[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: 26CFR1.706-1] [Page 457-467] TITLE 26--INTERNAL REVENUE CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY (CONTINUED) Determination of Tax Liability--Table of Contents Sec. 1.706-1 Taxable years of partner and partnership. (a) Year in which partnership income is includible. (1) In computing taxable income for a taxable year, a partner is required to include the partner's distributive share of partnership items set forth in section 702 and the regulations thereunder for any partnership taxable year ending within or with the partner's taxable year. A partner must also include in taxable income for a taxable year guaranteed payments under section 707(c) that are deductible by the partnership under its method of accounting in the partnership taxable year ending within or with the partner's taxable year. (2) The rules of this paragraph (a)(1) may be illustrated by the following example: Example. Partner A reports income using a calendar year, while the partnership of which A is a member reports its income using a fiscal year ending May 31. The partnership reports its income and deductions under the cash method of accounting. During the partnership taxable year ending May 31, 2002, the partnership makes guaranteed payments of $120,000 to A for services and for the use of capital. Of this amount, $70,000 was paid to A between June 1 and December 31, 2001, and the remaining $50,000 was paid to A between January 1 and May 31, 2002. The entire $120,000 paid to A is includible in A's taxable income for the calendar year 2002 (together with A's distributive share of partnership items set forth in section 702 for the partnership taxable year ending May 31, 2002). (3) If a partner receives distributions under section 731 or sells or exchanges all or part of a partnership interest, any gain or loss arising therefrom does not constitute partnership income. [[Page 458]] (b) Taxable year--(1) Partnership treated as a taxpayer. The taxable year of a partnership must be determined as though the partnership were a taxpayer. (2) Partnership's taxable year--(i) Required taxable year. Except as provided in paragraph (b)(2)(ii) of this section, the taxable year of a partnership must be-- (A) The majority interest taxable year, as defined in section 706(b)(4); (B) If there is no majority interest taxable year, the taxable year of all of the principal partners of the partnership, as defined in 706(b)(3) (the principal partners' taxable year); or (C) If there is no majority interest taxable year or principal partners' taxable year, the taxable year that produces the least aggregate deferral of income as determined under paragraph (b)(3) of this section. (ii) Exceptions. A partnership may have a taxable year other than its required taxable year if it makes an election under section 444, elects to use a 52-53-week taxable year that ends with reference to its required taxable year or a taxable year elected under section 444, or establishes a business purpose for such taxable year and obtains approval of the Commissioner under section 442. (3) Least aggregate deferral--(i) Taxable year that results in the least aggregate deferral of income. The taxable year that results in the least aggregate deferral of income will be the taxable year of one or more of the partners in the partnership which will result in the least aggregate deferral of income to the partners. The aggregate deferral for a particular year is equal to the sum of the products determined by multiplying the month(s) of deferral for each partner that would be generated by that year and each partner's interest in partnership profits for that year. The partner's taxable year that produces the lowest sum when compared to the other partner's taxable years is the taxable year that results in the least aggregate deferral of income to the partners. If the calculation results in more than one taxable year qualifying as the taxable year with the least aggregate deferral, the partnership may select any one of those taxable years as its taxable year. However, if one of the qualifying taxable years is also the partnership's existing taxable year, the partnership must maintain its existing taxable year. The determination of the taxable year that results in the least aggregate deferral of income generally must be made as of the beginning of the partnership's current taxable year. The director, however, may determine that the first day of the current taxable year is not the appropriate testing day and require the use of some other day or period that will more accurately reflect the ownership of the partnership and thereby the actual aggregate deferral to the partners where the partners engage in a transaction that has as its principal purpose the avoidance of the principles of this section. Thus, for example the preceding sentence would apply where there is a transfer of an interest in the partnership that results in a temporary transfer of that interest principally for purposes of qualifying for a specific taxable year under the principles of this section. For purposes of this section, deferral to each partner is measured in terms of months from the end of the partnership's taxable year forward to the end of the partner's taxable year. (ii) Determination of the taxable year of a partner or partnership that uses a 52-53-week taxable year. For purposes of the calculation described in paragraph (b)(3)(i) of this section, the taxable year of a partner or partnership that uses a 52-53-week taxable year must be the same year determined under the rules of section 441(f) and the regulations thereunder with respect to the inclusion of income by the partner or partnership. (iii) Special de minimis rule. If the taxable year that results in the