When considering buying into a partnership, it’s important to understand the equity value of existing assets and how that will impact your tax obligation. Section 754 of the tax code allows partnerships to adjust their tax basis to prevent new partners from paying taxes on gains and losses they didn’t benefit from. Understanding partnership taxation, inside basis, outside basis, step-ups, and step-downs is a great place to start.
PARTNERSHIPS VS CORPORATIONS
From a tax perspective, a partnership is a true flow-through entity where the income and losses of the partnership are passed to the partners based on ownership percentages and the partnership agreement allocations. The partners are treated as owning a percentage of the underlying assets and are therefore afforded flexibility, as opposed to corporate shareholders who own stock only. There are no restrictions on who can be a partner, what classes of stock/units are allowed, how distributions are made, and how income and losses are allocated (assuming it makes economic sense).
Partnerships are often considered when Qualified Small Business Stock is not an option (making C-Corporation formation less desirable) or when some owners are entities (making S-Corporation formation impracticable). Investment entities, law firms, and real estate ventures are commonly set up as partnerships. Navigating through M&A deals can also be much easier with partnerships versus corporations.This is mostly due to sections 721 and 731. One final benefit of a partnership is the ability to offer profits interests to owners.
INSIDE BASIS/OUTSIDE BASIS
To understand inside basis and outside basis, it’s helpful to take a look at the two general approaches for partnership taxation: the entity method and the aggregate method.
Entity method: In this approach, the partnership is treated as a separate entity, distinct from its owners.
Aggregate Method: In this approach, the partnership is treated as an aggregation of its owners, each with their own share of the partnership assets.
The definitions of inside basis and outside basis align with these methods. Inside basis is the partnership’s value of an asset (generally the original amount paid by the partnership), while outside basis is each individual partner’s value of an asset (typically the amount paid for their share). At the formation of a partnership, the two are usually equal. The difference comes into play when there are distributions or ownership changes. When a new partner buys out an existing partner, or when an existing partner has a distribution in excess of basis, a 754 election can help avoid unnecessary taxes on gains or losses.
For example, let’s say a partnership purchases a building for $1M. The inside basis is $1M, and the outside basis for a 50% partner at the time of that acquisition would be $500K. However, if a new partner purchases a 50% share of the partnership years later when the building has a fair market value of $10M, their outside basis would be $5M while the inside basis would still be the 50% of the original $1M on the books. This results in a $4.5M difference in basis and is an example of why 754 elections can be helpful. It provides a way to level the playing field so that new partners are not unfairly taxed on gains that were realized prior to their buy-in to the partnership. It also allows for depreciation and amortization on the stepped up basis, if appropriate.
STEP-UPS AND STEP-DOWNS
In the example above, a 754 election could be used to make an adjustment to the value of the asset so that the new partner is not responsible for capital gains on the difference between their share of the value at the time they bought into the partnership (outside basis) and the value on the books (the inside basis) which remains at $1M.
This is accomplished by making either an IRC § 734(b) or 743(b) basis adjustment, in line with the Section 754 regulations.
- IRC § 734(b) is used when there are distributions to partners in excess of basis
- IRC § 743(b) is used when there is a transfer of interest in the partnership for an amount over basis
This adjustment of the partnership basis is referred to as a “step up” when raising the asset value and a “step down” when lowering the asset value. When the step-up is related to a depreciable or amortizable asset, partners can begin to take deductions in the year the election is made.
It is important to note that once the election is made, it applies to all property distributions and transfers of partnership interests, not only for that filing year but for all future years as well. For this reason, care should be used in determining if/when to make these elections.
WHEN AND HOW TO MAKE A 754 ELECTION
So how do you know if a 754 election would be beneficial? When assessing whether or not to buy into a partnership, it’s important to 1) compare the tax basis balance sheet to the fair market value of the assets and liabilities of the partnership, and 2) review the partnership agreement, current partners’ capital accounts, and depreciation schedules. Together, this information will help you and your CPA determine your potential tax liability as a new partner and decide whether a 754 election step up will help minimize your tax burden and allow for depreciation and amortization deductions.
The logistics of making the basis adjustment involve filing a written statement with the tax return. There is no specific “754 election form.” The statement is a declaration that the partnership elects to apply the provisions of IRC § 734(b) or 743(b) and must be signed by a partner authorized to sign the tax return. The adjustments are then reported on Schedule K-1(s).
In cases where a new partner is paying less than the value of the assets on the books, it would be a step-down adjustment and would not make sense. Step downs generally only occur from a liquidating distribution.
Another item of note is the ability to apply IRS rulings 99-5 and 99-6 so that partnership changes involving LLCs can still take advantage of a 754 step-up in the same manner.
- Revenue ruling 99-5 can be applied in the case of a single-member LLC becoming a partnership.
- Revenue ruling 99-6 can be applied in the case of a multi-member LLC becoming a single member (when one of two partners buys out the other, or one new partner buys out all existing partners). Even though the company is no longer a partnership, the 754 election still applies.
DRAWBACKS OF A 754 ELECTION
While the tax benefits seem clear, there are some hurdles and drawbacks involved with making this election. It can create the need for a new set of financial statements, increase administrative burden due to tracking of additional information strictly for tax purposes, and is difficult to revoke. Once the election is made, it is in effect for that filing year and all future years and can only be revoked with the consent of the IRS.
Buying into a partnership can offer both risks and rewards, but when it comes to your tax liability, there are proactive steps you can take with your CPA to minimize tax surprises and ensure you are in the best position possible. Have questions on a potential buyout or concerns about your current tax basis? Contact us today.