Par. 2. Section 1.514(c)-2 is amended by: 1. In paragraph (a), adding entries for (d)(2)(i) through (iii), adding entries for (d)(3)(i) and (ii), revising the entry for (d)(6), removing entries for (d)(6)(i) and (ii), and (d)(7), adding entries for (k)(1)(i) through (iv), revising the entries for (k)(2)(i) and (ii), adding an entry for (k)(2)(iii), and revising the entry for (n). 2. Revising paragraphs (d)(2) and (3). 3. Removing paragraph (d)(6). 4. Redesignating paragraph (d)(7) as paragraph (d)(6). 5. Revising newly redesignated paragraph (d)(6) Example 1 paragraph (i) and adding paragraph (iv). 6. Removing the language “( i.e., reverse)” in paragraph (e)(1)(i) and adding the language “(that is, reverse)” in its place. 7. Removing the language “other partners; and” at the end of paragraph (e)(1)(iii) and adding the language “other partners;” in its place. 8. Removing the language “of § 1.704-1(b)(2)(ii)( d ).” at the end of paragraph (e)(1)(iv) and adding the language “of § 1.704-1(b)(2)(ii)( d );” in its place. 9. Removing the language “the regulations thereunder.” at the end of paragraph (e)(1)(v) and adding the language “the regulations thereunder;” in its place. 10. Adding new paragraphs (e)(1)(vi) and (vii). 11. Adding Example 5 to paragraph (e)(5). 12. Removing the word “and” at the end of paragraph (f)(3). 13. Redesignating paragraph (f)(4) as paragraph (f)(5) and adding new paragraph (f)(4). 14. Revising paragraph (k)(1). 15. Revising the subject heading for paragraph (k)(2)(i). 16. Revising paragraph (k)(2)(i)(A). 17. Redesignating paragraph (k)(2)(ii) as paragraph (k)(2)(iii) and adding new paragraph (k)(2)(ii). 18. Revising paragraph (k)(3)(ii)(B). 19. Removing the second sentence in paragraph (m)(1)(ii). 20. Revising Example 3 (ii) of paragraph (m)(2). 21. Revising the subject heading for paragraph (n). 22. Adding a sentence to the end of paragraph (n)(2). The revisions and additions read as follows:
(a) Table of contents. * * *
(d) * * *
(2) * * *
(i) In general.
(ii) Limitation.
(iii) Distributions disregarded.
(3) * * *
(i) In general.
(ii) Reasonable guaranteed payments may be deducted only when paid in cash.
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(6) Examples.
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(k) * * *
(1) * * *
(i) In general.
(ii) Acquisition of partnership interests after initial formation of partnership.
(iii) Capital commitment defaults or reductions.
(iv) Examples.
(2) * * *
(i) Qualified organizations.
(ii) Non-qualified organizations.
(iii) Example.
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(n) Effective/applicability dates.
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(d) * * *
(2) Preferred returns —(i) In general. Items of income (including gross income) and gain that may be allocated to a partner with respect to a current or cumulative reasonable preferred return for capital (including allocations of minimum gain attributable to nonrecourse liability (or partner nonrecourse debt) proceeds distributed to the partner as a reasonable preferred return) are disregarded in computing overall partnership income or loss for purposes of the fractions rule. Similarly, if a partnership agreement effects a reasonable preferred return with an allocation of what would otherwise be overall partnership income, those items comprising that allocation are disregarded in computing overall partnership income for purposes of the fractions rule.
(ii) Limitation. Except as otherwise provided in paragraph (d)(2)(iii) of this section, items of income and gain (or part of what would otherwise be overall partnership income) that may be allocated to a partner in a taxable year with respect to a reasonable preferred return for capital are disregarded under paragraph (d)(2)(i) of this section for purposes of the fractions rule only if the partnership agreement requires the partnership to make distributions first to pay any accrued, cumulative, and compounding unpaid preferred return to the extent such accrued but unpaid preferred return has not otherwise been reversed by an allocation of loss prior to such distribution.