least aggregate deferral produces an aggregate deferral that is less than .5 when compared to the aggregate deferral of the current taxable year, the partnership's current taxable year will be treated as the taxable year with the least aggregate deferral. Thus, the partnership will not be permitted to change its taxable year. (iv) Examples. The principles of this section may be illustrated by the following examples: [[Page 459]] Example 1. Partnership P is on a fiscal year ending June 30. Partner A reports income on the fiscal year ending June 30 and Partner B reports income on the fiscal year ending July 31. A and B each have a 50 percent interest in partnership profits. For its taxable year beginning July 1, 1987, the partnership will be required to retain its taxable year since the fiscal year ending June 30 results in the least aggregate deferral of income to the partners. This determination is made as follows: ---------------------------------------------------------------------------------------------------------------- Interest in Months of Test 6/30 Year end partnership deferral for 6/ Interestx profits 30 year end deferral ---------------------------------------------------------------------------------------------------------------- Partner A....................................... 6/30 .5 0 0 Partner B....................................... 7/31 .5 1 .5 --------------- Aggregate deferral.......................... .............. .............. .............. .5 ---------------------------------------------------------------------------------------------------------------- ---------------------------------------------------------------------------------------------------------------- Interest in Months of Test 7/31 Year end partnership deferral for 7/ Interestx profits 31 year end deferral ---------------------------------------------------------------------------------------------------------------- Partner A....................................... 6/30 .5 11 5.5 Partner B....................................... 7/31 .5 0 0 --------------- Aggregate deferral.......................... .............. .............. .............. 5.5 ---------------------------------------------------------------------------------------------------------------- Example 2. The facts are the same as in Example 1 except that A reports income on the calendar year and B reports on the fiscal year ending November 30. For the partnership's taxable year beginning July 1, 1987, the partnership is required to change its taxable year to a fiscal year ending November 30 because such year results in the least aggregate deferral of income to the partners. This determination is made as follows: ---------------------------------------------------------------------------------------------------------------- Interest in Months of Test 12/31 Year end partnership deferral for Interestx profits 12/31 year end deferral ---------------------------------------------------------------------------------------------------------------- Partner A....................................... 12/31 .5 0 0 Partner B....................................... 11/30 .5 11 5.5 --------------- Aggregate deferral.......................... .............. .............. .............. 5.5 ---------------------------------------------------------------------------------------------------------------- ---------------------------------------------------------------------------------------------------------------- Interest in Months of Test 11/30 Year end partnership deferral for Interestx profits 11/30 year end deferral ---------------------------------------------------------------------------------------------------------------- Partner A....................................... 12/31 .5 1 .5 Partner B....................................... 11/30 .5 0 0 --------------- Aggregate deferral.......................... .............. .............. .............. .5 ---------------------------------------------------------------------------------------------------------------- Example 3. The facts are the same as in Example 2 except that B reports income on the fiscal year ending June 30. For the partnership's taxable year beginning July 1, 1987, each partner's taxable year will result in identical aggregate deferral of income. If the partnership's current taxable year was neither a fiscal year ending June 30 nor the calendar year, the partnership would select either the fiscal year ending June 30 or the calendar year as its taxable year. However, since the partnership's current taxable year ends June 30, it must retain its current taxable year. The determination is made as follows: ---------------------------------------------------------------------------------------------------------------- Interest in Months of Test 12/31 Year end partnership deferral for Interestx profits 12/31 year end deferral ---------------------------------------------------------------------------------------------------------------- Partner A....................................... 12/31 .5 0 0 Partner B....................................... 6/30 .5 6 3.0 --------------- Aggregate deferral.......................... .............. .............. .............. 3.0 ---------------------------------------------------------------------------------------------------------------- [[Page 460]] ---------------------------------------------------------------------------------------------------------------- Interest in Months of Test 6/30 Year end partnership deferral for 6/ Interestx profits 30 year end deferral ---------------------------------------------------------------------------------------------------------------- Partner A....................................... 12/31 .5 6 3.0 Partner B....................................... 6/30 .5 0 0 --------------- Aggregate deferral.......................... .............. .............. .............. 