The basis of the assets of a partnership or LLC may not reflect the basis of the interest in the hands of the partners(s). If a Section 754 election is made, by the entity, certain events can trigger an equalization of basis without waiting until the assets are sold. Utilizing this election can accelerate deductions into earlier years, which may be beneficial for owners of LLC’s and partnerships.
What is a 754 election?
Section 754 allows a partnership to make an election to “step-up” the basis of the assets within a partnership when one of two events occurs: distribution of partnership property or transfer of an interest by a partner. This “step-up” in basis is used to make the outside basis (basis of the partnership in the hands of the owner) equal to the inside basis (the basis of the assets in partnership) for tax purposes. This equalization of basis can be beneficial to an owner when the “step-up” is deemed to be related to depreciable or amortizable property. It will allow for depreciation and amortization deductions, starting in the year the election is made, rather than recouping basis when the interest or property is transferred.
The election is made by filing a written statement with the tax return. It is important to note that the election is in effect for the year filed and all years thereafter. It can only be revoked with IRS consent. All distributions and transfers of interests will be subject to the election and the “step-up” or “step-down” must be calculated when one of these events occurs.
How does the election work in the case of a distribution?
In general, there is no effect on the basis of the undistributed pass-through entity’s assets when a current distribution is made. However, if a 754 election is made or is in place, there may be a “step-up” or “step-down” of the remaining assets. Any gain recognized by the distributee (because his outside basis is less than the basis of the property he received) increases the basis of the remaining assets in the partnership. Since current distributions cannot result in a loss to the distributee, there will only be a “step-down” of assets if the distribution is made in complete liquidation of the distributee’s interest.
The “step-up” or “step-down” is allocated to the other pass-through entity owners. This equalizes the other owners by providing them with a tax asset equal to the asset that the distributee partner received.
Example 1:How does the election work when there is a transfer of an interest?
ABC partnership distributes real estate with a value of $100,000 to partner A. Partner A’s outside basis in ABC is $90,000. The $10,000 difference (gain to be recognized by A) is allocated to partners B and C and any related depreciation/amortization deductions are specially allocated to B and C. No entry is made to record the $10,000 754 asset on the books of the partnership: the $10,000 is reflected in partner B and C’s outside bases. Additional depreciation/amortization deductions will be specifically allocated to these partners in the future.
When a new partner acquires an interest from a former partner, the price paid is based on the fair market value of the interest (which is based on the underlying value of assets of the partnership). However, if the assets of the partnership are greater in value than the outside basis, there is a distortion between the new partner’s outside basis and the proportionate value of the assets of the partnership. If a 754 election is made, the incoming partner receives a “step-up” or “step-down” for any difference in what he paid and the former partner’s previously taxed capital (essentially, the proportionate basis of the assets of the partnership). The “step-up” and any related depreciation or amortization deductions are allocated to the incoming partner.
Z owns 50% of XYZ partnership and has previously taxed capital of $25,000. Z sells his 50% interest to W for $50,000. The $25,000 difference is allocated to incoming partner W and any related depreciation/amortization deductions are specially allocated to W. No entry is made to record the $25,000 754 asset on the books of the partnership: the $25,000 is reflected in partner W’s outside basis. Additional depreciation/amortization deductions will be specifically allocated to this partner in the future.
What is the downside to the election?
As mentioned before, this is a permanent election that is only revocable with IRS consent. In one year there may be a “step-up”, making the election beneficial. However, if a “step-down” occurs in a subsequent year, it too must be calculated. Accounting for the election can be complicated as there will be special allocations of inside basis and related deductions to specific partners which will need to be tracked and disclosed on the partner’s form K-1. Furthermore, the election is an entity level election and all partners are subject to the rules (as they pertain to that specific partnership). It would be wise to check the operating agreement (if applicable) to see if a 754 election is allowed and how the determination to make it is made between the partners.
Is it right for my partnership (my client’s partnership)? If there is a transfer of an interest or a distribution in property and the inside and outside basis has a disparity, the election can be beneficial to accelerate deductions, if there is greater inside basis than outside basis. Before making the election, the partners should consider the likelihood of the assets declining in value and the extent of separate accounting they are willing and able to handle.