[Code of Federal Regulations]
[Title 26, Volume 8]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.704-4]

[Page 444-450]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
Determination of Tax Liability--Table of Contents
 
Sec. 1.704-4  Distribution of contributed property.

    (a) Determination of gain and loss--(1) In general. A partner that 
contributes section 704(c) property to a partnership must recognize gain 
or loss under section 704(c)(1)(B) and this section on the distribution 
of such property to another partner within five years of its 
contribution to the partnership in an amount equal to the gain or loss 
that would have been allocated to such partner under section 
704(c)(1)(A) and Sec. 1.704-3 if the distributed property had been sold 
by the partnership to the distributee partner for its fair market value 
at the time of the distribution. See Sec. 1.704-3(a)(3)(i) for a 
definition of section 704(c) property.
    (2) Transactions to which section 704(c)(1)(B) applies. Section 
704(c)(1)(B) and this section apply only to the extent that a 
distribution by a partnership is a distribution to a partner acting in 
the capacity of a partner within the meaning of section 731.
    (3) Fair market value of property. The fair market value of the 
distributed section 704(c) property is the price at which the property 
would change hands between a willing buyer and a willing seller at the 
time of the distribution, neither being under any compulsion to buy or 
sell and both having reasonable knowledge of the relevant facts. The 
fair market value that a partnership assigns to distributed section 
704(c) property will be regarded as correct,

[[Page 445]]

provided that the value is reasonably agreed to among the partners in an 
arm's-length negotiation and the partners have sufficiently adverse 
interests.
    (4) Determination of five-year period--(i) General rule. The five-
year period specified in paragraph (a)(1) of this section begins on and 
includes the date of contribution.
    (ii) Section 708(b)(1)(B) terminations. A termination of the 
partnership under section 708(b)(1)(B) does not begin a new five-year 
period for each partner with respect to the built-in gain and built-in 
loss property that the terminated partnership is deemed to contribute to 
the new partnership under Sec. 1.708-1(b)(1)(iv). See Sec. 1.704-
3(a)(3)(ii) for the definitions of built-in gain and built-in loss on 
section 704(c) property. This paragraph (a)(4)(ii) applies to 
terminations of partnerships under section 708(b)(1)(B) occurring on or 
after May 9, 1997; however, this paragraph (a)(4)(ii) may be applied to 
terminations occurring on or after May 9, 1996, provided that the 
partnership and its partners apply this paragraph (a)(4)(ii) to the 
termination in a consistent manner.
    (5) Examples. The following examples illustrate the rules of this 
paragraph (a). Unless otherwise specified, partnership income equals 
partnership expenses (other than depreciation deductions for contributed 
property) for each year of the partnership, the fair market value of 
partnership property does not change, all distributions by the 
partnership are subject to section 704(c)(1)(B), and all partners are 
unrelated.

