Effects on Partnership and Limited Liability Company Interests
Section 754 Elections to Enhance Value and Marketability
Paul J. Streer and Caroline D. Strobel
2005 - When a purchaser buys an existing partner’s
partnership interest, or the interest of a member of a limited
liability corporation (LLC) taxed as a partnership, for
its fair market value, the amount paid becomes the basis
for the purchaser’s partnership interest (outside
basis). The new partner assumes the seller’s pro rata
share of the partnership’s adjusted basis in its property
(inside basis). If the partnership’s assets have appreciated
sufficiently, the difference between the new partner’s
inside and outside basis can be substantial. This disparity
can deprive the new partner of depreciation deductions and
inflate his share of the gain from subsequent property dispositions.
A knowledgeable buyer who is aware of these negative tax
consequences can negotiate a discounted purchase price to
minimize the negative tax result.
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.
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
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:
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).
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.
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.)
Impact of the Section 754 Election
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.
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)].
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.
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
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
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)].
the Optional Basis Adjustment
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.
to the earlier example, assume that the partnership now
owns the following assets when S purchases his one-third
interest for $255,000:
$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.
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.
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.
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
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
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.
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)].
to Avoid a Section 754 Election
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.)
to the example above, assume the following balance sheet
of the ABC Partnership:
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.
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
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
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.
ruling provided results that were not always consistent
with the intent of IRC sections 705 and 1032, as illustrated
by the following example:
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.
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.
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.
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.
J. Streer, PhD, CPA, is a professor of accounting
at the J.M. Tull School of Accounting, Terry College of Business,
University of Georgia, Athens, Ga. Caroline D. Strobel, PhD,
CPA, is a professor of accounting at the Darla Moore School
of Business, University of South Carolina, Columbia, S.C.