Partnerships: Taking Advantage of the Optional Basis Adjustments
Transacting business in the form of a partnership provides certain advantages over a corporation. One of these advantages is the ability to make an election which protects an investor, when purchasing a partnership interest from an existing partner, from inheriting a taxable built-in gain. A built-in gain is the excess of the fair market value of a partnership interest (determined by the amount the partner paid to acquire the interest) over the partner’s pro-rata share of the partnership’s adjusted tax basis in property held by the partnership (inside basis).
To understand the value of this feature, consider what can happen if one purchases an interest in a mutual fund (a type of corporation that passes its investment income out to its investors). If the mutual fund has unrealized appreciation at the time an individual purchases an interest in the fund, the purchaser is susceptible to receiving a taxable capital gain distribution (“CGD”) should the mutual fund sell assets that appreciated prior to the purchase. While the investor will eventually recapture the benefit of tax paid on the CGD when he sells his interest, the acceleration of the tax paid on the recognized built-in gain amounts to a tax-free loan to the IRS.
THE 754 ELECTION AND HOW IT CAN HELP
A partnership can cure the problem associated with this transfer of built-in gain by making a section 754 election. In the case of a sale or exchange of a partnership interest (or the death of a partner), a section 754 election allows a partnership to make an adjustment to the basis of partnership property solely with respect to the transferee partner. In other words, the basis adjustment would apply only to the investor who purchased the partnership interest from a previous investor. The basis adjustment serves to equalize a partner’s tax basis in his or her partnership interest (outside basis) with his or her share of the underlying partnership property held by the partnership (inside basis), which is beneficial when a partner has acquired an interest in a partnership with built-in gain assets. An additional benefit of this basis adjustment, in the case of a partnership holding depreciable property or amortizable property such as goodwill, is that the acquiring partner does not have to wait until the partnership disposes of the depreciable/amortizable property to realize the benefits of the basis step-up. In this situation, the rules provide the transferee partner with an additional annual depreciation/amortization deduction to the extent of the stepped up basis attributable to depreciable/amortizable property.
CLIENT EXAMPLE: APPLYING THE 754 ELECTION
The benefit of a section 754 election can be illustrated by a recent transaction entered into by one of our clients. The client purchased a partnership interest in an operating business for approximately $45 million. As part of the negotiation process, we advised our client to amend the partnership agreement to require the partnership to make a section 754 election due to the transfer of the partnership interest. The partnership interest acquired had a built-in gain in the tens of millions of dollars. Absent a section 754 election and the associated basis adjustments, a sale by the partnership of all or part of the partnership’s assets would have resulted in a multi-million dollar allocation of gain to our client for gains which economically accrued to the partnership prior to our client becoming a partner. By requiring the partnership to make a section 754 election, our client will not be required to recognize a built-in gain, which economically accrued prior to our client joining the partnership, should the partnership sell any of the built-in gain assets. In addition, our client will receive an immediate benefit from an annual amortization deduction in excess of $1 million over a 15 year period attributable to the basis step-up.
Please note that a section 754 election will also trigger partnership basis adjustments in the case of certain partnership distributions resulting in gain or loss recognition by the recipient or adjustments to the basis of the distributed property. These basis adjustments serve to restore or diminish partnership basis that has been disproportionately removed or retained in the context of a distribution. The benefits of basis adjustments in the case of certain partnership distributions will be explained more fully in a later blog.
Despite the potential benefits of a section 754 election to transferee partners, partnerships sometimes do not make this election out of a concern that accounting for the basis adjustments is too burdensome. While cost/benefit should be considered in making any election, more often than not the benefit of making the election significantly outweighs the cost.
HOW FF&F CAN HELP
We regularly implement basis adjustments for our partnership clients so that transferee partners are not unnecessarily burdened by inherited built-in gains. This serves to maximize the value of the partnership interest being acquired. We also review the agreements of our clients’ prospective investments to ensure that when our clients are purchasing an appreciated partnership interest, a section 754 election is in effect or will be placed into effect following the purchase.
For more information on partnerships, the 754 election, or our services, please contact us at firstname.lastname@example.org or 212-245-5900.
Hunter Norton, J.D., LL.M., CPA, is an accomplished Tax Director with FF&F. Prior to joining the firm, he spent 7 years as an attorney at Withers Bergman LLP, a tax-oriented law firm, and 8 years in the Tax practice with Deloitte. His areas of expertise include business and investment partnerships, cross-border tax matters, high net worth individuals, and family offices. Hunter’s experience also allows him to advise clients in income tax matters related to trusts, estates and grantors, and taxable gifts, as well as estate planning.