    Example 1. Recognition of gain. (i) On January 1, 1995, A, B, and C 
form partnership ABC as equal partners. A contributes $10,000 cash and 
Property A, nondepreciable real property with a fair market value of 
$10,000 and an adjusted tax basis of $4,000. Thus, there is a built-in 
gain of $6,000 on Property A at the time of contribution. B contributes 
$10,000 cash and Property B, nondepreciable real property with a fair 
market value and adjusted tax basis of $10,000. C contributes $20,000 
cash.
    (ii) On December 31, 1998, Property A and Property B are distributed 
to C in complete liquidation of C's interest in the partnership.
    (iii) A would have recognized $6,000 of gain under section 
704(c)(1)(A) and Sec. 1.704-3 on the sale of Property A at the time of 
the distribution ($10,000 fair market value less $4,000 adjusted tax 
basis). As a result, A must recognize $6,000 of gain on the distribution 
of Property A to C. B would not have recognized any gain or loss under 
section 704(c)(1)(A) and Sec. 1.704-3 on the sale of Property B at the 
time of distribution because Property B was not section 704(c) property. 
As a result, B does not recognize any gain or loss on the distribution 
of Property B.
    Example 2. Effect of post-contribution depreciation deductions. (i) 
On January 1, 1995, A, B, and C form partnership ABC as equal partners. 
A contributes Property A, depreciable property with a fair market value 
of $30,000 and an adjusted tax basis of $20,000. Therefore, there is a 
built-in gain of $10,000 on Property A. B and C each contribute $30,000 
cash. ABC uses the traditional method of making section 704(c) 
allocations described in Sec. 1.704-3(b) with respect to Property A.
    (ii) Property A is depreciated using the straight-line method over 
its remaining 10-year recovery period. The partnership has book 
depreciation of $3,000 per year (10 percent of the $30,000 book basis), 
and each partner is allocated $1,000 of book depreciation per year (one-
third of the total annual book depreciation of $3,000). The partnership 
has a tax depreciation deduction of $2,000 per year (10 percent of the 
$20,000 tax basis in Property A). This $2,000 tax depreciation deduction 
is allocated equally between B and C, the noncontributing partners with 
respect to Property A.
    (iii) At the end of the third year, the book value of Property A is 
$21,000 ($30,000 initial book value less $9,000 aggregate book 
depreciation) and the adjusted tax basis is $14,000 ($20,000 initial tax 
basis less $6,000 aggregate tax depreciation). A's remaining section 
704(c)(1)(A) built-in gain with respect to Property A is $7,000 ($21,000 
book value less $14,000 adjusted tax basis).
    (iv) On December 31, 1997, Property A is distributed to B in 
complete liquidation of B's interest in the partnership. If Property A 
had been sold for its fair market value at the time of the distribution, 
A would have recognized $7,000 of gain under section 704(c)(1)(A) and 
Sec. 1.704-3(b). Therefore, A recognizes $7,000 of gain on the 
distribution of Property A to B.
    Example 3. Effect of remedial method. (i) On January 1, 1995, A, B, 
and C form partnership ABC as equal partners. A contributes Property A1, 
nondepreciable real property with a fair market value of $10,000 and an 
adjusted tax basis of $5,000, and Property A2, nondepreciable real 
property with a fair market value and adjusted tax basis of $10,000. B 
and C each contribute $20,000 cash. ABC uses the remedial method of 
making section 704(c) allocations described in Sec. 1.704-3(d) with 
respect to Property A1.
    (ii) On December 31, 1998, when the fair market value of Property A1 
has decreased

[[Page 446]]

to $7,000, Property A1 is distributed to C in a current distribution. If 
Property A1 had been sold by the partnership at the time of the 
distribution, ABC would have recognized the $2,000 of remaining built-in 
gain under section 704(c)(1)(A) on the sale (fair market value of $7,000 
less $5,000 adjusted tax basis). All of this gain would have been 
allocated to A. ABC would also have recognized a book loss of $3,000 
($10,000 original book value less $7,000 current fair market value of 
the property). Book loss in the amount of $2,000 would have been 
allocated equally between B and C. Under the remedial method, $2,000 of 
tax loss would also have been allocated equally to B and C to match 
their share of the book loss. As a result, $2,000 of gain would also 
have been allocated to A as an offsetting remedial allocation. A would 
have recognized $4,000 of total gain under section 704(c)(1)(A) on the 
sale of Property A1 ($2,000 of section 704(c) recognized gain plus 
$2,000 remedial gain). Therefore, A recognizes $4,000 of gain on the 
distribution of Property A1 to C under this section.

    (b) Character of gain or loss--(1) General rule. Gain or loss 
recognized by the contributing partner under section 704(c)(1)(B) and 
this section has the same character as the gain or loss that would have 
resulted if the distributed property had been sold by the partnership to 
the distributee partner at the time of the distribution.
    (2) Example. The following example illustrates the rule of this 
paragraph (b). Unless otherwise specified, partnership income equals 
partnership expenses (other than depreciation deductions for contributed 
property) for each year of the partnership, the fair market value of 
partnership property does not change, all distributions by the 
partnership are subject to section 704(c)(1)(B), and all partners are 
unrelated.

