Q UA R T E R LY
W E A LT H CO U N S E L
VOLUME 9 / NUMBER 3
Q3 2015
TA X AT I O N
QUARTERLY
When used properly, an IRC §754 election can be an important tool for an estate planning or business planning
attorney. It can make a big difference in the tax burden of a company’s partners and should be given consideration whenever there is a sale of a partnership interest, a death of a partner, or disproportionate distributions.
However, due to the binding nature of the election and its potential to affect future tax liability, the election
should only be made after a thorough evaluation of the pros and cons.
Effective Tax Planning
For Partnerships:
UNDERSTANDING THE IRC §754 ELECTION
ELLIOT P. SMITH, JD, MACC, MS, CPA, WEALTHCOUNSEL MEMBER SINCE 2013
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THE ELECTION
TAX BASIS OF PARTNERSHIP ASSETS
An election under Internal Revenue Code (“IRC”) §754 (“INSIDE BASIS”)
saves income taxes by increasing the tax basis of assets owned by a partnership. The election reduces the
difference between a partner’s high tax basis in his or
her partnership interest and the partnership’s low tax
basis in his or her share of the partnership’s assets.
Often this election can save a client significant money.
It should never be overlooked when working with any
entity that files IRS Form 1065.
Let’s start with the basics. Two great prongs of partnership taxation are: 1) the “outside basis,” or the adjusted basis of a partnership interest held by the partner; and 2), the “inside basis,” or the adjusted basis of
the assets held by or “inside” the partnership.
TAX BASIS OF PARTNERSHIP INTEREST
(“OUTSIDE BASIS”)
Outside basis is roughly comparable to a shareholder’s tax basis in corporate stock. However, it’s not that
simple because a corporation is a tax-paying entity
and a partnership is a pass-through entity: Partners
incur the tax liability instead of the partnership. Differences include increasing a partner’s outside basis
for contributions plus his or her share of income and
decreasing his or her outside basis for distributions
and losses.
For example, suppose Partner A contributes $20 to
a new partnership and during the first year of operation he is allocated $5 of taxable income. The $5 of
taxable income is reported to him on a Schedule K-1
and ends up on his personal Form 1040. For simplicity, also assume that the partnership has no debt and
no contributions or distributions were made by or to
Partner A during the tax year. Partner A’s outside basis would increase from $20 to $25 because of the $5
of taxable income. If Partner A subsequently sells his
partnership interest for $25, he would recognize zero
gain because his outside basis would equal the sales
price. This increase in outside basis prevents a partner from suffering the pain of double taxation – which
would occur with a C-corporation paying taxes on its
income followed by the shareholder paying taxes on
his $5 stock sale.
Inside basis is a partner’s share of the tax basis of the
partnership’s assets. Examples include inventory, accounts receivable, machinery, and goodwill. Generally,
fixed assets such as furniture and machinery are depreciated over a period of years providing significant
tax deductions. Purchased intangibles such as goodwill can also provide amortization deductions. However, these depreciation and amortization deductions
can only be taken if the inside assets have a tax basis.
Once the tax basis is exhausted, no further deductions can come from that particular asset. And, upon
the sale of a partnership asset with a high inside basis, less gain or additional loss passes through to the
partners.
RELATIONSHIP BETWEEN INSIDE AND
OUTSIDE BASIS
Due to adjustments to a partner’s outside basis based
on income, expense, contributions and distributions,
the tax basis of assets inside the partnership often
equals the partners’ aggregate outside bases. In the
previous example, the partnership realized $5 of income; simultaneously we observed an increase in
Partner A’s outside basis. The result is that both A’s
outside basis and A’s share of the inside basis equal
$25 prior to the sale of Partner A’s partnership interest. Several events, however, can cause a disparity between inside and outside basis: (1) the sale of a
partnership interest, (2) certain distributions from the
partnership, and (3) the death of a partner. The IRC
§754 election works to reduce these disparities so
that a partner’s outside basis comes closer to matching her share of the inside basis of the partnership assets. On a slightly deeper level, an IRC §754 election
also causes the tax equity account on a tax balance
sheet to equal a partner’s outside basis when added
to the partner’s share of liabilities.
