* * * * *

(c) * * *

(1) In general. * * *

* * * * *

(2) Certain prorated taxable periods. * * *

(3) Increase in taxable gross weight during the taxable period. * * *

(4) Prorated taxable period for sold, destroyed, or stolen vehicles—(i) In general. The tax on a taxpayer’s use of a highway vehicle for a taxable period is determined under paragraph (c)(4)(ii) of this section if—

(A) The vehicle is destroyed or stolen before the first day of the last month in the taxable period and is not later used by the taxpayer during the period; or

(B) The taxpayer sells the vehicle before the first day of the last month in the taxable period and does not later use the vehicle during the period.

(ii) Computation of tax. If the tax on a taxpayer’s use of a highway vehicle for a taxable period is determined under this paragraph (c)(4)(ii), the tax is computed by multiplying the amount of tax that would be due for a full taxable period, as computed under paragraph (c)(1) of this section, by a fraction. The fraction has as its numerator the number of months in the period from the first day of the month in the period in which the first taxable use of the highway motor vehicle occurs to and including the last day of the month in which the highway motor vehicle was sold, destroyed, or stolen, and as its denominator the number of months in the entire taxable period. (See paragraph (d) Example (3)(i) of this section.)

(iii) Overpayment. If a taxpayer’s liability for the tax on the use of a highway vehicle for a taxable period is determined under paragraph (c)(4)(ii) of this section, any tax the taxpayer paid under section 4481(a) on the use of the vehicle for such period in excess of the tax calculated under paragraph (c)(4)(ii) of this section is an overpayment of tax.

(iv) Definition of destroyed vehicle. For purposes of this paragraph (c)(4), a highway motor vehicle is destroyed if the vehicle is damaged due to an accident or other casualty to such an extent that it is not economical to rebuild.

(v) Form and content of claim. A claim for refund of an overpayment described in paragraph (c)(4)(iii) of this section must be made on Form 8849, “Claim for Refund of Excise Taxes” (or such other form as the Commissioner may designate) in accordance with the instructions for that form. A claim for a credit must be made on Form 2290, “Heavy Highway Vehicle Use Tax Return” (or such other form as the Commissioner may designate) in accordance with the instructions for that form. A claim for refund or credit for any vehicle must include—

(A) The vehicle identification number and taxable gross weight of the vehicle;

(B) The date of the sale, destruction, or theft of the vehicle; and

(C) If the vehicle was sold, the name and address of the purchaser of the vehicle.

(vi) Tax on buyer’s use of second-hand vehicles. If a vehicle is sold during the taxable period and a credit or refund of the tax imposed by section 4481 is allowable upon the sale under paragraph (c)(4)(iii) of this section, tax is imposed on the use of the vehicle after the sale and before the end of the taxable period. (See paragraph (c)(4)(vii) of this section for the rules regarding the computation of tax after the sale and before the end of the taxable period.)

(vii) Computation of tax on second-hand vehicles. The tax under paragraph (c)(4)(vi) of this section on the use of a vehicle after a sale upon which a credit or refund is allowable is computed by multiplying the amount of tax that would be due for a full taxable period as computed under paragraph (c)(1) of this section by a fraction. The fraction has as its numerator the number of months in the period from the first day of the month in which the first taxable use of the vehicle after the sale occurs (the first day of the month after such month if the first taxable use after the sale occurs in the month of the sale) through the end of the taxable period, and as its denominator the number of months in the entire taxable period. (See paragraph (d) Example (3)(ii) of this section.)

(5) Decrease in taxable gross weight, discontinued use, or converted use. The computation of the tax is not affected, and no right to a credit or refund of any tax paid under section 4481 arises, if in any taxable period—

(i) The taxable gross weight of a highway motor vehicle is decreased;

(ii) The use of a highway motor vehicle is discontinued (for reasons other than sale, destruction, or theft as described in paragraph (c)(4) of this section); or

(iii) The highway motor vehicle is converted to a use that is exempt from the tax imposed by section 4481(a).

(d) Examples. The application of §§ 41.4481–1, 41.4481–2, and 41.4482(c)–1(c) may be illustrated by the following examples:

* * * * *

Example (3). (i) In July, X uses a vehicle that is registered in X’s name and has a taxable gross weight of 70,000 pounds. The vehicle is not a logging vehicle. X pays the $430 of tax imposed by section 4481 for the taxable period. On September 2 of the same calendar year, X sells the vehicle to Y. X’s tax is calculated under paragraph (c)(4)(ii) by multiplying the amount of tax that would be due for a full taxable period by a fraction that has as its numerator the number of months in the period from the first day of the month in which X’s first taxable use of the highway motor vehicle occurs to and including the last day of the month in which the vehicle was sold, and as its denominator the number of months in the entire taxable period. Thus, X’s tax for the period is $107.50 (3/12 of $430), and X may claim a credit or refund of $322.50 ($430.00 – $107.50) in accordance with § 41.4481–1(c)(4)(v) after X sells the vehicle.

(ii) On September 23, Y uses the vehicle. Y is liable for tax on the use of the vehicle during the taxable period ending June 30 of the following calendar year. Y’s tax is calculated under paragraph (c)(4)(vii) by multiplying the amount of tax that would be due for a full taxable period by a fraction that has as its numerator the number of months in the period from the first day of the month in which Y’s first taxable use of the vehicle after the sale occurs (the first day of the month after such month if the first taxable use after the sale occurs in the month of the sale) through the end of the taxable period, and as its denominator the number of months in the entire taxable period. Y’s first use of the vehicle occurs in the month of the sale. Accordingly, Y’s tax is based on the number of months in the period from the first day of October (the month following the month of the first taxable use) through the end of June, and Y owes a section 4481 tax of $322.50 (9/12 of $430) for the taxable period.

Example (4). Assume the same facts as in Example (3)(i), except that on September 2, X sells the vehicle to Dealer, a dealer in highway motor vehicles. X may claim a credit or refund of $322.50. Dealer operates the vehicle exclusively for the purpose of demonstration, which is not a “use” of the vehicle under § 41.4482(c)–1(c). On May 2 of the following calendar year, Dealer sells the vehicle to Y. Dealer does not owe a section 4481 tax and may not claim a refund. Y’s first taxable use of the vehicle occurs on May 3. Y’s first taxable use of the vehicle does not occur in the month of a sale upon which a credit or refund is allowable. Accordingly, Y’s tax is calculated under paragraph (c)(2) by multiplying the amount of tax that would be due for a full taxable period by a fraction which has as its numerator the number of months in the taxable period beginning with the month of first taxable use and as its denominator the number of months in the entire taxable period. The numerator is the number of months in the period from the first day of May (the month of Y’s first taxable use after the sale) through the end of June, and Y owes a section 4481 tax of $71.67 (2/12 of $430) for the taxable period.

(e) Effective/applicability date. This section applies on and after July 1, 2015. For rules applicable before that date, see 26 CFR 41.4481–1 (revised as of April 1, 2014).

Par. 3. Section 41.4481–2 is amended by:

1. Removing the language “or any installment payment of the tax” in paragraph (a)(1)(i)(D).

2. Revising paragraph (a)(2) and adding paragraph (a)(3).

3. Adding a sentence at the end of paragraph (b).

4. Revising paragraph (c).

The revisions and additions read as follows:

(a) * * *

(2) If a vehicle is sold during the taxable period and a credit or refund is allowable upon the sale under § 41.4481–1(c)(4)(iii), paragraph (a)(1) of this section is applied with the following modifications:

(i) For purposes of determining the person liable for the tax determined under § 41.4481–1(c)(4)(ii), each reference to a taxable period in paragraph (a)(1) of this section is treated as a reference to the period that begins on the first day of the taxable period in which the vehicle is sold and ends on the date of sale.

(ii) For purposes of determining the person liable for the tax determined under § 41.4481–1(c)(4)(vi), each reference to a taxable period in paragraph (a)(1) of this section is treated as a reference to the period that begins on the date of the sale and ends on the last day of the taxable period in which the vehicle is sold.

(3) The application of paragraph (a) of this section may be illustrated by Examples (3) and (4) in § 41.4481–1(d).

(b) * * * For provisions relating to penalties for aiding and abetting an understatement of tax liability, see section 6701 of the Internal Revenue Code.

(c) Effective/applicability date. This section applies on and after July 1, 2015. For rules applicable before that date, see 26 CFR 41.4481–2 (revised as of April 1, 2014).

Par. 4. Section 41.4483–3 is amended as follows:

1. In the fourth sentence of paragraph (f), removing the language “to the extent

that the tax or an installment payment of the tax has” and adding “(determined in the case of a transfer described in § 41.4481–1(c)(4)(i) under § 41.4481–1(c)(4)(ii)) to the extent that the tax has” in its place.

2. Adding paragraph (i).

The addition reads as follows:

* * * * *

(i) Effective/applicability date. This section applies on and after July 1, 2015. For rules applicable before that date, see 26 CFR 41.4483–3 (revised as of April 1, 2014).

* * * * *

(b) Proof of payment required—(1) In general. * * *

* * * * *

(4) Registration during certain months * * *

* * * * *

(c) Proof of payment—(1) In general. The proof of payment required in paragraph (b) of this section consists of a receipted Schedule 1 (Form 2290 “Heavy Highway Vehicle Use Tax Return”) that is returned by the Internal Revenue Service, by mail or electronically, to a taxpayer that files a return of tax under section 4481(a), meets the requirements of § 41.6011(a)–1, and pays the amount of tax due with such return. A photocopy of such receipted Schedule 1 also serves as proof of payment. Such Schedule 1 serves as proof of suspension of such tax under § 41.4483–3 for the number of vehicles entered in that part of the Schedule 1 designated for vehicles for which tax has been suspended. The vehicle identification number of the vehicle being registered must appear on the Schedule 1 (or an attached page) in order for the Schedule 1 to be a valid proof of payment for such vehicle.

(2) Acceptable substitute for receipted Schedule 1. For purposes of this section, a State must accept as proof of payment a photocopy of the Form 2290 (with the Schedule 1 attached) that was filed with the Internal Revenue Service for the vehicle being registered with sufficient documentation of payment of tax due at the time the Form 2290 was filed (such as a photocopy of both sides of a cancelled check). This substitute proof of payment may be used to register a vehicle when, for example, the receipted Schedule 1 has been lost, or when at the time required for registration of a vehicle, a receipted Schedule 1 has not been received by a taxpayer who has filed a Form 2290 with respect to such vehicle.

* * * * *

(e) Effective/applicability date. Paragraph (c) of this section applies to registrations of highway motor vehicles pursuant to applications that are received by a State on or after July 1, 2015. The rules of section 7502 and § 301.7502–1 of this chapter (relating to timely mailing treated as timely filing) determine when an application for registration is considered to be received by a State. For rules applicable to applications before that date, see 26 CFR 41.6001–2 (revised as of April 1, 2014).

(a) * * *

(4) A person that is liable for tax under § 41.4481–2(a)(1)(i)(A), (B), (C), or (D), after taking into account the modification required under § 41.4481–2(a)(2), is treated as liable for tax by the same provision of § 41.4481–2(a)(1)(i) for purposes of this section and must file a return.

* * * * *

(c) Required use of electronic filing—(1) In general. A person that files any return reporting 25 or more vehicles must file the return electronically, as prescribed by the Commissioner. For this purpose, the number of vehicles reported on a return is the total number of vehicles for which tax is reported and does not include vehicles for which a suspension of tax is claimed.

(2) Examples. The application of this paragraph (c) may be illustrated by the following examples:

Example 1. A has 100 vehicles registered in its name, all of which have a taxable gross weight in excess of 55,000 pounds. Seventy-five of the vehicles are in use on July 1. Twenty-five are in dead storage as described in § 41.4482(c)–1(c). The vehicles in dead storage are not in use and they are not listed on the Schedule 1. A files Form 2290 electronically for the 75 vehicles in use on July 1 and receives a receipted Schedule 1. On August 23 of the same calendar year, A uses the remaining 25 vehicles. A does not file Form 2290 electronically but uses a paper Form 2290. A has failed to meet the requirements of section 4481(e) for the remaining 25 vehicles.

