Tax Effects on Partnership and Limited Liability Company Interests

Using Section 754 Elections to Enhance Value and Marketability

By Paul J. Streer and Caroline D. Strobel

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Alternatively, the partnership (or LLC) can make an IRC section 754 election to equalize a new partner’s outside and inside basis. This election can enhance the value of a partnership interest and make it more marketable. Making the election has no immediate positive impact on the continuing partners’ interests. A section 754 election does impose administratively burdensome recordkeeping requirements on the partnership and can negatively affect the basis of partnership property in the future.

Section 754 elections are a complex area of the IRC, and this article is intended as an introduction to the basic concept. Because of potentially conflicting interests, advising the purchasers, partnerships, and continuing partners requires care and caution.

Example

Assume that Mr. S is negotiating to purchase a one-third interest in the ABC Partnership from Partner C. The partnership has the following abbreviated balance sheet:

Partner C agrees to sell her one-third interest for $255,000 (one-third of the partnership’s FMV). C expects Partner S to pay $205,000 in cash and assume C’s one-third share of partnership liabilities. Thus, if the sale occurs, S will have an outside basis for his partnership interest of $255,000 ($205,000 + $50,000). However, his share of the partnership’s basis for its assets (his inside basis) is only $135,000 (one-third of $405,000). This $120,000 basis disparity ($255,000 – $135,000) will deprive him of depreciation deductions on the equipment. In addition, if the land is sold, S’s share of the taxable gain will be artificially inflated. If the land is immediately sold for its fair market value of $600,000, S’s share of the partnership gain recognized will be $100,000 [ !d x ($600,000 – $300,000)], even though S has no economic gain because his outside basis of $255,000 (the amount he paid for his partnership interest) includes his one-third share of the land’s fair market value ($200,000).

Including the $100,000 gain in S’s share of partnership income will benefit him by increasing his outside basis accordingly [IRC section 705(a)(1)(A)], but this will not provide a tax benefit in the form of a smaller recognized gain or a larger recognized loss until he disposes of his partnership interest at some future date. If the time horizon for disposition is substantial, the present value of this future benefit to S will be minimal.

On the other hand, if the partnership makes a section 754 election, S’s inside basis will equal his outside basis of $255,000 [IRC section 743(b); S’s optional basis adjustment is $120,000 (i.e., $255,000 – $135,000); the technical determination of the adjustment is more complex and beyond the scope of this article]. He will have an inside basis for his share of the land of $200,000. This consists of his $100,000 one-third share of the common partnership basis plus his $100,000 section 743(b) optional basis adjustment. (The IRC section 754 election triggers the application of IRC section 743, which provides the incoming partner with an optional basis adjustment—here, the $120,000 difference between S’s inside and outside basis. IRC section 755 specifies the rules for allocating the incoming partner’s basis adjustment to particular assets.)

The Impact of the Section 754 Election

To continue the example, assume that the partnership makes the IRC section 754 election. Making the election invokes the application of both IRC sections 743(b) and 734(b). Section 743(b) provides for an optional basis adjustment that directly affects only an incoming partner.

It requires the partnership to allocate the basis adjustment to its assets and separately compute the incoming partner’s annual share of depreciation and gain or loss from the sale of its property. For example, S’s share of annual depreciation is calculated using a $40,000 adjusted basis. S’s adjusted basis is computed using his $20,000 one-third share of the partnership’s basis in equipment plus his $20,000 share of the section 743(b) optional basis adjustment allocable to the equipment [see IRC Section 755(a)].

IRC section 734(b) also comes into play in a section 754 election. Section 734(b) will cause an upward or downward adjustment to a partnership’s basis for its remaining property following a disproportionate distribution of cash or other property to one or more partners. These adjustments affect all remaining partners, but accurately predicting whether these future adjustments will be beneficial or detrimental is usually difficult.

Once made, the section 754 election can be revoked only with the IRS’ consent. The application for revocation must be filed no later than 30 days after the close of the partnership tax year for which the revocation is intended to take effect and it must set forth the grounds for which the revocation is desired [Treasury regulations section 1.754-1(c)]. In cases where failure to meet the deadline was inadvertent, the IRS has granted an extension of the time within which to file the revocation (IRS Letter Ruling 200112023). Consent to revoke a section 754 election is not automatically granted. For example, the potential decrease in the basis of partnership property upon either the transfer of a partnership interest or the distribution of partnership property would be insufficient to grant a revocation request. Valid reasons for approving such a request include: a change in the nature of the partnership business; a substantial increase in the number of assets in the partnership; a change in the character of partnership assets; or an increased frequency of retirements or ownership shifts. Any of these situations can impose an increased administrative burden on the partnership as a result of having the election in place [Treasury Regulations section 1.754-1(c)]. Because there is no assurance that a section 754 election will not be detrimental to the continuing partners or may not be revoked in the future, there is no guarantee that the partnership will make the election to accommodate exiting or incoming partners.

