Part I. Rulings — Internal Revenue Bulletin 2002-16

and sense of well-being, and not to cure a specific ailment or disease, may not deduct the cost as a medical expense under § 213.

Rev. Rul. 55–261 (1955–1 C.B. 307) holds that medical care includes the cost of special food if (1) the food alleviates or treats an illness, (2) it is not part of the normal nutritional needs of the taxpayer, and (3) the need for the food is substantiated by a physician. However, special food that is a substitute for the food the taxpayer normally consumes and that satisfies the taxpayer’s nutritional needs is not medical care.

ANALYSIS

Amounts paid for the primary purpose of treating a disease are deductible as medical care. Obesity is medically accepted to be a disease in its own right. The National Heart, Lung, and Blood Institute, part of the National Institutes of Health, describes obesity as a “complex, multifactorial chronic disease.” Clinical Guidelines on the Identification, Evalua- tion, and Treatment of Overweight and Obesity in Adults (1998), page vii. This report is based on an evaluation by a panel of health professionals of scientific evidence published from 1980 to 1997.

Other government and scientific entities have reached similar conclusions. For example, in a preamble to final regulations the Food and Drug Administration states “obesity is a disease.” 65 Fed. Reg. 1027, 1028 (Jan. 6, 2000). The World Health Organization states that “[o]besity is now well recognized as a disease in its own right ....” Press Release 46 (June 12, 1997). In the present case, a physician has diagnosed A as suffering from a disease, obesity. Therefore, the cost of A ’s participation in the X weight-loss program as treatment for A ’s obesity is an amount paid for medical care under § 213(d)(1). Although B is not suffering from obesity, B ’s participation in X is part of the treatment for B ’s hypertension. Therefore, B ’s cost of participating in the program is also an amount paid for medical care. A and B may deduct under § 213 (subject to the limitations of that section) the fees to

Section 103.—Interest on State and Local Bonds

The Service announces a closing agreement program relating to certain state or local bonds issued in connection with affiliations of 501(c)(3) hospital organizations. See Ann. 2002–43, page 792.

Section 149(d).—Advance Refundings

The Service announces a closing agreement program relating to certain state or local bonds issued in connection with affiliations of 501(c)(3) hospital organizations. See Ann. 2002–43, page 792.

Section 150.—Definitions and Special Rules

26 CFR 1.150–1(d): Definition of refunding issue and related definitions.

The Service announces a closing agreement program relating to certain state or local bonds issued in connection with affiliations of 501(c)(3) hospital organizations. See Ann. 2002–43, page 792.

Section 213.—Medical, Dental, etc., Expenses

26 CFR 1.213–1: Medical, Dental, etc., Expenses. (Also § 262; 1.262–1.)

Medical expenses . Uncompensated amounts paid by individuals for participation in a weight-loss program as treatment for a specific disease or diseases (including obesity) diagnosed by a physician are expenses for medical care under section 213 of the Code. The cost of purchasing diet food items is not deductible under section 213 of the Code.

Rev. Rul. 2002–19

ISSUE

Are uncompensated amounts paid by individuals for participation in a weightloss program as treatment for a specific disease or ailment (including obesity) diagnosed by a physician and for diet food items expenses for medical care that

are deductible under § 213 of the Internal Revenue Code?

FACTS

Taxpayer A is diagnosed by a physician as obese. A does not suffer from any other specific disease. Taxpayer B is not obese but suffers from hypertension. B has been directed by a physician to lose weight as treatment for the hypertension.

A and B participate in the X weightloss program. A and B are required to pay an initial fee to join X and an additional fee to attend periodic meetings. At the meetings participants develop a diet plan, receive diet menus and literature, and discuss problems encountered in dieting. A and B also purchase X brand reducedcalorie diet food items. Neither A ’s nor B ’s costs are compensated by insurance or otherwise.

LAW

Section 213(a) allows a deduction for uncompensated expenses for medical care of an individual, the individual’s spouse or a dependent, to the extent the expenses exceed 7.5 percent of adjusted gross income. Section 213(d)(1) provides, in part, that medical care means amounts paid for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body.

Under § 1.213–1(e)(1)(ii) of the Income Tax Regulations, the deduction for medical care expenses will be confined strictly to expenses incurred primarily for the prevention or alleviation of a physical or mental defect or illness. An expense that is merely beneficial to the general health of an individual is not an expense for medical care. Whether an expenditure is primarily for medical care or is merely beneficial to general health is a question of fact.

Section 262 provides that, except as otherwise expressly provided by the Code, no deduction is allowed for personal, living, or family expenses.

Rev. Rul. 79–151 (1979–1 C.B. 116) holds that a taxpayer who participates in a weight reduction program to improve the taxpayer’s appearance, general health,

2002–16 I.R.B. 778 April 22, 2002

inventories for tax years ended on, or with reference to, February 28, 2002.

