Title 26

SECTION 1.337(d)-3

1.337(d)-3 Gain recognition upon certain partnership transactions involving a partner's stock.

§ 1.337(d)-3 Gain recognition upon certain partnership transactions involving a partner's stock.

(a) Purpose. The purpose of this section is to prevent corporate taxpayers from using a partnership to circumvent gain required to be recognized under section 311(b) or section 336(a). The rules of this section, including the determination of the amount of gain, must be applied in a manner that is consistent with and reasonably carries out this purpose.

(b) In general. This section applies when a partnership, either directly or indirectly, owns, acquires, or distributes Stock of the Corporate Partner (within the meaning of paragraph (c)(2) of this section). Under paragraphs (d) or (e) of this section, a Corporate Partner (within the meaning of paragraph (c)(1) of this section) is required to recognize gain when a transaction has the effect of the Corporate Partner acquiring or increasing an interest in its own stock in exchange for appreciated property in a manner that contravenes the purpose of this section as set forth in paragraph (a) of this section. Paragraph (f) of this section sets forth exceptions under which a Corporate Partner does not recognize gain.

(1) Corporate Partner. A Corporate Partner is a person that is classified as a corporation for federal income tax purposes and holds or acquires an interest in a partnership.

(2) Stock of the Corporate Partner - (i) In general. With respect to a Corporate Partner, Stock of the Corporate Partner includes the Corporate Partner's stock, or other equity interests, including options, warrants, and similar interests, in the Corporate Partner or a corporation that controls the Corporate Partner within the meaning of section 304(c) (except that section 318(a)(1) and (3) shall not apply). Stock of the Corporate Partner also includes interests in any entity to the extent that the value of the interest is attributable to Stock of the Corporate Partner.

(ii) Affiliated partner exception. Stock of the Corporate Partner does not include any stock or other equity interests held or acquired by a partnership if all interests in the partnership's capital and profits are held by members of an affiliated group as defined in section 1504(a) that includes the Corporate Partner.

(3) Section 337(d) Transaction. A Section 337(d) Transaction is a transaction (or series of transactions) that has the effect of an exchange by a Corporate Partner of its interest in appreciated property for an interest in Stock of the Corporate Partner owned, acquired, or distributed by a partnership. For example, a Section 337(d) Transaction may occur when -

(i) A Corporate Partner contributes appreciated property to a partnership that owns Stock of the Corporate Partner;

(ii) A partnership acquires Stock of the Corporate Partner;

(iii) A partnership that owns Stock of the Corporate Partner distributes appreciated property to a partner other than a Corporate Partner;

(iv) A partnership distributes Stock of the Corporate Partner to the Corporate Partner; or

(v) A partnership agreement is amended in a manner that increases a Corporate Partner's interest in Stock of the Corporate Partner (including in connection with a contribution to, or distribution from, a partnership).

(4) Gain Percentage. A Corporate Partner's Gain Percentage equals a fraction, the numerator of which is the Corporate Partner's interest (by value) in appreciated property effectively exchanged for Stock of the Corporate Partner under the test described in paragraphs (d)(1) and (2) of this section, and the denominator of which is the Corporate Partner's interest (by value) in that appreciated property immediately before the Section 337(d) Transaction. Paragraph (d) of this section requires a partnership to multiply the Gain Percentage by the Corporate Partner's aggregate gain in appreciated property to determine gain recognized under this section.

(d) Deemed redemption rule - (1) In general. A Corporate Partner in a partnership that engages in a Section 337(d) Transaction recognizes gain at the time, and to the extent, that the Corporate Partner's interest in appreciated property (other than Stock of the Corporate Partner) is reduced in exchange for an increased interest in Stock of the Corporate Partner, as determined under paragraph (d)(2) of this section. This section does not apply to the extent a transaction has the effect of an exchange by a Corporate Partner of non-appreciated property for Stock of the Corporate Partner, or has the effect of an exchange by a Corporate Partner for property other than Stock of the Corporate Partner.