To impact a current-year transfer or distribution, a partnership must file a section 754 election with the current-year tax return by its due date (including extensions). The partnership must also attach a statement to its tax return showing the computation and allocation of the optional basis adjustment [IRC regulations 1.734-1(d) and 1.743-1(k)(1)]. The IRS has implemented a liberal extension policy that normally allows a partnership additional time within which to act. For example, an erroneous belief that a section 754 election had already been made and an inadvertent failure to make the election have both been held by the government to be sufficient reasons for granting an extension request (IRS Letter Rulings 200229028 and 200202053). If a valid section 754 election made in a preceding tax year has not been revoked, a new election is not necessary, because both sections 743 and 734 will continue to be mandatorily applied [Treasury Regulations section 1.754-1(b)].

Allocating the Optional Basis Adjustment

An incoming partner’s IRC section 743 optional basis adjustment must be allocated to individual assets held by the partnership at the time of entry. IRC section 755 governs the specific allocation procedure to be employed. The allocation should decrease the difference between the basis and the FMV of the partnership property. All partnership property is divided into two classes: capital assets and section 1231 assets, and other property. (According to IRC regulation 1.755-2T, a portion of the optional basis adjustment must also be allocated to any goodwill.) The total optional basis adjustment is then allocated to each asset class based on the relative disparity between basis and FMV for each class. Finally, the adjustment allocated to each class is then apportioned to individual assets within each class, using relative appreciation or depreciation as the basis for allocation. This procedure can result in a negative basis adjustment to assets within a class that have depreciated in value even though the total optional basis adjustment is positive.

Returning to the earlier example, assume that the partnership now owns the following assets when S purchases his one-third interest for $255,000:

S’s $120,000 optional basis adjustment is now allocated on a pro rata basis to the two parcels of land and the equipment, all of which are section 1231 property. Nothing is allocated to the only item in the other property classification, cash, because it has not appreciated or depreciated in value. (There is no goodwill.) Because 125% of the total property appreciation is attributable to land 1, a positive $150,000 basis adjustment (125% x $120,000) is allocated to it.

Land 2 is allocated a negative basis adjustment of $50,000 (-41.7% x $120,000) because its adjusted basis exceeds its FMV. The remaining $20,000 of optional basis adjustment (16.67% x $120,000) is allocated to the equipment.

Transfers by Death

A beneficiary who inherits a deceased partner’s appreciated interest and continues on as a successor in interest can benefit from an IRC section 754 election. The beneficiary’s basis for the partnership interest will normally be the date-of-death fair market value of the decedent’s interest in partnership assets plus the beneficiary’s share of partnership liabilities [IRC section 1014(a)(1)]. This amount must be decreased by any income in respect of a decedent (IRD) related to the deceased partner’s share of unrealized receivables [see Woodhall (1972 CA9) 29 AFTR 2d 72-394, and Quick Trust (1971 CA8) 27 AFTR 2d 71-1581]. IRD is income earned by the partnership that has not yet been properly included in the partners’ taxable incomes due to the entity’s method of accounting (IRC section 691). The zero-basis accounts receivable of a cash basis partnership is an example of unrealized receivables.

Returning to the example above, assume now that Mr. S had inherited partner C’s interest rather than purchasing it, and will continue on as a partner. If the partnership had a section 754 election in effect or was willing to make one, S’s outside basis would be $255,000. This consists of the $205,000 FMV of C’s capital account plus his one-third share of the $150,000 of partnership liabilities. (The partnership has no IRD.) The optional basis adjustment for S would again be $120,000 ($255,000 less C’s inside basis of $135,000), and he could avoid the same depreciation deduction shortfalls and possible gain accelerations discussed above.

Safety-Valve Provision

If the partnership is unwilling to make a section 754 election, an alternative exists. IRC section 732(d) applies to a partnership interest transferred by sale, exchange, or death where a section 754 election has not been made. IRC section 732(d) allows an incoming partner to elect to attribute, to any partnership property actually distributed to her within two years of acquiring her interest, the same tax basis she would have had if a section 743(b) optional basis adjustment had applied.

The IRC section 732(d) election affects only the incoming partner. While the election can provide some relief, it does not have the same effect as a section 754 election. Property distributed outside of the two-year time horizon is unaffected. The election has no effect until a distribution is made. Both the basis of property sold by the partnership and the partnership’s allowance for depreciation or amortization are unaffected. In addition, there is no assurance that a minority partner can convince the partnership to make distributions in a timely manner.

