The genesis of Code Section 754 stretches back to the first third of the 20th century, as the IRS tried to combat tax avoidance through income shifting from higher-bracket taxpayers to lower-bracket taxpayers.

In 1901, Guy Earl and his wife entered into a contract that said any earnings or property either one received during the marriage would be considered “received, held, taken, and owned” by them as joint tenants. This contract wasn’t an attempt at tax avoidance; there was no federal income tax at the time because the prior income tax law had been declared unconstitutional in Pollack v. Farmers’ Loan and Trust Company, 157 U.S. 429 (1895) and the modern income tax wouldn’t be instituted until after the 16th Amendment took effect on March 1, 1913. The 1913 tax rates, while allowing a larger specific exemption for a married couple filing a joint return, had the same tax brackets for a single filers as for married jointly filers as for married separately filers (see instructions to Form 1040-1913, https://www.irs.gov/pub/irs-prior/f1040--1913.pdf, retrieved 01/04/2023). Similarly, the 1920 and 1921 tax years, the year in question for Mr. and Ms. Earl, had the same rates for single, married jointly, or married separately filers (https://www.irs.gov/pub/irs-prior/f1040--1920.pdf and https://www.irs.gov/pub/irs-prior/f1040--1921.pdf, retrieved 01/04/2023). The first time married filing jointly taxpayers benefited from lower tax brackets was for calendar year 1944 (https://www.irs.gov/pub/irs-prior/f1040--1944.pdf, retrieved 01/04/2023). Thus, Mr. and Ms. Earl received a tax benefit by splitting his income and filing separate returns.

The Supreme Court held that motive did not matter with regard to the Earls’ agreement. The individual who earns income must bear the tax on that income. Mr. Earl’s income would all be taxed to Mr. Earl: “fruits [cannot be] attributed to a different tree from that on which they grew.” Lucas v. Earl, 281 U.S. 111 (1930).

Overview

Here is an example of income shifting in a partnership.

John, Paul, George, and Pete are equal partners in Adagio, a string quartet. They each contributed $250 to the partnership and the partnership acquired its sole asset, a MacGuffin. Adagio incurred $200 of depreciation on the MacGuffin, and each partner’s capital account and basis was reduced from $250 to $200. The MacGuffin’s current adjusted basis is $800 and its fair market value (FMV) is $1,600.

Pete sells his interest in Adagio to Richard for cash in the amount of $400, which is equal to one-fourth of Adagio’s FMV. Pete realizes and recognizes $200 of gain; Richard’s basis in Adagio is $400.

Subsequently, Adagio sells the MacGuffin for $1,600, realizing $800 of gain, comprising $200 depreciation recapture and $600 Section 1231 gain. Each partner of Adagio reports one-fourth of the total, i.e., $200 of gain comprising $50 recapture and $150 §1231 gain.

Note that when we add Pete’s gain to Adagio’s gain, the aggregate gain reported by Adagio’s present and past members equals $1,000. Richard effectively reports gain that duplicates the gain reported by Pete. This is worst than income shifting, because income has been double-counted.

To prevent problems of this sort, Code Section 734 provides for adjustments in the case of certain distributions to partners and Code Section 743 provides for adjustments in the case of transfers of partnership interests. These adjustments can only be made if the partnership – not the partners! – makes an election under Code Section 754.

The Code Section 754 Election

A partnership makes the Code Section 754 election by including a statement with its tax return. The statement must be filed by the due date (with extensions) of the partnership return, and it must include:

• The name and address of the partnership;
• A declaration that the partnership elects under Section 754 to apply provisions of Section 734(b) and Section 743(b); and
• The signature of any partner (presumably an authorized partner under state law). [Treas. Reg. §1.754-1(b)]

The election applies to all transactions during the year and subsequent years, until revoked.

Effect of the Election

Code Section 743

I think it clarifies the issues to discuss Code Section 743 before discussing Code Section 734.

The trigger event for a Section 743 adjustment is a transfer of a partnership interest due to either a sale or exchange or to the death of a partner. In addition to a trigger event, one of two prerequisites must be in place before taking the adjustment: either the partnership has made a Section 754 election or there is a substantial built-in loss immediately after the transfer (i.e., the trigger event). [Code Section 743(b)]

Note: If there is a substantial built-in loss, the partnership must make the Section 743 adjustment even if it never made the election.

