Final Regs Update Percentage Depletion Rules

 [4830-01]

 ACTION: Final regulations.

 SUMMARY: This document contains amendments to final regulations that clarify the circumstances under which percentage depletion is available in the case of oil and gas wells. The final regulations in this document reflect changes to the applicable law that were made by section 501 of the Tax Reduction Act of 1975, section 2115(c) of the Tax Reform Act of 1976, section 403(a)(2)(B), (b), and (c) of the Energy Tax Act of 1978, sections 202(d)(2) and 203(b)(3)(B) of the Technical Corrections Act of 1982, section 3(a) of the Subchapter S Revision Act of 1982, sections 25(b) and 722(e)(1) of the Tax Reform Act of 1984, section 412(a)(1) of the Tax Reform Act of 1986, and sections 11521 and 11522 of the Revenue Reconciliation Act of 1990.

 DATES: These regulations are effective for taxable years beginning after May 13, 1991, except as provided below. A partnership may elect to apply the provisions of section 1.613A-3(e)(3)(i) through (iv), relating to the reallocation of partnership basis, for taxable years beginning on or before May 13, 1991. The provisions of section 1.613A-3(i)(2) apply to transfers of proven property after May 13, 1991, but a taxpayer may elect to apply these rules to transfers occurring after October 11, 1990, and on or before May 13, 1991.

 FOR FURTHER INFORMATION CONTACT: Brenda M. Stewart, 202-622-3120 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

PAPERWORK REDUCTION ACT

The collection of information requirement contained in this final regulation has been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act of 1980 (44 U.S.C. 3504(h)) under control number 1545-1251. The estimated annual burden per respondent varies from 10 minutes to 30 minutes, depending on individual circumstances, with an estimated average of 20 minutes.

 These estimates are an approximation of the average time expected to be necessary to collect information. They are based on the information available to the Internal Revenue Service. Individual respondents may require more time or less time, depending on their particular circumstances.

 Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be directed to the Internal Revenue Service, Attn: IRS Reports Clearance Officer TR:FP, Washington, D.C. 20224, and to the Office of Management and Budget, Paperwork Reduction Project, Washington, D.C. 20503.

BACKGROUND

 Proposed regulations under section 613A clarifying the circumstances under which percentage depletion is available in the case of oil and gas wells were published in the Federal Register on May 13, 1991. The provisions concerning oil and gas property held by partnerships were published as proposed regulations in the Federal Register on May 13, 1991 (56 FR 21965 (May 13, 1991)) because the partnership provisions in the 1991 proposed regulations under section 613A differ substantially from the partnership provisions in the 1977 proposed regulations. Other amendments proposed on May 13, 1991 reflect changes to the applicable law after the issuance of the 1977 proposed regulations under section 613A. These final regulations conform the regulations to section 501 of the Tax Reduction Act of 1975, section 2115(c) of the Tax Reform Act of 1976, section 403(a)(2)(B), (b), and (c) of the Energy Tax Act of 1978, sections 202(d)(2) and 203(b)(3)(B) of the Technical Corrections Act of 1982, section 3(a) of the Subchapter S Revision Act of 1982, sections 25(b) and 722(e)(1) of the Tax Reform Act of 1984, section 412(a)(1) of the Tax Reform Act of 1986, and sections 11521 and 11522 of the Revenue Reconciliation Act of 1990.

EXPLANATION OF PROVISIONS

I. REALLOCATION OF PARTNERSHIP BASIS

 Proposed section 1.613A-3(e)(3)(ii) provides that in the case of an entry of a new partner (or an additional contribution by an existing partner), a partnership must allocate to the new partner the partner's share of the aggregate of the partners' adjusted bases in each partnership oil or gas property. Concurrently, each existing partner is required to reduce the partner's basis in each partnership oil or gas property by the percentage of the partnership's aggregate basis in the property that has been allocated to the new partner. Proposed section 1.613A-3(e)(iii) provides that the partnership may determine the partners' aggregate bases by using data submitted by partners or by using certain assumptions.

 If a partner does not inform the partnership of the partner's basis in an oil or gas property, the partnership must use the following assumptions to determine the basis: (1) the partner deducted the partner's share of deductions under section 263(c) in the first year in which the partner could claim a deduction for such amounts, unless the partnership elected to capitalize such amounts, (2) the partner was not subject to the 65 percent-of-taxable income limitation of section 613A(d)(1) with respect to the partner's depletion allowance under section 611, and (3) the partner was not subject to the taxable income limitation of section 613(a), the depletable quantity limitations of section 613A(c), or the limitations of section 613A(d)(2), (3), and (4), except to the extent the limitation is applied at the partnership level.

 Use of the assumptions may result in the loss of a portion of the partners' collective basis in partnership property upon reallocation to an entering partner. A partnership may avoid the loss of any portion of the collective basis, however, by using written data submitted by partners.

 In the case of the withdrawal of a partner, the withdrawing partner's adjusted basis in each oil and gas property must be allocated to the remaining partners. If assumptions are used to determine the withdrawing partner's basis in the oil and gas property, a portion of the partners' collective basis may also be lost.

