The aggregate legal concept works behind the scenes to ensure
the partnership's inside basis equals the sum of the outside basis for all partners.
However, some transactions such as the sale of
a partnership interest in certain distributions,
can create a discrepancy between these amounts.
In such cases, Section 754 allows a partnership to make an election for
a special basis adjustment that brings the inside and outside bases back in balance.
Your inner accountant probably feels better already, not so fast.
The Section 754 election is unquestionably one of
the most complicated areas of Subchapter K. For example,
a journalist with Forbes recently wrote, "To date,
I have resisted the call to write about Section 754,
largely because it is nearly impossible to make any headway
on the subject in fewer than 3,000 words,
and that's approximately 2,500 words longer than the standard American attention span."
To be fair though, determining the adjustment needed to bring
the bases numbers back in sync is not too complex,
but allocating the adjustment to partnership assets is a completely different story.
In this lesson, you will learn about the special basis adjustment of Section 754.
Although the sale of partnership interests in certain distributions can both
create a discrepancy between inside and outside basis amounts,
this lesson will focus on sale transactions to keep things tractable and remain on topic.
In addition, our examination of Section 754 will be high-level so that you can develop
an appreciation for the purpose of
this special basis adjustment without getting lost in what has been called the quagmire,
that is Subchapter K. After learning the basic concepts,
you will apply them to Sunchaser Shakery like always.
Inside basis refers to the basis the partnership entity holds in its assets.
For example, assume that Nicholas and Emily each contribute
$500,000 to form Sunchaser Shakery partnership.
Afterwards, Sunchaser uses the contributed cash to acquire two assets,
beachfront property worth $600,000 and restaurant equipment worth $600,000.
Each partner has a capital account balance,
which is similar to an equity account,
that equals their contributed assets,
and the total of all capital accounts equals
the total basis the Sunchaser has in its assets.
In other words, Sunchaser has an inside basis in its assets of one million dollars,
and each partner share of that inside basis is $500,000.
Outside basis refers to the basis each partner holds in their partnership interests.
Returning to the example,
Nicholas and Emily each take an initial outside basis of $500,000,
the amount of cash contributed to Sunchaser.
As you can see, the aggregate legal concept has created a situation where
each partner has an outside basis equal to
their share of the inside basis of Sunchaser's assets.
Now, fast forward one year into the future,
assume that Sunchaser's beachfront property
has increased in value to one million dollars.
Although the positive change in value is unrealised,
it does create a unique situation.
If Emily now decides to sell her interests in Sunchaser,
based on the appreciated property,
the fair market value of Sunchaser's assets is now $1.4 million,
meaning Emily's share of those assets is now worth $700,000.
Consequently, Emily will sell her interest for not less than $700,000.
If Michael buys Emily's interest in Sunchaser for $700,000,
Emily will recognize a gain under Section 741 equal to the amount realized of
$700,000 less her outside basis of $500,000 or $200,000.
Michael receives an outside basis in the interest of $700,000,
the fair market value and sales price of the Interest as this was a taxable transaction.
However, after the sale,
a discrepancy exists between inside and outside basis.
Specifically, Michael has an outside basis to $700,000.
However, nothing has transpired with regard to Sunchaser.
Thus, Michael's 50% share of the inside basis is $500,000
since he conceptually steps into the shoes of Emily's previous capital account balance.
In other words, Michael's capital account of
$500,000 differs from his outside basis of $700,000.
This $200,000 difference can create some tax issues for Michael down the road.
For example, if Sunchaser sells its underlying assets,
it is possible for Michael to recognize a gain that was
previously recognized by Emily when she sold the interest to Michael,
resulting in the same economic gain being taxed twice.
While this issue might be resolved on its own in a liquidation of Sunchaser,
concerns about timing and character still remain.
Accordingly, Section 754 aims to mitigate
the out of balance situation by giving a new partner,
Michael in this case,
a share in the partnership equal to his outside basis.
As such, the special basis adjustment only applies to the new partner.
The share of inside bases for other partners remains the same.
In general, the special basis adjustment amount is the difference between
the new partner's outside basis and their proportionate share of inside basis.
This amount is allocated to partnership assets
pursuant to rules that go well beyond the focus of our discussion.
But for example, in some situations,
the amount is allocated according to
the partner's share of the adjusted basis of partnership property.
Once a Section 754 election is made,
a partnership must make the adjustment for all sales of partnership interests.
The election might even be mandatory in some situations.
For example, the special basis adjustment is required when a partner sells
an interest and the partnership has a substantial built-in loss at the time of the sale,
or when the partnership has a substantial basis reduction from a distribution.
Overall, the purpose of Section 754 is to prevent partners from
temporarily being over or undertaxed after a sale of partnership interests,
or distribution of property from the partnership.
Michael P Donohoe, PhD, CPAAssociate Professor of Accountancy and PwC Faculty Fellow