3.0 ---------------------------------------------------------------------------------------------------------------- Example 4. The facts are the same as in Example 1 except that on December 31, 1987, partner A sells a 4 percent interest in the partnership to Partner C, who reports income on the fiscal year ending June 30, and a 40 percent interest in the partnership to Partner D, who also reports income on the fiscal year ending June 30. The taxable year beginning July 1, 1987, is unaffected by the sale. However, for the taxable year beginning July 31, 1988, the partnership must determine the taxable year resulting in the least aggregate deferral as of July 1, 1988. In this case, the partnership will be required to retain its taxable year since the fiscal year ending June 30 continues to be the taxable year that results in the least aggregate deferral of income to the partners. Example 5. The facts are the same as in Example 4 except that Partner D reports income on the fiscal year ending April 30. As in Example 4, the taxable year during which the sale took place is unaffected by the shifts in interests. However, for its taxable year beginning July 1, 1988, the partnership will be required to change its taxable year to the fiscal year ending April 30. This determination is made as follows: ---------------------------------------------------------------------------------------------------------------- Interest in Months of Test 7/31 Year end partnership deferral for 7/ Interestx profits 31 year end deferral ---------------------------------------------------------------------------------------------------------------- Partner A....................................... 6/30 .06 11 .66 Partner B....................................... 7/31 .5 0 0 Partner C....................................... 6/30 .04 11 .44 Partner D....................................... 4/30 .4 9 3.60 --------------- Aggregate deferral.......................... .............. .............. .............. 4.70 ---------------------------------------------------------------------------------------------------------------- ---------------------------------------------------------------------------------------------------------------- Interest in Months of Test 6/30 Year end partnership deferral for 6/ Interestx profits 30 year end deferral ---------------------------------------------------------------------------------------------------------------- Partner A....................................... 6/30 .06 0 0 Partner B....................................... 7/31 .5 1 .5 Partner C....................................... 6/30 .04 0 0 Partner D....................................... 4/30 .4 10 4.0 --------------- Aggregate deferral.......................... .............. .............. .............. 4.5 ---------------------------------------------------------------------------------------------------------------- ---------------------------------------------------------------------------------------------------------------- Interest in Months of Test 4/30 Year end partnership deferral for 4/ Interestx profits 30 year end deferral ---------------------------------------------------------------------------------------------------------------- Partner A....................................... 6/30 .06 2 .12 Partner B....................................... 7/31 .5 3 1.50 Partner C....................................... 6/30 .04 2 .08 Partner D....................................... 4/30 .4 0 0 --------------- Aggregate deferral.......................... .............. .............. .............. 1.70 ---------------------------------------------------------------------------------------------------------------- Sec. 1.706-1(b)(3) Test Current taxable year (June 30).......................... 4.5 Less: Taxable year producing the least aggregate 1.7 deferral (April 30).................................... --------------- Additional aggregate deferral (greater than .5)......... 2.8 ------------------------------------------------------------------------ Example 6. (i) Partnership P has two partners, A who reports income on the fiscal year ending March 31, and B who reports income on the fiscal year ending July 31. A and B share profits equally. P has determined its taxable year under paragraph (b)(3) of this [[Page 461]] section to be the fiscal year ending March 31 as follows: ---------------------------------------------------------------------------------------------------------------- Interest in Test 3/31 Year end partnership Deferral for Interestx profits 3/31 year end deferral ---------------------------------------------------------------------------------------------------------------- Partner A....................................... 3/31 .5 0 0 Partner B....................................... 7/31 .5 4 2 --------------- Aggregate deferral.......................... .............. .............. .............. 2 ---------------------------------------------------------------------------------------------------------------- ---------------------------------------------------------------------------------------------------------------- Interest in Test 7/31 Year end partnership Deferral for Interestx profits 7/31 year end deferral ---------------------------------------------------------------------------------------------------------------- Partner A....................................... 3/31 .5 8 4 Partner B....................................... 7/31 .5 0 0 --------------- Aggregate deferral.......................... .............. .............. .............. 