Purchase of a Partnership Interest: The Step-Up in Basis

When an individual purchases an interest in a partnership, a disconnect often arises between the new partner’s purchase price and their share of the partnership’s underlying assets. The purchase price establishes the partner’s “outside basis,” while the partnership’s cost basis in its assets determines the “inside basis.” This discrepancy can create an inequitable tax situation, as the partnership can make an adjustment to ensure the purchasing partner is not taxed on gains economically borne by the seller or denied deductions related to their actual purchase price.

The Section 754 Election

The mechanism that permits a partnership to adjust the basis of its property is the Section 754 election, which is made by the partnership itself, not individual partners. When a partnership makes this election, it agrees to adjust the inside basis of its assets following certain events, like the sale of a partnership interest under Internal Revenue Code (IRC) Section 743 or certain property distributions under IRC Section 734.

Once made, the election is binding and applies to all subsequent transfers and distributions in that taxable year and all future years; it cannot be applied selectively. A partnership can only revoke the election with IRS consent, which requires showing the original reasons no longer apply or that it has become administratively burdensome.

To make the election, the partnership must file a written statement with its timely filed tax return (Form 1065) for the year the transfer occurred. Recent regulations have removed the requirement for a partner’s signature on this statement. If the partnership fails to make a timely election, it may need to seek relief from the IRS, which can be a complex process. While the election benefits an incoming partner, it creates an ongoing administrative requirement for the partnership to track basis adjustments for each partner and asset, which can complicate accounting.

Calculating the Section 743(b) Basis Adjustment

With an election in effect, the partnership calculates the basis adjustment for the purchasing partner. This adjustment is personal to the new partner and does not affect the common basis of the partnership’s assets or the other partners. The total adjustment is the difference between the new partner’s outside basis and their share of the partnership’s inside basis. A positive adjustment arises when the purchase price exceeds the partner’s share of the inside basis, while a negative adjustment occurs if the price is lower.

The purchaser’s outside basis is the amount of cash and fair market value of property paid for the interest, increased by the new partner’s share of partnership liabilities. For example, if a partner purchases a 25% interest for $200,000 and the partnership has $100,000 in liabilities, the new partner’s share of those liabilities is $25,000, making their total outside basis $225,000. The purchaser’s share of the inside basis is the sum of their interest in the partnership’s previously taxed capital plus their share of liabilities.

To illustrate, assume Chris buys a one-third interest in a partnership for $500,000. The partnership has assets with a total tax basis of $900,000 and liabilities of $300,000. Chris’s outside basis is the $500,000 purchase price plus his one-third share of liabilities ($100,000), for a total of $600,000.

The partnership’s inside basis in its capital is $600,000 ($900,000 assets – $300,000 liabilities), and Chris’s one-third share is $200,000. His total share of the inside basis is $300,000 ($200,000 capital share + $100,000 liability share). The adjustment is the outside basis ($600,000) minus the inside basis share ($300,000), which equals a positive adjustment of $300,000 to be allocated among the assets.

Allocating the Basis Adjustment Among Partnership Assets

After calculating the total adjustment, the next step is to allocate it among the partnership’s assets according to the rules of IRC Section 755. This process prevents partners from arbitrarily assigning the basis step-up to assets that would provide the most immediate tax benefit. The allocation ensures the adjustment is assigned to reduce the difference between the fair market value and the tax basis of each asset.

The allocation process first requires separating assets into two classes: capital assets and Section 1231 property (like real estate and equipment), and all other property (like inventory and accounts receivable). The total basis adjustment is divided between these two classes based on the unrealized gain or loss in each. Within each class, the adjustment is further allocated to individual assets based on the unrealized gain or loss associated with each one. A positive adjustment can only be allocated to appreciated assets, and a negative adjustment only to depreciated assets.

Continuing the example, Chris has a $300,000 positive adjustment. The partnership has a building (Section 1231 asset) with a $600,000 basis and $1,200,000 fair market value, and inventory with a $300,000 basis and $600,000 fair market value. The building has a $600,000 unrealized gain and the inventory has a $300,000 unrealized gain. Since the building represents two-thirds of the total gain, two-thirds of the adjustment ($200,000) is allocated to it, and one-third ($100,000) is allocated to the inventory.

Post-Adjustment Tax Consequences for the Purchasing Partner

The benefits of the basis adjustment materialize in the years following the purchase. If a positive basis adjustment is allocated to a depreciable or amortizable asset, the purchasing partner is entitled to additional depreciation deductions. This new depreciable basis is treated as a newly acquired asset, allowing the partner to claim depreciation on it over the asset’s statutory recovery period, which lowers their taxable income from the partnership.

The adjustment also impacts the calculation of gain or loss when the partnership sells an asset. If an asset with a special basis adjustment is sold, the partner’s share of the taxable gain or loss is calculated using their higher adjusted basis, reducing their taxable gain.

Using the ongoing example, Chris received a $200,000 basis step-up on the building and a $100,000 step-up on the inventory. The adjustment to the building creates additional annual depreciation deductions for Chris. If the partnership later sells the inventory for $600,000, it recognizes a $300,000 gain. Without the adjustment, Chris’s one-third share would be a $100,000 gain, but with his $100,000 basis adjustment, his taxable gain from the sale is reduced to zero.