Allocation of Partnership Debt

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [REG-103831-99] RIN 1545-AX09

TITLE: Allocation of Partnership Debt

AGENCY:Internal Revenue Service (IRS), Treasury.

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

SUMMARY:This document contains proposed regulations relating to the
allocation of nonrecourse liabilities by a partnership. The proposed
regulations revise tier three of the three-tiered allocation
structure contained in the current nonrecourse liability
regulations, and also provide guidance regarding the allocation of a
single nonrecourse liability secured by multiple properties. This
document also contains a notice of public hearing on these proposed
regulations.

DATES:Written comments must be received by April 12, 2000. Requests
to speak (with outlines of oral comments) at a public hearing
scheduled for May 3, 2000, at 10 a.m., must be received by April 12,
2000.

ADDRESSES:Send submissions to: CC:DOM:CORP:R (REG-103831-99), room
5228, Internal Revenue Service, POB 7604, Ben Franklin Station,
Washington, DC 20044. In the alternative, submissions may be hand
delivered between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R
(REG-103831-99), Courier's Desk, Internal Revenue Service, 1111
Constitution Avenue NW, Washington, DC. Alternatively,.2 taxpayers
may submit comments electronically via the Internet by selecting the
"Tax Regs" option of the IRS Home Page, or by submitting comments
directly to the IRS Internet site at:

http://www.irs.ustreas.gov/tax_regs/regslist.html. The public
hearing will be held in room 2615, Internal Revenue Building, 1111
Constitution Avenue, NW, Washington, DC.

FOR FURTHER INFORMATION CONTACT:Concerning the regulations,
Christopher Kelley, (202) 622-3070; concerning submissions of
comments, the hearing, and/or to be placed on the building access
list to attend the hearing, Guy Traynor, (202) 622- 7190 (not toll-
free numbers).

SUPPLEMENTARY INFOR ATION:

Introduction

This document proposes to revise §§1.752-3 and 1.752-5 of the Income
Tax Regulations (26 CFR part 1) relating to the allocation by a
partnership of nonrecourse liabilities.

Background

Treasury regulation §1.752-3 currently provides a three-tiered
system for allocating nonrecourse liabilities. The three-tiered
system applies sequentially. Thus, as a portion of a liability is
allocated to a partner under the first tier, that portion is not
available to be allocated under the second tier. Similarly, as a
portion of a liability is allocated to a partner under the second
tier, that portion is not available to be allocated in the third
tier.

Under the first tier, a partner is allocated an amount of the
liability equal to that partner's share of partnership minimum gain
under section 704(b). See §1.704-2(g)(1). Under the second tier, to
the extent the entire liability has not been allocated under the
first tier, a partner will be allocated an amount of liability equal
to the gain that partner would be allocated under section 704(c) if
the partnership disposed of all partnership property subject to one
or more nonrecourse liabilities in full satisfaction of the
liabilities (section 704(c) minimum gain). Under the third tier, a
partner is allocated any excess nonrecourse liabilities under one of
several methods that the partnership may choose.

One allocation method is based on the partner's share of partnership
profits. The partnership may specify in its partnership agreement
the partners' interests in partnership profits for purposes of
allocating excess nonrecourse liabilities provided the specified
interests are reasonably consistent with allocations of some other
significant item of partnership income or gain. The partnership also
may allocate excess nonrecourse liabilities in accordance with the
manner in which it is reasonably expected that the deductions
attributable to those nonrecourse liabilities will be allocated. The
partnership may change its allocation method under the third tier
from year to year.

In Rev. Rul. 95-41, 1995-1 C.B. 132, the IRS and Treasury addressed
the effect of the three section 704(c) allocation methods under
§1.704-3 upon the three tiers of §1.752-3(a). Rev. Rul. 95-41 also
stated that in determining the partners' interests in partnership
profits, solely for purposes of the third tier, section 704(c)
built-in gain (i.e., the excess of a property's book value over the
contributing partner's adjusted tax basis in the property upon
contribution) that was not taken into account under §1.752-3(a)(2)
(the second tier) is one factor, but not the only factor, to be
considered. This gain (excess section 704(c) gain) is equal to the
excess of the amount of section 704(c) built-in gain attributable to
an item of property over the amount of section 704(c) minimum gain
on that property.

