Section 754 Step-Up in Basis

Transcription

1 Section 754 Step-Up in Basis Understanding the Tax Issues for Partnerships and LLCs Copyright Notice Any reproduction or unauthorized use of these materials, without the express written permission of Surgent McCoy Self-Study CPE, LLC, is prohibited. 2 1

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5 Today's Presenter Michael J. Tucker, CPA Mike is an employee of Surgent McCoy CPE, LLC and a consultant for the accounting firm of T.M. Byxbee Co. in Hamden, CT. He is the author of many professional articles and a veteran TV and liveseminar presenter. In addition, he heads up Surgent McCoy's webinar efforts, where he writes and hosts many of the webinars Surgent McCoy sponsors and presents. 9 Today's Presenter Bob Lickwar, CPA, MST Bob is a partner at DelConte, Hyde, Annello and Schuch in Farmington, CT. He has more than 30 years of experience as a practicing CPA, and has worked exclusively with privately held businesses and owners to provide compliance services and sophisticated tax planning strategies including like-kind exchanges, tax efficient workouts and restructurings, reorganizations and estate planning services. 10 5

6 Optional Adjustments to Basis General Rule There is generally no adjustment to the bases of a partnership s assets as a result of: 1. A transfer of partner's interest by sale, exchange or death 2. A distribution by a partnership to a partner Exceptions: 743(b) - Election for benefit of transferee partner 734(b) - Distribution of partnership property to a partner 732(d) - Transfer by sale, exchange, or death where no 754 election was made 11 Inside and Outside Basis Outside basis refers to a partner s tax basis in the partnership interest Inside basis refers to the partner s share of the basis in the assets held by the partnership 12 6

7 743(b) Election for Benefit of Transferee Partner Requirements: 1. Transferee partner acquires interest by sale, exchange or death 2. Partnership makes a 754 election 3. Only transferee partner is benefited or penalized 4. Adjustment to partnership property for gain, loss, depreciation, etc (b) Distribution of Partnership Property to a Partner Requirements: 1. Distribution by partnership to partner election 3. Only remaining partners are effected 14 7

8 732(d) Transfer by Sale, Exchange, or Death No 754 Election Election applies to assets distributed within 2 years of the transfer Requirements: 1. Transferee partner acquires interest by sale, exchange, or death 2. No 754 election is made 3. Partner makes 732(d) election 4. Only distributee partner is affected 5. Adjustment to basis of the property distributed to the partner 15 Section 743(b) Accounts for the difference between a transferee partner's basis for his or her partnership interest and partner s share of the basis of partnership property Cash a partner would receive in a liquidating distribution, assuming all of the partnership assets were sold for their FMVs in a hypothetical taxable transaction This amount is increased by tax loss or decreased by the tax gain allocated to the partner (total interest in capital) This amount is further increased by the transferee s share of partnership liabilities 16 8

9 754 Election Requirements Made in a written statement that is filed with the partnership return for the tax year during which the distribution or transfer occurs Includes name and address of partnership, a statement that the partnership intends to make the election under 754 to apply the 743 and 734 adjustments as well as the signature of any partner The statement also includes a computation of the adjustment and the partnership properties to which the adjustment is allocated Must be filed by the due date of Form 1065, including extensions Automatic 12-month extension from the original deadline Election Requirements The IRS may also allow late 754 election for reasonable cause if government s interests are not prejudiced Partnership may ask IRS for permission to revoke on the following grounds: 1. A change in the nature of the partnership business 2. A substantial increase in the assets of the partnership 3. A change in the character of partnership assets 4. An increased frequency of retirements or shifts of partnership interests so that an increased administrative burden would result to the partnership from the election 18 9

10 754 Election Requirements Once made, the 754 election can be revoked only with the IRS consent The application for revocation must be filed no later than 30 days after the close of the partnership tax year for which the revocation is intended to take effect and it must set forth the grounds for which the revocation is desired In cases where failure to meet the deadline was inadvertent, the IRS has granted an extension of the time within which to file the revocation (IRS Letter Ruling ) Consent to revoke a 754 election is not automatically granted For example, the potential decrease in the basis of partnership property upon either the transfer of a partnership interest or the distribution of partnership property would be insufficient to grant a revocation request Election Requirements Valid reasons for approving such a request include: A change in the nature of the partnership business A substantial increase in the number of assets in the partnership A change in the character of partnership assets, or An increased frequency of retirements or ownership shifts 20 10

