In the world of business and entrepreneurship, tax planning is a critical component of financial success. When it comes to partnerships and Limited Liability Companies (LLCs) taxed as partnerships, there are several intricacies to consider. Among them, understanding basis adjustments and the significance of a Section 754 election can make a substantial difference in tax outcomes.
When Basis Matters: Appreciated Assets and Section 754 Elections
When a buyer acquires an interest in a partnership or LLC taxed as a partnership, it should determine whether the partnership or LLC has appreciated assets, meaning that the fair market value of the partnership's or LLC's assets exceeds their tax basis.
Additionally, it should investigate whether a valid IRC Section 754 election is in place to adjust the tax basis of partnership or LLC assets.
If the partnership or LLC has appreciated assets and has not previously made a valid Section 754 election, the buyer should consider requesting, together with the seller, that the partnership or LLC make the election.
One of the primary tax advantages of a Section 754 election is that the buyer is not subject to tax on the gain inherent in partnership or LLC assets at the time of the acquisition if the partnership or LLC later sells the appreciated property. For depreciable property, the buyer benefits from increased depreciation deductions that offset its share of taxable income from the partnership or LLC.
Section 754 Election Prevents Double Taxation of Same Economic Gain
When a buyer acquires an interest in a partnership or LLC taxed as a partnership by purchase, its tax basis in its partnership or LLC interest equals the amount paid for the interest. This is often referred to as "outside basis." The buyer also has a share of the partnership's or LLC's tax basis in its own assets, referred to as "inside basis." If the partnership's or LLC's assets have appreciated or depreciated before the buyer acquires its interest, the buyer may have a disparity between its inside and outside basis.
In the absence of an IRC Section 754 election, if the partnership or LLC has appreciated assets and sells one or more assets after the buyer has acquired its interest, the buyer pays tax on its share of gain from the asset sale even though the partner or member that sold its interest to the buyer already paid tax on that same economic gain.
A Practical Illustration
For instance, let's consider a scenario where X, Y, and Z decide to establish an LLC taxed as a partnership. Each of them contributes $700,000 to form the LLC, securing a one-third ownership interest. The LLC purchases real estate worth $1,500,000, while also maintaining $400,000 in cash reserves.
Here's a snapshot of the LLC's balance sheet:
Fair Market Value
Now, let's delve into the initial members' capital accounts and their corresponding share of inside basis:
Share of Inside Tax Basis
In this setup, X, Y, and Z each have an outside basis in their LLC interest, which amounts to $700,000, mirroring their share of the LLC's inside basis.
Now, let's fast forward to Year 1, where the real estate appreciates from $1,500,000 to $2,000,000. Here's how the LLC's balance sheet looks now:
Fair Market Value
Despite the substantial increase in the real estate's value, the tax basis of the LLC's assets remains the same. X, Y, and Z each continue to have a $700,000 share of the LLC's inside basis.
As Year 2 begins, Z decides to sell their entire interest to W for $800,000, which represents one-third of the current fair market value of the LLC's assets. Consequently, Z incurs a tax liability of $100,000, calculated as the difference between the sale proceeds ($800,000) and their basis in the LLC interest ($700,000).
W's basis in the LLC interest amounts to $800,000, which is the purchase price. However, without a Section 754 election, W's share of the LLC's inside basis remains at $700,000.
If, at the end of Year 2, the LLC decides to sell the real estate for $2,000,000, it would realize a gain of $500,000, distributed equally to X, Y, and W. Though, it's important to note that Z had already recognized $100,000 of gain when selling their LLC interest to W.
Without a Section 754 election, W's recognition of $100,000 in gain from the real estate's sale would typically be offset by either (1) a loss when W sells their LLC interest or when the LLC liquidates or (2) recognition of built-in loss on property distributed by the LLC. W can take a loss because of its increase in their LLC interest basis, rising from $700,000 to $800,000 after the $100,000 gain allocation.
If the LLC has a Section 754 election in place for the year in which W acquires the LLC interest, the resulting basis adjustments to the LLC's assets prevent the double taxation of the same economic gain. The basis adjustment amounts to $100,000, reflecting the difference between W's share of the LLC's basis in its assets ($700,000) and W's basis in the LLC interest acquired from Z.