Example 2. Assume the same facts as in Example 1 except that on August 23, A uses 15 of the vehicles that were not used in July. The remaining 10 vehicles are not used in August. A does not file Form 2290 electronically but uses a paper Form 2290. A has correctly filed a return as required by section 4481(e).

(d) Effective/applicability date. Paragraphs (a)(4) and (c) of this section apply to returns filed on and after July 1, 2015. For rules applicable before that date, see 26 CFR 41.6011(a)–1 (revised as of April 1, 2014).

Par. 10. Section 41.6071(a)–1 is amended as follows:

1. In paragraph (a) introductory text, the language “paragraph (b) or paragraph (c)” is removed and “paragraph (b)” is added in its place.

2. Revising paragraph (c).

3. Adding paragraph (d).

The additions and revision read as follows:

* * * * *

(c) Effect of sale during taxable period. A person that is liable for tax under § 41.4481–2(a)(1)(i)(A), (B), (C), or (D) after taking into account the modification required under § 41.4481–2(a)(2) is treated as liable for tax under the same provision of § 41.4481–2(a)(1)(i) for purposes of this section.

(d) Effective/applicability date. Paragraph (c) of this section applies on and after July 1, 2015. For rules applicable before that date, see 26 CFR 41.6071(a)–1 (revised as of April 1, 2014).

(a) In general. The tax must be paid at the time prescribed in § 41.6071(a)–1 for filing the return and at the place prescribed in § 41.6091–1 for filing the return.

(b) Effective/applicability date. This section applies on and after July 1, 2015. For rules applicable before that date, see 26 CFR 41.6151(a)–1 and 41.6151(a)–1T (revised as of April 1, 2014).

The first step in computing the effect of section 751(b) is to measure the partners’ interests in section 751 property. Commentators generally agreed that the hypothetical sale approach is a substantial improvement over the gross value approach in the existing regulations. As described in this preamble, the hypothetical sale approach requires a partnership to compare: (1) the amount of ordinary income (or ordinary loss) that each partner would recognize if the partnership sold its property for fair market value immediately before the distribution with (2) the amount of ordinary income (or ordinary loss) each partner would recognize if the partnership sold its property, and the distributee partner sold the distributed assets, for fair market value immediately after the distribution. The commentators agreed that, when compared against the gross value approach, the hypothetical sale approach is more consistent with Congress’s intent in enacting section 751(b), is easier to apply, and reduces the likelihood that section 751(b) would unnecessarily accelerate ordinary income. Accordingly, these proposed regulations adopt the hypothetical sale approach as the method by which the partners must measure their respective interests in section 751 property for the purpose of determining whether a distribution reduces a partner’s interest in the partnership’s section 751 property. (A distribution that reduces a partner’s interest in the partnership’s section 751 property is referred to as a “section 751(b) distribution.”)

Because the hypothetical sale approach relies on the principles of section 704(c) to preserve a partner’s share of the unrealized gain and loss in the partnership’s section 751 property, these proposed regulations make several changes to the regulations relating to section 704(c). Specifically, the proposed regulations revise § 1.704–1(b)(2)(iv)(f), regarding revaluations of partnership property, to make its provisions mandatory if a partnership distributes money or other property to a partner as consideration for an interest in the partnership, and the partnership owns section 751 property immediately after the distribution. (A partnership that does not own section 751 property immediately after the distribution may still revalue its property under the existing regulation, but is not required to do so under these proposed regulations.) If a partnership does not maintain capital accounts in accordance with § 1.704–1(b)(2)(iv), the partnership must comply with this requirement by computing each partner’s share of gain or loss in each partnership asset prior to a distribution, and making future allocations of partnership items in a manner that takes these amounts into account (making subsequent adjustments for cost recovery and other events that affect the property basis of each such asset).

In addition, the proposed regulations contain a special revaluation rule for distributing partnerships that own an interest in a lower-tier partnership. Because a partnership’s section 751 property includes, under section 751(f), the partnership’s proportionate share of section 751 property owned by any other partnership in which the distributing partnership is a partner, these proposed regulations also require a partnership in which the distributing partnership owns a controlling interest (which is defined as a greater than 50 percent interest) to revalue its property if the lower-tier partnership owns section 751 property immediately after the distribution. If the distributing partnership owns a non-controlling (that is, less than or equal to 50 percent) interest in a lower-tier partnership, these proposed regulations require the distributing partnership to allocate its distributive share of the lower-tier partnership’s items among its partners in a manner that reflects the allocations that would have been made had the lower-tier partnership revalued its partnership property. The IRS and the Treasury Department are aware that in some instances a distributing partnership may be unable to obtain sufficient information to comply with this requirement from a lower-tier partnership in which the distributing partnership holds a non-controlling interest. We request comments on reasonable approaches to address this issue.

Upon the revaluation of partnership property in connection with a partnership distribution, the regulations under section 704(c) permit a partnership to choose any reasonable method to account for the built-in gain or built-in loss that is consistent with the purpose of section 704(c). If property with built-in gain decreases in value (or property with built-in loss increases in value), then the partnership may be unable to allocate tax losses (or gains) to a non-contributing partner in an amount equal to the partner’s economic loss (or gain). If the property with built-in gain (or loss) is section 751 property, then the inability to allocate those tax losses (or gains) may cause ordinary income to shift among the partners. The regulations under section 704(c) provide two reasonable methods for a partnership to allocate items to cure or remediate that shift. However, the regulations under section 704(c) also provide a third reasonable method, the traditional method, under which the shift of ordinary income is not cured. The IRS and the Treasury Department are aware that distortions created under the section 704(c) traditional method may cause ordinary income to shift among partners. However, the regulations under section 704(c) contain an anti-abuse rule that provides that a method is not reasonable if, for example, the event that results in a reverse section 704(c) allocation and the corresponding allocation of tax items with respect to the property are made with a view to shifting the tax consequences of built-in gain or built-in loss among the partners in a manner that substantially reduces the present value of the partners’ aggregate tax liability. The IRS and the Treasury Department believe that this anti-abuse provision under section 704(c) properly addresses the possibility that taxpayers would use the traditional method to shift ordinary income.

Some commentators suggested changing the regulations under section 704(c) to minimize the situations in which section 751(b) applies. Generally, when a partnership revalues its assets, the partnership allocates a reverse section 704(c) amount with respect to each partnership asset, as opposed to an aggregate section 704(c) amount with respect to all assets (subject to certain exceptions). As a result, any distribution of appreciated section 751 property in which another partner has a share of income would trigger section 751(b) under the hypothetical sale approach. The commentators recommended that the IRS and the Treasury Department narrow the application of section 751(b) by allowing partners (subject to the substantiality requirements of § 1.704–1(b)(2)(iii)) to “exchange” reverse section 704(c) amounts resulting from a section 751 distribution. These proposed regulations do not adopt this comment because it is beyond the scope of these regulations and would impact other provisions of subchapter K. However, the IRS and the Treasury Department believe that the issue merits further study and request comments on how such permissible exchanges of reverse section 704(c) amounts might be addressed in future regulations.

While section 704(c) revaluations generally preserve partners’ interests in section 751 property upon a partnership distribution, certain basis adjustments under sections 732(c) or 734(b) may alter partners’ interests in section 751 property following the distribution. Accordingly, these proposed regulations provide rules on the effect of these basis adjustments on the computation of partners’ interests in section 751 property.

If a distribution of capital gain property results in a basis adjustment under section 734(b), that basis adjustment is allocated to capital gain property of the partnership under § 1.755–1(c)(1). However, some property that is characterized as capital gain property for purposes of section 755 can also result in ordinary income when sold. For example, section 1231 property is characterized as a capital asset for purposes of section 755, but selling the property can also result in ordinary income from recapture under section 1245(a)(1). The regulations under section 755 do not differentiate between the capital gain aspect of the property and the ordinary income aspect of the property for this purpose. Accordingly, allocating a section 734(b) positive basis adjustment to such property as capital gain property may reduce the amount of ordinary income that would result on a sale of the property. Under these proposed regulations, that reduction in ordinary income would constitute a reduction in the partners’ shares of unrealized gain in the partnership’s section 751 property, which could trigger section 751(b) in situations in which 751(b) would not have otherwise applied. A similar reduction in section 751 property could occur if the basis of the distributed property increases under section 732.

One commentator recommended allowing partnerships to avoid this result by eliminating a positive section 734(b) adjustment to the extent the section 734(b) adjustment would reduce the partnership’s ordinary income. Another commentator recommended allocating the section 734(b) adjustment to other partnership capital gain property. The same commentator alternatively recommended treating a positive section 734(b) adjustment that reduced the partnership’s ordinary income as a separate asset.

Although these proposed regulations do not treat the section 734(b) adjustment as a separate asset, the proposed regulations reach a similar result to this last recommendation. They provide that a basis adjustment under section 732(c) or section 734(b) (as adjusted for recovery of the basis adjustment) that is allocated to capital gain property and that reduces the ordinary income (attributable, for example, to recapture under section 1245(a)(1)) that the partner or partnership would recognize on a taxable disposition of the property is not taken into account in determining (1) the partnership’s basis for purposes of sections 617(d)(1), 1245(a)(1), 1250(a)(1), 1252(a)(1), and 1254(a)(1), and (2) the partner or partnership’s respective gain or loss for purposes of sections 995(c), 1231(a), and 1248(a). The IRS and the Treasury Department intend for these amendments to apply for purposes of other provisions that cross-reference those sections (for example, the reference in § 1.367(b)–2(c) to section 1248). The IRS and the Treasury Department are aware that these rules may result in additional administrative burden and, therefore, permit a partnership and its partners to elect to recognize ordinary income currently under section 751(b) in lieu of applying these rules.

In addition, one commentator raised questions about the application of section 751(b) upon the distribution to a partner of section 751 property for which another partner has a basis adjustment under section 743(b) (the transferee partner). The commentator questioned whether the distributee partner’s share of section 751 property could be increased inappropriately if the special basis adjustment is not taken into account in determining the distributee’s basis in the section 751 property under section 732. The IRS and the Treasury Department believe that although the distributee partner does not take the section 743(b) basis adjustment into account in determining its basis in the distributed property, the reallocation of the section 743(b) basis adjustment pursuant to § 1.743–1(g)(2)(ii) should generally reduce the transferee partner’s share of section 751 property, triggering an income inclusion to that partner under section 751(b) which is offset by the basis adjustment. The IRS and the Treasury Department acknowledge that, in situations in which the partnership holds no other section 751 property (and the section 743(b) basis adjustment is temporarily suspended under §§ 1.743–1(g)(2)(ii) and 1.755–1(c)(4) until the partnership acquires additional ordinary income property), the application of section 751(b) may be unclear. Accordingly, the proposed regulations require that partners include the effect of carryover basis adjustments when determining their shares of section 751 property, as though those basis adjustments were immediately allocable to ordinary income property. See Example 4 in § 1.751–1(g) of the proposed regulations.

The purpose of section 751 is to prevent a partner from converting its share of potential ordinary income into capital gain. A distribution of partnership property (including money) is a section 751(b) distribution if the distribution reduces any partner’s share of net section 751 unrealized gain or increases any partner’s share of net section 751 unrealized loss (as determined under the hypothetical sale approach described in Part 1.A of the Summary of Comments and Explanation of Provisions section of this preamble). For this purpose, a partner’s net section 751 unrealized gain or loss immediately before a distribution equals the amount of net gain or loss, as the case may be, from section 751 property that would be allocated to the partner if the partnership disposed of all of the partnership’s assets for cash in an amount equal to the fair market value of such property (taking into account section 7701(g)). A partner’s net section 751 unrealized gain or loss includes any remedial allocations under § 1.704–3(d).

