Prepared by Gina Lee, Senior Associate at Klug Counsel
Treasury and the Internal Revenue Service (“IRS”) have finalized regulations that eliminate the requirement that an Internal Revenue Code (“IRC”) 754 election statement to adjust the basis of partnership property be signed by one of the partners of the partnership to be valid.
To understand the effect of an IRC §754 election, it is important to review the concepts of inside basis and outside basis. When a taxpayer becomes a partner in a partnership, the basis in their partnership interest is generally the amount of cash and fair market value of the property contributed. The partner’s basis in their partnership interest is called “outside basis”. A separate but related concept is the partnership’s basis in its assets, which is called the “inside basis“. Each partner has a capital account representing that partner’s share of the partnership’s basis in the assets.
When a partnership interest is transferred (by sale, exchange, or on the death of a partner), the inside basis generally does not change, even though the incoming partner’s outside basis will generally reflect any appreciation in value of the partnership assets. Similarly, when property is retained by a partnership following a distribution, the inside basis in that property does not change, even though a distribution may cause a partner to recognize gain or loss. A mismatch between inside and outside basis can cause timing and character issues which may negatively affect the taxpayer. An IRC §754 election can effectively equalize inside and outside basis when distributions and transfers of partnership interest occur.
If the IRC §754 election increases the partner’s inside basis, this will eliminate or reduce the partner’s gains from the sale of assets already reflected in the price they paid for the partnership interest when the asset is sold. In addition, when the adjustment is to depreciable or amortizable property, the new partner can start taking the additional depreciation or amortization deductions in the year the election is made.
However, the IRC §754 election could result in a downward adjustment to the partner’s inside basis which would result in additional gain recognized on the sale of assets or less depreciation for that partner moving forward. There are situations where the IRC §754 election is not beneficial to the partner. Another consideration is the complexity of allocating the inside basis among the assets of the partnership.
IRC §754 permits partnerships to make an election to adjust the basis of partnership property when the partnership distributes property or a partnership interest is transferred. An IRC §754 election applies to all partnership property distributions and all transfers of partnership interest in the tax year the election is made and for all future years.
Since IRC §754 elections are common, it is important the election is completed correctly. The recent regulations are intended to both ease the burden on partnerships seeking to make a valid section 754 election and eliminate the need to request section 9100 relief for unsigned elections.
A valid IRC §754 election is made by filing a written statement with a timely filed partnership tax return. Under prior law, the rules required that the statement provide the name and address of the partnership making the election, be signed by any one of the partners, and declare that the partnership is electing under IRC §754 to apply the provisions of section 734(b) and 743(b).
A partnership that filed an unsigned IRC §754 election with its partnership tax return was considered to have made an invalid election. Treasury and the IRS explained in the preamble to the new regulations that eliminating the signature requirement would reduce compliance burdens, given that taxpayer’s only remedy was to apply for automatic relief if the error was discovered within 12 months, or seek a letter ruling.
Gina Jeyoung Lee is a Senior Associate at Klug Counsel. Gina is involved in individual and business tax planning and compliance, as well as domestic and international estate planning. Gina’s experience includes preparing and reviewing individual and business tax filings, preparing tax planning memoranda, and drafting estate planning documents. Klug Counsel PLLC represents companies, start-ups, private equity funds, family offices, and high-net-worth individuals. Through their strategic partnerships with law firms and other professional service firms in the U.S. and around the world, they are able to meet the tax and business needs of their clients in the U.S. and internationally.