(iii) Distributions disregarded. A distribution is disregarded for purposes of paragraph (d)(2)(ii) of this section if the distribution—
(A) Is made pursuant to a provision in the partnership agreement intended to facilitate the partners' payment of taxes imposed on their allocable shares of partnership income or gain;
(B) Is treated as an advance against distributions to which the distributee partner would otherwise be entitled under the partnership agreement; and
(C) Does not exceed the distributee partner's allocable share of net partnership income and gain multiplied by the sum of the highest statutory federal, state, and local tax rates applicable to such partner.
(3) Guaranteed payments —(i) In general. A current or cumulative reasonable guaranteed payment to a qualified organization for capital or services is treated as an item of deduction in computing overall partnership income or loss, and the income that the qualified organization may receive or accrue from the current or cumulative reasonable guaranteed payment is not treated as an allocable share of overall partnership income or loss. The treatment of a guaranteed payment as reasonable for purposes of section 514(c)(9)(E) does not affect its possible characterization as unrelated business taxable income under other provisions of the Internal Revenue Code.
(ii) Reasonable guaranteed payments may be deducted only when paid in cash. If a partnership that avails itself of paragraph (d)(3)(i) of this section would otherwise be required (by virtue of its method of accounting) to deduct a reasonable guaranteed payment to a qualified organization earlier than the taxable year in which it is paid in cash, the partnership must delay the deduction of the guaranteed payment until the taxable year it is paid in cash. For purposes of this paragraph (d)(3)(ii), a guaranteed payment that is paid in cash on or before the due date (not including extensions) for filing the partnership's return for a taxable year may be treated as paid in that prior taxable year.
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(6) * * *
Example 1.
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(i) The partnership agreement provides QO a 10 percent preferred return on its unreturned capital. The partnership agreement provides that the preferred return may be compounded (at 10 percent) and may be paid in future years and requires that when distributions are made, they must be made first to pay any accrued, cumulative, and compounding unpaid preferred return not previously reversed by a loss allocation. The partnership agreement also allows distributions to be made to facilitate a partner's payment of federal, state, and local taxes. Under the partnership agreement, any such distribution is treated as an advance against distributions to which the distributee partner would otherwise be entitled and must not exceed the partner's allocable share of net partnership income or gain for that taxable year multiplied by the sum of the highest statutory federal, state, and local tax rates applicable to the partner. The partnership agreement first allocates gross income and gain 100 percent to QO, to the extent of the preferred return. All remaining income or loss is allocated 50 percent to QO and 50 percent to TP.
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(iv) The facts are the same as in paragraph (i) of this Example 1, except the partnership makes a distribution to TP of an amount computed by a formula in the partnership agreement equal to TP's allocable share of net income and gain multiplied by the sum of the highest statutory federal, state, and local tax rates applicable to TP. The partnership satisfies the fractions rule. The distribution to TP is disregarded for purposes of paragraph (d)(2)(ii) of this section because the distribution is made pursuant to a provision in the partnership agreement that provides that the distribution is treated as an advance against distributions to which TP would otherwise be entitled and the distribution did not exceed TP's allocable share of net partnership income or gain for that taxable year multiplied by the sum of the highest statutory federal, state, and local tax rates applicable to TP. The income and gain that is specially allocated to QO with respect to its preferred return is disregarded in computing overall partnership income or loss for purposes of the fractions rule because the requirements of paragraph (d) of this section are satisfied. After disregarding those allocations, QO's fractions rule percentage is 50 percent (see paragraph (c)(2) of this section), and, under the partnership agreement, QO may not be allocated more than 50 percent of overall partnership income in any taxable year.
(e) * * *
(1) * * *
(vi) Allocations of what would otherwise be overall partnership income that may be made to chargeback (that is, reverse) prior allocations of partner-specific expenditures that were disregarded in computing overall partnership income or loss for purposes of the fractions rule under paragraph (f) of this section; and
(vii) Allocations of what would otherwise be overall partnership income that may be made to chargeback (that is, reverse) prior allocations of unlikely losses and deductions that were disregarded in computing overall partnership income or loss for purposes of the fractions rule under paragraph (g) of this section.
