Making the Sec. 754 election decision for a family partnership after TRA '97.

Your client, a surviving spouse, has just inherited the decedent spouse's partnership interest. The partnership is a family partnership in which the client's two children ore the other partners. Should a Sec. 754 election be made to equalize the surviving spouse's inside and outside bases? Should the surviving spouse's interest be liquidated? Through a comprehensive example, this article examines the family, income tax and estate tax issues that should enter into this decision.

The family partnership offers a unique situation for tax advisers--the analysis shifts from a single partner's tax consequences to that of the entire family; the estate planning implications must also be considered. This broadened view adds complexity to the decision-making process, but also allows for planning opportunities. One such opportunity arises when a partner dies and his partnership interest passes to another family member. The discussion that follows focuses on the effect on a family partnership of making (or not making) a Sec. 754 election, after a surviving spouse inherits her deceased husband's partnership interest.

Conventional wisdom suggests making the Sec. 754 election on the death of a partner. However, changes made by the Taxpayer Relief Act of 1997 (TRA '97) to the basis allocation rules on liquidation of a partner's interest make liquidation preferable to a Sec. 754 election in certain cases.

The Sec. 754 Election

Subchapter K offers a tax advantage when a successor to a decedent's partnership interest receives a basis step-up to fair market value (FMV) under Sec. 1014(a). If a Sec. 754 election is made, the successor partner can increase his share of the basis of partnership assets (i.e.,"inside" basis) by the difference between the stepped-up basis of his partnership interest (i.e.,"outside" basis) and the partnership's (lesser) basis in its individual assets. This basis increase is for the benefit of the inheriting partner only; other partners are unaffected. The increased basis stemming from the election allows the inheriting partner to recognize less gain when the assets are sold and to deduct higher depreciation or amortization before then.

Example: Partner A died on Dec. 31, 1997, leaving his one-third interest in the ABC partnership to his wife, W. ABC's balance sheet on that date was as follows:

                           Adjusted
                            basis            FMV

Assets

Cash                       $ 3,000         $ 3,000
Inventory                    6,000           9,000
Depreciable assets           9,000          18,000

                           $18,000         $30,000

Capital

A                          $ 6,000         $10,000
B                            6,000          10,000
C                            6,000          10,000

                           $18,000         $30,000

A's one-third interest in ABC's assets on his date of death was as follows:

                           Adjusted
                            basis            FMV

Assets

Cash                        $1,000         $ 1,000
Inventory                    2,000           3,000
Depreciable assets           3,000           6,000

                            $6,000         $10,000

Under Sec. 1014(a), W's basis in A's partnership interest is the FMV of that interest at A's death, $10,000 (ignoring valuation discounts, for simplicity's sake). Because W's share of ABC; bases in its assets is only $6,000, different results can occur than if W had acquired the assets from A directly. For instance, if ABC sells the inventory, the recognized gain is $3,000, W's distributive share of which is $1,000. Similarly, a sale of the depreciable assets would result in a $9,000 recognized gain to ABC, of which $3,000 would be included in W's taxable income However if a Sec. 754 election is made after A's death, W would recognize no gain on the sale of the inventory or depreciable assets.

A Sec. 754 election eliminates the difference between outside basis and inside basis. In the above example, if a Sec. 754 election is made, W will take a $3,000 basis for her one-third interest in ABC's inventory and a $6,000 basis for her interest in its depreciable assets.

If No Election Is Made

A step-up in outside basis occurs under Sec. 1014(a) whether or not a Sec. 754 election is made; it will eventually provide a tax savings to the successor partner, if the partnership interest is later sold or liquidated. The step-up increases the basis of the partnership interest, thereby reducing the gain (or increasing the loss) on sale. On a complete liquidation of the withdrawing partner's interest, the entire basis of said interest will be attributed to the assets received in liquidation, under Sec. 732(b). In most liquidations, (1) the distributed property must then be sold by the partner for tax benefits to be obtained.

Most partners and their tax advisers will be inclined to make a Sec. 754 election and obtain the immediate tax benefits of a basis step-up rather than wait for a sale or liquidation. In most situations, a tax preparer would not want to "miss" the election. However, in certain situations, for a family partnership, a better result can be obtained by forgoing the election and having the inheriting partner receive low-basis assets in liquidation of the partnership interest.

