FOR TAX PROFESSIONALS
Many assets received from a decedent receive a tax basis equal to the fair market value of the asset at the date of death or alternate valuation date, commonly referred to as the "step-up" in basis. Even during an economic downturn the original basis, combined with depreciation adjustments, often results in a step "up" rather than a step "down", although either can result.
When the decedent owned an interest in a partnership, particularly one with small "net" annual income or loss amounts, a common oversight by tax practitioners is to continue reflecting the items flowing through to the estate or other heir with no further thought given to the tax consequences of the step-up. This often results in a failure to substantially reduce the annual tax burden on the successor through the election available under IRC Section 754 - or worse, a failure to claim depreciation when the election was previously made by the partnership.
The tax basis of a partnership interest acquired from a decedent is the same as if the successor had paid cash in an amount equal to the fair market value to a "selling" partner. Thus, the basis of the interest (the "outside" basis) is the fair market value. The partnership continues to calculate depreciation, gain or loss based on its continuing tax basis (the "inside" basis) for each of its assets.
The balance of this discussion assumes that the new "outside" basis exceeds the "inside" basis - resulting in additional basis to the successor, and also assumes that the partnership is not terminated upon the transfer of the interest.
The additional basis acquired by the successor, although allocable to the underlying partnership assets, is treated in certain respects as if it were a composite of assets held directly by the partner separate and distinguishable from the partnership interest itself. Without the election (described below), the additional basis is not currently depreciable, nor is it deductible in recognizing gain or loss on sale of individual assets by the partnership. Recognition of this additional basis is deferred until certain other recognizable events occur, such as a sale of the partnership interest. Such a recognition event may be deferred for many years - or altogether lost such as upon the subsequent death of the heir.
The Section 754 election by the partnership provides for current depreciation (and/or adjustment to current gain or loss upon disposition of individual assets) for the step-up in basis attributable to the successor partner. A point of confusion has been the role of the partnership vis-a-vis the partner in this election.
The election affects the new and subsequent partners. One probable reason for the requirement that the election be made by the partnership could be that Congress did not want each new partner to choose whether they would be helped or hindered by the election - once the election is made by the partnership, the current recognition of the outside basis adjustment applies to such transfers of interest by current year and future year transferees, whether it is a positive or negative adjustment.
Note that reduction of basis by depreciation allowed or allowable applies. If the election is in effect, failure of the PARTNER to claim the annual additional depreciation will not prevent that partner's outside basis from being reduced by the depreciation allowable.
Although the mechanics of allocation of basis among the assets of the partnership are beyond the scope of this newsletter (see IRC Section 755), the above basis reduction requirement may provide guidance when the partnership has made the election, but fails to calculate depreciation, etc. applicable to the partner. The regulations issued under IRC Section 754 (and related Sections 743 and 734) call for the adjustment to basis to be made by the partnership. It is difficult to conceive of a court denying such depreciation when the partnership has made the election, but the partner has calculated and included the depreciation in his/her own tax return.
Having said this, many tax advisors recommend conforming with the regulations by having the partnership include the basis adjustment and annual calculations on the current and all subsequent partnership information returns. Consider also that an "inconsistent position" report may be required to avoid a mathematical adjustment; also, proposed regulations will clarify the reporting obligation of the partnership.
Other provisions of the Internal Revenue Code require that sufficient information be supplied by a partnership to the partners so that each may be able to properly report items of income and deductions. The allocation of the basis adjustment among the partnership assets requires a composite of information from each party (e.g. - relative fair market values of the partnership's assets and the new partner's tax basis in the partnership interest). Partnership agreements of the "larger" partnerships often include a provision precluding the election to avoid the existing partners being left with the task and expense of compliance as each partnership interest changes hands. Consider the exposure to liability for damages for general partners of a partnership without such a provision in the partnership agreement, and for the successor partner's advisors, where there is a failure to make the election with substantial adverse tax consequences.
The task of dealing with a conflict between the pre-existing partners and the successor partner as to making the election could require close cooperation of the successor's attorney. Since the election does not affect the tax consequences to the pre-existing partners, their principal objection to the election by the partnership is often the perceived annual compliance burden.
The deadline for the Section 754 election is the due date of the partnership return (including extensions thereof). An election effective for the first time in a year subsequent to a partner's death will not be effective at any time as to the interest transferred to the successor.
Regulation section 301.9100-2 provides for certain "late" amended returns to be timely for purposes of many election deadlines where the deadline authority is given to the Treasury Department by Congress. The Section 754 election is magnanimously included! If the omission is discovered timely, it may be possible to undo the damage by filing an amended partnership return within the time specified by the regulation.
Failing a timely election with the original partnership return or an amended return in accordance with the regulations, a private ruling granting a late election may be requested. Requests have frequently been granted where the successor's advisor(s) (or absence thereof) lacked sufficient tax sophistication and a "new" advisor promptly requested such a ruling. Perhaps this is an ideal circumstance in which to bring in tax counsel not previously involved in this matter.
If an election had been in effect but the additional depreciation was not claimed in closed years, Revenue Procedure 99-49 may allow current utilization of the depreciation.
Evaluation of the IRC Section 754 election must be made as promptly as possible at a most difficult time. The current values of depreciable or saleable assets within the partnerships must be compared to their adjusted tax basis, and the "class" and method under which the basis adjustment allocations will fall must be determined.
The effect of other code provisions, such as the passive activity limitations and the alternative minimum tax, must be evaluated. (Note that the basis adjustment for the alternative minimum tax will usually differ from the adjustment for the regular tax.)
Estimates of the tax consequences should be made even where the net items of income and deductions flowing from a partnership interest appear small prior to transfer of the interest from a decedent. Soliciting the cooperation of the other general partners should be done as soon as possible.
If the compliance and other follow up costs appear to make the election decision marginal, it may be wise to document that the alternatives were discussed with the client. Where an election deadline has been missed, the procedures which may allow for a late election should be pursued.
RICHARD A. LAVINE, CPA You DO have a
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