It's important to note that Section 754 adjustments only impact the partner or member acquiring a partnership or LLC interest—in this case, W. The transferee partner or member is treated as if they acquired a direct undivided interest in the partnership or LLC property.
After the adjustment in this example, the members' share of inside tax basis becomes:
Share of Inside Cash Basis
Share of Inside Land Basis
Total Member Inside Tax Basis
Upon the sale of the real estate, X, Y, and W are effectively treated as if they each sold an undivided one-third interest in the property. Consequently, the LLC allocates $100,000 of gain to each of X and Y ($800,000 purchase price for one-third of the property minus $700,000 share of inside tax basis). Notably, no gain is allocated to W.
Generally, a buyer of a partnership or LLC interest would prefer not to have the partnership or LLC make a Section 754 election if the entity possesses depreciated assets. However, basis adjustments can occur if either:
The partnership or LLC already has a Section 754 election in effect.
The partnership's or LLC's tax basis in its assets surpasses the fair market value of those assets by more than $250,000 immediately after the transfer of the partnership or LLC interest.
It's essential to understand these dynamics to make informed decisions about Section 754 elections in partnership ventures.
Mandatory Section 754 Basis Adjustments
In the world of LLCs or partnerships, there are instances where basis adjustments become mandatory. An LLC or partnership must make these adjustments when:
Immediately after a transfer of a partnership or LLC interest, the partnership's or LLC's tax basis in its property exceeds the fair market value of the property by more than $250,000.
The transferee would be allocated a loss of more than $250,000 if the partnership or LLC sold all of its assets for cash equal to their fair market value immediately after the acquisition of the partnership or LLC interest.
These mandatory basis adjustments are designed to ensure that tax basis aligns with economic reality, preventing unwarranted tax advantages or disadvantages in the event of transfers or changes in ownership.
The Mechanics of Basis Adjustment
When a partnership or LLC has a Section 754 election in effect, the adjustment to tax basis can take one of two forms:
Increase in Basis: The adjusted tax basis of partnership or LLC property is increased by the excess of the transferee's basis for the partnership or LLC interest over the transferee's share of the adjusted tax basis of partnership or LLC property.
Decrease in Basis: The adjusted tax basis of partnership or LLC property is decreased by the excess of the transferee's share of the adjusted tax basis of partnership or LLC property over the transferee's basis for the partnership or LLC interest.
The key lies in determining the transferee's share of the adjusted basis, which comprises the transferee's interest in the partnership's or LLC's previously taxed capital and the transferee's share of partnership or LLC liabilities.
Bonus Depreciation: An Added Advantage
In 2017, tax reform legislation introduced significant changes, particularly regarding bonus depreciation. This modification allowed for full expensing of qualified property acquired and placed into service between September 27, 2017, and January 1, 2023, with a phasedown for property placed in service from 2023 to 2026. Remarkably, full expensing applied to both new and used property. For used property acquisitions to qualify, specific conditions had to be met.
Under Treasury regulations, a person acquiring a partnership or LLC interest from an existing partner or member could generally claim bonus depreciation for any step-up in the basis of qualified property under IRC Sections 754 and 743(b) if specific requirements were met.
Basis Adjustments on Distributions
When an LLC or partnership has a Section 754 election in effect, it must adjust the basis of partnership or LLC property upon distributions to partners or members. These adjustments are required when a distributee partner or member recognizes gain or loss on the property distribution, or when the distributee partner or member does not take a carryover basis in the property distributed.
These basis adjustments are essential for ensuring equitable tax treatment during property distributions within the partnership or LLC.
Navigating the complex landscape of partnership and LLC taxation requires a deep understanding of basis adjustments, Section 754 elections, and the rules governing these tax mechanisms. Armed with this knowledge, business owners can make informed decisions to optimize their tax strategies and ensure compliance with tax laws. Maximizing tax efficiency is not just about minimizing tax liability; it's about leveraging the available tools to support business growth and profitability in a tax-efficient manner. By delving into these intricate tax strategies, entrepreneurs can chart a course toward financial success and security.