Common Traps To Avoid When Making Section 754 Elections

By:
Randy Schwartzman, CPA, MST; Jeffrey Bilsky, CPA; Patricia Brandstetter, JD, LL.M.
Published Date:
Apr 1, 2015

Requirements of a Valid Section 754 Election

Generally, a partnership seeking to adjust the basis of partnership property upon the transfer of an interest under Section 743(b), or following a distribution under Section 734(b), must have a valid Section 754 election in place. Although a seemingly simple election, it is not uncommon that a partnership intending to make a valid Section 754 election inadvertently fails to satisfy all of the regulatory requirements. Under those circumstances, however, there may be limited recourse available to the partnership to pursue corrective action.

Although most tax preparation software will generate Section 754 elections, it is incumbent that the tax preparer ensures the election statement meets the regulatory requirements and communicates to the partnership that the election must be signed by a partner prior to filing the tax return with the IRS. This signing requirement applies whether the tax return is filed via paper or electronically.

Specifically, Treasury Reg. § 1.754-1(b)(1) provides that a Section 754 election to adjust the basis of partnership property under Sections 734(b) and 743(b) shall be made in a written statement filed with the partnership return for the taxable year during which the distribution or transfer occurs. For the election to be valid, the return must be filed no later than the due date (including extensions thereof) for such taxable year. Further, a valid Section 754 election must include the name and address of the partnership making the election and be signed by any partner with a declaration that the partnership is making a Section 754 election to apply with respect to a distribution or transfer pursuant to Sections 734(b) and 743(b).

With respect to e-filing, IRS Publication 4163 provides guidance regarding the process of including forms and elections that require signatures when e-filing the tax return. Publication 4163 indicates that, where a taxpayer is making an election that requires a separate signature, a signed election may be attached to the e-filed return in PDF format. IRS Counsel has reviewed regulations to identify forms and elections requiring a separate signature to determine if the signature requirements could be changed. Although, amendments to the Income Tax Regulations and Procedure and Administration Regulations (Treasury Decisions (T.D.) 9300 and 9329) eliminate certain third-party signature requirements considered impediments to the electronic submission of tax returns and other forms, they appear to make no changes to the Section 754 election requirements, including the requirement of a partner’s signature.

Automatic Relief for Failure to Timely Elect under Section 754

If a partnership fails to file a valid Section 754 election, automatic relief may be available under Treas. Reg. § 301.9100-2. This regulation grants a 12 month automatic extension for making certain regulatory elections, including the Section 754 election. In order to obtain relief under these provisions, the taxpayer must file an original or amended partnership return including a correctly completed Section 754 election that complies with the statute and/or applicable regulations.

Any return, statement of election, or other form of filing made to obtain an automatic extension must provide the following statement at the top of the document: “FILED PURSUANT TO REG. § 301.9100-2.” Further, any filing made to obtain an automatic extension must be sent to the same address that would have applied had the filing been timely made. No request for a Private Letter Ruling is required to obtain an automatic extension. Accordingly, user fees do not apply to taxpayers taking corrective action to obtain an automatic extension.

Also, the regulations require taxpayers who seek an automatic extension (including all taxpayers whose tax liability would be affected by the election) to file their return(s) in a manner consistent with the election and comply with all other requirements applicable for the tax year the election should have been made as well as for all other affected tax years.  Otherwise, the Service may invalidate the election.

Other Relief for Failure to Timely Elect under Section 754

If a partnership fails to file a timely valid Section 754 election is unable to obtain automatic relief under Treas. Reg. § 301.9100-2, the only remaining recourse may be to seek relief under Treas. Reg. § 301.9100-3.

Under Treas. Reg. § 301.9100-3(a), requests for relief will generally be granted if the taxpayer provides evidence that establishes to the satisfaction of the Commissioner that the taxpayer acted reasonably and in good faith, and that granting the extension will not prejudice the interests of the Government.

A taxpayer will be deemed to have acted “reasonably and in good faith” with respect to the requested extension if the taxpayer (1) requests relief before the failure to make the election is discovered by the Service; (2) failed to make the election because of intervening events beyond the taxpayer’s control; (3) failed to make the election because, after exercising reasonable diligence (taking into account the taxpayer’s experience and the complexity of the return or issue), the taxpayer was unaware of the necessity for the election; (4) reasonably relied on the written advice of the Service; or (5) reasonably relied on a qualified tax professional (including an employee), and the tax professional failed to make, or advise the taxpayer to make, the election.

To pursue relief under Treas. Reg. § 301.9100-3, the taxpayer must satisfy specific factual and procedural requirements and pay user fees charged for seeking a Private Letter Ruling.  Specifically, the taxpayer must submit a detailed sworn affidavit (1) describing the events that led to the failure to make a valid election and to the discovery of the failure; (2) indicating the existence of grounds for the extension, along with sworn affidavits by others that support these grounds; and (3) stating whether the taxpayer’s return or returns for the taxable year(s) in which the election should have been made (or any taxable year(s) that would have been affected by the election had it been timely made) are either being examined by the Service or being considered by an appeals office or a federal court.