Family Partnerships

The Sec. 754 election decision requires closer investigation in the family partnership context. The vehicle itself was likely created on the recommendation of an estate planner, to save estate taxes; the estate planner may or may not fully appreciate the income tax implications of the family partnership. Tax advisers need to consider both the estate planning and the income tax planning opportunities available The following questions should be asked:

* What are the income tax effects of the

options available to the whole family?

* What estate planning opportunities can

be created for the family?

* What is the makeup of the partnership's

assets (e.g., does it own marketable securities)?(2)

A sale an interest in a family partnership is rare; if it occurs shortly after the partner's death (and the concomitant step-up in basis to FMV), there is likely to be little (if any) taxable gain or loss.(3) On the other hand, a liquidation of the inheriting partner's interest may provide both tax and nontax benefits to such partner and other family members/partners. Although such a liquidation may be motivated by nontax considerations, the tax implications should be addressed before the partnership reacts with the usual impulse to make the Sec. 754 election. The election decision turns on the Sec. 755 allocation provisions that apply the step-up to the partnership assets under a Sec. 754 election versus the Sec. 732(c) allocation of basis that will be made to assets distributed in liquidation to an exiting partner.

Basis Allocation Issues

As was discussed, a Sec. 754 election allows a partnership to adjust a partner's share of the basis of partnership assets. Regs. Sec. 1.754-1(b) states that the election must be in writing and filed with the partnership return for the tax year during which the distribution or transfer occurs. Once made, the election will apply to all subsequent tax years. Accordingly, the later death of another partner or sale (but not gift) of a partnership interest will trigger the basis adjustment. Regs. Sec. 1.754-1(c) allows the election to be revoked for a subsequent year only with IRS consent. The partnership must file with the district director in the district in which the partnership return is filed an application setting forth the grounds on which revocation is desired. An application for revocation will be denied if the purpose is primarily to avoid reducing the bases of partnership assets on a transfer or distribution.

Once the election is in effect, the adjustment for the tax year of the election (and any future years in which a triggering event occurs) is determined under Sec. 743(b). The adjustment is the difference between the new partner's outside basis in his partnership interest and his proportionate share of the inside basis of the partnership assets. If the new partner inherited his interest, the outside basis is the FMV of the interest at the decedent's date of death. The adjustment is added to the new partner's share of the partnership's inside basis. The adjustment is subtracted if the partner's outside basis is less than his inside basis.

Once the adjustment is made, it is necessary to track the two components of basis for the partner's assets, referred to in Regs. Sec. 1.743-1(b) as the"common basis" and the"special basis adjustment."(4) Regs. Sec. 1.743-1(b)(2)(iv) provides that a partner with a special basis adjustment who leaves the partnership (through sale of his interest or death) does not pass it to his other partners or to a new partner.

Once the adjustment is computed under Sec. 743(b), Sec. 755 directs how it is to be allocated among partnership assets Sec. 755(a) provides that the allocation is to be made in a manner that has the effect of reducing the difference between the FMV and the adjusted basis of partnership properties. Unfortunately, the allocation method is not quite this straightforward; the adjustment is allocated in two stages:

First, under Sec. 755(b), all partnership property is divided into two classes: capital assets (including Sec. 1231(b) property) and all other assets. The adjustment is then prorated between the two classes in proportion to the difference between FMV and the basis of each class. Second, under Regs. Sec. 1.755-1 (a)(1)(ii), the amount allocated to each class is allocated to assets within the class based on the proportion to the difference between FMV and basis.

If a Sec. 754 election results in an increase in inside basis for the incoming partner (via Secs. 743(b) and 755), what happens in the absence of the election? As was discussed, if the inheriting partner liquidates his interest shortly after receiving it, generally, no gain or loss will be recognized.(5) The result would be the same whether a Sec. 754 election is made or the new partner liquidated his interest without an election. In either case, the outside basis is applied to the partner's assets (his share of the partnership assets if a Sec. 754 election is made, or the assets liquidated to him in the absence of an election). However, the allocation of basis will vary depending on the option chosen.