4 ---------------------------------------------------------------------------------------------------------------- (ii) In May 1988, Partner A sells a 45 percent interest in the partnership to C, who reports income on the fiscal year ending April 30. For the taxable period beginning April 1, 1989, the fiscal year ending April 30 is the taxable year that produces the least aggregate deferral of income to the partners. However, under paragraph (b)(3)(iii) of this section the partnership is required to retain its fiscal year ending March 31. This determination is made as follows: ---------------------------------------------------------------------------------------------------------------- Interest in Test 3/31 Year end partnership Deferral for Interestx profits 3/31 year end deferral ---------------------------------------------------------------------------------------------------------------- Partner A....................................... 3/31 .05 0 0 Partner B....................................... 7/31 .5 4 2.0 Partner C....................................... 4/30 .45 1 .45 --------------- Aggregate deferral.......................... .............. .............. .............. 2.45 ---------------------------------------------------------------------------------------------------------------- ---------------------------------------------------------------------------------------------------------------- Interest in Test 7/31 Year end partnership Deferral for Interestx profits 7/31 year end deferral ---------------------------------------------------------------------------------------------------------------- Partner A....................................... 3/31 .05 8 .40 Partner B....................................... 7/31 .5 0 0 Partner C....................................... 4/30 .45 9 4.05 --------------- Aggregate deferral.......................... .............. .............. .............. 4.45 ---------------------------------------------------------------------------------------------------------------- ---------------------------------------------------------------------------------------------------------------- Interest in Test 4/30 Year end partnership Deferral for Interestx profits 4/30 year end deferral ---------------------------------------------------------------------------------------------------------------- Partner A....................................... 3/31 .05 11 .55 Partner B....................................... 7/31 .5 3 1.50 Partner C....................................... 4/30 .45 0 0 --------------- Aggregate deferral.......................... .............. .............. .............. 2.05 ---------------------------------------------------------------------------------------------------------------- Sec. 1.706-1(b)(3) Test Current taxable year (3/31)............................. 2.45 Less: Taxable year producing the least aggregate 2.05 deferral (4/30)........................................ --------------- Additional aggregate deferral (less than .5)............ .40 ------------------------------------------------------------------------ (4) Measurement of partner's profits and capital interest-- (i) In general. The rules of this paragraph (b)(4) apply in determining the majority interest taxable year, the [[Page 462]] principal partners' taxable year, and the least aggregate deferral taxable year. (ii) Profits interest--(A) In general. For purposes of section 706(b), a partner's interest in partnership profits is generally the partner's percentage share of partnership profits for the current partnership taxable year. If the partnership does not expect to have net income for the current partnership taxable year, then a partner's interest in partnership profits instead must be the partner's percentage share of partnership net income for the first taxable year in which the partnership expects to have net income. (B) Percentage share of partnership net income. The partner's percentage share of partnership net income for a partnership taxable year is the ratio of: the partner's distributive share of partnership net income for the taxable year, to the partnership's net income for the year. If a partner's percentage share of partnership net income for the taxable year depends on the amount or nature of partnership income for that year (due to, for example, preferred returns or special allocations of specific partnership items), then the partnership must make a reasonable estimate of the amount and nature of its income for the taxable year. This estimate must be based on all facts and circumstances known to the partnership as of the first day of the current partnership taxable year. The partnership must then use this estimate in determining the partners' interests in partnership profits for the taxable year. (C) Distributive share. For purposes of this paragraph (b)(4)(ii), a partner's distributive share of partnership net income is determined by taking into account all rules and regulations affecting that determination, including, without limitation, sections 704(b), (c), and (e), 736, and 743. (iii) Capital interest. Generally, a partner's interest in partnership capital is determined by reference to the assets of the partnership that the partner would be entitled to upon withdrawal from the partnership or upon liquidation of the partnership. If the partnership maintains capital accounts in accordance with Sec. 1.704- 1(b)(2)(iv), then for purposes of section 706(b), the partnership may assume that a partner's interest in partnership capital is the ratio of the partner's capital account to all partners' capital accounts as of the first day of the partnership taxable year. (5) Taxable year of a partnership with tax-exempt partners--(i) Certain tax-exempt partners disregarded. In determining the taxable year (the current year) of a partnership under section 706(b) and the regulations thereunder, a partner that is tax-exempt under section 501(a) shall be disregarded if such partner was not subject to tax, under chapter 1 of the Internal Revenue Code, on any income attributable to its investment in the partnership during the partnership's taxable year immediately preceding the current year. However, if a partner that is tax-exempt under section 501(a) was not a partner during the partnership's immediately preceding taxable year, such partner will be disregarded for the current year if the partnership reasonably believes that the partner will not be subject to tax, under chapter 1 of the Internal Revenue Code, on any income attributable to such partner's investment in the partnership during the current year. (ii) Example. The provisions of paragraph (b)(5)(i) of this section may be illustrated by the following example: Example. Assume that partnership A has historically used the calendar year as its taxable year. In addition, assume that A is owned by 5 partners, 4 calendar year individuals (each owning 10 percent of A's profits and capital) and a tax-exempt organization (owning 60 percent of A's profits and capital). The tax-exempt organization has never had unrelated business taxable income with respect to A and has historically used a June 30 fiscal year. Finally, assume that A desires to retain the calendar year for its taxable year beginning January 1, 2003. Under these facts and but for the special rule in paragraph (b)(5)(i) of this section, A would be required under section 706(b)(1)(B)(i) to change to a year ending June 30, for its taxable year beginning January 1, 2003. However, under the special rule provided in paragraph (b)(5)(i) of this section the partner that is tax-exempt is disregarded, and A must retain the calendar year, under section 706(b)(1)(B)(i), for its taxable year beginning January 1. (iii) Effective date. The provisions of this paragraph (b)(5) are applicable for taxable years beginning on or after [[Page 463]] July 23, 2002. For taxable years beginning before July 23, 2002, see Sec. 1.706-3T as contained in 26 CFR part 1 revised April 1, 2002. (6) Certain foreign partners disregarded--(i) Interests of disregarded foreign partners not taken into account. In determining the taxable year (the current taxable year) of a partnership under section 706(b) and the regulations thereunder, any interest held by a disregarded foreign partner is not taken into account. A foreign partner is a disregarded foreign partner unless such partner is allocated any gross income of the partnership that was effectively connected (or treated as effectively connected) with the conduct of a trade or business within the United States during the partnership's taxable year immediately preceding the current taxable year (or, if such partner was not a partner during the partnership's immediately preceding taxable year, the partnership reasonably believes that the partner will be allocated any such income during the current taxable year) and taxation of that income is not otherwise precluded under any U.S. income tax treaty. (ii) Definition of foreign partner. For purposes of this paragraph (b)(6), a foreign partner is any partner that is not a U.S. person (as defined in section 7701(a)(30)), except that a partner that is a controlled foreign corporation (as defined in section 957(a)) or a foreign personal holding company (as defined in section 552) shall not be treated as a foreign partner. (iii) Minority interest rule. If each partner that is not a disregarded foreign partner under paragraph (b)(6)(i) of this section (regarded partner) holds less than a 10-percent interest, and the regarded partners, in the aggregate, hold less than a 20-percent interest in the capital or profits of the partnership, then paragraph (b)(6)(i) of this section does not apply. In determining ownership in a partnership for purposes of this paragraph (b)(6)(iii), each regarded partner is treated as owning any interest in the partnership owned by a related partner. For this purpose, partners are treated as related if they are related within the meaning of sections 267(b) or 707(b) (using the language ``10 percent'' instead of ``50 percent'' each place it appears). However, for purposes of determining if partners hold less than a 20-percent interest in the aggregate, the same interests will not be considered as being owned by more than one regarded partner. (iv) Example. The provisions of paragraph (b)(6) of this section may be illustrated by the following example: Example. Partnership B is owned by two partners, F, a foreign corporation that owns a 95-percent interest in the capital and profits of partnership B, and D, a domestic corporation that owns the remaining 5-percent interest in the capital and profits of partnership B. Partnership B is not engaged in the conduct of a trade or business within the United States, and, accordingly, partnership B does not earn any income that is effectively connected with a U.S. trade or business. F uses a March 31 fiscal year, and causes partnership B to maintain its books and records on a March 31 fiscal year as well. D is a calendar year taxpayer. Under paragraph (b)(6)(i) of this section, F would be disregarded and partnership B's taxable year would be determined by reference to D. However, because D owns less than a 10-percent interest in the capital and profits of partnership B, the minority interest rule of paragraph (b)(6)(iii) of this section applies, and partnership B must adopt the March 31 fiscal year for Federal tax purposes. (v) Effective date--(A) Generally. The provisions of this paragraph (b)(6) are applicable for the first taxable year of a partnership other than an existing partnership