Explanation of Provisions

Modifications to Third Tier

The three tiers of §1.752-3(a) are structured to allocate
liabilities to those partners who generally would be allocated
income or gain upon the relief of those liabilities. Under section
752(b), any decrease in a partner's share of the liabilities of a
partnership will be considered a distribution of money to the
partner by the partnership. Under section 731(a), a partner will
recognize gain on the distribution of money by the partnership to
the extent that the distribution exceeds the partner's adjusted
basis in its partnership interest. Section 704(c) generally ensures
that any built-in gain on contributed property will be recognized by
the contributing partner upon the disposition of the property by the
partnership. The partnership liability allocation rules arguably
should not accelerate the contributing partner's recognition of that
gain when the amount of the partnership's liability attributable to
such property is sufficient, if allocated to the contributing
partner, to prevent such partner from recognizing gain.

In response to comments received, the proposed regulations modify
the third tier to allow a partnership to allocate the portion of a
nonrecourse liabilities in excess of the portions allocated in tiers
one and two (excess nonrecourse liabilities) based on the excess
section 704(c) gain attributable to the property securing the
liability. Thus, to.5 the extent a portion of a partnership
nonrecourse liability is available to be allocated in the third
tier, the partnership may allocate that portion to the contributing
partner based on the excess section 704(c) gain inherent in the
property.

Under §1.704-3(a)(2), section 704(c) generally applies on a
property-by-property basis. Therefore, in determining the amount of
excess section 704(c) gain, the built-in gains and losses on items
of contributed property cannot be aggregated. Section 1.704-3(a)(3)
(i) provides that the book value of contributed property is equal to
its fair market value at the time of contribution and is
subsequently adjusted for cost recovery and other events that affect
the basis of the property. Section 1.704- 3(a)(3)(ii) provides that
the section 704(c) built-in gain with respect to a property is the
excess of the property's book value over the contributing partner's
adjusted tax basis in the property upon contribution. The built-in
gain is thereafter reduced by decreases in the difference between
the property's book value and adjusted tax basis. Similarly, the
excess section 704(c) gain will decline as the difference between
the property's fair market value and tax basis declines.

If a partnership holds section 704(c) property subject to the
ceiling rule of §1.704-3(b)(1), in certain situations, the first
tier of §1.752-3(a) can gradually shift the allocation of
liabilities away from the partner that contributed the property (the
contributing partner) to a non-contributing partner who does not
necessarily need, for tax purposes, the entire amount of the
liability allocated to the non-contributing partner in the first
tier. This can give rise to deemed distributions to the contributing
partner, resulting in gain recognition under section 731(a)(1) at a
time that arguably is earlier than appropriate. The IRS and Treasury
considered other alternatives for amending §1.752-3 that would
address these liability shifts caused by the ceiling rule, but
rejected them because of their complexity. The proposed alternative
was adopted because it is simple and seems to address the
predominant concerns raised by practitioners regarding the
contribution of section 704(c) property. The IRS and Treasury
request comments on whether further modifications to the three-
tiered structure of §1.752-3(a) are necessary to more appropriately
allocate nonrecourse liabilities among partners and, if so, what
type of modifications would be appropriate.

The holding in Rev. Rul. 95-41, 1995-1 C.B. 132, that excess section
704(c) gain is one factor to consider in determining a partner's
interest in partnership profits will remain relevant where a partner
does not allocate nonrecourse debt under the third tier based on the
excess section 704(c) gain attributable to the property that is
subject to the debt. However, once a partner has allocated
nonrecourse indebtedness pursuant to the rule in these proposed
regulations based upon excess section 704(c) gain, that excess
section 704(c) gain cannot again be considered in determining a
partner's interest in partnership profits.