 Commentators have argued that a withdrawing partner may have little or no incentive to provide the partnership with the necessary data. Therefore, the partnership would be forced to use the assumptions set forth in proposed section 1.613A-3(e)(3)(iii)(C). The commentators suggested that a partnership be permitted to rebut the assumptions by showing that the use of the assumptions would result in inequitable treatment and a loss of partnership basis.

 The final regulations reflect the commentators' suggestion that a partnership be permitted to rebut the assumptions in the case of a withdrawing partner. However, the final regulations limit the opportunity to rebut the assumptions to the assumption relating to the status of the withdrawing partner as a retailer or refiner. A partnership may rebut the assumption that the withdrawing partner is not a retailer or a refiner by demonstrating that the withdrawing partner is a retailer or refiner. The opportunity to rebut the assumptions is limited to the retailer or refiner assumption because this is the only assumption rebuttable with the use of information in the public domain. See section 1.613A-3(e)(3)(iv)(B).

II. TRANSFERS AFTER OCTOBER 11, 1990

 Proposed section 1.613A-3(i)(2) reflects the repeal by section 11521 of the Revenue Reconciliation Act of 1990 of section 613A (c)(9), the "transfer rule," which made transferred proven properties ineligible for percentage depletion. Proposed section 1.613A- 3(i)(2)(ii) interpreted the term "transfer," for purposes of determining whether a transfer occurs following the effective date of the repeal, in the same manner as it was interpreted under prior law. The repeal of the transfer rule is effective for transferees of proven properties transferred after October 11, 1990. Under proposed section 1.613A-3(i)(2)(ii) the term "transfer" has the same meaning as under section 1.613A-7(n), which defines "transfer" under repealed section 613A(c)(9).

 Commentators expressed concern that the rules set forth in proposed section 1.613A-3(i)(2) regarding the repeal of the transfer rule are too restrictive and suggested that a facts and circumstances test would best implement the intent of Congress. Specifically commentators suggested a rule that would provide that a transfer after October 11, 1990 will restore percentage depletion on a proven property if the transfer is undertaken for: (1) a valid business purpose, (2) another valid non-tax reason (e.g., a transfer at death), or (3) the purpose of lowering the income tax liability of the transferee if the transfer was undertaken with the expectation that it would encourage better utilization of the percentage depletion benefit.

 The commentators' suggestion was not adopted because it would treat a disposition of property as a transfer even if the beneficial interest in the property is still retained by the transferor (e.g., the transfer of property to a partnership for a partnership interest). Had Congress intended to permit the restoration of percentage depletion without the transfer of the beneficial interest in property, the repeal of the transfer rule would have been effective as of a certain date, without regard to any transfer. Moreover, Congress provided a definition of the term "transfer" in repealed section 613A(c)(9). Because Congress also used the term "transfer" in the effective date of the repeal of section 613A(c)(9), it is reasonable to interpret the term as having the same meaning. Accordingly, proposed section 1.613A-3(i)(2)(ii) remains unchanged in the final regulations.

III. TRANSFER OF PROVEN PROPERTY IN EXCHANGE FOR STOCK

 Under former section 613A(c)(10), a transfer of proven property by an individual to a qualified transferee corporation solely in exchange for stock of that corporation was excepted from the transfer rule. If the transferor of the property disposed of the stock at any time during the transferor's lifetime, however, the depletable quantity of the transferee corporation would be reduced by an amount bearing the same ratio to the total depletable quantity as the fair market value of the stock disposed of bore to the aggregate fair market value of the stock of the corporation.

 Commentators have requested that the regulations make clear that for purposes of transfers of property occurring before October 12, 1990 under section 613A(c)(10), prior to its repeal, the transfer of stock after October 11, 1990 by a transferor will not result in a reduction in the depletable quantity of the transferee corporation.

 The comments are consistent with the intention of the final regulations that no transaction after October 11, 1990 will cause a property to become ineligible for percentage depletion. Accordingly, the final regulations provide that the disposition of stock received in exchange for proven property will not result in a reduction of the transferee corporation's depletable quantity under section 613A(c)(10)(F)(prior to its repeal). See section 1.613A-3(i)(2).

IV. BONUSES AND ADVANCED ROYALTIES

 Consistent with Commissioner v. Engle, 464 U.S. 206 (1984) (which holds that section 613A was not intended to disallow percentage depletion on a lease bonus or advanced royalty payment even when there is no actual production in the year of receipt), the final regulations under section 613A provide rules allowing percentage depletion for lease bonuses and advanced royalties received or accrued before August 17, 1986. However, section 412(a)(1) of the Tax Reform Act of 1986 added section 613A(d)(5) to the Code which overrules Engle. Thus, proposed section 1.613A-3(j)(1) provides that any advanced royalty (to the extent that actual production during the taxable year is insufficient to earn such royalty), lease bonus, or other amount payable without regard to production that is received or accrued after August 16, 1986, is not taken into account in computing the percentage depletion allowance pursuant to section 613A(c). This provision remains unchanged in the final regulations.

V. CONFORMING CHANGES TO SECTION 1.705-1(a)(4)

 Proposed section 1.705-1(a)(4) provided that the basis of any oil or gas property was decreased (but not below zero) by the amount of the partner's deduction for depletion allowable under section 611 for any partnership oil or gas property. Commentators noted that this provision did not reflect the changes to section 705(a)(3) by section 722(e)(1) of the Tax Reform Act of 1984.

