accordance

with Sec. 1.704-2(f)(1)) may be made to a partner pursuant to a minimum

gain chargeback attributable to the distribution of proceeds of a

nonrecourse liability are disregarded in computing overall partnership

income or loss for purposes of the fractions rule to the extent that

the allocations (subject to the requirements of paragraph (e)(2) of

this section) also charge back prior disproportionately large

allocations of overall partnership loss (or part of the overall

partnership loss) to a qualified organization. This exception applies

only to the extent the disproportionately large allocation consisted of

depreciation from real property (other than items of nonrecourse

deduction or partner nonrecourse deduction) that subsequently was used

to secure the nonrecourse liability providing the distributed proceeds,

and only if those proceeds were distributed as a return of capital and

in the same proportion as the disproportionately large allocation.

(5) Examples. The following examples illustrate the provisions of

this paragraph (e).

Example 1. Chargebacks of disproportionately large allocations

of overall partnership loss. (i) Qualified organization QO and

taxable corporation TP form a partnership. QO contributes $900 to

the partnership and TP contributes $100. The partnership agreement

allocates overall partnership loss 50 percent to QO and 50 percent

to TP until TP's capital account is reduced to zero; then 100

percent to QO until QO's capital account is reduced to zero; and

thereafter 50 percent to QO and 50 percent to TP. Overall

partnership income is allocated first 100 percent to QO to

chargeback overall partnership loss allocated 100 percent to QO, and

thereafter 50 percent to QO and 50 percent to TP.

(ii) The partnership satisfies the fractions rule. QO's

fractions rule percentage is 50 percent. See paragraph (c)(2) of

this section. Therefore, the 100 percent allocation of overall

partnership loss to QO is disproportionately large. See paragraph

(e)(2)(i) of this section. Accordingly, the 100 percent allocation

to QO of what would otherwise be overall partnership income (if it

were not disregarded), which charges back the disproportionately

large allocation of overall partnership loss, is disregarded in

computing overall partnership income and loss for purposes of the

fractions rule. The 100 percent allocation is in the same ratio as

the disproportionately large loss allocation, and the rest of the

allocations for the taxable year of the disproportionately large

loss allocation will independently satisfy the fractions rule. See

paragraph (e)(2)(i) of this section. After disregarding the

chargeback allocation of 100 percent of what would otherwise be

overall partnership income, QO will not be allocated a percentage

share of overall partnership income in excess of its fractions rule

percentage for any taxable year.

Example 2. Chargebacks of disproportionately small allocations

of overall partnership income. (i) Qualified organization QO and

taxable corporation TP form a partnership. QO contributes $900 to

the partnership and TP contributes $100. The partnership purchases

real property with money contributed by its partners and with money

borrowed by the partnership on a recourse basis. In any year, the

partnership agreement allocates the first $500 of overall

partnership income 50 percent to QO and 50 percent to TP; the next

$100 of overall partnership income 100 percent to TP (as an

incentive for TP to achieve significant profitability in managing

the partnership's operations); and all remaining overall partnership

income 50 percent to QO and 50 percent to TP. Overall partnership

loss is allocated first 100 percent to TP to chargeback overall

partnership income allocated 100 percent to TP at any time in the

prior three years and not reversed; and thereafter 50 percent to QO

and 50 percent to TP.

(ii) The partnership satisfies the fractions rule. QO's

fractions rule percentage is 50 percent because qualifying

chargebacks are disregarded pursuant to paragraph (e)(1)(i) in

computing overall partnership income or loss. See paragraph (c)(2)

of this section. The zero percent allocation to QO of what would

otherwise be overall partnership loss is a qualifying chargeback

that is disregarded because it is in the same ratio as the income

allocation it charges back, because the rest of the allocations for

the taxable year of that income allocation will independently

satisfy the fractions rule (see paragraph (e)(2)(i) of this

section), and because it charges back an allocation of zero overall

partnership income to QO, which is proportionately smaller (i.e.,

disproportionately small) than QO's 50 percent fractions rule

percentage. After disregarding the chargeback allocation of 100

percent of what would otherwise be overall partnership loss, QO will

not be allocated a percentage share of overall partnership income in

excess of its fractions rule percentage for any taxable year.

