When to advise a Sec. 754 election.

• Author: Grasinger, John L.
• Position: Partnerships

Variety and Complexity of Transactions to Which Election Applies Require Careful Planning

Sec. 754 may permit an adjustment to asset basis when a partnership distributes property or when an interest in the partnership is sold or exchanged. For practitioners and their clients, the variety and complexity of the transactions to which the Sec. 754 election applies necessitate extensive and careful planning before they decide whether or not to elect. Once made, the election is binding for all subsequent transactions; revocation is possible only with IRS permission.

The first category of transactions covered by a Sec. 754 election involves the sale or exchange of a partnership interest, resulting in an adjustment to the basis of partnership property for the transferee partner only.(1) The second category involves the distribution of partnership property, resulting in an adjustment to the basis of undistributed partnership property.(2)

This article will review the situations in which a Sec. 754 election will affect the basis of partnership property, with an emphasis on the manner of allocating basis among assets and the advisability of making the election in various situations; discuss the effects of Sec. 754 on the basis of assets in partnership formations and terminations; and provide guidance on the use of the Sec. 754 election to maximize tax benefits at the entity or partner level.

How to Make the Election

The election under Sec. 754 is made by the partnership and is binding for all future tax years. The election must be made in a written statement filed with the partnership return in a tax year in which a distribution or transfer occurs.(3)[ For the election to be valid the return must be filed on a timely basis, including any extensions.(4)

The statement must (1) provide the name and address of the partnership making the election, (2) be signed by one of the partners and (3) contain a declaration that the partnership elects under Sec. 754 to apply the provisions of Secs. 734(b) and 743(b).(5)

Sale or Exchange Transactions

When a partner purchases an interest in an existing partnership, he acquires a cost basis in the partnership interest(6) and a proportionate share of the basis of the assets represented by that interest. It is unlikely that the interest basis will equal the proportionate basis of the partnership assets. A Sec. 754 election will equate the aggregate basis of partnership assets represented by the purchaser's interest with the cost basis of that interest. See Example 1 on page 397.

Example 1: Adjustment to Basis of Partnership Interest

Partners A, B and C own one-third each of the ABC partnership with the following balance sheet.

Fair value Tax basis Cash $20,000 $20,000 Inventory 30,000 20,000 Sec. 1231 asset A 30,000 15,000 Sec. 1231 asset B 10,000 20,000 $90,000 $75,000 C sells his one-third interest to D for $30,000. D has a $30,000 basis in his partnership interest, but succeeds to C's $25,000 basis in one-third of the partnership property. If a valid Sec. 754 election is in effect, D will adjust the basis of his share of partnership assets to $30,000.(*)

(*) Sec. 743(b)(1).

In Example 1, D will be entitled to depreciate any portion of the $5,000 basis adjustment that is properly allocable to depreciable property. The adjustment will be treated as a new item of recovery property.(7) In the event that any partnership assets are disposed of in a taxable transaction, D will reduce his share of partnership gain (or increase his loss) by any unrecovered basis adjustment allocable to the assets sold or exchanged. Records of the adjustment must be maintained for the transferee partner and items of income, gain, deduction and loss must be allocated with respect to the adjustment.

In the event that a partner purchases an interest in the partnership for an amount below the aggregate basis of all partnership property, a Sec. 754 election would result in a negative adjustment. See Example 2 on page 398.

Example 2: Negative Adjustment to Basis of Partnership Interest

Assume the same facts as in Example 1, except that the fair value and the basis of the inventory and the Sec. 1231 assets are reversed.

Fair value Tax basis Cash $20,000 $20,000 Inventory 20,000 30,000 Sec. 1231 asset A 15,000 30,000 Sec. 1231 asset B 20,000 10,000 $75,000 $90,000 D will purchase a one-third interest for $25,000 and acquire a basis of $30,000 in the assets represented by that interest. If a Sec. 754 election is in effect. D will adjust the basis of his share of partnership assets downward to $25,000.(*)

(*) Sec. 743(b)(2).

While a partnership clearly would not make an election in order to produce this result, an election in effect at the time of the transaction would be binding on the partnership.

Distributions of Partnership Property

Under the aggregate concept of partnership taxation, the distribution of property from a partnership to a partner is generally not a taxable event.(8) To the extent there is no tax effect, there is no reason to adjust the basis of partnership assets. However, it is possible that a partnership distribution will result in recognition of gain or loss by the distributee partner, or in an adjustment to the basis of the distributed asset. in either of these situations, a Sec. 754 election will result in an adjustment to the basis of remaining partnership property.

* Positive adjustments on distribution

A positive adjustment to the basis of undistributed partnership property occurs on the distribution of property in either of two situations: (1) the distributee partner recognizes gain on the distribution or (2) the basis of distributed assets in the hands of the partner is less than the basis of such assets in the hands of the partnership.(9) Such transactions are unusual and normally occur only in investment partnerships.

Gain is recognized to the distributee partner when money is distributed in excess of the distributee's basis in his partnership interest.(10) Example 3: The DEF partnership distributes $5,000 cash to partner D, whose basis in her partnership interest is $2,000 immediately prior to the distribution. D will reduce the basis of her partnership interest to zero and recognize a $3,000 gain. If a Sec. 754...