When to advise a Sec. 754 election.
Sec. 754 may permit an adjustment to asset basis when a partnership distributes property or when an interest in the partnership is sold or exchanged. For practitioners and their clients, the variety and complexity of the transactions to which the Sec. 754 election applies necessitate extensive and careful planning before they decide whether or not to elect. Once made, the election is binding for all subsequent transactions; revocation is possible only with IRS permission.
The first category of transactions covered by a Sec. 754 election involves the sale or exchange of a partnership interest, resulting in an adjustment to the basis of partnership property for the transferee partner only.(1) The second category involves the distribution of partnership property, resulting in an adjustment to the basis of undistributed partnership property.(2)
This article will review the situations in which a Sec. 754 election will affect the basis of partnership property, with an emphasis on the manner of allocating basis among assets and the advisability of making the election in various situations; discuss the effects of Sec. 754 on the basis of assets in partnership formations and terminations; and provide guidance on the use of the Sec. 754 election to maximize tax benefits at the entity or partner level.
How to Make the Election
The election under Sec. 754 is made by the partnership and is binding for all future tax years. The election must be made in a written statement filed with the partnership return in a tax year in which a distribution or transfer occurs.(3)[ For the election to be valid the return must be filed on a timely basis, including any extensions.(4)
The statement must (1) provide the name and address of the partnership making the election, (2) be signed by one of the partners and (3) contain a declaration that the partnership elects under Sec. 754 to apply the provisions of Secs. 734(b) and 743(b).(5)
Sale or Exchange Transactions
When a partner purchases an interest in an existing partnership, he acquires a cost basis in the partnership interest(6) and a proportionate share of the basis of the assets represented by that interest. It is unlikely that the interest basis will equal the proportionate basis of the partnership assets. A Sec. 754 election will equate the aggregate basis of partnership assets represented by the purchaser's interest with the cost basis of that interest. See Example 1 on page 397.
Example 1: Adjustment to Basis of Partnership Interest
Partners A, B and C own one-third each of the ABC partnership with the following balance sheet.
Fair value Tax basis Cash $20,000 $20,000 Inventory 30,000 20,000 Sec. 1231 asset A 30,000 15,000 Sec. 1231 asset B 10,000 20,000 $90,000 $75,000
C sells his one-third interest to D for $30,000. D has a $30,000 basis in his partnership interest, but succeeds to C's $25,000 basis in one-third of the partnership property. If a valid Sec. 754 election is in effect, D will adjust the basis of his share of partnership assets to $30,000.(*)
(*) Sec. 743(b)(1).
In Example 1, D will be entitled to depreciate any portion of the $5,000 basis adjustment that is properly allocable to depreciable property. The adjustment will be treated as a new item of recovery property.(7) In the event that any partnership assets are disposed of in a taxable transaction, D will reduce his share of partnership gain (or increase his loss) by any unrecovered basis adjustment allocable to the assets sold or exchanged. Records of the adjustment must be maintained for the transferee partner and items of income, gain, deduction and loss must be allocated with respect to the adjustment.
In the event that a partner purchases an interest in the partnership for an amount below the aggregate basis of all partnership property, a Sec. 754 election would result in a negative adjustment. See Example 2 on page 398.
Example 2: Negative Adjustment to Basis of Partnership Interest
Assume the same facts as in Example 1, except that the fair value and the basis of the inventory and the Sec. 1231 assets are reversed.
Fair value Tax basis Cash $20,000 $20,000 Inventory 20,000 30,000 Sec. 1231 asset A 15,000 30,000 Sec. 1231 asset B 20,000 10,000 $75,000 $90,000
D will purchase a one-third interest for $25,000 and acquire a basis of $30,000 in the assets represented by that interest. If a Sec. 754 election is in effect. D will adjust the basis of his share of partnership assets downward to $25,000.(*)
(*) Sec. 743(b)(2).
While a partnership clearly would not make an election in order to produce this result, an election in effect at the time of the transaction would be binding on the partnership.