A partner’s net section 751 unrealized gain or loss also takes into account any section 743 basis adjustment pursuant to § 1.743–1(j)(3), including any carryover basis adjustment that results under any of § 1.743–1(g)(2)(ii), § 1.755–1(b)(5)(iii)(D), or § 1.755–1(c)(4) when the partnership must adjust the basis of a specific class of assets, but that adjustment is suspended because the partnership does not own assets in that class. The regulations take such suspended basis adjustments into account as though the basis adjustment is applied to the basis of notional partnership section 751 property with a fair market value of zero. For example, if A and B are partners in the AB partnership, which owns capital assets and a single ordinary income asset that is the subject of a section 743(b) adjustment with respect to B, and that asset is distributed to partner A, B’s basis adjustment is suspended because the partnership lacks other ordinary income property. However, the basis adjustment will eventually benefit B when the partnership acquires new ordinary income property. For this reason, the proposed regulations require B to take the suspended adjustment into account when determining whether section 751(b) applies to B with respect to the distribution.

A partner’s share of net section 751 unrealized gain or loss from section 751 property immediately following a distribution is computed using the same formula. However, the distributee partner also includes in its post-distribution amount its share of net income or loss from a hypothetical sale of the distributed section 751 property.

If section 751(b) applies to a distribution, each partner must generally recognize or take into account currently ordinary income equal to its “section 751(b) amount.” If a partner has net section 751 unrealized gain both before and after the distribution, then the partner’s section 751(b) amount equals the partner’s net section 751 unrealized gain immediately before the distribution less the partner’s net section 751 unrealized gain immediately after the distribution. If a partner has net section 751 unrealized loss both before and after the distribution, then the partner’s section 751(b) amount equals the partner’s net section 751 unrealized loss immediately after the distribution less the partner’s net section 751 unrealized loss immediately before the distribution. If a partner has net section 751 unrealized gain before the distribution and net section 751 unrealized loss after the distribution, then the partner’s section 751(b) amount equals the sum of the partner’s net section 751 unrealized gain immediately before the distribution and the partner’s net section 751 unrealized loss immediately after the distribution.

Commentators requested a de minimis exception to section 751(b). The IRS and the Treasury Department continue to study the issue and request comments describing the parameters of a de minimis rule that would be helpful.

The IRS and the Treasury Department believe that, despite the general principle that section 751(b) should apply only at the time that a partner’s share of net section 751 unrealized gain is reduced (or net section 751 loss is increased), the deferral of ordinary income upon the receipt of a distribution is inappropriate in certain circumstances. Specifically, deferral is inappropriate if a partner engages in a transaction that relies on the rules of section 704(c) to defer or eliminate ordinary income while monetizing most of the value of the partnership interest. Accordingly, these proposed regulations provide an anti-abuse rule that requires taxpayers to apply the rules set forth in the proposed regulations in a manner consistent with the purpose of section 751, and that allows the Commissioner to recast transactions for federal tax purposes as appropriate to achieve tax results that are consistent with the purpose of section 751.

The proposed regulations provide a list of situations that are presumed inconsistent with the purpose of section 751. Under this list, a distribution is presumed inconsistent with the purpose of section 751 if section 751(b) would apply but for the application of section 704(c) principles, and one or more of the following conditions exists: (1) a partner’s interest in net section 751 unrealized gain is at least four times greater than the partner’s capital account immediately after the distribution, (2) a distribution reduces a partner’s interest to such an extent that the partner has little or no exposure to partnership losses and does not meaningfully participate in partnership profits aside from a preferred return for the use of capital, (3) the net value of the partner (or its successor) becomes less than its potential tax liability from section 751 property as a result of a transaction, (4) a partner transfers a portion of its partnership interest within five years after the distribution to a tax-indifferent party in a manner that would not trigger ordinary income recognition in the absence of this anti-abuse rule, or (5) a partnership transfers to a corporation in a nonrecognition transaction section 751 property other than pursuant to a transfer of all property used in a trade or business (excluding assets that are not material to a continuation of the trade or business). In addition, the proposed regulations provide that an amendment to the partnership agreement that results in a reduction in a partner’s interest in section 751 property is also presumed inconsistent with the purpose of section 751. A partnership or a partner taking a position on its return that section 751 does not apply to a transaction that meets one or more of these situations must disclose its position on Form 8275, Disclosure Statement.

As described in Parts 2.A and 2.B of this preamble, these proposed regulations generally defer the recognition of ordinary income upon a distribution when the partner’s unrealized gain and loss in the partnership’s section 751 property is preserved through the application of the principles of section 704(c). This approach is consistent with the 1984 amendment to section 704(c). By mandating the application of section 704(c) principles, that amendment partially severed the relationship that had generally existed between a partner’s distributive share (that is, the right to share in the economic gain or loss) associated with a partnership item and the partner’s share of tax gain or loss from the sale of that item. The IRS and the Treasury Department believe that, by mandating the application of section 704(c) principles in 1984, Congress intended that impacted provisions be interpreted consistent with this new emphasis on tax gain or loss. Congress provided a broad delegation of authority to the Treasury Department to address these repercussions of amending section 704(c) on other provisions in subchapter K.

Some commentators interpret section 751(a) as limiting the amount of ordinary income that a transferor partner may recognize upon a transfer of a partnership interest to the amount of any money or property received by the transferor partner, without taking into account the total amount of ordinary income attributable to the partnership interest transferred that relates to section 751 property. However, interpreting section 751(a) as limiting ordinary income in this way would contravene Congress’s intent to tax partners on their shares of partnership ordinary income as determined by applying section 704(c) principles. The IRS and the Treasury Department believe that section 751(a) should be interpreted in a manner that accounts for the impact of section 704(c). Thus, these proposed regulations provide that the amount of money or the fair market value of property received for purposes of section 751(a) takes into account the transferor partner’s share of income or gain from section 751 property.

The IRS and the Treasury Department alternatively considered addressing this issue by deeming a partner that sells or exchanges its partnership interest to receive a distribution of the partner’s share of the section 751 property, followed by a sale of the property back to the partnership for its fair market value, recognizing the deferred ordinary income inherent in the section 751 property. The partner would then be deemed to contribute the cash proceeds to the partnership thereby increasing the partner’s basis in the partner’s partnership interest. Finally, upon the sale or exchange of the partnership interest, the partner would recognize the appropriate amount of capital loss. This potential multi-step deemed approach would result in additional complexity and would reach the same result that the current regulations under § 1.751–1(a) reach as clarified by these proposed regulations. Therefore, the IRS and the Treasury Department are not proposing this alternative approach.

Section 751(b)(2)(A) provides that section 751(b) does not apply to a distribution of property that the distributee contributed to the partnership (“previously contributed property exception”). Unlike other provisions in subchapter K that include similar previously contributed property exceptions, the current regulations under section 751(b) do not contain successor rules for purposes of applying the section 751(b) previously contributed property exception. These proposed regulations add successor rules to section 751(b) similar to the successor rules contained in other previously contributed property exceptions within subchapter K.

A commentator requested guidance confirming how the rules of section 751(b) apply in the case of an incorporation, merger, or division of a partnership. The proposed regulations do not adopt this comment because the IRS and the Treasury Department believe such guidance is beyond the scope of these proposed regulations.

These proposed regulations also make a number of technical corrections to account for changes in the law since the issuance of existing regulations under section 751. For example, these proposed regulations remove the language “substantially appreciated” from the first sentence of § 1.751–1(a)(1), which applies with respect to sales or exchanges of an interest in a partnership. In addition to conforming the language of the regulations to that of the Code, this change is intended to clarify that, upon a sale or exchange of a partnership interest, unrealized receivables and inventory items are treated in the same manner. Thus, a transferor partner may recognize an ordinary loss with respect to inventory items pursuant to section 751(a) to the extent the transferor would be allocated a net ordinary loss pursuant to § 1.751–1(a)(2). These proposed regulations also update the definition of “inventory items which have appreciated substantially in value” with respect to section 751(b) to reflect the 1993 amendment to the statute that eliminated the 10-percent test from the definition of “substantial appreciation.” See Public Law 103–66, Sec. 13206(e)(1). These proposed regulations also clarify that unrealized receivables are not included in the term “inventory items which have appreciated substantially in value.”

Finally, these proposed regulations address some of the comments received in response to Notice 2009–70 (2009–2 CB 255), in which the IRS and the Treasury Department requested comments on, among other things, whether additional events should be added to the list of events permitting a revaluation of partnership property pursuant to § 1.704–1(b)(2)(iv)(f) and whether, in a tiered partnership structure, a revaluation at one partnership in the tier should permit another partnership in the tier to revalue that partnership’s property. Commentators recommended that partnership recapitalizations (changes to the way partners agree to share partnership profits and losses) be added as a permissible revaluation event. The IRS and the Treasury Department agree that partnership recapitalizations should be added as a permissible event because, absent providing for a special allocation of any unrealized gain or loss in partnership assets that arose prior to the recapitalization, a revaluation is necessary to preserve each partner’s share of such unrealized amounts. In addition, commentators recommended that a partnership in a tiered partnership structure be able to revalue its partnership property if another partnership in the tiered structure was permitted to revalue its partnership property. The IRS and the Treasury Department agree and believe that permitting successive revaluations in a tiered partnership structure is necessary to properly allocate items with respect to a reverse section 704(c) allocation to the appropriate partner.

* * * * *

(c) * * *

(3) * * *

(ii) * * *

(g) * * * See also §§ 1.732–1(c)(2)(iii) and 1.755–1(c)(2)(iii) for rules governing the application of section 617 to partnership property in certain situations.

* * * * *

Par. 3. Section 1.704–1 is amended by:

a. Revising paragraph (b)(2)(iv)(f) introductory text.

b. Redesignating paragraph (b)(2)(iv)(f)(5)(v) as paragraph (b)(2)(iv)(f)(5)(vi).

c. Adding new paragraph (b)(2)(iv)(f)(5)(v).

d. Designating the undesignated text after paragraph (b)(2)(iv)(f)(5)(vi) as paragraph (b)(2)(iv)(f)(5)(vii).

The revisions and additions read as follows:

* * * * *

(b) * * *

(2) * * *

(iv) * * *

(f) Revaluations of property. A partnership agreement may, upon the occurrence of certain events, and must in the circumstances described in § 1.751–1(b)(2)(iv), increase or decrease the capital accounts of the partners to reflect a revaluation of partnership property (including intangible assets such as goodwill) on the partnership’s books. If a partnership that revalues its property pursuant to this paragraph owns an interest in another partnership, that partnership in which it owns an interest may also revalue its property in accordance with this section. Similarly, if an interest in a partnership that revalues its property pursuant to this paragraph is owned by another partnership, the partnership owning that interest may also revalue its property in accordance with this section. Capital accounts so adjusted will not be considered to be determined and maintained in accordance with the rules of this paragraph (b)(2)(iv) unless—

* * * * *

(5) * * *

(v) In connection with an agreement to change (other than a de minimis change) the manner in which the partners share any item or class of items of income, gain, loss, deduction or credit of the partnership under the partnership agreement, or

* * * * *

Par. 4. Section 1.704–3 is amended in paragraph (a)(9) by adding a sentence immediately following the first sentence to read as follows:

(a) * * *

(9) * * * If a partnership (the upper-tier partnership) owns an interest in another partnership (the lower-tier partnership), and both the upper-tier partnership and the lower-tier partnership simultaneously revalue partnership property pursuant to § 1.704–1(b)(2)(iv)(f), the principles of this paragraph (a)(9) shall apply to any reverse section 704(c) allocations created upon the revaluation. * * *

* * * * *

Par. 5. Section 1.732–1 is amended by adding paragraphs (c)(2)(iii), (iv), (v), (vi), and (vii), and revising paragraph (c)(5) to read as follows:

* * * * *

(c) * * *

(2) * * *

(iii) Property subject to section 1245. Any increase in basis allocated to capital gain property pursuant to the second sentence in paragraph (c)(2)(ii) of this section is not taken into account in determining the recomputed or adjusted basis in the property for purposes of section 1245(a)(1). Notwithstanding the prior sentence, any depreciation or amortization of the increase in basis that is allowed or allowable is taken into account in computing the property’s recomputed basis. In the case of property that is subject to section 617(d)(1), section 1250(a)(1), section 1252(a)(1), or section 1254(a)(1), rules similar to the rule in this paragraph (c)(2)(iii) shall apply. See Examples 2 and 3 in § 1.755–1(c)(6).

