Distribution of Marketable Securities by a Partnership

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8707]

RIN 1545-AT19

Distribution of Marketable Securities by a Partnership

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations providing rules for

partnership distributions of marketable securities under section 731(c)

of the

[[Page 67937]]

Internal Revenue Code of 1986, as amended, and for determining when

those distributions are taxable to the distributee partner. The

regulations reflect changes to the law made by the Uruguay Round

Agreements Act enacted on December 8, 1994.

DATES: These regulations are effective on December 26, 1996.

FOR FURTHER INFORMATION CONTACT: Terri A. Belanger or William M. Kostak

at (202) 622-3080 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

This document amends 26 CFR part 1 to provide rules relating to the

treatment of partnership distributions of marketable securities under

section 731(c). Under section 731(a), in the case of a distribution by

a partnership to a partner, gain is recognized to the partner only to

the extent that any money distributed exceeds the adjusted basis of the

partner's interest in the partnership. Prior to the enactment of

section 731(c), marketable securities were not considered money and,

therefore, the distribution of marketable securities by a partnership

to a partner was not a taxable event. Section 731(c) now treats a

partnership distribution of marketable securities as a distribution of

money and as a taxable event if the value of the distributed securities

exceeds the adjusted basis of the partner's interest in the

partnership. Section 731(c) also provides several exceptions to the

general rule that a distribution of marketable securities will be

treated as a distribution of money.

On January 2, 1996, the IRS published in the Federal Register (61

FR 28) a notice of proposed rulemaking (PS-2-95) to provide guidance

regarding section 731(c). A number of public comments were received

concerning the proposed regulations. However, the public hearing

scheduled for April 3, 1996, was cancelled because no one requested to

speak. After consideration of the written comments received, the

proposed regulations are adopted as revised by this Treasury decision.

Explanation of Provisions

I. General Background

The proposed regulations provide rules for determining when and the

extent to which a distribution of marketable securities by a

partnership to a partner will be treated as a distribution of money for

purposes of section 731(a). Although modified in response to comments,

the final regulations generally adopt the rules contained in the

proposed regulations.

II. Public Comments

Several comments requested that the IRS reconsider the requirement

in Sec. 1.731-2(d) (2)(ii) of the proposed regulations that a

marketable security must be actively traded on the date of distribution

to qualify for the ``nonrecognition transaction'' exception to section

731(c). Because of this rule, financial instruments (securities) that

are treated as marketable securities under section 731(c)(2)(B) on the

date of distribution, but that are not actively traded, would not

qualify for this exception. Commentators suggested that the final

regulations should not include this requirement or should include a

more narrowly drafted provision. In response to these comments, the

final regulations provide that a security that falls within the

definition of marketable security may qualify for the exceptions under

Sec. 1.731-2(d) of the final regulations even if the security is not

actively traded on the date of distribution. An anti-stuffing rule has

been added to address the concern to which the actively-traded

requirement of the proposed regulations was directed.

Several comments also suggested that Sec. 1.731-2(d)(2) of the

proposed regulations should allow a de minimis amount of cash and

marketable securities to be transferred in a nonrecognition

transaction. The final regulations provide that if the value of money

and marketable securities transferred in a nonrecognition transaction

is less than 20 percent of the total amount of all property transferred

in exchange for the distributed security, the entire value of the

distributed security will qualify for the nonrecognition transaction

exception under Sec. 1.731-2(d)(1)(ii) of the final regulations.

Several commentators also suggested that the five-year rules of

Sec. 1.731-2(d)(2) and (3) of the proposed regulations be eliminated.

Section 1.731-2(d)(2) of the proposed regulations provided that a

marketable security that was acquired in a nonrecognition transaction

in exchange for other property and distributed within five years by the

partnership would not be subject to section 731(c). Section 1.731-

2(d)(3) of the proposed regulations provided that a marketable security

that was acquired by the partnership before it became actively traded

would also not be subject to section 731(c) if it was distributed by

the partnership within five years of becoming actively traded. One

commentator, for example, argued that a security is no less a

substitute for the underlying assets in a nonrecognition transaction

after five years than before five years. These five-year rules were

included in the proposed regulations because of administrative

concerns. For example, it may be difficult, after the passage of many

years, for taxpayers or the IRS to determine the circumstances in which

a partnership acquired a particular security. Moreover, it is not clear

whether certain exceptions should apply to a distribution of securities

if those securities were acquired by a partnership many years ago and

are now distributed to a partner who was not a partner at the time the

securities were acquired. These administrative concerns remain valid,

and a five year time limitation provides a reasonable and simple

solution to such problems. Therefore, the final regulations retain both

five-year rules.