Distributions of Partnership Property
Under the aggregate concept of partnership taxation, the distribution of property from a partnership to a partner is generally not a taxable event.(8) To the extent there is no tax effect, there is no reason to adjust the basis of partnership assets. However, it is possible that a partnership distribution will result in recognition of gain or loss by the distributee partner, or in an adjustment to the basis of the distributed asset. in either of these situations, a Sec. 754 election will result in an adjustment to the basis of remaining partnership property.
* Positive adjustments on distribution
A positive adjustment to the basis of undistributed partnership property occurs on the distribution of property in either of two situations: (1) the distributee partner recognizes gain on the distribution or (2) the basis of distributed assets in the hands of the partner is less than the basis of such assets in the hands of the partnership.(9) Such transactions are unusual and normally occur only in investment partnerships.
Gain is recognized to the distributee partner when money is distributed in excess of the distributee's basis in his partnership interest.(10) Example 3: The DEF partnership distributes $5,000 cash to partner D, whose basis in her partnership interest is $2,000 immediately prior to the distribution. D will reduce the basis of her partnership interest to zero and recognize a $3,000 gain. If a Sec. 754 election is in effect, the basis of undistributed partnership assets will be increased by the $3,000 gain recognized.
Since a decrease in a partner's share of partnership liabilities is treated as a deemed distribution of money,(11) gain is recognized to the extent that the deemed distribution is in excess of the distributee partner's basis in his partnership interest. A reduction in a partner's share of liabilities typically occurs due to principal payments on partnership debt, or from a contribution or distribution of encumbered property. A Sec. 754 election will permit the partnership to increase the basis of assets when liability reductions trigger gain at the partner level.(12)
Example 4: Partner J in the JKL partnership has a basis of $1,000 in his partnership interest, which includes J's one-third share of a $60,000 partnership liability. If JKL makes a $15,000 principal payment on the partnership debt, J will recognize $4,000 of gain from a deemed distribution of $5,000 (one-third of $15,000) of money. A Sec. 754 election would permit a $4,000 increase to the basis of the partnership assets.
At the formation of a partnership, liability relief in excess of the basis of contributed property will result in gain recognition to the contributing partner. When gain is recognized by the transferor partner as a result of a contribution, the partnership is entitled to increase the basis of contributed property by the amount of gain recognized.(13) However, when gain recognition is the result of liability relief in excess of the basis of contributed assets, on basis adjustment is available. This is because the gain occurs not as a result of the contribution, but instead from a deemed distribution of money one moment after the contribution. An entity level Sec. 754 election will permit the partnership to recover this basis under Sec. 734. (Note:) The same result is obtained if property is contributed to an existing partnership. However, the liability relief would need to exceed the sum of the basis of contributed property and the basis of the contributing partner's interest immediately prior to the contribution.)
Example 5: Partner G of GHI partnership has a $1,000 basis in his partnership interest. G contributes property with a zero basis subject to a liability. Assume that based on the liability sharing rules of Sec. 752, G realizes liability relief of $8,000. The deemed distribution of $8,000 in cash is in excess of G's interest in GHI, resulting in the recognition of a $7,000 gain. A Sec. 754 election will permit a $7,000 increase in the basis of undistributed partnership assets.
The second situation in which a positive Sec. 754 adjustment occurs is when the tax basis of an asset in the hands of a distributee partner is less than the basis of such asset in the hands of the partnership. While the basis of a distributed asset is generally carryover from the partnership, the aggregate basis assigned to distributed assets cannot exceed the basis of the distributee partner's interest immediately before the distribution.(14)
The distribution of property with a basis in excess of the distributee partner's basis in his partnership interest will then result in a "step-down" of tax basis. The Sec. 754 election will operate to restore the basis lost as a result of the distribution.
Example 6: Partner R's interest in the RST partnership has a basis of $3,000. RST distributes to R property with a basis of $5,000. The basis of the asset in R's hands is limited to the basis of his partnership interest, $3,000. Thus, the asset has lost $2,000 of basis. With a Sec. 754 election, RST will increase the basis of remaining assets by the $2,000 reduction in the basis of the distributed property.