(iv) Section 1231 property. Any increase in basis allocated to capital gain property pursuant to the second sentence in paragraph (c)(2)(ii) of this section is not taken into account in determining section 1231 gain and loss, as defined in section 1231(a)(3). See Examples 2 and 3 in § 1.755–1(c)(6).

(v) Property subject to section 1248. Any increase in basis allocated to stock in a foreign corporation pursuant to the second sentence in paragraph (c)(2)(ii) of this section or any decrease in basis allocated to stock in a foreign corporation pursuant to the second sentence in paragraph (c)(2)(i) of this section is not taken into account in determining the amount of gain recognized on the sale or exchange of such stock for purposes of section 1248(a). In the case of property that is subject to section 995(c), rules similar to the rule set forth in this paragraph (c)(2)(v) shall apply. See Examples 8 and 9 in § 1.751–1(g).

(vi) Special rule. Any basis adjustment to an asset that is not taken into account under paragraph (c)(2)(iii), (iv), or (v) of this section shall, upon a taxable disposition, be treated as gain or loss, as the case may be, from the sale or exchange of a capital asset with the same holding period as the underlying asset. See Examples 2 and 3 in § 1.755–1(c)(6).

(vii) Election not to apply the provisions of paragraphs (c)(2)(iii), (iv), and (v). See § 1.755–1(c)(2)(vi) for rules regarding an election to have the provisions of paragraphs (c)(2)(iii), (iv), and (v) of this section, and § 1.755–1(c)(2)(iii), (iv), and (v) not apply. See Examples 2 and 3 in § 1.755–1(c)(6).

* * * * *

(5) Effective/applicability date. This paragraph (c) applies to distributions of property from a partnership that occur on or after December 15, 1999, except that paragraphs (c)(2)(iii), (iv), (v), (vi), and (vii) of this section apply to distributions of property from a partnership that occur on or after the date of publication of a Treasury decision adopting these rules as final regulations in the Federal Register.

* * * * *

Par. 6. Section 1.736–1 is amended in paragraph (b)(4) by removing the language “paragraph (b)(3)(iii)” from the last sentence and adding the language “paragraph (b)(3)” in its place.

Par. 7. Section 1.751–1 is amended by:

a. Revising paragraphs (a)(1) and (2).

b. Revising the first sentence of paragraph (b)(1)(i) and adding a new sentence at the end of paragraph (b)(1)(i).

c. Removing the last four sentences of paragraph (b)(1)(ii).

d. Revising paragraphs (b)(1)(iii) and (b)(2) and (3).

e. Redesignating paragraphs (b)(4) and (5) as paragraphs (b)(5) and (6).

f. Adding a new paragraph (b)(4).

g. Revising the paragraph heading of newly designated paragraph (b)(5).

h. Further redesignating newly redesignated paragraph (b)(5)(ii) as paragraph (b)(5)(vi) and adding paragraphs (b)(5)(ii), (iii), (iv), and (v).

i. Revising newly designated paragraph (b)(6).

j. Revising paragraph (c)(4)(vi).

k. Adding paragraph (c)(4)(x).

l. Removing paragraphs (c)(5) and (6).

m. Revising the first and second sentences of paragraph (d)(1).

n. Revising paragraphs (e), (f), and (g).

The additions and revisions read as follows:

(a) * * * (1) Character of amount realized. To the extent that money or property received by a partner in exchange for all or part of his partnership interest is attributable to his share of the value of partnership unrealized receivables or inventory items, the money or fair market value of the property received shall be considered as an amount realized from the sale or exchange of property other than a capital asset. The remainder of the total amount realized on the sale or exchange of the partnership interest is realized from the sale or exchange of a capital asset under section 741. For definition of “unrealized receivables” and “inventory items,” see section 751(c) and (d). See paragraph (e) of this section for the definition of section 751 property.

(2) Determination of gain or loss. The income or loss realized by a partner upon the sale or exchange of its interest in section 751 property is the amount of income or loss from section 751 property (taking into account allocations of tax items applying the principles of section 704(c), including any remedial allocations under § 1.704–3(d), and any section 743 basis adjustment pursuant to § 1.743–1(j)(3)) that would have been allocated to the partner (to the extent attributable to the partnership interest sold or exchanged) if the partnership had sold all of its property in a fully taxable transaction for cash in an amount equal to the fair market value of such property (taking into account section 7701(g)) immediately prior to the partner’s transfer of the interest in the partnership. Any gain or loss recognized that is attributable to section 751 property will be ordinary gain or loss. The difference between the amount of capital gain or loss that the partner would realize in the absence of section 751 and the amount of ordinary income or loss determined under this paragraph (a)(2) is the transferor’s capital gain or loss on the sale of its partnership interest. For purposes of section 751(a) and paragraph (a) of this section, the amount of money or the fair market value of property received by the partner in exchange for all or part of his partnership interest must take into account the partner’s share of income or gain from section 751 property. See Example 1 in paragraph (g) of this section. See § 1.460–4(k)(2)(iv)(E) for rules relating to the amount of ordinary income or loss attributable to a contract accounted for under a long-term contract method of accounting.

* * * * *

(b) Certain distributions treated as sales or exchanges—(1) In general. (i) Certain distributions to which section 751(b) applies are treated in whole or in part as sales or exchanges of property, and not as distributions to which sections 731 through 736 apply. * * * For purposes of section 751 and this section, a partner’s interest in the partnership’s section 751 property includes allocations of tax items applying the principles of section 704(c).

* * * * *

(iii) If a distribution is a section 751(b) distribution, as described in paragraph (b)(2)(i) of this section, the tax consequences of the section 751(b) distribution, as determined under paragraph (b)(3) of this section, shall first apply, and then the rules of sections 731 through 736 shall apply. See paragraph (b)(5)(vi) of this section for treatment of payments under section 736(a).

(2) Distributions to which section 751(b) applies—(i) Section 751(b) amount. A distribution is a section 751(b) distribution if it gives rise to a “section 751(b) amount” for any partner. A partner’s section 751(b) amount (if any) associated with a distribution of partnership property (including money) equals the greatest of—

(A) The amount by which the partner’s net section 751 unrealized gain immediately before the distribution exceeds the partner’s net section 751 unrealized gain immediately after the distribution;

(B) The amount by which the partner’s net section 751 unrealized loss immediately after the distribution exceeds the partner’s net section 751 unrealized loss immediately before the distribution; and

(C) The amount of the partner’s net section 751 unrealized gain immediately before the distribution, increased by the total amount of the partner’s net section 751 unrealized loss immediately after the distribution (where neither of those numbers equals zero).

(ii) Net section 751 unrealized gain or loss before a distribution. A partner’s net section 751 unrealized gain or loss immediately before a distribution equals the amount of net income or loss, as the case may be, from section 751 property that would be allocated to the partner if the partnership disposed of all of the partnership’s assets for cash in an amount equal to the fair market value of such property (taking into account section 7701(g)). For this purpose, a partner’s net section 751 unrealized gain or loss includes any remedial allocations under § 1.704–3(d), and takes into account any section 743 basis adjustment pursuant to § 1.743–1(j)(3) and any carryover basis adjustment described in §§ 1.743–1(g)(2)(ii), 1.755–1(b)(5)(iii)(D), or 1.755–1(c)(4) as though the carryover basis adjustment was applied to the basis of new partnership section 751 property with fair market value of zero.

(iii) Net section 751 unrealized gain or loss after a distribution. A partner’s net section 751 unrealized gain or loss immediately after a distribution equals the sum of (to the extent applicable)—

(A) With respect to a partner remaining in the partnership immediately after the distribution (including a distributee partner remaining in the partnership), the amount of net income or loss, as the case may be (including any remedial allocations under § 1.704–3(d) and taking into account any section 743 basis adjustment pursuant to § 1.743–1(j)(3) and any carryover basis adjustment described in §§ 1.743–1(g)(2)(ii), 1.755–1(b)(5)(iii)(D), or 1.755–1(c)(4) as though the carryover basis adjustment was applied to the basis of new partnership section 751 property with fair market value of zero), from section 751 property that would be allocated to the partner if the partnership disposed of all of the partnership’s assets for cash in an amount equal to the fair market value of such property (taking into account section 7701(g)); and

(B) With respect to a partner receiving a distribution, the amount of net income or loss, as the case may be, from section 751 property that would be recognized by the distributee if, immediately after the distribution, the distributee disposed of the distributed assets for cash in an amount equal to the fair market value of such property (taking into account section 7701(g)).

(iv) Revaluation of assets. For a partnership that distributes money or property (other than a de minimis amount) to a partner as consideration for an interest in the partnership, and that owns section 751 property immediately after the distribution, if the partnership maintains capital accounts in accordance with § 1.704–1(b)(2)(iv), the partnership must revalue its assets immediately prior to the distribution in accordance with § 1.704–1(b)(2)(iv)(f). If a partnership does not maintain capital accounts in accordance with § 1.704–1(b)(2)(iv), the partnership must comply with this section by computing its partners’ shares of partnership gain or loss immediately before the distribution as if the partnership assets were sold for cash in a fully taxable transaction (taking into account section 7701(g)), and by taking those computed shares of gain or loss into account under the principles of section 704(c) (making subsequent adjustments for cost recovery and other events that affect the basis of the property). In addition, if the partnership (upper-tier partnership) owns another partnership directly or indirectly through one or more partnerships (lower-tier partnership), and the same persons own, directly or indirectly (through one or more entities), more than 50 percent of the capital and profits interests in both the upper-tier partnership and the lower-tier partnership, the lower-tier partnership must also revalue its assets immediately prior to the distribution in accordance with § 1.704–1(b)(2)(iv)(f) if the lower-tier partnership owns section 751 property. If the same persons do not own, directly or indirectly, more than 50 percent of the capital and profits interests in both the upper-tier partnership and the lower-tier partnership, the upper-tier partnership must allocate its distributive share of the lower-tier partnership’s items among its partners in a manner that reflects the allocations that would have been made had the lower-tier partnership revalued its property.

(3) Tax consequences of a section 751(b) distribution—(i) Reasonable approach. In the case of a section 751(b) distribution described in paragraph (b)(2) of this section, the partnership must choose a reasonable approach that is consistent with the purpose of section 751(b) under which each partner with a section 751(b) amount recognizes ordinary income (or takes it into account by eliminating a basis adjustment) equal to that section 751(b) amount immediately prior to the section 751(b) distribution. In certain circumstances described in paragraph (b)(3)(ii) of this section, a distributee partner may also be permitted or required to recognize capital gain. To be reasonable, an approach must conform to the general principles and anti-abuse rules described in paragraph (b)(4) of this section. An approach is not necessarily unreasonable merely because another approach would result in a higher aggregate tax liability. Once the partnership has adopted a reasonable approach, it must apply that approach consistently for all section 751(b) distributions, including for any distributions the partnership makes after a termination of the partnership under section 708(b)(1)(B). If the application of the adopted approach to a later section 751(b) distribution produces results inconsistent with the purpose of section 751, the partnership must adopt another reasonable approach that achieves the purposes of section 751 for that distribution only. See Example 3 through Example 8 in paragraph (g) of this section.

(ii) Gain Recognition—(A) Mandatory recognition. A partner’s net section 751 unrealized gain or net section 751 unrealized loss for purposes of paragraph (b)(3)(i) of this section is determined before taking into account any basis adjustments required by paragraph (b)(3)(iii) of this section. In certain instances, the application of paragraph (b)(3)(iii) of this section may cause a partner to receive distributed property with a basis that differs from the basis of the property in the hands of the distributing partnership. If an adjustment to the basis of the distributed section 751 property results in a section 734(b) basis adjustment, and that basis adjustment would have altered the amount of net section 751 unrealized gain or loss computed under paragraph (b)(2) of this section if the section 734(b) adjustment had been included immediately prior to the distribution, then the distributee partner must recognize capital gain immediately prior to the distribution in an amount sufficient to eliminate that section 734(b) basis adjustment. See Examples 5 and 6 in paragraph (g) of this section. If, however, the partnership makes an election under § 1.755–1(c)(2)(vi), then the partner must characterize all or a portion of the gain recognized under this paragraph as ordinary income or a dividend, as appropriate, to preserve the character of the gain in the adjusted asset. See Example 9 in paragraph (g) of this section.

