Partnership Basis Adjustments Under
Internal Revenue Code Section 754
Risë Flenner, CPA/PFS, JD
Tax Partner
November , 2014
Background Example
• D&D, LLC formed January 1, 2003
• Dumb and Dumber each put in $250,000 cash
• Purchased Prime Ocean Front Property in Arizona for
$500,000
• January 1, 2006 property has appreciated to $1,000,000.
Background Example (continued)
• Dumber sells interest to Dumbest for $500,000
• D&D’s CPA firm, Larry, Moe & Curly, LLC, make no mention of
a 754 Election
• Partnership then sells land for $1,000,000 on February 1, 2007
Background Example (continued)
• Gain on sale is $500,000, split 50/50 each
• Dumbest’ outside basis now $750,000 ($500,000 purchase
price plus allocated gain of $250,000)
• Partnership liquidates on July 1, 2007
Background Example (continued)
• Cash split 50/50 per operating agreement and 704 principles
• $500,000 to Dumbest
• Dumbest recognizes a $250,000 capital loss
• Dumbest fires and sues Larry, Moe and Curly, LLC
Background Example (continued)
Dumb
Dumbest
Initial Investment
250,000
500,000
Value of P’ship assets
on date of investment
250,000
500,000
Tax Basis
Outside Basis
500,000
750,000
Basis in Partnership
Property
500,000
500,000
Today’s Agenda
• Overview
• 734 Adjustments
• History/Background
• 755 Allocations
• Purpose
• Top 10 Mistakes
• 754 Election
• Examples
• 743 Adjustments
Overview
Applicable Code Sections:
•754 – Election (to make a basis adjustment)
•734 – Basis Adjustments for
Distributions
•743 – Basis Adjustments for Sales
or Exchanges
Overview (continued)
Applicable Code Sections:
•755 – Allocation of Basis
Adjustments under 734 or 743
History
Prior
to
1954:
• Case law only
• No basis adjustments allowed
• Entity approach – From Henry
W. Healy v. Commissioner:
• “Partnership property
belongs to the partnership
and not to the partners.”
History (continued)
What Changed?
• Implementation of the Internal Revenue
Code of 1954; added Code Sections 734,
743, 754 and 755.
• Aggregate Approach – Think in terms of
a partner’s share of partnership assets
Purpose / Theory
Seek to maintain equilibrium between inside and
outside basis
Operates from a true aggregate approach
(particularly the 743 adjustment – sale or exchange)
• As if the purchasing partner were purchasing his or her share of
the underlying partnership assets
Entity Approach Remnant – Election still made by
partnership itself and is applicable to all partners
754 Election
Attach Statement:
• Name and address of partnership
• Signed by partner (covered by 8879 if efiling)
• Contain declaration electing under 754 to apply provisions of 734(b) and
743(b)
Make on timely filed return including extensions
Automatic 12-Month Relief under Reg. 301.9100-2(a)(2)(vi)
Permanent election (can only be revoked with permission of IRS)
743 Adjustments
• Covers Transfers of Interests:
– Sale or Exchange
– Death of Partner
• Exchanges include:
– Deemed distribution under 708(b)(1)(B) (technical
termination)
– Where transferee basis determined in reference to
transferor’s basis:
• Partnership interest contributed to corp. (tax-free re-org.)
• Partnership interest contributed to partnership
743 Adjustments – Calculation
Compare transferee’s basis in partnership
interest (outside basis) to his/her share of
basis in partnership property (inside basis)
• If outside basis > inside basis…step-up
• If inside basis > outside basis…step-down
Only applies to transferee partner
743 Adjustments – Calculation
(continued)
Transferee’s Basis
in Partnership
Interest –
• Purchase – The purchase price plus share of
liabilities
• Inherited – FMV date of death plus share of
liabilities
• Substituted Basis - Carryover
Transferee’s Share
of the
Partnership’s
Adjusted Basis in
its Property –
• Transferee’s share of previously taxed capital
plus share of partnership liabilities
743 Adjustments – Calculation
(continued)
Previously
Taxed Capital
– Hypothetical
Sale
• Transferee’s share of cash from sale of
assets (FMV)
• Plus tax loss allocated to transferee
• Minus tax gain allocated to transferee
Layman’s
Terms – IF:
• Partnership formed through
contribution of cash only and
• No prior ownership changes, then
• PTC will equal the tax capital account.
