Rev. Rul. 77-311

Advice has been requested whether, under the circumstances described below, the method of allocating a partnership loss is an acceptable method of allocation for purposes of section 706(c)(2)(B) of the Internal Revenue Code of 1954, as amended by the Tax Reform Act of 1976, Pub. L. 94-455, 1976-3 C.B. (Vol. 1) 23.

A, an individual, was the general partner of X, a limited partnership formed on January 2, 1976. Y, another limited partnership formed on January 2, 1976, was one of the limited partners of X. The sole activity of both partnerships is investing in real property (other than mineral property). Under the X partnership agreement, the profits and losses were to be shared 10 percent for A and 30 percent each for Y and the other two limited partners. When Y was formed, the general partner of Y was B, an individual, and the sole limited partner of Y was C, an individual. Under the Y partnership agreement, the profits and losses originally were to be shared 20 percent for B and 80 percent for C. On December 1, 1976, D, an individual, contributed cash to Y's capital and was admitted as a limited partner of Y. The Y partnership agreement was amended in accordance with the partners' relative investments. D's profits and losses sharing percentage was established at 25 percent and B's and C's percentages were reduced to 15 percent and 60 percent respectively.

For its taxable year ended December 31, 1976, X sustained a loss from its business operations in substantially equal amounts each month. Y's distributive share of X's loss for its taxable year ended December 31, 1976, 1200x dollars, was allocated to Y's partners at year end as follows:

            Profits and

Section 702(a) of the Code provides the general rule that in determining a partner's income tax, the partner shall take into account separately such partner's distributive share of partnership items of income, gain, loss, deduction, or credit.

Section 704(d) of the Code, which provides a limitation on the allowance of a partner's distributive share of partnership loss, does not apply with respect to any activity to the extent that section 465 (relating to amounts at risk in certain activities) applies, nor does it apply to any partnership, the principal activity of which (as in the instant case) is investing in real property (other than mineral property).

Section 706(a) of the Code provides, in part, that in computing the taxable income of a partner for a taxable year, the inclusions required by section 702 with respect to a partnership shall be based on the income, gain, loss, deduction, or credit of the partnership for any taxable year of the partnership ending within or with the taxable year of the partner.

The language of section 706(a) of the Code does not mean that Y's distributive share of X's loss was sustained by Y on December 31, 1976. That language merely describes in which taxable year the partnership items shall be included in the taxable income of a partner.

Section 706(c)(2)(B) of the Code provides, in part, that the taxable year of a partnership shall not close (other than at the end of a partnership's taxable year) with respect to a partner whose interest is reduced (whether by entry of a new partner, partial liquidation of a partner's interest, gift, or otherwise), but such partner's distributive share of items described in section 702(a) shall be determined by taking into account such partner's varying interests in the partnership during the taxable year.

The report of the Senate Finance Committee on the Tax Reform Act of 1976, S. Rep. No. 94-938, 94th Cong., 2d Sess. 96-97 (1976), 1976-3 C.B. (Vol. 3) 134-135, states, in part, that while not specifically stated in section 706(c)(2)(B) of the Code or the relevant regulations, it is implicit that the transferee of less than the entire interest of the transferor-partner would necessarily be subject to the same rule as the transferor. This means that the transferee-partner's distributive share of partnership income and loss would be determined by taking into account the transferee-partner's varying interests in the partnership during the year. The report also states that in order to deal with the problem of retroactive allocations and clarify the treatment of a partner's interest where the partner acquired the interest directly from the partnership, the committee amendment specifically denies retroactive allocations and provides that the present varying interests rule is to apply to a partner's interest acquired directly from the partnership.

The import of section 706(c)(2)(B) of the Code is that partners whose interests are changed will not be allocated income they have not realized nor losses they have not sustained. This same principle applies even when a partnership (Y in this case) is itself a partner in a second partnership (X in this case). Further, Y's distributive share of any items of income gain, loss, deduction, or credit of X would be considered to be realized or sustained by Y at the same time and in the same manner as such items were realized or sustained by X. Thus, the partners of Y are considered to have sustained that portion of their distributive shares of Y's loss (which consists of X's loss distributed to Y) at the same time and in the same manner that the loss was considered to be sustained by Y.

Accordingly, in the instant case, since the method of computing the partners' distributive shares of Y's partnership loss did not take into account the existing partners' and the new partner's varying interests in Y during the year, the method used is not a proper method for purposes of section 706(c)(2)(B) of the Code.

An acceptable method in the instant case, for purposes of section 706(c)(2)(B) of the Code, is to allocate the partnership's items among the partners based on their differing profit and loss sharing percentages and the periods during the year each partner's differing percentage interests existed. Thus, for example, D would be allocated a distributive share of the partnership loss only for the period (1 month) that D was a partner. In the instant case, the partners would have computed their distributive shares of the 1200x dollars loss as follows:

          Profit/Loss  Months                         Distributive