If a Section 754 election is in effect, the difference between the transferee partner's basis in the partnership and the proportionate share of the partnership's basis in its underlying assets is treated as an adjustment to the basis of partnership assets. This adjustment is made solely for the benefit of the transferee partner. The adjustment can result in either an increase or a decrease in the transferee-partner's share of the partnership's basis in its assets. The allocation of the adjustment among partnership assets is made in accordance with rules established in Section 755. The following example demonstrates the effect of such a basis adjustment.

Allocating the Adjustment Amount Among Partnership Properties

After the partnership makes a Section 754 election or when a Section 754 election is already in effect for the partnership, the partnership must allocate the amount of the adjustment among its remaining assets. This allocation must be made in a manner that will reduce the difference between the fair market value and the adjusted basis of the partnership properties.¹⁰ How this allocation is made depends on the type of triggering event.

TRANSFERS OF PARTNERSHIP INTERESTS

When a partner transfers an interest in a partnership by sale or bequest, and the partnership has a Section 754 election in effect or agrees to make such an election, Section 743(b) requires that the partnership adjust its basis in its assets to reflect the amount paid for them by the acquiring partner. For this purpose, all assets of the partnership are classified as either

•     Capital assets and Section 1231 (b) assets (capital gain assets), or

•     All other assets (ordinary income assets).¹¹

After classifying all partnership assets, the partnership must allocate the basis adjustment first between the two classes of assets and then among the assets within each class. The regulations under Section 755 require that both allocations be based on a hypothetical sale of all partnership assets for their fair values.¹² Allocation of the basis adjustment is then based on the amount of gain or loss that would be allocated to the transferee-partner as a result of the hypothetical sale. Thus, some assets may be allocated negative adjustments and others allocated positive adjustments even though the total adjustment is positive (or negative). Indeed, the regulations make clear that positive and negative adjustments may be made to different assets of the partnership even when the total adjustment under Section 743(b) is zero.¹³ Note that the principles of Section 704(c) are applied in making this determination, so that the acquirer of an interest from a contributor-partner is protected from the seller's share of both the partnership's Section 704(b) book gain and his or her Section 704(c) tax gain.

Allocation Between Classes of Property

The adjustment is first made to the ordinary income class of property. The adjustment to this class of property is equal to the amount of income, gain, or loss that would be allocated to the transferee-partner (including Section 704(c) allocations) from the sale of all partnership ordinary income property in the hypothetical sale. The remainder of the Section 743(b) adjustment is then made to capital asset class of partnership properties.

Allocation of Adjustment Among Assets Within Each Class of Property

Once the adjustment is allocated between the classes of property, the portion allocable to each class must be apportioned among the assets within that class. Generally speaking, this allocation is straightforward. Each asset within the class is allocated a basis adjustment equal to the amount of income, gain, or loss that would be allocated to the transferee-partner if the asset were sold for its fair market value immediately after the partner's acquisition of the partnership interest.¹⁴ If the total adjustment is less than the aggregate amount of gain that would be recognized by the transferee-partner, the deficit is divided among properties in the class by reference to their relative fair market values.¹⁵

KNOWLEDGE CHECK

10.   Partnership XYZ has the following balance sheets:

X sells her interest in the partnership to W for $71,000, recognizing a $14,000 gain. If the partnership has a Section 754 election in effect, what will be its adjusted basis in the inventory following the acquisition of X's interest by W?

a.     $72,000.

b.     $56,000.

c.     $55,385.

d.     $48,000.

INCOME IN RESPECT OF A DECEDENT

When a partnership interest is transferred as a result of the death of a partner, the beneficiary generally takes a stepped-up basis in the interest equal to its fair market value at the date of death (or the alternative valuation date if applicable). To the extent that any portion of the partnership interest constitutes income in respect of a decedent (IRD) under Section 691, however, the basis is not stepped up. Thus, for example, to the extent of the decedent's interest in partnership unrealized receivables, no step-up is allowed. The regulations under Section 755 make clear that no portion of any adjustment allowed under Section 743(b) may be allocated to the transferee-partner's interest in partnership items that constitute IRD.¹⁶

PARTNERSHIP GOODWILL

If goodwill exists at the time of the transfer and is reflected in the transfer price, it must be included in the allocation of the adjustment.¹⁷ All goodwill must be valued using the residual method (IRC Section 1060, enacted by the Tax Reform Act of 1986). This method specifies that purchase price be allocated

•     First to cash and general deposit accounts; then,

•     Marketable securities, certificates of deposits, and foreign currency; next,

•     Accounts receivable, mark-to-market assets, and certain debt instruments from unrelated borrowers; next,

•     Stock in trade and other inventory items; then,

•     All other tangible assets; then,

•     Tangible and intangible assets other than goodwill; and then,

•     The balance to goodwill.