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(5) * * *
Example 5.
Chargeback of prior allocations of unlikely losses and deductions. (i) Qualified organization (QO) and taxable corporation (TP) are equal partners in a partnership that holds encumbered real property. The partnership agreement generally provides that QO and TP share partnership income and deductions equally. QO contributes land to the partnership, and the partnership agreement provides that QO bears the burden of any environmental remediation required for that land, and, as such, the partnership will allocate 100 percent of the expense attributable to the environmental remediation to QO. In the unlikely event of the discovery of environmental conditions that require remediation, the partnership agreement provides that, to the extent its cumulative net income (without regard to the remediation expense) for the taxable year the partnership incurs the remediation expense and for subsequent taxable years exceeds $500x, after allocation of the $500x of cumulative net income, net income will first be allocated to QO to offset any prior allocation of the environmental remediation expense deduction. On January 1 of Year 3, the partnership incurs a $100x expense for the environmental remediation of the land. In that year, the partnership had gross income of $60x and other expenses of $30x for total net income of $30x without regard to the expense associated with the environmental remediation. The partnership allocated $15x of income to each of QO and TP and $100x of remediation expense to QO.
(ii) The partnership satisfies the fractions rule. The allocation of the expense attributable to the remediation of the land is disregarded under paragraph (g) of this section. QO's share of overall partnership income is 50 percent, which equals QO's share of overall partnership loss.
(iii) In Year 8, when the partnership's cumulative net income (without regard to the remediation expense) for the taxable year the partnership incurred the remediation expense and subsequent taxable years is $480x (the $30x from Year 3, plus $450x of cumulative net income for Years 4-7), the partnership has gross income of $170x and expenses of $50x, for total net income of $120x. The partnership's cumulative net income for all years from Year 3 to Year 8 is $600x ($480x for Years 3-7 and $120x for Year 8). Pursuant to the partnership agreement, the first $20x of net income for Year 8 is allocated equally between QO and TP because the partnership must first earn cumulative net income in excess of $500x before making the offset allocation to QO. The remaining $100x of net income for Year 8 is allocated to QO to offset the environmental remediation expense allocated to QO in Year 3.
(iv) Pursuant to paragraph (e)(1)(vii) of this section, the partnership's allocation of $100x of net income to QO in Year 8 to offset the prior environmental remediation expense is disregarded in computing overall partnership income or loss for purposes of the fractions rule. The allocation does not cause the partnership to violate the fractions rule.
(f) * * *
(4) Expenditures for management and similar fees, if such fees in the aggregate for the taxable year are not more than 2 percent of the partner's capital commitments; and * * *
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(k) Special rules —(1) Changes in partnership allocations arising from a change in the partners' interests —(i) In general. A qualified organization that acquires a partnership interest from another qualified organization is treated as a continuation of the prior qualified organization partner (to the extent of that acquired interest) for purposes of applying the fractions rule. Changes in partnership allocations that result from other transfers or shifts of partnership interests will be closely scrutinized (to determine whether the transfer or shift stems from a prior agreement, understanding, or plan or could otherwise be expected given the structure of the transaction), but generally will be taken into account only in determining whether the partnership satisfies the fractions rule in the taxable year of the change and subsequent taxable years.
(ii) Acquisition of partnership interests after initial formation of partnership. Changes in partnership allocations due to an acquisition of a partnership interest by a partner (new partner) after the initial formation of a partnership will not be closely scrutinized under paragraph (k)(1)(i) of this section, but will be taken into account only in determining whether the partnership satisfies the fractions rule in the taxable year of the change and subsequent taxable years, and disproportionate allocations of income, loss, or deduction to the partners to adjust the partners' capital accounts as a result of, and to reflect, the new partner acquiring the partnership interest and the resulting changes to the other partners' interests will be disregarded in computing overall partnership income or loss for purposes of the fractions rule if such changes and disproportionate allocations are not inconsistent with the purpose of the fractions rule under paragraph (k)(4) of this section and—
(A) The new partner acquires the partnership interest no later than 18 months following the formation of the partnership (applicable period);
(B) The partnership agreement and other relevant documents anticipate the new partners acquiring the partnership interest during the applicable period, set forth the time frame in which the new partners will acquire the partnership interests, and provide for the amount of capital the partnership intends to raise;
(C) The partnership agreement and other relevant documents specifically set forth the method for determining any applicable interest factor and for allocating income, loss, or deduction to the partners to account for the economics of the arrangement in the partners' capital accounts after the new partner acquires the partnership interest; and
(D) The interest rate for any applicable interest factor is not greater than 150 percent of the highest applicable Federal rate, at the appropriate compounding period or periods, at the time the partnership was formed.
