Section 754 election

What Is Section 754 Election?

A Section 754 election is a provision under U.S. federal tax law that allows a partnership to adjust the tax basis of its assets when certain events occur, specifically a distribution of partnership property or a transfer of a partnership interest. This election, governed by the Internal Revenue Code, aims to mitigate discrepancies that can arise between a partner's outside basis (the partner's basis in their partnership interest) and the partnership's inside basis (the partnership's basis in its underlying assets). By making a Section 754 election, the partnership can "step up" or "step down" the adjusted basis of its assets to better reflect the fair market value at the time of the triggering event, thereby preventing potential inequities in future taxable income or capital gains for incoming or exiting partners. The Section 754 election applies to all such transactions in the taxable year it is made and in all subsequent years, unless revoked.

History and Origin

The Section 754 election stems from Subchapter K of the Internal Revenue Code, which governs the taxation of partnerships. Its purpose is to address situations where the total basis of partnership property in the hands of the partnership (inside basis) does not align with the total basis of partnership interests held by the partners (outside basis). This disparity can arise from various transactions, such as the sale of a partnership interest at a price different from the underlying asset basis or certain property distributions. The statutory language for Section 754 states that if a partnership files an election, the basis of partnership property shall be adjusted in the manner provided in Section 734 (for distributions) and Section 743 (for transfers of interests).²⁴ The Internal Revenue Service (IRS) and the Treasury Department issue regulations to provide guidance on the specifics of making and revoking this election. For instance, recent regulations issued in 2022 streamlined the process by removing the requirement for a partner's signature on the election statement, aiming to ease administrative burdens on partnerships.²², ²³

Key Takeaways

• A Section 754 election allows partnerships to adjust the basis of their assets upon certain events, such as a partner's death or sale of a partnership interest, or a distribution of property.
• The primary goal of the Section 754 election is to align a partner's outside basis with their proportionate share of the partnership's inside basis, preventing distortions in taxable income and capital gains.
• Once made, a Section 754 election generally applies to all future qualifying transactions unless permission to revoke is granted by the Commissioner of the IRS.²¹
• The election can lead to increased depreciation deductions for new partners or a reduction in potential capital gains upon asset sales.
• While beneficial for tax purposes, the Section 754 election can increase the administrative complexity and recordkeeping requirements for a partnership.

Formula and Calculation

The Section 754 election itself is not a formula but rather an election that triggers the application of other Internal Revenue Code sections, specifically Section 734(b) for property distributions and Section 743(b) for transfers of partnership interests.

For a transfer of a partnership interest, the Section 743(b) adjustment is calculated as:

Where:

• Transferee Partner's Outside Basis is the acquiring partner's adjusted basis in their partnership interest.
• Transferee Partner's Share of Partnership's Inside Basis is the acquiring partner's proportionate share of the partnership's adjusted basis in its property.

This adjustment is then allocated among the partnership's assets according to rules specified in Section 755 of the Internal Revenue Code. The goal is to decrease the difference between the basis and the fair market value of the partnership property for the transferee partner.

For a distribution of property, the Section 734(b) adjustment generally occurs when the distributee partner recognizes gain or loss on the distribution, or when the distributed property takes a basis different from the partnership's adjusted basis. The adjustment affects the common basis of the remaining partnership property.

Interpreting the Section 754 Election

The presence of a Section 754 election indicates that a partnership intends to provide an incoming partner with a tax basis in their share of the partnership's assets that aligns with the price they paid for their partnership interest. Without this election, an incoming partner might face a situation where their economic investment in the partnership's appreciated assets is not reflected in the partnership's inside basis, leading to potentially higher future tax liabilities. For example, if a partner buys into a partnership holding appreciated assets, a Section 754 election allows that partner to receive a step-up in their share of the basis of those assets, which can then be used to calculate higher depreciation deductions or lower capital gains upon sale of the assets. Conversely, if assets have depreciated, the election can result in a step-down. The election applies solely to the transferee partner's share of the partnership's assets; it does not impact the continuing partners' basis.²⁰

Hypothetical Example

Imagine ABC Partnership, which owns a piece of real estate with an adjusted basis of $1 million and a current fair market value of $2.5 million. There are three partners, A, B, and C, each with a one-third interest.

Partner C decides to sell their one-third interest to new Partner D for $833,333 (one-third of the $2.5 million fair market value). Partner D's outside basis in their partnership interest is now $833,333. However, without a Section 754 election, Partner D's proportionate share of the partnership's inside basis in the real estate would only be $333,333 (one-third of $1 million).

