26 C.F.R. §§ 1.706-4

Current through September 30, 2024

Section 1.706-4 - Determination of distributive share when a partner's interest varies

(a)General rule -

(1)Variations subject to this section. Except as provided in paragraph (a)(2) of this section, this section provides rules for determining the partners' distributive shares of partnership items when a partner's interest in a partnership varies during the taxable year as a result of the disposition of a partial or entire interest in a partnership as described in § 1.706-1(c)(2) and (3) , or with respect to a partner whose interest in a partnership is reduced as described in § 1.706-1(c)(3) , including by the entry of a new partner (collectively, a "variation").

(2) Coordination with sections 706(d)(2) and 706(d)(3) and other Code sections. Items subject to allocation under other rules, including sections 108(e)(8) and 108(i) (which provide special allocation rules for certain items from the discharge or retirement of indebtedness section), section 704(c) (relating to allocations with respect to certain contributed property), § 1.704-3(a)(6) (relating to allocations with respect to revalued property), section 706(d)(2) (relating to the determination of partners' distributive shares of allocable cash basis items), and section 706(d)(3) (relating the determination of partners' distributive share of any item of an upper tier partnership attributable to a lower tier partnership), are not subject to the rules of this section. In addition, the rules of this section do not apply in making allocation of book items pursuant to § 1.704-1(b)(2)(iv) (e), (f), or (s). In all cases, all partnership items for each taxable year must be allocated among the partners, and no partnership items may be duplicated, regardless of the particular provision of section 706 (or other Code section) which applies, and regardless of the method or convention adopted by the partnership.

(3)Allocation of items subject to this section. In determining the distributive share under section 702(a) of partnership items subject to this section, the partnership shall follow the steps described in this paragraph (a)(3)(i) through (x).

(i) First, determine whether either of the exceptions in paragraph (b) of this section (regarding certain changes among contemporaneous partners and partnerships for which capital is not a material income-producing factor) applies.

(ii) Second, determine which of its items are subject to allocation under the special rules for extraordinary items in paragraph (e) of this section, and allocate those items accordingly.

(iii) Third, determine with respect to each variation whether it will apply the interim closing method or the proration method. Absent an agreement of the partners (within the meaning of paragraph (f) of this section) to use the proration method, the partnership shall use the interim closing method. The partnership may use different methods (interim closing or proration) for different variations within each partnership taxable year; however, the Commissioner may place restrictions on the ability of partnerships to use different methods during the same taxable year in guidance published in the Internal Revenue Bulletin.

(iv) Fourth, determine when each variation is deemed to have occurred under the partnership's selected convention (as described in paragraph (c) of this section).

(v) Fifth, determine whether there is an agreement of the partners (within the meaning of paragraph (f) of this section) to perform regular monthly or semi-monthly interim closings (as described in paragraph (d) of this section). If so, then the partnership will perform an interim closing of its books at the end of each month (in the case of an agreement to perform monthly closings) or at the end and middle of each month (in the case of an agreement to perform semi-monthly closings), regardless of whether any variation occurs. Absent an agreement of the partners to perform regular monthly or semi-monthly interim closings, the only interim closings during the partnership's taxable year will be at the deemed time of the occurrence of variations for which the partnership uses the interim closing method.

(vi) Sixth, determine the partnership's segments, which are specific periods of the partnership's taxable year created by interim closings of the partnership's books. The first segment shall commence with the beginning of the taxable year of the partnership and shall end at the time of the first interim closing. Any additional segment shall commence immediately after the closing of the prior segment and shall end at the time of the next interim closing. However, the last segment of the partnership's taxable year shall end no later than the close of the last day of the partnership's taxable year. If there are no interim closings, the partnership has one segment, which corresponds to its entire taxable year.

(vii) Seventh, apportion the partnership's items for the year among its segments. The partnership shall determine the items of income, gain, loss, deduction, and credit of the partnership for each segment. In general, a partnership shall treat each segment as though the segment were a separate distributive share period. For example, a partnership may compute a capital loss for a segment of a taxable year even though the partnership has a net capital gain for the entire taxable year. For purposes of determining allocations to segments, any special limitation or requirement relating to the timing or amount of income, gain, loss, deduction, or credit applicable to the entire partnership taxable year will be applied based upon the partnership's satisfaction of the limitation or requirement as of the end of the partnership's taxable year. For example, the expenses related to the election to expense a section 179 asset must first be calculated (and limited if applicable) based on the partnership's full taxable year, and then the effect of any limitation must be apportioned among the segments in accordance with the interim closing method or the proration method using any reasonable method.

