Key Takeaways:
- Internal Revenue Code Section 754 addresses basis adjustments within partnerships triggered by distributions or transfers of partnership interests, aiming to align inside and outside basis of assets to prevent tax disparities.
- Making an IRC Sec. 754 election allows partnerships to adjust basis, reducing capital gains tax for new partners by stepping up the inside cost basis.
- The election must be filed with the partnership’s tax return, applies to all relevant transactions in the tax year and subsequent years, and can only be revoked with permission from the commissioner. Late relief for failing to make the election is possible under certain conditions.
Sec. 754 Aligns Tax Treatment Within Partnerships on Triggering Events
Internal Revenue Code Section 754 deals with the complex issues that arise in connection with assets held within a partnership. Specifically, Sec. 754 allows a partnership to adjust the basis of property held within the partnership when one of two triggering events occurs – a distribution of partnership property or transfer of a partnership interest.
The purpose of Sec. 754 is to avoid incongruent tax treatment of assets that may occur when partners leave or new partners join, and the assets – which typically include real estate – experience significant changes in value.
Sec. 754 also has the effect of aligning the “inside” and “outside” basis of partnership assets. Inside basis refers to the basis that applies to the partnership as a whole, while outside basis refers to the basis that is apportioned to each partner.
To illustrate the issues that arise, consider a partnership with four founding members – A, B, C and D. Each partner initially pays $250,000 into the partnership for a total capitalization of $1 million. The partnership purchases land worth $800,000 and another $200,000 in assets. So the inside basis of the partnership is $1 million and the outside basis for each partner is $250,000.
But two years later, the value of the land and assets has appreciated to $1.4 million, meaning even though the fair market value of the partnership’s assets has increased, the basis of those assets remains at $1 million (inside) and $250,000 for each partner (outside).
Now Partner A has decided to leave the partnership. With the appreciation in asset value, the value of A’s share is now $350,000. A new partner, E, will join the partnership and must pay $350,000 – the current fair market value – to get in. After the sale, a disparity has been created between E’s inside and outside basis. Consequently, E now has a capital account that is different than his tax basis.
Differing inside and outside basis can have significant impacts on the timing and character of gains and losses recognized by partners, resulting in incongruent tax treatment.
IRC Sec. 754 Election
An IRC Section 754 election would allow the partnership to adjust the basis of the property within the partnership under IRC Sections 734(b) and 743(b). These adjustments can only be made if the partnership has made an election under IRC Section 754.
When a Sec. 754 election is made, the partnership steps up the inside cost basis – but only for the new partner. This balances the inside cost basis and outside cost basis and reduces the capital gains tax when a property that has appreciated is sold.
The adjustment in the basis of the assets of the partnership is equal to the transferee partner’s initial basis in the partnership, less their proportionate share of the adjusted basis of the partnership assets.
To make the election, a partnership must attach a statement to the partnership’s tax return for the tax year during which a distribution or transfer occurs. The statement must include (1) the name and address of the partnership, and (2) a declaration that the partnership elects under IRC Section 754 to apply the provisions of IRC Sections 734(b) and 743(b). The election applies to all distributions and transfers during the tax year with respect to which the election is initially filed, and to all such transactions in any subsequent years. It cannot be revoked without permission from the commissioner.
If the partnership fails to make the election, it can file for late relief under Treasury Regulation Section 301.9100-2, which is an automatic 12-month extension for IRC Sec. 754 elections. If more than 12 months have passed, late relief can still be requested but must be approved by the commissioner.
Once the election is made, it can only be revoked with permission of the commissioner.
If you have questions or concerns about the tax treatment of assets held by your partnership, contact your KRD advisor.