743 Adjustments – Other
Considerations
Subsequent Transfers – Prior Adjustments Removed from
Calculations
Technical Terminations:
• Election can be made in final or initial return (produces different allocation
results)
• Basis adjustments in existence as of final return carry over to new partnership
Adjustments only made to basis of transferee share of property
and not to the common basis of partnership property
743 Adjustments – Other
Considerations (continued)
Adjustments should not impact transferee capital account
(1.743-1(j)(2))
Recovery of adjustment – increase:
• As if new asset depreciated with any applicable recovery period and method
• Section 179 – Yes?
• Bonus – Likely no
Recovery of adjustment – decrease:
• Over remaining life of related asset
743 Adjustments – Other
Considerations (continued)
Statement of Adjustment:
•Name and taxpayer ID for
transferee
•Computation of adjustment
•Properties to which adjustment
allocated
743 Adjustments – Other
Considerations (continued)
Notification of Partnership (sale):
• In writing within 30 days of sale
• Signed under penalties of perjury
• Include names and addresses of transferee
and transferor including TIN’s and relationship
of parties
• Date of transfer
• Liabilities assumed and money paid
743 Adjustments – Other
Considerations (continued)
Notification of Partnership (death):
• In writing within 1 year of death
• Signed under penalties of perjury
• Include names and addresses of deceased partner
and transferee including TIN’s and the relationship
of the parties
• Date of death and date transferee became owner
• FMV of partnership interest and manner of
determining FMV
743 Adjustments – Other
Considerations (continued)
Notification of Partnership – If not received:
• It’s ok if partner responsible for returns has knowledge of
such transfer
• If partner knows of transfer, but does not receive necessary
info to calculate adjustments must file return with the
following:
• Statement containing transferee’s name and ID
• Include the following statement “RETURN FILED
PURSUANT TO §1.743-1(k)(5).” on top of page 1 of the
return and any other schedule of transferee relating to
their income, deductions, credits, etc.
734 Adjustments
Arise From Distributions
Types:
1. Cash Distributions – 731(a)
• Liquidating Distributions (gain or loss recognition)
• Non-liquidating Distributions (potential gain recognition)
• Gain Recognition: Step-Up
• Loss Recognition: Step-Down
734 Adjustments (continued)
Types:
2. Other Property Distributions – 732
• Excess of adjusted basis of property (inside basis) over
adjusted basis of partnership interest (outside basis):
step-up (liquidating or non-liquidating)
• Excess of adjusted basis of partnership interest
(outside basis) over adjusted basis of property (inside
basis): step-down (liquidating only)
734 Adjustments – Other
Considerations (continued)
Attach Statement of Adjustment:
• Computation of adjustment
• Properties to which adjustment
allocated
734 Adjustments – Other
Considerations (continued)
Adjustments allocable to all partners
Adjustments will impact remaining partner capital
accounts
When distributing non-cash property, partnership
needs to know partner’s outside basis
734 Adjustments – Other
Considerations (continued)
Recovery of adjustment – increase:
• As if new asset depreciated with any applicable
recovery period and method
• Section 179 – Yes?
• Bonus – Likely no
Recovery of adjustment – decrease:
• Over remaining life of related asset
755 Allocations
According to code section 755, adjustment
shall be allocated in 1 of 2 ways:
• In such a way as to reduce difference between FMV
and adjusted basis of partnership properties or
• Any other way permitted by regulations
755 Allocations (continued)
“It may be useful to think of the goal of the
Section 755 regulations, in the case of nonsubstituted basis exchanges… as being to put
the transferee partner in a position where no tax
gain or tax loss would be allocated to the
transferee partner if any partnership asset was
sold for its fair market value immediately
following the transferee’s acquisition of the
partnership interest.” Brian Knudson @ SFTI
755 Allocations (continued)
Three Basic Steps:
1. Determine value of partnership assets
2. Allocate Basis Adjustment between two
classes of property:
a. Capital gain property (capital assets and section
1231(b) property)
b. Ordinary income property (all other)
3. Allocate Basis Adjustment within each class
755 Allocations – Nonsubstituted Basis Transactions
Determine Value of Partnership Assets:
I. For trade or business – Use Residual Method (see
principles under Section 1060):
A.