(viii) Eighth, determine the partnership's proration periods, which are specific portions of a segment created by a variation for which the partnership chooses to apply the proration method. The first proration period in each segment begins at the beginning of the segment, and ends at the first time of the first variation within the segment for which the partnership selects the proration method. The next proration period begins immediately after the close of the prior proration period and ends at the time of the next variation for which the partnership selects the proration method. However, each proration period shall end no later than the close of the segment.

(ix) Ninth, prorate the items of income, gain, loss, deduction, and credit in each segment among the proration periods within the segment.

(x) Tenth, determine the partners' distributive shares of partnership items under section 702(a) by taking into account the partners' interests in such items during each segment and proration period.

(4)Example.

At the beginning of 2017, PRS, a calendar year partnership, has three equal partners, A, B, and C. On April 16, 2017, A sells 50% of its interest in PRS to new partner D. On August 6, 2017, B sells 50% of its interest in PRS to new partner E. During 2015, PRS earned $75,000 of ordinary income, incurred $33,000 of ordinary deductions, earned $12,000 of capital gain in the ordinary course of its business, and sustained $9,000 of capital loss in the ordinary course of its business. Within that year, PRS earned $60,000 of ordinary income, incurred $24,000 of ordinary deductions, earned $12,000 of capital gain, and sustained $6,000 of capital loss between January 1, 2017, and July 31, 2017, and PRS earned $15,000 of gross ordinary income, incurred $9,000 of gross ordinary deductions, and sustained $3,000 of capital loss between August 1, 2017, and December 31, 2017. None of PRS's items are extraordinary items within the meaning of paragraph (e)(2) of this section. Capital is a material income-producing factor for PRS. For 2017, PRS determines the distributive shares of A, B, C, D, and E as follows:

(i) First, PRS determines that none of the exceptions in paragraph (b) of this section apply because capital is a material-income producing factor and no variation is the result of a change in allocations among contemporaneous partners.

(ii) Second, PRS determines that none of its items are extraordinary items subject to allocation under paragraph (e) of this section.

(iii) Third, the partners of PRS agree (within the meaning of paragraph (f) of this section) to apply the proration method to the April 16, 2017, variation, and PRS accepts the default application of the interim closing method to the August 6, 2017, variation.

(iv) Fourth, PRS determines the deemed date of the variations for purposes of this section based upon PRS's selected convention. Because PRS applied the proration method to the April 16, 2017, variation, PRS must use the calendar day convention with respect to the April 16, 2017, variation pursuant to paragraph (c) of this section. Therefore, the variation that resulted from A's sale to D on April 16, 2017, is deemed to occur for purposes of this section at the end of the day on April 16, 2017. Further, the partners of PRS agree (within the meaning of paragraph (f) of this section) to apply the semi-monthly convention to the August 6, 2017, variation. Therefore, the August 6, 2017, variation is deemed to occur at the end of the day on July 31, 2017.

(v) Fifth, the partners of PRS do not agree to perform regular semi-monthly or monthly closings as described in paragraph (d) of this section. Therefore, PRS will have only one interim closing for 2017, occurring at the end of the day on July 31.

(vi) Sixth, PRS determines that it has two segments for 2017. The first segment commences January 1, 2017, and ends at the close of the day on July 31, 2017. The second segment commences at the beginning of the day on August 1, 2017, and ends at the close of the day on December 31, 2017.

(vii) Seventh, PRS determines that during the first segment of its taxable year (beginning January 1, 2017, and ending July 31, 2017), it had $60,000 of ordinary income, $24,000 of ordinary deductions, $12,000 of capital gain, and $6,000 of capital loss. PRS determines that during the second segment of its taxable year (beginning August 1, 2017, and ending December 31, 2017), it had $15,000 of gross ordinary income, $9,000 of gross ordinary deductions, and $3,000 of capital loss.

