Section

[Code of Federal Regulations]
[Title 26, Volume 1]
[Revised as of April 1, 2003]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.1(h)-1]

[Page 11-14]

TITLE 26--INTERNAL REVENUE

CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY

PART 1--INCOME TAXES--Table of Contents

Sec. 1.1(h)-1 Capital gains look-through rule for sales or exchanges of interests in a partnership, S corporation, or trust.

(a) In general. When an interest in a partnership held for more than
one year is sold or exchanged, the transferor may recognize ordinary
income (e.g., under section 751(a)), collectibles gain, section 1250
capital gain, and residual long-term capital gain or loss. When stock in
an S corporation held for more than one year is sold or exchanged, the
transferor may recognize ordinary income (e.g., under sections 304, 306,
341, 1254), collectibles gain, and residual long-term capital gain or
loss. When an interest in a trust held for more than one year is sold or
exchanged, a transferor who is not treated as the owner of the portion
of the trust attributable to the interest sold or exchanged (sections
673 through 679) (a non-grantor transferor) may recognize collectibles
gain and residual long-term capital gain or loss.
(b) Look-through capital gain--(1) In general. Look-through capital
gain is the share of collectibles gain allocable to an interest in a
partnership, S corporation, or trust, plus the share of section 1250
capital gain allocable to an interest in a partnership, determined under
paragraphs (b)(2) and (3) of this section.
(2) Collectibles gain--(i) Definition. For purposes of this section,
collectibles gain shall be treated as gain from the sale or exchange of
a collectible (as defined in section 408(m) without regard to section
408(m)(3)) that is a capital asset held for more than 1 year.
(ii) Share of collectibles gain allocable to an interest in a
partnership, S corporation, or a trust. When an interest in a
partnership, S corporation, or trust held for more than one year is sold
or exchanged in a transaction in which all realized gain is recognized,
the transferor shall recognize as collectibles gain the amount of net
gain (but not net loss) that would be allocated to that partner (taking
into account any remedial allocation under Sec. 1.704-3(d)),
shareholder, or beneficiary (to the extent attributable to the portion
of the partnership interest, S corporation stock, or trust interest
transferred that was held for more than one year) if the partnership, S
corporation, or trust transferred all of its collectibles for cash equal
to the fair market value of the assets in a fully taxable transaction
immediately before the transfer of the interest in the partnership, S
corporation, or trust. If less than all of the realized gain is
recognized upon the sale or exchange of an interest in a partnership, S
corporation, or trust, the same methodology shall apply to determine the
collectibles gain recognized by the transferor, except that the
partnership, S corporation, or trust shall be treated as transferring
only a proportionate amount of each of its collectibles determined as a
fraction that is the amount of gain recognized in the sale or exchange
over the amount of gain realized in the sale or exchange. With respect
to the transfer of an interest in a trust, this paragraph (b)(2) applies
only to transfers by non-grantor transferors (as defined in paragraph
(a) of this section). This paragraph (b)(2) does not apply to a
transaction that is treated, for Federal income tax purposes, as a
redemption of an interest in a partnership, S corporation, or trust.
(3) Section 1250 capital gain--(i) Definition. For purposes of this
section, section 1250 capital gain means the capital gain (not otherwise
treated as ordinary income) that would be treated as ordinary income if
section 1250(b)(1) included all depreciation and the applicable
percentage under section 1250(a) were 100 percent.
(ii) Share of section 1250 capital gain allocable to interest in
partnership. When an interest in a partnership held for more than one
year is sold or exchanged in a transaction in which all realized gain is
recognized, there shall

