Making a 754 Election After the Death of a Partner: Key Considerations

When a partner in a business partnership dies, the tax implications can be complex. One key decision for the remaining partners is whether to make a Section 754 election, which adjusts the basis of partnership assets to reflect their fair market value at the time of the partner’s death. This election can help reduce future tax burdens by aligning asset values more accurately.

Making this election requires careful consideration of timing, filing requirements, and the specific circumstances that trigger it. Understanding these factors ensures compliance with IRS rules while maximizing potential tax benefits.

Circumstances Triggering the Election

A Section 754 election is typically made when a partner’s interest in a partnership changes due to death, sale, or a distribution. This adjustment helps prevent unnecessary tax burdens for incoming or remaining partners.

Transfer on Death

When a partner dies, their ownership stake transfers to heirs or designated beneficiaries. Under Section 1014 of the Internal Revenue Code, the new owner’s basis in the partnership interest is adjusted to its fair market value as of the date of death. However, this step-up does not automatically apply to the partnership’s underlying assets unless a Section 754 election is made.

Without the election, the new partner may face higher taxes when selling their interest or when the partnership disposes of assets with a low basis. By making the election, the partnership can adjust asset values to fair market value, reducing taxable gains when those assets are sold. This adjustment also affects depreciation deductions, impacting the new partner’s tax liabilities in future years.

Sale or Exchange

When a partner sells their interest to a third party, the buyer’s outside basis equals the purchase price, but the inside basis of the partnership’s assets remains unchanged unless a Section 754 election is made. This discrepancy can result in the new partner being allocated taxable income based on historical asset costs rather than their actual investment.

For example, if a partnership asset was acquired decades ago at a low cost and has since appreciated, the new partner could be taxed on gains they did not realize. The election corrects this by adjusting the inside basis to align with the purchase price, ensuring tax obligations reflect actual economic gains.

Partnership Distribution

Certain distributions, particularly liquidating distributions, can also warrant a Section 754 election. If a partner fully exits the partnership and receives assets in return, their outside basis is adjusted, but the partnership’s inside basis remains unchanged unless the election is made.

This can create disparities if the distributed assets have appreciated or depreciated significantly. By making the election, the partnership adjusts the remaining partners’ bases in the retained assets, ensuring tax consequences align with economic reality. This is especially relevant when a departing partner receives assets with a low historical basis but high fair market value, as failing to adjust the basis could result in future taxable gains that do not reflect the actual transaction.

Scope of Basis Adjustments

A Section 754 election triggers basis adjustments under Sections 743(b) and 734(b) of the Internal Revenue Code, depending on whether the change results from a transfer of a partnership interest or a distribution of partnership property.

Under Section 743(b), when a partnership interest is transferred due to a sale or inheritance, the partnership adjusts the basis of its assets to reflect the difference between the new partner’s outside basis and their share of the partnership’s inside basis. This adjustment applies only to the incoming partner and does not affect other partners.

For example, if a new partner acquires their interest for $500,000 but the partnership’s inside basis in the assets attributable to that interest is $300,000, a $200,000 step-up is applied to the relevant assets. This ensures that future depreciation deductions and gain recognition are based on the new partner’s actual investment rather than outdated historical costs.

Section 734(b) adjustments apply when a distribution alters the remaining partners’ interests in the partnership’s assets. If a liquidating distribution results in a partner receiving assets with a basis different from their outside basis, or if the partnership recognizes a gain or loss due to the distribution, the partnership adjusts the basis of its remaining assets.

For instance, if a departing partner receives a property distribution with a fair market value significantly higher than its tax basis, the partnership increases the basis of its remaining assets to reflect the economic shift. This adjustment helps maintain parity between the book and tax values of the partnership’s assets, preventing distortions in income allocation.

Filing Requirements

To make a Section 754 election, a partnership must notify the IRS by attaching a written statement to its timely filed tax return for the year in which the election is to take effect. This statement must indicate that the partnership is electing under Section 754 to adjust the basis of its property under Sections 734(b) and 743(b). It should include the partnership’s name, address, and taxpayer identification number, along with a declaration that the election is being made in accordance with IRS regulations.

The election must be filed with Form 1065, the partnership’s annual tax return, by the original or extended due date. If a partnership fails to make a timely election, it generally cannot retroactively apply the adjustment unless it obtains relief under Treasury Regulation 301.9100-2 or 301.9100-3.

Regulation 301.9100-2 provides an automatic six-month extension if the partnership timely filed its return without the election and subsequently files an amended return within the extension period. Regulation 301.9100-3 requires a formal request for relief, demonstrating that the failure to timely elect was due to reasonable cause. The IRS evaluates these requests on a case-by-case basis, considering factors such as reliance on professional advice, internal miscommunication, or unintentional oversight.

Once an election is made, the partnership must maintain detailed records of basis adjustments for each affected asset. These adjustments should be tracked separately for each impacted partner, as they apply individually rather than at the entity level. Proper documentation is essential when assets are later sold, as the adjusted basis directly influences gain or loss calculations.

Timing Constraints

Determining when to make a Section 754 election requires careful planning, as the decision has long-term tax implications. While the election must be filed with a timely tax return, broader considerations include its impact on depreciation methods, capital gain recognition, and future partnership transactions.

For partnerships with frequent ownership changes, making the election too early can create administrative burdens, while delaying it could mean missing tax benefits. The impact on depreciation deductions is particularly important, especially when high-value assets are involved. If the election is made in a year when major capital expenditures have been placed into service, the adjusted basis could allow for increased depreciation deductions under Section 168(k) bonus depreciation or the Section 179 expensing rules. However, if the election is made in a year when the partnership anticipates lower taxable income, the benefit may not be fully utilized, potentially resulting in wasted deductions or carryforwards.