SERVICE EXPLAINS HOW TAX-EXEMPT PARTNERS MAY EXCLUDE DEBT-FINANCED REAL PROPERTY INCOME FROM UBIT.

Notice 90-41

I. PURPOSE

This notice provides guidance regarding the application of section 514(c)(9)(E) of the Internal Revenue Code to certain partnerships in which one or more (but not all) of the partners are qualified tax-exempt organizations within the meaning of section 514(c)(9)(C). Specifically, this notice provides guidance regarding (1) reasonable preferred returns and guaranteed payments that will be permitted pursuant to regulations that will be issued under section 514(c)(9)(E)(ii)(II), and (2) regulations that will be issued under section 514(c)(9)(E)(iii) to carry out the purposes of section 514(c)(9)(E), including regulations excluding certain items from the determination of whether the requirements of section 514(c)(9)(E) are satisfied. More complete guidance will be provided in regulations.

II. BACKGROUND

Under section 511 of the Code, tax-exempt organizations are generally taxable on their unrelated business taxable income (as defined in section 512). Section 514(a) generally provides that in computing unrelated business taxable income there shall be included as an item of gross income an amount that is a specified percentage of the total gross income derived from or on account of debt-financed property. However, section 514(c)(9) provides an exception to the debt-financed income rules for certain debt-financed investments in real property made by tax-exempt organizations described in section 514(c)(9)(C) ("qualified organizations"). Qualified organizations include only educational organizations described in section 170(b)(1)(A)(ii) and their affiliated support organizations, and qualified trusts described in section 401. (Although the definition of qualified organizations also includes, in effect, any of the foregoing organizations to the extent of their interests in property- holding organizations described in section 501(c)(25), the flush language of section 501(c)(25)(A) precludes such property-holding organizations from making the types of partnership investments described in section 514(c)(9) and in this notice, because that language prohibits indirect interests in real property.) If the requirements of section 514(c)(9) are satisfied, the income derived by the qualified organization from debt-financed real property is not subject to taxation as unrelated business income.

In addition to the basic requirements that must be satisfied for the exception provided by section 514(c)(9) to apply, special rules apply in the case of debt-financed real property held by a partnership in which one or more (but not all) of the partners are qualified organizations. Under these rules, either (1) each allocation to a partner that is a qualified organization must be a "qualified allocation" (within the meaning of section 168(h)(6)) or (2) the partnership must satisfy the requirements of section 514(c)(9)(E). This notice provides guidance regarding the requirements of section 514(c)(9)(E).

Section 514(c)(9)(E) was added to the Code by section 10214 of the Omnibus Budget Reconciliation Act of 1987, Pub. 2. No. 100-203, and was subsequently amended by section 2004(h) of the Technical and Miscellaneous Revenue Act of 1988, Pub. 2. No. 100-647. Under section 514(c)(9)(E)(i) of the Code, a partnership satisfies the requirements of section 514(c)(9)(E) if:

(I) The allocation of items to any partner that is a qualified organization cannot result in that partner having a share of overall partnership income for any taxable year greater than that partner's share of overall partnership loss for the taxable year for which that partner's loss share will be the smallest (the "fractions rule"), and

(II) Each allocation with respect to the partnership has substantial economic effect within the meaning of section 704(b)(2).

For example, if a qualified organization is allocated 30 percent of overall partnership loss for year 1, 25 percent of overall partnership loss for year 2, and 20 percent of overall partnership loss for year 3 and all later years, the partnership allocations will violate the fractions rule if the qualified organization may be allocated more than 20 percent of overall partnership income for any taxable year.

For purposes of the fractions rule, the items of partnership income, gain, loss, and deduction that are taken into account are the items of income, gain, loss, and deduction as computed for purposes of maintaining the partners' capital accounts under section 1.704- 1(b)(2)(iv) of the regulations. As a result, tax items allocated under section 704(c) are disregarded for purposes of applying the fractions rule. See also part V of this notice, below, regarding allocations that cannot have substantial economic effect.