(2) Corporate Partner's interest in partnership property. The Corporate Partner's interest with respect to both Stock of the Corporate Partner and the appreciated property that is the subject of the exchange is determined based on all facts and circumstances, including the allocation and distribution rights set forth in the partnership agreement. The Corporate Partner's interest in an identified share of Stock of the Corporate Partner will never be less than the Corporate Partner's largest interest (by value) in that share of Stock of the Corporate Partner that was taken into account when the partnership previously determined whether there had been a Section 337(d) Transaction with respect to such share (regardless of whether the Corporate Partner recognized gain in the earlier transaction). See Example 7 of paragraph (h) of this section. However, this limitation will not apply if any reduction in the Corporate Partner's interest in the identified share of Stock of the Corporate Partner occurred as part of a plan or arrangement to circumvent the purpose of this section. See Example 8 of paragraph (h) of this section.

(3) Amount and character of gain recognized on the exchange - (i) Amount of gain. The amount of gain the Corporate Partner recognizes under paragraph (d)(1) of this section equals the product of the Corporate Partner's Gain Percentage and the gain from the appreciated property that is the subject of the exchange that the Corporate Partner would recognize if, immediately before the Section 337(d) Transaction, all assets of the partnership and any assets contributed to the partnership in the Section 337(d) Transaction were sold 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)), reduced, but not below zero, by any gain the Corporate Partner is required to recognize with respect to the appreciated property in the Section 337(d) Transaction under any other provision of this chapter. This gain is computed taking into account allocations of tax items applying the principles of section 704(c), including any remedial allocations under § 1.704-3(d), and also taking into account any basis adjustments including adjustments made pursuant to section 743(b).

(ii) Character of gain. The character of the gain that the Corporate Partner recognizes under paragraph (d)(1) of this section from the appreciated property that is the subject of the exchange shall be the character of the gain that the Corporate Partner would recognize if, immediately before the Section 337(d) Transaction, the Corporate Partner had disposed of the appreciated property that is the subject of the exchange 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)).

(4) Basis adjustments - (i) Corporate Partner's basis in the partnership interest. The basis of the Corporate Partner's interest in the partnership is increased by the amount of gain that the Corporate Partner recognizes under this paragraph (d).

(ii) Partnership's basis in partnership property. The partnership's adjusted tax basis in the appreciated property that is treated as the subject of the exchange under this paragraph (d) is increased by the amount of gain recognized with respect to that property by the Corporate Partner as a result of that exchange, regardless of whether the partnership has an election in effect under section 754. For basis recovery purposes, this basis increase is treated as property that is placed in service by the partnership in the taxable year of the Section 337(d) Transaction.

(e) Distribution of Stock of the Corporate Partner - (1) In general. This paragraph (e) applies to distributions to the Corporate Partner of Stock of the Corporate Partner to which section 732(f) does not apply and that have previously been the subject of a Section 337(d) Transaction or become the subject of a Section 337(d) Transaction as a result of the distribution. Upon the distribution of Stock of the Corporate Partner to the Corporate Partner, paragraph (d) of this section will apply as though immediately before the distribution the partners amended the partnership agreement to allocate to the Corporate Partner a 100 percent interest in that portion of the Stock of the Corporate Partner that is distributed, and to allocate an appropriately reduced interest in other partnership property away from the Corporate Partner.

(2) Basis rules - (i) Basis allocation on distributions of stock and other property. If, as part of the same transaction, a partnership distributes Stock of the Corporate Partner and other property (other than cash) to the Corporate Partner, see § 1.732-1(c)(1)(iii) for a rule allocating basis first to the Stock of the Corporate Partner before the distribution of the other property.

(ii) Computation of basis. For purposes of determining the basis of property distributed to a partner in a transaction that includes the distribution of Stock of the Corporate Partner (other than the basis of the Corporate Partner in its own stock), the basis of the partner's remaining partnership interest, and the partnership's basis in undistributed Stock of the Corporate Partner, and for purposes of computing gain under paragraph (e)(3) of this section, the partnership's basis of Stock of the Corporate Partner distributed to the partner equals the greater of -

(A) The partnership's basis of that distributed Stock of the Corporate Partner immediately before the distribution; or

(B) The fair market value of that distributed Stock of the Corporate Partner immediately before the distribution less the partner's allocable share of gain from all of the Stock of the Corporate Partner if the partnership sold all of its assets 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 before the distribution.

(iii) Section 732(f) basis reduction. For purposes of determining the amount of the decrease to the basis of property held by a distributed corporation pursuant to section 732(f), the amount of this decrease shall be reduced by the amount of gain that a Corporate Partner has recognized under this section in the same Section 337(d) Transaction or in a prior Section 337(d) Transaction involving the property.