    Example. Character of gain. (i) On January 1, 1995, A and B form 
partnership AB. A contributes $10,000 and Property A, nondepreciable 
real property with a fair market value of $10,000 and an adjusted tax 
basis of $4,000, in exchange for a 25 percent interest in partnership 
capital and profits. B contributes $60,000 cash for a 75 percent 
interest in partnership capital and profits.
    (ii) On December 31, 1998, Property A is distributed to B in a 
current distribution. Property A is used in a trade or business of B.
    (iii) A would have recognized $6,000 of gain under section 
704(c)(1)(A) on a sale of Property A at the time of the distribution 
(the difference between the fair market value ($10,000) and the adjusted 
tax basis ($4,000) of the property at that time). Because Property A is 
not a capital asset in the hands of Partner B and B holds more than 50 
percent of partnership capital and profits, the character of the gain on 
a sale of Property A to B would have been ordinary income under section 
707(b)(2). Therefore, the character of the gain to A on the distribution 
of Property A to B is ordinary income.

    (c) Exceptions--(1) Property contributed on or before October 3, 
1989. Section 704(c)(1)(B) and this section do not apply to property 
contributed to the partnership on or before October 3, 1989.
    (2) Certain liquidations. Section 704(c)(1)(B) and this section do 
not apply to a distribution of an interest in section 704(c) property to 
a partner other than the contributing partner in a liquidation of the 
partnership if--
    (i) The contributing partner receives an interest in the section 
704(c) property contributed by that partner (and no other property); and
    (ii) The built-in gain or loss in the interest distributed to the 
contributing partner, determined immediately after the distribution, is 
equal to or greater than the built-in gain or loss on the property that 
would have been allocated to the contributing partner under section 
704(c)(1)(A) and Sec. 1.704-3 on a sale of the contributed property to 
an unrelated party immediately before the distribution.
    (3) Section 708(b)(1)(B) terminations. Section 704(c)(1)(B) and this 
section do not apply to the deemed distribution of interests in a new 
partnership caused by the termination of a partnership under section 
708(b)(1)(B). A subsequent distribution of section 704(c) property by 
the new partnership to a partner of the new partnership is subject to 
section 704(c)(1)(B) to the same extent that a distribution by the 
terminated partnership would have been subject to section 704(c)(1)(B). 
See also Sec. 1.737-2(a) for a similar rule in the context of section 
737. This paragraph (c)(3) applies to terminations of partnerships under 
section 708(b)(1)(B) occurring on or after May 9, 1997; however, this 
paragraph (c)(3) may be applied to terminations occurring on or after 
May 9, 1996, provided that the partnership and its partners apply this 
paragraph (c)(3) to the termination in a consistent manner.

[[Page 447]]

    (4) Complete transfer to another partnership. Section 704(c)(1)(B) 
and this section do not apply to a transfer by a partnership (transferor 
partnership) of all of its assets and liabilities to a second 
partnership (transferee partnership) in an exchange described in section 
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. A subsequent distribution of section 704(c) 
property by the transferee partnership to a partner of the transferee 
partnership is subject to section 704(c)(1)(B) to the same extent that a 
distribution by the transferor partnership would have been subject to 
section 704(c)(1)(B). See Sec. 1.737-2(b) for a similar rule in the 
context of section 737.
    (5) Incorporation of a partnership. Section 704(c)(1)(B) and this 
section do not apply to an incorporation of a partnership by any method 
of incorporation (other than a method involving an actual distribution 
of partnership property to the partners followed by a contribution of 
that property to a corporation), provided that the partnership is 
liquidated as part of the incorporation transaction. See Sec. 1.737-
2(c) for a similar rule in the context of section 737.
    (6) Undivided interests. Section 704(c)(1)(B) and this section do 
not apply to a distribution of an undivided interest in property to the 
extent that the undivided interest does not exceed the undivided 
interest, if any, contributed by the distributee partner in the same 
property. See Sec. 1.737-2(d)(4) for the application of section 737 in 
a similar context. The portion of the undivided interest in property 
retained by the partnership after the distribution, if any, that is 
treated as contributed by the distributee partner, is reduced to the 
extent of the undivided interest distributed to the distributee partner.
    (7) Example. The following example illustrates the rule of paragraph 
(c)(2) of this section. Unless otherwise specified, partnership income 
equals partnership expenses (other than depreciation deductions for 
contributed property) for each year of the partnership, the fair market 
value of partnership property does not change, all distributions by the 
partnership are subject to section 704(c)(1)(B), and all partners are 
unrelated.