* Negative adjustments on distribution
A Sec. 754 election will result in a negative adjustment to undistributed partnership assets in two situations: (1) recognition of a loss by a distributee partner or (2) when the basis of distributed assets in the hands of the partner is greater than the basis of such assets in the hands of the partnership.(15) Neither of these results can occur unless a partner's interest is completely liquidated.
The basis of property distributed by a partnership in complete liquidation of a partner's interest will equal the adjusted basis of the distributee partner's interest in the partnership, reduced by any money received in the same transaction.(16) To preserve the amount of ordinary income potential, unrealized receivables and inventory items are allocated a carryover basis.(17) A loss occurs only when the distributee receives solely money, unrealized receivables or inventory (or any combination of the three) in complete liquidation of a partnership interest and the distributee partner's basis in his partnership interest is in excess of the sum of money and the aggregate bases of any unrealized receivables and inventory items received.(18) This result occurs because the partner has basis in his liquidated interest that cannot be allocated to distributed assets. If assets other than money, inventory and unrealized receivables are allocated, any remaining basis is distributed to such assets and no loss occurs. in a nonliquidating distribution any remaining basis stays with the partnership interest.
The effect of a Sec. 754 election is a negative adjustment to the basis of undistributed partnership property equal to the loss recognized by the distributee partner.
Example 7: The MNO partnership distributes $1,000 cash, and inventory with a basis of $2,000, to partner M in complete liquidation of her interest. M's basis in her partnership interest is $10,000. The cash and inventory will retain their bases and M will recognize a $7,000 loss on liquidation of her interest ($10,000 basis in her partnership interest - the $1,000 allocated to cash - $2,000 allocated to inventory). With a Sec. 754 election, this transaction will result in a $7,000 downward adjustment to the basis of undistributed partnership property. (Note: It is assumed that Sec. 751 docs not apply to the transaction.)
The second situation in which a negative Sec. 754 adjustment may result occurs when the basis of distributed property in the hands of the partner exceeds the basis of such property in the hands of the partnership. This can occur only in a liquidating distribution. After allocating carryover basis to money, inventory and unrealized receivables, any remaining basis in the partner's interest is allocated to other property.(19) A "step-up" in the basis of distributed property in the hands of the distributee partner may then occur since the allocation to other property is not limited to the carryover basis from the partnership. In the absence of a Sec. 754 election, there is no effect on the basis of undistributed partnership assets.(20) However, with a Sec. 754 election, the basis of undistributed partnership property must be adjusted downward by the amount of the step-up in the hands of the distributee partner.
Example 8: Partner O's interest in the OPQ partnership has a basis of $8,000. OPQ distributes a capital asset with a basis of $5,000 to O in complete liquidation of his interest. The distributed property acquires the basis of the partnership interest, $8,000. With a Sec. 754 election, the $3,000 step-up in basis (from $5,000 in OPQ'S hands to $8,000 in O's hands) results in a $3,000 downward adjustment to the basis of undistributed partnership property.
Allocating the Sec. 754 Adjustment
Sec. 743(c), governing sale and exchange transactions, and Sec. 734(c), governing distributions of partnership property, both refer to Sec. 755 for the rules pertaining to the allocation of the Sec. 754 basis adjustment. Sec. 755 provides both a general rule and a special rule for the allocation of the Sec. 754 optional basis adjustment among partnership properties.
The regulations clarify the application of a twotier system of allocation. Under the first tier, the amount of the increase (or decrease) is divided among two census of property: capital assets (including Sec. 1231 property) and other partnership property.(21) The basis adjustment is then allocated between capital assets and other assets in proportion to the "net" appreciation (or depreciation) within each class. Under the second tier of allocation, the regulations preclude an upward adjustment to the basis of any assets with fair market value (FMV) less than tax basis, or a downward adjustment to the basis of any assets with FMV in excess of tax basis.(22) See Example 9 on page 401.
When ignore than one asset allocated and adjustment under the second timer, the allocation among individual assets is made in proportion to the difference between the FMVs and the bases of the assets that will receive the allocation.(23)
The requirement that a basis adjustment be allocated to assets of a similar class may lead to situations in which it is not possible to allocate the adjustment to existing partnership assets.