Section 514(c)(9)(E)(ii) contains special rules regarding the tax treatment of certain chargebacks, preferred rates of return, and guaranteed payments. To the extent provided in regulations issued under section 514(c)(9)(E)(ii)(II), a partnership may provide for reasonable preferred returns or reasonable guaranteed payments without violating the requirements of section 514(c)(9)(E). See part III of this notice, below. In addition, section 514(c)(9)(E)(iii) grants the Treasury Department the authority to prescribe such regulations as may be necessary to carry out the purposes of section 514(c)(9)(E), including regulations that may provide for the exclusion or segregation of items. See parts IV, V and VI of this notice, below. If an item is excluded from the application of the fractions rule, the item is not taken into account in determining whether the fractions rule has been satisfied. In other words, if the allocation of an item of income or deduction to a qualified organization is excluded by regulation from the application of the fractions rule, the allocation of this item to the qualified organization will not be taken into account in determining the organization's share of overall partnership income or loss for the year.

III. PREFERRED RETURNS AND GUARANTEED PAYMENTS

A. General Rule

Generally, a qualified organization may not be allocated a disproportionately high share of partnership income (i.e., a share of overall partnership income for a taxable year that exceeds its lowest share of overall partnership loss for any taxable year) without violating the requirements of section 514(c)(9)(E). Section 514(c)(9)(E)(ii)(II), however, permits a partnership, to the extent allowed by regulation, to provide for reasonable preferred returns or reasonable guaranteed payments without violating the requirements of the general rule of section 514(c)(9)(E).

The Internal Revenue Service will issue regulations under section 514(c)(9)(E)(ii)(II) establishing rules for determining whether a preferred return or guaranteed payment to a qualified organization is reasonable, and whether income that is allocated to support a reasonable preferred return or income that is accrued with respect to a reasonable guaranteed payment is taken into account in applying the fractions rule. The regulations will not provide special rules dealing with preferred returns or guaranteed payments payable to partners other than qualified organizations because the fractions rule does not limit the amount of income that may be allocated to such other partners. For purposes of this notice, the term "preferred return" means a partner's right to a preferential distribution of cash flow with respect to capital contributed to the partnership by the partner which will be matched, to the extent available, by an allocation of income or gain from operations or the sale of assets, and the term "guaranteed payment" means any payment to a partner that is described in section 707(c).

The regulations that will be issued under section 514(c)(9)(E)(ii)(II) will provide as follows:

(1) For purposes of determining whether the partnership satisfies the fractions rule, an allocation to a qualified organization of partnership gross or net income to support the payment to the organization of a reasonable preferred return for capital is disregarded only to the extent that the amount of income so allocated will not exceed the excess of actual distributions made to the organization in satisfaction of the preferred return during the current and all prior taxable years over the partnership income previously allocated to the organization to support the payment of the preferred return.

(2) For purposes of determining whether the partnership satisfies the fractions rule, any income of a qualified organization from reasonable guaranteed payments during a partnership taxable year is disregarded only to the extent that the guaranteed payment that accrues for each partnership taxable year will actually be paid during that year. See section 1.461-1(a)(2) of the regulations and paragraph (3) of this part III.A. For purposes of this notice, a guaranteed payment accrues as the partnership takes that payment into account as paid or accrued under its method of accounting.

(3) For purposes of paragraphs (1) and (2) of this part III.A, any distribution or payment made by the partnership to a partner in satisfaction of a preferred return or guaranteed payment, as the case may be, within 75 days after the end of a partnership taxable year may be treated by the partnership as a distribution or payment made on the last day of that year.

(4) The regulations will provide that a preferred return or guaranteed payment is reasonable only if it meets the requirements specified in part III.B. (reasonable preferred returns and guaranteed payments for capital) or part III.C. (reasonable guaranteed payments for services) of this notice.

B. Reasonable Preferred Returns and Guaranteed Payments for Capital

For purposes of this notice, a preferred return or guaranteed payment for capital that is paid to a qualified organization is reasonable only if the following requirements are satisfied:

(1) The terms of the preferred return or guaranteed payment for capital are set forth in a written partnership agreement.