Example 3. Chargebacks of partner nonrecourse deductions and

compensating allocations of other items. (i) Qualified organization

QO and taxable corporation TP form a partnership to own and operate

encumbered real property. QO and TP each contribute $500 to the

partnership. In addition, QO makes a $300 nonrecourse loan to the

partnership. The partnership agreement contains a partner

nonrecourse debt minimum gain chargeback provision and a provision

that allocates partner nonrecourse deductions to the partner who

bears the economic burden of the deductions in accordance with

Sec. 1.704-2. The partnership agreement also provides that to the

extent partner nonrecourse deductions are allocated to QO in any

taxable year, other compensating items of partnership loss or

deduction (and, if appropriate, section 705(a)(2)(B) expenditures)

will first be allocated 100 percent to TP. In addition, to the

extent items of income or gain are allocated to QO in any taxable

year pursuant to a partner nonrecourse debt minimum gain chargeback

of deductions, items of partnership income and gain will first be

allocated 100 percent to TP. The partnership agreement allocates all

other overall partnership income or loss 50 percent to QO and 50

percent to TP.

(ii) The partnership satisfies the fractions rule on a

prospective basis. The allocations of the partner nonrecourse

deductions and the compensating allocation of other items of loss,

deduction, and expenditure that may be made to TP (but which will

not be made unless there is an allocation of partner nonrecourse

deductions to QO) are not taken into account for purposes of the

fractions rule until a taxable year in which an allocation is made.

See paragraph (j)(1) of this section. In addition, partner

nonrecourse debt minimum gain chargebacks of deductions and

allocations of income or gain to other partners that chargeback

compensating allocations of other deductions are disregarded in

computing overall partnership income or loss for purposes of the

fractions rule. See paragraph (e)(1)(iii) of this section. Since all

other overall partnership income and loss is allocated 50 percent to

QO and 50 percent to TP, QO's fractions rule percentage is 50

percent (see paragraph (c)(2) of this section), and QO will not be

allocated a percentage share of overall partnership income in excess

of its fractions rule percentage for any taxable year.

(iii) The facts are the same as in paragraph (i) of this Example

3, except that the partnership agreement provides that compensating

allocations of loss or deduction (and section 705(a)(2)(B)

expenditures) to TP will not be charged back until year 10. The

partners expect $300 of partner nonrecourse deductions to be

allocated to QO in year 1 and $300 of income or gain to be allocated

to QO in year 2 pursuant to the partner nonrecourse debt minimum

gain chargeback provision.

(iv) The partnership fails to satisfy the fractions rule on a

prospective basis under the anti-abuse rule of paragraph (k)(4) of

this section. If the partners' expectations prove correct, at the

end of year 2, QO will have been allocated $300 of partner

nonrecourse deductions and an offsetting $300 of partner nonrecourse

debt minimum gain. However, the $300 of compensating deductions and

losses that may be allocated to TP will not be charged back until

year 10. Thus, during the period beginning at the end of year 2 and

ending eight years later, there may be $300 more of unreversed

deductions and losses allocated to TP than to QO, which would be

inconsistent with the purpose of the fractions rule.

Example 4. Minimum gain chargeback attributable to distributions

of nonrecourse debt proceeds. (i) Qualified organization QO and

taxable corporation TP form a partnership. QO contributes $900 to

the partnership and TP contributes $100. The partnership agreement

generally allocates overall partnership income and loss 90 percent

to QO and 10 percent to TP. However, the partnership agreement

contains a minimum gain chargeback provision, and also provides that

in any partnership taxable year in which there is a chargeback of

partnership minimum gain to QO attributable to distributions of

proceeds of nonrecourse liabilities, all other items comprising

overall partnership income or loss will be allocated in a manner

such that QO is not allocated more than 90 percent of the overall

partnership income for the year.