 Accordingly, section 1.705-1(a)(4) of the final regulations provides that the basis of any oil or gas property is decreased (but not below zero) by the amount of the partner's deduction of depletion of any partnership oil and gas property to the extent the deduction does not exceed the proportionate share of the adjusted basis of the property allocated to the partner under section 613A(c)(7)(D).

SPECIAL ANALYSES

 It has been determined that these rules are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, an initial Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, these regulations have been submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

DRAFTING INFORMATION

 The principal author of these regulations is Walter H. Woo, Office of the Assistant Chief Counsel (Passthroughs and Special Industries), Internal Revenue Service. However, personnel from other offices of the IRS and Treasury Department participated in their development.

LIST OF SUBJECTS

26 CFR 1.611-0 through 1.617-4

 Income taxes, Natural resources, Reporting and recordkeeping requirements.

26 CFR 1.701-1 through 1.771-1

 Income taxes, Reporting and recordkeeping requirements.

Treasury Decision 8437

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1 -- INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1953

Paragraph 1. The authority citation for part 1 continues to read in part as follows:

Authority: 26 U.S.C. 7805

Par. 2. Paragraph (a) of section 1.613-1 is amended by revising the second sentence to read as follows:

SECTION 1.613-1 PERCENTAGE DEPLETION; GENERAL RULE.

(a) The deduction shall not exceed 50 percent (100 percent in the case of oil and gas properties for taxable years beginning after December 31, 1990) of the taxpayer's taxable income from the property (computed without regard to the allowance for depletion).

* * * * *

Par. 3. Section 1.613A-0 is amended as follows:

1. The entry for section 1.613A-3(e) is amended by removing the language "[Reserved]" and adding new paragraph headings to read as set forth below.

2. The entry for section 1.613A-3(f) is amended by removing the language "[Reserved]".

3. The entry for section 1.613A-3(i)(2) is amended by removing the language "[Reserved]" and adding new paragraph headings to read as set forth below.

4. The entry for section 1.613A-3(j)(1) is amended by removing the language "[Reserved]".

5. The entry for section 1.613A-7(e) is amended by removing the language "[Reserved]".

SECTION 1.613A-0 LIMITATIONS ON PERCENTAGE DEPLETION IN THE CASE OF OIL AND GAS WELLS; TABLE OF CONTENTS.

* * * * *

 SECTION 1.613A-3 EXEMPTION FOR INDEPENDENT PRODUCERS AND ROYALTY OWNERS.

SECTION 1.613A-2 EXEMPTION FOR CERTAIN DOMESTIC GAS WELLS.

(a) * * *

(3) Any geothermal deposit in the United States or in a possession of the United States that is determined to be a gas well within the meaning of former section 613(b)(1)(A) (as in effect before enactment of the Tax Reduction Act of 1975) for taxable years ending after December 31, 1974, and before October 1, 1978 (see section 613(e) for depletion on geothermal deposits thereafter),

* * * * *

(b) For taxable years ending after September 30, 1978, the allowance for depletion under section 611 shall be computed in accordance with section 613 with respect to any qualified natural gas from geopressured brine (as defined in paragraph (e) of section 1.613A-7), and 10 percent shall be deemed to be specified in section 613(b) for purposes of section 613(a).

* * * * *

Par. 5. Section 1.613A-3 is amended as follows:

1. The text of paragraphs (e) and (f) is added as set forth below.

2. Paragraph (h)(1) is amended by revising the last sentence to read as set forth below.

3. The text of paragraph (i)(2) is added as set forth below.

4. The text of paragraph (j)(1) is added as set forth below.

SECTION 1.613A-3 EXEMPTION FOR INDEPENDENT PRODUCERS AND ROYALTY OWNERS.

* * * * *

(e) PARTNERSHIPS -- (1) GENERAL RULE. In the case of a partnership, the depletion allowance under section 611 with respect to production from domestic oil and gas properties shall be computed separately by the partners and not by the partnership. The determination of whether cost or percentage depletion is applicable is to be made at the partner level. The partnership must allocate to each partner the partner's proportionate share of the adjusted basis of each partnership oil or gas property in accordance with the provisions of paragraphs (e)(2) through (e)(6) of this section. This allocation of the adjusted basis of oil or gas property does not affect a partner's adjusted basis in his or her partnership interest.

(2) INITIAL ALLOCATION OF ADJUSTED BASIS OF OIL OR GAS PROPERTY AMONG PARTNERS -- (i) GENERAL RULE. Each partner shall be allocated his or her proportionate share of the adjusted basis of each partnership domestic oil or gas property. The initial allocation of adjusted basis is to be made as of the later of the date of acquisition of the oil or gas property by the partnership or January 1, 1975.

(ii) ALLOCATION METHODS. Except as otherwise provided in paragraph (e)(5) of this section, the provisions of this paragraph (e)(2)(ii) govern the determination under paragraph (e)(2)(i) of this section of a partner's proportionate share of the adjusted basis of oil or gas property. Each partner's proportionate share is determined in accordance with the partner's proportionate interest in partnership capital at the time of the allocation unless both --

(A) The partnership agreement provides that a partner's share of the adjusted basis of one or more properties is determined in accordance with his or her proportionate interest in partnership income; and

(B) At the time of allocation under the partnership agreement the share of each partner in partnership income is reasonably expected to be substantially unchanged throughout the life of the partnership, other than changes merely to reflect the admission of a new partner, an increase in a partner's interest in consideration for money, property, or services, or a partial or complete withdrawal of an existing partner.

