Termination of a Partnership under Section 708(b)(1)(B)

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[PS-5-96]

RIN 1545-AU14

Termination of a Partnership under Section 708(b)(1)(B)

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations relating to the

termination of a partnership upon the sale or exchange of 50 percent or

more of the total interest in partnership capital and profits. The

proposed regulations affect all partners and partnerships that

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

DATES: Written comments and requests to speak (with outlines of oral

comments) at a public hearing scheduled for September 5, 1996, must be

received by August 15, 1996.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (PS-5-96), room 5228,

Internal Revenue Service, POB 7604, Ben Franklin Station, Washington,

DC 20044. In the alternative, submissions may be hand delivered between

the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (PS-5-96), Courier's

Desk, Internal Revenue Service, 1111 Constitution Avenue, NW.,

Washington, DC. The public hearing will be held in the IRS Auditorium,

Seventh Floor, 7400 Corridor, Internal Revenue Building, 1111

Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations,

Steven R. Schneider, (202) 622-3060; concerning submissions and the

hearing, Christina Vasquez, (202) 622-7190; (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Introduction

This document proposes to revise section 1.708-1(b)(1)(iv) of the

Income

[[Page 21986]]

Tax Regulations (26 CFR Part 1) under section 708(b)(1)(B) of the

Internal Revenue Code (Code). This document also proposes revisions to

other sections of the Income Tax Regulations to reflect the proposed

revision to Sec. 1.708- 1(b)(1)(iv).

Background

Section 708(b)(1)(B) provides that, for purposes of section 708(a),

a partnership shall be considered terminated if within a 12-month

period there is a sale or exchange of 50 percent or more of the total

interest in partnership capital and profits. The Code and the

legislative history to section 708(b)(1)(B) do not specify the tax

consequences of that termination or the steps by which such a

termination occurs.

However, Sec. 1.708-1(b)(1)(iv) of the Income Tax Regulations

provides that, if a partnership is terminated by a sale or exchange of

an interest, the following is deemed to occur: the partnership

distributes its properties to the purchaser and the other remaining

partners in proportion to their respective interests in the partnership

properties; and, immediately thereafter, the purchaser and the other

remaining partners contribute the properties to a new partnership,

either for the continuation of the business or for its dissolution and

winding up.

The distribution of property that is deemed to occur upon a

termination under section 708(b)(1)(B) is treated like an actual

distribution for federal tax purposes. As a result, a continuing

partner may recognize gain under section 731(a) if the amount of money

deemed distributed to the partner (including any money deemed

distributed upon a shift in liabilities under section 752) exceeds the

partner's basis in the partnership interest. In addition, the

distribution may affect the basis of the partnership's assets because

the basis of the distributed property in the hands of the partners (and

thus in the hands of the reconstituted partnership) is determined under

section 732(b) by reference to the partners' bases in their partnership

interests. Another possible consequence of the deemed distribution is a

change in the holding periods of the partners' interests in the

partnership.

The deemed distribution of partnership property that occurs on a

termination raises particular concerns with respect to the interaction

of sections 708(b)(1)(B), 704(c), and 737. Section 704(c)(1)(A)

requires that gain or loss with respect to property contributed to a

partnership by a partner be shared among the partners so as to take

into account any built-in gain or loss in the property at the time of

the contribution. Section 704(c)(1)(B) provides that, if property

contributed by a partner is distributed to another partner within five

years, 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. Section 737 provides that, if property is distributed to a

partner that had contributed other property to the partnership within

five years, the distributee partner must recognize gain equal to 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. Net precontribution gain is the net gain, if any, that

would have been recognized by the distributee partner under section

704(c)(1)(B) if all partnership property contributed by the distributee

partner within five years of the distribution had been distributed to

another partner.