Rev. Rul. 2002–18

The following Department Store Inventory Price Indexes for February 2002 were issued by the Bureau of Labor Statistics. The indexes are accepted by the Internal Revenue Service, under § 1.472–1(k) of the Income Tax Regulations and Rev. Proc. 86–46 (1986–2 C.B. 739), for appropriate application to inventories of department stores employing the retail inventory and last-in, first-out inventory methods for tax years ended on, or with reference to, February 28, 2002.

The Department Store Inventory Price Indexes are prepared on a national basis and include (a) 23 major groups of departments, (b) three special combinations of the major groups - soft goods, durable goods, and miscellaneous goods, and (c) a store total, which covers all departments, including some not listed separately, except for the following: candy, food, liquor, tobacco, and contract departments.

join the program and to attend periodic meetings. These situations are distinguishable from the facts of Rev. Rul. 79–151, in which the taxpayer was not suffering from any specific disease or ailment and participated in a weight-loss program merely to improve the taxpayer’s general health and appearance. However, A and B may not deduct any portion of the cost of purchasing reduced-calorie diet foods because the foods are substitutes for the food A and B normally consume and satisfy their nutritional requirements.

HOLDING

Uncompensated amounts paid by individuals for participation in a weight-loss program as treatment for a specific disease or diseases (including obesity) diagnosed by a physician are expenses for medical care that are deductible under § 213, subject to the limitations of that section. The cost of purchasing diet food items is not deductible under § 213.

EFFECT ON OTHER DOCUMENTS

Rev. Rul. 79–151 and Rev. Rul. 55–261 are distinguished.

CONTACT INFORMATION

For further information regarding this revenue ruling, contact John T. Sapienza, Jr., at (202) 622–7900 (not a toll-free call).

Section 262.—Personal, Living, and Family Expenses

Are uncompensated amounts paid by individuals for participation in a weight-loss program as treatment for a specific disease or diseases (including obesity) diagnosed by a physician expenses for medical care under § 213. See Rev. Rul. 2002–19 on page 778.

Section 472.—Last-in, First- out Inventories

26 CFR 1.472–1: Last-in, first-out inventories.

LIFO; price indexes; department stores . The February 2002 Bureau of Labor Statistics price indexes are accepted for use by department stores employing the retail inventory and last-in, first-out inventory methods for valuing

BUREAU OF LABOR STATISTICS, DEPARTMENT STORE INVENTORY PRICE INDEXES BY DEPARTMENT GROUPS

(January 1941 = 100, unless otherwise noted)

Groups Feb. Feb. 2001 2002

Percent Change from Feb. 2001

to Feb. 2002 ¹

Piece Goods ------------------------------------------------------------ 507.2 485.6 -4.3
Domestics and Draperies -------------------------------------------- 606.8 580.1 -4.4
Women’s and Children’s Shoes ------------------------------------ 642.9 621.0 -3.4
Men’s Shoes ----------------------------------------------------------- 881.9 877.6 -0.5
Infants’ Wear ----------------------------------------------------------- 620.5 609.4 -1.8
Women’s Underwear ------------------------------------------------- 563.4 571.0 1.3
Women’s Hosiery ----------------------------------------------------- 351.5 351.1 -0.1
Women’s and Girls’ Accessories ----------------------------------- 550.1 563.0 2.3
Women’s Outerwear and Girls’ Wear ----------------------------- 388.0 375.0 -3.4
Men’s Clothing -------------------------------------------------------- 594.4 579.7 -2.5
Men’s Furnishings ---------------------------------------------------- 608.1 586.7 -3.5
Boys’ Clothing and Furnishings ------------------------------------ 484.7 473.6 -2.3
Jewelry ------------------------------------------------------------------ 943.6 889.5 -5.7
Notions ------------------------------------------------------------------ 794.5 775.7 -2.4
Toilet Articles and Drugs -------------------------------------------- 986.1 975.9 -1.0
Furniture and Bedding ----------------------------------------------- 685.9 626.0 -8.7
Floor Coverings ------------------------------------------------------- 630.2 618.8 -1.8

1 Absence of a minus sign before the percentage change in this column signifies a price increase.

April 22, 2002 779 2002–16 I.R.B.