Prior to the TRA '97, the Sec. 732(c) allocation scheme was based on the ratio of the partnership's bases of the assets; thus, a liquidating partner would be allocated little or no basis on assets that had little or no basis to the partnership. TRA '97 Section 1061 amended Sec. 732(c); for partnership distributions after Aug. 5, 1997,outside basis is allocated to assets received in liquidation in relation to their FMVs. An important result of this change is that a depreciable asset with little or no basis, but significant FMV, will be attributed more basis than under pre-TRA '97 law. Unfortunately, revised Sec. 732(c), although using a FMV approach, does not follow the same approach as the FMV scheme of Secs. 743(b) and 755; obviously, tax simplification is not quite here yet.

Comprehensive Example

In 1981, H created a partnership, HDS, in which he, his daughter D and his son S were equal partners. H died on Dec. 31, 1997. W, H's surviving spouse, inherited H's partnership interest. HDS owns three properties: Apt. 1, Apt. 2 and Apt. 3, with an aggregate adjusted basis of $791,225; each property's FMV is $600,000.

D and S are integrally involved in the partnership's business, and would like to continue (and possibly increase) their involvement. HDS has been a reliable source of income for the family.

W's estate is worth $6,000,000; income from HDS is not critical to her financial future. W would prefer to leave the day-to-day operation of HDS to D and S. W's life expectancy at H's death is approximately 10 years.

W, D and S have discussed whether W should own Apt. 1 outright. D and S are indifferent, because they were planning to help W manage all three properties, whether or not owned by HDS. Outright ownership would allow W to sell Apt. 1, if managing all three properties proved too difficult for D and S.

The following discussion depicts the outcome to the family of either making a Sec. 754 election or forgoing the election and distributing Apt. 1 and cash to W in liquidation of her partnership interest. The resulting basis, depreciation and gain on sale are addressed. The depreciation issues are significant, regardless of whether election or liquidation is chosen. The gain on sale issues are also critical, regardless of whether W sells Apt. 1 after receiving it in liquidation or it is sold by HDS after a Sec. 754 election.

Basis Issues

The basis calculations are illustrated in Exhibit 1 on page 37.

Exhibit 1: HDS Partnership After H's Death
Allocation of Basis(1)

Basis with Sec. 754 election

                       Original                   Excess
                       adjusted                   of FMV
                        basis          FMW      over basis

Assets:
Cash                 $  36,000     $   36,000   $        0

Apartment 1, cost       100,000
 Less depreciation     (100,000)      500,000      500,000
Land                     20,000       100,000       80,000

Apartment 2, cost       250,000
 Less depreciation      (89,775)      500,000      339,775
Land                     50,000       100,000       50,000

Apartment 3, cost       500,000
 Less depreciation      (75,000)      500,000       75,000
Land                    100,000       100,000            0

Total                 $ 791,225    $1,836,000   $1,044,775

Capital:
W(1/3)                $ 263,742    $  612,000      348,258
D(1/3)                  263,742       612,000      348,258
S(1/3)                  263,742       612,000      348,258

Total                 $ 791,225    $1,836,000   $1,044,775

Basis without Sec. 754 election (liquidation of W's interest under
Sec. 732)
                                                  Step 1:
                          HDS                     HDS
                          basis          FMV      basis

Liquidation proceeds:   $  12,000    $  12,000    $  12,000
Cash

Apartment 1, cost         100,000                   100,000
 Less depreciation       (100,000)     500,000     (100,000)
Land                       20,000      100,000       20,000

Total                   $  32,000      612,000    $  32,000

Less 25% valuation
 discount                             (153,000)
Outside basis to
 allocate                            $ 459,000

Basis with Sec. 754 election

                      Percent     W's
                         of     Sec. 743      Ending adjusted basis
                       excess   adjustment   W's 1/3
                                allocated    pre-Sec.
                                              743
Assets:
Cash                                         $ 12,000     $ 12,000

Apartment 1, cost                              33,333      126,778
 Less depreciation     47.86%   $ 93,445      (33,333)     (33,333)
Land                    7.66      14,951        6,667       21,618