(viii) Eighth, PRS determines that it has two proration periods. The first proration period begins January 1, 2017, and ends at the close of the day on April 16, 2017; the second proration period begins April 17, 2017, and ends at the close of the day on July 31, 2017.

(ix) Ninth, PRS prorates its income from the first segment of its taxable year among the two proration periods. Because each proration period has 106 days, PRS allocates 50% of its items from the first segment to each proration period. Thus, each proration period contains $30,000 gross ordinary income, $12,000 gross ordinary deductions, $6,000 capital gain, and $3,000 capital loss.

(x) Tenth, PRS calculates each partner's distributive share. Because A, B, and C were equal partners during the first proration period, each is allocated one-third of the partnership's items attributable to that proration period. Thus, A, B, and C are each allocated $10,000 gross ordinary income, $4,000 gross ordinary deductions, $2,000 capital gain, and $1,000 capital loss for the first proration period. For the second proration period, A and D each had a one-sixth interest in PRS and B and C each had a one-third interest in PRS. Thus, A and D are each allocated $5,000 gross ordinary income, $2,000 gross ordinary deductions, $1,000 capital gain, and $500 capital loss, and B and C are each allocated $10,000 gross ordinary income, $4,000 gross ordinary deductions, $2,000 capital gain, and $1,000 capital loss for the second proration period. For the second segment of PRS's taxable year, A, B, D, and E each had a one-sixth interest in PRS and C had a one-third interest in PRS. Thus, A, B, D, and E are each allocated $2,500 gross ordinary income, $1,500 gross ordinary deductions, and $500 capital loss, and C is allocated $5,000 gross ordinary income, $3,000 gross ordinary deductions, and $1,000 capital loss for the second segment.

(b)Exceptions -

(1)Permissible changes among contemporaneous partners. The general rule of paragraph (a)(3) of this section, with respect to the varying interests of a partner described in § 1.706-1(c)(3) , will not preclude changes in the allocations of the distributive share of items described in section 702(a) among contemporaneous partners for the entire partnership taxable year (or among contemporaneous partners for a segment if the item is entirely attributable to a segment), provided that-

(i) Any variation in a partner's interest is not attributable to a contribution of money or property by a partner to the partnership or a distribution of money or property by the partnership to a partner; and

(ii) The allocations resulting from the modification satisfy the provisions of section 704(b) and the regulations promulgated thereunder.

(2)Safe harbor for partnerships for which capital is not a material income-producing factor. Notwithstanding paragraph (a)(3) of this section, with respect to any taxable year in which there is a change in any partner's interest in a partnership for which capital is not a material income-producing factor, the partnership and such partner may choose to determine the partner's distributive share of partnership income, gain, loss, deduction, and credit using any reasonable method to account for the varying interests of the partners in the partnership during the taxable year provided that the allocations satisfy the provisions of section 704(b).

(c)Conventions -

(1)In general. Conventions are rules of administrative convenience that determine when each variation is deemed to occur for purposes of this section. Because the timing of each variation is necessary to determine the partnership's segments and proration periods, which are used to determine the partners' distributive shares, the convention used by the partnership with respect to a variation will generally affect the allocation of partnership items. However, see paragraph (e) of this section for special rules regarding extraordinary items, which generally must be allocated without regard to the partnership's convention. Subject to the limitations set forth in paragraphs (c)(2) and (3) of this section, partnerships may generally choose from the following three conventions:

(i)Calendar day convention. Under the calendar day convention, each variation is deemed to occur for purposes of this section at the end of the day on which the variation occurs.

(ii)Semi-monthly convention. Under the semi-monthly convention, each variation is deemed to occur for purposes of this section either:

(A) In the case of a variation occurring on the 1st through the 15th day of a calendar month, at the end of the last day of the immediately preceding calendar month; or

(B) In the case of a variation occurring on the 16th through the last day of a calendar month, at the end of the 15th calendar day of that month.

(iii)Monthly convention. Under the monthly convention, each variation is deemed to occur for purposes of this section either:

(A) In the case of a variation occurring on the 1st through the 15th day of a calendar month, at the end of the last day of the immediately preceding calendar month; or

(B) In the case of a variation occurring on the 16th through the last day of a calendar month, at the end of the last day of that calendar month.

