Final rules on distributions of partnership property.

The IRS released final regulations under Secs. 704 (c) (1) (B) and 737, providing guidance on the treatment of distributions made by a partnership to a partner. These regulations apply to distributions made by a partnership to a partner on or after Jan. 9, 1995. Generally, the final regulations do not contain significant changes from the proposed regulations, but reflect some differences.

Sec. 704 (c) (1) (B)

The final regulations under Sec. 704 (c) (1) (B) relate to the recognition of gain or loss on certain distributions of contributed property by a partnership. Sec. 704 (c) (1) (B) states that, if any contributed property is distributed by the partnership (other than to the contributing partner) within five years of being contributed, the contributing partner shall recognize gain or loss from the sale of the property in an amount equal to the gain or loss allocated to the partner due to the variation between the basis of the property to the partnership and its fair market value (FMV).

Final Regs. Sec. 1.704-4 (a) (2) provides that Sec. 704 (c) (1) (B) applies only to the extent a transaction is a distribution under Sec. 731.

The language used in the proposed regulations, "same plan or arrangement," has been replaced with "distributions that are part of the same distribution." This change was made for simplification purposes only, and was not intended as a substantive change to the scope of a distribution for tax purposes.

Regs. Sec. 1.704-4 (c) (3) provides that for terminations under Sec. 708 (b) (1) (B), a new five-year period does not begin to the extent of any pretermination gain or loss that would have been allocated to a contributing partner under Sec. 704 (c) (1) (A) on a sale of contributed property immediately before the termination. However, a new five-year period does begin for any precontribution gain or loss in excess of the amount described above for property deemed contributed to the new partnership after the termination.

The final regulations clarified the following exceptions to Sec. 704 (c) (1) (B): On a distribution to a noncontributing partner in liquidation of the partnership, if the contributing partner receives an interest in property originally contributed by that partner, the amount of the built-in gain or loss that reattaches to the property must be equal to or greater than the built-in gain or loss that would have otherwise been allocated to the contributing partner if the contributed property had been sold immediately before the distribution. This exception allows a partner to avoid Sec. 704 (c) (1) (B) as long as the built-in gain or loss in the property distributed to the contributing partner is at least equal to the gain or loss that would have been allocated to the contributing partner under Sec. 704 (c) (1) (A).

Regs. Sec. 1.704-4 (b) also adds the following additional three exceptions to Sec. 704 (c) (1) (B):

* A complete transfer by a partnership of all its assets and liabilities to a second partnership in an exchange described in Sec. 721, followed by a distribution of the interest in the transferee partnership in liquidation of the transferor partnership as part of the same plan or arrangement (Regs. Sec. 1.704-4 (b) (4)).

* An incorporation of a partnership by any method of incorporation, provided that the partnership is liquidated as part of the incorporation transaction (Regs. Sec. 1.704-4 (b) (5)).

* A distribution of an undivided interest in property to the extent that the distributed interest does not exceed any undivided interest contributed by the distributee partner in the same property (Regs. Sec. 1.704-4 (b) (6)).

Sec. 737

The final regulations under Sec. 737 relate to the recognition of gain on certain distributions to a contributing partner and adopt the proposed regulations without significant changes. Sec. 737 states that, on distribution by a partnership, the distributee partner is required to recognize gain in an amount equal to the lesser of any net precontribution gain or the excess of the FMV of property received over the adjusted basis of the partner's interest in the partnership immediately before the distribution reduced (but not below zero) by the amount of money received in the distribution.

Regs. Sec. 1.737-1 (a) (2) provides that Sec. 737 applies only to the extent that a transaction is a distribution under Sec. 731.

The final regulations maintain the controversial rule that Sec. 737 does not contain a like-kind exception similar to the exception in Sec. 704 (c) (2). Sec. 737 applies even if the property received by the partner is of like kind with the contributed property, unless the property contributed by the distributee partner is actually distributed to another partner in a transaction related to the Sec. 737 transaction.

The final regulations add that the character of gain or loss, for Sec. 737 purposes, is determined at the partnership level. This clarifies that, as in the case of gain triggered under Sec. 704 (c) (1) (B), Sec. 737 posits a sale of the property contributed by the distributee partner at the partnership level.

Regs. Sec. 1.737-2 added two exceptions to the proposed rules. Both are similar to exceptions in the final regulations of Sec. 704 (c) (1) (B). The first exception is for the transfer of contributed property by a transferor partnership to a transferee partnership, followed by a distribution of an interest in the transferee partnership (and no other property) to the contributing partner in complete liquidation of the partner's interest (Regs. Sec. 1.737-2 (d) (1)). The second exception is for distributions of an undivided interest in property. In addition, the final regulations add an example relating to the distribution of an undivided interest in property (Regs. Sec. 1.737-2 (d) (4)).