ELITE ADVISOR BEST PRACTICES
The ABC’s of Partnership Taxation - Part Three
When your clients purchase or inherit a partnership interest: special focus on inside basis
By Janice Eiseman
- Entities taxed as partnerships offer the unique ability to have the basis of their assets adjusted for a partner who has acquired his or her interest by purchase or inheritance.
- When a partner sells his or her partnership interest, or when a partner dies, the partnership can make an election, referred to as a “Section 754 election,” which allows the partnership to adjust the inside basis of its assets with respect to the transferee.
- Adjustments made by the partnership to its inside basis may provide positive or negative income tax consequences to your client.
Inside basis: a concept unique to partnerships
In addition to “outside basis,” which we discussed in Part One of this series of articles, there is another basis concept in the partnership world that’s important to your clients. This concept involves your client’s share of the adjusted basis of the assets held by the partnership. The adjusted basis of the assets held by the partnership is referred to as the “inside basis.” When a partner sells his or her partnership interest, or when a partner dies, the partnership can make an election, referred to as a “Section 754 election,” which allows the partnership to adjust the inside basis of its assets with respect to the transferee. The adjustments to the basis of partnership assets apply only to the transferee. The purpose of the adjustments is to put the transferee in the same position as if the transferee had purchased a direct interest in each asset held by the partnership. The ability to make adjustments on behalf of the transferee to the tax basis of assets owned by the partnership, i.e., to the inside basis of the assets, does not have an analogue in the corporate world.
Let’s see how a Section 754 election could be beneficial to your client. When your client acquires a partnership interest, the tax basis in his or her partnership interest (the “outside basis”) is equal to its cost or “date of death” value plus your client’s share of the liabilities. Therefore, it necessarily takes into account the fair market value of the assets held by the partnership at the point in time that the interest is acquired. Without an election by the partnership, however, the inside basis of the partnership assets do not change.
For example, assume that your client has purchased a one-third partnership interest in a partnership that has no liabilities and that holds two parcels of real estate. Assume that the appraised value of Parcel No. 1 is $300,000, and the appraised value of Parcel No. 2 is $210,000, which means that the total fair market value of the partnership’s assets is $510,000.
Your client agrees to pay the selling partner one-third of the total of the appraised values of the partnership assets, or $170,000. The tax basis to the partnership of Parcel No. 1 is $330,000 and for Parcel No. 2 is $99,000. So the total inside basis of the assets to the partnership is $429,000. The balance sheet of the ABC partnership would be as follows:
Also, assume that the outside tax basis of the selling partner is $143,000 (one-third of the total inside basis of $429,000).
The selling partner will recognize a tax gain of $27,000 upon the sale of the interest. The total gain of $27,000 comes from a gain in Parcel No. 2 that’s allocated to the selling partner of $37,000 and a loss in Parcel No. 1 that’s allocated to the selling partner of $10,000. To the partnership, the tax basis of these two parcels does not change unless the partnership has made a Section 754 election.
Suppose no Section 754 election is in effect, and shortly after the sale of the partnership interest to your client, the partnership sells Parcel No. 2 for its appraised value of $210,000. Your client will receive one-third of the gain, or $37,000, which is exactly the same gain attributable to Parcel No. 2 that’s picked up by the selling partner.
Your client will have to pay a tax on the allocation of $37,000 of gain in the year of the sale. The tax basis of your client’s partnership interest will be increased by $37,000. However, if the partnership had made a Section 754 election, then your client will pay no income tax on the gain on the sale because he or she would be entitled to eliminate the gain allocation of $37,000 due to a downward adjustment equal to $37,000 pursuant to the rules applicable under a Section 754 election.
A Code Section 754 election causes your client’s share of the inside basis of Parcel No. 2, in effect, to equal the share of the outside basis that’s attributable to the purchase of Parcel No. 2. The purpose of the Section 754 election is to treat your client as if he or she had purchased a one-third interest in Parcel No. 2.
In contrast, let’s say that Parcel No. 1 is sold right after your client has purchased his or her partnership interest. If a Section 754 election has not been made, your client will be allocated one-third of the loss, or $10,000. However, if a Section 754 election has been made, your client will recognize no loss upon the sale of Parcel No.1. The $10,000 loss allocated to your client by the partnership will be adjusted by a $10,000 upward adjustment under the Section 754 rules. The consequence is the same as if your client had acquired a one-third interest in Parcel No.1 for $100,000.
This simple example shows that a Section 754 election is a two-edged sword. In gain situations it is wonderful, and in loss situations it is bad. Because many partnerships holding assets with large losses would not make a Section 754 election, the rules under Section 754 were amended so that a partnership with a greater than $250,000 loss in its assets must treat its partners as if a Section 754 election had been made. There are exceptions to this mandatory use of Section 754 if the partnership is an “electing investment partnership” or a “securitization partnership.”
Often the partnership agreement gives the general partner (or the manager in the case of a limited liability company) the discretion to make a Section 754 election. The Section 754 election is made either in the year that a partnership interest is sold or the year of the death of a partner. Once the election is made, it usually stays in effect for the life of the partnership. The general partner or manager may not want to make such an election because an election places an added administrative burden on the partnership’s accountants. The accountants have to keep track of the adjustments required in calculating the amount of gain or loss allocated to partners who have purchased or inherited their partnership interests. However, with the use of computers, it is harder and harder for the general partner or manager to make the argument about added administrative burden. It is important that your clients know about the Section 754 election, so that they can talk to the general partner or manager about whether the partnership has made such an election or will make such an election.
It is important that you have an overview of the partnership tax basis rules so you can advise your clients properly and confidently about them. By understanding the tax basis rules, you can talk to your client about “phantom gain.” By understanding the impact of a possible Section 754 election, you can tell your client that he or she should ask the general partner or manager whether a Section 754 election is in effect, and if the election is not in effect, whether your client would like the general partner or manager to make such an election on the partnership tax return for the year of purchase or the year of death.