If the requirements of paragraph (e)(2)(ii)(A) and (B) of this section are met, a partner's proportionate share is determined in accordance with his or her proportionate interest in partnership income. The partners' shares of adjusted basis are determined on a property-by-property basis. Accordingly, the basis of one property may be allocated in proportion to capital and the basis of another property may be allocated in proportion to income. See sections 1.613A-3(e)(5) and 1.704-1(b)(4)(v) for special rules concerning allocation of the adjusted basis of oil and gas properties.

(3) ADJUSTMENTS BY PARTNERSHIP TO ALLOCATED ADJUSTED BASES -- (i) CAPITAL EXPENDITURES BY PARTNERSHIP. Appropriate adjustments shall be made to the partners' adjusted bases in any domestic oil and gas property for any partnership capital expenditures relating to such property that are made after the initial allocation. These adjustments shall be allocated among the partners in accordance with the principles set forth in paragraph (e)(2)(ii) of this section.

(ii) ADMISSION OF A NEW PARTNER OR INCREASE IN PARTNER'S INTEREST -- (A) IN GENERAL. Upon a contribution of money, other property, or services to the partnership by a new or existing partner ("contributing partner") as consideration for an interest in the partnership, the partnership shall allocate, in accordance with paragraph (e)(3)(ii)(B) of this section, a share of the partnership's basis in each existing oil and gas property to the contributing partner, and each existing partner shall reduce, in accordance with paragraph (e)(3)(ii)(C) of this section, his or her share of the partnership's basis in such property.

(B) ALLOCATION OF BASIS TO CONTRIBUTING PARTNER. The partnership shall allocate to a contributing partner his or her proportionate share (determined under paragraph (e)(2)(ii) of this section in accordance with the partner's proportionate interest in partnership capital or income) of the partnership's adjusted basis in each existing partnership oil or gas property. For purposes of this allocation, the partnership's adjusted basis in such property equals the aggregate of its partners' adjusted bases in the property, as determined under paragraph (e)(3)(iii) of this section.

(C) REDUCTION OF EXISTING PARTNERS' BASES. Each existing partner's basis in each existing partnership oil or gas property is reduced by the percentage of the partnership's aggregate basis in the property that is allocated to the contributing partner. Thus, if one third of the partnership's aggregate basis in a property is allocated to a contributing partner because the contributing partner has a one- third interest in partnership capital, after the admission of the contributing partner each existing partner's basis (including the contributing partner's pre-existing basis if such partner is also an existing partner) in each property equals the partner's basis (prior to the admission) reduced by one-third.

(iii) DETERMINATION OF AGGREGATE OF PARTNERS' ADJUSTED BASES IN THE PROPERTY -- (A) IN GENERAL. To determine the aggregate of its partners' adjusted bases for purposes of this paragraph (e)(3), the partnership must determine each partner's adjusted basis under either paragraph (e)(3)(iii)(B) (written data) or paragraph (e)(3)(iii)(C) (assumptions) of this section. The partnership is permitted to determine the bases of some partners under paragraph (e)(3)(iii)(B) of this section and of others under paragraph (e)(3)(iii)(C) of this section. For this purpose, a partner's basis in an oil or gas property does not include any basis adjustment under section 743(b).

(B) WRITTEN DATA. A partnership may determine a partner's basis in an oil or gas property by using written data provided by a partner stating the amount of the partner's adjusted basis or depletion deductions with respect to the property unless the partnership knows or has reason to know that the written data is inaccurate. In determining depletion deductions, a partner must treat as actually deducted any amount disallowed and carried over as a result of the 65 percent-of-income limitation of section 613A(d)(1). If a partnership does not receive written data upon which it may rely, the partnership must use the assumptions provided in paragraph (e)(3)(iii)(C) of this section in determining a partner's adjusted basis in an oil or gas property.

(C) ASSUMPTIONS. Except as provided in paragraph (e)(3)(iv)(B) of this section, a partnership that does not use written data pursuant to paragraph (e)(3)(iii)(B) of this section to determine a partner's basis must use the following assumptions to determine the partner's adjusted basis in an oil or gas property:

(1) The partner deducted his or her share of deductions under section 263(c) in the first year in which the partner could claim a deduction for such amounts, unless the partnership elected to capitalize such amounts;

(2) The partner was not subject to the 65 percent-of-income limitation of section 613A(d)(1) with respect to the partner's depletion allowance under section 611; and

(3) The partner was not subject to the following limitations, with respect to the partner's depletion allowance under section 611, except to the extent a limitation applied at the partnership level: the taxable income limitation of section 613(a); the depletable quantity limitations of section 613A(c); the prohibition against claiming percentage depletion on transferred proven property under section 613A(c)(9), prior to its repeal; or the limitations of section 613A(d)(2), (3), and (4) (exclusion of retailers and refiners).