that begins on or after July 23, 2002. For this purpose, an existing partnership is a partnership that was formed prior to September 23, 2002. (B) Voluntary change in taxable year. An existing partnership may change its taxable year to a year determined in accordance with this section. An existing partnership that makes such a change will cease to be exempted from the requirements of paragraph (b)(6) of this section. (C) Subsequent sale or exchange of interests. If an existing partnership terminates under section 708(b)(1)(B), the resulting partnership is not an existing partnership for purposes of paragraph (b)(6)(v)(A) of this section. (D) Transition rule. If, in the first taxable year beginning on or after July 23, 2002, an existing partnership voluntarily changes its taxable year to a year determined in accordance with this paragraph (b)(6), then the partners [[Page 464]] of that partnership may apply the provisions of Sec. 1.702-3T to take into account all items of income, gain, loss, deduction, and credit attributable to the partnership year of change ratably over a four-year period. (7) Adoption of taxable year. A newly-formed partnership may adopt, in accordance with Sec. 1.441-1(c), its required taxable year, a taxable year elected under section 444, or a 52-53-week taxable year ending with reference to its required taxable year or a taxable year elected under section 444 without securing the approval of the Commissioner. If a newly-formed partnership wants to adopt any other taxable year, it must establish a business purpose and secure the approval of the Commissioner under section 442. (8) Change in taxable year--(i) Partnerships-(A) Approval required. An existing partnership may change its taxable year only by securing the approval of the Commissioner under section 442 or making an election under section 444. However, a partnership may obtain automatic approval for certain changes, including a change to its required taxable year, pursuant to administrative procedures published by the Commissioner. (B) Short period tax return. A partnership that changes its taxable year must make its return for a short period in accordance with section 443, but must not annualize the partnership taxable income. (C) Change in required taxable year. If a partnership is required to change to its majority interest taxable year, then no further change in the partnership's required taxable year is required for either of the two years following the year of the change. This limitation against a second change within a three-year period applies only if the first change was to the majority interest taxable year and does not apply following a change in the partnership's taxable year to the principal partners' taxable year or the least aggregate deferral taxable year. (ii) Partners. Except as otherwise provided in the Internal Revenue Code or the regulations thereunder (e.g., section 859 regarding real estate investment trusts or Sec. 1.442-2(c) regarding a subsidiary changing to its consolidated parent's taxable year), a partner may not change its taxable year without securing the approval of the Commissioner under section 442. However, certain partners may be eligible to obtain automatic approval to change their taxable years pursuant to the regulations or administrative procedures published by the Commissioner. A partner that changes its taxable year must make its return for a short period in accordance with section 443. (9) Retention of taxable year. In certain cases, a partnership will be required to change its taxable year unless it obtains the approval of the Commissioner under section 442, or makes an election under section 444, to retain its current taxable year. For example, a partnership using a taxable year that corresponds to its required taxable year must obtain the approval of the Commissioner to retain such taxable year if its required taxable year changes as a result of a change in ownership, unless the partnership previously obtained approval for its current taxable year or, if appropriate, makes an election under section 444. (10) Procedures for obtaining approval or making a section 444 election. See Sec. 1.442-1(b) for procedures to obtain the approval of the Commissioner (automatically or otherwise) to adopt, change, or retain a taxable year. See Sec. Sec. 1.444-1T and 1.444-2T for qualifications, and Sec. 1.444-3T for procedures, for making an election under section 444. (11) Effect of partner elections under section 444--(i) Election taken into account. For purposes of section 706(b)(1)(B), any section 444 election by a partner in a partnership shall be taken into account in determining the taxable year of the partnership. See Sec. 1.7519- 1T(d), Example (4). (ii) Effective date. The provisions of this paragraph (b)(11) are applicable for taxable years beginning on or after July 23, 2002. For taxable years beginning before July 23, 2002, see Sec. 1.706-3T as contained in 26 CFR part 1 revised April 1, 2002. (c) Closing of partnership year--(1) General rule. Section 706(c) and this paragraph provide rules governing the closing of partnership years. The closing of a partnership taxable year or a [[Page 465]] termination of a partnership for Federal income tax purposes is not necessarily governed by the ``dissolution'', ``liquidation'', etc., of a partnership under State or local law. The taxable year of a partnership shall not close as the result of the death of a partner, the entry of a new partner, the liquidation of a partner's entire interest in the partnership (as defined in section 761(d)), or the sale or exchange of a partner's interest in the partnership, except in the case of a termination of a partnership and except as provided in subparagraph (2) of this paragraph. In the case of termination, the