(ii) The partnership satisfies the fractions rule on a

prospective basis. QO's fractions rule percentage is 90 percent. See

paragraph (c)(2) of this section. The chargeback that may be made to

QO of minimum gain attributable to distributions of nonrecourse

liability proceeds is taken into account for purposes of the

fractions rule only to the extent an allocation is made. See

paragraph (e)(4) of this section. Accordingly, that potential

allocation to QO is disregarded in applying the fractions rule on a

prospective basis (see paragraph (b)(2) of this section), and QO is

treated as not being allocated a percentage share of overall

partnership income in excess of its fractions rule percentage in any

taxable year. (Similarly, QO is treated as not being allocated items

of income or gain in a taxable year when the partnership has an

overall partnership loss.)

(iii) In year 3, the partnership borrows $400 on a nonrecourse

basis and distributes it to QO as a return of capital. In year 8,

the partnership has $400 of gross income and cash flow and $300 of

overall partnership income, and the partnership repays the $400

nonrecourse borrowing.

(iv) The partnership violates the fractions rule for year 8 and

all future years. Pursuant to the minimum gain chargeback provision,

the entire $400 of partnership gross income is allocated to QO.

Accordingly, notwithstanding the curative provision in the

partnership agreement that would allocate to TP the next $44

(($400.9) x 10%) of income and gain included in computing

overall partnership income, the partnership has no other items of

income and gain to allocate to QO. Because the $400 of gross income

actually allocated to QO is taken into account for purposes of the

fractions rule in the year an allocation is made (see paragraph

(e)(4) of this section), QO's percentage share of overall

partnership income in year 8 is greater than 100 percent. Since this

exceeds QO's fractions rule percentage (i.e., 90 percent), the

partnership violates the fractions rule for year 8 and all

subsequent taxable years. See paragraph (b)(2) of this section.

(f) Exclusion of reasonable partner-specific items of deduction or

loss. Provided that the expenditures are allocated to the partners to

whom they are attributable, the following partner-specific expenditures

are disregarded in computing overall partnership income or loss for

purposes of the fractions rule--

(1) Expenditures for additional record-keeping and accounting

incurred in connection with the transfer of a partnership interest

(including expenditures incurred in computing basis adjustments under

section 743(b));

(2) Additional administrative costs that result from having a

foreign partner;

(3) State and local taxes or expenditures relating to those taxes;

and

(4) Expenditures designated by the Internal Revenue Service by

revenue ruling or revenue procedure, or, on a case-by-case basis, by

letter ruling. (See Sec. 601.601(d)(2)(ii)(b) of this chapter).

(g) Exclusion of unlikely losses and deductions. Unlikely losses or

deductions (other than items of nonrecourse deduction) that may be

specially allocated to partners that bear the economic burden of those

losses or deductions are disregarded in computing overall partnership

income or loss for purposes of the fractions rule, so long as a

principal purpose of the allocation is not tax avoidance. To be

excluded under this paragraph (g), a loss or deduction must have a low

likelihood of occurring, taking into account all relevant facts,

circumstances, and information available to the partners (including

bona fide financial projections). The types of events that may give

rise to unlikely losses or deductions, depending on the facts and

circumstances, include tort and other third-party litigation that give

rise to unforeseen liabilities in excess of reasonable insurance

coverage; unanticipated labor strikes; unusual delays in securing

required permits or licenses; abnormal weather conditions (considering

the season and the job site); significant delays in leasing property

due to an unanticipated severe economic downturn in the geographic

area; unanticipated cost overruns; and the discovery of environmental

conditions that require remediation. No inference is drawn as to

whether a loss or deduction is unlikely from the fact that the

partnership agreement includes a provision for allocating that loss or

deduction.

(h) Provisions preventing deficit capital account balances. A

provision in the partnership agreement that allocates items of loss or

deduction away from a qualified organization in instances where

allocating those items to the qualified organization would cause or

increase a deficit balance in its capital account that the qualified

organization is not obligated to restore (within the meaning of

Sec. 1.704-1(b)(2)(ii) (b) or (d)), is disregarded for purposes of the

fractions rule in taxable years of the partnership in which no such

allocations are made pursuant to the provision. However, this exception

applies only if, at the time the provision becomes part of the

partnership agreement, all relevant facts, circumstances, and

information (including bona fide financial projections) available to

the partners reasonably indicate that it is unlikely that an allocation

will be made pursuant to the provision during the life of the

partnership.