(3) Gain recognition. The Corporate Partner will recognize gain on a distribution of Stock of the Corporate Partner to the Corporate Partner to the extent that the partnership's adjusted basis in the distributed Stock of the Corporate Partner (as determined under paragraph (e)(2)(ii) of this section) immediately before the distribution exceeds the Corporate Partner's adjusted basis in its partnership interest immediately after the distribution.

(f) Exceptions - (1) De minimis rule - (i) In general. Unless Stock of the Corporate Partner is acquired as part of a plan to circumvent the purpose of this section, this section does not apply to a Corporate Partner if at the time that the partnership acquires Stock of the Corporate Partner or at the time of a revaluation event as described in § 1.704-1(b)(2)(iv)(f) (without regard to whether or not the partnership revalues its assets) -

(A) The Corporate Partner and any persons related to the Corporate Partner under section 267(b) or section 707(b) own in the aggregate less than 5 percent of the partnership;

(B) The partnership holds Stock of the Corporate Partner with a value of less than 2 percent of the partnership's gross assets (including the Stock of the Corporate Partner); and

(1) Stock of the Corporate Partner with a fair market value greater than $1,000,000; or

(2) More than 2 percent of any particular class of Stock of the Corporate Partner.

(ii) De minimis rule ceases to apply. If a partnership satisfies the conditions of the de minimis rule of paragraph (f)(1) of this section upon an acquisition of Stock of the Corporate Partner or revaluation event as described in § 1.704-1(b)(2)(iv)(f), but later fails to satisfy the conditions of the de minimis rule upon a subsequent acquisition or revaluation event, then solely for purposes of paragraph (d) of this section, the Corporate Partner may compute its gain on the subsequent acquisition or revaluation event as if it had already recognized gain at the previous event. Neither the Corporate Partner nor the partnership increases its basis by the gain the Corporate Partner would have recognized if the de minimis rule of paragraph (f)(1) of this section did not apply to the prior acquisition or revaluation event.

(2) Certain dispositions of stock. Unless acquired as part of a plan to circumvent the purpose of this section, this section does not apply to Stock of the Corporate Partner that -

(i) Is disposed of (by sale or distribution) by the partnership before the due date (including extensions) of its federal income tax return for the taxable year during which the Stock of the Corporate Partner is acquired (or for the taxable year in which the Corporate Partner becomes a partner, whichever is applicable); and

(ii) Is not distributed to the Corporate Partner or a corporation that controls the Corporate Partner within the meaning of section 304(c), except that section 318(a)(1) and (3) shall not apply.

(g) Tiered partnerships. The rules of this section shall apply to tiered partnerships in a manner that is consistent with the purpose set forth in paragraph (a) of this section.

(h) Examples. The following examples illustrate the principles of this section. All amounts in the following examples are reported in millions of dollars:

Example 1.Deemed redemption rule - contribution of Stock of the Corporate Partner. (i) In Year 1, X, a corporation, and A, an individual, form partnership AX as equal partners in all respects. X contributes Asset 1 with a fair market value of $100 and a basis of $20. A contributes X stock, which is Stock of the Corporate Partner, with a basis and fair market value of $100.

(ii) Because A and X are equal partners in AX in all respects, the partnership formation causes X's interest in X stock to increase from $0 to $50 and its interest in Asset 1 to decrease from $100 to $50. Thus, the partnership formation is a Section 337(d) Transaction because the formation has the effect of an exchange by X of $50 of Asset 1 for $50 of X stock.

(iii) X must recognize gain under paragraph (d) of this section with respect to Asset 1 to prevent the circumvention of section 311(b) principles. X's gain equals the product of X's Gain Percentage and the gain from Asset 1 that X would recognize (decreased, but not below zero, by any gain that X recognized with respect to Asset 1 in the Section 337(d) Transaction under any other provision of this chapter) if, immediately before the Section 337(d) Transaction, all assets were sold in a fully taxable transaction for cash in an amount equal to the fair market value of such property. If Asset 1 had been sold in a fully taxable transaction immediately before the formation of partnership AX, X's allocable share of gain would have been $80. X's Gain Percentage is 50 percent (equal to a fraction, the numerator of which is X's $50 interest in Asset 1 effectively exchanged for X stock, and the denominator of which is X's $100 interest in Asset 1 immediately before the Section 337(d) Transaction). Thus, X recognizes $40 of gain ($80 multiplied by 50 percent) under the deemed redemption rule in paragraph (d) of this section. Under paragraph (d)(4)(i) of this section, X's basis in its AX partnership interest increases from $20 to $60. Under paragraph (d)(4)(ii) of this section, AX's basis in Asset 1 increases from $20 to $60 because Asset 1 is the appreciated property treated as the subject of the exchange.