One comment requested clarification regarding whether a section

708(b)(1)(B) termination affects a partnership's qualification for the

exceptions under Sec. 1.731-2 (d) and (e) of the regulations. Another

commentator suggested that the regulations be modified to provide that

marketable securities will not be treated as money when there is a

deemed distribution of marketable securities by the terminating

partnership as the result of a section 708(b)(1)(B) termination. In

response to these comments, the final regulations provide that a

section 708(b)(1)(B) termination does not have any effect on a

partnership's qualification for the exceptions under section 731(c). In

addition, a deemed distribution occurring as a result of a section

708(b)(1)(B) termination will not be subject to section 731(c).

Several comments suggested that the 10-percent test in the

investment partnership look-through rule under Sec. 1.731-2(e)(4) of

the proposed regulations should be modified or eliminated. A

partnership can qualify for the investment partnership exception only

if it has never been engaged in a trade or business and substantially

all of its assets are investment assets. Under the proposed

regulations, a partnership is treated as engaged in a trade or business

engaged in by, or as holding a proportionate share of the assets of, a

lower-tier partnership in which the partnership holds a partnership

interest unless the upper-tier partnership does not participate in the

management of the lower-tier partnership and the interest held by the

upper-tier partnership is less than 10 percent of the total profits and

capital interests in the lower-tier partnership. According to the

comments, the requirement that the upper-tier partnership not

participate in

[[Page 67938]]

the management of the lower-tier partnership should be sufficient to

ensure passive ownership of the interest in the lower-tier partnership.

The commentators further argued that ownership of more than 10 percent

of the capital and profits interest in a lower-tier partnership may

still be consistent with passive ownership. After consideration of

these comments, the final regulations modify the rule in the proposed

regulations to increase the threshold ownership percentage amount from

10 to 20 percent.

In response to a comment, the final regulations clarify that an

interest in a lower-tier partnership that qualifies for the exception

to the investment partnership ``look-through'' rule is treated as

eligible property for purposes of determining whether the partner who

contributed the lower-tier partnership interest is an eligible partner

of the upper-tier investment partnership.

One commentator recommended that the regulations include an example

that illustrates the section 732(a)(2) ordering rules for distributions

that include money, marketable securities and other property, and to

clarify whether marketable securities are treated as money for purposes

of section 732(a)(2). Because the statute and the regulations provide

that marketable securities are treated as money only for purposes of

sections 731(a)(1) and 737, no additional examples are necessary.

One comment suggested that the effective date of the regulations

should be the same as the effective date of section 731(c) because the

regulations contain guidance for the various exceptions provided for by

the Internal Revenue Code. In response to this comment, the final

regulations provide that, for the period between the effective date of

the statutory provision and the effective date of these regulations,

taxpayers may apply the rules contained in these regulations. Another

comment suggested that the final regulations should make clear that the

rules in the investment partnership exception apply with respect to all

property contributed to, or held by, a partnership at any time

(including any period prior to the enactment of section 731(c)). The

IRS and Treasury believe that this is sufficiently clear from the

statutory language, and an explicit statement to this effect in these

regulations is not necessary and may be confusing.

One comment requested that the regulations provide several examples

illustrating abusive transactions intended to be covered by the anti-

abuse rules of Sec. 1.731-2(h), and that these rules be coordinated

with the general anti-abuse rules of Sec. 1.701-2. After consideration

of this comment, it has been determined that the text of the

regulations adequately describes several situations that would be

considered abusive under these rules, and that additional examples are

unnecessary.