A substantial built-in loss [Code Section 743(d)] exists if:

• The partnership’s adjusted basis in partnership property exceeds the fair market value of the property by more than $250,000 (the “Partnership-level Test”); or
• The transferee partner would be allocated a loss of more than $250,000 if the partnership assets were sold for cash equal to fair market value immediately after transfer (the “Partner-level Test”)

The interplay between the Partnership-level Test and the Partner-level Test is not immediately apparent, but an example from the Conference Committee Report to the Tax Cuts and Jobs Act gives some clarity. [Conf. Rept. No. 115-466 (PL 115-97) p. 512-513 (TCJA)] I have modified the example somewhat to ensure internal consistency.

Enterprise is a partnership with three partners, Kirk, Spock, and McCoy, that did not make the 754 election. It owns two assets: a dilithium crystal with a basis of $100,000 and an FMV of $1.1 million and a matter/anti-matter reactor with a basis of $2 million and an FMV of $1.1 million.

Partnership-level Test. The adjusted basis in partnership assets is $2.1 million and the FMV  is $2.2 million. The adjusted basis does not exceed fair market value, so there is no substantial built-in loss under the Partnership-level Test.

Partner-level Test. Kirk had contributed the dilithium crystal to the partnership, and under both Code Section 704(c) and the partnership operating agreement, there is built-in gain on the dilithium crystal in the amount of $1 million that will be specially allocated to Kirk. The three partners share equally in all other gains and losses.

McCoy sells his interest to Scott for $33,333. This sale satisfies the Code Section 743 trigger event of a sale or exchange.

To calculate the Partner-level Test, we perform a hypothetical transaction: assume Enterprise sells all its assets for their FMVs immediately after the trigger event. In the hypothetical transaction, Enterprise recognizes gain on the dilithium crystal in the amount of $1.1 million less $100,000 basis, which equals $1 million. This entire gain is allocated to Kirk. Enterprise recognizes loss on the sale of the matter/anti-matter reactor in the amount of the excess of the $2 million basis over the $1.1 million FMV, which equals $900,000. The loss is allocated $300,000 to each of Kirk, Spock, and Scott.

The transferee partner, Scott, has been allocated a hypothetical loss in excess of $250,000, and there is substantial built-in loss under the Partner-level Test.

An electing investment partnership shall not be treated as having a substantial built-in loss. However, a transferee partner in an electing investment partnership can only recognize loss in excess of loss recognized by the transferor. Furthermore, disallowed losses do not decrease the transferee partner’s outside basis in the partnership.

The Code’s language on this point is particularly obtuse: [Code Section 743(e)(4)]:

In the case of a transferee partner whose basis in property distributed by the partnership is reduced under section 732(a)(2), the amount of the loss recognized by the transferor on the transfer of the partnership interest which is taken into account under paragraph (2) shall be reduced by the amount of such basis reduction.

The basis reduction under Section 732(a)(2) is best explained by an example:

Diana had an interest in Supreme Co., an electing investment partnership. She sold her interest to Jean for $100 and recognized a loss in the amount of $10. Jean’s outside basis in Supreme is $100. Supreme distributes securities to Jean that have an inside basis of $150 and a fair market value of $20. The general rule is that the inside basis carries over to the partner on a property distribution, but it’s limited to the partner’s outside basis. Jean’s basis in the property is limited to $100, and Jean’s basis in the partnership has been reduced to zero by the distribution.

The basis reduction pursuant to Section 732(a)(2) is $50.

Jean sells the securities for $20. Her realized loss is $20 minus $100 = ($80). She can only recognize loss to the extent it exceeds the loss recognized by the transferor, Diana. That loss is $10, and without Section 743(e)(4), Jean’s loss would be limited to the excess of $80 over $10, or $70.

Pursuant to Section 743(e)(4), Diana’s loss of $10 is reduced by Jean’s basis reduction of $50, so Diana’s loss is reduced to zero. Thus, Jean’s loss is limited to the excess of $80 over zero, which is $80.

Code Section 743(e)(5) defines an electing investment partnership.

• Partnership makes election;
• Partnership would be an investment company under Investment Company Act of 1940 but for exemptions under Section 3(c)(1) or (7);
• Partnership never engaged in a trade or business;
• Substantially all assets are held for investment;
• At least 95% of assets contributed are money;
• No assets contributed had adjusted basis in excess of fair market value;
• All partnership interests issued pursuant to private offering within 24 months after date of first contribution to capital;
• Partnership agreement has substantive restrictions on partner’s ability to redeem;
• Partnership agreement provides for term not exceeding 15 years; and
• The election can only be revoked with Secretary’s consent.

A securitization partnership shall not be treated as having a substantial built-in loss. [Code Section 743(f)] A securitization partnership is one whose sole activity is to issue securities with fixed principal serviced by discrete pool of financial assets that convert into cash in a finite period, and the sponsor reasonably believes that the financial assets are not acquired to be disposed of (i.e., no intention to buy and sell).