Example 2.Deemed redemption rule - contribution of stock in a corporation that controls the Corporate Partner. (i) In Year 1, X, a corporation, and A, an individual, form partnership AX as equal partners in all respects. X contributes Asset 1 with a fair market value of $100 and a basis of $20. A contributes stock in P, with a basis and fair market value of $100. P is the sole owner of X. P's interest in X constitutes 10 percent of P's total assets.

(ii) Because P controls X within the meaning of section 304(c), stock in P is Stock of the Corporate Partner under paragraph (c)(2)(i) of this section.

(iii) Because A and X are equal partners in AX in all respects, the partnership formation causes X's interest in Stock of the Corporate Partner stock to increase from $0 to $50 and its interest in Asset 1 to decrease from $100 to $50. Thus, the partnership formation is a Section 337(d) Transaction because the formation has the effect of an exchange by X of $50 of Asset 1 for $50 of Stock of the Corporate Partner.

(iv) X must recognize gain under paragraph (d) of this section with respect to Asset 1 to prevent the circumvention of section 311(b) principles. X's gain equals the product of X's Gain Percentage and the gain from Asset 1 that X would recognize (decreased, but not below zero, by any gain that X recognized with respect to Asset 1 in the Section 337(d) Transaction under any other provision of this chapter) if, immediately before the Section 337(d) Transaction, all assets were sold in a fully taxable transaction for cash in an amount equal to the fair market value of such property. If Asset 1 had been sold in a fully taxable transaction immediately before the formation of partnership AX, X's allocable share of gain would have been $80. X's Gain Percentage is 50 percent (equal to a fraction, the numerator of which is X's $50 interest in Asset 1 effectively exchanged for Stock of the Corporate Partner, and the denominator of which is X's $100 interest in Asset 1 immediately before the Section 337(d) Transaction). Thus, X recognizes $40 of gain ($80 multiplied by 50 percent) under the deemed redemption rule in paragraph (d) of this section. Under paragraph (d)(4)(i) of this section, X's basis in its AX partnership interest increases from $20 to $60. Under paragraph (d)(4)(ii) of this section, AX's basis in Asset 1 increases from $20 to $60 because Asset 1 is the appreciated property treated as the subject of the exchange.

Example 3.Distribution of Stock of the Corporate Partner - pro rata distribution. (i) The facts are the same as in Example 1(i) of this paragraph (h). AX liquidates in Year 9, when Asset 1 and the X stock each have a fair market value of $200. X and A each receive 50 percent of Asset 1 and 50 percent of the X stock in the liquidation. At the time AX liquidates, X's basis in its AX partnership interest is $60 and A's basis in its AX partnership interest is $100.

(ii) When AX liquidates, X's interests in its stock and in Asset 1 do not change. Thus, the liquidation is not a Section 337(d) Transaction because it does not have the effect of an exchange by X of appreciated property for Stock of the Corporate Partner.

(iii) Paragraph (e) of this section applies because the distributed X stock was the subject of a previous Section 337(d) Transaction and because section 732(f) does not apply. Under § 1.732-1(c)(1)(iii), the distribution to X of X stock is deemed to immediately precede the distribution of 50 percent of Asset 1 to X for purposes of determining X's basis in the distributed property. For purposes of determining X's basis in Asset 1 and X's gain on distribution, the basis of the distributed X stock is treated as $50, the greater of $50 (50 percent of the stock's $100 basis in the hands of the partnership), or $50, the fair market value of that distributed X stock ($100) less X's allocable share of gain from the distributed X stock if AX had sold all of its assets in a fully taxable transaction for cash in an amount equal to the fair market value of such property immediately before the distribution ($50). Thus, X reduces its basis in its partnership interest by $50 prior to the distribution of Asset 1. Accordingly, X's basis in the distributed portion of Asset 1 is $10. Because AX's basis in the distributed X stock immediately before the distribution ($50) does not exceed X's basis in its AX partnership interest immediately before the distribution ($60), X recognizes no gain under paragraph (e)(3) of this section.