Apartment 2, cost                              83,333      146,834
 Less depreciation     32.52      63,501      (29,925)     (29,925)
Land                    4.79       9,345       16,667       26,011

Apartment 3, cost                             166,667      180,683
 Less depreciation      7.18      14,017      (25,000)     (25,000)
Land                    0.00           0       33,333       33,333

Total                 100.00%   $195,258     $263,742     $459,000

Capital:
W(1/3)
D(1/3)
S(1/3)

Total

Basis without Sec. 754 election (liquidation of W's interest under
Sec. 732)

                        Step 2:         Step: 3      Step 4:
                        proportion of   proportion   sum of
                        appreciation    of FMV(2)    steps 1-3

Liquidation proceeds    $       0          $0        $   12,000
Cash

Apartment 1, cost                                       468,103
 Less depreciation        368,103(3)        0          (100,000)
Land                       58,897(4)        0            78,897

Total                   $ 427,000          $0        $  459,000

Less 25% valuation
 discount
Outside basis to
 allocate

W succeeded to H's partnership interest. At H's death, the FMV of HDS's property was $1,836,000; thus, H's one-third interest was worth $612,000. After minority and marketability discounts and other factors, the FMV of said interest reported on H's estate tax return was $459,000. Under Sec. 1014(a),this is W's basis in H's partnership interest.

Basis with Sec. 754 election: W's $459,000 outside basis in HDS is greater than $263,742, her share of the inside basis of HDS's assets ($791,225 [divided by] 3). Thus, under Sec. 743(b), there will be a positive adjustment to her share of inside basis of $195,258 ($459,000 - $263,742). This special basis adjustment is added to the bases of HDS's assets to arrive at W's total inside basis as a result of the Sec. 754 election (see the top half of Exhibit 1). This adjustment is allocated to assets in accordance with Sec. 755's instruction of reducing the difference between the FMV and adjusted basis, by applying the adjustment to the extent ("percent of excess") that an individual asset's FMV exceeds its basis. The percent of excess is the excess of FMV over basis for each asset divided by the total excess of FMV over basis for all assets ($1,044,775). Here, the result: of adding the special basis adjustment (" W's Sec. 743 adjustment allocated," i.e., $195,258 X percent of excess for each asset) to W's one-third share of the common basis (" W's 1/3 pre-Sec. 743," i.e., one-third of each asset in the "Original adjusted basis" column) is reflected in the far right-hand column of Exhibit 1 (" W's 1/3 post-Sec. 743"). These are W's basis amounts when making future determinations of depreciation, gain, loss and distributions.

Basis without Sec. 754 election: The premise of this option (reflected in the bottom half of Exhibit 1) is that W will receive Apt. 1 plus her one-third share of HDS's cash as consideration for her one-third interest in HDS. This leaves D and S as 50% equal partners.

W is receiving a liquidating distribution; thus, the basis of the assets received will be governed by Sec. 732(b). The allocation of basis is governed by Sec. 732(c), as recently revised by the TRA '97. The four-step process is reflected in the bottom half of Exhibit 1.(6) W's $459,000 outside basis is allocated as shown in the far right-hand column ("Step 4: sum of steps 1-3"). Prior to the TRA '97, no basis would have been attributed to the fully depreciated building distributed to W.

Observations: Whether a Sec. 754 election or a liquidation (without an election) occurs, the total basis to be allocated is $459,000. However, under the election, W obtains the basis step-up for her share of all HDS properties; under a liquidation, this step-up applies only to the property actually distributed to her (Apt. 1).

The significance of the difference in these allocations will depend on what W does with the property after receiving it--i.e., selling it or continuing to hold it. If W sells Apt. 1 after receiving it in liquidation of her partnership interest, her $447,000 basis ($459,000 - $12,000 cash) will be used to calculate the capital gain. (The basis allocation between the building and the land will be irrelevant, because the total gain will be treated as capital.(7)) If, instead, Sec. 754 was elected, a portion of W's step-up in basis will have been allocated to each of Apts. 1, 2 and 3. Accordingly, a subsequent sale of Apt. 1 by the partnership may"waste" a portion of this step-up--the portion that was applied to the other apartments. To the extent that the Apt. 2 and 3 special basis adjustments are not depreciated (or these assets are not sold) before W's death, such adjustments will never result in a tax benefit.