The legislative history of sections 704(c)(1)(B) and 737 indicates

that Congress intended these sections to be coordinated with the rules

governing partnership terminations under section 708(b)(1)(B). The

legislative history states that such coordination will provide that (1)

no gain is recognized under sections 704(c)(1)(B) and 737 as a result

of a deemed distribution on termination; (2) the deemed distribution

will not change the application of the sharing requirements of section

704(c) to precontribution gain or loss with respect to property

contributed to the partnership before the termination; and (3) the

constructive contribution of partnership property to a new partnership

is treated as beginning a new five-year period for all contributed

property to the extent that the pretermination appreciation in the

value of property was not already required to be allocated to the

original contributor (if any) of the property. H.R. Rep. No. 247, 101st

Cong., 1st Sess. 1355 (1989); H.R. Conf. Rep. No. 1018, 102d Cong., 2d

Sess. 428 (1992). These results are difficult to integrate with the

current regulations under section 708(b)(1)(B). The difficulty arises

primarily because the section 708(b)(1)(B) regulations provide for a

pro rata distribution of property to the partners, while the

legislative history seems to contemplate that partnership property

previously contributed to the partnership by a partner will be

distributed to that partner, at least to the extent of the remaining

built-in gain or loss in the property.

The IRS and Treasury Department recently issued final regulations

under sections 704(c)(1)(B) and 737. Commentators, however, noted that

the approach taken in the legislative history and the final regulations

would not be required if the section 708(b)(1)(B) regulations did not

create a deemed distribution of partnership property to the partners as

part of a section 708(b)(1)(B) termination. The preamble to the final

regulations indicated that the IRS and Treasury would consider issuing

separate guidance on the interaction of sections 704(c) and

708(b)(1)(B) and invited additional comments and suggestions regarding

the project.

Explanation of Provisions

The proposed regulations under section 708(b)(1)(B) provide that,

if a partnership is terminated by a sale or exchange of an interest,

the following is deemed to occur: the partnership transfers all of its

assets and liabilities to a new partnership in exchange for an interest

in the new partnership; immediately thereafter, the terminated

partnership distributes interests in the new partnership to the

purchasing partner and the other remaining partners in liquidation of

the terminated partnership, either for the continuation of the business

or for its dissolution and winding up.

Under the proposed regulations, a termination under section

708(b)(1)(B) will no longer result in a deemed distribution of the

terminated partnership's assets to the purchasing and remaining

partners. As a result, the federal tax consequences of a termination

that result from the deemed distribution of assets will no longer occur

on a section 708(b)(1)(B) termination. Such consequences include the

possibility of gain under section 731(a), a change in the partnership's

basis in partnership property, and the commencement of a new five-year

period for purposes of sections 704(c)(1)(B) and 737. In addition, the

interaction between section 704(c) and section 708(b)(1)(B) is greatly

simplified under the proposed regulation. The section 704(c) property

held by the terminated partnership (and deemed contributed to a new

partnership) will continue to be treated as section 704(c) property in

the hands of the new partnership under Sec. 1.704-3(a)(9). A

distribution of property by the new partnership will have the same

effect for purposes of section 704(c)(1)(B) and section 737 as a

distribution from the terminated partnership. See Secs. 1.704-

[[Page 21987]]

4(c)(4) and 1.737-2(b)(1) as proposed to be amended by this document.

The proposed regulations do not change the federal tax consequences

of a termination under section 708(b)(1)(B) to the extent that the

consequences were not dependent on the deemed distribution. Such

consequences will continue under the proposed regulations. For example,

the tax year of the terminated partnership will still close as a result

of the termination, the elections of the terminated partnership will be

invalidated, and a termination will continue to be treated as a

liquidation under the section 704(b) regulations.

In addition, the proposed regulations will not change the effect of

a termination on the depreciation of partnership property by the new

partnership. Property deemed contributed to the new partnership will

continue to be subject to the anti- churning provisions of section

168(f)(5), which generally require the new partnership to depreciate

the property as if it were newly acquired property under the same

depreciation system used by the terminated partnership. This result is

required by statute and is not affected by the specific mechanics of a

termination under section 708(b)(1)(B). See Code sections 168(f)(5);

168(i)(7); 168(e)(4) and (f)(10) (repealed 1986).

This document also contains proposed regulations under sections

704(b), 704(c)(1)(B), 743(b), 737, and 761(e). These proposed

regulations relate to the elimination of a deemed distribution of

partnership assets as part of a section 708(b)(1)(B) termination. The

proposed regulations under section 704(b) will eliminate the reference

to a deemed contribution of partnership property by the partners of the

continuing partnership. The proposed regulations under sections

704(c)(1)(B) and 737 provide that a termination under section

708(b)(1)(B) does not commence a new five-year period for partnership

property and that a distribution of property by the new partnership

will be treated in the same manner as a distribution by the terminated

partnership would have been treated. Although the legislative history

suggests the beginning of a new five year period for built in gain or

loss in the property deemed contributed to the new partnership, that

legislative history was commenting on a deemed contribution of property

by the partners to the new partnership, as then required by the section

708 regulations. Under the approach proposed in this regulation, a new

five year period is no longer appropriate.