(iv) WITHDRAWAL OF PARTNER OR DECREASE IN PARTNER'S INTEREST -- (A) IN GENERAL. Upon a distribution of money or other property to a withdrawing partner as consideration for an interest in the partnership, the withdrawing partner's adjusted basis in each domestic oil or gas property that continues to be held by the partnership is allocated to the remaining partners in proportion to their proportionate interest in partnership capital or income after taking into account any increase or decrease as a result of the event giving rise to the reallocation. A similar rule shall apply in the case of a diminution of a continuing partner's interest in the partnership.

(B) SPECIAL RULE FOR DETERMINING A WITHDRAWING PARTNER'S BASIS IN THE PROPERTY. If a partnership is required to determine a withdrawing partner's adjusted basis using the assumptions under paragraph (e)(3)(iii)(C) of this section, the partnership may rebut the assumption in paragraph (e)(3)(iii)(C)(3) of this section that the withdrawing partner was not subject to the limitations of sections 613A(d)(2), (3), and (4) (exclusion of retailers and refiners) by demonstrating that the withdrawing partner was subject to the limitations of sections 613A(d)(2), (3), or (4).

(v) EFFECTIVE DATE. The provisions of section 1.613A-3(e)(3)(i) through (iv) are effective for taxable years beginning after May 13, 1991. However, a partnership may elect to apply these provisions to taxable years beginning on or before May 13, 1991.

(4) DETERMINATION OF A PARTNER'S INTEREST IN PARTNERSHIP CAPITAL OR INCOME. For purposes of this paragraph (e), a partner's interest in partnership capital or income is determined by taking into account all facts and circumstances relating to the economic arrangement of the partners. See the factors listed in section 1.704-1(b)(3)(ii).

(5) SPECIAL RULES ON ALLOCATION OF ADJUSTED BASIS TO PARTNERS. An allocation or reallocation of the adjusted basis of oil or gas property is pursuant to this paragraph (e) of this section deemed to be in accordance with the partner's proportionate interest in partnership capital or income for purposes of this paragraph (e) where so provided in section 1.704-1(b)(4)(v). In addition, in connection with a revaluation described in section 1.704-1(b)(2)(iv)(f), the basis of an oil or gas property is allocated among the partners based on the principles used under section 1.704-1(b)(4)(i) of allocating tax items to take into account variations between the adjusted basis of the property and its fair market value. In the case of an oil or gas property contributed to a partnership by a partner, section 704(c) is taken into account in determining the partner's share of the adjusted basis.

(6) MISCELLANEOUS RULES -- (i) Each partner must separately keep records of his or her share of the adjusted basis in each domestic oil or gas property of the partnership, adjust his or her share of such basis pursuant to section 1016 (including adjustments for any depletion allowed or allowable with respect to such property), and use that adjusted basis each year in the computation of his or her cost depletion or in the computation of his or her gain or loss on the disposition (including abandonment) of the property by the partnership.

(ii) The adjusted basis of a partner's interest in a partnership is decreased (but not below zero) pursuant to section 705(a)(3) by the amount of the depletion deduction allowed or allowable to the partner with respect to a domestic oil or gas property to the extent such deduction does not exceed the proportionate share of the adjusted basis of such property allocated to the partner under section 613A(c)(7)(D), as adjusted by the partner after the initial allocation. Section 705(a)(1)(C) does not apply to depletion deductions that are not included in a partner's distributive share under section 702. Accordingly, the adjusted basis of a partner's interest in a partnership is not increased under section 705(a)(1)(C) with respect to depletion of oil or gas properties. See section 1.705-1(a)(2)(iii).

(iii) Upon the disposition of an oil or gas property by the partnership, each partner must subtract the partner's adjusted basis in the property from his or her allocable portion of the amount realized from the sale of the property to determine gain or loss. The partner's allocable portion of amount realized must, except to the extent governed by section 704(c) (or related principles under section 1.704-1(b)(4)(i)), be determined in accordance with section 1.704-1(b)(4)(v). Except as otherwise provided (e.g., section 751), the sale of a partnership interest is not treated as a sale of an oil and gas property.

(iv) In the case of a transfer of an interest in a partnership, the transferor partner's adjusted basis in each partnership oil or gas property carries over to the transferee partner. If an election under section 754 (relating to optional adjustment to the basis of partnership property) is in effect, such basis is adjusted in accordance with section 743.

(v) For purposes of section 732 (relating to basis of distributed property other than money) and section 734(b) (relating to optional adjustment to basis of partnership property), the partnership's adjusted basis in oil and gas property is an amount equal to the aggregate of its partners' adjusted bases in the property as determined under the rules provided in paragraph (e)(3) of this section.

(7) EXAMPLES. The provisions of this paragraph may be illustrated by the following examples:

EXAMPLE 1. A, B, and C have equal interests in capital in Partnership ABC. On January 1, 1990, the partnership acquired a producing domestic oil property. The partnership's basis in the property was $90x. The partnership allocated the adjusted basis of the property to each partner in proportion to the partner's interest in partnership capital. Accordingly, each partner was allocated an adjusted basis of $30x. Each partner must separately compute his or her depletion allowance. The amount of percentage depletion allowable for each partner for 1992 was $10x. On January 1, 1993, each partner's adjusted basis in the property was $20x ($30x minus $10x). On January 1, 1993, the oil property was sold for $150x. Each partner's gain was $30x ($50x allocable share of amount realized minus the partner's adjusted basis of $20x). Each partner must adjust the partner's adjusted basis in his or her partnership interest to reflect the gain.