(iii) Capital commitment defaults or reductions. Changes in partnership allocations that result from an unanticipated partner default on a capital contribution commitment or an unanticipated reduction in a partner's capital contribution commitment, that are effected pursuant to provisions prescribing the treatment of such events in the partnership agreement, and that are not inconsistent with the purpose of the fractions rule under paragraph (k)(4) of this section, will not be closely scrutinized under paragraph (k)(1)(i) of this section, but will be taken into account only in determining whether the partnership satisfies the fractions rule in the taxable year of the change and subsequent taxable years. In addition, partnership allocations of income, loss, or deduction to partners made pursuant to the partnership agreement to adjust partners' capital accounts as a result of unanticipated capital contribution defaults or reductions will be disregarded in computing overall partnership income or loss for purposes of the fractions rule. The adjustments may include allocations to adjust partners' capital accounts to be consistent with the partners' adjusted capital commitments.
(iv) Examples. The following examples illustrate the provisions of paragraph (k)(1) of this section.
Example 1.
Staged closing. (i) On July 1 of Year 1, two taxable partners (TP1 and TP2) form a partnership that will invest in debt-financed real property. The partnership agreement provides that, within an 18-month period, partners will be added so that an additional $1000x of capital can be raised. The partnership agreement sets forth the method for determining the applicable interest factor that complies with paragraph (k)(1)(ii)(D) of this section and for allocating income, loss, or deduction to the partners to account for the economics of the arrangement in the partners' capital accounts. During the partnership's Year 1 taxable year, partnership had $150x of net income. TP1 and TP2, each, is allocated $75x of net income.
(ii) On January 1 of Year 2, qualified organization (QO) joins the partnership. The partnership agreement provides that TP1, TP2, and QO will be treated as if they had been equal partners from July 1 of Year 1. Assume that the interest factor is treated as a reasonable guaranteed payment to TP1 and TP2, the expense from which is taken into account in the partnership's net income of $150x for Year 2. To balance capital accounts, the partnership allocates $100x of the income to QO ($50x, or the amount of one-third of Year 1 income that QO was not allocated during the partnership's first taxable year, plus $50x, or one-third of the partnership's income for Year 2) and the remaining income equally to TP1 and TP2. Thus, the partnership allocates $100x to QO and $25x to TP1 and TP2, each.
(iii) The partnership's allocation to QO would violate the fractions rule because QO's overall percentage of partnership income for Year 2 of 66.7 percent is greater than QO's fractions rule percentage of 33.3 percent. However, the special allocation of $100x to QO for Year 2 is disregarded in determining QO's percentage of overall partnership income for purposes of the fractions rule because the requirements in paragraph (k)(1)(ii) of this section are satisfied.
Example 2.
Capital call default. (i) On January 1 of Year 1, two taxable partners, (TP1 and TP2) and a qualified organization (QO) form a partnership that will hold encumbered real property and agree to share partnership profits and losses, 60 percent, 10 percent, and 30 percent, respectively. TP1 agreed to a capital commitment of $120x, TP2 agreed to a capital commitment of $20x, and QO agreed to a capital commitment of $60x. The partners met half of their commitments upon formation of the partnership. The partnership agreement requires a partner's interest to be reduced if the partner defaults on a capital call. The agreement also allows the non-defaulting partners to make the contribution and to increase their own interests in the partnership. Following a capital call default, the partnership agreement requires allocations to adjust capital accounts to reflect the change in partnership interests as though the funded commitments represented the partner's interests from the partnership's inception.