(B) Elective recognition. A distributee partner may elect to recognize capital gain (in addition to amounts required to be recognized under this section) to eliminate section 732(a)(2) or (b) basis adjustments to the asset or assets received in distribution if, and to the extent that, the basis adjustments required by paragraph (b)(3)(iii) of this section would otherwise cause the distributee partner’s net section 751 unrealized gain to be greater immediately after the distribution than it was immediately before the distribution or would cause the distributee partner’s net section 751 unrealized loss to be less immediately after the distribution than it was immediately before the distribution. A distributee partner elects under this paragraph (b)(3)(ii)(B) by providing the partnership with written notification of its intent to make the election and reporting the capital gain on its return. An extension of time to make an election under this paragraph (b)(3)(ii)(B) will not be granted under § 301.9100–3 of this chapter. The requirement in paragraph (b)(1)(i) of this section that a partnership apply a chosen reasonable method consistently across all partnership distributions does not apply for purposes of this paragraph. See Example 7 in paragraph (g) of this section.

(iii) Adjustments to Basis. The partnership and its partners must make appropriate adjustments to the adjusted basis of the partners’ interests in the partnership, and of section 751 property and other property held by the partnership or partners, in a manner consistent with the adopted approach to reflect any ordinary income or capital gain recognized upon application of paragraph (b)(3) of this section, and section 704(c) amounts must be adjusted accordingly.

(4) General principles and anti-abuse rules. (i) The purpose of section 751 is to prevent a partner from converting its rights to ordinary income into capital gain, including by relying on the rules of section 704(c) to defer ordinary income while monetizing most of the value of the partnership interest. The partnership and all partners of the partnership must apply the rules of section 751 and § 1.751–1 in a manner consistent with the purpose of section 751. Accordingly, if a principal purpose of a transaction is to achieve a tax result that is inconsistent with the purpose of section 751, the Commissioner may recast the transaction for federal tax purposes as appropriate to achieve tax results that are consistent with the purpose of section 751. The Commissioner will determine whether a tax result is inconsistent with the purpose of section 751 based on all the facts and circumstances. The existence of one or more of the situations set forth below is presumed to establish that a transaction is inconsistent with the purpose of section 751 and disclosure to the Internal Revenue Service in accordance with § 1.751–1(b)(4)(ii) is required.

(A) Circumstances in which a partner received a distribution that would otherwise be subject to section 751(b), but for the application of the principles of section 704(c), and one or more of the following conditions exist (whether at the time of the distribution or, in the case of paragraph (b)(4)(i)(A)(2), (3), (4), or (5) of this section, a later date):

(1) The partner’s interest in net section 751 unrealized gain is at least four times greater than the partner’s capital account immediately after the distribution, pursuant to § 1.704–1(b)(2)(iv) (or comparable amount for partnerships not maintaining capital accounts under § 1.704–1(b)(2)(iv));

(2) The partner is substantially protected from losses from the partnership’s activities and has little or no participation in the profits from the partnership’s activities other than a preferred return that is in the nature of a payment for the use of capital;

(3) The partner engages in a transaction that, at the time of the transaction, causes the net value of the partner (or its successor) to be less than the tax liability that the partner (or its successor) would incur with respect to its interest in the partnership’s section 751 property upon a sale of its partnership interest for its fair market value at the time of the transaction. For this purpose, the net value of the partner (or its successor) equals—

(i) The fair market value of all assets owned by the partner (or its successor) that may be subject to creditor’s claims under local law (including the partner’s enforceable right to contributions from its owner or owners), less

(ii) All obligations of the partner (or its successor) other than the partner’s obligation with respect to the tax liability for which the net value is being determined;

(4) The partner transfers a portion of its partnership interest within five years after the distribution in a manner that does not trigger ordinary income recognition, and ordinary income or gain with respect to the partnership interest is subject to Federal income tax in the hands of the transferor partner immediately before the transfer, but any ordinary income or gain with respect to the partnership interest is exempt from, or otherwise not subject to, Federal income tax in the hands of the transferee partner immediately after the transfer;

(5) The partnership transfers to a corporation in a nonrecognition transaction section 751 property other than pursuant to a transfer of all property used in a trade or business (excluding assets that are not material to a continuation of the trade or business); or

(B) The partners agree to change (other than a de minimis change) the manner in which the partners share any item or class of items of income, gain, loss, deduction or credit of the partnership under the partnership agreement and that change reduces the partner’s net section 751 unrealized gain.

(ii) If a partner participates in a transaction described in paragraph (b)(4)(i)(A) or (B) of this section and does not recognize and report its share of ordinary income from section 751 property on its tax return for the taxable year of the transaction, the partner must file Form 8275-R, Regulation Disclosure Statement, or any appropriate successor form, disclosing its participation in the transaction for the taxable year in which the transaction occurred.

(5) Special rules. * * *

* * * * *

(ii) The transferee in a nonrecognition transaction of all or a portion of the partnership interest of a contributing partner is treated as the contributing partner for purposes of section 751(b)(2) in an amount attributable to the interest transferred.

(iii) For purposes of section 751(b)(2), if a partnership disposes of contributed section 751 property in a nonrecognition transaction, the substituted basis property (within the meaning of section 7701(a)(42)) received in exchange for such substituted basis property is treated as the contributed section 751 property with regard to the contributing partner. If a partnership transfers contributed section 751 property together with other property in a nonrecognition transaction, the substituted basis property (within the meaning of section 7701(a)(42)) is treated as the contributed section 751 property with regard to the contributing partner in the same proportion as the fair market value of the contributed section 751 property, at the time of the transfer, bears to the fair market value of the other property transferred at the time of the transfer. If a transfer described in this paragraph (b)(5)(iii) was in exchange for an interest in an entity, the interest in the entity will not be treated as the contributed section 751 property with regard to the contributing partner to the extent the value of the interest is attributable to other property the partnership contributed to the entity.

(iv) For purposes of section 751(b)(2), an interest in an entity previously contributed to the partnership is not treated as previously contributed property to the extent the value of the interest is attributable to property the partnership contributed to the entity after the interest was contributed to the partnership. The preceding sentence does not apply to the extent that the property contributed to the entity was contributed to the partnership by the partner that also contributed the interest in the entity to the partnership.

(v) For purposes of section 751(b)(2), the distribution of an undivided interest in property is treated as the distribution of previously contributed property to the extent that the undivided interest does not exceed the undivided interest, if any, contributed by the distributee partner in the same property.

* * * * *

(6) Statements required— (i) Partnership. A partnership that makes a section 751(b) distribution must submit with its return for the year of the distribution a statement for each section 751(b) distribution made during the year that includes the following:

(A) A caption identifying the statement as the disclosure of a section 751(b) distribution and the date of the distribution; and

(B) A brief description of the reasonable approach adopted by the partnership pursuant to paragraph (b)(3)(i) of this section for recognizing the ordinary income; if applicable, the capital gain required to be recognized; and if relevant, whether the approach varies from an approach previously adopted within any of the three tax years preceding the current tax year.

(ii) Partner. A partnership that makes a section 751(b) distribution during the partnership’s tax year must submit with its return for the year of the distribution a statement for each partner that has a section 751(b) amount greater than $0 in connection with that distribution. The statement must be attached to the statement for that partner required by section 6031(b) and § 1.6031(b)–1T(a), and must include the following:

(A) The date of the section 751(b) distribution;

(B) The amount of ordinary income the partner recognized pursuant to paragraph (b)(3)(i) of this section; and

(C) The amount of capital gain the partner recognized, if any, pursuant to paragraph (b)(3)(ii)(A) or (B) of this section.

(c) * * *

(4) * * *

(vi) With respect to any taxable year of a partnership beginning after July 18, 1984, amounts treated as ordinary income under section 467 are treated as ordinary income under this section in the same manner as amounts treated as ordinary income under section 1245 (see paragraph (c)(4)(iii) of this section) or section 1250 (see paragraph (c)(4)(v) of this section).

* * * * *

(x) With respect to any taxable year of a partnership beginning after July 18, 1984, the term unrealized receivables, for purposes of this section and sections 731, 732, and 741 (but not for purposes of section 736), includes any market discount bond (as defined in section 1278) and any short-term obligation (as defined in section 1283) but only to the extent of the amount that would be treated as ordinary income if (at the time of the transaction described in this section or section 731, 732, or 741, as the case may be) such property had been sold by the partnership.

* * * * *

(d) Inventory items which have substantially appreciated in value— (1) Substantial appreciation. Partnership inventory items shall be considered to have appreciated substantially in value if, at the time of the distribution, the total fair market value of all the inventory items of the partnership exceeds 120 percent of the aggregate adjusted basis for such property in the hands of the partnership (without regard to any special basis adjustment to the partner). The terms “inventory items which have appreciated substantially in value” or “substantially appreciated inventory items” refer to the aggregate of all partnership inventory items but do not include any unrealized receivables. * * *

* * * * *

(e) Section 751 property and other property. For purposes of paragraph (a) of this section, section 751 property means unrealized receivables or inventory items. For purposes of paragraph (b) of this section, section 751 property means unrealized receivables or substantially appreciated inventory items. For purposes of all paragraphs of this section, other property means all property (including money) that is not section 751 property.

(f) Applicability date. The rules contained in paragraph (a)(2) of this section apply to transfers of partnership interests that occur on or after November 3, 2014. The rules contained in paragraph (a)(3) of this section apply to transfers of partnership interests that occur on or after December 15, 1999. The rules contained in paragraphs (b)(2) and (3) of this section apply to distributions of partnership property that occur on or after the date of publication of a Treasury decision adopting these rules as final regulations in the Federal Register. However, a partnership and its partners may apply the rules contained in paragraph (b)(2) of this section for purposes of determining a partner’s interest in the partnership’s section 751 property on or after November 3, 2014, provided the partnership and its partners apply paragraphs (a)(2), (b)(2), and (b)(4) of this section consistently for all partnership sales, exchanges, and distributions, including for any distributions the partnership makes after a termination of the partnership under section 708(b)(1)(B).

(g) Examples. Application of the provisions of section 751 may be illustrated by the following examples. In each of Examples 2 through 9 of this paragraph (g), none of the section 751 property qualifies as property that the distributee previously contributed as described in section 751(b)(2)(A), and no distribution to a retiring partner is a payment described in section 736(a):

Example 1. (i)(A) A and B are equal partners in personal service partnership PRS. A contributed nondepreciable capital assets (the “Capital Assets”) to PRS with a basis and fair market value of $14,000. B contributed unrealized receivables described in paragraph (c) of this section (the “Unrealized Receivables”) to PRS with a basis of zero and fair market value of $14,000. Later, when the fair market value of the Capital Assets had declined to $2,000, B transferred its interest in PRS to T for $9,000 when PRS’s balance sheet (reflecting a cash receipts and disbursements method of accounting) was as follows:

(B) The total amount realized by B is $10,000, consisting of the cash received, $9,000, plus $1,000, B’s share of the partnership liabilities assumed by T. See section 752. B’s interest in the partnership property includes an interest in the partnership’s Unrealized Receivables. B’s basis in its partnership interest is $2,000 ($1,000, plus $1,000, B’s share of partnership liabilities). If section 751(a) did not apply to the sale, B would recognize $8,000 of capital gain from the sale of the interest in PRS. However, section 751(a) does apply to the sale.

(ii) For purposes of section 751(a), the amount of money or the fair market value of property received by the partner in exchange for all or part of his partnership interest must take into account the partner’s share of income or gain from section 751 property. If PRS sold all of its section 751 property in a fully taxable transaction immediately prior to the transfer of B’s partnership interest to T, B would have been allocated $14,000 of ordinary income from the sale of PRS’s Unrealized Receivables under section 704(c). Therefore, B will recognize $14,000 of ordinary income with respect to the Unrealized Receivables. The difference between the amount of capital gain or loss that the partner would realize in the absence of section 751 ($8,000) and the amount of ordinary income or loss determined under paragraph (a)(2) of this section ($14,000) is the transferor’s capital gain or loss on the sale of its partnership interest. In this case, B will recognize a $6,000 capital loss.