EXAMPLE 2. The facts are the same as in Example 1 except that on January 1, 1993, the property was not sold but transferred by the partnership to partner A. A's basis in the property was $60x (the sum of A's, B's, and C's adjusted bases in the property).

EXAMPLE 3. The facts are the same as in Example 1 with the exception that in 1990 C was a retailer of oil and gas and was only entitled to a cost depletion deduction of $5x. C's gain from the sale of the mineral property on January 1, 1993, was $25x ($50x allocable share of amount realized minus C's adjusted basis of $25x ($30x minus $5x)).

EXAMPLE 4. D, a calendar year taxpayer, is a partner in Partnership DEF which owns a domestic producing oil property. On January 1, 1993, the partnership's adjusted basis in the property was $900x. On January 1, 1993, D's adjusted basis in D's partnership interest was $300x and D's adjusted basis in the partnership's oil property was $300x. D's allowable percentage depletion for 1993 with respect to production from the oil property was $50x. On January 1, 1994, D's adjusted basis in D's partnership interest was $250x and D's adjusted basis in the partnership's oil property was $250x ($300x minus $50x).

EXAMPLE 5. On January 1, 1993, G has an adjusted basis of $5x in partnership GH's proven domestic oil property, which is the sole asset of the partnership. On January 1, 1993 G sells G's partnership interest to I for $100x when the election under section 754 is in effect. I has a special basis adjustment for the oil property of $95x (the difference between I's basis, $100x, and I's share of the basis of the partnership property, $5x). I is not entitled to percentage depletion with respect to I's distributive share of the oil property income because I is a transferee of an interest in a proven oil property. However, I is entitled to cost depletion and for this purpose I's interest in the oil property has an adjusted basis to I of $100x ($5x, plus I's special basis adjustment of $95x).

EXAMPLE 6. On January 1, 1960, partnership JK acquired a domestic producing oil property. On January 1, 1993, the partnership's adjusted basis in the property was zero. on January 1, 1993, L is admitted as a partner to the partnership.

Since the partnership's adjusted basis in the oil property is zero, L's proportionate share of the basis in the property is also zero. L is not entitled to percentage depletion because L is a transferee of a proven oil property (see paragraph (g) of this section). Since the property's basis is zero, L is also not entitled to any cost depletion with respect to production from the property.

EXAMPLE 7. (i) O and P have equal interests in capital in Partnership OP. On January 1, 1993, the partnership acquired an unproven domestic oil property X the basis of which is $200x to the partnership. The partnership allocates $100x of the basis of the property to each partner in accordance with each partner's proportionate interest in partnership capital. For the 1993 taxable year, O has a $10x cost depletion allowance and P has a $25x percentage depletion allowance. Accordingly, at the end of the 1993 taxable year, O's adjusted basis in the property is $90x, and P's adjusted basis in the property is $75x. On January 1, 1994, Q is admitted as an equal partner. The partnership does not use written data from the partners and must therefore assume that each partner was entitled to $25x depletion based on the assumptions provided in section 1.613A-3(e)(3)(iii). This would result in a $50x combined depletion allowance for the partners and an aggregate adjusted basis in the oil property of $150x. Accordingly, the partnership allocates $50x of the basis of the property to Q, one-third of the aggregate adjusted basis determined by the partnership. O and P must each reduce their basis in the property by one-third. Accordingly, after the admission of Q, O's adjusted basis in the property is $60x ($90x minus $30x), and P's adjusted basis in the property is $50x ($75x minus $25x).

(ii) Assume the same facts as in paragraph (i) of this EXAMPLE 7 except that O informs the partnership that its adjusted basis in the property is $90x (determined without regard to section 613A(d)(1)). The partnership uses the written data provided by O and determines the aggregate adjusted basis in the property to be $165x ($90x + $75X). Accordingly, the partnership allocates $55x (1/3 of $165x) of the basis of the property to Q, and O and P must each reduce their adjusted basis in the property by one-third, as in paragraph (i) of this EXAMPLE 7. Thus, after the admission of Q, O's adjusted basis in the property is $60x and P's adjusted basis in the property is $50x.

(f) S CORPORATIONS. For purposes of section 613A(c)(13), adjustments to shareholders' adjusted bases in any domestic oil or gas property to reflect capital expenditures by S corporations, the addition of a new shareholder or an increase in a shareholder's interest by reason of a contribution to the S corporation, the redemption of a shareholder's interest, or other appropriate transaction shall be made in accordance with principles similar to the principles under section 1.613A-3(e) applicable to the entry or withdrawal of a partner.

* * * * *

(h) * * *

(1) * * * Accordingly, the group shares the depletable oil (or natural gas) quantity prescribed for a taxpayer for the taxable year and the secondary production (to which gross income from the property is attributable before January 1, 1984) of a member of the group will reduce the other members' share of the group's depletable quantity.