BUREAU OF LABOR STATISTICS, DEPARTMENT STORE INVENTORY PRICE INDEXES BY DEPARTMENT GROUPS—CONTINUED

(January 1941 = 100, unless otherwise noted)

Groups Feb. Feb. 2001 2002

Percent Change from Feb. 2001

to Feb. 2002 ¹

Housewares ------------------------------------------------------------ 774.9 757.3 -2.3
Major Appliances ----------------------------------------------------- 227.8 224.5 -1.4
Radio and Television ------------------------------------------------- 56.3 51.7 -8.2
Recreation and Education ² ------------------------------------------ 90.7 87.9 -3.1
Home Improvements ² ------------------------------------------------ 128.0 125.6 -1.9
Auto Accessories ² ----------------------------------------------------- 108.8 110.3 1.4

Groups 1 - 15: Soft Goods ----------------------------------------------- 592.0 575.3 -2.8

Groups 16 - 20: Durable Goods ----------------------------------------- 433.1 415.5 -4.1

Groups 21 - 23: Misc. Goods ² ------------------------------------------- 99.2 97.4 -1.8

Store Total ³ ------------------------------------------------------------- 532.4 516.6 -3.0

1 Absence of a minus sign before the percentage change in this column signifies a price increase. 2 Indexes on a January 1986=100 base. 3 The store total index covers all departments, including some not listed separately, except for the following: candy, food, liquor, tobacco, and contract departments.

DRAFTING INFORMATION

The principal author of this revenue ruling is Michael Burkom of the Office of Associate Chief Counsel (Income Tax and Accounting). For further information regarding this revenue ruling, contact Mr. Burkom at (202) 622–7718 (not a tollfree call).

Section 705.—Determination of Basis of Partner’s Interest

26 CFR 1.705–1: Determination of basis of part- ner’s interest.

T.D. 8986

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1

Determination of Basis of Partner’s Interest; Special Rules

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations

SUMMARY: This document contains final regulations relating to special rules on determination of basis of a partner’s interest under section 705 of the Internal Revenue Code. The final regulations are necessary to coordinate sections 705 and 1032.

DATES: Effective Date : These regulations are effective on March 29, 2002.

Applicability Date : These regulations are applicable with respect to sales or exchanges of stock occurring after December 6, 1999.

FOR FURTHER INFORMATION CONTACT: Barbara MacMillan or Rebekah A. Myers (202) 622–3050 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

In Rev. Rul. 99–57 (1999–2 C.B. 678), the IRS issued guidance with respect to the tax consequences for a partnership and a corporate partner where the corporate partner contributes its own stock to the partnership, and the partnership later exchanges the stock with a third party in

a taxable transaction. Under that ruling, section 1032 will protect a corporate partner from recognizing gain or loss (to the extent allocated to such partner) when the partnership exchanges stock of the corporate partner in a taxable transaction. The ruling also concludes that, under section 705, the corporate partner increases its basis in its partnership interest by an amount equal to its share of the gain resulting from the partnership’s sale or exchange of the stock.

In situations where a corporation acquires an interest in a partnership that holds that corporation’s stock, a section 754 election is not in effect with respect to the partnership for the taxable year in which the corporation acquires the partnership interest, and the partnership later sells or exchanges the stock, it may be inconsistent with the intent of sections 705 and 1032 to increase the basis of the corporation’s partnership interest by the full amount of the gain that is not recognized.

For instance, assume that a corporation (A) purchases a 50 percent interest in a partnership for $100,000. The partnership’s only asset is A stock with a basis of $100,000 and a value of $200,000. If the

2002–16 I.R.B. 780 April 22, 2002

partnership had not made a section 754 election, then when the partnership disposes of the property for $200,000, A would be allocated $50,000 of gain. Under section 1032, the gain allocated to A would not be subject to tax. If A’s basis in the partnership interest were increased to $150,000 under section 705(a)(1), A would recognize a corresponding $50,000 loss (or reduced gain) upon a subsequent sale of the partnership interest. In this situation, it would be inconsistent with the intent of sections 705 and 1032 to increase the basis of A’s partnership interest for the gain that is not recognized. To do so would create a recognizable loss (or reduced gain) in a situation where no economic loss was incurred and no offsetting gain had previously been recognized.

Accordingly, in Notice 99–57 (1999–2 C.B. 692), the IRS announced that it intended to promulgate regulations under section 705 to address certain situations where a corporation acquires an interest in a partnership that holds stock in that corporation, and a section 754 election is not in effect with respect to the partnership for the taxable year in which the corporation acquired the interest. The IRS announced that rules regarding tieredentity structures also would be included in the regulations. The IRS requested comments as to the appropriate scope of the regulations regarding other situations where the price paid for a partnership interest reflects built-in gain or accrued income items that will not be subject to tax, or built-in loss or accrued deductions that will be permanently denied, when allocated to the transferee partner, and the partnership has not made an election under section 754. No formal comments were received.

On January 3, 2001, the Treasury Department and the IRS published a notice of proposed rulemaking (REG– 106702–00, 2001–4 I.R.B. 424) under section 705 of the Internal Revenue Code (Code) in the Federal Register (66 FR 315). Only one commentator submitted written comments in response to the notice of proposed rulemaking, and no public hearing was requested or held. After consideration of the comment, the proposed regulations are adopted as revised by this Treasury decision.