In response to several comments, the final regulations clarify that

the 90 percent test of Sec. 1.731-2(c)(2)(i) and the 20 percent test of

Sec. 1.731-2(c)(2)(ii) are determined using the gross value of the

entity's assets, disregarding any debt that may encumber or otherwise

be allocable to those assets, other than debt that is incurred to

acquire property with a principal purpose of avoiding or reducing the

effect of section 731(c).

Finally, the regulations clarify the interaction of the limitation

on gain rule in section 731(c)(3)(B) and the various exceptions listed

in paragraph (d). The regulations provide that any gain or loss on a

distributed security that qualifies for an exception is not taken into

account in determining the distributee partner's limitation on gain.

III. Effective Dates

In general, section 731(c) applies to distributions made after

December 8, 1994. These regulations are effective for distributions

made on or after December 26, 1996. However, taxpayers may apply the

rules of this section to distributions made after December 8, 1994, and

before December 26, 1996.

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)

does not apply to these regulations, and because the notice of proposed

rulemaking preceding the regulations was issued prior to March 29,

1996, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not

apply. 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 authors of these regulations are Terri A. Belanger

and William M. Kostak, 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.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

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

an entry in numerical order to read as follows:

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

Section 1.731-2 also issued under 26 U.S.C. 731(c). * * *

Par. 2. Section 1.731-2 is added to read as follows:

Sec. 1.731-2 Partnership distributions of marketable securities.

(a) Marketable securities treated as money. Except as otherwise

provided in section 731(c) and this section, for purposes of sections

731(a)(1) and 737, the term money includes marketable securities and

such securities are taken into account at their fair market value as of

the date of the distribution.

(b) Reduction of amount treated as money--(1) Aggregation of

securities. For purposes of section 731(c)(3)(B) and this paragraph

(b), all marketable securities held by a partnership are treated as

marketable securities of the same class and issuer as the distributed

security.

(2) Amount of reduction. The amount of the distribution of

marketable securities that is treated as a distribution of money under

section 731(c) and paragraph (a) of this section is reduced (but not

below zero) by the excess, if any, of--

(i) The distributee partner's distributive share of the net gain,

if any, which would be recognized if all the marketable securities held

by the partnership were sold (immediately before the transaction to

which the distribution relates) by the partnership for fair market

value; over

(ii) The distributee partner's distributive share of the net gain,

if any, which is attributable to the marketable securities held by the

partnership immediately after the transaction, determined by using the

same fair market value as used under paragraph (b)(2)(i) of this

section.

(3) Distributee partner's share of net gain. For purposes of

section 731(c)(3)(B) and paragraph (b)(2) of this section, a partner's

distributive share of net gain is determined--

(i) By taking into account any basis adjustments under section

743(b) with respect to that partner;

[[Page 67939]]

(ii) Without taking into account any special allocations adopted

with a principal purpose of avoiding the effect of section 731(c) and

this section; and

(iii) Without taking into account any gain or loss attributable to

a distributed security to which paragraph (d)(1) of this section

applies.

(c) Marketable securities--(1) In general. For purposes of section

731(c) and this section, the term marketable securities is defined in

section 731(c)(2).

(2) Actively traded. For purposes of section 731(c) and this

section, a financial instrument is actively traded (and thus is a

marketable security) if it is of a type that is, as of the date of

distribution, actively traded within the meaning of section 1092(d)(1).

Thus, for example, if XYZ common stock is listed on a national

securities exchange, particular shares of XYZ common stock that are

distributed by a partnership are marketable securities even if those

particular shares cannot be resold by the distributee partner for a

designated period of time.

(3) Interests in an entity--(i) Substantially all. For purposes of

section 731(c)(2)(B)(v) and this section, substantially all of the

assets of an entity consist (directly or indirectly) of marketable

securities, money, or both only if 90 percent or more of the assets of

the entity (by value) at the time of the distribution of an interest in

the entity consist (directly or indirectly) of marketable securities,

money, or both.

(ii) Less than substantially all. For purposes of section

731(c)(2)(B)(vi) and this section, an interest in an entity is a

marketable security to the extent that the value of the interest is

attributable (directly or indirectly) to marketable securities, money,

or both, if less than 90 percent but 20 percent or more of the assets

of the entity (by value) at the time of the distribution of an interest

in the entity consist (directly or indirectly) of marketable

securities, money, or both.