SECTION 754 AND THE SALE OF
PARTNERSHIP INTEREST
The sale of a partnership interest is frequently the
reason for making an IRC §754 election. Often, a purPAGE
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chaser seeks to obtain the same tax benefit that he
would receive if assets were purchased outright rather
than indirectly as part of a partnership interest. If no
election is in effect, nothing happens at the partnership level and the purchaser does not get the benefit
of the depreciation, amortization, and/or decreased
gain which (in all fairness) should have been his. However, with an IRC §754 election in place, the tax basis
of the assets inside the partnership are adjusted according to IRC §743(b) so the aggregate inside basis
of the purchaser’s share of assets generally equals the
purchase price for the partnership interest.
One of the most important assets to consider when
evaluating whether to make an IRC §754 election is
goodwill. According to IRC §197, goodwill only has an
amortizable tax basis if it has been purchased. Otherwise the tax basis of goodwill is zero. However, if an
IRC §754 election is in effect at the time of purchase
there is often a significant increase in the tax basis of
the goodwill, which could then be amortized over a
15-year period.
Also, an IRC §754 election only impacts the partner
who paid real money to the old partner for her interest in the partnership. Any corresponding depreciation, amortization, or other benefit (or detriment) will
be included in the new partner’s distributive share of
income or loss. That is, any adjustment made to the
inside basis of partnership assets under IRC §743(b)
due to a sale of partnership interest makes no difference for the other partners in the partnership.
SECTION 754 AND PARTNERSHIP
DISTRIBUTIONS
An IRC §754 election also affects the tax basis of the
assets inside the partnership when certain distributions from a partnership occur. And, in marked contrast with the solitary impact on the one partner who
buys her partnership interest, distribution-based adjustments affect all of the partners who remain in the
partnership.
However, not all distributions from a partnership
cause a tax basis adjustment under the election. According to IRC §734(b), in order for a distribution to
cause inside basis to be adjusted as a result of the
IRC §754 election, a distribution from a partnership
must either (i) cause the partner receiving the asset
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to recognize gain or loss from the distribution, or (ii)
change the basis of a distributed asset.
Generally, under IRC §732, when an asset is distributed from a partnership, the partner’s outside basis
is decreased by the tax basis of the distributed asset.
For example, if the partner’s outside basis is $50 and
machinery with a tax basis of $12 is distributed, the
partner’s outside basis would decrease by $12 to $38.
The partner would then hold the machinery outside
the partnership with a $12 tax basis. Sometimes, however, a partner does not have sufficient outside basis
to absorb the tax basis of an asset being distributed.
If cash and marketable securities were distributed in
excess of the partner’s outside basis a gain would result equaling the excess amount. If an IRC §754 election has been made the resulting gain would cause
an increase of the tax basis of the remaining assets
inside the partnership.
In a similar situation where assets other than cash and
marketable securities are also distributed from a partnership, a partner’s outside basis is first decreased by
the cash distributed, and then any remaining outside
basis is allocated to the non-cash assets based on
their relative market values. If cash and other property is distributed together and the cash exceeds the
partner’s outside basis a gain would result and there
would be zero basis to allocate to the other property.
The consequence of such distribution is that the distributed assets end up with a new basis less than they
had inside the partnership. This situation would cause
an adjustment under IRC §734(b) if an IRC §754 election was in effect so that the tax basis of assets inside
the partnership would be increased – for the benefit
of all partners – by the same amount the distributed
asset basis was decreased.
A distribution could also cause an increase in the basis of distributed assets. This could occur only upon a
liquidating distribution when a partner’s outside basis is greater than the tax basis of the assets being
distributed. In this situation, the distributed assets assume the entire amount of the partner’s outside basis. If an IRC §754 election is in effect, the tax basis
of assets remaining inside the partnership would be
reduced by an amount equal to the excess of the partner’s outside basis over the inside basis of the assets
immediately prior to the distribution.
But what happens when a partner recognizes loss
on a distribution? A loss could only occur upon a liq-
VOLUME
9 NUMBER 3 / Q3 2015
uidating distribution when a partner fully exits the
partnership, and when the departing partner gets
cash and marketable securities (and no other assets)
which equal less than the partner’s outside basis. The
result of the loss if an IRC §754 election is in effect is
an increase in the tax basis of the assets inside the
partnership.
be an important estate planning tool because it can
be made after the death of a partner so long as an
election statement is filed along with a timely filed
partnership tax return in the subsequent year.