If W decides not to sell Apt. 1 after receiving it in liquidation, the amount allocated to the depreciable building versus the land will be a critical issue; future depreciation is a tax benefit to be optimized. The tax adviser should tailor his recommendations toward any option that offers significantly more basis for depreciable property. However, looking at the total family picture, D's and S's tax future is improved if W's interest is liquidated; they will share as equal partners in the two properties that will yield the most depreciation (the liquidation removes fully depreciated Apt. 1). The tax adviser must run the numbers to determine the optimal choice.

Depreciation Issues

The depreciation calculations are illustrated in Exhibit 2 on page 39. A 10-year time frame is used (W's life expectancy at H's death).

Exhibit 2: HDS Partnership After H's Death
Depreciation 1998-2007

Depreciation with Sec. 754 election

                                              HDS's
                                    Date     unadjusted
                                  acquired   basis

HDS's properties:

Apartment 1, common basis          1/1/81    $        0
 Sec. 743 increase                 1/1/98           ---

Apartment 2, common basis          2/1/88        60,606
 Sec. 743 increase                 1/1/98           ---

Apartment 3, common basis         11/1/93       121,212
 Sec. 743                          1/1/98           ---

Total                                        $1,020,963

Depreciation without Sec. 754 election

                                                W's or
                                  Date       unadjusted
                                  Acquired      basis

HDS's properties:

Apartment 2, basis                 2/1/88    $  250,000

Apartment 3, basis                11/1/93       500,000

W's Property (liquidated):

Apartment 1, carryover basis       1/1/81       100,000
 Sec. 732 increase                 1/1/98       368,103

Total                                        $1,218,103

Difference in depreciation
1998-2007, use of Sec. 754
election versus no election

Depreciation with Sec. 754 election

                                      Depreciation 1998-2007
                                D and S         W          W,D,S
                                 (2/3)        (1/3)        total

HDS's properties:

Apartment 1, common basis              0    $      0     $
 Sec. 743 increase              $    ---      33,838       33,838

Apartment 2, common basis         60,606      30,303       90,909
 Sec. 743 increase                   ---      22,995       22,995

Apartment 3, common basis        121,212      60,606      181,818
 Sec. 743                            ---       4,635        4,635

Total                           $181,818    $152,377     $334,195

Depreciation without Sec. 754 election

                                                         W, D, S
                                D and S          W         total

HDS's properties:

Apartment 2, basis              $ 90,909    $    ---     $90,909

Apartment 3, basis               181,818         ---      181,818

W's Property (liquidated):

Apartment 1, carryover basis         ---           0            0
 Sec. 732 increase                   ---     133,298      133,298

Total                           $272,727    $133,298     $406,025

Difference in depreciation
1998-2007, use of Sec. 754      $ 90,909    $(19,079)    $ 71,830
election versus no election

Depreciation with Sec. 754 election: After the basis increase stemming from the Sec. 754 election, two components of basis must be tracked for depreciation purposes. W's share of common basis must be depreciated under HDS's preexisting life and method, according to Sec. 168(i)(7)(A). Prop. Regs. Sec. 1.168-2(n)(2) provides that depreciation for the special basis adjustment (computed under Sec. 743(b)) is taken into account as if it were newly purchased recovery property placed in service when the distribution or transfer occurs. Accordingly, the special basis adjustment for the building portion of Apt. 1 will be depreciated using 27 1/2-year modified accelerated cost recovery system (MACRS).

The depreciation for the common basis is allocated between the partners based on their relative interests (as to capital, profits and losses). However, only W will receive the benefits of the depreciation for the special basis adjustment ("Sec. 743 increase"), as it belongs exclusively to her.

Depreciation without Sec. 754 election: In this example, W is presumed to have liquidated her interest in HDS. The depreciation for Apts. 2 and 3, which remain in HDS, continues to benefit D and S.