In some situations, the IRS may force the application of IRC section 732(d) when property is distributed by the partnership without consideration of the two-year rule. This power can be invoked only if the FMV of the partnership’s property (other than cash) exceeds 110% of its adjusted basis to the partnership at the time of acquisition by the partner. The regulations limit the application of this mandatory adjustment to circumstances where the absence of the IRC section 732(d) election would cause a shift in basis from nondepreciable property to depreciable property [Treasury Regulations section 1.732-1(d)(4)(ii)].

When to Avoid a Section 754 Election

An IRC section 754 election can sometimes be detrimental. If the incoming partner’s share of an entity’s basis for its assets (inside basis) exceeds her outside basis, she will be saddled with a negative optional basis adjustment. Consequently, she will forfeit additional depreciation deductions and report more property disposition gain or less loss. She will lose the entire current benefit from the positive difference between her inside and outside basis had the election not been made. (As discussed above, the incoming partner will eventually benefit from the higher partnership tax basis that results from the additional partnership income passed through.)

Returning to the example above, assume the following balance sheet of the ABC Partnership:

Mr. S purchases Partner C’s one-third interest for $135,000 ($85,000 cash plus the assumption of one-third of the partnership’s liabilities of $150,000). His outside basis of $135,000 is less than his inside basis of $255,000. If an IRC section 754 election is not in effect and the equipment is immediately sold upon S’s entry into the partnership, S’s one-third share of the partnership loss is –$20,000 [ !d x ($60,000 – $120,000)]. On the other hand, a section 754 election will produce a negative section 743(b) optional basis adjustment. IRC section 755 requires that the $20,000 loss be allocated to the equipment. Thus, S’s potential loss pass-through is eliminated.

Obviously, S would prefer that an IRC section 754 election not be in effect, so that a section 743(b) optional basis adjustment will not apply. If the partnership had previously made the election, however, the adjustment must be applied. The IRS will not grant permission to revoke a section 754 election because of basis loss upon the transfer of a partnership interest.

The American Jobs Creation Act of 2004 provides for mandatory application of section 743(b) in the case of a partnership interest transfer where a “substantial built-in loss” exists (for transfers after October 22, 2004). A built-in loss is “substantial” if a partnership’s total adjusted basis for its assets exceeds FMV by more than $250,000, which would apply to the example above. The 2004 act may also provide for the mandatory application of a negative section 734(b) adjustment at the partnership level (for distributions after October 22, 2004). If the potential negative adjustment exceeds $250,000, it now must be implemented whether or not a section 754 election is present.

Tiered Partnerships

The IRS has issued guidance on the tax consequences for a partnership and a corporate partner where the corporate partner contributes its own stock to the partnership and the partnership later exchanges the corporate stock with a third party in a taxable transaction [Revenue Ruling 99-57 (1999-2 C.B. 678)]. The corporation is protected from recognizing gain on the disposition by the partnership of its stock under IRC section 1032. The ruling allows the corporate partner to increase its basis in its partnership interest by an amount equal to its share of the gain.

This ruling provided results that were not always consistent with the intent of IRC sections 705 and 1032, as illustrated by the following example:

Assume corporation A purchases a 50% interest in a partnership for $100,000. The partnership’s only asset is A stock with a basis of $100,000 and a FMV of $200,000. If the partnership has not made a section 754 election, then if the partnership disposes of the property for $200,000, A would be allocated $50,000 gain. Under section 1032, the gain allocated to A would not be subject to tax. If A’s basis in the partnership were increased to $150,000, A would recognize a corresponding $50,000 loss or reduced gain upon the sale of the partnership interest.

Because this result is inconsistent with the intent of sections 705 and 1032, the IRS issued Treasury Regulations sections 1.705-1 and 2, which provide that if a corporation acquires an interest in a partnership that holds the corporation’s stock, or if the partnership subsequently acquires stock of the corporation, and the partnership does not have a section 754 election in place, the adjustment to the corporation’s basis in the partnership resulting from the sale or exchange of stock will reflect the basis adjustment had a section 754 election been in place. This is true regardless of whether gain or loss is recognized under section 1032.

Under the new regulations, when A’s stock is sold by the partnership, A will recognize no gain or loss under section 1032, and A’s outside basis will remain $100,000. A will not adjust basis upward, because if a section 754 election had been in place, A would have had an inside basis of $100,000, reflecting the purchase price of his partnership interest. Thus, A’s share of the gain on the sale would be zero. If the partnership is then liquidated, A will not recognize a gain or loss on the distributed proceeds.

These rules cannot be avoided through the use of tiered partnerships or other arrangements. If a corporation acquires an indirect interest in its own stock through a chain of two or more partnerships, either through acquiring a direct interest in a partnership or by a partnership in the chain acquiring another partnership, this gain or loss is allocated down to the corporation. The basis in the corporation’s partnership interest must be adjusted to reflect the gain had a section 754 election been in place.