    Example. (i) On January 1, 1995, A and B form partnership AB, as 
equal partners. A contributes Property A, nondepreciable real property 
with a fair market value and adjusted tax basis of $20,000. B 
contributes Property B, nondepreciable real property with a fair market 
value of $20,000 and an adjusted tax basis of $10,000. Property B 
therefore has a built-in gain of $10,000 at the time of contribution.
    (ii) On December 31, 1998, the partnership liquidates when the fair 
market value of Property A has not changed, but the fair market value of 
Property B has increased to $40,000.
    (iii) In the liquidation, A receives Property A and a 25 percent 
interest in Property B. This interest in Property B has a fair market 
value of $10,000 to A, reflecting the fact that A was entitled to 50 
percent of the $20,000 post-contribution appreciation in Property B. The 
partnership distributes to B a 75 percent interest in Property B with a 
fair market value of $30,000. B's basis in this portion of Property B is 
$10,000 under section 732(b). As a result, B has a built-in gain of 
$20,000 in this portion of Property B immediately after the distribution 
($30,000 fair market value less $10,000 adjusted tax basis). This built-
in gain is greater than the $10,000 of built-in gain in Property B at 
the time of contribution to the partnership. B therefore does not 
recognize any gain on the distribution of a portion of Property B to A 
under this section.

    (d) Special rules--(1) Nonrecognition transactions. Property 
received by the partnership in exchange for section 704(c) property in a 
nonrecognition transaction is treated as the section 704(c) property for 
purposes of section 704(c)(1)(B) and this section to the extent that the 
property received is treated as section 704(c) property under Sec. 
1.704-3(a)(8). See Sec. 1.737-2(d)(3) for a similar rule in the context 
of section 737.
    (2) Transfers of a partnership interest. The transferee of all or a 
portion of the partnership interest of a contributing partner is treated 
as the contributing partner for purposes of section 704(c)(1)(B) and 
this section to the extent of the share of built-in gain or loss 
allocated to the transferee partner. See Sec. 1.704-3(a)(7).
    (3) Distributions of like-kind property. If section 704(c) property 
is distributed to a partner other than the contributing partner and 
like-kind property

[[Page 448]]

(within the meaning of section 1031) is distributed to the contributing 
partner no later than the earlier of (i) 180 days following the date of 
the distribution to the non-contributing partner, or (ii) the due date 
(determined with regard to extensions) of the contributing partner's 
income tax return for the taxable year of the distribution to the 
noncontributing partner, the amount of gain or loss, if any, that the 
contributing partner would otherwise have recognized under section 
704(c)(1)(B) and this section is reduced by the amount of built-in gain 
or loss in the distributed like-kind property in the hands of the 
contributing partner immediately after the distribution. The 
contributing partner's basis in the distributed like-kind property is 
determined as if the like-kind property were distributed in an unrelated 
distribution prior to the distribution of any other property distributed 
as part of the same distribution and is determined without regard to the 
increase in the contributing partner's adjusted tax basis in the 
partnership interest under section 704(c)(1)(B) and this section. See 
Sec. 1.707-3 for provisions treating the distribution of the like-kind 
property to the contributing partner as a disguised sale in certain 
situations.
    (4) Example. The following example illustrates the rules of this 
paragraph (d). Unless otherwise specified, partnership income equals 
partnership expenses (other than depreciation deductions for contributed 
property) for each year of the partnership, the fair market value of 
partnership property does not change, all distributions by the 
partnership are subject to section 704(c)(1)(B), and all partners are 
unrelated.

