Making the Sec. 754 election decision for a family partnership after TRA '97.

• Author: Keene, David
• Position: Internal Revenue Code section 754, Taxpayer Relief Act of 1997

Your client, a surviving spouse, has just inherited the decedent spouse's partnership interest. The partnership is a family partnership in which the client's two children ore the other partners. Should a Sec. 754 election be made to equalize the surviving spouse's inside and outside bases? Should the surviving spouse's interest be liquidated? Through a comprehensive example, this article examines the family, income tax and estate tax issues that should enter into this decision.

The family partnership offers a unique situation for tax advisers--the analysis shifts from a single partner's tax consequences to that of the entire family; the estate planning implications must also be considered. This broadened view adds complexity to the decision-making process, but also allows for planning opportunities. One such opportunity arises when a partner dies and his partnership interest passes to another family member. The discussion that follows focuses on the effect on a family partnership of making (or not making) a Sec. 754 election, after a surviving spouse inherits her deceased husband's partnership interest.

Conventional wisdom suggests making the Sec. 754 election on the death of a partner. However, changes made by the Taxpayer Relief Act of 1997 (TRA '97) to the basis allocation rules on liquidation of a partner's interest make liquidation preferable to a Sec. 754 election in certain cases.

The Sec. 754 Election

Subchapter K offers a tax advantage when a successor to a decedent's partnership interest receives a basis step-up to fair market value (FMV) under Sec. 1014(a). If a Sec. 754 election is made, the successor partner can increase his share of the basis of partnership assets (i.e.,"inside" basis) by the difference between the stepped-up basis of his partnership interest (i.e.,"outside" basis) and the partnership's (lesser) basis in its individual assets. This basis increase is for the benefit of the inheriting partner only; other partners are unaffected. The increased basis stemming from the election allows the inheriting partner to recognize less gain when the assets are sold and to deduct higher depreciation or amortization before then.

Example: Partner A died on Dec. 31, 1997, leaving his one-third interest in the ABC partnership to his wife, W. ABC's balance sheet on that date was as follows:

Adjusted basis FMV Assets Cash $ 3,000 $ 3,000 Inventory 6,000 9,000 Depreciable assets 9,000 18,000 $18,000 $30,000 Capital A $ 6,000 $10,000 B 6,000 10,000 C 6,000 10,000 $18,000 $30,000

A's one-third interest in ABC's assets on his date of death was as follows:

Adjusted basis FMV Assets Cash $1,000 $ 1,000 Inventory 2,000 3,000 Depreciable assets 3,000 6,000 $6,000 $10,000

Under Sec. 1014(a), W's basis in A's partnership interest is the FMV of that interest at A's death, $10,000 (ignoring valuation discounts, for simplicity's sake). Because W's share of ABC; bases in its assets is only $6,000, different results can occur than if W had acquired the assets from A directly. For instance, if ABC sells the inventory, the recognized gain is $3,000, W's distributive share of which is $1,000. Similarly, a sale of the depreciable assets would result in a $9,000 recognized gain to ABC, of which $3,000 would be included in W's taxable income However if a Sec. 754 election is made after A's death, W would recognize no gain on the sale of the inventory or depreciable assets.

A Sec. 754 election eliminates the difference between outside basis and inside basis. In the above example, if a Sec. 754 election is made, W will take a $3,000 basis for her one-third interest in ABC's inventory and a $6,000 basis for her interest in its depreciable assets.

If No Election Is Made

A step-up in outside basis occurs under Sec. 1014(a) whether or not a Sec. 754 election is made; it will eventually provide a tax savings to the successor partner, if the partnership interest is later sold or liquidated. The step-up increases the basis of the partnership interest, thereby reducing the gain (or increasing the loss) on sale. On a complete liquidation of the withdrawing partner's interest, the entire basis of said interest will be attributed to the assets received in liquidation, under Sec. 732(b). In most liquidations, (1) the distributed property must then be sold by the partner for tax benefits to be obtained.

Most partners and their tax advisers will be inclined to make a Sec. 754 election and obtain the immediate tax benefits of a basis step-up rather than wait for a sale or liquidation. In most situations, a tax preparer would not want to "miss" the election. However, in certain situations, for a family partnership, a better result can be obtained by forgoing the election and having the inheriting partner receive low-basis assets in liquidation of the partnership interest.

Family Partnerships

The Sec. 754 election decision requires closer investigation in the family partnership context. The vehicle itself was likely created on the recommendation of an estate planner, to save estate taxes; the estate planner may or may not fully appreciate the income tax implications of the family partnership. Tax advisers need to consider both the estate planning and the income tax planning opportunities available The following questions should be asked:

* What are the income tax effects of the

options available to the whole family?

* What estate planning opportunities can

be created for the family?

* What is the makeup of the partnership's

assets (e.g., does it own marketable securities)?(2)

A sale an interest in a family partnership is rare; if it occurs shortly after the partner's death (and the concomitant step-up in basis to FMV), there is likely to be little (if any) taxable gain or loss.(3) On the other hand, a liquidation of the inheriting partner's interest may provide both tax and nontax benefits to such partner and other family members/partners. Although such a liquidation may be motivated by nontax considerations, the tax implications should be addressed before the partnership reacts with the usual impulse to make the Sec. 754 election. The election decision turns on the Sec. 755 allocation provisions that apply the step-up to the partnership assets under a Sec. 754 election versus the Sec. 732(c) allocation of basis that will be made to assets distributed in liquidation to an exiting partner.

Basis Allocation Issues

As was discussed, a Sec. 754 election allows a partnership to adjust a partner's share of the basis of partnership assets. Regs. Sec. 1.754-1(b) states that the election must be in writing and...