Apt. 1 depreciation for W is based on H's carryover basis plus the Sec. 732 recovery system basis increase. The common basis component will be depreciated as it would have been by HDS, as directed by Sec. 168(i)(7)(A) (Such depreciation will be zero, as the building had been fully depreciated before liquidation.) The Sec. 732 basis increase will be depreciated in the same fashion as the Sec. 743(b) increase previously discussed. A new holding period and method will be applied to the increase 27 1/2-year MACRS).(8)

Observations: Although W will have a smaller depreciation deduction if no Sec. 754 election is made and Apt. 1 is liquidated to her, D's and S's depreciation is $71,830 higher, as seen in Exhibit 2.

Why is there so much more depreciation if no Sec. 754 electron is made? Because D and S now share 50% of all partnership items (as opposed to one-third each), and HDS is rid of fully depreciated Apt. 1.

Gain on Sale Issues

The gain on sale issues are illustrated in Exhibit 3 on page 40.

Exhibit 3: HDS Partnership After H's Death
Gain on Sale of Apartment 1

Gain with Sec. 754 election

                              D and S          W           W,D,S
                               (2/3)         (1/3)         total

HDS's property:
Sales proceeds                $400,000      $200,000      $600,000

Apartment 1, common basis       66,667        33,333       100,000
 Less depreciation             (66,667)      (33,333)     (100,000)
 Sec. 743 increase                  --        93,445        93,445
Land, common basis              13,333         6,667        20,000
 Sec. 743 increase                  --        14,951        14,951

Total basis                     13,333       115,063       128,396

Gain                          $386,667      $ 84,937      $471,604

Gain without Sec. 754 election

                              D and S          W           W,D,S
                                                           total

W's property (liquidated):
Sales proceeds                $     --      $600,000     $ 600,000

Apartment 1, carryover
basis                               --       100,000       100,000
 Less depreciation                  --      (100,000)     (100,000)
 Sec. 732 increase                  --       368,103       368,103
 Land, carryover basis              --        20,000        20,000
 Sec. 732 increase                  --        58,897        58,897

Total basis                         --       447,000       447,000

Gain                          $      0      $153,000      $153,000

Difference in gain, use
of Sec. 754 election
versus no election           $(275,667)      $68,063     $(318,604)

If a Sec. 754 election is made (i.e., Apt. 1 remains in HDS), D and S, lacking the advantage of a basis step-up, recognize considerable gain. W will recognize less gain under the election, because only one-third of the sales proceeds are attributable to her. Although W will be attributed one-third of the sales proceeds if Sec. 754 is elected, her estate does not change much regardless of whether the election is made. If the election is not made, W, in effect, retains a one-third interest in HDS via her outright ownership of Apt. 1; if the election is made, W remains an interest holder in all three apartments. On balance, changes in W's estate as a result of the election versus liquidation decision are principally due to the income tax effects of the two options. Without the Sec. 754 election, W's estate is diminished slightly due to an increased taxable gain.

D and S clearly have very different outcomes, depending on whether or not the election is made. If not made, W will bear the entire income tax burden from the sale of Apt. 1 received by her in liquidation. D's and S's estates do not change appreciably, regardless of the option chosen, except for the income tax effects. If a Sec. 754 election is made, D and S will own two-thirds of Apts. 2 and 3, plus a right to two-thirds of the sales proceeds of Apt. 1. If the election is not made, they end up owning all of Apts. 2 and 3 (via their partnership interests), and none of the sales proceeds from Apt. 1. These two options are approximately equal in value. However, if the income tax effects are examined, D's and S's taxable gain is reduced by $386,667 if no election is made.

The difference in the family's estates resulting from the election versus liquidation decision stems from the differing income tax burden.

Conclusion

Under the example presented, the better alternative is for W to receive Apt. I in liquidation of her HDS interest and for HDS not to make a Sec. 754 election. This would not necessarily have been the case prior to the TRA '97 revision to Sec. 732(c) (because W would have had no basis to depreciate).

If W chose to keep Apt. 1, D, S and W would have benefited by $71,830 in additional depreciation by choosing not to elect Sec. 754. Wealth would have shifted from W to D and S due to the income tax benefits of W's reduced depreciation deductions and D's and S's increased deductions. In effect, W would give D and S a reduction in income tax, without any gift tax consequences.