The effect of this requirement is only to specify the methodology for determining the value of goodwill. Once this value is established, goodwill is included in the classification of capital gain assets, and the remainder of the allocation under Section 755 is unchanged.

DISTRIBUTIONS OF PARTNERSHIP PROPERTY

The allocation of an adjustment under Section 734(b) (due to a distribution of partnership property) is different from the allocation of an adjustment under Section 743(b) (due to the transfer of a partnership interest). The allocation of a Section 734(b) adjustment is made to assets of the same character as those that gave rise to the adjustment. As before, all assets of the partnership are classified as either capital gain assets or ordinary income assets.¹⁸ The allocation of the adjustment resulting from a distribution depends on the type of distribution triggering the adjustment.

KNOWLEDGE CHECK

11.   Partnership ABC has the following assets:

The partnership is required to reduce the basis of its assets by $(18,000) under Section 734(b) as the result of a distribution of capital gain property to a partner. What will be its tax basis in the inventory after the adjustment has been made?

a.     $20,000.

b.     $24,000.

c.     $36,000.

d.     $15,000.

Proposed Regulations: Increases in Basis of Section 1245 Property

Under proposed regulations issued in November 2013, positive adjustments to the basis of Section 1245 property associated with the distribution of property to a partner are ignored in calculating the partnership's subsequent gain or loss realized upon sale of such property.²⁴ The proposed regulations, which will not be effective until issued in the Federal Register as final regulations, provide that basis adjustments under Section 734 (for example, as a result of gain recognized by the distributee partner in connection with a cash distribution) will not reduce the amount of ordinary income recognized by the partnership under Section 1245 on the subsequent sale of such property. The proposed regulations clarify, however, that this is the only purpose for which such basis adjustments are ignored. Depreciation or amortization deductions may be claimed with respect to the basis adjustment and such deductions are taken into account in computing the property's recomputed basis. These proposed regulations, if finalized, will increase the complexity of subchapter K and create a potentially significant trap for the unwary.

Change in Basis of Distributed Assets

If the adjustment is the result of a distribution in which the basis of the property distributed was increased or decreased, the adjustment must be made to property of a similar character to the distributed property from which the adjustment arose.²⁵ Any increase in the basis of property distributed (for example, from a liquidating distribution where the inside basis of distributed property is less than the partner's outside basis) will result in a decrease in the basis of partnership property of the same class as the property whose basis was increased as part of the distribution. Any decrease in the basis of property distributed (for example, from a distribution where the inside basis of distributed property is greater than the partner's outside basis) will result in an increase in the basis of partnership property of the same class as the property whose basis was increased as part of the distribution. This approach attempts to preserve the character of the gain or loss to be recognized by the other partners.

Once the character of the asset is determined, the adjustment should be made in the same manner as described previously. That is, an increase will be made first to appreciated assets to the extent of their appreciation, and any remaining increase will be allocated according to the relative fair market values of the properties in that class of property. Any decrease would first be made to depreciated assets to the extent of their depreciation, and any further decrease would be allocated to property of the same class according to the relative adjusted basis of the properties in that class.

Where an increase or a decrease in the basis of undistributed property cannot be made because the partnership owns no property of the same character, or because the basis of all the property of the same character has been reduced to zero, the adjustment will be made when the partnership subsequently acquires property of a like character to which an adjustment can be made.

KNOWLEDGE CHECK

12.   Bar-X Partners has the following assets.

The partnership is obligated to reduce the basis of its assets (assume they are all capital assets) under Section 734(b) by $10,000. To which asset(s) will the basis adjustment be allocated?

a.     Property 1.

b.     Property 2.

c.     Property 3.

d.     All three properties.

13.   The ABC Partnership has the following assets:

The partnership is required to make a positive basis adjustment under Section 734(b) in the amount of $10,000. Whatwill be the partnership's tax basis in Property 2 after the basis adjustment is made?

a.     $10,000.

b.     $15,000.

c.     $20,000.

d.     $40,000.