(2)Exceptions.

(i) Notwithstanding paragraph (c)(1) of this section, all variations within a taxable year shall be deemed to occur no earlier than the first day of the partnership's taxable year, and no later than the close of the final day of the partnership's taxable year. Thus, in the case of a calendar year partnership applying either the semi-monthly or monthly convention to a variation occurring on January 1st through January 15th, the variation will be deemed to occur for purposes of this section at the beginning of the day on January 1st.

(ii) In the case of a partner who becomes a partner during the partnership's taxable year as a result of a variation, and ceases to be a partner as a result of another variation, if both such variations would be deemed to occur at the same time under the rules of paragraph (c)(1) of this section, then the variations with respect to that partner's interest will instead be treated as occurring on the dates each variation actually occurred. Thus, the partnership must treat such a partner as a partner for the entire portion of its taxable year during which the partner actually owned an interest. See Example 2 of paragraph (c)(4) of this section. However, this paragraph (c)(2)(ii) does not apply to publicly traded partnerships (as defined in section 7704(b)) that are treated as partnerships with respect to holders of publicly traded units (as described in § 1.7704-1(b) or 1.7704-1(c)(1) ).

(iii) Notwithstanding paragraph (c)(1)(iii) of this section, a publicly traded partnership (as defined in section 7704(b)) that is treated as a partnership may consistently treat all variations occurring during each month as occurring at the end of the last day of that calendar month if the publicly traded partnership uses the monthly convention for those variations.

(3)Permissible conventions for each variation -

(i)Rules applicable to all partnerships. A partnership generally shall use the calendar day convention for each variation; however, for all variations during a taxable year for which the partnership uses the interim closing method, the partnership may instead use the semi-monthly or monthly convention by agreement of the partners (within the meaning of paragraph (f) of this section). The partnership must use the same convention for all variations for which the partnership uses the interim closing method.

(ii)Publicly traded partnerships. A publicly traded partnership (as defined in section 7704(b)) that is treated as a partnership may, by agreement of the partners (within the meaning of paragraph (f) of this section) use any of the calendar day, the semi-monthly, or the monthly conventions with respect to all variations during the taxable year relating to its publicly-traded units (as described in § 1.7704-1(b) or (c)(1) ), regardless of whether the publicly traded partnership uses the proration method with respect to those variations. A publicly traded partnership must use the same convention for all variations during the taxable year relating to its publicly traded units. A publicly traded partnership must use the calendar day convention with respect to all variations relating to its non-publicly traded units for which the publicly traded partnership uses the proration method.

(4)Examples. The following examples illustrate the principles in this paragraph (c).

Example 1. PRS is a calendar year partnership with four equal partners A, B, C, and D. PRS is not a publicly traded partnership. PRS has the following three variations that occur during its 2016 taxable year: on March 11, A sells its entire interest in PRS to new partner E; on June 12, PRS partially redeems B's interest in PRS with a distribution comprising a partial return of B's capital; on October 21, C sells part of C's interest in PRS to new partner E. These transfers do not result in a termination of PRS under section 708. Pursuant to paragraph (a)(3)(iii) of this section, the partners of PRS agree (within the meaning of paragraph (f) of this section) to use the interim closing method with respect to the variations occurring on March 11 and October 21 and agree to use the proration method with respect to the variation occurring on June 12. Pursuant to paragraph (c)(3) of this section, the partners of PRS may agree (within the meaning of paragraph (f) of this section) to use any of the calendar day, semi-monthly, or monthly conventions with respect to the March 11 and October 21 variations, but must use the same convention for both variations. If the partners of PRS agree to use the calendar day convention, the March 11 and October 21 variations will be deemed to occur for purposes of this section at the end of the day on March 11, 2016, and October 21, 2016, respectively. If the partners of PRS agree to use the semi-monthly convention, the March 11 and October 21 variations will be deemed to occur for purposes of this section at the end of the day on February 29, 2016, and October 15, 2016, respectively. If the partners of PRS agree to use the monthly convention, the March 11 and October 21 variations will be deemed to occur for purposes of this section at the end of the day on February 29, 2016, and October 31, 2016, respectively. Pursuant to paragraph (c)(3) of this section PRS must use the calendar day convention with respect to the June 12 variation; thus, the June 12 variation is deemed to occur for purposes of this section at the end of the day on June 12, 2016.