partnership taxable year closes for all partners as of the date of termination. See section 708(b) and paragraph (b) of Sec. 1.708-1. (2) Partner who retires or sells interest in partnership--(i) Disposition of entire interest. A partnership taxable year shall close with respect to a partner who sells or exchanges his entire interest in a partnership, and with respect to a partner whose entire interest is liquidated. However, a partnership taxable year with respect to a partner who dies shall not close prior to the end of such partnership taxable year, or the time when such partner's interest (held by his estate or other successor) is liquidated or sold or exchanged, whichever is earlier. See subparagraph (3) of this paragraph. (ii) Inclusions in taxable income. In the case of a sale, exchange, or liquidation of a partner's entire interest in a partnership, the partner shall include in his taxable income for his taxable year within or with which his membership in the partnership ends, his distributive share of items described in section 702(a), and any guaranteed payments under section 707(c), for his partnership taxable year ending with the date of such sale, exchange, or liquidation. In order to avoid an interim closing of the partnership books, such partner's distributive share of items described in section 702(a) may, by agreement among the partners, be estimated by taking his pro rata part of the amount of such items he would have included in his taxable income had he remained a partner until the end of the partnership taxable year. The proration may be based on the portion of the taxable year that has elapsed prior to the sale, exchange, or liquidation, or may be determined under any other method that is reasonable. Any partner who is the transferee of such partner's interest shall include in his taxable income, as his distributive share of items described in section 702(a) with respect to the acquired interest, the pro rata part (determined by the method used by the transferor partner) of the amount of such items he would have included had he been a partner from the beginning of the taxable year of the partnership. The application of this subdivision may be illustrated by the following example: Example. Assume that a partner selling his partnership interest on June 30, 1955, has an adjusted basis for his interest of $5,000 on that date; that his pro rata share of partnership income up to June 30 is $15,000; and that he sells his interest for $20,000. Under the provisions of section 706(c)(2), the partnership year with respect to him closes at the time of the sale. The $15,000 is includible in his income as his distributive share and, under section 705, it increases the basis of his partnership interest to $20,000, which is also the selling price of his interest. Therefore, no gain is realized on the sale of his partnership interest. The purchaser of this partnership interest shall include in his income as his distributive share his pro rata part of partnership income for the remainder of the partnership taxable year. (3) Partner who dies. (i) When a partner dies, the partnership taxable year shall not close with respect to such partner prior to the end of the partnership taxable year. The partnership taxable year shall continue both for the remaining partners and the decedent partner. Where the death of a partner results in the termination of the partnership, the partnership taxable year shall close for all partners on the date of such termination under section 708(b)(1)(A). See also paragraph (b)(1)(i)(b) of Sec. 1.708-1 for the continuation of a 2-member partnership under certain circumstances after the death of a partner. However, if the decedent partner's estate or other successor sells or exchanges its entire interest in the partnership, or if its entire interest is liquidated, the partnership taxable year with respect to the estate or other successor in interest shall close on the [[Page 466]] date of such sale or exchange, or the date of completion of the liquidation. (ii) The last return of a decedent partner shall include only his share of partnership taxable income for any partnership taxable year or years ending within or with the last taxable year for such decedent partner (i. e., the year ending with the date of his death). The distributive share of partnership taxable income for a partnership taxable year ending after the decedent's last taxable year is includible in the return of his estate or other successor in interest. If the estate or other successor in interest of a partner continues to share in the profits or losses of the partnership business, the distributives share thereof is includible in the taxable year of the estate or other successor in interest within or with which the taxable year of the partnership ends. See also paragraph (a)(1)(ii) of Sec. 1.736-1. Where the estate or other successor in interest receives distributions, any gain or loss on such distributions is includible in its gross income for its taxable year in which the distribution is made. (iii) If a partner (or a retiring partner), in accordance with the terms of the partnership agreement, designates a person to succeed to his interest in the partnership after his death, such designated person shall be regarded as a successor in interest of the deceased for purposes of this chapter. Thus, where a partner designates his widow as the successor in interest, her distributive share of income for the taxable year of the partnership ending within or with her taxable year may be included in a joint return in accordance with the provisions of sections 2 and 6013(a) (2) and (3). (iv) If, under the terms of an agreement existing at the date of death of a partner, a sale or exchange of the decedent partner's interest in the