11 754 Election Requirements If a partnership terminates under 708(b)(1)(B) sale or exchange of 50% or more of the interests in partnership capital and profits within a 12-month period and the terminating partnership has a 754 election in effect at that time, the bases of the partnership assets are adjusted pursuant to 743(b) and 755 before their deemed contribution to the new partnership 21 Effect of 754 Election Once a 754 election has been made, basis adjustments under 734(b) (e.g., distributions) and 743(b) (e.g., sales/inheritance) are mandatory. May result in positive or negative adjustments to bases of partnership s properties

12 Optional Basis Adjustments: 743(b) General rule under 743(a) bases of partnership assets are not adjusted when a partnership interest is transferred or when a partner dies. When a partner sells or exchanges a partnership interest, inequities may occur for the incoming partner. The incoming partner will usually have a cost basis in his partnership interest this is the partner s outside basis. The partner s outside basis will be different from the partner s share of the partnership s adjusted basis in its assets this is the inside basis. 23 Optional Basis Adjustments: 743(b) A discrepancy between the inside and the outside basis can result in an inequity for the new partner. 743(b) applies if an interest in a partnership is transferred by reason of a sale or exchange or by death of a partner and: 1. A 754 election is in effect; or 2. The partnership has a substantial built-in loss

13 Optional Basis Adjustments: 743(b) The effect of making the 743(b) adjustment is to: Increase the adjusted basis of the partnership property by the excess of the basis to the transferee partner of the partner s interest in the partnership over the partner s proportionate share of the adjusted basis of the partnership property; or Decrease the adjusted basis of the partnership property by the excess of the transferee partner s proportionate share of the adjusted basis of the partnership property over the basis of the partner's interest in the partnership. 25 Optional Basis Adjustments: 743(b) Unless the 743(b) adjustment is made, sale of a partnership interest and partnership assets could produce double taxation: 1. Gain on the sale of the partnership interest. 2. Gain on the sale of partnership property unadjusted to fair market value at time of purchase. See Examples 1 and 2 in the Supplement

14 743(b) The 743(b) adjustment is mandatory when there is a substantial built-in loss. A partnership has a substantial built-in loss if the partnership s basis in its property exceeds the property's fair market value by more than $250,000. The existence of a built-in loss is determined at the partnership level not at a partner level. See Examples 3 and 4 in the Supplement (b) Adjustment Calculation Transferee partner will: Increase his/her share of the partnership s bases in its properties by the excess of the basis to the transferee partner of his/her interest in the partnership over his/her proportionate share of the adjusted basis of the partnership s property; or Decrease the transferee s share of the partnership's bases in its assets by the excess of the transferee partner s proportionate share of the adjusted basis of the partnership property over the partner s basis in the partnership interest

15 New Partner s Share of the Adjusted Partnership s Basis in its Property The transferee partner s adjusted basis in partnership property is equal to: 1. Transferee s interest as a partner in the partnership s previously taxed capital; plus 2. Transferee s share of partnership liabilities (b) Adjustment New partner s basis in the partnership interest minus new partner s share of partnership s adjusted basis in its assets

16 Transferee Partner s Share of Previously Taxed Capital Determined through a hypothetical transaction in which the partnership sells all of its assets in a fully taxable transaction at FMV for cash. Sale immediately after the transfer of the partnership interest. Partner s share of Previously Taxed Capital (PTC) equals: 1. Amount of cash transferee partner would receive upon liquidation of the partnership immediately following the hypothetical sale; plus 2. Amount of tax loss that would be allocated to the transferee from the hypothetical sale; less 3. Amount of tax gain allocated to the transferee partner. 31 Transferee Partner s Share of Previously Taxed Capital Increase for tax loss/decrease for tax gain computed by taking into account any remedial allocations. See Example

17 Effect of the 754 Election The 743(b) adjustment either increases or decreases the transferee partner s share of the adjusted basis to all of the partnership property. Transferee partner will receive a special basis in partnership property for purpose of computing items such as depreciation, gain, loss, and distributions. Adjustment to the partnership assets is allocated under 755 and its regulations. Section 755 regulations apply to adjustments under 732(d), 734(b), and 743(b) Allocation Adjustment Adjustment reduces difference between FMV and adjusted basis of partnership properties. Under 755, the 743(b) adjustment is first allocated between: 1231 and capital assets and Ordinary income property; Then allocated among the assets in each category. This allocation requires determining the FMV of the partnership s properties