There are two situations that may lead to a carryforward of the adjustment: (1) The adjustment is negative and the total negative adjustment exceeds the basis of assets within the class that is required to absorb the adjustment. Asset basis within the required class is reduced to zero and any excess adjustment will carry forward and reduce the basis of such assets acquired in future. (2) There are no assets in the class to which the adjustment is required to be made (either a positive or negative adjustment). The adjustment will carry forward and affect the basis of such assets acquired in the future.
Note that the adjustment can result in an FMV in excess of basis for certain assets (in Example 9, Sec. 1231 asset A) and an FMV less than basis for other assets (Sec. 1231 asset B). If the regulations had provided for the allocation of a downward basis adjustment to asset B, with an offsetting upward adjustment to asset A ,the stated objective of Sec. 755(a) (allocating the basis adjustment in a manner that has the effect of reducing the difference between the FMV and the adjusted basis of partnership properties) would have been achieved.
It should be noted that FMV is a question of fact, which in the case of a Sec. 755 allocation is not supported by an arm's-length transaction. The assignment of FMV to individual assets can have important tax consequences to the partners. In addition, if the partnership operations constitute a trade or business, an allocation to goodwill may be required, which could reduce or eliminate the benefits of an election.(24)
An application may be made with the district director to use another method of allocation, which could include an increase to the basis of some assets and a decrease to the basis of others.(25)
Technical Termination of the Partnership
A technical termination of a partnership occurs if 50% or more of the total interest in partnership capital and profits is sold or exchanged within a 12-month period.(26) A technical termination results in a deemed distribution to the purchasing and remaining partners in proportion to their respective interests in the partnership properties, followed immediately thereafter by a contribution of the properties to a new partnership.(27) As previously discussed under the rules of Sec. 732(b), assets distributed in complete liquidation of a partner's interest assume a basis equal to the adjusted basis of such partner's interest in the partnership. Even in the absence of a Sec. 754 election, a basis adjustment occurs on the distribution of the assets in liquidation of the old partnership in accordance with the rules of Sec. 732. The allocation of basis is first to any unrealized receivables and inventory items in an amount equal to the adjusted basis of such property to the partnership. Any remaining basis is allocated in proportion to the adjusted basis of the distributed assets in the hands of the partnership. On the subsequent deemed contribution of these assets to the new partnership, the newly adjusted basis of these assets will carry over to the new partnership.(28) See Example 10.
Example 10: Basis Adjustment in Technical Termination
Partnership ST's balance sheet is as follows.
Basis FMV Cash $1,000 $ 1,000 Land 3,000 5,000 Inventory 3,000 4,000 Total assets $7,000 $10,000
Partner S sells his partnership interest to U for $5,000, triggering a technical termination and a deemed distribution of partnership assets in complete liquidation of the partnership. On liquidation, assets deemed distributed to U will acquire a basis of $5,000. The total basis is allocated $500 to cash, $1,500 to inventory (carryover basis) and the remaining $3,000 to land. Thus, the asset basis is adjusted to the purchase price of U's interest without a Sec. 754 election. In the absence of a technical termination, U would have acquired S's $3,500 basis in partnership assets. The termination adjusts the asset basis by $1,500, which is allocated entirely to land.
If a Sec. 754 election is in effect for the year of a technical termination, Sec. 732 still applies, but Sec. 754 is applied first. The purchasing partner's basis in partnership assets is adjusted on the purchase of his interest in the old (liquidating) partnership.(29) This adjustment is allocated in accordance with the rules of Sec. 755. Since the optional basis adjustment under Sec. 754/Sec. 743 has the effect of equalizing the purchasing partner's inside (basis in partnership assets) and outside (basis in partnership interest) bases, n() further adjustment occurs on the deemed distribution under Sec. 732.
Example 11: Assume the same facts as in Example 10, except that a Sec. 754 election is in effect. On U's purchase of S's partnership interest, U's basis in partnership assets must be increased by $1,500 under Sec. 743. Under the first tier of allocation, land will receive $1,000 of the Sec. 754 adjustment ($2,000 / $3,000 x $1,500). The basis of the inventory will be adjusted by $500 ($1,000 / $3,000 x $1,500). No allocation is necessary under the second tier of the Sec. 754 adjustment.