    Example. Distribution of like-kind property. (i) On January 1, 1995, 
A, B, and C form partnership ABC as equal partners. A contributes 
Property A, nondepreciable real property with a fair market value of 
$20,000 and an adjusted tax basis of $10,000. B and C each contribute 
$20,000 cash. The partnership subsequently buys Property X, 
nondepreciable real property of a like-kind to Property A with a fair 
market value and adjusted tax basis of $8,000. The fair market value of 
Property X subsequently increases to $10,000.
    (ii) On December 31, 1998, Property A is distributed to B in a 
current distribution. At the same time, Property X is distributed to A 
in a current distribution. The distribution of Property X does not 
result in the contribution of Property A being properly characterized as 
a disguised sale to the partnership under Sec. 1.707-3. A's basis in 
Property X is $8,000 under section 732(a)(1). A therefore has $2,000 of 
built-in gain in Property X ($10,000 fair market value less $8,000 
adjusted tax basis).
    (iii) A would generally recognize $10,000 of gain under section 
704(c)(1)(B) on the distribution of Property A, the difference between 
the fair market value ($20,000) of the property and its adjusted tax 
basis ($10,000). This gain is reduced, however, by the amount of the 
built-in gain of Property X in the hands of A. As a result, A recognizes 
only $8,000 of gain on the distribution of Property A to B under section 
704(c)(1)(B) and this section.

    (e) Basis adjustments--(1) Contributing partner's basis in the 
partnership interest. The basis of the contributing partner's interest 
in the partnership is increased by the amount of the gain, or decreased 
by the amount of the loss, recognized by the partner under section 
704(c)(1)(B) and this section. This increase or decrease is taken into 
account in determining (i) the contributing partner's adjusted tax basis 
under section 732 for any property distributed to the partner in a 
distribution that is part of the same distribution as the distribution 
of the contributed property, other than like-kind property described in 
paragraph (d)(3) of this section (pertaining to the special rule for 
distributions of like-kind property), and (ii) the amount of the gain 
recognized by the contributing partner under section 731 or section 737, 
if any, on a distribution of money or property to the contributing 
partner that is part of the same distribution as the distribution of the 
contributed property. For a determination of basis in a distribution 
subject to section 737, see Sec. 1.737-3(a).
    (2) Partnership's basis in partnership property. The partnership's 
adjusted tax basis in the distributed section 704(c) property is 
increased or decreased immediately before the distribution by the amount 
of gain or loss recognized by the contributing partner under section 
704(c)(1)(B) and this section. Any increase or decrease in basis

[[Page 449]]

is therefore taken into account in determining the distributee partner's 
adjusted tax basis in the distributed property under section 732. For a 
determination of basis in a distribution subject to section 737, see 
Sec. 1.737-3(b).
    (3) Section 754 adjustments. The basis adjustments to partnership 
property made pursuant to paragraph (e)(2) of this section are not 
elective and must be made regardless of whether the partnership has an 
election in effect under section 754. Any adjustments to the bases of 
partnership property (including the distributed section 704(c) property) 
under section 734(b) pursuant to a section 754 election must be made 
after (and must take into account) the adjustments to basis made under 
paragraph (e)(2) of this section. See Sec. 1.737-3(c)(4) for a similar 
rule in the context of section 737.
    (4) Example. The following example illustrates the rules of this 
paragraph (e). Unless otherwise specified, partnership income equals 
partnership expenses (other than depreciation deductions for contributed 
property) for each year of the partnership, the fair market value of 
partnership property does not change, all distributions by the 
partnership are subject to section 704(c)(1)(B), and all partners are 
unrelated.