(2) The preferred return or guaranteed payment that is payable to a qualified organization for any period (not to exceed one year) may not exceed the amount determined by multiplying the qualified organization's unreturned capital (plus any unpaid preferred return or guaranteed payment for capital that is payable to the qualified organization for prior periods) at the beginning of the period by the maximum acceptable interest rate for that period. The maximum acceptable interest rate for a period equals 120 percent of the highest applicable federal rate in effect at any time beginning on or after the time that the right to the preferred return or guaranteed payment is first established pursuant to a binding, written agreement among the partners and ending at the beginning of that period. For this purpose, the highest applicable federal rate is the highest of the federal short-term, mid-term, or long-term rate described in section 1274(d) of the Code, appropriately adjusted for the length of the period and the period of compounding.

(3) A qualified organization's unreturned capital equals the excess of the aggregate amount of money and the fair market value of other property contributed by the qualified organization to the partnership (net of liabilities secured by that property that the partnership is considered to assume or take subject to under section 752 and the regulations thereunder) over the aggregate amount of money and the fair market value of other property distributed by the partnership to the qualified organization (net of liabilities secured by the property that the qualified organization is considered to assume or take subject to under section 752 and the regulations thereunder) that constitutes a return of the qualified organization's capital taking into account all of the facts and circumstances, including the terms of the partnership agreement that provide for the distribution. Generally, a distribution shall be treated as a return of a qualified organization's capital contribution if it constitutes a material distribution that is not attributable to the partnership's cash flow from its business operations, or if the distribution otherwise constitutes a return of contributed capital under the partnership agreement. The Service will closely scrutinize the value assigned to property contributed by any qualified organization (or distributed by the partnership to any qualified organization) that is entitled to a preferred return or guaranteed payments.

The following examples illustrate the foregoing rules. For simplicity, the examples consider only the case of a preferred return.

Example (1). (i) T, a taxable real estate developer, and Q, a qualified organization, form a partnership to construct and operate an office building. T contributes $10x and Q contributes $90x to the partnership. The partnership will borrow additional amounts to construct the office building. The partnership agreement provides that operating cash flow of the partnership will be distributed first, pro rata, to provide each partner with a preferred return on unreturned capital (within the meaning of part 111.b.(3) of this notice), and thereafter 50 percent to T and 50 percent to Q. The preferred return that is payable to each partner for each partnership taxable year is determined by multiplying the partner's unreturned capital (plus any unpaid preferred return) by 120 percent of the highest applicable federal rate in effect at any time on or after the formation of the partnership. The partnership agreement also provides that net income will be allocated first, pro rata, to offset prior allocations of loss; then, 10 percent to T and 90 percent to Q, to the extent necessary to support any distributions made to the partners in satisfaction of the preferred return in the current and in all prior taxable years; and, last, 50 percent to T and 50 percent to Q. Partnership net taxable loss will be allocated 50 percent to T and 50 percent to Q. The allocations required under the partnership agreement have substantial economic effect within the meaning of section 704(b) and the regulations thereunder.

(ii) Under the rules of this notice, the preferred return payable to Q constitutes a reasonable preferred return, and the allocation of income to support this preferred return will be disregarded in applying the fractions rule. As a result, Q's highest share of overall partnership income for any taxable year is 50 percent, not 90 percent. Accordingly, because 50 percent is not greater than Q's smallest share of overall partnership loss for any taxable year (50 percent), the partnership allocations satisfy the fractions rule.

Example (2). The facts are the same as in Example (1), except that the preferred return on each partner's unreturned capital is 200 percent of the highest applicable federal rate in effect at any time on or after the formation of the partnership. Income allocated to support this preferred return will not be disregarded in applying the fractions rule. Accordingly, since Q's highest share of overall partnership income for any taxable year (90 percent) is greater than its smallest share of overall partnership loss for any taxable year (50 percent), the partnership allocations do not satisfy the fractions rule.

Example (3). The facts are the same as in Example (2), except that the partnership agreement allocates net loss 10 percent to T and 90 percent to Q throughout the life of the partnership. Again, income allocated to support the preferred return will not be disregarded in applying the fractions rule. Nevertheless, because Q's highest share of overall partnership income for any taxable year (90 percent) is not greater than its smallest share of overall partnership loss for any taxable year (90 percent), the partnership allocations satisfy the fractions rule.

