FEDERAL TAXATION

March 2000

IRS PROPOSED REGULATIONS ON SALE OF PASSTHROUGH ENTITIES

By Eusebio George Teixeira, CPA, American Express Tax & Business Services Inc.

The IRS has proposed regulations relating to the sale or exchange of interests in partnerships, S corporations, and trusts. These regulations interpret the look-through provisions of IRC section 1(h), added by the Taxpayer Relief Act of 1997 and amended by the IRS Restructuring and Reform Act of 1998. They also explain the rules relating to the holding period of a partnership interest. The proposed regulations would affect partnerships, partners, S corporations,
S corporation shareholders, trusts, and trust beneficiaries.

Sales or Exchanges of Passthrough Entities

IRC section 1(h) provides for maximum capital gains rates on the sale or exchange of certain types of property in three categories: 20%, 25%, and 28% rate gain. Effective for taxable years ending after May 6, 1997, when an interest in a partnership, an S corporation, or trust held for more than one year (or 18 months during certain periods in 1997) is sold or exchanged, IRC section 1(h) provides special treatment for gains attributable to the appreciation of underlying collectibles held by S corporations and trusts and IRC section 1250 property held by partnerships.

Under the proposed regulations, when a gain is recognized on a sale or exchange of an interest in a partnership, S corporation, or trust owning collectibles, the amount of gain to be taxed at the 28% rate is determined as if the entity had sold all of its collectibles in a fully taxable transaction immediately before the proposed sale or exchange. Likewise, the gain recognized on the sale of a partnership interest is subject to the 25% rate to the extent of the selling partner's share in the partnership's potential unrecaptured IRC section 1250 gain (gains on the sale of S corporation and trust interests are not subject to the IRC section 1250 gain look through). The proposed regulations provide special rules that would apply when a partner, shareholder, or beneficiary recognizes less than all of the underlying potential gain on the sale or exchange of the interest. Also, any gain from the sale of a partnership interest that results in IRC section 1250 capital gain is not treated as an IRC section 1231 gain even if IRC section 1231 could apply to the disposition of the underlying partnership property. For illustrations, see Proposed Regulations section 1.1(h)-1(f). It should be noted that the special 25% gain on the sale of partnership interest is defined as an "IRC section 1250 capital gain," not to be confused with an "unrecaptured IRC section 1250 gain," which describes the gain on the underlying asset.

Division of the Holding Period of a Partnership Interest

The proposed regulations also provide rules on the allocation of a divided holding period for a partnership interest. Generally, a holding period will be divided if a partner acquired portions of an interest at different times or if an interest is acquired in a single transaction that would give rise to different holding periods under IRC section 1223. In this case, the holding period would be determined by a fraction equal to the fair market value of the portion to which the holding period relates (determined immediately following the acquisition) over the fair market value of the entire interest. For illustrations see Proposed Regulations section 1.1223-3(e).

Effective Date. The proposed regulations, if and when issued in final form, will apply to all transfers of interests in a partnership, S corporation, or trust and for all distributions from a partnership on or after the date the regulations are published as final regulations in the Federal Register. *