When a taxpayer purchases an interest in a partnership (or membership interest in an LLC taxed as a partnership) owning appreciated assets, the taxpayer may able to obtain a step-up in his, her or its share of the partnership’s basis in its assets (i.e., “inside basis”) to reflect the amount paid for the interest. In general, this is accomplished by treating the transaction as if the purchaser had purchased an undivided interest in each asset of the partnership. In this situation, the basis adjustment is only applicable to the purchaser of the partnership interest and does not impact the selling partner nor the other partners. The basis adjustment is not made if the partnership interest is acquired by making a capital contribution to the partnership rather than by purchase from an existing partner.
This adjustment to the inside basis of the assets may be extremely beneficial to the purchaser as it will be used to determine, among other things, the purchaser’s share of (i) depreciation and amortization deductions attributable to the partnership’s assets and (ii) gain or loss on the sale of partnership assets.
In order to take advantage of this special basis adjustment, the partnership (not the purchaser) must have a valid election under Section 754 in effect. If the partnership does not have a Section 754 election in effect at the time of the transfer, it must file a statement with its partnership return for the taxable year of the partnership during which the transfer of the interest occurs.
Once a partnership makes a Section 754 election, the election applies to all transfers, including all future transfers, of partnership interests. In addition, the Section 754 election may apply to require adjustments to the basis of partnership assets when distributions are made from the partnership. Importantly, certain transactions may cause a downward adjustment in the basis of the partnership assets which may not be desirable.
Once made, the Section 754 election can be revoked only with IRS permission and, therefore, while often beneficial to a purchaser, the election should only be made by the partnership after careful consideration of all of its implications (current and future) to the partnership and its partners.