(4) Value of assets. For purposes of section 731(c) and this

section, the value of the assets of an entity is determined without

regard to any debt that may encumber or otherwise be allocable to those

assets, other than debt that is incurred to acquire an asset with a

principal purpose of avoiding or reducing the effect of section 731(c)

and this section.

(d) Exceptions--(1) In general. Except as otherwise provided in

paragraph (d)(2) of this section, section 731(c) and this section do

not apply to the distribution of a marketable security if--

(i) The security was contributed to the partnership by the

distributee partner;

(ii) The security was acquired by the partnership in a

nonrecognition transaction, and the following conditions are

satisfied--

(A) The value of any marketable securities and money exchanged by

the partnership in the nonrecognition transaction is less than 20

percent of the value of all the assets exchanged by the partnership in

the nonrecognition transaction; and

(B) The partnership distributed the security within five years of

either the date the security was acquired by the partnership or, if

later, the date the security became marketable; or

(iii) The security was not a marketable security on the date

acquired by the partnership, and the following conditions are

satisfied--

(A) The entity that issued the security had no outstanding

marketable securities at the time the security was acquired by the

partnership;

(B) The security was held by the partnership for at least six

months before the date the security became marketable; and

(C) The partnership distributed the security within five years of

the date the security became marketable.

(2) Anti-stuffing rule. Paragraph (d)(1) of this section does not

apply to the extent that 20 percent or more of the value of the

distributed security is attributable to marketable securities or money

contributed (directly or indirectly) by the partnership to the entity

to which the distributed security relates after the security was

acquired by the partnership (other than marketable securities

contributed by the partnership that were originally contributed to the

partnership by the distributee partner). For purposes of this paragraph

(d)(2), money contributed by the distributing partnership does not

include any money deemed contributed by the partnership as a result of

section 752.

(3) Successor security. Section 731(c) and this section apply to

the distribution of a marketable security acquired by the partnership

in a nonrecognition transaction in exchange for a security the

distribution of which immediately prior to the exchange would have been

excepted under this paragraph (d) only to the extent that section

731(c) and this section otherwise would have applied to the exchanged

security.

(e) Investment partnerships--(1) In general. Section 731(c) and

this section do not apply to the distribution of marketable securities

by an investment partnership (as defined in section 731(c)(3)(C)(i)) to

an eligible partner (as defined in section 731(c)(3)(C)(iii)).

(2) Eligible partner--(i) Contributed services. For purposes of

section 731(c)(3)(C)(iii) and this section, a partner is not treated as

a partner other than an eligible partner solely because the partner

contributed services to the partnership.

(ii) Contributed partnership interests. For purposes of determining

whether a partner is an eligible partner under section 731(c)(3)(C), if

the partner has contributed to the investment partnership an interest

in another partnership that meets the requirements of paragraph

(e)(4)(i) of this section after the contribution, the contributed

interest is treated as property specified in section 731(c)(3)(C)(i).

(3) Trade or business activities. For purposes of section

731(c)(3)(C) and this section, a partnership is not treated as engaged

in a trade or business by reason of----

(i) Any activity undertaken as an investor, trader, or dealer in

any asset described in section 731(c)(3)(C)(i), including the receipt

of commitment fees, break-up fees, guarantee fees, director's fees, or

similar fees that are customary in and incidental to any activities of

the partnership as an investor, trader, or dealer in such assets;

(ii) Reasonable and customary management services (including the

receipt of reasonable and customary fees in exchange for such

management services) provided to an investment partnership (within the

meaning of section 731(c)(3)(C)(i)) in which the partnership holds a

partnership interest; or

(iii) Reasonable and customary services provided by the partnership

in assisting the formation, capitalization, expansion, or offering of

interests in a corporation (or other entity) in which the partnership

holds or acquires a significant equity interest (including the

provision of advice or consulting services, bridge loans, guarantees of

obligations, or service on a company's board of directors), provided

that the anticipated receipt of compensation for the services, if any,

does not represent a significant purpose for the partnership's

investment in the entity and is incidental to the investment in the

entity.