SECTION 754 AND DEATH OF A PARTNER
IRC §755 and the corresponding regulations govern
the allocation of the tax basis adjustments which result under IRC §743(b) and IRC §734(b) if an IRC §754
election is in effect. However, the process is slightly different depending on whether the adjustment is due to
a sale or exchange or transfer on death or whether the
adjustment is as a result of a distribution.
If an IRC §754 election is in effect for the year of a
partner’s death, a proportionate share of inside basis
would also be adjusted in tandem with any tax basis adjustment under IRC §1014(a). Similar to sales or
exchanges, the adjustment of inside basis following
the death of a partner is governed by IRC §734(b)
and benefits only the successor partner who inherits
the partnership interest. The IRC §754 election can
SECTION 755 ALLOCATION OF
ADJUSTMENT TO SPECIFIC ASSETS
Adjustments that result under IRC §743(b) from the
sale or exchange or from a transfer of a deceased
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partner’s interest are treated similarly. First, the adjustment is divided into two different buckets: (i)
ordinary income producing property such as inventory and accounts receivable and (ii) capital gain plus
IRC §1231 property (real estate or depreciable property used in a trade or business for more than one
year). Generally, an amount equal to the built-in net
gain or loss is first allocated to the ordinary income
producing property (up to its market value), with any
remainder allocated to the capital gain and IRC §1231
property. This method of separation into the two different groups causes any discount or premium on the
purchase of the partnership interest to be allocated to
the capital gain bucket rather than the bucket of ordinary income producing assets. Once the allocation
between the two different asset buckets occurs, allocation within the two different buckets takes place
based on the amount of gain or loss that would occur
if the assets were sold for market value.
Conversely, under IRC §734(b), any adjustment occurring as a result of gain or loss recognized as a result of a distribution is only allocated to capital gain
bucket. Once in the capital gain bucket, the adjustment is further allocated based on the relative value
of each of the assets. Any adjustment occurring as a
result of a change in the tax basis of the distributed
assets is allocated between the two different buckets
based on the type of asset distributed. For example,
if inventory is distributed and assumes a smaller tax
basis outside the partnership, only the tax basis of the
partnership’s ordinary assets, such as inventory and
accounts receivable inside the partnership, would be
adjusted.
A DOUBLE-EDGED SWORD
Although an IRC §754 election can provide a positive
tax benefit, it can also have a detrimental effect if the
value of the partnership decreases in the future. If time
passes after a partnership makes an IRC §754 election
and the value of the partnership is lower than the tax
basis of the assets inside the partnership, any sale or
exchange, distribution, or transfer upon the death of a
partner could cause the tax basis of assets inside the
partnership to decrease. Due to the often hazy nature
of future values, making an IRC §754 election should
be done with caution.
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ADMINISTRATIVE CONCERNS
For partnerships that have significant partner turnover, the IRC §754 election can cause significant burden and expense due to the fact that the partnership
must maintain separate tax basis records for each
partner. That’s because the partnership must maintain separate tax basis records for each partner. These
additional records often cause complexity, increased
risk for error on the tax return and must be balanced
against any tax savings from making the election.
TECHNICAL TERMINATION
IRC §708(b) is also a valuable statute that can be
used in conjunction with an IRC §754 election when
50 percent or more of the total interest in partnership capital and profits is sold or exchanged within
a 12-month period. This is because the sale of such
interest causes a partnership to terminate for tax purposes and a new partnership is deemed to be formed.
Under IRC §708(b) the old partnership is treated as
contributing all of its assets and liabilities to a new
partnership in exchange for the new partnership interest. The old partnership is then deemed to liquidate
and distribute its only asset, which is the new partnership interest, to the new partners. This is important
because the old partnership files a final tax return and
none of the elections of the old partnership are applicable to the new partnership. If an IRC §754 election
is made on the old partnership final return the assets
inside the partnership could be stepped up to reflect
the purchase price without having future uncertainty.
The new partnership would simply take the assets
with the increased basis and have no IRC §754 election in place to cause future unwanted results.
MAKING AND REVOKING THE ELECTION
An IRC §754 election is made by attaching a statement to the IRS Form 1065 that is filed for the taxable
year in which the election first applies. The election is
a partnership election and not a partner election. This
distinction is important because the election affects
all the partners in a partnership and a partnership can
only revoke the election by receiving special approval
from the IRS, which is only granted under special circumstances.