Tax Effects on Partnership and Limited Liability Company Interests
Streer, Paul J., Strobel, Caroline D., The CPA Journal
Using Section 754 Elections to Enhance Value and Marketability
When a purchaser buys an existing partner's partnership interest, or the interest of a member of a limited liability corporation (LLC) taxed as a partnership, for its fair market value, the amount paid becomes the basis for the purchaser's partnership interest (outside basis). The new partner assumes the seller's pro rata share of the partnership's adjusted basis in its property (inside basis). If the partnership's assets have appreciated sufficiently, the difference between the new partner's inside and outside basis can be substantial. This disparity can deprive the new partner of depreciation deductions and inflate his share of the gain from subsequent property dispositions. A knowledgeable buyer who is aware of these negative tax consequences can negotiate a discounted purchase price to minimize the negative tax result.
Alternatively, the partnership (or LLC) can make an IRC section 754 election to equalize a new partner's outside and inside basis. This election can enhance the value of a partnership interest and make it more marketable. Making the election has no immediate positive impact on the continuing partners' interests. A section 754 election does impose administratively burdensome recordkeeping requirements on the partnership and can negatively affect the basis of partnership property in the future. Section 754 elections are a complex area of the IRC, and this article is intended as an introduction to the basic concept. Because of potentially conflicting interests, advising the purchasers, partnerships, and continuing partners requires care and caution.
Assume that Mr. S is negotiating to purchase a one-third interest in the ABC Partnership from Partner C. The partnership has the following abbreviated balance sheet:
Partner C agrees to sell her one-third interest for $255,000 (one-third of the, partnership's FMV). C expects Partner S to pay $205,000 in cash and assume C's one-third share of partnership liabilities. Thus, if the sale occurs, S will have an outside basis for his partnership internst of $255,000 ($205,000 + $50,000). However, his share of the partnership's basis for its assets (his inside basis) is only $135,000 (one-third of $405,000). This $120,000 basis disparity ($255,000 - $135,000) will deprive him of depreciation deductions on the equipment. In addition, if the land is sold, S's share of the taxable gain will be artificially inflated. If the land is immediately sold for its fair market value of $600,000, S's share of the partnership gain recognized will be $100,000 [ 1/3 × ($600,000 - $300,000)], even though S has no economic gain because his outside basis of $255,000 (the amount he paid for his partnership interest) includes his one-third share of the land's fair market value ($200,000).
Including the $ 100,000 gain in S's share of partnership income will benefit him by increasing his outside basis accordingly [IRC section 705(a)(1)(A)], but this will not provide a tax benefit in the form of a smaller recognized gain or a larger recognized loss until he disposes of his partnership interest at some future date. If the time horizon for disposition is substantial, the present value of this future benefit to S will be minimal.
On the other hand, if the partnership makes a section 754 election, S's inside basis will equal his outside basis of $255,000 [IRC section 743(b); S's optional basis adjustment is $120,000 (i.e., $255,000 $135,000); the technical determination of the adjustment is more complex and beyond the scope of this article]. He will have an inside basis for his share of the land of $200,000. This consists of his $100,000 onethird share of the common partnership basis plus his $100,000 section 743(b) optional basis adjustment. (The IRC section 754 election triggers the application of IRC section 743, which provides the incoming partner with an optional basis adjustment-here, the $120,000 difference between S's inside and outside basis. …