Explanation of Revisions and Summary of Contents

1. Overview of Provisions

As discussed in Notice 99–57, these final regulations are being issued in order to prevent inappropriate increases or decreases in the adjusted basis of a corporate partner’s interest in a partnership resulting from the partnership’s disposition of the corporate partner’s stock.

The final regulations set forth a detailed statement of the purpose for these regulations which is consistent with the discussion in Notice 99–57. The final regulations then provide a specific rule implementing this purpose in situations where a corporate partner holds a direct interest in a partnership that owns stock of the corporate partner. This rule applies where a corporation acquires an interest in a partnership that holds stock in that corporation (or the partnership subsequently acquires stock in that corporation in an exchanged basis transaction), the partnership does not have an election under section 754 in effect for the year in which the corporation acquires the interest, and the partnership later sells or exchanges the stock. In these situations, the increase (or decrease) in the corporation’s adjusted basis in its partnership interest resulting from the sale or exchange of the stock equals the amount of gain (or loss) that the corporate partner would have recognized (absent the application of section 1032) if, for the taxable year in which the corporation acquired the interest, a section 754 election had been in effect.

The purpose of these final regulations cannot be avoided through the use of tiered partnerships or other arrangements. For example, the final regulations provide that if a corporation acquires an indirect interest in its own stock through a chain of two or more partnerships (either where the corporation acquires a direct interest in a partnership or where one of the partnerships in the chain acquires an interest in another partnership), and gain or loss from the sale or exchange of the stock is subsequently allocated to the corporation, then the bases of the interests in the partnerships included in the chain shall be adjusted in a manner that is consistent with the purpose of the final regulations. As stated above, the final regulations

include a statement describing the purpose of these regulations which is intended to guide taxpayers in making basis adjustments in the tiered partnership context. In addition, the final regulations include two examples illustrating the basis adjustments that are required by the final regulations where a corporation acquires an indirect interest in its own stock through a chain of two or more partnerships.

2. The Secretary’s Authority

The only comment received in response to the notice of proposed rulemaking discussed the Secretary’s authority under section 705 to issue the regulations as proposed. Specifically, the comment suggested that the regulations could be challenged as inconsistent with the plain language of section 705. The comment acknowledged that the proposed regulations are a reasonable interpretation of section 705, but argued that the aggregate treatment of partnerships in the context of section 1032 provides a stronger basis for the Secretary’s authority.

Accordingly, the final regulations clarify that the authority for the regulations includes both sections 705 and 1032. As explained in Rev. Rul. 99–57, the use of the aggregate theory of partnerships in the context of section 1032 is necessary to carry out the intent of that section. To reflect this application of the aggregate theory of partnerships and prevent any unintended benefit or detriment to the partners, appropriate adjustments under section 705 must be made to a corporate partner’s outside basis. See H.R. Rep. No. 1337, 83d Cong., 2d Sess. 225 (1954); S. Rep. No. 1337, 83d Cong. 2d Sess. 384 (1954). Thus, the regulations provide the mechanical rules necessary to implement Congressional intent under both sections 705 and 1032.

3. Technical Correction Relating to Tiered Partnerships

The comment suggested technical changes to the proposed regulations to prevent taxpayers in tiered partnership situations from inappropriately allocating to the corporate partner a loss resulting from a sale of a lower-tier partnership (LTP) interest that is attributable to gain

April 22, 2002 781 2002–16 I.R.B.

allocated to and recognized by the noncorporate partners upon the LTP’s sale of the corporate partner’s stock. The final regulations include modifications to prevent such inappropriate allocations.

4. De Minimis Rule

The comment suggested that an elective de minimis rule would be appropriate as a matter of administrative convenience. However, after considering the purpose of these regulations and issues of administrative burden and technical complexity, Treasury and the IRS have determined that a de minimis rule is unnecessary.

5. Scope of the Regulations

The comment suggested that the regulations provide guidance with respect to the issues addressed in Rev. Rul. 96–10 (1996–1 C.B. 138) (partners’ bases in their partnership interests are increased to reflect gain from the sale of partnership property that is not recognized under sections 267(d) and 707(b)(1)) and Rev. Rul. 96–11 (1996–1 C.B. 140) (a charitable contribution of property by a partnership reduces each partner’s basis in the partnership by the partner’s share of the partnership’s basis in the property contributed). Treasury and the IRS believe that these issues are beyond the scope of these regulations. Accordingly, this comment is not addressed in these regulations.

6. Other Developments

The notice of proposed rulemaking (REG–167648–01) issued elsewhere in this issue of the Bulletin addresses remaining issues that Treasury and the IRS considered during the development of the final regulations. Specifically, the proposed regulations apply principles similar to those applied in the final regulations where a corporation’s indirect interest in its own stock held through one or more partnerships increases as the result of a distribution of partnership property to another partner and the partnership does not have a section 754 election in effect at the time of the distribution. In addition, the proposed regulations clarify that references in the regulations to stock of a corporate partner include any position in stock of a corporate partner to which section 1032 applies. Certain

minor, nonsubstantive changes were made to the final regulations to accommodate the eventual incorporation of the proposed regulations.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and because the regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking preceding these regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small businesses.