B.
C.
Determine value of assets other than 197 intangibles
(facts and circumstances – generally same as used in
hypothetical sale under section 743)
Determine Partnership Gross Value – generally purchase
price or DOD value
Determine value of 197 intangibles:
1.
2.
If “A” > “B”, then nothing assigned to 197 intangibles
If “B” > “A”, then excess represents 197 intangibles, first to other
than goodwill/going concern with balance to said goodwill/going
concern
755 Allocations – Non-substituted
Basis Transactions (continued)
Determine Value of Partnership Assets:
II. For other than trade or business (i.e.
investment type companies – no goodwill):
–
Determine value of assets – based on facts and
circumstances – presumably same values as
used in hypothetical sale in section 743
755 Allocations – Non-substituted
Basis Transactions (continued)
Allocate Basis Adjustment Between Two Classes:
Hypothetical Transaction – After transaction, sell all
property at FMV and allocate g/l accordingly:
• Ordinary property – all adjusted to FMV
• Capital Gain – Total 743(b) adjustment less
portion allocated to ordinary
If no purchase premium or discount, then both
types of property (ordinary and capital) are
adjusted to FMV
755 Allocations – Non-substituted
Basis Transactions (continued)
Allocate Basis Adjustment Within Ordinary Class:
Gain/Loss for each property from Hypothetical
Transaction
755 Allocations – Non-substituted
Basis Transactions (continued)
Allocate Basis Adjustment Within Capital Class:
1. Gain/Loss for each property from Hypothetical
Transaction
2. Adjusted for Premium or Discount purchase
price (allocated on relative FMVs)
For trade or business, any premium would be
allocated to goodwill or other 197 intangibles under
1.755-1(a)(5). For investment partnership, any
premium would be allocated to capital assets as
described above using relative FMV.
755 Allocations – Non-substituted
Basis Transactions (continued)
This methodology allows for step-ups to some assets and
step-downs for other assets regardless of whether there is
an overall step-up or step-down. This is even the case if
there is an overall $0 adjustment.
Original regs only allowed individual asset adjustments in
the same direction as the overall adjustment unless
permission obtained from IRS.
• This methodology continues on with Substituted Basis Transactions and
734(b) adjustments
755 Allocations – Substituted
Basis Transactions
• What gives rise to Substituted Basis
Transactions?:
– Situation 1 (Reg. 1.755-1(b)(5)(i)) –
• Prior sale or death occurs
• No 754 election at that time
• At a later date when there is a 754 election in place:
– Partner contributes interest in LTP to UTP in section 721
contribution or
– Partner contributes interest in partnership to corporation in
section 351 exchange
– Situation 2 – Technical Termination (Reg. 1.761-1(e))
755 Allocations – Substituted
Basis Transactions (continued)
IF ADJUSTMENT IS $0, STOP!!!!
NOTHING TO ALLOCATE
Partnership Basis Adjustments
Polling Question #3
• True or False – In a situation where a
partnership interest is sold and the overall
Section 743 adjustment is $0, you can stop
and not worry about the 755 allocation.
755 Allocations – Substituted
Basis Transactions (continued)
Determine Value of Partnership Assets:
I. For trade or business – Use Residual Method
(see principles under Section 1060):
A. Determine value of assets other than 197 intangibles
(based on facts and circumstances)
B. Determine Partnership Gross Value – value of
partnership as a going concern
C. Determine value of 197 intangibles:
1.
2.