(i) [Reserved]

(j) Exception for partner nonrecourse deductions--(1) Partner

nonrecourse deductions disregarded until actually allocated. Items of

partner nonrecourse deduction that may be allocated to a partner

pursuant to Sec. 1.704-2, and compensating allocations of other items

of loss, deduction, and section 705(a)(2)(B) expenditures that may be

allocated to other partners, are not taken into account for purposes of

the fractions rule until the taxable years in which they are allocated.

(2) Disproportionate allocation of partner nonrecourse deductions

to a qualified organization. A violation of the fractions rule will be

disregarded if it arises because an allocation of partner nonrecourse

deductions to a qualified organization that is not motivated by tax

avoidance reduces another qualified organization's fractions rule

percentage below what it would have been absent the allocation of the

partner nonrecourse deductions.

(k) Special rules--(1) Changes in partnership allocations arising

from a change in the partners' interests. A qualified organization that

acquires a partnership interest from another qualified organization is

treated as a continuation of the prior qualified organization partner

(to the extent of that acquired interest) for purposes of applying the

fractions rule. Changes in partnership allocations that result from

other transfers or shifts of partnership interests will be closely

scrutinized (to determine whether the transfer or shift stems from a

prior agreement, understanding, or plan or could otherwise be expected

given the structure of the transaction), but generally will be taken

into account only in determining whether the partnership satisfies the

fractions rule in the taxable year of the change and subsequent taxable

years.

(2) De minimis interest rule--(i) In general. Section

514(c)(9)(B)(vi) does not apply to a partnership otherwise subject to

that section if--

(A) Qualified organizations do not hold, in the aggregate,

interests of greater than five percent in the capital or profits of the

partnership; and

(B) Taxable partners own substantial interests in the partnership

through which they participate in the partnership on substantially the

same terms as the qualified organization partners.

(ii) Example. Partnership PRS has two types of limited partnership

interests that participate in partnership profits and losses on

different terms. Qualified organizations (QOs) only own one type of

limited partnership interest and own no general partnership interests.

In the aggregate, the QOs own less than five percent of the capital and

profits of PRS. Taxable partners also own the same type of limited

partnership interest that the QOs own. These limited partnership

interests owned by the taxable partners are 30 percent of the capital

and profits of PRS. Thirty percent is a substantial interest in the

partnership. Therefore, PRS satisfies paragraph (k)(2) of this section

and section 514(c)(9)(B)(vi) does not apply.

(3) De minimis allocations disregarded. A qualified organization's

fractions rule percentage of the partnership's items of loss and

deduction, other than nonrecourse and partner nonrecourse deductions,

that are allocated away from the qualified organization and to other

partners in any taxable year are treated as having been allocated to

the qualified organization for purposes of the fractions rule if--

(i) The allocation was neither planned nor motivated by tax

avoidance; and

(ii) The total amount of those items of partnership loss or

deduction is less than both--

(A) One percent of the partnership's aggregate items of gross loss

and deduction for the taxable year; and

(B) $50,000.

(4) Anti-abuse rule. The purpose of the fractions rule is to

prevent tax avoidance by limiting the permanent or temporary transfer

of tax benefits from tax-exempt partners to taxable partners, whether

by directing income or gain to tax-exempt partners, by directing

losses, deductions, or credits to taxable partners, or by some other

similar manner. This section may not be applied in a manner that is

inconsistent with the purpose of the fractions rule.

(l) [Reserved].

(m) Tiered partnerships--(1) In general. If a qualified

organization holds an indirect interest in real property through one or

more tiers of partnerships (a chain), the fractions rule is satisfied

only if--

(i) The avoidance of tax is not a principal purpose for using the

tiered-ownership structure (investing in separate real properties

through separate chains of partnerships so that section 514(c)(9)(E)

is, effectively, applied on a property-by-property basis is not, in and

of itself, a tax avoidance purpose); and

(ii) The relevant partnerships can demonstrate under any reasonable

method that the relevant chains satisfy the requirements of paragraphs

(b)(2) through (k) of this section. For purposes of applying

Sec. 1.704-2(k) under the independent chain approach described in

Example 3 of paragraph (m)(2) of this section, allocations of items of

income or gain that may be made pursuant to a provision in the

partnership agreement that charges back minimum gain are taken into

account for purposes of the fractions rule only to the extent an

allocation is made.