The adjustment itself seems almost obvious. [Code Section 743(b)]

• If transferee partner’s outside basis exceeds their proportionate share of inside basis, increase the inside basis by that excess;
• If transferee partner’s proportionate share of inside basis exceeds their outside basis, decrease the inside basis by that excess.

The increase or decrease is an adjustment only for the transferee partner. The Partner’s proportionate share is determined in accordance with partnership capital. In the case of contributed capital, Code Section 704(c) (special allocation of built-in gain/loss) applies.

The partnership must allocate the basis adjustment among its assets to reduce the difference between FMVs and the adjusted bases of the partnership properties. [Code Section 743(c), cross-referring Code Section 755]

Basis adjustments arising from a distribution (Code Section 734, discussed below) or from a transfer of interest in capital assets or other property shall be allocated to property of a like character. In case of a distribution where there is not sufficient basis in like-kind property, the adjustment is applied to subsequently acquired property.

Code Section 734

The trigger event for a Section 734 adjustment is a distribution of property. In addition to a trigger event, one of two prerequisites must be in place before taking the adjustment: either the partnership has made a Section 754 election or there is a substantial basis reduction with respect to the distribution.

Note: If there is a substantial basis reduction with respect to the distribution, the partnership must make the Section 734 adjustment even if it never made the election.

A substantial basis reduction [Code Section 734(d)] exists if the sum of the loss recognized to distributee partner under Section 731(a)(2), plus the excess of the basis of distributed property to the distributee over the inside basis of the property exceeds $250,000. A partner recognizes a loss under Section 731(a)(2) only when there has been a total liquidation of the partner’s interest, the only assets received by the partner are money, unrealized receivables, and inventory, and the partner’s outside basis in the partnership exceeds the amount received.

Example: Al is a founding member of BST, a partnership. His outside basis in his partnership interest is $100. The other partners think he should retire and have convinced him to accept a liquidating distribution. BST has cash plus inventory with an inside basis of $10. BST liquidates Al’s interest for cash $70 plus the inventory. Al’s amount realized is $70 cash plus $10 carryover basis from the inventory = $80, so he realizes and recognizes a loss of $20.

The adjustment is analogous to the Section 743 adjustment [Code Section 734(b)]. Unlike the Section 743 adjustment that affects the transferee partner, the Section 734 adjustment affects the partnership.

The partnership increases the inside basis of partnership property (i.e., the remaining property that was not distributed) by:

• Gain recognized under Section 731(a)(1), i.e., cash in excess of basis; and
• The excess of the inside basis of distributed property over the basis of the property to the distributee.

Example: David joined BST as a partner after Al retired. David’s outside basis in his partnership interest is $10. After a while, the other partners decide to accept his wholly voluntary retirement. BST distributes to David property with an inside basis of $50. David’s basis in the property is $10 and his outside basis is reduced to zero. The excess of inside basis over partner’s basis in the property is $50 minus $10 = $40.

There shall be no basis increase for distribution of an interest in a lower-tier partnership that does not have a §754 election in place.

The partnership decreases the inside basis of partnership property by:

• The loss recognized by distributee under §731(a)(2); and
• The excess of the basis of distributed property to distributee over partnership’s inside basis.

Example: Jerry joined BST after David retired. Jerry’s outside basis in his partnership interest is $60. After a while, the other partners… well, you know the rest. BST distributed property with an inside basis of $40 to Jerry, in complete liquidation. Jerry’s basis in the property is $40. The excess of basis of distributed property to the distributee over partnership’s inside basis is $60 minus $40 = $20.

Just as with a Section 743 adjustment, the partnership must allocate the basis adjustment among its assets. [Code Section 734(c), cross-referring Code Section 755]

There is a special rule for a corporate partner.

• If there is an adjustment for distribution §734;
• The adjustment would result in decrease in basis to partnership property; and
• The partnership owns stock in a corporation that is a partner in the partnership or related to a partner in the partnership; then
• There shall be no adjustment to basis of that corporate stock owned by the partnership.

To determine whether a corporation is related to a partner in the partnership, we must look to the related partner rules of Code Section 267(b) and Section 707(b)(1).

Code Section 267 deals with loss disallowance on transactions between related parties. As relevant here, a related party means a Corporation and an individual who holds more than 50% in value of the outstanding stock, directly or indirectly (i.e., family or trust relationship is indirect ownership). Family means siblings, spouse, ancestors, and lineal descendants. [Code Section 267(c)(4)]

Code Section 707 deals with guaranteed payments. As relevant here, a related party means a partnership and person owning more than 50% of the capital interest or profits interest, directly or indirectly; or two partnerships in which the same persons own more than 50% of the capital interest or profits interest, directly or indirectly.