Example 4.Distribution of Stock of the Corporate Partner - non pro rata distribution. (i) The facts are the same as Example 3(i) of this paragraph (h), except that when AX liquidates, X receives 75 percent of the X stock and 25 percent of Asset 1 and A receives 25 percent of the X stock and 75 percent of Asset 1.

(ii) The liquidation of AX causes X's interest in X stock to increase from $100 to $150 and its interest in Asset 1 to decrease from $100 to $50. Thus, AX's liquidating distributions of X stock and Asset 1 to X are a Section 337(d) Transaction because the distributions have the effect of an exchange by X of $50 of Asset 1 for $50 of X stock.

(iii)(A) X must recognize gain with respect to Asset 1 to prevent the circumvention of section 311(b) principles. Under paragraph (e)(1) of this section, paragraph (d) of this section is applied as if X and A amended the AX partnership agreement to allocate to X a 100 percent interest in the distributed portion of the X stock. X must recognize gain equal to the product of X's Gain Percentage and the gain from Asset 1 that X would have recognized (decreased, but not below zero, by any gain X recognized with respect to Asset 1 in the Section 337(d) Transaction under any other provision of this chapter) if, immediately before the Section 337(d) Transaction, AX had sold all of its assets in a fully taxable transaction for cash in an amount equal to the fair market value of such property.

(B) If Asset 1 had been sold in a fully taxable transaction immediately before the amendment of the AX partnership agreement, X's allocable share of gain would have been $90, or the sum of X's $40 remaining gain under section 704(c) and $50 of the $100 post-contribution appreciation. X's Gain Percentage is 50 percent (equal to a fraction, the numerator of which is X's $50 interest in Asset 1 effectively exchanged for X stock, and the denominator of which is X's $100 interest in Asset 1 immediately before the Section 337(d) Transaction). Thus, X recognizes $45 of gain ($90 multiplied by 50 percent) under the deemed redemption rule in paragraph (d) of this section. Under paragraph (d)(4)(i) of this section, X's basis in its AX partnership interest increases from $60 to $105. Under paragraph (d)(4)(ii) of this section, AX's basis in Asset 1 increases from $60 to $105 because Asset 1 is the appreciated property treated as the subject of the exchange.

(iv)(A) Paragraph (e) of this section applies because the distributed X stock was the subject of a previous Section 337(d) Transaction and because section 732(f) does not apply. Under § 1.732-1(c)(1)(iii), AX is treated as first distributing the X stock to X before the distribution of 25 percent of Asset 1. For purposes of determining X's basis in Asset 1 and X's gain on distribution, the basis of the distributed X stock is treated as $100, the greater of $75 (75 percent of the stock's $100 basis in the hands of the partnership) or $100, the fair market value of the distributed X stock ($150) less X's allocable share of gain if the partnership had sold all of the X stock immediately before the distribution for cash in an amount equal to its fair market value ($50). Thus, X will reduce its basis in its partnership interest by $100 prior to the distribution of Asset 1. Accordingly, X's basis in the distributed portion of Asset 1 is $5. Because AX's basis in the distributed X stock immediately before the distribution as computed for purposes of this section ($100) does not exceed X's basis in its AX partnership interest immediately before the distribution ($105), X recognizes no additional gain under paragraph (e)(3) of this section.

(B) For purposes of determining A's basis in Asset 1 and A's gain on distribution, the basis of the distributed X stock is treated as $25, the greater of $25 (25 percent of the stock's $100 basis in the hands of the partnership) or $0, the fair market value of the distributed X stock ($50) less A's allocable share of gain if the partnership had sold all of the X stock immediately before the distribution for cash in an amount equal to its fair market value ($50). Thus, A will reduce its basis in its partnership interest by $25 prior to the distribution of Asset 1. Accordingly, A's basis in the distributed portion of Asset 1 is $75. Because AX's basis in the distributed X stock immediately before the distribution as computed for purposes of this section ($100) does not exceed A's basis in its AX partnership interest immediately before the distribution ($100), A recognizes no additional gain under paragraph (e)(3) of this section.