(4) Partnership tiers. For purposes of section 731(c)(3)(C)(iv) and

this section, a partnership (upper-tier partnership) is not treated as

engaged in a trade or business engaged in by, or as holding (instead of

a partnership interest) a proportionate share of the assets of, a

partnership (lower-tier partnership) in which the partnership holds a

partnership interest if----

(i) The upper-tier partnership does not actively and substantially

[[Page 67940]]

participate in the management of the lower-tier partnership; and

(ii) The interest held by the upper-tier partnership is less than

20 percent of the total profits and capital interests in the lower-tier

partnership.

(f) Basis rules--(1) Partner's basis--(i) Partner's basis in

distributed securities. The distributee partner's basis in distributed

marketable securities with respect to which gain is recognized by

reason of section 731(c) and this section is the basis of the security

determined under section 732, increased by the amount of such gain. Any

increase in the basis of the marketable securities attributable to gain

recognized by reason of section 731(c) and this section is allocated to

marketable securities in proportion to their respective amounts of

unrealized appreciation in the hands of the partner before such

increase.

(ii) Partner's basis in partnership interest. The basis of the

distributee partner's interest in the partnership is determined under

section 733 as if no gain were recognized by the partner on the

distribution by reason of section 731(c) and this section.

(2) Basis of partnership property. No adjustment is made to the

basis of partnership property under section 734 as a result of any gain

recognized by a partner, or any step-up in the basis in the distributed

marketable securities in the hands of the distributee partner, by

reason of section 731(c) and this section.

(g) Coordination with other sections--(1) Sections 704(c)(1)(B) and

737--(i) In general. If a distribution results in the application of

sections 731(c) and one or both of sections 704(c)(1)(B) and 737, the

effect of the distribution is determined by applying section

704(c)(1)(B) first, section 731(c) second, and finally section 737.

(ii) Section 704(c)(1)(B). The basis of the distributee partner's

interest in the partnership for purposes of determining the amount of

gain, if any, recognized by reason of section 731(c) (and for

determining the basis of the marketable securities in the hands of the

distributee partner) includes the increase or decrease, if any, in the

partner's basis that occurs under section 704(c)(1)(B)(iii) as a result

of a distribution to another partner of property contributed by the

distributee partner in a distribution that is part of the same

distribution as the marketable securities.

(iii) Section 737--(A) Marketable securities as other property. A

distribution of marketable securities is treated as a distribution of

property other than money for purposes of section 737 to the extent

that the marketable securities are not treated as money under section

731(c). In addition, marketable securities contributed to the

partnership are treated as property other than money in determining the

contributing partner's net precontribution gain under section 737(b).

(B) Basis increase under section 737. The basis of the distributee

partner's interest in the partnership for purposes of determining the

amount of gain, if any, recognized by reason of section 731(c) (and for

determining the basis of the marketable securities in the hands of the

distributee partner) does not include the increase, if any, in the

partner's basis that occurs under section 737(c)(1) as a result of a

distribution of property to the distributee partner in a distribution

that is part of the same distribution as the marketable securities.

(2) Section 708(b)(1)(B). If a partnership termination occurs under

section 708(b)(1)(B), the successor partnership will be treated as if

there had been no termination for purposes of section 731(c) and this

section. Accordingly, a section 708(b)(1)(B) termination will not

affect whether a partnership qualifies for any of the exceptions in

paragraphs (d) and (e) of this section. In addition, a deemed

distribution that may occur as a result of a section 708(b)(1)(B)

termination will not be subject to section 731(c) and this section.

(h) Anti-abuse rule. The provisions of section 731(c) and this

section must be applied in a manner consistent with the purpose of

section 731(c) and the substance of the transaction. Accordingly, if a

principal purpose of a transaction is to achieve a tax result that is

inconsistent with the purpose of section 731(c) and this section, the

Commissioner can recast the transaction for Federal tax purposes as

appropriate to achieve tax results that are consistent with the purpose

of section 731(c) and this section. Whether a tax result is

inconsistent with the purpose of section 731(c) and this section must

be determined based on all the facts and circumstances. For example,

under the provisions of this paragraph (h)--

(1) A change in partnership allocations or distribution rights with

respect to marketable securities may be treated as a distribution of

the marketable securities subject to section 731(c) if the change in

allocations or distribution rights is, in substance, a distribution of

the securities;

(2) A distribution of substantially all of the assets of the

partnership other than marketable securities and money to some partners

may also be treated as a distribution of marketable securities to the

remaining partners if the distribution of the other property and the

withdrawal of the other partners is, in substance, equivalent to a

distribution of the securities to the remaining partners; and

(3) The distribution of multiple properties to one or more partners

at different times may also be treated as part of a single distribution

if the distributions are part of a single plan of distribution.