Example 2. PRS is a calendar year partnership that uses the interim closing method and monthly convention to account for variations during its taxable year. PRS is not a publicly traded partnership. On January 20, 2016, new partner A purchases an interest in PRS from one of PRS's existing partners. On February 14, 2016, A sells its entire interest in PRS. These transfers do not result in a termination of PRS under section 708. Under the rules of paragraph (c)(1)(iii) of this section, the January 20, 2016, variation and the February 14, 2016, variation would both be deemed to occur at the same time: the end of the day on January 31, 2016. Therefore, under the exception in paragraph (c)(2)(ii) of this section, the rules of paragraph (c)(1) of this section do not apply, and instead the January 20, 2016, variation and the February 14 variation are considered to occur on January 20, 2016, and February 14, 2016, respectively. PRS must perform a closing of the books on both January 20, 2016, and February 14, 2016, and allocate A a share of PRS's items attributable to that segment.

(d)

(1)Optional regular monthly or semi-monthly interim closings. Under the rules of this section, a partnership is not required to perform an interim closing of its books except at the time of any variation for which the partnership uses the interim closing method (taking into account the applicable convention). However, a partnership may, by agreement of the partners (within the meaning of paragraph (f) of this section) perform regular monthly or semi-monthly interim closings of its books, regardless of whether any variation occurs. Regardless of whether the partners agree to perform these regular interim closings, the partnership must continue to apply the interim closing or proration method to its variations according to the rules of this section.

(2)Example. The following example illustrates the principles in this paragraph (d).

Example.

(i) PRS is a calendar year partnership with five equal partners A, B, C, D, and E. PRS has the following two variations that occur during its 2016 taxable year: on August 29, A sells its entire interest in PRS to new partner F; on December 27, PRS completely liquidates B's interest in PRS with a distribution. These variations do not result in a termination of PRS under section 708.

(ii) The partners of PRS agree (within the meaning of paragraph (f) of this section) to use the interim closing method and the semi-monthly convention with respect to the variation occurring on August 29. Thus, the August variation is deemed to occur for purposes of this section at the end of the day on August 15, 2016. The partners of PRS agree (within the meaning of paragraph (f) of this section) to use the proration method with respect to the December 27 variation. Therefore, PRS must use the calendar day convention with respect to the December variation pursuant to paragraph (c) of this section. Thus, the December variation is deemed to occur for purposes of this section at the end of the day on December 27, 2016.

(iii) Pursuant to paragraph (d)(1) of this section, the partners of PRS agree (within the meaning of paragraph (f) of this section) to perform regular monthly interim closings. Therefore, PRS will have twelve interim closings for its 2016 taxable year, one at the end of every month and one at the end of the day on August 15. Therefore, PRS will have thirteen segments for 2016, one corresponding to each month from January through July, one segment from August 1 through August 15, one segment from August 16 through August 31, and one corresponding to each month from September through December. PRS must apportion its items among these segments under the rules of paragraph (a)(3) of this section.

(iv) PRS will have two proration periods for 2016, one from December 1 through December 27, and one from December 28 through December 31. Pursuant to the rules of paragraph (a)(3) of this section, PRS will prorate the items in its December segment among these two proration periods. Therefore, PRS will apportion 27/31 of all items in its December segment to the proration period from December 1 through December 27, and 4/31 of all items in its December segment to the proration period from December 28 through December 31.

(v) Pursuant to the rules of paragraph (a)(3)(x) of this section, PRS determines the partners' distributive shares of partnership items under section 702(a) by taking into account the partners' interests in such items during each of the thirteen segments and two proration periods. Thus, A, B, C, D, and E will each be allocated one-fifth of all items in the following segments: January, February, March, April, May, June, July, and August 1 through August 15. B, C, D, E, and F will each be allocated one-fifth of all items in the following segments: August 16 through August 31, September, October, and November. B, C, D, E, and F will each be allocated one-fifth of all items in the proration period from December 1 through December 27. C, D, E, and F will each be allocated one-quarter of all items in the proration period from December 28 through December 31.