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be taken into account under section 1(h)(7)(A)(i) in determining the
partner's unrecaptured section 1250 gain the amount of section 1250
capital gain that would be allocated (taking into account any remedial
allocation under Sec. 1.704-3(d)) to that partner (to the extent
attributable to the portion of the partnership interest transferred that
was held for more than one year) if the partnership transferred all of
its section 1250 property in a fully taxable transaction for cash equal
to the fair market value of the assets immediately before the transfer
of the interest in the partnership. If less than all of the realized
gain is recognized upon the sale or exchange of an interest in a
partnership, the same methodology shall apply to determine the section
1250 capital gain recognized by the transferor, except that the
partnership shall be treated as transferring only a proportionate amount
of each section 1250 property determined as a fraction that is the
amount of gain recognized in the sale or exchange over the amount of
gain realized in the sale or exchange. This paragraph (b)(3) does not
apply to a transaction that is treated, for Federal income tax purposes,
as a redemption of a partnership interest.
(iii) Limitation with respect to net section 1231 gain. In
determining a transferor partner's net section 1231 gain (as defined in
section 1231(c)(3)) for purposes of section 1(h)(7)(B), the transferor
partner's allocable share of section 1250 capital gain in partnership
property shall not be treated as section 1231 gain, regardless of
whether the partnership property is used in the trade or business (as
defined in section 1231(b)).
(c) Residual long-term capital gain or loss. The amount of residual
long-term capital gain or loss recognized by a partner, shareholder of
an S corporation, or beneficiary of a trust on account of the sale or
exchange of an interest in a partnership, S corporation, or trust shall
equal the amount of long-term capital gain or loss that the partner
would recognize under section 741, that the shareholder would recognize
upon the sale or exchange of stock of an S corporation, or that the
beneficiary would recognize upon the sale or exchange of an interest in
a trust (pre-look-through long-term capital gain or loss) minus the
amount of look-through capital gain determined under paragraph (b) of
this section.
(d) Special rule for tiered entities. In determining whether a
partnership, S corporation, or trust has gain from collectibles, such
partnership, S corporation, or trust shall be treated as owning its
proportionate share of the collectibles of any partnership, S
corporation, or trust in which it owns an interest either directly or
indirectly through a chain of such entities. In determining whether a
partnership has section 1250 capital gain, such partnership shall be
treated as owning its proportionate share of the section 1250 property
of any partnership in which it owns an interest, either directly or
indirectly through a chain of partnerships.
(e) Notification requirements. Reporting rules similar to those that
apply to the partners and the partnership under section 751(a) shall
apply in the case of sales or exchanges of interests in a partnership, S
corporation, or trust that cause holders of such interests to recognize
collectibles gain and in the case of sales or exchanges of interests in
a partnership that cause holders of such interests to recognize section
1250 capital gain. See Sec. 1.751-1(a)(3).
(f) Examples. The following examples illustrate the requirements of
this section:

Example 1. Collectibles gain. (i) A and B are equal partners in a
personal service partnership (PRS). B transfers B's interest in PRS to T
for $15,000 when PRS's balance sheet (reflecting a cash receipts and
disbursements method of accounting) is as follows:

------------------------------------------------------------------------
ASSETS
-------------------
Adjusted Market
basis value
------------------------------------------------------------------------
Cash................................................ $3,000 $3,000
Loans Owed to Partnership........................... 10,000 10,000
Collectibles...................................... 1,000 3,000
Other Capital Assets.............................. 6,000 2,000
-------------------
Capital Assets...................................... 7,000 5,000
Unrealized Receivables.............................. 0 14,000
-------------------
Total........................................... 20,000 32,000
------------------------------------------------------------------------

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------------------------------------------------------------------------
LIABILITIES AND
CAPITAL
-------------------
Adjusted Market
basis value
------------------------------------------------------------------------
Liabilities......................................... 2,000 2,000
Capital:
A................................................. 9,000 15,000
B................................................. 9,000 15,000
-------------------
Total........................................... 20,000 32,000
------------------------------------------------------------------------