A further estate planning opportunity arises if W decides to keep Apt. 1. W would be able to form a new family partnership by contributing Apt. 1 and gifting interests therein to D and S. This will allow for valuation discounts for lifetime gifts as well as valuation discounts for W's remaining interest at her death.

The benefits to the family are even greater if W sells Apt. 1. While W would have to pay more income tax (than under a Sec. 754 election and no liquidation), D and S avoid $386,667 in taxable gain. Accordingly, W's estate would decrease by her increase in income tax and D and S would receive a significant income tax benefit from W without gift tax consequences.

If the Sec. 754 election had been made and W died in 2007, any remaining step-up in basis allocated to Apts. 2 and 3 would be lost. By not electing Sec. 754 and allocating the entire step-up to Apt. 1, the tax benefits were maximized.

Family issues must be considered, as well as income and estate tax issues. For example, it may have been important for W to leave HDS to allow D and S to manage it on their own. Some considerations in making the Sec. 754 election versus liquidation decision are listed in the box on page 38.

(1) If only cash, unrealized receivables and inventory items (as defined by sec. 751) are received in liquidation and their aggregate bases are less than the partner's basis ill his interest, the partner's recognized loss will equal the excess of his outside basis over the inside basis of the items received.

(2) A partner must recognize gain under Sec. 731 (c) on the receipt of marketable securities. The gain recognized may be avoidable if securities without inherent gain (i.e. FMV less shall or equal to basis) are distributed. Nonetheless, marketable securities are an undesirable choice of assets to distribute to an inheriting partner.

(3) If a partnership interest is to be sold after the partner's death, the tax adviser should examine the Sec. 755 allocation scheme for the step-up in basis to the partnership assets, and how this may influence the characterization of gain or loss (i.e., capital versus ordinary income) under Secs. 741 and 751.

(4) Regs. Sec. 1.743-1 (b)(1) states that for purposes of depreciation, depletion, gain or loss and distributions, the transferee partner will have a special basis for those partnership properties adjusted under Sec. 743(b) and the regulation This special basis is his share of the common partnership basis (i.e., the adjusted basis of such properties to the partnership without regard to any special basis adjustments of any transferee), plus or minus his special basis adjustments.

(5)See notes 1 and 2 for exceptions.

(6) An additional step is required when the partnership has unrealized receivables and inventory and the Sec. 743(b) adjustment is positive.

(7) However, as provided by TRA '97 Section 311(a), the "unrecaptured" portion of Sec. 1250 gain will be taxed at a rate of up to 25%.

(8) See Prop. Regs. Sec. 1.168-2(n)(2). Although not specifically addressed in that regulations (which refers only to Secs. 743(b) and 734(b) increases), because the common basis must be depreciated under the preexisting life and method, it follows that a new life and method would be appropriate for Sec. 732 basis increases (because these basis increases are treated similarly in other respects).

RELATED ARTICLE: EXECUTIVE SUMMARY

* A Sec. 754 election eliminates the difference between inside basis (the partner's share of the partnership's basis in its assets) and outside basis (the partner's basis in his partnership interest).

* After the TRA '97, outside basis is allocated to assets received in liquidation in relation to their FMVs; thus a depreciable asset with little (or no) basis but significant FMV will be attributed more basis on liquidation than under pre-TRA '97 law.

* When determining whether to make a Sec. 754 election in the family partnership context, the tax consequences to the entire family should be considered.

RELATED ARTICLE: Liquidation or Sec. 754 Election?

When to consider Liquidation

1. There exists a mix of assets, some with low basis and high FMV, others with higher basis in relation to FMV. (The low-basis asset(s) should be liquidated.)

2. A sale of a low-basis asset is planned.

3. The inheriting partner is inclined to exit the partnership's business, while other partners are inclined to remain.

4. The life expectancy of the inheriting partner is shorter than that of other partners.

When to Consider Sec. 754 Election

1. Partnership assets are principally marketable securities.

2. Liquidation would be cumbersome because undivided interests in assets have to be distributed (e.g., inheriting partner and partnership would tenants in common).

3. The expectation of selling significant partnership assets is low.