The proposed regulations under section 743(b) provide that any

special basis adjustment a partner has in assets of the terminated

partnership as a result of a section 754 election will carry over to

the new partnership. The proposed regulations under section 761(e)

provide that the distribution of interests in the new partnership by

the terminated partnership is not treated as a sale or exchange of the

interests in the new partnership. This provision is necessary to

prevent the distribution of interests in the new partnership from

causing a termination of the new partnership.

Proposed Effective Date

This section is proposed to apply to terminations of partnerships

under section 708(b)(1)(B) occurring on or after the date on which

these regulations are published as final regulations in the Federal

Register.

Special Analyses

It has been determined that this notice of proposed rulemaking 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, this notice of proposed rulemaking will be

submitted to the Chief Counsel for Advocacy of the Small Business

Administration for comment on its impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any written comments (a signed original

and eight (8) copies) that are timely submitted to the IRS. All

comments will be available for public inspection and copying.

A public hearing has been scheduled for September 5, 1996, at 10

a.m. in the Auditorium of the Internal Revenue Building, 1111

Constitution Avenue NW., Washington, DC. Because of access

restrictions, visitors will not be admitted beyond the Internal Revenue

Building lobby more than 15 minutes before the hearing starts.

The rules of 26 CFR 601.601(a)(3) apply to the hearing.

Persons that wish to present oral comments at the hearing must

submit written comments by August 15, 1996, and submit an outline of

the topics to be discussed and the time to be devoted to each topic

(signed original and eight (8) copies) by August 15, 1996.

A period of 10 minutes will be allotted to each person for making

comments.

An agenda showing the scheduling of the speakers will be prepared

after the deadline for receiving outlines has passed. Copies of the

agenda will be available free of charge at the hearing.

Drafting Information

The principal author of these regulations is Steven R. Schneider of

the Office of Assistant Chief Counsel (Passthroughs and Special

Industries), IRS. 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.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in

part as follows:

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

Section 1.704-4 also issued under 26 U.S.C. 704(c). * * *

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

1. Paragraph (b)(2)(iv)(l) is amended by removing the fourth

sentence.

2. Paragraph (b)(5) Example 13(v) is amended by removing sentences

five to the end and adding five new sentences in their place.

The revisions and addition read as follows:

Sec. 1.704-1 Partner's distributive share.

* * * * *

(b) * * *

(5) * * *

Example 13. * * *

(v) * * * In accordance with paragraph (b)(2)(iv)(e) of this

section, the partnership agreement provides that the partners'

capital accounts are adjusted to reflect how unrealized taxable gain

would have been allocated if the property distributed to the

partners in liquidation of the partnership (i.e., the interest in

the new partnership constructively received by the terminated

partnership under Sec. 1.708-1(b)(1)(iv)) had been sold for its fair

market value of $40,000. Accordingly, the $18,000 of unrealized gain

($40,000 less $22,000 adjusted tax basis) is credited to the

partners' capital accounts as follows:

[[Page 21988]]

Z LK

Capital account following sale.................... $11,000 $11,000

Deemed sale adjustment............................ 9,000 9,000

---------------------

Capital account before constructive liquidation... 20,000 20,000

Constructive liquidating distributions of the interests in the new

partnership are made with reference to its $40,000 fair market

value. Under section 732(b), the adjusted tax basis of the 50

percent interest in the new partnership constructively distributed

to Z is equal to the $11,000 adjusted tax basis of Z's partnership

interest before the constructive liquidation, and the adjusted tax

basis of the 50 percent interest in the new partnership

constructively distributed to LK is equal to the $20,000 adjusted

tax basis of LK's partnership interest before the constructive

liquidation. Under paragraph (b)(2)(iv)(d) of this section, the

capital account of the terminated partnership with respect to the

new partnership would be $40,000 (i.e., the fair market value of the

property constructively contributed to the new partnership by the

terminated partnership). The capital accounts of Z and LK with

respect to the constructively distributed interests in the new

partnership are stated at $20,000 (i.e., one-half of the $40,000

capital account of the terminated partnership). This Example 13(v)

applies to terminations of partnerships under section 708(b)(1)(B)

occurring on or after the date on which these regulations are

published as final regulations in the Federal Register.