(2) Examples. The following examples illustrate the provisions of

this paragraph (m).

Example 1. Tiered partnerships--collapsing approach. (i)

Qualified organization QO3 and taxable individual TP3 form upper-

tier partnership P2. The P2 partnership agreement allocates overall

partnership income 20 percent to QO3 and 80 percent to TP3. Overall

partnership loss is allocated 30 percent to QO3 and 70 percent to

TP3. P2 and taxable individual TP2 form lower-tier partnership P1.

The P1 partnership agreement allocates overall partnership income 60

percent to P2 and 40 percent to TP2. Overall partnership loss is

allocated 40 percent to P2 and 60 percent to TP2. The only asset of

P2 (which has no outstanding debt) is its interest in P1. P1

purchases real property with money contributed by its partners and

with borrowed money. There is no tax avoidance purpose for the use

of the tiered-ownership structure, which is illustrated by the

following diagram.

TR13MY94.006

(ii) P2 can demonstrate that the P2/P1 chain satisfies the

requirements of paragraphs (b)(2) through (k) of this section by

collapsing the tiered-partnership structure. On a collapsed basis,

QO3's fractions rule percentage is 12 percent (30 percent of 40

percent). See paragraph (c)(2) of this section. P2 satisfies the

fractions rule because QO3 may not be allocated more than 12 percent

(20 percent of 60 percent) of overall partnership income in any

taxable year.

Example 2. Tiered partnerships--entity-by-entity approach. (i)

Qualified organization QO3A is a partner with taxable individual

TP3A in upper-tier partnership P2A. Qualified organization QO3B is a

partner with taxable individual TP3B in upper-tier partnership P2B.

P2A, P2B, and taxable individual TP2 are partners in lower-tier

partnership P1, which owns encumbered real estate. None of QO3A,

QO3B, TP3A, TP3B or TP2 has a direct or indirect ownership interest

in each other. P2A has been established for the purpose of investing

in numerous real estate properties independently of P2B and its

partners. P2B has been established for the purpose of investing in

numerous real estate properties independently of P2A and its

partners. Neither P2A nor P2B has outstanding debt. There is no tax

avoidance purpose for the use of the tiered-ownership structure,

which is illustrated by the following diagram.

TR13MY94.007

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(ii) The P2A/P1 chain (Chain A) will satisfy the fractions rule

if P1 and P2A can demonstrate in a reasonable manner that they

satisfy the requirements of paragraphs (b)(2) through (k) of this

section. The P2B/P1 chain (Chain B) will satisfy the fractions rule

if P1 and P2B can demonstrate in a reasonable manner that they

satisfy the requirements of paragraphs (b)(2) through (k) of this

section. To meet its burden, P1 treats P2A and P2B as qualified

organizations. Provided that the allocations that may be made by P1

would satisfy the fractions rule if P2A and P2B were direct

qualified organization partners in P1, Chain A will satisfy the

fractions rule (for the benefit of QO3A) if the allocations that may

be made by P2A satisfy the requirements of paragraphs (b)(2) through

(k) of this section. Similarly, Chain B will satisfy the fractions

rule (for the benefit of QO3B) if the allocations that may be made

by P2B satisfy the requirements of paragraphs (b)(2) through (k) of

this section. Under these facts, QO3A does not have to know how

income and loss may be allocated by P2B, and QO3B does not have to

know how income and loss may be allocated by P2A. QO3A's and QO3B's

burden would not change even if TP2 were not a partner in P1.

Example 3. Tiered partnerships--independent chain approach. (i)

Qualified organization QO3 and taxable corporation TP3 form upper-

tier partnership P2. P2 and taxable corporation TP2 form lower-tier

partnership P1A. P2 and qualified organization QO2 form lower-tier

partnership P1B. P2 has no outstanding debt. P1A and P1B each

purchase real property with money contributed by their respective

partners and with borrowed money. Each partnership's real property

is completely unrelated to the real property owned by the other

partnership. P1B's allocations do not satisfy the requirements of

paragraphs (b)(2) through (k) of this section because of allocations

that may be made to QO2. However, if P2's interest in P1B were

completely disregarded, the P2/P1A chain would satisfy the

requirements of paragraphs (b)(2) through (k) of this section. There

is no tax avoidance purpose for the use of the tiered-ownership

structure, which is illustrated by the following diagram.

