When used properly, an IRC 754 election can be an important tool for an estate planning or business planning attorney. It can make a big difference in the tax burden of a company s partners and should be given consideration whenever there is a sale of a partnership interest, a death of a partner, or disproportionate distributions. However, due to the binding nature of the election and its potential to affect future tax liability, the election should only be made after a thorough evaluation of the pros and cons. Effective Tax Planning For Partnerships: UNDERSTANDING THE IRC 754 ELECTION ELLIOT P. SMITH, JD, MACC, MS, CPA, WEALTHCOUNSEL MEMBER SINCE 2013 PAGE 4
VOLUME 9 NUMBER 3 / Q3 2015 THE ELECTION An election under Internal Revenue Code ( IRC ) 754 saves income taxes by increasing the tax basis of assets owned by a partnership. The election reduces the difference between a partner s high tax basis in his or her partnership interest and the partnership s low tax basis in his or her share of the partnership s assets. Often this election can save a client significant money. It should never be overlooked when working with any entity that files IRS Form 1065. Let s start with the basics. Two great prongs of partnership taxation are: 1) the outside basis, or the adjusted basis of a partnership interest held by the partner; and 2), the inside basis, or the adjusted basis of the assets held by or inside the partnership. TAX BASIS OF PARTNERSHIP INTEREST ( OUTSIDE BASIS ) Outside basis is roughly comparable to a shareholder s tax basis in corporate stock. However, it s not that simple because a corporation is a tax-paying entity and a partnership is a pass-through entity: Partners incur the tax liability instead of the partnership. Differences include increasing a partner s outside basis for contributions plus his or her share of income and decreasing his or her outside basis for distributions and losses. For example, suppose Partner A contributes $20 to a new partnership and during the first year of operation he is allocated $5 of taxable income. The $5 of taxable income is reported to him on a Schedule K-1 and ends up on his personal Form 1040. For simplicity, also assume that the partnership has no debt and no contributions or distributions were made by or to Partner A during the tax year. Partner A s outside basis would increase from $20 to $25 because of the $5 of taxable income. If Partner A subsequently sells his partnership interest for $25, he would recognize zero gain because his outside basis would equal the sales price. This increase in outside basis prevents a partner from suffering the pain of double taxation which would occur with a C-corporation paying taxes on its income followed by the shareholder paying taxes on his $5 stock sale. TAX BASIS OF PARTNERSHIP ASSETS ( INSIDE BASIS ) Inside basis is a partner s share of the tax basis of the partnership s assets. Examples include inventory, accounts receivable, machinery, and goodwill. Generally, fixed assets such as furniture and machinery are depreciated over a period of years providing significant tax deductions. Purchased intangibles such as goodwill can also provide amortization deductions. However, these depreciation and amortization deductions can only be taken if the inside assets have a tax basis. Once the tax basis is exhausted, no further deductions can come from that particular asset. And, upon the sale of a partnership asset with a high inside basis, less gain or additional loss passes through to the partners. RELATIONSHIP BETWEEN INSIDE AND OUTSIDE BASIS Due to adjustments to a partner s outside basis based on income, expense, contributions and distributions, the tax basis of assets inside the partnership often equals the partners aggregate outside bases. In the previous example, the partnership realized $5 of income; simultaneously we observed an increase in Partner A s outside basis. The result is that both A s outside basis and A s share of the inside basis equal $25 prior to the sale of Partner A s partnership interest. Several events, however, can cause a disparity between inside and outside basis: (1) the sale of a partnership interest, (2) certain distributions from the partnership, and (3) the death of a partner. The IRC 754 election works to reduce these disparities so that a partner s outside basis comes closer to matching her share of the inside basis of the partnership assets. On a slightly deeper level, an IRC 754 election also causes the tax equity account on a tax balance sheet to equal a partner s outside basis when added to the partner s share of liabilities. SECTION 754 AND THE SALE OF PARTNERSHIP INTEREST The sale of a partnership interest is frequently the reason for making an IRC 754 election. Often, a pur- PAGE 5