18 755 Allocation Adjustment Transferee partner increases his or her share of the partnership s bases in its assets by the excess of the basis to the transferee partner of his or her interest in the partnership over his or her proportionate share of the adjusted basis of the partnership property, or Decreases the transferee s share of the partnership's bases in its assets by the excess of the transferee partner s proportionate share of the adjusted basis of the partnership property over the basis of his or her interest in the partnership Allocation Adjustment Partnership first values FMV of all assets other than 197 intangibles, which includes goodwill and going concern value. Cannot be less than amount of any nonrecourse debt to which the property is subject. Partnership determines the gross value of all partnership assets partnership gross value. Partnership gross value is generally the amount that, if assigned to all partnership property, would result in a liquidating distribution to the transferee partner equal to the partner s basis reduced by the amount of that basis that is attributable to partnership liabilities

19 755 Allocation Adjustment Partnership uses residual method to allocate values to the partnership s 197 intangibles. 743(b) adjustment is first divided between: 1. Capital and 1231 assets (capital gain property); and 2. All other property (ordinary income property). Portion allocated to one class may be an increase, while portion allocated to the other may be a decrease even if the total amount of the basis adjustment is $ Allocation Adjustment Allocation of basis adjustment between capital gain property and ordinary income property based on allocations of income, gain or loss that the transferee partner would receive if, immediately after the transfer of the partnership interest, all of the partnership properties were disposed of in a fully taxable transaction for cash in an amount equal to the FMV of the partnership property. To allocate the 743(b) adjustment between and among the two classes of partnership property, the partnership must value each of its assets. The determination of the FMV of partnership assets is integral to the allocation of the adjustment

20 755 Allocation Adjustment 743(b) Upward Adjustment Step #1: Calculate total income, gain or loss, including remedial allocations, that would be allocated to transferee partner from sale of all partnership ordinary income property in a sale where all ordinary income property sold for an amount of cash equal to the property s FMV. Step #2: In the event Step #1 allocates a loss, allocate to the ordinary income property a downward adjustment equal to the amount of loss. Add the amount of loss to the 743(b) adjustment allocated to the capital assets Allocation Adjustment 743(b) Upward Adjustment Step #3: If Step #1 generates a gain allocable to the transferee partner, allocate to the ordinary income property class an upward adjustment equal to the amount of that gain. If the amount of the upward adjustment is less than or equal to the 743(b) adjustment then subtract the amount of the adjustment from the 743(b) upward adjustment. This results in a 743(b) upward adjustment for the capital gain property

21 755 Allocation Adjustment 743(b) Upward Adjustment If the amount of the 743(b) upward adjustment to ordinary income property is greater than the amount of the 743(b) upward adjustment, subtract the amount of the 743(b) upward adjustment from the 743(b) upward adjustment allocated to ordinary income property. The result is a downward basis adjustment allocated to the capital asset class Allocation Adjustment 743(b) Upward Adjustment Step #4: Allocate the upward basis adjustment computed in the prior steps to capital gain property. This completes the upward basis adjustment to the two classes of property. Step #5: If Step #3 yielded a downward basis adjustment for capital assets, then the amount of the downward basis adjustment allocated to the capital asset class is limited to that amount of aggregate basis or share of remedial loss, and the remaining downward basis adjustment (excess basis decrease) is allocated to the ordinary income class. See Examples 6, 7 and

22 Allocating the 743(b) Within Each Class of Partnership Property Assuming that the partnership has allocated the 743(b) adjustment to each class of property, then the partnership must allocate the amount of the adjustment to the various properties within the class. With respect to the amount allocated to ordinary income assets: Step #1: Determine amount of income, gain, or loss that would be allocated to the transferee partner from the hypothetical sale of ordinary income items identify the amount as W. If there is a loss allocated the transferee partner, then W will be a negative number. 43 Allocating the 743(b) Within Each Class of Partnership Property Step #2: Determine the amount of any excess basis decrease that was allocated to the ordinary income property pursuant to the allocation of the adjustment between the classes an amount identified as X. Step #3: Calculate the FMV of the item of ordinary income property and the total FMV of all the partnership s ordinary income items identified as Y. Step #4: The adjustment allocated to a particular item of ordinary income property is determined by using the following formula: W - (X x (Y/X)

23 Allocating the 743(b) Adjustment to Capital Assets For each asset in the capital asset group: Step #1: Calculate the total income, gain, or loss that would be allocated to the transferee partner from the hypothetical sale of the capital asset. This amount will be W. Step #2: Determine the total amount of gain or loss allocated to the transferee partner from the hypothetical sale of all of the partnership s capital gain property. Step #3: Calculate the total amount of the adjustment allocated to the capital asset class Y. Step #4: Determine the FMV of the capital asset to the partnership (Z) and the total FMV of all the partnership s capital gain (Q). 45 Allocating the 743(b) Adjustment to Capital Assets Step #5: If the total adjustment allocated to the capital asset group of assets is positive (Y), calculate the amount of the adjustment allocated to the capital asset by using the following formula: W - ((X-Y) x Z/Q)) If the total adjustment allocated to the capital assets is negative (a downward adjustment), then the following formula applies: W - (( X - Y*) x (Z/Q)) *In a downward adjustment Y is a negative number. See Example 9 in the Supplement