    Example. Basis adjustment. On January 1, 1995, A, B, and C form 
partnership ABC as equal partners. A contributes $10,000 cash and 
Property A, nondepreciable real property with a fair market value of 
$10,000 and an adjusted tax basis of $4,000. B and C each contribute 
$20,000 cash.
    (ii) On December 31, 1998, Property A is distributed to B in a 
current distribution.
    (iii) Under paragraph (a) of this section, A recognizes $6,000 of 
gain on the distribution of Property A because that is the amount of 
gain that would have been allocated to A under section 704(c)(1)(A) and 
Sec. 1.704-3 on a sale of Property A for its fair market value at the 
time of the distribution (fair market value of Property A ($10,000) less 
its adjusted tax basis at the time of distribution ($4,000)). The 
adjusted tax basis of A's partnership interest is increased from $14,000 
to $20,000 to reflect this gain. The partnership's adjusted tax basis in 
Property A is increased from $4,000 to $10,000 immediately prior to its 
distribution to B. B's adjusted tax basis in Property A is therefore 
$10,000 under section 732(a)(1).

    (f) Anti-abuse rule--(1) In general. The rules of section 
704(c)(1)(B) and this section must be applied in a manner consistent 
with the purpose of section 704(c)(1)(B). Accordingly, if a principal 
purpose of a transaction is to achieve a tax result that is inconsistent 
with the purpose of section 704(c)(1)(B), the Commissioner can recast 
the transaction for federal tax purposes as appropriate to achieve tax 
results that are consistent with the purpose of section 704(c)(1)(B) and 
this section. Whether a tax result is inconsistent with the purpose of 
section 704(c)(1)(B) and this section must be determined based on all 
the facts and circumstances. See Sec. 1.737-4 for an anti-abuse rule 
and examples in the context of section 737.
    (2) Examples. The following examples illustrate the anti-abuse rule 
of this paragraph (f). The examples set forth below do not delineate the 
boundaries of either permissible or impermissible types of transactions. 
Further, the addition of any facts or circumstances that are not 
specifically set forth in an example (or the deletion of any facts or 
circumstances) may alter the outcome of the transaction described in the 
example. Unless otherwise specified, partnership income equals 
partnership expenses (other than depreciation deductions for contributed 
property) for each year of the partnership, the fair market value of 
partnership property does not change, all distributions by the 
partnership are subject to section 704(c)(1)(B), and all partners are 
unrelated.

    Example 1. Distribution in substance made within five-year period; 
results inconsistent with the purpose of section 704(c)(1)(B). (i) On 
January 1, 1995, A, B, and C form partnership ABC as equal partners. A 
contributes Property A, nondepreciable real property with a fair market 
value of $10,000 and an adjusted tax basis of $1,000. B and C each 
contributes $10,000 cash.
    (ii) On December 31, 1998, the partners desire to distribute 
Property A to B in complete liquidation of B's interest in the 
partnership. If Property A were distributed at that time, however, A 
would recognize $9,000 of gain under section 704(c)(1)(B), the 
difference between the $10,000 fair market value and the $1,000 adjusted 
tax basis of Property A, because Property A was contributed to the 
partnership less than five years before December 31, 1998. On becoming 
aware of this

[[Page 450]]