Example 5.Deemed redemption rule - subsequent purchase of Stock of the Corporate Partner. The facts are the same as Example 1(i) of this paragraph (h), except that A contributes cash of $100 instead of X stock. In a later year, when the value of Asset 1 has not changed, AX uses the contributed cash to purchase X stock for $100. AX's purchase of X stock has the effect of an exchange by X of appreciated property for X stock, and thus, is a Section 337(d) Transaction. X must recognize gain at the time, and to the extent, that X's share of appreciated property (other than X stock) is reduced in exchange for X stock. Thus, the consequences of the partnership's purchase of X stock are the same as those described in Example 1(ii) and (iii) of this paragraph (h), resulting in X recognizing $40 of gain. Example 6.Change in allocation ratios - amendment of partnership agreement. (i) The facts are the same as Example 3(i) of this paragraph (h), except that in Year 9, AX does not liquidate, and the AX partnership agreement is amended to allocate to X 80 percent of the income, gain, loss, and deduction from the X stock and to allocate to A 80 percent of the income, gain, loss, and deduction from Asset 1. If AX had sold the partnership assets immediately before the change to the partnership agreement, X would have been allocated $90 of gain from Asset 1 and $50 of gain from the X stock.

(ii) The amendment to the AX partnership agreement causes X's interest in its stock to increase from $100 (50 percent of the stock value immediately before the amendment of the agreement) to $160 (80 percent of stock value immediately following amendment of agreement) and its interest in Asset 1 to decrease from $100 to $40. Thus, the amendment of the partnership agreement is a Section 337(d) Transaction because the amendment has the effect of an exchange by X of $60 of Asset 1 for $60 of its stock.

(iii) X must recognize gain equal to the product of X's Gain Percentage and the gain from Asset 1 that X would have recognized (decreased, but not below zero, by any gain X recognized with respect to Asset 1 in the Section 337(d) Transaction under any other provision of this chapter) if, immediately before the Section 337(d) Transaction, AX had sold all of its assets in a fully taxable transaction for cash in an amount equal to the fair market value of such property. If Asset 1 had been sold in a fully taxable transaction immediately before the amendment of the AX partnership agreement, X's allocable share of gain would have been $90, or the sum of X's $40 remaining gain under section 704(c) and 50 percent of the $100 post-contribution appreciation. X's Gain Percentage is 60 percent (equal to a fraction, the numerator of which is X's $60 interest in Asset 1 effectively exchanged for X stock, and the denominator of which is X's $100 interest in Asset 1 immediately before the Section 337(d) Transaction). Thus, X recognizes $54 of gain ($90 multiplied by 60 percent) under the deemed redemption rule in paragraph (d) of this section. Under paragraph (d)(4)(i) of this section, X's basis in its AX partnership interest increases from $60 to $114. Under paragraph (d)(4)(ii) of this section, AX's basis in Asset 1 increases from $60 to $114 because Asset 1 is the appreciated property treated as the subject of the exchange.

Example 7.Change in allocation ratios - admission and exit of a partner. (i) The facts are the same as Example 1(i) of this paragraph (h). In addition, in Year 2, when the values of Asset 1 and the X stock have not changed, B contributes $100 of cash to AX in exchange for a one-third interest in the partnership. Upon the admission of B as a partner, X's interest in Asset 1 decreases from $50 to $33.33, and its interest in B's contributed cash increases. B's admission is not a Section 337(d) Transaction because it does not have the effect of an exchange by X of its interest in Asset 1 for X stock. Accordingly, X does not recognize gain under paragraph (d) of this section.

(ii) In Year 9, when the values of Asset 1 and the X stock have not changed, the partnership distributes $50 of cash and 50 percent of Asset 1 (valued at $50) to B in liquidation of B's interest. X and A are equal partners in all respects after the distribution. Upon the liquidation of B's interest, X's interest in Asset 1 decreases from $33.33 to $25, and its interest in X stock increases from $33.33 to $50. AX's liquidation of B's interest has the effect of an exchange by X of appreciated property for X stock, and thus, is a Section 337(d) Transaction.

(iii) Pursuant to paragraph (d)(2) of this section, X's interest in X stock and other appreciated property held by the partnership is determined based on all facts and circumstances, including allocation and distribution rights in the partnership agreement. However, paragraph (d)(2) of this section also requires that X's interest in its stock for purposes of paragraph (d) will never be less than the Corporate Partner's largest interest (by value) in those shares of Stock of the Corporate Partner taken into account when the partnership previously determined whether there had been a Section 337(d) Transaction (regardless of whether the Corporate Partner recognized gain in the earlier transaction). Although X's interest in X stock increases to $50 upon AX's liquidation of B's interest, X's largest interest previously taken into account under paragraph (d)(1) of this section was $50. Thus, X's interest in its stock is not considered to be increased, and X therefore recognizes no gain under paragraph (d) of this section, provided that the transactions did not occur as part of a plan or arrangement to circumvent the purpose of this section.