Allocation of Single Liability Among Multiple Properties Several
commentators have requested that the IRS and Treasury issue guidance
regarding the calculation of section 704(c) minimum gain under the
second tier when a partnership holds multiple properties subject to
a single nonrecourse liability. This situation typically arises when
a partnership that holds several properties, each subject to an
individual liability, refinances the individual liabilities with a
single nonrecourse liability.

To apply the second tier, partnerships must determine the amount of
the liability that encumbers each asset. This allows the
partnerships to determine the section 704(c) minimum gain in each
asset. See §1.704-3(a)(2). The proposed regulations provide that if
a partnership holds multiple properties subject to a single
liability, the liability may be allocated among the properties based
on any reasonable method. Under the proposed regulations, a method
is not reasonable if it allocates to any property an amount that
exceeds the fair market value of the property. Thus, for example,
the liability may be allocated to the properties based on the
relative fair market value of each property.

The portion of the nonrecourse liability allocated to each item of
partnership property is treated as a separate loan under §1.752-3(a)
(2). The proposed regulations provide that once a liability is
allocated among the properties, a partnership may not change the
method for allocating the liability. However, if one of the
properties is no longer subject to the liability, the portion of the
liability allocated to that property must be reallocated to the
properties still subject to the liability so that the amount
allocated to any property does not exceed the fair market value of
such property at the time of the reallocation.

If the outstanding principal of a liability is reduced, the
reduction will affect the amount of section 704(c) minimum gain
under the second tier. The proposed regulations provide that as the
outstanding principal of a liability is reduced, the reduction in
principal outstanding is allocated among the properties in the same
proportion that the principal originally was allocated to the
properties. These rules affect only the calculation of section
704(c) minimum gain under the second tier of §1.752-3(a).

Allocation of Single Liability Among Multiple Partnerships

Some commentators also have requested guidance on allocations of a
nonrecourse liability among multiple partnerships. This situation
may arise when a partner contributes multiple properties subject to
the same nonrecourse liability to more than one partnership. It also
may arise in a division of a partnership under section 708. Although
the proposed regulations do not address this issue, the IRS and
Treasury request comments regarding appropriate methods of
allocating such liabilities. Proposed Effective Date These
regulations are proposed to apply to any liability incurred or
assumed by a partnership on or after the date final regulations are
published in the Federal Register.

Special Analyses

It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in Executive Order
12866. Therefore, a regulatory assessment is not required. It also
has been determined that section 553(b) of the Administrative
Procedure Act (5 U.S.C. chapter 5) does not apply to these
regulations, and because the regulations do not impose a collection
of information on small entities, a Regulatory Flexibility Analysis
is not required. Pursuant to section 7805(f) of the Internal Revenue
Code, this notice of proposed rulemaking will be submitted to the
Chief Counsel for Advocacy of the Small Business Administration for
comment on its impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,
consideration will be given to any written comments (preferably a
signed original and eight (8) copies) that are submitted timely to
the IRS. The IRS and Treasury specifically request comments on the
clarity of the proposed regulations and how they may be made easier
to understand. All comments will be available for public inspection
and copying.

A public hearing has been scheduled for May 3, 2000, at 10 a.m., in
Room 2615, Internal Revenue Building, 1111 Constitution Avenue NW,
Washington, DC. Due to building security procedures, visitors must
enter at the 10 Street entrance, located th between Constitution and
Pennsylvania Avenues, NW. In addition, all visitors must present
photo identification to enter the building. Because of access
restrictions, visitors will not be admitted beyond the Internal
Revenue Building lobby more than 15 minutes before the hearing
starts. For information about having your name placed on the
building access list to attend the hearing, see the "FOR FURTHER
INFORMATION CONTACT" section of this preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons that
wish to present oral comments at the hearing must submit timely
written comments and an outline of the topics to be discussed and
the time to be devoted to each topic (preferably a signed original
and eight (8) copies) by April 12, 2000. A period of 10 minutes will
be allotted to each person for making comments. An agenda showing
the scheduling of the speakers will be prepared after the deadline
for receiving outlines has passed. Copies of the agenda will be
available free of charge at the hearing.