(ii) In Year 1, partnership had income of $100x, which was allocated to the partners $60x to TP1, $10x to TP2, and $30x to QO.
(iii) In Year 2, partnership required each partner to contribute the remainder of its capital commitment, $60x from TP1, $10x from TP2, and $30x from QO. TP1 could not make its required capital contribution, and QO contributed $90x, its own capital commitment, in addition to TP1's. TP1's default was not anticipated. As a result and pursuant to the partnership agreement, TP1's interest was reduced to 30 percent and QO's interest was increased to 60 percent. Partnership had income of $60x and losses of $120x in Year 2, for a net loss of $60x. Partnership allocated to TP1 $48x of loss (special allocation of $30x of gross items of loss to adjust capital accounts and $18x of net loss (30 percent of $60x net loss)), TP2 $6x of net loss (10 percent of $60x net loss), and QO $6x of loss (special allocation of $30x of gross items of income to adjust capital accounts—$36x of net loss (60 percent of $60x net loss)). At the end of Year 2, TP1's capital account equals $72x (capital contribution of $60x + $60x income from Year 1—$48x loss from Year 2); TP2's capital account equals $24x (capital contributions of $20x + $10x income from Year 1—$6x loss from Year 2); and QO's capital account equals $144x (capital contributions of $120x ($30x + $90x) + $30x income from Year 1—$6x loss from Year 2).
(iv) The changes in partnership allocations to TP1 and QO due to TP1's unanticipated default on its capital contribution commitment were effected pursuant to provisions prescribing the treatment of such events in the partnership agreement. Therefore these changes in allocations will not be closely scrutinized under paragraph (k)(1)(i) of this section, but will be taken into account only in determining whether the partnership satisfies the fractions rule in the taxable year of the change and subsequent taxable years. In addition, pursuant to paragraph (k)(1)(iii) of this section, the special allocations of $30x additional loss to TP1 and $30x additional income to QO to adjust their capital accounts to reflect their new interests in the partnership are disregarded when calculating QO's percentage of overall partnership income and loss for purposes of the fractions rule.
(2) * * *
(i) Qualified organizations. * * *
(A) Qualified organizations do not hold (directly or indirectly through a partnership), in the aggregate, interests of greater than five percent in the capital or profits of the partnership; and
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(ii) Non-qualified organizations. Section 514(c)(9)(B)(vi) does not apply to a partnership otherwise subject to that section if—
(A) All partners other than qualified organizations do not hold (directly or indirectly through a partnership), in the aggregate, interests of greater than five percent in the capital or profits of the partnership; and
(B) Allocations have substantial economic effect without application of the special rules in § 1.704-1(b)(2)(iii)( c ) (regarding the presumption that there is a reasonable possibility that allocations will affect substantially the dollar amounts to be received by the partners from the partnership if there is a strong likelihood that offsetting allocations will not be made in five years, and the presumption that the adjusted tax basis (or book value) of partnership property is equal to the fair market value of such property).
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(3) * * *
(ii) * * *
(B) $1,000,000.
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(m) * * *
(2) * * *
Example 3.
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(ii) P2 satisfies the fractions rule with respect to the P2/P1A chain. See § 1.702-1(a)(8)(ii) (for rules regarding separately stating partnership items). P2 does not satisfy the fractions rule with respect to the P2/P1B chain.
(n) Effective/applicability dates. * * *
(2) * * * However, paragraphs (d)(2)(ii) and (iii), (d)(6) Example 1 (i) and (iv), (e)(1)(vi) and (vii), (e)(5) Example 5, (f)(4), (k)(1)(ii) through (iv), (k)(2)(i)(A), (k)(2)(ii), (k)(3)(ii)(B), (m)(1)(ii), and (m)(2) Example 3 (ii) of this section apply to taxable years ending on or after the date these regulations are published as final regulations in the Federal Register .
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