Drafting Information

The principal author of these regulations is Barbara MacMillan of the Office of the Associate Chief Counsel (Passthroughs and Special Industries). However, personnel from other offices of the IRS and the Treasury Department participated in their development.

- - - -

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding a citation to read in part as follows:

Authority: 26 U.S.C. 7805 - - Section 1.705–2 also issued under 26 U.S.C. 705 and 1032.

- Par. 2. Section 1.705–1 is amended by adding paragraph (a)(7) to read as follows:

§ 1.705–1 Determination of basis of part- ner’s interest .

(a) - -

(7) For basis adjustments necessary to coordinate sections 705 and 1032 in certain situations in which a partnership disposes of stock of a corporation that holds a direct or indirect interest in the partnership, see § 1.705–2.

Par. 3. Section 1.705–2 is added to read as follows:

§ 1.705–2 Basis adjustments coordinating sections 705 and 1032 .

(a) Purpose . This section coordinates the application of sections 705 and 1032 and is intended to prevent inappropriate increases or decreases in the adjusted basis of a corporate partner’s interest in a partnership resulting from the partnership’s disposition of the corporate partner’s stock. The rules under section 705 generally are intended to preserve equality between the adjusted basis of a partner’s interest in a partnership (outside basis) and such partner’s share of the adjusted basis in partnership assets (inside basis). However, in situations where a section 754 election was not in effect for the year in which a partner acquired its interest, the partner’s inside basis and outside basis may not be equal. In these situations, gain or loss allocated to the partner upon disposition of the partnership assets that is attributable to the difference between the adjusted basis of the partnership assets absent the section 754 election and the adjusted basis of the partnership assets had a section 754 election been in effect generally will result in an adjustment to the basis of the partner’s interest in the partnership under section 705(a). Such gain (or loss), therefore, generally will be offset by a corresponding decrease in the gain or increase in the loss (or increase in the gain or decrease in the loss) upon the subsequent disposition by the partner of its interest in the partnership. Where such a difference exists with respect to stock of a corporate partner that is held by the partnership, gain or loss from the disposition of corporate partner stock attributable to the difference is not recognized by the corporate partner under section 1032. To adjust the basis of the corporate partner’s interest in the partnership for this unrecognized gain or loss would not be appropriate because

2002–16 I.R.B. 782 April 22, 2002

it would create an opportunity for the recognition of taxable gain or loss on a subsequent disposition of the partnership interest where no economic gain or loss has been incurred by the corporate partner and no corresponding taxable gain or loss had previously been allocated to the corporate partner by the partnership.

(b) Single partnership —(1) Required adjustments relating to acquisitions of partnership interest . (i) This paragraph (b)(1) applies in situations where a corporation acquires an interest in a partnership that holds stock in that corporation (or the partnership subsequently acquires stock in that corporation in an exchanged basis transaction), the partnership does not have an election under section 754 in effect for the year in which the corporation acquires the interest, and the partnership later sells or exchanges the stock. In these situations, the increase (or decrease) in the corporation’s adjusted basis in its partnership interest resulting from the sale or exchange of the stock equals the amount of gain (or loss) that the corporate partner would have recognized (absent the application of section 1032) if, for the year in which the corporation acquired the interest, a section 754 election had been in effect.

(ii) The provisions of this paragraph (b)(1) are illustrated by the following example:

Example . (i) A, B, and C form equal partnership PRS. Each partner contributes $30,000 in exchange for its partnership interest. PRS has no liabilities. PRS purchases stock in corporation X for $30,000, which appreciates in value to $120,000. PRS also purchases inventory for $60,000, which appreciates in value to $150,000. A sells its interest in PRS to corporation X for $90,000 in a year for which an election under section 754 is not in effect. PRS later sells the X stock for $150,000. PRS realizes a gain of $120,000 on the sale of the X stock. X’s share of the gain is $40,000. Under section 1032, X does not recognize its share of the gain.

(ii) Normally, X would be entitled to a $40,000 increase in the basis of its PRS interest for its allocable share of PRS’s gain from the sale of the X stock, but a special rule applies in this situation. If a section 754 election had been in effect for the year in which X acquired its interest in PRS, X would have been entitled to a basis adjustment under section 743(b) of $60,000 (the excess of X’s basis for the transferred partnership interest over X’s share of the adjusted basis to PRS of PRS’s property). See § 1.743–1(b). Under § 1.755–1(b), the basis adjustment under section 743(b) would have been allocated $30,000 to the X stock (the amount of the gain that would have been allocated to X from the hypothetical sale of the stock), and $30,000 to the inven

tory (the amount of the gain that would have been allocated to X from the hypothetical sale of the inventory).

