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Final sec. 704(c) regulations issued.

In late December 1994, the IRS issued final Regs. Sec. 1.704-3, which addresses aggregation of securities for securities partnerships as well as the remedial allocation method. These regulations adopt a more flexible approach to securities aggregation that will significantly benefit investment partnerships.

Regs. Sec. 1.704-3(e)(3)(iii) has broadened the definition of a "securities partnership" eligible to aggregate securities for Sec. 704(c) purposes. A securities partnership is now defined as a partnership that is either a "management company" or "investment partnership" that makes all of its book allocations in proportion to the partners' relative book capital accounts (except for reasonable special allocations for management or investment advisory services). A management company is defined as one registered under the Securities Act of 1940. An investment partnership is defined as a partnership, which, on the date of each capital account restatement, holds qualified financial assets constituting at least 90% of the fair market value of its noncash assets and that reasonably expects to revalue its qualified assets at least annually, as of the end of the first tax year in which the partnership adopts an aggregate See. 704(c) method.

Regs. Sec. 1.704-3(e)(3) permits securities partnerships to aggregate gains and losses from qualified financial assets, defined as any personal property (including stock) actively traded (as defined in Regs. Sec. 1.1092(d)-1), even if it is not readily tradeable on an established securities market (e.g., it is traded on a secondary market such as a commodities or interdealer market). In addition to items defined in Regs. Sec. 1.1092(d)-1, management companies may also aggregate gains and losses from stock, debt instruments, notional principal contracts, derivative financial instruments, options, forward or futures contracts, short positions and similar financial instruments, whether or not actively traded.

The final regulations eliminate the requirement that gains be aggregated separately from losses. Partnerships may net book gains with book losses and may also net tax gains with tax losses when making reverse Sec. 704(c) allocations, as long as the partnership's aggregate approach is reasonable and does not violate the general Sec. 704(c) anti-abuse rule.

Under Regs. Sec. 1.704-3(e)(3)(vi), the character and other tax attributes of gain or loss allocated to the partners must (1) preserve the tax attributes of each item of gain or loss realized by the partnership; (2) be determined under an approach that is consistently applied; and (3) not be determined with a view to substantially reducing the present value of the partners' aggregate tax liability.

Regs. Sec. 1.704-3(e)(3)(vii) continues to prohibit aggregating precontribution gain or loss under the regular Sec. 704(c) provisions with reverse Sec. 704(c) layers. However, when the likelihood of character and timing distortions is minimal and the burden of making Sec. 704(c) allocations is great, the Service is now willing to issue letter rulings.

Regs. Sec. 1.704-3(e)(3)(viii) provides a transitional rule allowing securities partnerships to use any reasonable approach to coordinate revaluations occurring before and after Dec. 21, 1993.

Regs. Sec. 1.704-3(d) also finalized the remedial allocation method of making Sec. 704(c) allocations (with a few minor clarifications). This method requires an allocation of partnership income, gain, loss or deduction to noncontributing partners to eliminate distortions caused by the ceiling rule and a corresponding remedial allocation to the contributing partner to offset that amount.
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Author:Edquist, David
Publication:The Tax Adviser
Date:Apr 1, 1995
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