24 734(b) Adjustment 734(a) adjustment applies if: 1. There is a 754 election in effect with respect to a distribution by a partnership to a partner; or 2. There is a substantial basis reduction with respect to a distribution in liquidation of the distributee partner s interest if the following two amounts together are greater than $250,000: a. The distributee's loss on the distribution; and b. The excess of the basis of the distributed property to the distributee over the adjusted basis of the distributed property to the partnership immediately before the distribution (b) Adjustment If a partnership makes an adjustment to the basis of partnership property under 734(b), it must attach a statement to the partnership return for the year in which the distribution occurs setting forth the computation of the adjustment and the partnership properties to which the adjustment has been allocated

25 734(b) Adjustment Applies in the following four circumstances: 1. The distributee partner recognizes gain under 731(a)(1); 2. The distributee partner recognizes loss under 731(a)(2); 3. The distributee partner s adjusted basis in the distributed property is less than the partnership s adjusted basis in the property immediately preceding the distribution; or 4. The distributee partner s adjusted basis in the distributed property is greater than the partnership s adjusted basis in the property immediately preceding the distribution (b) Adjustment The 734(b) basis adjustment is an upward adjustment in situations #1 and #3 (on prior slide). In situation #1, when the distributee partner recognizes gain, the basis adjustment is equal to the amount of gain recognized. In situation #3, when the distributee partner s adjusted basis in the distributed property is less than the partnership s adjusted basis in the property immediately preceding the distribution, the basis adjustment is equal to the amount of such excess, as generally no gain or loss is recognized on distributions of partnership property. In situations #2 and #4, the basis adjustment is a downward adjustment

26 734(b) Adjustment In situation #2, where the distributee partner recognizes loss under 731(a)(2), the basis adjustment is equal to the amount of loss recognized. In situation #4, the distributee partner s adjusted basis in the distributed property is greater than the partnership s adjusted basis in the property immediately preceding the distribution, the downward basis adjustment is equal to the amount of such excess as described in situation #2. The 734(b) adjustment is allocated in accordance with the rules in 755 and affects all of the remaining partners. See Examples 10 through Allocating the 734(b) Adjustment in Accordance with the Rules in 755 Divide the partnership assets into two asset classes: ordinary income assets and capital assets. Then allocate to the various assets within each class although usually the allocation is only within one class. If the adjustment arises from disappearing or created basis, the adjustment is allocated to the asset class from which the distributed property came which gave rise to the distributed or created basis. If the adjustment arose from a capital gain or loss arising under 731(a), the adjustment will be allocated to the capital assets

27 Allocating the 734(b) Adjustment in Accordance with the Rules in 755 With respect to an intra-class allocation, an upward allocation is allocated as follows: First allocate to properties with unrealized appreciation in proportion to the amount of unrealized appreciation in each item of property in that class before the adjustment is taken into account. This allocation may not exceed the property s unrealized appreciation. Any adjustment remaining is allocated among items of property within the class in proportion to the FMVs. If there are no items of property in the class to which the upward adjustment has been allocated, then the adjustment is made when the partnership subsequently acquire property belonging to that class. 53 Allocating the 734(b) Adjustment in Accordance with the Rules in 755 A downward adjustment is first allocated to properties with unrealized depreciation in proportion to the amount of unrealized depreciation in each item of property in that class, before the adjustment is taken into account. The amount of adjustment allocated to an item of property cannot exceed the amount of unrealized depreciation in that item of property

28 732(d) election If the partnership has not made and will not make a 754 election, an alternative exists through the application of 732(d). 732(d) applies to a partnership interest transferred by sale, exchange, or death where a 754 election has not been made. 732(d) allows an incoming partner to elect to attribute, to any partnership property actually distributed to him or her within two years of acquiring her interest, the same tax basis he or she would have had if a 743(b) optional basis adjustment had applied (d) Election The 732(d) election affects only the incoming partner and does not have the same effect as a 754 election. Property distributed outside of the 2 year time horizon is unaffected and the election has no effect until a distribution is made. Both the basis of property sold by the partnership and the partnership s allowance for depreciation or amortization are unaffected. Can a minority partner can convince the partnership to make distributions in a timely manner? 56 28

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