(iii) If a section 754 election had been in effect for the year in which X acquired its interest in PRS, the amount of gain that X would have recognized upon PRS’s disposition of X stock (absent the application of section 1032) would be $10,000 (X’s share of PRS’s gain from the stock sale, $40,000, minus the amount of X’s basis adjustment under section 743(b), $30,000). See § 1.743–1(j). Accordingly, the increase in the basis of X’s interest in PRS is $10,000.

(2) [Reserved] (c) Tiered partnerships and other arrangements —(1) Required adjustments . The purpose of these regulations as set forth in paragraph (a) of this section cannot be avoided through the use of tiered partnerships or other arrangements. For example, if a corporation acquires an indirect interest in its own stock through a chain of two or more partnerships (either where the corporation acquires a direct interest in a partnership or where one of the partnerships in the chain acquires an interest in another partnership), and gain or loss from the sale or exchange of the stock is subsequently allocated to the corporation, then the bases of the interests in the partnerships included in the chain shall be adjusted in a manner that is consistent with the purpose of this section.

(2) Examples . The provisions of this paragraph (c) are illustrated by the following examples:

Example 1 . Acquisition of upper-tier partnership interest by corporation . (i) A, B, and C form a partnership (UTP), with each partner contributing $25,000. UTP and D form a partnership (LTP). UTP contributes $75,000 in exchange for its interest in LTP, and D contributes $25,000 in exchange for D’s interest in LTP. Neither UTP nor LTP has any liabilities. LTP purchases stock in corporation E for $100,000, which appreciates in value to $1,000,000. C sells its interest in UTP to corporation E for $250,000 in a year for which an election under section 754 is not in effect for UTP or LTP. LTP later sells the E stock for $2,000,000. LTP realizes a $1,900,000 gain on the sale of the E stock. UTP’s share of the gain is $1,425,000, and E’s share of the gain is $475,000. Under section 1032, E does not recognize its share of the gain.

(ii) With respect to the basis of UTP’s interest in LTP, if all of the gain from the sale of the E stock (including E’s share) were to increase the basis of UTP’s interest in LTP, UTP’s basis in such interest would be $1,500,000 ($75,000 + $1,425,000). The fair market value of UTP’s interest in LTP is $1,500,000. Because UTP did not have a section 754 election in effect for the taxable year in which E acquired its interest in UTP, UTP’s basis in the LTP interest does not reflect the purchase price paid by E for its interest. Increasing the basis of UTP’s

interest in LTP by the full amount of the gain that would be recognized (in the absence of section 1032) on the sale of the E stock preserves the conformity between UTP’s inside basis and outside basis with respect to LTP ( i.e., UTP’s share of LTP’s cash is equal to $1,500,000, and UTP’s basis in the LTP interest is $1,500,000) and appropriately would cause UTP to recognize no gain or loss on the sale of UTP’s interest in LTP immediately after the sale of the E stock. Accordingly, increasing the basis of UTP’s interest in LTP by the entire amount of gain allocated to UTP (including E’s share) from LTP’s sale of the E stock is consistent with the purpose of this section. The $1,425,000 of gain allocated by LTP to UTP will increase the adjusted basis of UTP’s interest in LTP under section 705(a)(1). The basis of UTP’s interest in LTP immediately after the sale of the E stock is $1,500,000.

(iii) With respect to the basis of E’s interest in UTP, if E’s share of the gain allocated to UTP and then to E were to increase the basis of E’s interest in UTP, E’s basis in such interest would be $725,000 ($250,000 + $475,000) and the fair market value of such interest would be $500,000, so that E would recognize a loss of $225,000 if E sold its interest in UTP immediately after LTP’s disposition of the E stock. It would be inappropriate for E to recognize a taxable loss of $225,000 upon a disposition of its interest in UTP because E would not incur an economic loss in the transaction, and E did not recognize a taxable gain upon LTP’s disposition of the E stock that appropriately would be offset by a taxable loss on the disposition of its interest in UTP. Accordingly, increasing E’s basis in its UTP interest by the entire amount of gain allocated to E from the sale of the E stock is not consistent with the purpose of this section. (Conversely, because A and B were allocated taxable gain on the disposition of the E stock, it would be appropriate to increase A’s and B’s bases in their respective interests in UTP by the full amount of the gain allocated to them.)