chaser seeks to obtain the same tax benefit that he would receive if assets were purchased outright rather than indirectly as part of a partnership interest. If no election is in effect, nothing happens at the partnership level and the purchaser does not get the benefit of the depreciation, amortization, and/or decreased gain which (in all fairness) should have been his. However, with an IRC 754 election in place, the tax basis of the assets inside the partnership are adjusted according to IRC 743(b) so the aggregate inside basis of the purchaser s share of assets generally equals the purchase price for the partnership interest. One of the most important assets to consider when evaluating whether to make an IRC 754 election is goodwill. According to IRC 197, goodwill only has an amortizable tax basis if it has been purchased. Otherwise the tax basis of goodwill is zero. However, if an IRC 754 election is in effect at the time of purchase there is often a significant increase in the tax basis of the goodwill, which could then be amortized over a 15-year period. Also, an IRC 754 election only impacts the partner who paid real money to the old partner for her interest in the partnership. Any corresponding depreciation, amortization, or other benefit (or detriment) will be included in the new partner s distributive share of income or loss. That is, any adjustment made to the inside basis of partnership assets under IRC 743(b) due to a sale of partnership interest makes no difference for the other partners in the partnership. SECTION 754 AND PARTNERSHIP DISTRIBUTIONS An IRC 754 election also affects the tax basis of the assets inside the partnership when certain distributions from a partnership occur. And, in marked contrast with the solitary impact on the one partner who buys her partnership interest, distribution-based adjustments affect all of the partners who remain in the partnership. However, not all distributions from a partnership cause a tax basis adjustment under the election. According to IRC 734(b), in order for a distribution to cause inside basis to be adjusted as a result of the IRC 754 election, a distribution from a partnership must either (i) cause the partner receiving the asset PAGE 6 to recognize gain or loss from the distribution, or (ii) change the basis of a distributed asset. Generally, under IRC 732, when an asset is distributed from a partnership, the partner s outside basis is decreased by the tax basis of the distributed asset. For example, if the partner s outside basis is $50 and machinery with a tax basis of $12 is distributed, the partner s outside basis would decrease by $12 to $38. The partner would then hold the machinery outside the partnership with a $12 tax basis. Sometimes, however, a partner does not have sufficient outside basis to absorb the tax basis of an asset being distributed. If cash and marketable securities were distributed in excess of the partner s outside basis a gain would result equaling the excess amount. If an IRC 754 election has been made the resulting gain would cause an increase of the tax basis of the remaining assets inside the partnership. In a similar situation where assets other than cash and marketable securities are also distributed from a partnership, a partner s outside basis is first decreased by the cash distributed, and then any remaining outside basis is allocated to the non-cash assets based on their relative market values. If cash and other property is distributed together and the cash exceeds the partner s outside basis a gain would result and there would be zero basis to allocate to the other property. The consequence of such distribution is that the distributed assets end up with a new basis less than they had inside the partnership. This situation would cause an adjustment under IRC 734(b) if an IRC 754 election was in effect so that the tax basis of assets inside the partnership would be increased for the benefit of all partners by the same amount the distributed asset basis was decreased. A distribution could also cause an increase in the basis of distributed assets. This could occur only upon a liquidating distribution when a partner s outside basis is greater than the tax basis of the assets being distributed. In this situation, the distributed assets assume the entire amount of the partner s outside basis. If an IRC 754 election is in effect, the tax basis of assets remaining inside the partnership would be reduced by an amount equal to the excess of the partner s outside basis over the inside basis of the assets immediately prior to the distribution. But what happens when a partner recognizes loss on a distribution? A loss could only occur upon a liq-
VOLUME 9 NUMBER 3 / Q3 2015 uidating distribution when a partner fully exits the partnership, and when the departing partner gets cash and marketable securities (and no other assets) which equal less than the partner s outside basis. The result of the loss if an IRC 754 election is in effect is an increase in the tax basis of the assets inside the partnership. SECTION 754 AND DEATH OF A PARTNER If an IRC 754 election is in effect for the year of a partner s death, a proportionate share of inside basis would also be adjusted in tandem with any tax basis adjustment under IRC 1014(a). Similar to sales or exchanges, the adjustment of inside basis following the death of a partner is governed by IRC 734(b) and benefits only the successor partner who inherits the partnership interest. The IRC 754 election can be an important estate planning tool because it can be made after the death of a partner so long as an election statement is filed along with a timely filed partnership tax return in the subsequent year. SECTION 755 ALLOCATION OF ADJUSTMENT TO SPECIFIC ASSETS IRC 755 and the corresponding regulations govern the allocation of the tax basis adjustments which result under IRC 743(b) and IRC 734(b) if an IRC 754 election is in effect. However, the process is slightly different depending on whether the adjustment is due to a sale or exchange or transfer on death or whether the adjustment is as a result of a distribution. Adjustments that result under IRC 743(b) from the sale or exchange or from a transfer of a deceased PAGE 7
partner s interest are treated similarly. First, the adjustment is divided into two different buckets: (i) ordinary income producing property such as inventory and accounts receivable and (ii) capital gain plus IRC 1231 property (real estate or depreciable property used in a trade or business for more than one year). Generally, an amount equal to the built-in net gain or loss is first allocated to the ordinary income producing property (up to its market value), with any remainder allocated to the capital gain and IRC 1231 property. This method of separation into the two different groups causes any discount or premium on the purchase of the partnership interest to be allocated to the capital gain bucket rather than the bucket of ordinary income producing assets. Once the allocation between the two different asset buckets occurs, allocation within the two different buckets takes place based on the amount of gain or loss that would occur if the assets were sold for market value. Conversely, under IRC 734(b), any adjustment occurring as a result of gain or loss recognized as a result of a distribution is only allocated to capital gain bucket. Once in the capital gain bucket, the adjustment is further allocated based on the relative value of each of the assets. Any adjustment occurring as a result of a change in the tax basis of the distributed assets is allocated between the two different buckets based on the type of asset distributed. For example, if inventory is distributed and assumes a smaller tax basis outside the partnership, only the tax basis of the partnership s ordinary assets, such as inventory and accounts receivable inside the partnership, would be adjusted. A DOUBLE-EDGED SWORD Although an IRC 754 election can provide a positive tax benefit, it can also have a detrimental effect if the value of the partnership decreases in the future. If time passes after a partnership makes an IRC 754 election and the value of the partnership is lower than the tax basis of the assets inside the partnership, any sale or exchange, distribution, or transfer upon the death of a partner could cause the tax basis of assets inside the partnership to decrease. Due to the often hazy nature of future values, making an IRC 754 election should be done with caution. ADMINISTRATIVE CONCERNS For partnerships that have significant partner turnover, the IRC 754 election can cause significant burden and expense due to the fact that the partnership must maintain separate tax basis records for each partner. That s because the partnership must maintain separate tax basis records for each partner. These additional records often cause complexity, increased risk for error on the tax return and must be balanced against any tax savings from making the election. TECHNICAL TERMINATION IRC 708(b) is also a valuable statute that can be used in conjunction with an IRC 754 election when 50 percent or more of the total interest in partnership capital and profits is sold or exchanged within a 12-month period. This is because the sale of such interest causes a partnership to terminate for tax purposes and a new partnership is deemed to be formed. Under IRC 708(b) the old partnership is treated as contributing all of its assets and liabilities to a new partnership in exchange for the new partnership interest. The old partnership is then deemed to liquidate and distribute its only asset, which is the new partnership interest, to the new partners. This is important because the old partnership files a final tax return and none of the elections of the old partnership are applicable to the new partnership. If an IRC 754 election is made on the old partnership final return the assets inside the partnership could be stepped up to reflect the purchase price without having future uncertainty. The new partnership would simply take the assets with the increased basis and have no IRC 754 election in place to cause future unwanted results. MAKING AND REVOKING THE ELECTION An IRC 754 election is made by attaching a statement to the IRS Form 1065 that is filed for the taxable year in which the election first applies. The election is a partnership election and not a partner election. This distinction is important because the election affects all the partners in a partnership and a partnership can only revoke the election by receiving special approval from the IRS, which is only granted under special circumstances. PAGE 8