partnership occurs upon that date, then the taxable year of the partnership with respect to such decedent partner shall close upon the date of death. See section 706(c)(2)(A)(i). The sale or exchange of a partnership interest does not, for the purpose of this rule, include any transfer of a partnership interest which occurs at death as a result of inheritance or any testamentary disposition. (v) To the extent that any part of a distributive share of partnership income of the estate or other successor in interest of a deceased partner is attributable to the decedent for the period ending with the date of his death, such part of the distributive share is income in respect of the decedent under section 691. See section 691 and the regulations thereunder. (vi) The provisions of this subparagraph may be illustrated by the following examples: Example 1. B has a taxable year ending December 31 and is a member of partnership ABC, the taxable year of which ends on June 30. B dies on October 31, 1955. His estate (which as a new taxpayer may, under section 441 and the regulations thereunder, adopt any taxable year) adopts a taxable year ending October 31. The return of the decedent for the period January 1 to October 31, 1955, will include only his distributive share of taxable income of the partnership for its taxable year ending June 30, 1955. The distributive share of taxable income of the partnership for its taxable year ending June 30, 1956, arising from the interest of the decedent, will be includible in the return of the estate for its taxable year ending October 31, 1956. That part of the distributive share attributable to the decedent for the period ending with the date of his death (July 1 through October 31, 1955) is income in respect of a decedent under section 691. Example 2. Assume the same facts as in example 1 of this subdivision, except that, prior to B's death, B and D had agreed that, upon B's death, D would purchase B's interest for $10,000. When B dies on October 31, 1955, the partnership taxable year beginning July 1, 1955, closes with respect to him. Therefore, the return for B's last taxable year (January 1 to October 31, 1955) will include his distributive share of taxable income of the partnership for its taxable year ending June 30, 1955, plus his distributive share of partnership taxable income for the period July 1 to October 31, 1955. See subdivision (iv) of this subparagraph. Example 3. H is a member of a partnership having a taxable year ending December 31. Both H and his wife W are on a calendar year and file joint returns. H dies on March 31, 1955. Administration of the estate is completed and the estate, including the partnership interest, is distributed to W as legatee on November 30, 1955. Such distribution by the estate is not a sale or exchange of H's partnership interest. No part of the taxable income of the partnership for the taxable [[Page 467]] year ending December 31, 1955, which is allocable to H, will be included in H's taxable income for his last taxable year (January 1 through March 31, 1955) or in the taxable income of H's estate for the taxable year April 1 through November 30, 1955. The distributive share of partnership taxable income for the full calendar year that is allocable to H will be includible in the taxable income of W for her taxable year ending December 31, 1955, and she may file a joint return under sections 2 and 6013(a)(3). That part of the distributive share attributable to the decedent for the period ending with the date of his death (January 1 through March 31, 1955) is income in respect of a decedent under section 691. Example 4. M is a member of partnership JKM which operates on a calendar year. M and his wife S file joint returns for calendar years. In accordance with the partnership agreement, M designated S to succeed to his interest in the partnership upon his death. M, who had withdrawn $10,000 from the partnership before his death, dies on October 20, 1955. S's distributive share of income for the taxable year 1955 is $15,000 ($10,000 of which represents the amount withdrawn by M). S shall include $15,000 in her income, even though M received $10,000 of this amount before his death. S may file a joint return with M for the year 1955 under sections 2 and 6013(a). That part of the $15,000 distributive share attributable to the decedent for the period ending with the date of his death (January 1 through October 20, 1955) is income in respect of a decedent under section 691. (4) Disposition of less than entire interest. If a partner sells or exchanges a part of his interest in a partnership, or if the interest of a partner is reduced, the partnership taxable year shall continue to its normal end. In such case, the partner's distributive share of items which he is required to include in his taxable income under the provisions of section 702(a) shall be determined by taking into account his varying interests in the partnership during the partnership taxable year in which such sale, exchange, or reduction of interest occurred. (5) Transfer of interest by gift. The transfer of a partnership interest by gift does not close the partnership taxable year with respect to the donor. However, the income up to the date of gift attributable to the donor's interest shall be allocated to him under section 704(e)(2). (d) Effective date. The rules of this section are applicable for taxable years ending on or after May 17, 2002, except for paragraph (c), which applies for taxable years beginning after December 31, 1953. [T.D. 6500, 25 FR 11814, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960, as amended by T.D. 7286, 38 FR 26912, Sept. 27, 1973; T.D. 8123, 52 FR 3623, Feb. 5, 1987; T.D. 8996, 67 FR 35020, May 17, 2002; T.D. 9009, 67 FR 48019, July 23, 2002]