(iv) The appropriate basis adjustment for E’s interest in UTP upon the disposition of the E stock by LTP can be determined as the amount of gain that E would have recognized (in the absence of section 1032) upon the sale by LTP of the E stock if both UTP and LTP had made section 754 elections for the taxable year in which E acquired the interest in UTP. If section 754 elections had been in effect for UTP and LTP for the year in which E acquired E’s interest in UTP, the following would occur. E would be entitled to a $225,000 positive basis adjustment under section 743(b) with respect to the property of UTP. The entire basis adjustment would be allocated to UTP’s only asset, its interest in LTP. In addition, the sale of C’s interest in UTP would be treated as a deemed sale of E’s share of UTP’s interest in LTP for purposes of sections 754 and 743. The deemed selling price of E’s share of UTP’s interest in LTP would be $250,000 (E’s share of UTP’s adjusted basis in LTP, $25,000, plus E’s basis adjustment under section 743(b) with respect to the assets of UTP, $225,000). The deemed sale of E’s share of UTP’s interest in LTP would trigger a basis adjustment under section 743(b) of $225,000 with respect to the assets of LTP (the excess of E’s share of UTP’s adjusted basis in LTP, including E’s basis adjustment ($225,000), $250,000, over E’s share of the adjusted basis of LTP’s property, $25,000). This $225,000 adjustment by LTP would be allocated to

April 22, 2002 783 2002–16 I.R.B.

LTP’s only asset, the E stock, and would be segregated and allocated solely to E. The amount of LTP’s gain from the sale of the E stock (before considering section 743(b)) would be $1,900,000. E’s share of this gain, $475,000, would be offset in part by the $225,000 basis adjustment under section 743(b), so that E would recognize gain equal to $250,000 in the absence of section 1032.

(v) If the basis of E’s interest in UTP were increased by $250,000, the total basis of E’s interest would equal $500,000. This would conform to E’s share of UTP’s basis in the LTP interest ($1,500,000 x 1/3 = $500,000) as well as E’s indirect share of the cash held by LTP ((1/3 x 3/4) x $2,000,000 = $500,000). Such a basis adjustment does not create the opportunity for the recognition of an inappropriate loss by E on a subsequent disposition of E’s interest in UTP and is consistent with the purpose of this section. Accordingly, under this paragraph (c), of the $475,000 gain allocated to E, only $250,000 will apply to increase the adjusted basis of E in UTP under section 705(a)(1). E’s adjusted basis in its UTP interest following the sale of the E stock is $500,000.

Example 2 . Acquisition of lower-tier partnership interest by upper-tier partnership . (i) A, corporation B, and C form an equal partnership (UTP), with each partner contributing $100,000. D, E, and F also form an equal partnership (LTP), with each partner contributing $30,000. LTP purchases stock in corporation B for $90,000, which appreciates in value to $900,000. LTP has no liabilities. UTP purchases D’s interest in LTP for $300,000. LTP does not have an election under section 754 in effect for the taxable year of UTP’s purchase. LTP later sells the B stock for $900,000. UTP’s share of the gain is $270,000, and B’s share of that gain is $90,000. Under section 1032, B does not recognize its share of the gain. (ii) With respect to the basis of UTP’s interest in LTP, if all of the gain from the sale of the B stock (including B’s share) were to increase the basis of UTP’s interest in LTP, UTP’s basis in the LTP interest would be $570,000 ($300,000 + $270,000), and the fair market value of such interest would be $300,000, so that B would be allocated a loss of $90,000 (($570,000 — $300,000) x 1/3) if UTP sold its interest in LTP immediately after LTP’s disposition of the B stock. It would be inappropriate for B to recognize a taxable loss of $90,000 upon a disposition of UTP’s interest in LTP. B would not incur an economic loss in the transaction, and B was not allocated a taxable gain upon LTP’s disposition of the B stock that appropriately would be offset by a taxable loss on the disposition of UTP’s interest in LTP. Accordingly, increasing UTP’s basis in its LTP interest by the gain allocated to B from the sale of the B stock is not consistent with the purpose of this section. (Conversely, because E and F were allocated taxable gain on the disposition of the B stock, it would be appropriate to increase E’s and F’s bases in their respective interests in LTP by the full amount of such gain.)

(iii) The appropriate basis adjustment for UTP’s interest in LTP upon the disposition of the B stock by LTP can be determined as the amount of gain that UTP would have recognized (in the absence of section 1032) upon the sale by LTP of the B stock if

the portion of the gain allocated to UTP that subsequently is allocated to B were determined as if LTP had made an election under section 754 for the taxable year in which UTP acquired its interest in LTP. If a section 754 election had been in effect for LTP for the year in which UTP acquired its interest in LTP, then with respect to B, the following would occur. UTP would be entitled to a $90,000 positive basis adjustment under section 743(b), allocable to B, in the property of LTP. The entire basis adjustment would be allocated to LTP’s only asset, its B stock. The amount of LTP’s gain from the sale of the B stock (before considering section 743(b)) would be $810,000. UTP’s share of this gain, $270,000, would be offset, in part, by the basis adjustment under section 743(b), so that UTP would recognize gain equal to $180,000.