(ii) At the time of the transfer, B has held the interest in PRS for
more than one year, and B's basis for the partnership interest is
$10,000 ($9,000 plus $1,000, B's share of partnership liabilities). None
of the property owned by PRS is section 704(c) property. The total
amount realized by B is $16,000, consisting of the cash received,
$15,000, plus $1,000, B's share of the partnership liabilities assumed
by T. See section 752. B's undivided one-half interest in PRS includes a
one-half interest in the partnership's unrealized receivables and a one-
half interest in the partnership's collectibles.
(iii) If PRS were to sell all of its section 751 property in a fully
taxable transaction for cash equal to the fair market value of the
assets immediately prior to the transfer of B's partnership interest to
T, B would be allocated $7,000 of ordinary income from the sale of PRS's
unrealized receivables. Therefore, B will recognize $7,000 of ordinary
income with respect to the unrealized receivables. The difference
between the amount of capital gain or loss that the partner would
realize in the absence of section 751 ($6,000) and the amount of
ordinary income or loss determined under Sec. 1.751-1(a)(2) ($7,000) is
the partner's capital gain or loss on the sale of the partnership
interest under section 741. In this case, the transferor has a $1,000
pre-look-through long-term capital loss.
(iv) If PRS were to sell all of its collectibles in a fully taxable
transaction for cash equal to the fair market value of the assets
immediately prior to the transfer of B's partnership interest to T, B
would be allocated $1,000 of gain from the sale of the collectibles.
Therefore, B will recognize $1,000 of collectibles gain on account of
the collectibles held by PRS.
(v) The difference between the transferor's pre-look-through long-
term capital gain or loss (-$1,000) and the look-through capital gain
determined under this section ($1,000) is the transferor's residual
long-term capital gain or loss on the sale of the partnership interest.
Under these facts, B will recognize a $2,000 residual long-term capital
loss on account of the sale or exchange of the interest in PRS.
Example 2. Special allocations. Assume the same facts as in Example
1, except that under the partnership agreement, all gain from the sale
of the collectibles is specially allocated to B, and B transfers B's
interest to T for $16,000. All items of income, gain, loss, or deduction
of PRS, other than the gain from the collectibles, are divided equally
between A and B. Under these facts, B's amount realized is $17,000,
consisting of the cash received, $16,000, plus $1,000, B's share of the
partnership liabilities assumed by T. See section 752. B will recognize
$7,000 of ordinary income with respect to the unrealized receivables
(determined under Sec. 1.751-1(a)(2)). Accordingly, B's pre-look-through
long-term capital gain would be $0. If PRS were to sell all of its
collectibles in a fully taxable transaction for cash equal to the fair
market value of the assets immediately prior to the transfer of B's
partnership interest to T, B would be allocated $2,000 of gain from the
sale of the collectibles. Therefore, B will recognize $2,000 of
collectibles gain on account of the collectibles held by PRS. B will
recognize a $2,000 residual long-term capital loss on account of the
sale of B's interest in PRS.
Example 3. Net collectibles loss ignored. Assume the same facts as
in Example 1, except that the collectibles held by PRS have an adjusted
basis of $3,000 and a fair market value of $1,000, and the other capital
assets have an adjusted basis of $4,000 and a fair market value of
$4,000. (The total adjusted basis and fair market value of the
partnership's capital assets are the same as in Example 1.) If PRS were
to sell all of its collectibles in a fully taxable transaction for cash
equal to the fair market value of the assets immediately prior to the
transfer of B's partnership interest to T, B would be allocated $1,000
of loss from the sale of the collectibles. Because none of the gain from
the sale of the interest in PRS is attributable to unrealized
appreciation in the value of collectibles held by PRS, the net loss in
collectibles held by PRS is not recognized at the time B transfers the
interest in PRS. B will recognize $7,000 of ordinary income (determined
under Sec. 1.751-1(a)(2)) and a $1,000 long-term capital loss on account
of the sale of B's interest in PRS.
Example 4. Collectibles gain in an S corporation. (i) A corporation
(X) has always been an S corporation and is owned by individuals A, B,
and C. In 1996, X invested in antiques. Subsequent to their purchase,
the antiques appreciated in value by $300. A owns one-third of the
shares of X stock and has held that stock for more than one year. A's
adjusted basis in the X stock is $100. If A were to sell all of A's X
stock to T for $150, A would realize $50 of pre-look-through long-term
capital gain.
(ii) If X were to sell its antiques in a fully taxable transaction
for cash equal to the fair market value of the assets immediately before
the transfer to T, A would be allocated $100 of gain on account of the
sale. Therefore, A will recognize $100 of collectibles gain (look-
through capital gain) on account of the collectibles held by X.

