The way your company is formed and legally structured can make a substantial difference to how you are taxed and what incentives or potential advantages are available to you throughout the life of the business.
If your business is structured as a partnership, it creates a landscape where you can grow by inviting new partners to become a part of the enterprise and share in its success going forward. However, you need to consider how you are going to prevent a new partner from being subjected to taxes on any gains or losses they were not there to benefit from.
The way to adjust a new partner’s tax basis to prevent this scenario would be to make a section 754 election. This part of tax law is a fundamental aspect of partnership taxation and is often considered a good starting point when discussing how to create the fairest and most tax-efficient situation for all partners, new and existing.
Let’s take a look at what a 754 election involves and the arguments for considering using this tax instrument for a partnership.
Section 754 Election – An Overview
A good starting point would be to gain an understanding of what a section 754 election is and what it is designed to do.
Section 754 of the Internal Revenue Code is a tax provision that allows partnerships to adjust the basis of their partnership property. This election is often considered crucial when there’s a proposed transfer of a partnership interest, or when a partnership intends to distribute property to a partner.
When a partner sells their interest in a partnership or when a partner dies, the new partner’s basis in the partnership interest typically steps up, or down, to the purchase price or fair market value at the time of death. However, without making a Section 754 election, the inside basis of the partnership’s assets remains unchanged in the eyes of existing tax laws. This leads to a disparity between the inside basis (the partnership’s basis in its assets) and the outside basis (the partner’s basis in their partnership interest).
You can negate the negative consequences of this situation by making a Section 754 election. This allows the partnership to align the inside basis with the new partner’s outside basis. By doing this, you ensure that any future gains or losses on the sale of the partnership assets are accurately reflected. This election can also apply when the partnership distributes property. A section 754 election allows the basis of the distributed property to reflect its fair market value. Taking this step helps prevent potential double taxation.
In general terms, a tax instrument like a Section 754 election involves complex calculations and administrative burdens. Although it offers obvious advantages and offers a way of distributing assets and tax burdens fairly, it is always highly advisable to consult tax professionals in order to navigate this election effectively and gain a good understanding of all of its implications.
What are step-ups and step-downs?
One of the terms used above to describe how a section 754 election works was when talking about a step-up or step-down basis. What is this?
Step-ups and step-downs refer to adjustments made to the basis of an asset. This is typically upon inheritance or sale, and also applies when a new partner is introduced to the business.These adjustments are rightly considered crucial as they directly impact the taxable gain or loss when the asset is eventually sold.
A step-up in basis occurs when the value of an asset increases. For example, if an individual inherits a property worth $700,000, but the original owner purchased it for $200,000, the basis of the property “steps up” to $700,000. Making this adjustment allows you to minimize the capital gains tax the new partner would owe if they sold the property shortly after inheriting. This is because the taxable gain is calculated from the stepped-up basis, not the original purchase price.
Conversely, a step-down in basis happens when the asset’s value decreases. Using the same example, if the inherited property’s market value drops to $100,000, the basis steps down to this lower value. This reduces the potential loss claimed if the property is sold at the decreased value.
These basis adjustments are pivotal in estate planning and taxation. They ensure that the taxable amount reflects the current market value rather than the historical cost. You can see why this would be useful to apply when introducing a new partner into the business, as it helps to create a more accurate calculation of gains or losses for tax purposes.
What are the main pros and cons of a section 754 election?
Some of the obvious advantages of making a section 754 election include –
Alignment of inside and outside basis – One of the primary advantages of a Section 754 election is that it aligns the inside basis (the partnership’s basis in its assets) with the outside basis (the partner’s basis in their partnership interest). This ensures that the new partner’s tax basis in the partnership property reflects its fair market value. This helps prevent unfair distortions in taxable income.
Improves tax efficiency – The election can help prevent double taxation. Without the election, there could be scenarios where gains are taxed both at the partnership level and again when the partner sells their interest. By adjusting the basis, the partnership is more able to avoid this duplication of taxes.
It can be beneficial in transfer scenarios – In cases of a partner’s death or the sale of a partnership interest, the Section 754 election can be very advantageous. It allows for a step-up in basis to the fair market value at the time of transfer. This can significantly reduce the capital gains tax liability for the new partner.
Fairer distributions – When the partnership distributes property, the election allows for an adjustment to the basis of the distributed property. This ensures that the basis reflects the current market value.
What are some potential disadvantages to consider?
It can be complex and create an additional administrative burden – Implementing a Section 754 election can be complex. It requires detailed calculations and record-keeping to ensure that the basis adjustments are correctly applied. This administrative burden can be time-consuming and often requires the expertise of tax professionals. This increases costs but helps to make sure you get your calculations and filings correct.
This is a permanent election – Once made, the Section 754 election is irrevocable without IRS consent. This permanence means that partnerships need to carefully consider the long-term implications before making the election.
Potential negative impact on minority partners – In some cases, the basis adjustments can lead to disparities among partners, particularly minority partners who might not benefit equally from the election. This scenario needs to be highlighted and considered from the onset of discussions.
All things considered, a Section 754 election offers significant tax benefits, particularly in aligning basis and preventing double taxation. You should always weigh these advantages against the potential costs and long-term implications. That’s why consulting with tax professionals is essential in helping you to make an informed decision that is right for your partnership.