Example 2. (i) A, B, and C each contribute $120 to partnership ABC in exchange for a 1/3 interest. A, B, and C each share in the profits and losses of ABC in accordance with their 1/3 interest. ABC purchases land for $100 in Year 1. At the end of Year 3, when ABC holds $260 in cash and land with a value of $100 and has generated $90 in zero-basis unrealized receivables, ABC distributes $50 cash to C in a current distribution, reducing C’s interest in ABC from 1/3 to 1/4. ABC has a section 754 election in effect. To determine if the distribution is a distribution to which section 751(b) applies, ABC must apply the test set forth in paragraph (b)(2) of this section.

(ii)(A) Pursuant to paragraph (b)(2)(iv) of this section, ABC revalues its assets and its partners’ capital accounts are increased under § 1.704–1(b)(2)(iv)(f) to reflect each partner’s share of the unrealized gain in the partnership’s assets. Before the distribution, ABC’s balance sheet is as follows:

(B) If ABC disposed of all of its assets for cash in an amount equal to the fair market value of such property immediately before the distribution, A, B, and C would each be allocated $30 of net income from ABC’s section 751 property. Accordingly, A, B, and C’s net section 751 unrealized gain immediately before the distribution is $30 each under paragraph (b)(2)(ii) of this section.

(iii)(A) After the distribution (but before taking into account any consequences under this section), ABC’s balance sheet would be as follows:

(B) If ABC disposed of all of its assets in exchange for cash in amounts equal to the fair market values of those assets immediately after the distribution, A, B, and C would each still be allocated $30 of net income from ABC’s section 751 property pursuant to § 1.704–3(a)(6). C did not receive any section 751 property in the distribution. Accordingly, A, B, and C’s net section 751 unrealized gain immediately after the distribution is $30 each under paragraph (b)(2)(iii) of this section.

(iv) Because no partner’s net section 751 unrealized gain is greater immediately before the distribution than immediately after the distribution, and because no partner’s net section 751 unrealized loss is greater immediately after the distribution than immediately before the distribution, the distribution is not a section 751(b) distribution under paragraph (b)(2)(i) of this section. Accordingly, section 751(b) does not apply to the distribution.

Example 3. (i) Assume the same facts as in Example 2 of this paragraph (g), but assume ABC distributes $150 cash to C in complete liquidation of C’s interest. To determine if the distribution is a distribution to which section 751(b) applies, ABC must apply the test set forth in paragraph (b)(2) of this section.

(ii)(A) Pursuant to paragraph (b)(2)(iv) of this section, ABC revalues its assets and its partners’ capital accounts are increased under § 1.704–1(b)(2)(iv)(f) to reflect each partner’s share of the unrealized gain in the partnership’s assets. Before the distribution, ABC’s balance sheet is as follows:

(B) If ABC disposed of all of its assets in exchange for cash in amounts equal to the fair market values of these assets immediately before the distribution, A, B, and C would each be allocated $30 of net income from ABC’s section 751 property. Accordingly, A, B, and C’s net section 751 unrealized gain immediately before the distribution is $30 each under paragraph (b)(2)(ii) of this section.

(iii)(A) Because ABC has elected under section 754, and because A recognizes $30 gain on the distribution of cash, the basis of the real property is increased to $130 under section 734(b). After the distribution (but before taking into account any consequences under this section), ABC’s balance sheet would be as follows:

(B) Because C is no longer a partner in ABC, C would not be allocated any net income from ABC’s section 751 property immediately after the distribution. Also, C did not receive any section 751 property in the distribution. Accordingly, C’s net section 751 unrealized gain immediately after the distribution is $0 under paragraph (b)(2)(iii) of this section.

(iv) Because C’s net section 751 unrealized gain is greater immediately before the distribution than immediately after the distribution, section 751(b) applies to the distribution. Under paragraph (b)(2)(i) of this section, C has a section 751(b) amount equal to $30, the amount by which C’s share of pre-distribution net section 751 unrealized gain ($30) exceeds C’s share of post-distribution net section 751 unrealized gain ($0). Accordingly, paragraph (b)(3)(i) of this section requires C to recognize $30 of ordinary income using a reasonable approach consistent with the purpose of this section. ABC considers two approaches, the first of which is described in paragraphs (v) and (vi) of this example, and the second of which is described in paragraphs (vii) and (viii) of this example.

(v) Assume ABC adopts an approach under which, immediately before the section 751(b) distribution, C is deemed to recognize $30 of ordinary income. To reflect C’s recognition of $30 of ordinary income, C increases its basis in its ABC partnership interest by $30, and the partnership increases its basis in the unrealized receivable by the $30 of income recognized by C, immediately before the distribution. Provided the partnership applies the approach consistently for all section 751(b) distributions, ABC’s adopted approach is reasonable. After taking into account the tax consequences of the section 751(b) distribution immediately prior to the cash distribution, ABC’s modified balance sheet is as follows:

(vi) After determining the tax consequences of the section 751(b) distribution, the rules of sections 731 through 736 apply. Accordingly, C recognizes no gain or loss under section 731(a) upon the distribution. Because C recognizes no gain on the distribution, the basis of the partnership real property is not adjusted. After the distribution, ABC’s balance sheet is as follows:

(vii) Assume alternatively that ABC adopts an approach under which, immediately before the section 751(b) distribution, C is deemed to—

(A) Receive a distribution of ABC’s unrealized receivables with a fair market value of $30 and a tax basis of $0;

(B) Sell the unrealized receivable to ABC in exchange for $30, recognizing $30 of ordinary income; and

(C) Contribute the $30 to ABC. Provided the partnership applies the approach consistently for all section 751(b) distributions, ABC’s adopted approach is reasonable. After taking into account the tax consequences of the section 751(b) distribution immediately prior to the cash distribution, ABC’s modified balance sheet is the same as the balance sheet shown in paragraph (v) of this example.

(viii) After determining the tax consequences of the section 751(b) distribution, the rules of sections 731 through 736 apply. The tax consequences under the rules of sections 731 through 736 are the same tax consequences described in paragraph (vi) of this example.

Example 4. (i) A and B are equal partners in a partnership, AB, that owns Unrealized Receivable with a fair market value of $50 and nondepreciable real property with a basis of $50 and a fair market value of $100. A has an adjusted basis in its partnership interest of $25, and B has an adjusted basis in its partnership interest of $50. The partnership has a section 754 election in effect, and B has a basis adjustment under section 743(b) of $25 that is allocated to Unrealized Receivable. AB distributes Unrealized Receivable to A in a current distribution. To determine if the distribution is a distribution to which section 751(b) applies, AB must apply the test set forth in paragraph (b)(2) of this section.

(ii)(A) AB makes a non-mandatory revaluation of its assets and its partners’ capital accounts are increased under § 1.704–1(b)(2)(iv)(f) to reflect each partner’s share of the unrealized gain in the partnership’s assets. Before the distribution, AB’s balance sheet is as follows:

(B) If AB disposed of all of its assets in exchange for cash in amounts equal to the fair market values of these assets immediately before the distribution, A and B would each be allocated $25 of net income from AB’s section 751 property. However, B’s net income from Unrealized Receivable would be offset by its $25 section 743 adjustment. § 1.743–1(j)(3). Accordingly, A and B’s net section 751 unrealized gain immediately before the distribution are $25 and $0, respectively, under paragraph (b)(2)(ii) of this section.

(iii)(A) After the distribution (but before taking into account any consequences under this section), AB’s balance sheet would be as follows:

(B) If AB disposed of all of its assets in exchange for cash in amounts equal to the fair market values of those assets immediately after the distribution, no partner would be allocated net income or loss from section 751 property. However, B has a carryover basis adjustment to ordinary income property of $25 under §§ 1.743–1(g)(2)(ii) and 1.755–1(c)(4), which B must treat as applied to section 751 property with fair market value of $0 pursuant to paragraph (b)(2)(ii) of this section. Accordingly, B’s net section 751 unrealized loss immediately after the distribution is $25 under paragraph (b)(2)(iii)(A) of this section. If, immediately after the distribution, A disposed of Unrealized Receivable in exchange for $50 cash, A would recognize $50 of net income from section 751 property. Accordingly, A’s net section 751 unrealized gain immediately after the distribution is $50 under paragraph (b)(2)(iii)(B) of this section.

(iv) Because B’s net section 751 unrealized loss immediately after the distribution ($25) exceeds B’s net section 751 unrealized loss immediately before the distribution ($0), the distribution is a section 751(b) distribution. Under paragraph (b)(2)(i) of this section, B has a section 751(b) amount equal to $25, the difference of B’s share of pre-distribution net section 751 unrealized gain ($0) and B’s share of post-distribution net section 751 unrealized loss ($25). Accordingly, paragraph (b)(3)(i) of this section requires B to account for $25 of ordinary income using a reasonable approach consistent with the purpose of this section.

(v) Assume AB adopts an approach under which, immediately before the section 751(b) distribution, B is deemed to—

(A) Receive a distribution of Unrealized Receivable with a fair market value of $25 and a tax basis of $25 (which consists of B’s section 743(b) basis adjustment and is determined solely for purposes of applying a reasonable method consistent with the purposes of section 751(b));

(B) Sell Unrealized Receivable to AB in exchange for $25, so that B recognizes $0 of ordinary income, and AB receives Unrealized Receivable with a basis of $25; and

(C) Contribute the $25 to AB. Provided the partnership applies the approach consistently for all section 751(b) distributions, AB’s adopted approach is reasonable. After taking into account the tax consequences of the section 751(b) distribution, AB’s modified balance sheet is as follows:

(vi) After determining the tax consequences of the section 751(b) distribution, the rules of sections 731 through 736 apply. Accordingly, A recognizes no gain on the distribution of Unrealized Receivable, which A takes with a basis of $25.

Example 5. Capital Gain Recognition Required. (i) A, B, and C are each 1/3 partners in a partnership, ABC, that holds Unrealized Receivable 1 with a fair market value of $90, Unrealized Receivable 2 with a fair market value of $30, and nondepreciable real property with a fair market value of $180. The partnership has a section 754 election in effect. Each of the partners has an adjusted basis in its partnership interest of $0 with a fair market value of $100. None of the partners has a capital loss carryforward. ABC distributes to A Unrealized Receivable 1 in a current distribution. To determine if the distribution is a distribution to which section 751(b) applies, ABC must apply the test set forth in paragraph (b)(2) of this section.

(ii)(A) Pursuant to paragraph (b)(2)(iv) of this section, ABC revalues its assets and its partners’ capital accounts are increased under § 1.704–1(b)(2)(iv)(f) to reflect each partner’s share of the unrealized gain in the partnership’s assets. Before the distribution, ABC’s balance sheet is as follows:

(B) If ABC disposed of all of its assets for cash in an amount equal to the fair market value of such property immediately before the distribution, A, B, and C would each be allocated $40 of net income from ABC’s section 751 property ($30 each from Unrealized Receivable 1 and $10 each from Unrealized Receivable 2). Accordingly, A, B, and C’s net section 751 unrealized gain immediately before the distribution is $40 each under paragraph (b)(2)(ii) of this section.

(iii)(A) After the distribution (but before taking into account any consequences under this section), ABC’s balance sheet would be as follows:

(B) If ABC disposed of all of its assets in exchange for cash in amounts equal to the fair market values of those assets immediately after the distribution, A, B, and C would each be allocated $10 of net income from ABC’s section 751 property ($10 each from Unrealized Receivable 2). If immediately after the distribution, A disposed of Unrealized Receivable 1 in exchange for $90 cash, A would recognize $90 of net income from section 751 property. Accordingly, B and C’s net section 751 unrealized gain immediately after the distribution is $10 each under paragraph (b)(2)(iii)(A) of this section, and A’s is $100 under paragraphs (b)(2)(iii)(A) and (B) of this section.