C. Reasonable Guaranteed Payments for Services

For purposes of this notice, a guaranteed payment for services that is payable to a qualified organization is reasonable only if such payment is reasonable in amount under the rules of section 1.162-7 of the regulations (relating to the deduction for payment of personal services). A determination, however, that such a guaranteed payment is reasonable for purposes of section 514(c)(9)(E) does not affect whether that payment constitutes unrelated business taxable income to the qualified organization under other provisions of the Code.

IV. EXCLUSION OR SEGREGATION OF PARTNERSHIP ITEMS

Generally, in order for a partnership to satisfy section 514(c)(9)(E) of the Code: (1) the allocation of items to a qualified organization must comply with the fractions rule of section 514(c)(9)(E)(i)(I); and (2) each partnership allocation must have substantial economic effect as set forth in section 704(b)(2). The fact that a particular allocation is required by section 704(b) will not preclude such allocation from violating the fractions rule. Thus, if an allocation that is respected for tax purposes under section 704(b) violates the limitations of the fractions rule, the allocation will cause the partnership to fail the requirements of section 514(c)(9)(E) unless the regulations thereunder provide otherwise.

As stated above, the fractions rule provides that the allocation of items to any partner that is a qualified organization cannot result in that partner having a share of the overall partnership income for any taxable year greater than the partner's share of the overall partnership loss for the taxable year for which the partner's share of loss will be the smallest. Under section 514(c)(9)(E)(iii), however, the Treasury Department has been granted the authority to prescribe regulations that permit the exclusion or segregation of items. An item excluded from the application of the fractions rule is not taken into account in determining whether the fractions rule has been satisfied.

The legislative history of section 514(c)(9)(E) indicates that the Treasury Department's authority to exclude certain items from the application of the fractions rule must be exercised in a manner that is consistent with the purpose of that section -- that is, to limit the transfer of tax benefits from tax-exempt partners to taxable partners. H.R. Rep. No. 795, 100th Cong., 2d Sess. 404 (1988); Report on the Technical Corrections Act of 1988, S. Rep. No. 445, 100th Cong., 2d Sess. 428 (1988). The transfer of tax benefits to taxable partners that the fractions rule is intended to prevent could otherwise occur either by directing income to tax-exempt partners or by directing losses and deductions to taxable partners. Accordingly, the regulations will not exclude allocations that are designed to shift tax benefits to taxable partners.

In general, the regulations will exclude from the determination of whether the fractions rule is satisfied any allocation for a partnership taxable year of items of loss or deduction (other than nonrecourse deductions, within the meaning of section 1.704- 1T(b)(4)(iv) (or, if applicable, section 1.704-1(b)(4)(iv)) of the regulations) that may be made to partners other than qualified organizations only if --

(1) Under the partnership agreement, the allocation will be made only after no partner that is a qualified organization has a positive capital account balance (as determined and maintained in accordance with section 1.704-1(b)(2)(iv));

(2) The partnership has a partnership net taxable loss for the year, and the allocation will not exceed the amount of that loss; and

(3) At the time that the provision requiring the allocation becomes part of the partnership agreement, it is unlikely that such an allocation will be made.

This exclusion is referred to below as the Unlikely Allocation Exclusion. For purposes of the Unlikely Allocation Exclusion, the term "partnership net taxable loss" means, for any partnership taxable year, the amount by which the aggregate partnership items of loss, deduction, and section 705(a)(2)(B) expenditure for the year (other than items that are treated as nonrecourse deductions within the meaning of section 1.704-1T(b)(4)(iv) or, if applicable, section 1.704-1(b)(4)(iv) of the regulations) exceed the aggregate partnership items of income and gain (including tax-exempt income) for the year (other than items allocated pursuant to a minimum gain chargeback in accordance with section 1.704-1T(b)(4)(iv)(e) or, if applicable, section 1.704-1(b)(4)(iv)(e) of the regulations).