(e)Extraordinary items -

(1)General principles. Extraordinary items may not be prorated. The partnership must allocate extraordinary items among the partners in proportion to their interests in the partnership item at the time of day on which the extraordinary item occurred, regardless of the method (interim closing or proration method) and convention (daily, semi-monthly, or monthly) otherwise used by the partnership. These rules require the allocation of extraordinary items as an exception to the proration method, which would otherwise ratably allocate the extraordinary items across the segment, and the conventions, which could otherwise inappropriately shift extraordinary items between a transferor and transferee. However, publicly traded partnerships (as defined in section 7704(b)) that are treated as partnerships may, but are not required to, apply their selected convention in determining who held publicly traded units (as described in § 1.7704-1(b) or (c)(1) ) at the time of the occurrence of an extraordinary item. Extraordinary items continue to be subject to any special limitation or requirement relating to the timing or amount of income, gain, loss, deduction, or credit applicable to the entire partnership taxable year (for example, the limitation for section 179 expenses).

(2)Definition. Except as provided in paragraph (e)(3) of this section, an extraordinary item is:

(i) Any item from the disposition or abandonment (other than in the ordinary course of business) of a capital asset as defined in section 1221 (determined without the application of any other rules of law);

(ii) Any item from the disposition or abandonment (other than in the ordinary course of business) of property used in a trade or business as defined in section 1231(b) (determined without the application of any holding period requirement);

(iii) Any item from the disposition or abandonment of an asset described in section 1221(a)(1), (a)(3), (a)(4), or (a)(5) if substantially all the assets in the same category from the same trade or business are disposed of or abandoned in one transaction (or series of related transactions);

(iv) Any item from assets disposed of in an applicable asset acquisition under section 1060(c);

(v) Any item resulting from any change in accounting method initiated by the filing of the appropriate form after a variation occurs;

(vi) Any item from the discharge or retirement of indebtedness (except items subject to section 108(e)(8) or 108(i), which are subject to special allocation rules provided in section 108(e)(8) and 108(i));

(vii) Any item from the settlement of a tort or similar third-party liability or payment of a judgment;

(viii) Any credit, to the extent it arises from activities or items that are not ratably allocated (for example, the rehabilitation credit under section 47, which is based on placement in service);

(ix) Any specified credit portion transferred pursuant to section 6418 and §§ 1.6418-1 through 1.6418-5 ;

(x) For all partnerships, any additional item if, the partners agree (within the meaning of paragraph (f) of this section) to consistently treat such item as an extraordinary item for that taxable year; however, this rule does not apply if treating that additional item as an extraordinary item would result in a substantial distortion of income in any partner's return; any additional extraordinary items continue to be subject to any special limitation or requirement relating to the timing or amount of income, gain, loss, deduction, or credit applicable to the entire partnership taxable year (for example, the limitation for section 179 expenses);

(xi) Any item which, in the opinion of the Commissioner, would, if ratably allocated, result in a substantial distortion of income in any return in which the item is included;

(xii) Any item identified as an additional class of extraordinary item in guidance published in the Internal Revenue Bulletin.

(xii) [Reserved]

(xiii) Applicable for partnership taxable years ending after December 29, 2022, any qualified conservation contribution (as defined in section 170(h)(1) and § 1.170A-14(a) without regard to whether such contribution is a disallowed qualified conservation contribution within the meaning of § 1.170A-14(j)(3)(vii) ) made after December 29, 2022.

(3)Small item exception -

(i)In general. A partnership may treat an item described in paragraph (e)(2) of this section (except for an item described in paragraph (e)(2)(xiii) of this section) as other than an extraordinary item for purposes of this paragraph (e) if, for the partnership's taxable year the total of all items in the particular class of extraordinary items (as enumerated in paragraphs (e)(2)(i) through (xii) of this section, for example, all tort or similar liabilities, but in no event counting an extraordinary item more than once) is less than five percent of the partnership's gross income, including tax-exempt income described in section 705(a)(1)(B), in the case of income or gain items, or gross expenses and losses, including section 705(a)(2)(B) expenditures, in the case of losses and expense items; and the total amount of the extraordinary items from all classes of extraordinary items amounting to less than five percent of the partnership's gross income, including tax-exempt income described in section 705(a)(1)(B), in the case of income or gain items, or gross expenses and losses, including section 705(a)(2)(B) expenditures, in the case of losses and expense items, does not exceed $10 million in the taxable year, determined by treating all such extraordinary items as positive amounts.

