New partnership basis rules.

• Author: Bakale, Anthony

The IRS issued final regulations in December 1999, which, among other things, change the way taxpayers account for the difference between their outside bases in their partnership interests and their proportionate share of the partnership's inside basis of its assets. These differences occur when a partner dies and the basis of that interest is stepped up to its fair market value (FMV), or when a partner sells or exchanges an interest to either another partner or an outside third party. In certain circumstances, distributions of partnership property can also cause these differences.

A three-step process must be followed to protect partners from the adverse tax consequences that result when differences arise between inside and outside bases:

1. Partnerships must make a valid Sec. 754 election to adjust the inside basis of partnership property.

2. They must calculate an adjustment to reconcile inside and outside bases differences. Sec. 743(b) provides the mechanism to calculate this adjustment when a sale of an interest or partner's death occurs, and Sec. 734 when a property distribution causes the adjustment.

3. The adjustment calculated in the second step must be allocated to partnership assets under Sec. 755.

   Sec. 754 Elections

   A partnership, not individual partners, makes this election on a timely filed return (including extensions) for the adjustment year. Once made, this election is applicable to all subsequent years and future transactions, unless the partnership can obtain the Service's permission to revoke it. An election cannot be used to step up the basis of partnership assets in the first year, and then ignored in the second year when a step-down is required. Ordinarily, permission to revoke an election is difficult to obtain and is granted only when there is a significant change to partnership operations.

   Regs. Sec. 1.754-1 provides taxpayers with a short window of opportunity in which to revoke a current Sec. 754 election. It can be accomplished by attaching a statement to the partnership's return for the year that includes Dec. 15, 1999. This revocation only applies to transfers or distributions occurring after Dec. 14,1999. The IRS feels that, due to the significant changes made, it is appropriate to grant taxpayers a one-time revocation (see Regs. Sec. 1.754-1(c)(2) for details).

   Sec. 743(b) Basis Adjustments

   The major difference under the new regulations is in the calculation and allocation of the basis adjustment. Generally, the old rules allocated overall increases in basis only to assets whose FMVs exceeded their tax bases. Assets that declined in value were not be adjusted. Inversely, negative overall adjustments were allocated only to assets whose FMVs fell below their bases; appreciated assets were left untouched. Sometimes, this resulted in an overall distortion of the character of gains and losses to a partner over the life of the partnership. Under new Regs. Sec. 1.743-1, all assets are adjusted (both up and down) to reduce the difference between their tax bases and their FMVs, regardless of overall adjustments being positive or negative.

   An overall adjustment is calculated using the formula provided in...