potential gain recognition, and with a principal purpose of avoiding 
such gain, the partners amend the partnership agreement on December 31, 
1998, and take any other steps necessary to provide that substantially 
all of the economic risks and benefits of Property A are borne by B as 
of December 31, 1998, and that substantially all of the economic risks 
and benefits of all other partnership property are borne by A and C. The 
partnership holds Property A until January 5, 2000, at which time it is 
distributed to B in complete liquidation of B's interest in the 
partnership.
    (iii) The actual distribution of Property A occurred more than five 
years after the contribution of the property to the partnership. The 
steps taken by the partnership on December 31, 1998, however, are the 
functional equivalent of an actual distribution of Property A to B in 
complete liquidation of B's interest in the partnership as of that date. 
Section 704(c)(1)(B) requires recognition of gain when contributed 
section 704(c) property is in substance distributed to another partner 
within five years of its contribution to the partnership. Allowing a 
contributing partner to avoid section 704(c)(1)(B) through arrangements 
such as those in this Example 1 that have the effect of a distribution 
of property within five years of the date of its contribution to the 
partnership would effectively undermine the purpose of section 
704(c)(1)(B) and this section. As a result, the steps taken by the 
partnership on December 31, 1998, are treated as causing a distribution 
of Property A to B for purposes of section 704(c)(1)(B) on that date, 
and A recognizes gain of $9,000 under section 704(c)(1)(B) and this 
section at that time.
    (iv) Alternatively, if on becoming aware of the potential gain 
recognition to A on a distribution of Property A on December 31, 1998, 
the partners had instead agreed that B would continue as a partner with 
no changes to the partnership agreement or to B's economic interest in 
partnership operations, the distribution of Property A to B on January 
5, 2000, would not have been inconsistent with the purpose of section 
704(c)(1)(B) and this section. In that situation, Property A would not 
have been distributed until after the expiration of the five-year period 
specified in section 704(c)(1)(B) and this section. Deferring the 
distribution of Property A until the end of the five-year period for a 
principal purpose of avoiding the recognition of gain under section 
704(c)(1)(B) and this section is not inconsistent with the purpose of 
section 704(c)(1)(B). Therefore, A would not have recognized gain on the 
distribution of Property A in that case.
    Example 2. Suspension of five-year period in manner consistent with 
the purpose of section 704(c)(1)(B). (i) A, B, and C form partnership 
ABC on January 1, 1995, to conduct bona fide business activities. A 
contributes Property A, nondepreciable real property with a fair market 
value of $10,000 and an adjusted tax basis of $1,000, in exchange for a 
49.5 percent interest in partnership capital and profits. B contributes 
$10,000 in cash for a 49.5 percent interest in partnership capital and 
profits. C contributes cash for a 1 percent interest in partnership 
capital and profits. A and B are wholly owned subsidiaries of the same 
affiliated group and continue to control the management of Property A by 
virtue of their controlling interests in the partnership. The 
partnership is formed pursuant to a plan a principal purpose of which is 
to minimize the period of time that A would have to remain a partner 
with a potential acquiror of Property A.
    (ii) On December 31, 1997, D is admitted as a partner to the 
partnership in exchange for $10,000 cash.
    (iii) On January 5, 2000, Property A is distributed to D in complete 
liquidation of D's interest in the partnership.
    (iv) The distribution of Property A to D occurred more than five 
years after the contribution of the property to the partnership. On 
these facts, however, a principal purpose of the transaction was to 
minimize the period of time that A would have to remain partners with a 
potential acquiror of Property A, and treating the five-year period of 
section 704(c)(1)(B) as running during a time when Property A was still 
effectively owned through the partnership by members of the contributing 
affiliated group of which A is a member is inconsistent with the purpose 
of section 704(c)(1)(B). Prior to the admission of D as a partner, the 
pooling of assets between A and B, on the one hand, and C, on the other 
hand, although sufficient to constitute ABC as a valid partnership for 
federal income tax purposes, is not a sufficient pooling of assets for 
purposes of running the five-year period with respect to the 
distribution of Property A to D. Allowing a contributing partner to 
avoid section 704(c)(1)(B) through arrangements such as those in this 
Example 2 would have the effect of substantially nullifying the five-
year requirement of section 704(c)(1)(B) and this section and elevating 
the form of the transaction over its substance. As a result, with 
respect to the distribution of Property A to D, the five-year period of 
section 704(c)(1)(B) is tolled until the admission of D as a partner on 
December 31, 1997. Therefore, the distribution of Property A occurred 
before the end of the five-year period of section 704(c)(1)(B), and A 
recognizes gain of $9,000 under section 704(c)(1)(B) on the 
distribution.

    (g) Effective date. This section applies to distributions by a 
partnership to a partner on or after January 9, 1995.

[T.D. 8642, 60 FR 66730, Dec. 26, 1995, as amended by T.D. 8717, 62 FR 
25500, May 9, 1997]

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