Additionally, the taxpayer must submit a copy of any documents referring to the election, and, upon request, submit a copy of the taxpayer’s return (and any return of other taxpayers affected by the election) for any taxable year for which an extension to make the election has been requested.

Tax Return Filing and Notification Requirements upon a Transfer of Partnership Interest

If a transfer of a partnership interest gives rise to a basis adjustment under Section 743, the partnership must attach a statement to the partnership return for the year of the transfer that provides the name and TIN of the transferee partner and the computation and allocation of the basis adjustment. Generally, the computation of the basis adjustment is determined as follows:

Transferee’s Outside Basis   $______________
Less: Transferee’s share of the basis of Partnership property:    
   Previously Taxed Capital ____________  
   Plus: Transferee’s share of Partnership liabilities ____________ ________________
Basis Increase (Decrease)   $_______________

Within 30 days of a transferee partner acquiring an interest by sale or exchange, such partner must notify the partnership of the transfer in writing. The written notice (signed under penalty of perjury) must contain the name, address, the TIN of the transferee, and, if known, the transferor, the date of the transfer, the amount of any liabilities assumed or taken subject to by the transferee, and the amount of any money and the FMV of any other property delivered or to be delivered for the partnership interest.

If a partnership interest is transferred upon death, within one year of the date of the transferor’s death, the transferee partner must notify the partnership of the transfer in writing (signed under penalty of perjury).  The written notice must include the name, address, and TIN of the deceased and the transferee partner; the date the transferee became the owner of the partnership interest; the applicable valuation date FMV of the partnership interest; and the method used to determine FMV.

In computing the basis adjustment, the partnership may rely on the information provided in the written notice.  Until the partnership actually receives the written notice, it is not required to make the adjustment. However, the partnership is deemed to have received written notice if the tax matters partner or other partner responsible for the partnership federal income tax reporting has knowledge of the transfer of the partnership interest.

If the transferee partner fails to provide written notice, when the partnership is otherwise notified, it must attach a statement to its return setting forth the name and TIN, if known, of the transferee. In addition, the caption “RETURN FILED PURSUANT TO REG. § 1.743-1(k)(5)” must prominently appear on the first page of the partnership's return as well as the first page(s) of any schedule(s) or information statement(s) relating to the transferee partner's share of income, deductions, credits, etc.

Thus, until the partnership receives written notice, the partnership reports the transferee partner's share of partnership items without making an adjustment to the basis of partnership property for the transferee partner's benefit. Upon receipt of written notice, effective as of the date of transfer, the partnership must make the applicable inside basis adjustments to the partnership property in an amended return or in the next regularly filed return. At such time, the partnership must provide sufficient information to the transferee partner so he or she is able to file an amended return(s) to properly reflect the Section 743 adjustment.

Adherence to this regulation is especially important to practitioners representing sellers in M&A transactions who are engaged solely to prepare the final return of a technically terminated partnership (i.e., when a sale of 50% or more of the partnership interests occurs within 12 months under Section 708(b)(1)(B)). This is because such practitioners may not have the ability to amend the final return post-sale nor be engaged to prepare the initial return of a technically terminated partnership. Obviously, this creates another area of potential exposure for which corrective action may not be easily accessible.

Conclusion

A valid Section 754 election may provide substantial tax benefits to the owners of entities taxed as partnerships because it allows for an adjustment to the partnership’s basis of property Generally, in the case of a basis adjustment of depreciable or amortizable property, depreciation and amortization deductions (with respect to the basis “step up”) are allowed in the year of the election.

Failure to properly execute tax elections is a major area of litigation for practitioners. Because a Section 754 election requires a partner’s signature, the advent of tax return e-filing technology has complicated the process and presented procedural challenges in properly executing such elections. Therefore, it is crucial that taxpayers and practitioners have a strong understanding of the requirements for making a valid Section 754 election. Because a partnership may inadvertently not meet the procedural requirements of the election, it is of equal importance to have a strong understanding of existing relief procedures that may allow for corrective action. 

schwartzman1Randy Schwartzman, CPA, MST, is the Regional Managing Partner for the Northeast Tax Practice and the leader of the Tax Practice for the Northeast Transaction Advisory Services group of BDO USA, LLP. Randy is also a member of the NYSSCPA’s Taxation of Mergers and Acquisitions and Closely Held and S Corporations committees. 




 bilskyJeffrey Bilsky, CPA,
is a Senior Director in BDO USA, LLP’s National Tax Office focusing on complex partnership tax issues. 




brandstetter1

Patricia Brandstetter, JD, LL.M,
is a Senior Tax Associate in BDO USA, LLP’s Northeast Transaction Advisory Services group.

 
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