(ii)Applicability date. This paragraph (e)(3) applies to partnership taxable years ending after December 29, 2022. For partnership taxable years ending before December 30, 2022, see paragraph (e)(3) of this section contained in 26 CFR part 1, as revised April 1, 2024.

(4)Examples. The following examples illustrate the provisions of this paragraph (e).

Example 1. PRS, a calendar year partnership, uses the proration method and calendar day convention to account for varying interests of the partners. At 3:15 p.m. on December 7, 2015, PRS recognizes an extraordinary item within the meaning of paragraph (e)(2) of this section. On December 12, 2016, A, a partner in PRS, disposes of its entire interest in PRS. PRS does not experience a termination under section 708 during 2016. PRS has no other extraordinary items for the taxable year, the small item exception of paragraph (e)(3) of this section does not apply, the exceptions in paragraph (b) of this section do not apply, and PRS is not a publicly traded partnership. Pursuant to paragraph (e)(1) of this section, the item of income, gain, loss, deduction, or credit attributable to the extraordinary item will be allocated in accordance with the partners' interests in the extraordinary item at 3:15 p.m. on December 7, 2016. The remaining partnership items of PRS that are subject to this section must be prorated across the partnership's taxable year in accordance with paragraph (a)(3) of this section.

Example 2. Assume the same facts as in Example 1, except that PRS uses the interim closing method and monthly convention to account for varying interests of the partners. Pursuant to paragraph (c)(1)(iii) of this section, the December 12 variation is deemed to have occurred for purposes of this section at the end of the day on November 30, 2016. Thus, A will not generally be allocated any items of PRS attributable to the segment between December 1, 2016, and December 31, 2016; however, pursuant to paragraph (e)(1) of this section, PRS must allocate the item of income, gain, loss, deduction, or credit attributable to the extraordinary item in accordance with the partners' interests in the extraordinary item at the time of day on which the extraordinary item occurred, regardless of the convention used by PRS. Thus, because A was a partner in PRS at 3:15 p.m. on December 7, 2016 (ignoring application of PRS's convention), A must be allocated a share of the extraordinary item.

Example 3. Assume the same facts as in Example 2, except that PRS is a publicly traded partnership (within the meaning of section 7704(b)) and A held a publicly traded unit (as described in § 1.7704-1(b) or 1.7704-1(c)(1) ) in PRS. Under PRS's monthly convention, the December 12 variation is deemed to have occurred for purposes of this section at the end of the day on November 30, 2016. Pursuant to paragraph (e)(1) of this section, a publicly traded partnership (as defined in section 7704(b)) may choose to respect its conventions in determining who held its publicly traded units (as described in § 1.7704-1(b) or § 1.7704-1(c)(1) ) at the time of the occurrence of an extraordinary item. Therefore, PRS may choose to treat A as not having been a partner in PRS for purposes of this paragraph (e) at the time the extraordinary item arose, and thus PRS may choose not to allocate A any share of the extraordinary item.

Example 4. A and B each own a 15 percent interest in PRS, a partnership that is not a publicly traded partnership and for which capital is a material income-producing factor. At 9:00 a.m. on April 25, 2016, A sells its entire interest in PRS to new partner D. At 3:00 p.m. on April 25, 2016, PRS incurs an extraordinary item (within the meaning of paragraph (e)(2) of this section). At 5:00 p.m. on April 25, 2016, B sells its entire interest in PRS to new partner E. Under paragraph (e)(1) of this section, PRS must allocate the extraordinary item in accordance with the partners' interests at 3:00 p.m. on April 25, 2016. Accordingly, a portion of the extraordinary item will be allocated to each of B and D, but no portion will be allocated to A or E.

