Should I make a 754 Election when a Partner Dies
Robert Aufseeser

If you just inherited a share of a partnership, you should strongly consider having that partnership make a “754 election” for federal tax purposes.

What is a 754 election?

A 754 election allows a partnership to adjust the basis of partnership property when there is a distribution of property or a transfer of a partnership interest. By making a 754 election, the partnership can potentially minimize the tax impact on individual partners and align the basis of partnership property with its fair market value after certain partnership events.

A 754 Election can save you money
A 754 Election can save you money

Can the 754 election save me money?

Yes, making a section 754 election can save money by adjusting the basis of partnership property, resulting in tax benefits in certain scenarios, such as when a partnership interest is sold or there is a distribution of property. Here’s an example:

Scenario

  • Partnership ABC has three partners: Partner A, Partner B, and Partner C.
  • Partner C passes away, and their partnership interest is inherited by a new partner, Partner D.
  • The partnership owns an asset with a fair market value (FMV) of $1,500,000 and an adjusted basis of $900,000.
  • Partner C’s share of the partnership’s basis in the asset is $300,000 (one-third of $900,000).
  • The FMV of Partner C’s share at the time of death is $500,000.

Without a Section 754 Election

When Partner C passes away:

  • No basis adjustment is made to the partnership’s assets.
  • Partner D’s basis in the inherited partnership interest is stepped up to FMV, which is $500,000, but the inside basis remains $300,000 for Partner D’s share.
  • If the partnership sells the asset later for its FMV of $1,500,000:
    • Total gain recognized by the partnership: $1,500,000 – $900,000 = $600,000.
    • Partner D’s share of the gain (one-third): $600,000 / 3 = $200,000.

So, Partner D would recognize a gain of $200,000, despite having inherited a share valued at $500,000.

With a Section 754 Election

When Partner C passes away:

  • The partnership makes a section 754 election to adjust the basis of the partnership’s property.
  • Basis adjustment is the difference between Partner D’s inherited value ($500,000) and Partner C’s share of the inside basis ($300,000), which is $200,000.
    • The inside basis for Partner D is increased by $200,000.

If the partnership sells the asset later for its FMV of $1,500,000:

  • Adjusted inside basis of the asset for Partner D’s share is $500,000 (original $300,000 + $200,000 adjustment).
  • Total gain recognized by the partnership: $1,500,000 – $900,000 = $600,000.
  • Partner D’s share of the gain: $600,000 / 3 = $200,000.
  • Partner D’s recognized gain: $200,000 – $200,000 basis adjustment = $0.

Comparison of Tax Outcomes

Without the 754 Election, Partner D recognizes a gain of $200,000.
With the 754 Election, Partner D recognizes no gain due to the basis adjustment.

The Section 754 election allows Partner D to avoid recognizing a $200,000 gain, resulting in significant tax savings. This adjustment aligns the inside basis with the stepped-up basis received through inheritance, thereby preventing the recognition of phantom gains and resulting in potential tax savings.

When must a 754 election be made?

The election must be made in a timely manner. It is generally filed with the partnership’s tax return for the year in which the transfer or distribution occurs.

How do I make a 754 election?

Ask a tax professional for assistance. Generally, you must prepare a statement that includes:

  • The name and address of the partnership.
  • A declaration that the partnership elects under Section 754 to apply the provisions of Section 734(b) and Section 743(b).
  • The signature of a partner authorized to sign the partnership return.

Attach the statement of election to the partnership’s timely filed tax return (including extensions) for the year in which the election is made. The tax return should be filed using Form 1065, “U.S. Return of Partnership Income.”

Maintain records and prepare schedules to reflect the basis adjustments under Sections 734(b) and 743(b) as applicable.

kids on park bench

Ensure the election is filed with the original or amended tax return for the year in which the partnership event requiring the election occurs.

Once made, the 754 election applies to all future transfers and distributions unless revoked with IRS approval.

Conclusion

If you are inheriting a share of a partnership, contact a tax professional to determine whether the making of a 754 election is in your best interest.