(iv) Because B and C’s net section 751 unrealized gain is greater immediately before the distribution than immediately after the distribution, the distribution is a section 751(b) distribution. Under paragraph (b)(2)(i) of this section, each of B and C has a section 751(b) amount equal to $30, the amount by which each partner’s share of pre-distribution net section 751 unrealized gain ($40) exceeds its share of post-distribution net section 751 unrealized gain ($10). Accordingly, paragraph (b)(3)(i) of this section requires each of B and C to recognize $30 of ordinary income using a reasonable approach consistent with the purpose of this section. ABC considers three approaches, the first of which is described in paragraphs (v) and (vi) of this example, the second of which is described in paragraphs (vii) and (viii) of this example, and the third of which is described in paragraph (ix) of this example.

(v) Assume ABC adopts an approach under which, immediately before the section 751(b) distribution, B and C are each deemed to recognize $30 of ordinary income. To reflect B and C’s recognition of $30 of ordinary income, B and C increase their bases in their ABC partnership interests by $30 each, and the partnership increases its basis in Unrealized Receivable 1 by $60 immediately before the distribution to A. Following the distribution to A, A’s basis in Unrealized Receivable 1 is $0 under section 732(a)(2). Because ABC has elected under section 754, the distribution of Unrealized Receivable 1 to A would result in a $60 section 734(b) adjustment to Unrealized Receivable 2. See § 1.755–1(c)(1). Because that basis adjustment would have altered the amount of net section 751 unrealized gain or loss computed under paragraph (b)(2) of this section, A must recognize $60 of capital gain prior to the distribution of Unrealized Receivable 1 pursuant to paragraph (b)(3)(ii)(A) of this section. This gain recognition increases A’s basis in its ABC partnership interest by $60 immediately before the distribution to A, eliminating the section 734(b) adjustment. See section 732(a)(2). In addition, the partnership increases its basis in Real Property by $60 pursuant to paragraph (b)(3)(iii) of this section, and treats A’s gain recognized as reducing A’s $60 reverse section 704(c) amount in the Real Property. Provided the partnership applies the approach consistently for all section 751(b) distributions, ABC’s adopted approach is reasonable. After taking into account the tax consequences of the deemed gain approach described in this example, ABC’s modified balance sheet immediately prior to the distribution is as follows:

(vi) After determining the tax consequences of the section 751(b) distribution, the rules of sections 731 through 736 apply. Thus, Unrealized Receivable 1 would take a $60 basis in A’s hands under section 732(a), and no section 734(b) adjustment would be made to Unrealized Receivable 2. After the distribution, ABC’s balance sheet is as follows:

(vii) Assume alternatively that ABC adopts an approach under which, immediately before the section 751(b) distribution, B and C are each deemed to:

(A) Receive a distribution of Unrealized Receivable 1 with a fair market value of $30 and tax basis of $0;

(B) Sell the unrealized receivable to ABC for $30, recognizing $30 of ordinary income; and

(C) Contribute the $30 to ABC. For the same reasons stated in paragraph (v) of this example, A recognizes capital gain of $60. To accomplish this, A, immediately before the section 751(b) distribution, is deemed to:

(1) Receive a distribution of Real Property with a fair market value of $60 and tax basis of $0;

(2) Sell the Real Property to ABC for $60, recognizing $60 of capital gain; and

(3) Contribute the $60 to ABC.

(viii) The partnership treats the $60 of gain recognized by A as reducing A’s $60 reverse section 704(c) amount in the Real Property. Provided the partnership applies the approach consistently for all section 751(b) distributions, ABC’s adopted approach is reasonable. Before taking into account the tax consequences of the section 751(b) distribution, ABC’s balance sheet is the same as the balance sheet shown in paragraph (v) of this example. After determining the tax consequences of the section 751(b) distribution, the rules of sections 731 through 736 apply. The tax consequences under the rules of sections 731 through 736 are the same tax consequences described in paragraph (vi) of this example.

(ix) Assume alternatively that A does not recognize capital gain of $60. As a result, upon the distribution of Unrealized Receivable 1 to A, ABC makes a $60 section 734(b) adjustment to Unrealized Receivable 2. The adopted approach is not reasonable because it is contrary to paragraph (b)(3)(ii)(A) of this section.

Example 6. Capital Gain Recognition Required. (i)(A) Assume the same facts as Example 5 of this paragraph (g), except that Unrealized Receivable 1 has a $9 tax basis, and each of the partners has an adjusted basis in its partnership interest of $3. Before the distribution, ABC’s balance sheet is as follows:

(B) If ABC disposed of all of its assets for cash in an amount equal to the fair market value of such property immediately before the distribution, A, B, and C would each be allocated $37 of net income from ABC’s section 751 property ($27 each from Unrealized Receivable 1 and $10 each from Unrealized Receivable 2). Accordingly, A, B, and C’s net section 751 unrealized gain immediately before the distribution is $37 each under paragraph (b)(2)(ii) of this section.

(ii)(A) After the distribution (but before taking into account any consequences under this section), ABC’s balance sheet would be as follows:

(B) If ABC disposed of all of its assets for cash in an amount equal to the fair market value of such property immediately after the distribution, taking into account the $6 section 734(b) adjustment allocated to Unrealized Receivable 2, A, B, and C would each be allocated $8 of net income from ABC’s section 751 property ($8 each from Unrealized Receivable 2). If, immediately after the distribution, A disposed of Unrealized Receivable 1 for cash in an amount equal to its fair market value, A would recognize $87 of net income from section 751 property. Accordingly, B and C’s net section 751 unrealized gain immediately after the distribution is $8 each under paragraph (b)(2)(iii)(A) of this section, and A’s is $95 under paragraphs (b)(2)(iii)(A) and (B) of this section.

(iii) Because B and C’s net section 751 unrealized gain is greater immediately before the distribution than immediately after the distribution, the distribution is a section 751(b) distribution. Under paragraph (b)(2)(i) of this section, each of B and C has a section 751(b) amount equal to $29, the amount by which each partner’s share of pre-distribution net section 751 unrealized gain ($37) exceeds its share of post-distribution net section 751 unrealized gain ($8). Accordingly, paragraph (b)(3)(i) of this section requires each of B and C to recognize $29 of ordinary income using a reasonable approach consistent with the purpose of this section. ABC considers two approaches, the first of which is described in paragraphs (iv) and (v) of this example, and the second of which is described in paragraphs (vi) and (vii) of this example.

(iv) Assume ABC adopts an approach under which, immediately before the section 751(b) distribution, B and C are each deemed to recognize $29 of ordinary income. To reflect B and C’s recognition of $29 of ordinary income, B and C increase their bases in their ABC partnership interests by $29 each, and the partnership increases its basis in Unrealized Receivable 1 by $58 to $67 immediately before the distribution to A. Following the distribution to A, A’s basis in Unrealized Receivable 1 is $3 under section 732(a)(2). Because ABC has elected under section 754, the distribution of Unrealized Receivable 1 to A would result in a $64 section 734(b) adjustment to Unrealized Receivable 2 (rather than the $6 section 734(b) adjustment computed prior to the application of this section). See § 1.755–1(c)(1). Because that additional basis adjustment would have altered the amount of net section 751 unrealized gain or loss computed under paragraph (b)(2) of this section, A must recognize $58 of capital gain prior to the distribution of Unrealized Receivable 1 pursuant to paragraph (b)(3)(ii)(A) of this section. This gain recognition increases A’s basis in its ABC partnership interest by $58 to $61 immediately before the distribution to A. In addition, the partnership increases its basis in Real Property by $58 pursuant to paragraph (b)(3)(iii) of this section, and treats A’s gain recognized as reducing A’s $60 reverse section 704(c) amount in the Real Property. Provided the partnership applies the approach consistently for all section 751(b) distributions, ABC’s adopted approach is reasonable. After taking into account the tax consequences of the deemed gain approach described in this example, ABC’s modified balance sheet immediately prior to the distribution is as follows:

(v) After determining the tax consequences of the section 751(b) distribution, the rules of sections 731 through 736 apply. Thus, A would take a $61 tax basis in Unrealized Receivable 1 under section 732(a), and a $6 section 734(b) adjustment would be made to Unrealized Receivable 2. After the distribution, ABC’s balance sheet is as follows:

(vi) Assume alternatively that ABC adopts an approach under which, immediately before the section 751(b) distribution, B and C are each deemed to:

(A) Receive a distribution of Unrealized Receivable 1 with a fair market value of $29 and tax basis of $0;

(B) Sell the unrealized receivable to ABC for $29, recognizing $29 of ordinary income; and

(C) Contribute the $29 to ABC. For the same reasons stated in paragraph (iv) of this example, A recognizes capital gain of $58. To accomplish this, A, immediately before the section 751(b) distribution, is deemed to:

(1) Receive a distribution of Real Property with a fair market value of $58 and tax basis of $0;

(2) Sell the Real Property to ABC for $58, recognizing $58 of capital gain; and

(3) Contribute the $58 to ABC.

(vii) The partnership treats the $58 of gain recognized by A as reducing A’s $60 reverse section 704(c) amount in the Real Property. Provided the partnership applies the approach consistently for all section 751(b) distributions, ABC’s adopted approach is reasonable. After taking into account the tax consequences of the section 751(b) distribution, ABC’s balance sheet is the same as the balance sheet shown in paragraph (iv) of this example. After determining the tax consequences of the section 751(b) distribution, the rules of sections 731 through 736 apply. The tax consequences under the rules of sections 731 through 736 are the same tax consequences described in paragraph (v) of this example.

Example 7. Capital Gain Recognition Elective. (i)(A) Assume the same facts as described in Example 6 of this paragraph (g), including that ABC adopts the deemed gain approach described in paragraph (iv), except that ABC does not have a section 754 election in effect. As in Example 6, each of A, B, and C has net section 751 unrealized gain of $37 immediately before the distribution. After the distribution (but before taking into account any consequences under this section), ABC’s balance sheet would be as follows:

(B) If ABC disposed of all of its assets for cash in an amount equal to the fair market value of such property immediately after the distribution, because there is no section 734(b) adjustment allocated to Unrealized Receivable 2, A, B, and C would each be allocated $10 of net income from ABC’s section 751 property ($10 each from Unrealized Receivable 2). If, immediately after the distribution, A disposed of Unrealized Receivable 1 for cash in an amount equal to its fair market value, A would recognize $87 of net income from section 751 property. Accordingly, B and C’s net section 751 unrealized gain immediately after the distribution is $10 each under paragraph (b)(2)(iii)(A) of this section, and A’s is $97 under paragraphs (b)(2)(iii)(A) and (B) of this section.

(ii) Because B and C’s net section 751 unrealized gain is greater immediately before the distribution than immediately after the distribution, the distribution is a section 751(b) distribution. Under paragraph (b)(2)(i) of this section B and C each have a section 751(b) amount equal to $27, the amount by which those partners’ shares of pre-distribution net section 751 unrealized gain ($37), exceeds their shares of post-distribution net section 751 unrealized gain ($10). Accordingly, paragraph (b)(3)(i) of this section requires each of B and C to recognize $27 of ordinary income using a reasonable approach consistent with the purpose of this section.