All the facts and circumstances must be taken into account in determining whether the Unlikely Allocation Exclusion applies. For purposes of this rule, an allocation made pursuant to a provision in the partnership agreement is considered unlikely only if all of the information (including bona fide financial projections) available to the partners at the time the provision requiring the allocation becomes part of the partnership agreement reasonably indicates that it is more likely than not that the allocation will not be made. All possible events that could occur must be taken into account in determining whether an allocation is unlikely; an allocation will be considered unlikely if the allocation will be made only as a result of any event or combination of events that the parties reasonably believe will not occur. These types of events include, for example, tort losses in excess of insurance; unforeseen third-party litigation, strikes, or delays in securing required permits and licenses; abnormal weather conditions (considering the season and the job site); a significant delay in leasing the property due to an economic downturn in the geographic area; and unanticipated cost overruns. On the other hand, an allocation attributable to one or more expenditures will not be considered unlikely to the extent that an allowance for the expenditures (e.g., insurance for a tort liability or an allowance for cost overruns) was or reasonably should have been included in the financial projections for, and in the provisions for funding of, the project. The fact that the partnership agreement provides for an allocation does not, in and of itself, imply that an allocation is likely to be made pursuant to that provision.

The regulations also will provide that upon the occurrence of an "extraordinary partnership event" the Unlikely Allocation Exclusion will continue to apply to an allocation only if, immediately after such event, it is still reasonable to believe that the allocation is unlikely to be made. In other words, the allocation will be retested to determine whether it satisfies the Unlikely Allocation Exclusion at the time of the extraordinary partnership event. An event is an extraordinary partnership event only if the event is within the control of the partnership (or its partners) and involves a material change in the capital of the partnership resulting from a contribution to the partnership by one or more partners, or a distribution by the partnership to one or more partners. For example, a material distribution of the proceeds of a refinancing will constitute an extraordinary partnership event. Similarly, a material disposition of partnership property and the distribution of the proceeds to the partners will constitute an extraordinary partnership event, if the disposition is within the control of the partnership (or its partners).

In addition to the Unlikely Allocation Exclusion, the regulations will exclude from the determination of whether the fractions rule is satisfied any allocation that may be made pursuant to a qualified income offset within the meaning of section 1.704- 1(b)(2)(ii)(d) of the regulations because a qualified income offset is -- by its terms -- triggered only by certain unexpected events specified in such regulations.

The following examples illustrate the application of the Unlikely Allocation Exclusion. In each example, the partnership agreement provides that the partners' capital accounts will be determined and maintained in accordance with section 1.704- 1(b)(2)(iv) of the regulations; that distributions in liquidation of the partnership (or of any partner's interest) will be made in accordance with the partners' positive capital account balances (as set forth in section 1.704-1(b)(2)(ii)(b)(2)); that T will be required to restore any deficit balance in T's capital account following the liquidation of T's interest (as set forth in section 1.704-1(b)(2)(ii)(b)(3)); and that Q will not be required to restore any deficit balance in Q's capital account following the liquidation of Q's interest. The partnership agreement contains a minimum gain chargeback provision (in accordance with section 1.704- 1T(b)(4)(iv)(e)). In addition, the partnership agreement contains a qualified income offset (as defined in section 1.704-1(b)(2)(ii)(d)), and, as of the end of each taxable year discussed herein, the items described in sections 1.704-1(b)(2)(ii)(d)(4), (5), and (6) are not reasonably expected to cause or increase a deficit balance in Q's capital account.

Example (1). (i) T, a taxable real estate developer, and Q, a qualified organization, form a partnership to construct and operate an office building. T contributes $10x and Q contributes $90x. The partnership obtains a nonrecourse loan commitment of $300x to provide the additional financing that, according to financial projections, will be required to fund construction costs, start-up costs, and reserves. The partnership agreement allocates net income first, pro rata, to offset prior allocations of loss and distributions of operating cash flow, and then 50 percent to T and 50 percent to Q. The partnership agreement allocates all partnership net taxable loss (as defined in this section IV) 10 percent to T and 90 percent to Q, except that after Q's capital account has been reduced to zero all partnership net taxable loss will be allocated entirely to T. The partnership agreement allocates nonrecourse deductions (within the meaning of section 1.704-1T(b)(4)(iv) or, if applicable, section 1.704-1(b)(4)(iv) of the regulations) 10 percent to T and 90 percent to Q. Bona fide financial projections reasonably indicate that at the time the partnership agreement is executed it is unlikely that the partnership will incur a partnership net taxable loss after Q's capital account has been reduced to zero. Operating cash flow will be distributed 10 percent to T and 90 percent to Q until the partnership has earned net income equal to prior net losses, after which time operating cash flow will be distributed 50 percent to T and 50 percent to Q. The terms of this partnership agreement satisfy the requirements of the fractions rule and section 704(b)(2).