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(iii) The difference between the transferor's pre-look-through long-
term capital gain or loss ($50) and the look-through capital gain
determined under this section ($100) is the transferor's residual long-
term capital gain or loss on the sale of the S corporation stock. Under
these facts, A will recognize $100 of collectibles gain and a $50
residual long-term capital loss on account of the sale of A's interest
in X.
Example 5. Sale or exchange of partnership interest where part of
the interest has a short-term holding period. (i) A, B, and C form an
equal partnership (PRS). In connection with the formation, A contributes
$5,000 in cash and a capital asset with a fair market value of $5,000
and a basis of $2,000; B contributes $7,000 in cash and a collectible
with a fair market value of $3,000 and a basis of $3,000; and C
contributes $10,000 in cash. At the time of the contribution, A had held
the contributed property for two years. Six months later, when A's basis
in PRS is $7,000, A transfers A's interest in PRS to T for $14,000 at a
time when PRS's balance sheet (reflecting a cash receipts and
disbursements method of accounting) is as follows:

------------------------------------------------------------------------
ASSETS
-------------------
Adjusted Market
basis value
------------------------------------------------------------------------
Cash................................................ $22,000 $22,000
Unrealized Receivables.............................. 0 6,000
Capital Asset..................................... 2,000 5,000
Collectible....................................... 3,000 9,000
Capital Assets...................................... 5,000 14,000
-------------------
Total........................................... 27,000 42,000
------------------------------------------------------------------------

(ii) Although at the time of the transfer A has not held A's
interest in PRS for more than one year, 50 percent of the fair market
value of A's interest in PRS was received in exchange for a capital
asset with a long-term holding period. Therefore, 50 percent of A's
interest in PRS has a long-term holding period. See Sec. 1.1223-3(b)(1).
(iii) If PRS were to sell all of its section 751 property in a fully
taxable transaction immediately before A's transfer of the partnership
interest, A would be allocated $2,000 of ordinary income. Accordingly, A
will recognize $2,000 ordinary income and $5,000 ($7,000-$2,000) of
capital gain on account of the transfer to T of A's interest in PRS.
Fifty percent ($2,500) of that gain is long-term capital gain and 50
percent ($2,500) is short-term capital gain. See Sec. 1.1223-3(c)(1).
(iv) If the collectible were sold or exchanged in a fully taxable
transaction immediately before A's transfer of the partnership interest,
A would be allocated $2,000 of gain attributable to the collectible. The
gain attributable to the collectible that is allocable to the portion of
the transferred interest in PRS with a long-term holding period is
$1,000 (50 percent of $2,000). Accordingly, A will recognize $1,000 of
collectibles gain on account of the transfer of A's interest in PRS.
(v) The difference between the amount of pre-look-through long-term
capital gain or loss ($2,500) and the look-through capital gain ($1,000)
is the amount of residual long-term capital gain or loss that A will
recognize on account of the transfer of A's interest in PRS. Under these
facts, A will recognize a residual long-term capital gain of $1,500 and
a short-term capital gain of $2,500.

(g) Effective date. This section applies to transfers of interests
in partnerships, S corporations, and trusts that occur on or after
September 21, 2000.

[T.D. 8902, 65 FR 57096, Sept. 21, 2000]