Either on the purchase of the interest or on the immediate deemed liquidating distribution, the aggregate basis of partnership assets with respect to the partner purchasing the interest is adjusted to the amount that he paid for his interest. However, Sec. 732 allocates the adjustment in proportion to the basis of assets in the hands of the partnership while Sec. 755 seeks to reduce the difference between fair value and basis. The chart on page 403 compares the results in the two allocation methods.
In the event of a technical termination in which a Sec. 754 election is not already in effect, the results of an allocation under Sec. 732 can be compared with those of an allocation under Sec. 755.(30)
If an allocation under Sec. 732 is desired, the partnership should not make a Sec. 754 election on the final return of the terminated partnership. If an allocation under Sec. 755 is preferred, the partnership may make a Sec. 754 election on its final return, and the collection will be effective for the incoming partner's purchase of an interest in the partnership.(31) If the partnership is not willing to make a Sec. 754 election on its final return, the incoming partner can make his own election under Sec. 732(d) to use a Sec. 755 allocation.
Revoking the Election
The Sec. 754 election applies to all transactions during the tax year for which the election was filed, and for transactions that occur in all subsequent years.(32) The regulations state that an election may be revoked only with the approval of the district director for the district in which the partnership return is filed. The application for revocation must be filed not later than 30 days after the close of the partnership's tax year in which the revocation is intended to take effect.(33) Situations that may be considered sufficient for approving an application include a change in the nature of the partnership business, a substantial increase in the assets of the partnership, a change in the character of partnership assets, or an increased frequency of retirements or shifts of partnership interests resulting in an increased administrative burden from the election. No application will be approved when the purpose of the revocation is primarily to avoid a step-down in the basis of partnership assets on an interest transfer or a distribution.
The binding nature of a Sec. 754 election, and associated compliance costs, suggests that the election should be limited to those situations in which the benefit is deemed substantial. There are three general issues that may diminish the attractiveness of a Sec. 754 election. First, a transfer of a partnership interest or a distribution in liquidation of a partner's interest can result in a downward adjustment to the basis of partnership assets. Second, any positive adjustment may be small in amount. Finally, even if a positive adjustment is substantial in amount, the allocation of the adjustment to specific assets may minimize the benefits of the election. The allocation may increase the basis of nondepreciable assets, or assets with a long recovery period. Additional problems can arise in the determination of the FMV of partnership assets, which includes the possible allocation of a portion of the adjustment to partnership goodwill. For these reasons, a Sec. 754 election should be carefully weighed whenever a transaction may give rise to an adjustment to basis.
Under ordinary circumstances, a partnership should not make a Sec. 754 election on its first return. It is atypical for an event to occur that would give rise to an adjustment, and the election could be binding for all future tax years. This point is not clear because Sec. 754 appears to make the election effective only if it is made in a year in which a transaction occurred that would give rise to an adjustment. Since it is impossible to know the future effects of an election, the election should be deferred until a transaction occurs that will result in a Sec. 734 or Sec. 743 adjustment. in the year of formation, the election would provide a basis adjustment when a partner contributing assets is relieved of liabilities in excess of the basis of property contributed.(34) Without the election, the partnership receives no basis increase for gain recognized by the partner, since the gain results from a deemed distribution of money rather than from the contribution. it would be necessary to weigh the benefit of the basis adjustment against the cost of a binding election.
During the operations of the partnership, distributions of property may provide an opportunity for a basis adjustment. Once again, the partners must decide whether the effects of the adjustment are more beneficial than the cost of a binding election. A basis adjustment must be allocated under the two-tier system, which requires a determination of the FMVs of all partnership property. To the extent an allocation is made to depreciable property, a new asset is created requiring separate cost recovery computations. The entity has an incentive to allocate any adjustment to assets with a relatively short recovery period, and the allocation is not the result of an arm's-length bargaining process. If an allocation among assets is questioned, the costs associated with an audit adjustment to the returns of many partners must also be considered.