Drafting Information

The principal author of these regulations is Christopher Kelley,
Office of Chief Counsel (Passthroughs and Special Industries).
However, other personnel from the IRS and Treasury Department
participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements. Proposed
Amendments to the Regulations Accordingly, 26 CFR part 1 is proposed
to be amended as follows:

PART 1--INCOME TAXES

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

Authority: 26 U.S.C. 7805 * * *.
Par. 2. Section 1.752-3 is amended as follows:
1. Paragraph (a)(3) is amended by adding two sentences immediately
before the last sentence in the paragraph.
2. Paragraph (b) is redesignated as paragraph (c).
3. New paragraph (b) is added.
4. Paragraph (d) is added.
The revision and additions read as follows:
§1.752-3 Partner's share of nonrecourse liabilities.

(a) * * *

(3) * * * Additionally, the partnership may first allocate an excess
nonrecourse liability to a partner up to the amount of built-in gain
on section 704(c) property (as defined under §1.704-3(a)(3)(ii))
that is allocable to the partner on the property subject to that
nonrecourse liability to the extent that such built-in gain exceeds
the gain described in paragraph (a)(2) of this section with respect
to such property. To the extent a partnership uses this additional
method and the entire amount of the excess nonrecourse liability is
not allocated to the contributing partner, the partnership must
allocate the remaining amount of the excess nonrecourse liability
under one of the other methods in this paragraph (a)(3).* * *

(b) Allocation of a single nonrecourse liability among multiple
properties--(1) In general. For purposes of determining the amount
of taxable gain under paragraph (a)(2) of this section, if a
partnership holds multiple properties subject to a single
nonrecourse liability, the partnership may allocate the liability
among the multiple properties under any reasonable method. A method
is not reasonable if it allocates to any item of property an amount
of the liability in excess of the fair market value of the property
at the time the liability is incurred. The portion of the
nonrecourse liability allocated to each item of partnership property
is then treated as a separate loan under paragraph (a)(2) of this
section. In general, a partnership may not change the method of
allocating a single nonrecourse liability under this paragraph (b)
while any portion of the liability is outstanding. However, if one
or more of the multiple properties subject to the liability is no
longer subject to the liability, the portion of the property
allocated to that property must be reallocated among the properties
still subject to the liability so that the amount of the liability
allocated to any property does not exceed the fair market value of
such property at the time of reallocation.

(2) Reductions in principal. For this paragraph (b), when the
outstanding principal of a partnership liability is reduced, the
reduction of outstanding principal is allocated among the multiple
properties in the same proportion that the partnership liability
originally was allocated to the properties under paragraph (b)(1) of
this section.

* * * * *

(d) Effective date. This section applies to partnership liabilities
incurred or assumed on or after the date final regulations are
published in the Federal Register ..Par. 3 The first sentence of
paragraph (a) of §1.752-5 is revised to read as follows:

§1.752-5 Effective dates and transition rules

(a) In general. Except as otherwise provided in §1.752-3(d), unless
a partnership makes an election under paragraph (b)(1) of this
section to apply the provisions of §§1.752-1 through 1.752-4
earlier, §§1.752-1 through 1.752-4 apply to any liability incurred
or assumed by a partnership on or after December 28, 1991, other
than a liability incurred or assumed by the partnership pursuant to
a written binding contract in effect prior to December 28, 1991 and
at all times thereafter. * * *

* * * * *

Robert E. Wenzel
Deputy Commissioner of Internal Revenue

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