* * * * *

(i) * * *

(2) TRANSFERS AFTER OCTOBER 11, 1990 -- (i) GENERAL RULE. Section 613A(c)(9) and (10), as in effect prior to the Revenue Reconciliation Act of 1990 (relating to prohibition of percentage depletion on transferred proven properties) has been repealed effective for transfers after October 11, 1990. Accordingly, a transferee of a proven oil or gas property transferred after October 11, 1990 is permitted to claim percentage depletion with respect to production from the property. For purposes of transfers of property occurring before October 12, 1990 under section 613A(c)(10), prior to its repeal, the disposition of stock after October 11, 1990 by a transferor will not result in a reduction in the depletable quantity of the transferee corporation under section 613A(c)(10)(F).

(ii) TRANSFER. The term "transfer" has the same meaning as under section 1.613A-7(n).

(iii) TRANSFEREE. A person shall not be treated as a transferee with respect to a transferred property to the extent that such person held an interest in the property but was not entitled to a percentage depletion allowance on mineral produced with respect to the property immediately before the transfer. Thus, for example, if a taxpayer who is not entitled to claim percentage depletion on a proven property transfers the property to a partnership for an interest in the partnership, the taxpayer is not a transferee with respect to the property in the hands of the partnership.

(iv) EFFECTIVE DATE. The provisions of paragraph (i)(2) of section 1.613A-3 are effective for transfers occurring after May 13, 1991. However, a taxpayer may elect to apply these provisions to transfers occurring after October 11, 1990 and on or before May 13, 1991.

(v) EXAMPLES. The examples below illustrate the provisions of this subparagraph. The examples ignore the application of any restriction on percentage depletion other than the proven property transfer rule.

EXAMPLE 1. On December 31, 1991, A transfers a proven oil property to B. B may claim percentage depletion with respect to production from the property regardless of whether production from the property was eligible for percentage depletion in A's hands (even if A were a retailer or refiner of oil or gas).

EXAMPLE 2. On October 10, 1990, A transfers a proven oil property to B. B may not claim percentage depletion with respect to production from the property.

EXAMPLE 3. On January 1, 1990, C purchases a proven oil property. Because C is a transferee of a proven property, production from the property is not eligible for percentage depletion in C's hands. On December 31, 1991, C contributes the property to Corporation M, an S corporation in which C owns 100 percent of the stock. The contribution of the property is a transfer, but C is not a transferee with respect to the property in the hands of the corporation. Accordingly, C may not claim percentage depletion with respect to production from the property. However, if prior to the contribution C had been entitled to claim percentage depletion with respect to production from the property, C would be entitled to claim percentage depletion with respect to production from the property after the contribution.

EXAMPLE 4. On December 31, 1991, C contributes a proven oil property (with respect to which C is not entitled to claim percentage depletion) to Corporation N, an S corporation in which C owns 30 percent and D owns 70 percent of the stock. The contribution of the property is a transfer, but C is not a transferee with respect to the property in the hands of the corporation. Accordingly, C may not claim percentage depletion with respect to C's share of the production from the property. D is a transferee with respect to the property in the hands of Corporation N, and may claim percentage depletion with respect to D's share of production from the property.

EXAMPLE 5. On December 31, 1991, D transfers a proven oil property (with respect to which D is not entitled to claim percentage depletion) to DE, an equal partnership between D and E. E is a transferee with respect to the property and may claim percentage depletion with respect to production from the property allocated to E under the DE partnership agreement. D is not a transferee with respect to the property, and may not claim percentage depletion with respect to production from the property allocated to E under the DE partnership agreement. However, if D had been entitled to claim percentage depletion with respect to production from the property, then D would be entitled to claim percentage depletion with respect to production from the property in the hands of DE.

EXAMPLE 6. On January 1, 1990, Corporation P contributes a proven property to Corporation O, its wholly owned subsidiary. Under section 1.613-7(n)(4), the contribution is not treated as a transfer, but only for so long as the tentative quantity is required under section 613A(c)(8) to be allocated between P and O. On December 31, 1991, P sells 90% of the O stock to an unrelated person; accordingly, the tentative quantity is no longer required under section 613A(c)(8) to be allocated between P and O. After the sale of O stock, production from the property in O's hands is eligible for percentage depletion because a transfer of a proven property is deemed to occur upon the transfer of the stock.

EXAMPLE 7. On October 10, 1990, G transfers a proven oil property to his minor son, H. G had been entitled to claim percentage depletion with respect to production from the property. Under section 1.613A-7(n)(5), H is permitted to claim percentage depletion for so long as G and H are related persons under section 613A(c)(8)(C). On December 31, 1991, H reaches majority and is no longer related to G under section 613A(c)(8)(C). H is entitled to continue to claim percentage depletion on production from the property because the property is treated as being transferred to H on December 31, 1991.

EXAMPLE 8. On December 31, 1991, I sells a proven property to J, her husband. L had not been entitled to claim percentage depletion with respect to production from the property. Under section 1.613A-7(n)(5), the sale is not a transfer because it is made between persons related under section 613A(c)(8). Accordingly, J may not claim percentage depletion with respect to production from the property. If, however, I had been entitled to claim percentage depletion with respect to production from the property, J would be entitled to claim percentage depletion with respect to production from the property.