(i) [Reserved]

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

section. Unless otherwise specified, all securities held by a

partnership are marketable securities within the meaning of section

731(c); the partnership holds no marketable securities other than the

securities described in the example; all distributions by the

partnership are subject to section 731(a) and are not subject to

sections 704(c)(1)(B), 707(a)(2)(B), 751(b), or 737; and no securities

are eligible for an exception to section 731(c). The examples are as

follows:

Example 1. Recognition of gain. (i) A and B form partnership AB

as equal partners. A contributes property with a fair market value

of $1,000 and an adjusted tax basis of $250. B contributes $1,000

cash. AB subsequently purchases Security X for $500 and immediately

distributes the security to A in a current distribution. The basis

in A's interest in the partnership at the time of distribution is

$250.

(ii) The distribution of Security X is treated as a distribution

of money in an amount equal to the fair market value of Security X

on the date of distribution ($500). (The amount of the distribution

that is treated as money is not reduced under section 731(c)(3)(B)

and paragraph (b) of this section because, if Security X had been

sold immediately before the distribution, there would have been no

gain recognized by AB and A's distributive share of the gain would

therefore have been zero.) As a result, A recognizes $250 of gain

under section 731(a)(1) on the distribution ($500 distribution of

money less $250 adjusted tax basis in A's partnership interest).

Example 2. Reduction in amount treated as money--in general. (i)

A and B form partnership AB as equal partners. AB subsequently

distributes Security X to A in a current distribution. Immediately

before the distribution, AB held securities with the following fair

market values, adjusted tax bases, and unrecognized gain or loss:

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

Gain

Value Basis (Loss)

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

Security X................................... 100 70 30

Security Y................................... 100 80 20

Security Z................................... 100 110 (10)

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

(ii) If AB had sold the securities for fair market value

immediately before the distribution to A, the partnership would have

[[Page 67941]]

recognized $40 of net gain ($30 gain on Security X plus $20 gain on

Security Y minus $10 loss on Security Z). A's distributive share of

this gain would have been $20 (one-half of $40 net gain). If AB had

sold the remaining securities immediately after the distribution of

Security X to A, the partnership would have $10 of net gain ($20 of

gain on Security Y minus $10 loss on Security Z). A's distributive

share of this gain would have been $5 (one-half of $10 net gain). As

a result, the distribution resulted in a decrease of $15 in A's

distributive share of the net gain in AB's securities ($20 net gain

before distribution minus $5 net gain after distribution).

(iii) Under paragraph (b) of this section, the amount of the

distribution of Security X that is treated as a distribution of

money is reduced by $15. The distribution of Security X is therefore

treated as a distribution of $85 of money to A ($100 fair market

value of Security X minus $15 reduction).

Example 3. Reduction in amount treated as money--carried

interest. (i) A and B form partnership AB. A contributes $1,000 and

provides substantial services to the partnership in exchange for a

60 percent interest in partnership profits. B contributes $1,000 in

exchange for a 40 percent interest in partnership profits. AB

subsequently distributes Security X to A in a current distribution.

Immediately before the distribution, AB held securities with the

following fair market values, adjusted tax bases, and unrecognized

gain:

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

Value Basis Gain

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

Security X................................... 100 80 20

Security Y................................... 100 90 10

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

(ii) If AB had sold the securities for fair market value

immediately before the distribution to A, the partnership would have

recognized $30 of net gain ($20 gain on Security X plus $10 gain on

Security Y). A's distributive share of this gain would have been $18

(60 percent of $30 net gain). If AB had sold the remaining

securities immediately after the distribution of Security X to A,

the partnership would have $10 of net gain ($10 gain on Security Y).