SECTION 751(B) DISTRIBUTIONS

A Section 751 (b) distribution is one that results in a disproportionate distribution of “hot” assets (unrealized receivables and inventory items that have substantially appreciated in value). As discussed in the preceding chapter, a Section 751 (b) distribution is treated as part-sale and part-distribution. Practitioners should be careful to apply the provisions of Section 734(b) only to the distribution portion of the transaction when Section 751(b) applies.

MAKING THE SECTION 754 ELECTION

The election to make the optional basis adjustments allowed by Sections 734(b) and 743(b) must be made in a timely partnership return filed in the year in which the distribution or transfer occurred or in a preceding year.²⁶ The election must be signed by one of the partners and must include

•     the name and address of the partnership; and

•     a declaration that the partnership elects, under Section 754, to apply the provisions of Sections 734(b) and 743(b).

If a Section 754 election is not filed in a timely manner, the taxpayer may request an extension of time to make the election. Once made, an election under Section 754 is effective until revoked.

In any year in which a partnership adjusts the basis of property under Section 734(b), the partnership must attach a statement to its return showing the computation of the adjustment and the assets to which the adjustment has been allocated.²⁷

A partnership wishing to revoke a Section 754 election must obtain the permission of the District Director for the IRS District in which the partnership is required to file its return (26 CFR Section1.754-1 (c)). The request must be filed within 30 days of the close of the partnership year for which the revocation will be effective, must set forth the grounds on which revocation is sought, and must be signed by a partner. Situations that may be considered valid justifications for revoking the election are

•     A change in the nature of the partnership business.

•     A substantial increase in the assets of the partnership.

RELIEF WHEN ELECTION NOT MADE

When a partner obtains a partnership interest by transfer from another partner, he or she may not be able to force the partnership to make a Section 754 election even though it would be beneficial to the transferee-partner for the election to be made. In that instance, the transferee partner may be able to obtain some relief if

•     The partner obtains all or part of the partnership interest by sale or exchange, or upon the death of a partner;

•     Within two years of such transfer a distribution of assets from the partnership is made to the transferee partner; and

•     The partnership did not make an optional basis adjustment upon the original transfer.²⁸

In this circumstance, the distributee partner can elect to determine the basis of the distributed assets in his or her hands as if the basis adjustment under Section 743(b) had been made when the transfer originally occurred.

A partner wishing to make the election under Section 732(d) does so by attaching to his or her tax return a statement

•     Stating that he or she is making an election under Section 732(d),

•     Showing the computation of the special basis adjustment for the property distributed using the allocation rules under Section 755, and

•     Showing the assets to which the adjustment has been allocated.²⁹

If the distribution includes any property subject to the allowance for depreciation, depletion, or amortization, the election must be in the tax return for the year of the distribution. Otherwise, it must be made in the tax return for the first year in which the basis of the distributed property is pertinent in determining his or her income tax liability.³⁰

The adjustment amount and the assets to which it is allocated are determined as of the date of the transfer. No adjustment is made for additional depletion or depreciation which would have been claimed if the Section 743(b) election had been made because no deduction was allowable for such amounts.³¹ If the property received in the distribution is not the same property which would have had a basis adjustment under Section 743(b), the basis adjustment under Section 743(d) can be applied to any like property received in the distribution so long as the transferee has relinquished his or her interest in the original basis adjustment property (whether or not the partnership still owns that property).³²

A partner is required to apply the special basis rule of Section 732(d) to any distribution (whether or not within two years of his or her acquisition) if

•     He or she acquired any part of his or her interest in the partnership by transfer when a Section 754 election was not in effect;

•     At the date of his or her acquisition the fair market value of all partnership property (other than money) exceeded 110 percent of its tax basis;

•     A distribution in liquidation immediately after the acquisition would have resulted in a shift of basis [determined under Section 732(c)] from property not subject to an allowance for depreciation, depletion, or amortization to property subject to such an allowance; and

•     A basis adjustment under Section 743(b) would change the basis of the property actually distributed.³³

KNOWLEDGE CHECK

14.   Joe inherited a 20 percent interest in a real estate partnership from his grandmother. The partnership did not have a Section 754 election in effect, and opted not to make one. One year later, the partnership distributed appreciated property to Joe in a non-liquidating distribution. What will be Joe's tax basis in the property received from the partnership?

a.     Its fair market value as of the date of Joe's grandmother's death.

b.     The basis the partnership would have had in the property if a Section 754 election had been in effect at the date of his grandmother's death.

c.     Joe will take a carryover basis in the property received equal to the partnership's basis in such property.

d.     Joe will take a tax basis in the property received equal to his tax basis in the partnership interest just prior to receipt of the distribution.