(iv) If the basis of UTP’s interest in LTP were increased by $180,000, the total basis of UTP’s partnership interest would equal $480,000. This would conform to the sum of UTP’s share of the cash held by LTP ((1/3 x $900,000 = $300,000) and the taxable gain recognized by A and C on the disposition of the B stock that appropriately may be offset on the disposition of their interests in UTP ($90,000 + $90,000 = $180,000). Such a basis adjustment does not inappropriately create the opportunity for the allocation of a loss to B on a subsequent disposition of UTP’s interest in LTP and is consistent with the purpose of this section. Accordingly, of the $270,000 gain allocated to UTP, only $180,000 will apply to increase the adjusted basis of UTP in LTP under section 705(a)(1). Such $180,000 basis increase must be segregated and allocated $90,000 each to solely A and C. UTP’s adjusted basis in its LTP interest following the sale of the B stock is $480,000.

(v) With respect to B’s interest in UTP, if B’s share of the gain allocated to UTP and then to B were to increase the basis of B’s interest in UTP, B would have a UTP partnership interest with an adjusted basis of $190,000 ($100,000 + $90,000) and a value of $100,000, so that B would recognize a loss of $90,000 if B sold its interest in UTP immediately after LTP’s disposition of the B stock. It would be inappropriate for B to recognize a taxable loss of $90,000 upon a disposition of its interest in UTP because B would not incur an economic loss in the transaction, and B did not recognize a taxable gain upon LTP’s disposition of the B stock that appropriately would be offset by a taxable loss on the disposition of its interest in UTP. Accordingly, increasing B’s basis in its UTP interest by the gain allocated to B from the sale of the B stock is not consistent with the purpose of this section. (Conversely, because A and C were allocated taxable gain on the disposition of the B stock that is a result of LTP not having a section 754 election in effect, it would be appropriate for A and C to recognize an offsetting taxable loss on the disposition of A’s and C’s interests in UTP. Accordingly, it would be appropriate to increase A’s and C’s bases in their respective interests in UTP by the amount of gain recognized by A and C.)

(vi) The appropriate basis adjustment for B’s interest in UTP upon the disposition of the B stock by LTP can be determined as the amount of gain

that B would have recognized (in the absence of section 1032) upon the sale by LTP of the B stock if the portion of the gain allocated to UTP that is subsequently allocated to B were determined as if LTP had made an election under section 754 for the taxable year in which UTP acquired its interest in LTP. If a section 754 election had been in effect for LTP for the year in which UTP acquired its interest in LTP, then with respect to B, the following would occur. UTP would be entitled to a basis adjustment under section 743(b) in the property of LTP of $90,000 with respect to B. The entire basis adjustment would be allocated to LTP’s only asset, its B stock. The amount of LTP’s gain from the sale of the B stock (before considering section 743(b)) would be $810,000. UTP’s share of this gain, $270,000, would be offset, in part, by the $90,000 basis adjustment under section 743(b), so that UTP would recognize gain equal to $180,000. The $90,000 basis adjustment would completely offset the gain that otherwise would be allocated to B.

(vii) If no gain were allocated to B so that the basis of B’s interest in UTP was not increased, the total basis of B’s interest would equal $100,000. This would conform to B’s share of UTP’s basis in the LTP interest (($480,000 - $180,000 ( i.e., A’s and C’s share of the basis that should offset taxable gain recognized as a result of LTP’s failure to have a section 754 election)) x 1/3 = $100,000) as well as B’s indirect share of the cash held by LTP ((1/3 x 1/3) x $900,000 = $100,000). Such a basis adjustment does not create the opportunity for the recognition of an inappropriate loss by B on a subsequent disposition of B’s interest in UTP and is consistent with the purpose of this section. Accordingly, under this paragraph (c), of the $90,000 gain allocated to B, none will apply to increase the adjusted basis of B in UTP under section 705(a)(1). B’s adjusted basis in its UTP interest following the sale of the B stock is $100,000.

(viii) Immediately after LTP’s disposition of the B stock, UTP sells its interest in LTP for $300,000. UTP’s adjusted basis in its LTP interest is $480,000, $180,000 of which must be allocated $90,000 each to A and C. Accordingly, upon UTP’s sale of its interest in LTP, UTP realizes $180,000 of loss, and A and C in turn each realize $90,000 of loss.

(d) [Reserved] (e) Effective date . This section applies to gain or loss allocated with respect to sales or exchanges of stock occurring after December 6, 1999.

Robert E. Wenzel, Deputy Commissioner of

Internal Revenue.

Approved March 14, 2002.

Mark Weinberger, Assistant Secretary of the Treasury.

(Filed by the Office of the Federal Register on March 28, 2002, 8:45 a.m., and published in the issue of the Federal Register for March 29, 2002, 67 F.R. 15112)

2002–16 I.R.B. 784 April 22, 2002