A's distributive share of this gain would have been $6 (60 percent

of $10 net gain). As a result, the distribution resulted in a

decrease of $12 in A's distributive share of the net gain in AB's

securities ($18 net gain before distribution minus $6 net gain after

distribution).

(iii) Under paragraph (b) of this section, the amount of the

distribution of Security X that is treated as a distribution of

money is reduced by $12. The distribution of Security X is therefore

treated as a distribution of $88 of money to A ($100 fair market

value of Security X minus $12 reduction).

Example 4. Reduction in amount treated as money--change in

partnership allocations.

(i) A is admitted to partnership ABC as a partner with a 1

percent interest in partnership profits. At the time of A's

admission, ABC held no securities. ABC subsequently acquires

Security X. A's interest in partnership profits is subsequently

increased to 2 percent for securities acquired after the increase. A

retains a 1 percent interest in all securities acquired before the

increase. ABC then acquires Securities Y and Z and later distributes

Security X to A in a current distribution. Immediately before the

distribution, the securities held by ABC had the following fair

market values, adjusted tax bases, and unrecognized gain or loss:

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

Gain

Value Basis (Loss)

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

Security X................................... 1,000 500 500

Security Y................................... 1,000 800 200

Security Z .................................. 11,000 1,100 (100)

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

(ii) If ABC had sold the securities for fair market value

immediately before the distribution to A, the partnership would have

recognized $600 of net gain ($500 gain on Security X plus $200 gain

on Security Y minus $100 loss on Security Z). A's distributive share

of this gain would have been $7 (1 percent of $500 gain on Security

X plus 2 percent of $200 gain on Security Y minus 2 percent of $100

loss on Security Z).

(iii) If ABC had sold the remaining securities immediately after

the distribution of Security X to A, the partnership would have $100

of net gain ($200 gain on Security Y minus $100 loss on Security Z).

A's distributive share of this gain would have been $2 (2 percent of

$200 gain on Security Y minus 2 percent of $100 loss on Security Z).

As a result, the distribution resulted in a decrease of $5 in A's

distributive share of the net gain in ABC's securities ($7 net gain

before distribution minus $2 net gain after distribution).

(iv) Under paragraph (b) of this section, the amount of the

distribution of Security X that is treated as a distribution of

money is reduced by $5. The distribution of Security X is therefore

treated as a distribution of $995 of money to A ($1000 fair market

value of Security X minus $5 reduction).

Example 5. Basis consequences--distribution of marketable

security. (i) A and B form partnership AB as equal partners. A

contributes nondepreciable real property with a fair market value

and adjusted tax basis of $100.

(ii) AB subsequently distributes Security X with a fair market

value of $120 and an adjusted tax basis of $90 to A in a current

distribution. At the time of distribution, the basis in A's interest

in the partnership is $100. The amount of the distribution that is

treated as money is reduced under section 731(c)(3)(B) and paragraph

(b)(2) of this section by $15 (one-half of $30 net gain in Security

X). As a result, A recognizes $5 of gain under section 731(a) on the

distribution (excess of $105 distribution of money over $100

adjusted tax basis in A's partnership interest).

(iii) A's adjusted tax basis in Security X is $95 ($90 adjusted

basis of Security X determined under section 732(a)(1) plus $5 of

gain recognized by A by reason of section 731(c)). The basis in A's

interest in the partnership is $10 as determined under section 733

($100 pre-distribution basis minus $90 basis allocated to Security X

under section 732).

Example 6. Basis consequences--distribution of marketable

security and other property. (i) A and B form partnership AB as

equal partners. A contributes nondepreciable real property, with a

fair market value of $100 and an adjusted tax basis of $10.

(ii) AB subsequently distributes Security X with a fair market

value and adjusted tax basis of $40 to A in a current distribution

and, as part of the same distribution, AB distributes Property Z to

A with an adjusted tax basis and fair market value of $40. At the

time of distribution, the basis in A's interest in the partnership

is $10. A recognizes $30 of gain under section 731(a) on the

distribution (excess of $40 distribution of money over $10 adjusted

tax basis in A's partnership interest).