If a transfer of interest occurs, any potential Sec. 743 adjustment applies only to the incoming partner Since the Sec. 754 election must be made at the entity level, the partnership may not see the value of a binding election that benefits only one partner. This is particularly true since the partnership generally maintains the records to allocate the adjustment to the affected partner, although there is no explicit authority requiring the partnership to do so for a Sec. 743 adjustment. Note, however, that any dispute with respect to the allocation of any adjustment among assets will affect only the transferee partner. The incoming partner may consider separately bargaining for a Sec. 754 election if one is not already in effect at the entity level.
Partnership terminations under Sec. 708(b)(1)(b), resulting from a 50% shift in interests, present unique opportunities for a Sec. 754 election. By operation of Sec. 732, inside and outside basis is adjusted for all partners. However, a partner acquiring an interest by sale or exchange in the year of the termination may find that the method of allocation of a basis adjustment under Sec. 755 is more or less favorable than the Sec. 732 allocation. if an entity level Sec. 754 election is already in effect, the Sec. 755 allocation is required before applying the Sec. 732 allocation. If, however, no election is in effect, the incoming partner may choose which allocation he prefers. If Sec. 732 is preferable, no action is necessary. If Sec. 755 is preferable, the terminated partnership should file a Sec. 754 election with its final return, There is no cost associated with this election since the entity is liquidated and the election is not binding on the newly formed partnership. Nonetheless, if the entity refuses to make the election, the transferee partner may make a Sec. 732(d) election, producing the same tax result.
Basis adjustments to partnership property under a Sec. 754 election can result in both positive and negative tax effects for the partners of a partnership. Further, the specific allocation among assets may diminish the attractiveness of a positive adjustment. The binding nature of the election mandates careful tax planning. While all future events cannot be planned for, considering a partnership's future intentions as to the distribution of assets, the sale of assets and the transfer of partnership interests should be an integral part of determining whether a Sec. 754 election is advisable.
Incoming Partner's Basis in One-Half Interest in Assets Allocation Total Cash Inventory Land Sec. 755 $5,000 $500 $2,000 $2,500 Sec. 732 5,000 500 1,500 3,000 Difference $ 0 $ 0 $ 500 $ (500)
(1) Sec. 734(b). (2) Sec. 734(b). (3) Regs. Sec. 1.754-1(b)(1). (4) See Rev. Proc. 79-63, 1979-2 CB 578, for the factors that will be taken into consideration in determining whether an extension for making an election or relief from failure to make a timely election will be granted. (5) Regs. Sec. 1.754-1(b)(1). (6) Sec. 1012. (7) Prop. Regs. Sec. 1.168-2(n). (8) Sec. 731(a). (9) Sec. 734(b)(1). (10) Sec. 731(a)(1). (11) Sec. 752(b). (12) Sec. 734(a)(1). (13) Sec. 723. (14) Sec. 732(a)(2). (15) Sec. 734(b)(2). (16) Sec. 732(b). (17) Sec. 732(c). (18) Sec. 731(a)(2). (19) Sec. 732(c). (20) Sec. 731(a)(1). (21) Regs. Sec. 1.755-1(b)(1)(i). (22) See Regs. Sec. 1.755-1(a)(1)(ii) and (iii). (23) Regs. Sec. 1.755-1(a)(1)(ii) and (iii). (24) See Sec. 1060(d) and Regs. Sec. 1.755-1(a)(1)(iv). (25) Regs. Sec. 1.755-1(a)(2). (26) Sec. 708(b)(1)(B). (27) Regs. Sec. 1.708-1(b)(1)(iv) (28) Sec. 723. (29) See Rev. Rul. 86-73, 1986-1 CB 283. (30) Under certain circumstances, the application of Sec. 732(d) is required. See Regs. Sec. 1.732-1(d)(4) for the application of Sec. 732(d) when the FMV of all partnership property exceeds 110% of its adjusted basis to the partnership. (31) See Rev. Rul. 88-42, 1988-1 CB 265. (32) 31 Sec. 754. (33) Regs. Sec. 1.754-1(c). (34) The temporary Sec. 752 regulations will determine the extent to which a partner was relieved of a liability.