Similarly to the rule for Section 743 and substantial built-in loss, a securitization partnership shall not be treated as having a substantial basis reduction. [Code Section 734(e)]

With all this in mind, it’s time to return to the Adagio partnership.

Example – the Adagio partnership redux

John, Paul, George, and Pete are equal partners in Adagio, a string quartet. They each contributed $250 to the partnership and the partnership acquired its sole asset, a MacGuffin. Adagio incurred $200 of depreciation on the MacGuffin, and each partner’s capital account and basis was reduced from $250 to $200. The MacGuffin’s current adjusted basis is $800 and its FMV is $1,600.

Adagio made a Code Section 754 election.

Pete sells his interest in Adagio to Richard for cash in the amount of $400, which is equal to one-fourth of Adagio’s FMV. Pete realizes and recognizes $200 of gain; Richard’s basis in Adagio is $400.

Richard’s proportionate share of Adagio’s inside basis is one-fourth of $800, or $200. The excess of his outside basis over his proportionate share of inside basis is $400 minus $200 = $200. Adagio increases the basis of the MacGuffin – but only allocable to Richard! – by $200.

Adagio sells the MacGuffin for $1,600. Visualize it as if $400 amount realized allocated to each partner. John, Paul, and George have basis of $200 each, so they realize $200 gain each. Of that gain, $50 represented their previously deducted depreciation recapture and the remaining gain is §1231 gain. For Richard, his basis is $200 plus the special allocation under Section 743 of $200 for a total basis of $400. Richard realizes and recognizes zero gain – and thus zero recapture.

Note: When we add Pete’s gain to Adagio’s gain, the aggregate gain reported by Adagio’s present and past members equals $800 – i.e., there has been no double counting of Pete’s built-in gain to Richard.

Effect of the election on a partner’s capital account

The adjustment to basis pursuant to Section 743 does not affect the capital account of the transferee partner. [Treas. Reg. §1.704-1(b)(2)(iv)(m)(2)] The adjustment to basis pursuant to Section 734 affects the capital account of a distributee (in a non-liquidating distribution) and it affects capital account of all partners by amount of adjustment to the adjusted tax basis of partnership property. [Treas. Reg. §1.704-1(b)(2)(iv)(m)(4)] The adjustment is allocated among partners the same way gain on the affected property would be allocated among the partners.

Effect of the election on deductions

The basis increase is treated as newly purchased recovery property. [Treas. Reg. 1.743-1(j)(4)(i)(B)(1)] The partnership chooses the depreciation method to use.

Example: Partner A was allocated $1,000 §743 basis adjustment. The partnership’s sole asset is computer with a recovery period of 5 years. The partnership elects out of bonus depreciation and records the basis adjustment as the purchase of a new computer.

The partnership makes a special allocation to A of the depreciation on the “newly-purchased computer.” The depreciation deduction for Year 1 is $200.

A’s remaining basis adjustment is $800 and will decrease each year as more depreciation is specially allocated to him.

Effect on capital account reporting

Implemented over the past two years, the IRS requires Schedule K-1 to show a partner’s tax-basis capital account, which differs from the capital account computed under Treas. Reg. §1.704-1(b). Because the partnership operating agreements are generally drafted to incorporation the Regulations, they usually require the capital accounts for purposes of partnership allocations, distributions, and the like, to be computed on a book basis, not a tax basis.

The IRS instructions to Form 1065 state that the partner’s tax-basis capital account shall be increased or decreased by adjustments under Section 734(b). However, the tax-basis capital account shall not be adjusted by adjustments under Section 743(b). This makes sense, because the former adjustments affect all partners but the latter adjustments are particular to one partner.

Intercompany sale of partnership interest

An interesting potential conflict arises in the context of a controlled group of corporations. Usually, gain is deferred on a sale from subsidiary to parent until there is a trigger event (under the matching rule). But if Subsidiary S sells a partnership interest to Parent P at a gain when the partnership has a Section 754 election in place, P would be entitled to increased depreciation deductions due to the Section 743 adjustment. To offset the increased depreciation and reach the same result as if P and S were a single entity, S recognizes gain on the sale to P equal to and offsetting of P’s increased depreciation deduction. [Treas. Reg. §1.1502-1(c)(7)(ii)(I), Example 9]

Distribution of adjusted property

Distribution to transferee

The basis adjustment is taken into account to compute the recipient’s effect on basis. [Treas. Reg. §1.743-1(g) and §1.732-2(b)]

Example (from the Regulations): Property X has an inside basis $1,000 and a basis adjustment with respect to partner D of $500. The partnership distributes Property X to Partner D. D’s basis in Property X is the lesser of $1,500 or D’s outside basis before the distribution.