(ii) After completion of the office building and several years of operations, the partnership incurs an unanticipated tort loss (in excess of reasonable insurance) of $30x, and incurs a partnership net taxable loss for the year of $25x. The partnership funds the payment of this liability with a capital contribution of $30x by T. Immediately after T's additional $30x capital contribution and before allocation of the partnership's net taxable loss for the year, T's positive capital account balance equals $32x and Q's positive capital account balance equals $18x. Under the partnership agreement, net taxable loss for the taxable year must first be allocated 10 percent to T and 90 percent to Q until Q's capital account has been reduced to zero, with any remaining partnership net taxable loss being allocated entirely to T. Therefore, the first $20x of the $25x net taxable loss for the year is allocated $18x to Q and $2x to T, and the remaining $5x of partnership net taxable loss is allocated to T.

(iii) In determining whether the partnership's allocations satisfy the fractions rule, the allocation made pursuant to the provision in the partnership agreement requiring all partnership net taxable loss to be allocated to T after Q's capital account has been reduced to zero will be disregarded under the Unlikely Allocation Exclusion. This allocation is excluded from the application of the fractions rule because all of the information available at the time that the partnership agreement is executed reasonably indicates that it is more likely than not that no allocation will be made pursuant to that provision. The fact that an allocation is actually made pursuant to the provision as a result of unexpected events does not affect the applicability of the exclusion if such an allocation was unlikely at the time the provision was included in the partnership agreement. Accordingly, the Unlikely Allocation Exclusion continues to apply even after $5x of partnership net taxable loss is allocated to T under the excluded allocation provision. The allocation provision does not have to be tested again at the time it becomes operable because the event that triggered the provision (the unanticipated tort loss) is not an extraordinary partnership event.

(iv) The conclusion reached in this example would be the same if, instead of T's making a capital contribution of $30x, the partnership funded the payment of the tort liability through a $30x recourse loan obtained from an unrelated lender.

(v) The conclusion reached in this example does not depend on the tort nature of the event giving rise to the unlikely loss allocation. This is because, as stated in paragraph (i) of this example, the partnership could demonstrate that, at the time the allocation provision became part of the partnership agreement, all of the information available reasonably indicated that it was more likely than not that no allocation would be made pursuant to that provision. By contrast, the partnership could not make this showing to the extent that, for example, its projections at the time the partnership was formed failed to include a reasonable allowance for events which, in the aggregate, are likely to occur.

Example (2). (i) The facts are the same as in Example (1), except that the partnership does not incur an unanticipated tort loss. After several years of operations, T has a positive capital account balance of $3x and Q has a positive capital account balance of $27x. At this time, the partnership borrows from an unrelated bank an additional $30x, on a recourse basis, and distributes the proceeds $3x to T and $27x to Q, thus reducing the capital account balances to zero. In the following year, the partnership incurs a partnership net taxable loss of $10x. The entire $10x of partnership net taxable loss is allocated to T under the partnership agreement.

(ii) The distribution of loan proceeds to T and Q constitutes an extraordinary partnership event. Accordingly, after the distribution of the loan proceeds, the Unlikely Allocation Exclusion will continue to apply to the allocation provision in the partnership agreement requiring all partnership net taxable loss to be allocated to T after Q's capital account has been reduced to zero only if immediately after the distribution of the loan proceeds it is still unlikely that an allocation will be made pursuant to that provision. Otherwise, the fractions rule will not be satisfied after the distribution of the loan proceeds.