(iii) A's adjusted tax basis in Security X is $35 ($5 adjusted

basis determined under section 732(a)(2) plus $30 of gain recognized

by A by reason of section 731(c)). A's basis in Property Z is $5, as

determined under section 732(a)(2). The basis in A's interest in the

partnership is $0 as determined under section 733 ($10 pre-

distribution basis minus $10 basis allocated between Security X and

Property Z under section 732).

(iv) AB's adjusted tax basis in the remaining partnership assets

is unchanged unless the partnership has a section 754 election in

effect. If AB made such an election, the aggregate basis of AB's

assets would be increased by $70 (the difference between the $80

combined basis of Security X and Property Z in the hands of the

partnership before the distribution and the $10 combined basis of

the distributed property in the hands of A under section 732 after

the distribution). Under section 731(c)(5), no adjustment is made to

partnership property under section 734 as a result of any gain

recognized by A by reason of section 731(c) or as a result of any

step-up in basis in the distributed marketable securities in the

hands of A by reason of section 731(c).

Example 7. Coordination with section 737. (i) A and B form

partnership AB. A contributes Property A, nondepreciable real

property with a fair market value of $200 and an adjusted basis of

$100 in exchange for a 25 percent interest in partnership capital

and profits. AB owns marketable Security X.

(ii) Within five years of the contribution of Property A, AB

subsequently distributes Security X, with a fair market value of

$120 and an adjusted tax basis of $100, to A in a current

distribution that is subject to section 737. As part of the same

distribution, AB distributes Property Y to A with a fair market

value of $20 and an adjusted tax basis of $0. At the time of

distribution, there has been no change in the fair market value of

Property A or the adjusted tax basis in A's interest in the

partnership.

(iii) If AB had sold Security X for fair market value

immediately before the distribution to A, the partnership would have

recognized $20 of gain. A's distributive share of this gain would

have been $5 (25 percent of $20 gain). Because AB has no other

marketable securities, A's distributive share of gain in partnership

securities after the distribution would have been $0. As a result,

the distribution resulted in a decrease of $5 in A's share of the

net gain in AB's securities ($5 net gain before distribution minus

$0 net

[[Page 67942]]

gain after distribution). Under paragraph (b)(2) of this section,

the amount of the distribution of Security X that is treated as a

distribution of money is reduced by $5. The distribution of Security

X is therefore treated as a distribution of $115 of money to A ($120

fair market value of Security X minus $5 reduction). The portion of

the distribution of the marketable security that is not treated as a

distribution of money ($5) is treated as other property for purposes

of section 737.

(iv) A recognizes total gain of $40 on the distribution. A

recognizes $15 of gain under section 731(a)(1) on the distribution

of the portion of Security X treated as money ($115 distribution of

money less $100 adjusted tax basis in A's partnership interest). A

recognizes $25 of gain under section 737 on the distribution of

Property Y and the portion of Security X that is not treated as

money. A's section 737 gain is equal to the lesser of (i) A's

precontribution gain ($100) or (ii) the excess of the fair market

value of property received ($20 fair market value of Property Y plus

$5 portion of Security X not treated as money) over the adjusted

basis in A's interest in the partnership immediately before the

distribution ($100) reduced (but not below zero) by the amount of

money received in the distribution ($115).

(v) A's adjusted tax basis in Security X is $115 ($100 basis of

Security X determined under section 732(a) plus $15 of gain

recognized by reason of section 731(c)). A's adjusted tax basis in

Property Y is $0 under section 732(a). The basis in A's interest in

the partnership is $25 ($100 basis before distribution minus $100

basis allocated to Security X under section 732(a) plus $25 gain

recognized under section 737).

(k) Effective date. This section applies to distributions made on

or after December 26, 1996. However, taxpayers may apply the rules of

this section to distributions made after December 8, 1994, and before

December 26, 1996.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

Approved: November 27, 1996.

Donald C. Lubick,

Acting Assistant Secretary of the Treasury (Tax Policy).

[FR Doc. 96-32854 Filed 12-24-96; 8:45 am]

BILLING CODE 4830-01-U