TR13MY94.008

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(ii) P2 satisfies the fractions rule with respect to the P2/P1A

chain, but only if the P2 partnership agreement allocates those

items allocated to P2 by P1A separately from those items allocated

to P2 by P1B. For this purpose, allocations of items of income or

gain that may be made pursuant to a provision in the partnership

agreement that charges back minimum gain, are taken into account for

purposes of the fractions rule only to the extent an allocation is

made. See paragraph (m)(1)(ii) of this section. P2 does not satisfy

the fractions rule with respect to the P2/P1B chain.

(n) Effective date--(1) In general. Section 514(c)(9)(E), as

amended by sections 2004(h) (1) and (2) of the Technical and

Miscellaneous Revenue Act of 1988, Pub. L. 100-647, applies generally

with respect to property acquired by partnerships after October 13,

1987, and to partnership interests acquired after October 13, 1987.

(2) General effective date of the regulations. Section 1.514(c)-2

(a) through (m) applies with respect to partnership agreements entered

into after December 30, 1992, property acquired by partnerships after

December 30, 1992, and partnership interests acquired by qualified

organizations after December 30, 1992 (other than a partnership

interest that at all times after October 13, 1987, and prior to the

acquisition was held by a qualified organization). For this purpose,

paragraphs (a) through (m) of this section will be treated as satisfied

with respect to partnership agreements entered into on or before May

13, 1994, property acquired by partnerships on or before May 13, 1994,

and partnership interests acquired by qualified organizations on or

before May 13, 1994, if the guidance set forth in (paragraphs (a)

through (m) of Sec. 1.514(c)-2 of) PS-56-90, published at 1993-5 I.R.B.

42, February 1, 1993, is satisfied. (See Sec. 601.601(d)(2)(ii)(b) of

this chapter).

(3) Periods after June 24, 1990, and prior to December 30, 1992. To

satisfy the requirements of section 514(c)(9)(E) with respect to

partnership agreements entered into after June 24, 1990, property

acquired by partnerships after June 24, 1990, and partnership interests

acquired by qualified organizations after June 24, 1990, (other than a

partnership interest that at all times after October 13, 1987, and

prior to the acquisition was held by a qualified organization) to which

paragraph (n)(2) of this section does not apply, paragraphs (a) through

(m) of this section must be satisfied as of the first day that section

514(c)(9)(E) applies with respect to the partnership, property, or

acquired interest. For this purpose, paragraphs (a) through (m) of this

section will be treated as satisfied if the guidance in sections I

through VI of Notice 90-41, 90-1 C.B. 350, (see

Sec. 601.601(d)(2)(ii)(b) of this chapter) has been followed.

(4) Periods prior to the issuance of Notice 90-41. With respect to

partnerships commencing after October 13, 1987, property acquired by

partnerships after October 13, 1987, and partnership interests acquired

by qualified organizations after October 13, 1987, to which neither

paragraph (n)(2) nor (n)(3) of this section applies, the Internal

Revenue Service will not challenge an interpretation of section

514(c)(9)(E) that is reasonable in light of the underlying purposes of

section 514(c)(9)(E) (as reflected in its legislative history) and that

is consistently applied as of the first day that section 514(c)(9)(E)

applies with respect to the partnership, property, or acquired

interest. A reasonable interpretation includes an interpretation that

substantially follows the guidance in either sections I through VI of

Notice 90-41, (see Sec. 601.601(d)(2)(ii)(b) of this chapter) or

paragraphs (a) through (m) of this section.

(5) Material modifications to partnership agreements. A material

modification will cause a partnership agreement to be treated as a new

partnership agreement in appropriate circumstances for purposes of this

paragraph (n).

Margaret Milner Richardson,

Commissioner of Internal Revenue.

Approved: April 21, 1994.

Leslie Samuels,

Assistant Secretary of the Treasury.

[FR Doc. 94-11612 Filed 5-11-94; 8:45 am]

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