V. ALLOCATIONS THAT CANNOT HAVE SUBSTANTIAL ECONOMIC EFFECT

Section 514(c)(9)(E)(i)(II) requires that allocations must have substantial economic effect within the meaning of section 704(b)(2). The regulations will provide that allocations will be deemed to have substantial economic effect for this purpose if the allocations cannot have substantial economic effect but are deemed to be in accordance with the partners' interests in the partnership under section 1.704-1T(b)(4)(iv) (or, if applicable, section 1.704- 1(b)(4)(iv)) of the regulations. This category includes allocations of tax credits; allocations of deduction and loss (including minimum gain chargebacks) attributable to nonrecourse debt; and allocations of percentage depletion in excess of basis. This category also includes allocations made under section 704(c) as a result of a contribution of property to the partnership, or any allocations made in the same manner as under section 704(c) in connection with a revaluation of partnership property pursuant to sections 1.704- 1(b)(2)(iv)(f) or (r). The regulations will require the allocations described in this paragraph to comply both with section 1.704- 1(b)(4)(iv) (or, if applicable, section 1.704-lT(b)(4)(iv)) and with the relevant Code or regulations section that governs the particular allocation.

VI. SPECIAL RULES

The regulations will disregard a change in the allocations (including allocations required by the varying interests rules of section 706(d) and allocations arising from basis adjustments under section 743(b)) made to a qualified organization in connection with either (1) the acquisition, transfer, or liquidation of all or a part of an interest in the partnership; or (2) the default of a partner (other than a prearranged default) under the terms of the partnership agreement. Such a change in allocations will be disregarded, however, only if: (1) the transaction which gives rise to the change is the result of arm's-length dealing or has the same result as would have occurred in an arm's-length dealing (i.e., based on fair market value at the time of the transaction); (2) the allocations (other than allocations excluded by section 514(c)(9)(E) or this notice) that may be made under the partnership agreement after the change satisfy the fractions rule; and (3) the change does not have the principal effect of avoiding the restrictions of section 514(c)(9)(E) or the regulations thereunder.

In addition, the allocation provisions in the partnership agreement need not satisfy the fractions rule until the first year in which the partnership incurs debt.

VII. EFFECTIVE DATE

As amended, section 514(c)(9)(E) of the Code applies generally to property acquired by partnerships after October 13, 1987, and to partnership interests acquired after October 13, 1987. See Pub. L. No. 100-203, section 10214(c), and Pub. L. No. 100-647, section 2004(u). Regulations to be issued under section 514(c)(9)(E) will provide that the rules described in this notice will be applicable as of June 25, 1990.

In view of this effective date, the regulations will treat a partnership agreement as if it satisfied the requirements of section 514(c)(9)(E) for the period beginning after October 13, 1987, and ending on June 25, 1990, if during that period the partnership's allocations would have satisfied the requirements of section 514(c)(9)(E) (as described in this notice) if this notice had been published on October 13, 1987.

Moreover, an amendment to a partnership agreement to provide for a preferred return or guaranteed payment to a qualified organization for any period after June 25, 1990, will be disregarded in determining whether the partnership's allocations satisfy the fractions rule if: (1) the allocations (other than allocations excluded by section 514(c)(9)(E) or this notice) made under the partnership agreement before this amendment satisfy the fractions rule; and (2) the allocations (other than allocations excluded by section 514(c)(9)(E) or this notice) that may be made under the partnership agreement after this amendment satisfy the fractions rule.

VIII. REQUEST FOR COMMENT ON FUTURE GUIDANCE

The Service is considering adopting rules similar to those set forth in this notice in regulations to be issued under the "tax- exempt entity leasing" rules of section 168(h)(6) of the Code.

In addition, consideration is being given to adopting a de minimis rule pursuant to the authority granted in section 514(c)(9)(E)(iii). For example, the regulations could provide that the fractions rule will be deemed to be satisfied for partnerships in which partners other than tax-exempt organizations hold 98 percent of the interests in partnership capital, if the exempt partners participate on substantially the same terms as the taxable partners and if the principal purpose of the allocations is not tax avoidance.

The Service is also studying the appropriate treatment of chargebacks with respect to disproportionate losses previously allocated to qualified organizations and to disproportionate income previously allocated to other partners, as described in section 514(c)(9)(E)(ii)(I).

The Service invites public comment on these issues, as well as comments generally on this notice and on issues arising under other paragraphs of section 514(c)(9).

X. FURTHER INFORMATION

For further information regarding this notice, contact Christopher Kehoe of the Office of Assistant Chief Counsel (Passthroughs and Special Industries) on (202) 566-3352 or Monice Rosenbaum of the Office of Assistant Chief Counsel (Employee Benefits and Exempt Organizations) on (202) 566-3505 (neither of these is a toll-free call).