Distribution to a partner other than the transferee

The basis adjustment is not taken into account to compute the recipient’s effect on basis. [Treas. Reg. §1.743-1(g) and §1.732-2(b)]

Example (from the Regulations): Property X has an inside basis $1,000 and basis adjustment with respect to partner D of $500. The partnership distributes Property X to Partner E. E’s basis in Property X is the lesser of $1,000 or E’s outside basis before the distribution.

D’s basis adjustment of $500 previously allocated to Property X is reallocated among the remaining items of partnership property. [Treas. Reg. §1.755-1(c)] The basis adjustment must be allocated to property of the same class as Property X, i.e., capital or ordinary.

• Increase to basis: within each class, allocate first to properties with unrealized appreciation and any remaining increase allocate in proportion to FMV;
• Decrease to basis: within each class, allocate first to properties with unrealized depreciation and any remaining decrease allocate in proportion to adjusted bases.

There is a limitation on decrease in basis, because basis cannot be less than zero. Thus, if there is any decrease that cannot be allocated since basis of property of the same class has been reduced to zero, the unallocated decrease is a suspended adjustment, to be made when the partnership acquires property of a like character.

Transferee receives partnership interest

Transferee must provide information to the partnership relating to the transfer. [Treas. Reg. §1.743-1(k),§1.755-1(d)]

The partnership must attach a statement showing computation of basis adjustment and allocation to partnership properties.

If transferee receives a distribution

The partnership must provide information to partner reporting a basis adjustment and the transferee must attach a statement to their return showing computation of basis adjustment.

If transferee does not notify the partnership, the partnership will be entitled to report transferee’s shares without any adjustment. If the transferee later provides full information, the partnership must make adjustments in any amended return or in next annual return. The partnership must attach a statement to the return for the year in which it receives notice of the transfer. [Treas. Reg. §1.743-1(k)(5)] The statement “RETURN FILED PURSUANT TO §1.743-1(k)(5)” must appear on the first page of return and first page of any schedule relating to the transferee’s share of income, credits, deductions, etc.

Tiered partnership

Where there are distributions between tiered partnerships, the Regulations try to preserve the economic effect of the adjustments. [Treas. Reg. §1.743-1(h)]

Example with two partnerships: Partnership Disni forms new lower-tier partnership Pixi. Disni owns an animation cel (the “Cel”), subject to basis adjustment with respect to partner Bob, that it contributes to Pixi. The inside basis to Disni of the Cel is $1,000 and the adjustment with respect to Partner Bob is $500.

Pixi’s inside basis in the Cel is $1,500 and Disni’s outside basis in Pixi is $1,500. Of that outside basis, $500 is Bob and the remaining $1,000 outside basis is allocated among all partners.

Example with one partnership and one corporation: Partnership Disni forms new lower-tier corporation Marvi. Disni owns an animation cel (the “Cel”)— subject to basis adjustment with respect to partner Bob—that it contributes to Marvi. The inside basis to Disni of the Cel is $1,000 and the adjustment with respect to Partner Bob is $500.

Marvi’s inside basis in the Cel is $1,500. If Disni recognizes gain on the transaction (e.g., from boot received on the Section 351 exchange of contributing property to a controlled corporation), Disni’s gain is determined without reference to the basis adjustment. When Disni allocates this gain to its partners, Bob’s share is adjusted to reflect his basis adjustment.

Disni’s basis in Marvi stock is determined without reference to the basis adjustment. Bob will have a basis adjustment in the Marvi stock, reduced by any basis adjustment taken into account if there was gain recognized on the Section 351 exchange.

Conclusion

The Code Section 754 election is a valuable tool for ensuring tax equity among the partners in a partnership. Its use should be accompanied by careful record keeping at the partner and the partnership level.

Dean L. Surkin, JD, LLM, is a tax director at Gettry Marcus CPA, P.C. He is a tax attorney with broad-based experience in tax planning and research, has litigated major cases in the fields of taxation, probate, and general commercial matters, and has been peer-reviewed by Martindale-Hubbell. He is admitted to the New York State Bar, the Federal District Courts of the Southern and Eastern Districts of New York, the Second Circuit Court of Appeals, and the U.S. Tax Court. Mr. Surkin holds the faculty appointment of Professor (Adjunct) at Pace University Graduate School of Business, where he teaches taxation of entities. He was recently honored for 35 years of service to Pace.