Example 5. PRS, a calendar year partnership that is not a publicly traded partnership, has a variation in a partner's interest during 2016 and the exceptions in paragraph (b) of this section do not apply. During 2016 PRS has two extraordinary items: PRS recognizes $8 million of gross income on the sale outside the ordinary course of business of an asset described in paragraph (e)(2)(ii) of this section, and PRS also recognizes $12 million of gross income from a tort settlement as described in paragraph (e)(2)(vii) of this section. PRS's gross income (including the gross income from the extraordinary items) for the taxable year is $200 million. The gain from all items described in paragraph (e)(2)(ii) of this section is less than five percent of PRS's gross income ($8 million gross income from the asset sale divided by $200 million total gross income, or four percent) and all of the extraordinary items of PRS from classes that are less than five percent of PRS's gross income ($8 million), in the aggregate, do not exceed $10 million for the taxable year. Thus, the $8 million gain recognized on the asset sale is considered a small item under paragraph (e)(3) of this section and is therefore excepted from the rules of paragraph (e)(1) of this section. Because the gross income attributable to the tort settlement exceeds five percent of PRS's gross income (six percent), the tort settlement gross income is not considered a small item under paragraph (e)(3) of this section. Therefore, the $12 million gross income attributable to the tort settlement must be allocated according to the rules of paragraph (e)(1) of this section in accordance with PRS's partners' interests in the item at the time of the day that the tort settlement income arose.

Example 6. Assume the same facts as Example 5, except that during the year, PRS also recognizes two additional extraordinary items: $2 million of gross income from the sale of a capital asset described in paragraph (e)(2)(i) of this section, and $1 million of gross income from discharge of indebtedness described in paragraph (e)(2)(vi) of this section. Although the gain from items described in each of paragraphs (e)(2)(i), (e)(2)(ii), and (e)(2)(vi) of this section is each less than five percent of PRS's gross income, the extraordinary items of PRS from classes that are less than five percent of PRS's gross income ($11 million), in the aggregate, exceeds $10 million for the taxable year. Thus, none of the items are considered small items under paragraph (e)(3) of this section. Therefore, the items attributable to the sale of the capital asset, the sale of the trade or business asset, the discharge of indebtedness income, and the tort settlement must each be allocated according to the rules of paragraph (e)(1) of this section in accordance with PRS's partners' interests in the items at the time of the day that the items arose.

(f)Agreement of the partners. For purposes of paragraphs (a)(3)(iii) (relating to selection of the proration method), (c)(3) (relating to selection of the semi-monthly or monthly convention), (d) (relating to performance of regular monthly or semi-monthly interim closings), and (e)(2)(ix) (relating to selection of additional extraordinary items) of this section, the term agreement of the partners means either an agreement of all the partners to select the method, convention, or extraordinary item in a dated, written statement maintained with the partnership's books and records, including, for example, a selection that is included in the partnership agreement, or a selection of the method, convention, or extraordinary item made by a person authorized to make that selection, including under a grant of general authority provided for by either state law or in the partnership agreement, if that person's selection is in a dated, written statement maintained with the partnership's books and records. In either case, the dated written agreement must be maintained with the partnership's books and records by the due date, including extension, of the partnership's tax return.

(g)Applicability date.

(1) Except with respect to paragraph (c)(3) of this section, this section applies for partnership taxable years that begin on or after August 3, 2015. The rules of paragraph (c)(3) of this section apply for taxable years of partnerships other than existing publicly traded partnerships that begin on or after August 3, 2015. For purposes of the immediately preceding sentence, an existing publicly traded partnership is a partnership described in section 7704(b) that was formed prior to April 14, 2009. For purposes of this effective date provision, the termination of a publicly traded partnership under section 708(b)(1)(B) due to the sale or exchange of 50 percent or more of the total interests in partnership capital and profits is disregarded in determining whether the publicly traded partnership is an existing publicly traded partnership.

(2) Paragraph (e)(2)(ix) of this section applies to taxable years ending on or after April 30, 2024.

26 C.F.R. §§1.706-4

T.D. 9728, 80 FR 45878, Aug. 3, 2015; 80 FR 68243, 68244, Nov. 4, 2015, as amended by TD 9999, 89 FR 54327, June 28, 2024; T.D. 9993, 89 FR 34800, Apr. 30, 2024

89 FR 34800, 7/1/2024; As amended by TD 9999, 89 FR 54327, 6/28/2024