If ABC Partnership makes a Section 754 election, a Section 743(b) adjustment would be calculated for Partner D:

This $500,000 adjustment would be specifically allocated to Partner D's share of the real estate asset. As a result, for tax purposes, Partner D's share of the real estate's basis would be $333,333 + $500,000 = $833,333. This prevents Partner D from being taxed on the $500,000 appreciation that occurred before they acquired their interest, providing them with a more accurate reflection of their investment for future depreciation or sale calculations.

Practical Applications

The Section 754 election is a critical tool in partnership tax law for various real-world scenarios. It is frequently employed when there's a transfer of a partnership interest due to a sale, exchange, or the death of a partner. For instance, when a partner dies, their beneficiaries typically receive a stepped-up basis in the partnership interest to its fair market value at the date of death.¹⁹ Without a Section 754 election, this step-up only applies to the partner's outside basis, not the underlying partnership assets, potentially leading to future phantom gains. The election ensures the inside basis is also adjusted, allowing the heirs to benefit from increased depreciation deductions and reduced capital gains upon subsequent sale of partnership property.¹⁸

Furthermore, the Section 754 election is relevant for partnerships undergoing significant changes in ownership or asset composition. The IRS provides guidance and FAQs on making and revoking the Section 754 election, emphasizing its importance in partnership taxation.¹⁷ This election can significantly impact a partner's overall income tax liability and is a key consideration for tax planning in partnership structures.

Limitations and Criticisms

While often beneficial, the Section 754 election does come with limitations and potential drawbacks. One significant aspect is its enduring nature: once made, the election applies to all distributions of property and transfers of partnership interest in the taxable year of the election and all subsequent years, unless revoked with the approval of the Commissioner of the IRS.¹⁵, ¹⁶ Revocation is generally difficult to obtain, particularly if the purpose is to avoid a basis step-down (i.e., a reduction in asset basis).¹³, ¹⁴ This means a future decline in asset values could lead to mandatory negative adjustments, which might be undesirable.

Another criticism revolves around the increased administrative burden it places on partnerships. Maintaining separate basis adjustments for each affected partner and property requires detailed recordkeeping and can add complexity to tax compliance.¹¹, ¹² Accounting professionals often emphasize the need for careful consideration before making the election, as unforeseen events could render it detrimental.¹⁰ The complexity can also lead to inadvertent failures in making a valid Section 754 election, requiring taxpayers to seek relief from the IRS for late filings.⁸, ⁹

Section 754 Election vs. Partnership Basis Adjustment

The Section 754 election is the mechanism by which a partnership basis adjustment is achieved under U.S. tax law. A "partnership basis adjustment" is the broader concept of modifying the tax basis of a partnership's assets. Without a valid Section 754 election in place, these specific adjustments generally do not occur, even if circumstances (like a transfer of interest at a gain) would otherwise suggest a need for them. The election itself signals the partnership's intent to apply the rules outlined in Sections 734(b) and 743(b) of the Internal Revenue Code, which are the provisions that detail how the basis adjustments are calculated and applied. Therefore, while a partnership basis adjustment is the outcome, the Section 754 election is the necessary prerequisite for that outcome in most cases, particularly for transfers of partnership interests or certain property distributions.

FAQs

Q: Who makes the Section 754 election: the partner or the partnership?
A: The partnership itself makes the Section 754 election, not the individual partners. It files a statement with its tax return to elect the application of Sections 734(b) and 743(b).⁷

Q: Does a Section 754 election only apply to the year it's made?
A: No, once a Section 754 election is made, it applies to all qualifying property distributions and transfers of partnership interest in the taxable year for which it's filed and all subsequent taxable years, unless it is revoked with IRS approval.⁵, ⁶

Q: What is the main benefit of a Section 754 election for an incoming partner?
A: The main benefit for an incoming partner is the ability to receive a step-up in their proportionate share of the partnership's asset basis, often leading to increased depreciation deductions and a reduction in potential future capital gains when the partnership's assets are sold. This aligns their tax basis with the price they paid for their interest.³, ⁴

Q: Can a Section 754 election be revoked easily?
A: No, revoking a Section 754 election requires the permission of the Commissioner of the IRS. Permission is generally not granted if the primary purpose of the revocation is to avoid a basis step-down.¹, ²