Example 8.Change in allocation ratios - plan to circumvent purpose of this section. (i) In Year 1, X, a corporation, and A, an individual, contribute $99 and $1, respectively, to newly-formed partnership AX, with X receiving a 99 percent interest in AX and A receiving a 1 percent interest in AX. AX borrows $100,000 from a third-party lender and uses the proceeds to purchase X stock, which is Stock of the Corporate Partner. Later, as part of a plan or arrangement to circumvent the purposes of this section, A contributes $99,999 of cash, which AX uses to repay the loan, and X contributes Asset 1 with a fair market value of $99,901 and basis of $20,000. After these contributions, A and X are equal partners in AX in all respects.

(ii) Pursuant to paragraph (d)(2) of this section, X's interest in X stock and other appreciated property held by the partnership is determined based on all facts and circumstances, including allocation and distribution rights in the partnership agreement. Generally, pursuant to paragraph (d)(2) of this section, X's interest in X stock for purposes of paragraph (d) of this section will never be less than the Corporate Partner's largest interest (by value) in those shares of Stock of the Corporate Partner taken into account when the partnership previously determined whether there had been a Section 337(d) Transaction (regardless of whether the Corporate Partner recognized gain in the earlier transaction). This limitation does not apply, however, if the reduction in X's interest in X's stock occurred as part of a plan or arrangement to circumvent the purpose of this section. Because the transactions described in this example are part of a plan or arrangement to circumvent the purpose of this section, the limitation in paragraph (d)(2) of this section does not apply. Accordingly, the deemed redemption rule under paragraph (d) of this section applies to the transactions with the consequences described in Example 1(iii) of this paragraph (h), resulting in X recognizing $39,950.50 of gain.

Example 9.Tiered partnership. (i) In Year 1, X, a corporation, and A, an individual, form partnership UTP. X contributes Asset 1 with a fair market value of $80 and a basis of $0 in exchange for an 80 percent interest in UTP. A contributes $20 of cash in exchange for a 20 percent interest in UTP. UTP and B, an individual, form partnership LTP as equal partners. UTP contributes Asset 1 and $20 of cash. B contributes X stock, which is Stock of the Corporate Partner, with a basis and fair market value of $100.

(ii) Pursuant to paragraph (g) of this section, the rules of this section shall apply to tiered partnerships in a manner that is consistent with the purpose set forth in paragraph (a) of this section. Pursuant to paragraph (d)(1) of this section, if X is in a partnership that engages in a Section 337(d) Transaction, X must recognize gain at the time, and to the extent, that X's share of appreciated property is reduced in exchange for X stock. The formation of LTP causes X's interest in X stock to increase from $0 to $40 and its interest in Asset 1 to decrease from $64 to $32. Thus, LTP's formation is a Section 337(d) Transaction because the formation has the effect of an exchange by X of $32 of Asset 1 for $32 of X stock.

(iii) X must recognize gain with respect to Asset 1 to prevent the circumvention of section 311(b) principles. X must recognize gain equal to the product of X's Gain Percentage and the gain from Asset 1 (decreased, but not below zero, by any gain X recognized with respect to Asset 1 in the Section 337(d) Transaction under any other provision of this chapter) that X would recognize if, immediately before the Section 337(d) Transaction, all assets were sold in a fully taxable transaction for cash in an amount equal to the fair market value of such property. If Asset 1 had been sold in a fully taxable transaction immediately before LTP's formation, X's allocable share of gain would have been $80 pursuant to section 704(c). X's Gain Percentage is 50 percent (equal to a fraction, the numerator of which is X's $32 interest in Asset 1 effectively exchanged for X stock, and the denominator of which is X's $64 interest in Asset 1 immediately before the Section 337(d) Transaction). Thus, X recognizes $40 of gain ($80 multiplied by 50 percent) under the deemed redemption rule in paragraph (d) of this section. Under paragraphs (d)(4)(i) and (ii) of this section, X's basis in its UTP partnership interest increases from $0 to $40, UTP's basis in its LTP partnership interest increases from $20 to $60, and LTP's basis in Asset 1 increases from $0 to $40 pursuant to paragraph (g) of this section.

(i) Applicability date. This section applies to transactions occurring on or after June 12, 2015.

[T.D. 9833, 83 FR 26588, June 8, 2018]