EXAMPLE 9. On December 31, 1991, L inherits a proven property from K. K had not been entitled to claim percentage depletion with respect to production from the property. Under section 1.613A-7(n)(1), the inheritance is not a transfer. Accordingly, L may not claim percentage depletion with respect to production from the property. If, however, K had been entitled to claim percentage depletion with respect to production from the property, L would be entitled to claim percentage depletion with respect to production from the property.

EXAMPLE 10. On December 31, 1991, Corporation R, a calendar year taxpayer, made an S election effective for the taxable year beginning January 1, 1992 and succeeding taxable years. Since Corporation R is deemed to have transferred its oil and gas properties on January 1, 1992, the shareholders of Corporation R are eligible to claim percentage depletion with respect to the production from the properties.

EXAMPLE 11. Assume the same facts as in Example 10 except that Corporation R makes the S election on December 31, 1989, effective for the taxable year beginning January 1, 1990 and succeeding taxable years. Since Corporation R is deemed to have transferred its oil and gas properties on January 1, 1990, the shareholders of Corporation R are not eligible to claim percentage depletion with respect to the production from the properties.

(j) PERCENTAGE DEPLETION WITH RESPECT TO BONUSES AND ADVANCED ROYALTIES -- (1) AMOUNTS RECEIVED OR ACCRUED AFTER AUGUST 16, 1986. In computing the percentage depletion allowance pursuant to section 613A(c) with respect to amounts received or accrued after August 16, 1986, there shall not be taken into account any advance royalty (to the extent that actual production during the taxable year is insufficient to earn such royalty), lease bonus, or other amount payable without regard to production, even though the amount may be taken into account for purposes of sections 61 and 612 (relating to definitions of gross income and cost depletion, respectively).

* * * * *

Par. 6. Section 1.613A-7 is amended as follows:

1. The text of paragraph (e) is added as set forth below.

2. Paragraph (f)(1) is amended by revising the last sentence to read as set forth below.

3. Paragraph (h) is revised as set forth below.

4. Paragraph (n) is amended by adding a sentence immediately following the first sentence to read as set forth below.

5. Paragraph (o) is amended by revising the first sentence to read as set forth below.

6. Paragraph (r)(1), concluding text, is amended by adding a sentence immediately following the first sentence to read as set forth below.

SECTION 1.613A-7 DEFINITIONS.

* * * * *

(e) QUALIFIED NATURAL GAS FROM GEOPRESSURED BRINE. The term "qualified natural gas from geopressured brine" means any natural gas which is determined in accordance with section 503 of the Natural Gas Policy Act of 1978 to be produced from geopressured brine and which is produced from any well the drilling of which began after September 30, 1978, and before January 1, 1984.

(f) * * *

(1) * * * Average daily production does not include production resulting from secondary or tertiary processes to which gross income from the property is attributable before January 1, 1984.

* * * * *

(h) DEPLETABLE OIL QUANTITY. The taxpayer's depletable oil quantity, within the meaning of section 613A(c)(1)(A), shall be equal to the tentative quantity determined under the table contained in section 613A(c)(3)(B) and paragraph (b) of section 1.613A-3 (except that, in the case of determinations with respect to days prior to January 1, 1984, such quantity shall be reduced (but not below zero) by the taxpayer's average daily secondary or tertiary production for the taxable year).

* * * * *

(n) * * * For taxable years beginning after 1982, the term "transfer" includes an election by a C corporation to be an S corporation (properties deemed transferred by the C corporation on the day the election first becomes effective) and a termination of an S election (each shareholder's pro rata share of assets of S corporation deemed transferred to C corporation on the day that the termination first becomes effective). * * *

* * * * *

(o) * * * The term "transferee", as used in section 613A(c)(9), paragraph (i)(1) of section 1.613A-3, and this section includes the original transferee of proven property and his or her successors in interest (excluding successors in interest of "proven property transferred after October 11, 1990). * * *

* * * * *

(r) * * *

(1) * * *

* * * Bulk sales made after September 18, 1982, of aviation fuels to the Department of Defense shall be also disregarded. * * *

* * * * *

Par. 7. Section 1.705-1 is amended by:

1. Revising paragraph (a)(2)(iii) to read as set forth below.

2. Redesignating paragraph (a)(4) as paragraph (a)(6) and adding paragraphs (a)(4) and (a)(5) to read as set forth below.

SECTION 1.705-1 DETERMINATION OF BASIS OF PARTNER'S INTEREST.

(a) * * *

(2) * * *

(iii) The excess of the deductions for depletion over the basis of the depletable property, unless the property is an oil or gas property the basis of which has been allocated to partners under section 613A(c)(7)(D).

* * * * *

(4) The basis shall be decreased (but not below zero) by the amount of the partner's deduction for depletion allowable under section 611 for any partnership oil and gas property to the extent the deduction does not exceed the proportionate share of the adjusted basis of the property allocated to the partner under section 613A(c)(7)(D).

(5) The basis shall be adjusted (but not below zero) to reflect any gain or loss to the partner resulting from a disposition by the partnership of a domestic oil or gas property after December 31, 1974.

* * * * *

Part 602 -- OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par 8. The authority citation for part 602 continues to read as follows:

Authority: 26 U.S.C. 7805.

Par. 9. Section 602.101(c) is amended by adding the entry

"1.613A-3(e).....................1545-1251" to the table.