If “A” > “B”, then nothing assigned to 197 intangibles
If “B” > “A”, then excess represents 197 intangibles, first to
other than goodwill/going concern with balance to said
goodwill/going concern
755 Allocations – Substituted
Basis Transactions (continued)
Determine Value of Partnership Assets:
II. For other than trade or business (i.e.
investment type companies – no goodwill):
–
Determine value of assets – based on facts and
circumstances – presumably same values as
used in hypothetical sale in section 743
755 Allocations – Substituted
Basis Transactions (continued)
Allocate Basis Adjustment Between Two Classes:
• Only one class matches overall direction:
– Step-up – only allocate to ordinary or capital gain property
if there is net gain from a hypothetical sale of partnership
property (i.e. net excess of basis in partnership interest
over basis in partnership property)
– Step-down – only allocate to ordinary or capital gain
property if there is net loss from a hypothetical sale of
partnership property (i.e. net excess of basis in partnership
property over basis in partnership interest)
755 Allocations – Substituted
Basis Transactions (continued)
Allocate Basis Adjustment Between Two Classes:
• Both classes match direction of 743(b) adjust.:
– Allocate between classes based on relative gain or
loss (determined by sale of all assets in each class)
755 Allocations – Substituted
Basis Transactions (continued)
Allocate Basis Adjustment Within a Class:
1. Increases:
A.
B.
2.
To properties with unrealized appreciation to the extent of
appreciation
Excess amongst all properties in class in proportion to fair market
value of assets
Decreases:
A.
B.
To properties with unrealized depreciation to the extent of
depreciation
Remaining decrease amongst all properties in class in proportion to
their adjusted bases (incl. adjustments from “A”).
**Cannot adjust basis below $0; excess creates carryover pending
purchase of similar property in future
755 Allocations – Substituted
Basis Transactions
• 754 Planning Idea!
– What if you miss the 754 election?
– Have partner contribute interest in the
partnership to another partnership creating a
substituted basis transaction and make 754
election in current year.
– You will not end up with the same allocation but
will still get a step-up.
755 Allocations – 734 Adjustments
Determine Value of Partnership Assets:
Same as substituted basis transactions
Allocate Basis Adjustment Between Two Classes:
1. Cash distribution – capital gain property
2. Non-cash distribution:
– One Property – allocated to remaining property of similar character
– Multiple Properties – Follow the lead of how basis allocated to
distributee under 732(c) rules. These rules often result in difference
being allocated to capital gain property. If so, basis adjustment would
go to capital gain property for partnership as well.
3.
Liquidating – Often capital
755 Allocations – 734
Adjustments (continued)
Allocate Basis Adjustment Within The Classes:
• Increases:
• To properties with unrealized appreciation in proportion to their
respective unrealized appreciation (only to extent of appreciation)
• In excess of appreciation, in proportion to FMVs
• Decreases:
• To properties with unrealized depreciation in proportion to their
respective unrealized depreciation (only to extent of depreciation)
• In excess of depreciation, in proportion to adjusted bases
(including effects of first step).
755 Allocations – 734
Adjustments (continued)
Allocate Basis
Adjustment Within
The Classes:
•If decrease
exceeds basis,
carryover excess
Mandatory Adjustments
734
Adjustments – • If negative adjustment
Substantial Basis
exceeds $250,000
Reduction:
743
Adjustments –
Substantial
Built-In Loss:
• Partnership Adjusted Basis
in Assets exceeds FMV by
more than $250,000
Top 10 Mistakes
1. Making adjustment for 721 Contributions
2. Overlooking mandatory step-down provisions
3. Misunderstanding mandatory step-down
provision for “substantial built-in losses” under
743
4. Recording basis adjustment from 743 transfer on
partnership’s books
5. Neglecting to maintain original 754 election in
perm files
Top 10 Mistakes (continued)
6. Timely filing of Election
7. Election is made in year without a qualifying
event
8. Technical Termination – Consider options of
filing with final or initial return
9. Not realizing that the allocations under 755
differ between 743 and 734 adjustments
10.Adjustments with negative capital balances
Questions