* * * * *

Par. 3. Section 1.704-4 is amended by revising paragraphs

(a)(4)(ii) and (c)(3) to read as follows:

Sec. 1.704-4 Distribution of contributed property.

(a) * * *

(4) * * *

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

partnership under section 708(b)(1)(B) does not begin a new five-year

period for each partner with respect to the built-in gain and built-in

loss property that the terminated partnership is deemed to contribute

to a new partnership following the termination. See Sec. 1.704-

3(a)(3)(ii) for the definitions of built-in gain and built-in loss on

section 704(c) property. This paragraph (a)(4)(ii) applies to

terminations of partnerships under section 708(b)(1)(B) occurring on or

after the date on which these regulations are published as final

regulations in the Federal Register.

* * * * *

(c) * * *

(3) Section 708(b)(1)(B) terminations. Section 704(c)(1)(B) and

this section do not apply to a deemed distribution of interests in a

new partnership caused by a termination of a partnership under section

708(b)(1)(B). A subsequent distribution of section 704(c) property by

the new partnership to a partner of the new partnership is subject to

section 704(c)(1)(B) to the same extent that a distribution by the

terminated partnership would have been subject to section 704(c)(1)(B).

See also Sec. 1.737-2(a) for a similar rule in the context of section

737. This paragraph (c)(3) applies to terminations of partnerships

under section 708(b)(1)(B) occurring on or after the date on which

these regulations are published as final regulations in the Federal

Register.

* * * * *

Par. 4. In Sec. 1.708-1, paragraph (b)(1)(iv) is amended by

removing the first sentence and adding two new sentences in its place

to read as follows:

Sec. 1.708-1 Continuation of Partnership.

* * * * *

(b) * * *

(1) * * *

(iv) If a partnership is terminated by a sale or exchange of an

interest, the following is deemed to occur: The partnership transfers

all of its assets and liabilities to a new partnership in exchange for

an interest in the new partnership; and, immediately thereafter, the

terminated partnership distributes an interest in the new partnership

to the purchasing partner and the other remaining partners in

liquidation of the terminated partnership, either for the continuation

of the business of the new partnership or for its dissolution and

winding up. The first sentence of this paragraph (b)(1)(iv) applies to

terminations of partnerships under section 708(b)(1)(B) occurring on or

after the date on which these regulations are published as final

regulations in the Federal Register. * * *

* * * * *

Par. 5. Section 1.743-1 is amended by adding paragraph (d) as

follows:

Sec. 1.743-1 Optional adjustment to basis of partnership property.

* * * * *

(d) Section 708(b)(1)(B) terminations. A partner with a special

basis adjustment in property held by a partnership that terminates

under section 708(b)(1)(B) will continue to have the same special basis

adjustment with respect to property contributed by the terminated

partnership to the new partnership under Sec. 1.708-1(b)(1)(iv). This

paragraph (d) applies to terminations of partnerships under section

708(b)(1)(B) occurring on or after the date on which these regulations

are published as final regulations in the Federal Register.

Par. 6. In Sec. 1.737-2, paragraph (a) is revised to read as

follows:

Sec. 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 interests in a new partnership

caused by a termination of a partnership under section 708(b)(1)(B). A

subsequent distribution of section 704(c) property by the new

partnership to a partner of the new partnership is subject to section

737 to the same extent that a distribution by the terminated

partnership would have been subject to section 737. See also

Sec. 1.704-4(c)(3) for a similar rule in the context of section

704(c)(1)(B). This paragraph (a) applies to terminations of

partnerships under section 708(b)(1)(B) occurring on or after the date

on which these regulations are published as final regulations in the

Federal Register.

* * * * *

Par 7. In Sec. 1.761-1, paragraph (e) is added to read as follows:

Sec. 1.761-1 Terms defined.

* * * * *

(e) Distribution of partnership interest. For purposes of section

708(b)(1)(B) and Sec. 1.708-1(b)(1)(iv), the distribution of an

interest in a new partnership by a partnership that terminates under

section 708(b)(1)(B) is not a sale or exchange of an interest in the

new partnership. This paragraph (e) applies to terminations of

partnerships under section 708(b)(1)(B) occurring on or after the date

on which these regulations are published as final regulations in the

Federal Register.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

[FR Doc. 96-11779 Filed 5-9-96; 8:45 am]

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