(iii) Assume ABC adopts an approach under which, immediately before the section 751(b) distribution, B and C are each deemed to recognize $27 of ordinary income. To reflect B and C’s recognition of $27 of ordinary income, B and C increase their bases in their ABC partnership interests by $27, and the partnership increases its basis in Unrealized Receivable 1 by $54 to $63 immediately before the distribution to A. The distribution to A results in an adjustment to the basis of the distributed Unrealized Receivable 1 under section 732(a)(2), reducing the basis of Unrealized Receivable 1 in the hands of A to $3. Because ABC has not elected under section 754 and does not have a substantial basis reduction under section 734(d), this $60 decrease to the basis of Unrealized Receivable 1 will not affect the basis of other assets held by ABC. Thus, the distribution does not alter the amount of net section 751 unrealized gain or loss computed under paragraph (b)(2) of this section. Accordingly, A is not obligated under paragraph (b)(3)(ii)(A) of this section to recognize gain or income upon the distribution of Unrealized Receivable 1. However, A may elect to recognize $60 of capital gain under paragraph (b)(3)(ii)(B) of this section to eliminate the section 732 basis adjustment to the distributed Unrealized Receivable 1 which would otherwise cause A’s net section 751 unrealized gain to be greater immediately after the distribution than it was immediately before the distribution. This gain recognition increases A’s basis in its ABC partnership interest by $60 immediately before the distribution to A. In addition, the partnership increases its basis in Real Property by $60 pursuant to paragraph (b)(3)(iii) of this section, and treats A’s gain recognized as reducing A’s $60 reverse section 704(c) amount in the Real Property. A receives the distributed Unrealized Receivable 1 with a basis of $63, so that the distribution does not increase A’s net section 751 unrealized gain. After the distribution, ABC’s balance sheet is as follows:

Example 8. (i) A, B, and C, each domestic corporations, are 1/3 partners in a domestic partnership ABC. ABC purchased 100% of the stock in two foreign corporations, X and Y. X and Y each have one share of stock outstanding. ABC has a basis of $15 in its X share with a fair market value of $150, and a basis of $3 in its Y share with a fair market value of $30. The earnings and profits of X that are attributable to ABC’s X stock under section 1248 are $135; the earnings and profits of Y that are attributable to ABC’s Y stock are $27. ABC has a section 754 election in effect. Each of A, B, and C has a partnership interest with an adjusted basis of $6 and a fair market value of $60. On January 1, 2013, ABC distributes the Y share to A in a current distribution. To determine if the distribution is a distribution to which section 751(b) applies, ABC must apply the test set forth in paragraph (b)(2) of this section.

(ii)(A) Pursuant to paragraph (b)(2)(iv) of this section, ABC revalues its assets. Its partners’ capital accounts are increased under § 1.704–1(b)(2)(iv)(f) to reflect each partner’s share of the unrealized gain in the partnership’s assets. Before the distribution, ABC’s balance sheet is as follows (with the shares of X and Y each reflected as having both an unrealized receivable component and a capital gain component):

(B) If ABC disposed of all of its assets for cash in an amount equal to the assets’ fair market value immediately before the distribution, A, B, and C would each be allocated $54 of net income from ABC’s section 751 property ($45 each from X stock and $9 each from Y stock). Accordingly, A, B, and C’s net section 751 unrealized gain immediately before the distribution is $54 each under paragraph (b)(2)(ii) of this section.

(iii)(A) After the distribution (but before taking into account any consequences under this section), ABC’s balance sheet is as follows:

(B) If ABC disposed of its asset for cash in an amount equal to the fair market value of that asset immediately after the distribution, A, B, and C would each be allocated $45 of net income from ABC’s section 751 property pursuant to § 1.704–3(a)(6). A, however, received Y stock, which continues to be section 751 property in A’s hands under section 735(a), with a holding period that includes the partnership’s holding period under section 735(b). If A disposed of its Y stock for cash in an amount equal to its fair market value, A would recognize $27 of gain under section 751(b) on the Y stock (a foreign corporation described in section 1248) that is included in A’s income under section 1248 as a dividend to the extent of the attributable earnings. Accordingly, B and C’s net section 751 unrealized gain immediately after the distribution is $45 each under paragraph (b)(2)(iii)(A) of this section, and A’s is $72 under paragraphs (b)(2)(iii)(A) and (B) of this section.

(iv) Because B and C’s net section 751 unrealized gain is greater immediately before the distribution than immediately after the distribution, the distribution is a section 751(b) distribution. Under paragraph (b)(2)(i) of this section, B and C each have a section 751(b) amount equal to $9, the amount by which those partners shares of pre-distribution net section 751 unrealized gain ($54) exceeds their shares of post-distribution net section 751 unrealized gain ($45). Accordingly, paragraph (b)(3)(i) of this section requires each of B and C to recognize $9 as a dividend under section 1248 using a reasonable approach consistent with the purpose of this section. ABC considers two approaches, the first of which is described in paragraphs (v) and (vi) of this example, and the second of which is described in paragraph (vii) of this example.

(v) Assume ABC adopts an approach under which, immediately before the section 751(b) distribution, B and C are each deemed to recognize $9 of gain includible as a dividend with respect to the distribution of the Y stock, which is treated as a sale or exchange for purposes of section 1248. To reflect B and C’s recognition of $9 of dividend income, B and C increase the bases in their ABC partnership interests by $9 each, and the partnership increases its basis in the Y share unrealized receivable component by $18 immediately before the distribution. The portion of the unrealized receivable component of the Y share that is deemed to be sold or exchanged under section 1248 has a new holding period beginning on the day after the section 751(b) distribution (“the new holding period portion”). The earnings and profits of $18 attributable to the new holding period portion of the Y share are 2/3 of the total earnings and profits attributable to the Y share immediately before the distribution (B and C’s $18 aggregate gain recognized under section 751(b) divided by $27, the aggregate of all the partners’ net section 751 unrealized gain immediately before the distribution). The remaining earnings and profits are allocated to the remainder of the Y share. Provided the partnership applies the approach consistently for all section 751(b) distributions, ABC’s adopted approach is reasonable. After taking into account the tax consequences of the deemed gain approach described in this example, ABC’s modified balance sheet immediately before the distribution is as follows:

(vi) After determining the tax consequences of the section 751(b) distribution, the rules of sections 731 through 736 apply. Accordingly, the basis of the distributed Y stock in A’s hands is limited under section 732(a)(2) to A’s $6 basis in its partnership interest. Pursuant to section 732(c)(3)(B), the $15 decrease in basis from $21 to $6 must be allocated to the distributed components of the Y stock in proportion to their respective adjusted bases. A must allocate the $15 decrease in basis in the Y stock between the new holding period portion (which has a basis of $18) and the remainder of the Y share (which has a basis of $3). Accordingly, A receives the new holding period portion of the Y share with an adjusted basis of $5.14 ($6 multiplied by ($18 divided by $21)), and the remainder of the Y share with an adjusted basis of $0.86 ($6 multiplied by ($3 divided by $21)). Because the basis of the distributed Y stock in A’s hands was reduced from $21 (the basis of the Y stock in the hands of ABC) to $6 (the basis in A’s hands), ABC must increase the basis of its remaining asset under section 734(b)(1)(B) by $15. ABC must allocate the $15 under § 1.755–1(c)(1)(i) to the capital gain portion of the X stock. After the distribution, ABC’s balance sheet is as follows:

(vii) Assume alternatively that ABC adopts an approach under which, immediately before the section 751(b) distribution, B and C are each deemed to:

(A) Receive a distribution of the portion of the partnership’s Y stock with a fair market value of $9 and a tax basis of $0;

(B) Sell the Y stock back to ABC for $9, recognizing $9 of gain includible as a dividend; and

(C) Contribute the $9 to ABC. ABC will be deemed to have purchased for $18 a portion of the Y stock unrealized receivable component, which will have a new holding period. The deemed sale of Y stock by B and C to ABC will be treated as a sale or exchange for purposes of section 1248. Provided that the partnership applies the approach consistently for all section 751(b) distributions, Partnership ABC’s adopted approach is reasonable. After taking into account the tax consequences of the deemed transaction, ABC’s balance sheet is the same as the balance sheet shown in paragraph (v) of this example. After taking into account the tax consequences of the section 751(b) distribution, ABC’s balance sheet is the same as the balance sheet shown in paragraph (vi) of this example.

(viii) Assume that in a later unrelated transaction, A sells its Y stock at a time when its fair market value, earnings and profits, and adjusted basis have not changed. The sale of Y stock by A is a sale or exchange subject to section 1248. Pursuant to § 1.732–1(c)(2)(v), in determining the dividend portion of its gain on the Y stock under section 1248, A does not take into account the $15 decrease in basis under section 732. Accordingly, upon the sale of the Y stock, A recognizes $9 of gain, the lesser of $9 ($0 gain on the new holding period portion ($18 fair market value minus $18 basis) plus $9 gain on the remainder ($12 fair market value minus $3 basis)) or $9 (earnings and profits attributable to the remainder of the Y share) as dividend income under section 1248. A recognizes $15 of capital gain in addition to the $9 of dividend income ($30 amount realized minus $15 ($6 aggregate basis in Y share plus $9 section 1248 dividend income)).

(ix) Assume that ABC also sells its X stock in a later unrelated transaction at a time when its fair market value has declined to $120 but earnings and profits have remained the same. ABC has not made an election under § 1.755–1(c)(2)(vi). In determining the dividend portion of its gain on the X stock under section 1248, ABC does not take into account the $15 increase in basis under section 734(b). Upon the sale of the stock, ABC recognizes $105, the lesser of $105 ($120 – $15) or $135 (earnings and profits attributable to the X stock for the partnership’s holding period) as dividend income. In addition to the $105 of gain includible as a dividend, ABC recognizes $15 of capital loss ($120 amount realized minus $135 ($30 aggregate basis in X stock plus $105 section 1248 dividend income)).

Example 9. (i) Assume the same facts as in Example 8 of this paragraph (g), except assume that Partnership ABC makes an election under § 1.755–1(c)(2)(vi). As in Example 8, paragraph (b)(3)(i) of this section requires each of B and C to recognize $9 as a dividend under section 1248 using a reasonable approach consistent with the purpose of this section for the reasons described in paragraphs (ii) through (iv) of Example 8. Further assume that ABC adopts the deemed gain approach described in paragraph (v) of Example 8. As in Example 8, B and C are each deemed to recognize $9 of dividend income with respect to the distribution of the Y stock, which is treated as a sale or exchange for purposes of section 1248. To reflect B and C’s recognition of $9 of dividend income, B and C increase the bases in their ABC partnership interests by $9 each. The partnership increases its basis in the Y share unrealized receivable component by $18 immediately before the distribution. The portion of the unrealized receivable component of the Y share that is deemed to be sold or exchanged under section 1248 has a new holding period beginning on the day after the section 751(b) distribution (“the new holding period portion”).

(ii) Because ABC makes an election under § 1.755–1(c)(2)(vi), the distribution of the Y share to A results in a $15 section 734(b) adjustment to the unrealized receivable component of the X share. Because that basis adjustment would have altered the amount of net section 751 unrealized gain or loss computed under paragraph (b)(2) of this section, A must recognize $15 of gain with respect to the X share pursuant to paragraph (b)(3)(ii)(A) of this section. Also pursuant to paragraph (b)(3)(ii)(A) of this section, A’s recognition of income with respect to the X stock is a sale or exchange for purposes of section 1248 and begins a new holding period for this portion of ABC’s X stock, including for purposes of attributing earnings and profits. This income recognition increases A’s basis in its ABC partnership interest by $15 immediately before the distribution to A. In addition, the partnership increases its basis in the X share by $15, immediately before the distribution to A. The partnership treats the $15 of dividend income recognized by A as reducing A’s $15 reverse section 704(c) amount in the X stock. Provided the partnership applies the approach consistently for all section 751(b) distributions, ABC’s adopted approach is reasonable. After taking into account the tax consequences of the deemed gain approach described above, ABC’s balance sheet is as follows:

(iii)(A) After determining the tax consequences of the section 751(b) distribution, the rules of sections 731 through 736 apply. Accordingly, the Y stock would take a $21 basis in A’s hands under section 732(a), and no section 734(b) adjustment would be made to the X stock. After the distribution, ABC’s balance sheet is as follows:

(B) If the partnership sells the X stock, the gain recognized is $120 ($150 – $30), all of which is recharacterized as a dividend under section 1248. Because A’s recognition of $15 of dividend income reduced A’s reverse section 704(c) amount in the X stock, this gain is allocated $45 to B, $45 to C, and $30 to A.

Par. 8. Section 1.755–1 is amended by:

a. Adding paragraphs (c)(2)(iii), (iv), (v), and (vi).

b. Revising the paragraph heading and the introductory text of paragraph (c)(6).

c. Removing the paragraph heading “Example.” in paragraph (c)(6) and adding “Example 1.” in its place.

d. Adding Examples 2 and 3 to paragraph (c)(6).

e. Revising paragraph (e)(2).

The additions and revisions read as follows: