Partnership Basis: Inside Basis and Outside Basis
Advising a partnership to make a Code Section 754 election is an important decision and requires an understanding of the partnership concepts of "inside basis" and "outside basis”.
June 20, 2011
Unlike corporate tax law, partnership tax law provides for adjustments to the tax bases of partnership assets if the partnership has made a Code Section 754 election (754 election). In general, a 754 election allows adjustments to be made to a partner’s share of the tax basis of the partnership assets, referred to as the “inside basis,” so that it is equal to the tax basis of his partnership interest, referred to as the “outside basis.” If no 754 election has been made, no adjustments can be made to the inside bases of partnership assets unless mandatory adjustments are required. I.R.C. §§ 743(a) & 734(b).
Section 754 Elections
Partnerships have the option to make a 754 election when certain types of distribution of property from the partnership to a partner occur or when there is a transfer of a partnership interest by sale or exchange or upon the deathof a partner. If a triggering event has not occurred, no 754 election can be made For example, a 754 election is not allowed when there is a transfer by gift, because a gift is not a “sale or exchange.” Once it is made, a 754 election applies to all applicable transfers and it is revocable only with the consent of the district director for the district in which the partnership’s returns are filed. Treas. Reg. § 754-1(c).
A 754 election activates both Section 734(b) and Section 743(b). A Section 743(b) adjustment is made when there is a sale or exchange of a partnership interest or on the death of a partner. The Section 743(b) adjustment equals the difference between the value of the outside basis to the transferee partner (e.g., purchase price or date of death value) and his share of the partnership’s adjusted basis to the partnership of the partnership property. Treas. Reg. § 1.743-1. This adjustment, which can be either positive or negative, is pro-rated over the partnership assets under the rules set forth in Section 755. The goal of the adjustment is to make the transferee have an inside basis in the partnership assets equal to the amount he would have had if he had purchased an undivided interest in the partnership assets. The adjustment applies only to the transferee and has no effect on the partnership’s income or loss. Treas. Reg. § 1.743-1(j)(1). It does not affect the transferee’s capital account. The partnership reports the adjustment on Form 1065 (PDF), Schedule B, Line 12b, Schedule K, Line 11 or 13 and the transferee’s
Sections 734(b) and 743(b)
Under Section 734(b), an adjustment is made to the tax basis of partnership assets after two types of distributions:
When there is a change in the tax bases of distributed assets, the adjustment is the amount required to equalize the aggregate, post-distribution bases of the assets distributed and retained by the partnership to the total pre-distribution basis of the assets. When gain or loss is recognized, the adjustment increases the bases of the partnership assets by the gain recognized and decreases the bases of the partnership assets by the loss recognized. This adjustment, which can be either positive or negative, is prorated over the partnership assets under the rules set forth in Section 755. Unlike the Section 743(b) adjustment, the Section 734(b) adjustment applies to the common basis of partnership property and, therefore, affects all continuing partners. The adjustment is reported on Form 1065, Schedule B, Line 12b.
Example: Assume the decedent owned a 10 percent limited partner interest in a partnership owning a commercial building. The partnership has three assets: cash in the amount of $9 million, non-appreciated assets in the amount of $1.5 million and the building with a tax basis of $3.5 million giving us a total tax basis equal to $14 million. The appraised value of the building at date of death was $64.5 million. Because of discounts, the fair market value at date of death of the limited partnership interest was determined to be $5 million. The estate’s 10 percent share of the tax basis of the partnership assets equals $1.4 million. The fair market value of estate’s partnership interest is $5 million. Thus, the Section 743(b) adjustment equals $3.6 million. Because the building is the only appreciated asset, the entire adjustment is allocated to the building giving the estate a tax basis in the building of $3,950,000 ($3,600,000 + $350,000). Depreciation of the building to the estate will be based on $3,950,000 rather than $350,000 and upon sale of the building gain will be calculated based upon an adjusted tax basis starting at $3,950,000 rather than $350,000. If the 754 election is not made, the difference should be recouped by the estate recognizing a capital loss upon the sale of the building and distribution of proceeds. However, a timing and character difference may exist.
Regardless of whether the partnership has made a 754 election, mandatory Section 743(b) adjustments must be made to the basis of partnership assets if immediately after the transfer of a partnership interest, the adjusted tax basis of all of the partnership assets exceeds the fair market value of the partnership assets by more than $250,000 (“substantial built-in loss”). I.R.C. § 743(d). Exceptions exist for electing investment partnerships (e.g., buyout funds, venture capital funds and fund of funds) and securitization partnerships. I.R.C. §§ 743(e) & (f). Similarly, mandatory Section 734(b) adjustments must be made if there is a distribution of partnership property in liquidation of a partner’s interest and the downward adjustment to the basis of partnership assets would exceed $250,000 if a Section 734(b) election had been in effect. I.R.C. § 734(d). There is an exception for securitization partnerships. I.R.C. § 734(e). Mandatory adjustments must be disclosed on Form 1065, Schedule B, Line 12c.
The 754 election is made by checking Box 12a, Schedule B of the Form 1065 and attaching a statement to the Form 1065 signed by a partner authorized to sign the return setting forth:
The election is supposed to be filed with a timely filed partnership tax return for the partnership taxable year during which the distribution or transfer occurs, i.e., on or before the due date (including extensions) of the partnership tax return. Treas. Reg. § 1.754-1(b). Treasury Regulation § 301.9100-2(vi) provides for an automatic 12-month extension from the due date of the partnership return or from the extended due date of the partnership return if there is an extension provided that the partnership takes “corrective action” during this 12-month extension period. “Corrective action” means filing an amended return (or an original return, if one has not yet been filed) for the year in which the election should have been made and attaching to the return the required election statement. The statement “FILED PURSUANT TO § 301.9100–2” must be written at the top of the return. If the terms of the automatic extension have not been met, a discretionary extension of time to file the Section 754 election may still be requested from the Internal Revenue Service (IRS) and will generally be granted if the requirements of Treasury Regulation § 301.9100-3 are met. E.g., see PLR 201122015 (Jan. 18, 2011).
Janice Eiseman, JD, LLM, is a principal at Cummings & Lockwood in Stamford, Conn. office where she focuses on the taxation of closely held businesses and tax planning for owners and investors. Eiseman has broad-based experience counseling clients on the formation, ownership and structuring of various business entities, as well as drafting and negotiating tax-based and transactional documentation for both individual and business clients. She has also done controversy work before the Internal Revenue Service and the New York State Department of Taxation and Finance. Prior to joining Cummings & Lockwood, she served as senior tax and benefits counsel at the New York City-based law firm Morrison & Cohen LLP.