Section 743(b) vs. 734(b): Key Differences in Adjustments

A common tax complexity in partnerships is the difference between a partner’s basis in their partnership interest, known as “outside basis,” and the partnership’s basis in its assets, or “inside basis.” A partner’s outside basis reflects their investment, while the inside basis is the partnership’s historical cost. When these values diverge, it can create tax inequities. For example, a new partner might pay tax on appreciation that occurred before they joined.

To address these imbalances, the Internal Revenue Code provides two remedies. Sections 743(b) and 734(b) allow adjustments to the inside basis but are triggered by different events and operate in distinct ways.

The Foundational Section 754 Election

Before a partnership can use either a Section 743(b) or 734(b) adjustment, it must have a Section 754 election in effect. This election permits the partnership to adjust the basis of its property in specific situations. Without it, the basis of partnership property remains unchanged unless a substantial basis reduction of over $250,000 occurs.

To make the election, the partnership attaches a written statement to its timely filed tax return, typically Form 1065, for the year the triggering transfer or distribution occurs. The statement declares the partnership elects to apply the provisions of both Section 734(b) and Section 743(b), as a partnership cannot choose to apply only one.

Once made, the election is binding for the year of the election and all subsequent taxable years. Revoking the election requires consent from the IRS, and a partnership must file a formal request demonstrating a valid reason, such as a significant administrative burden. The IRS will not approve a revocation if its primary purpose is to avoid a downward basis adjustment, making the initial choice to elect a lasting decision.

Section 743(b) Adjustments for Transferees

A Section 743(b) adjustment is triggered by the transfer of a partnership interest, either through a sale or exchange, or upon the death of a partner. Its purpose is to resolve the imbalance between what a new partner pays for their interest and their proportional share of the partnership’s existing basis in its assets. This ensures the new partner does not inherit the tax consequences of value changes that occurred before they joined. The adjustment is calculated as the difference between the transferee’s new outside basis and their share of the partnership’s inside basis.

To illustrate, consider a partnership with one asset, a building with a fair market value of $450,000 and an adjusted basis to the partnership of $300,000. A new partner purchases a one-third interest for $150,000. The new partner’s outside basis is their $150,000 purchase price, but their one-third share of the partnership’s inside basis is only $100,000 (1/3 of $300,000). The Section 743(b) adjustment is the $50,000 difference.

This adjustment is personal to the transferee partner and has no effect on the other partners. The $50,000 positive adjustment belongs exclusively to the new partner. If the partnership were to sell the building, the new partner could use this additional basis to reduce their share of the taxable gain from the sale. This special basis adjustment would also generate higher depreciation deductions allocated solely to them.

The partnership calculates the adjustment and attaches a statement to its Form 1065 detailing the computation and allocation of the adjustment to specific assets under the rules of Section 755. The transferee partner must account for this special basis when determining their share of partnership income, gain, loss, or deduction.

Section 734(b) Adjustments for Distributions

A Section 734(b) adjustment is triggered by a distribution of property from the partnership to a partner, not a transfer of interest. Its purpose is to prevent the tax consequences of the distribution from distorting the partnership’s overall asset basis. This adjustment applies to the partnership’s remaining assets and therefore affects all remaining partners collectively.

One scenario for an adjustment occurs when a partner recognizes a gain or loss on a distribution. A partner recognizes a gain if they receive cash in excess of their outside basis. A loss can be recognized in a liquidating distribution if the partner receives only certain assets and their outside basis exceeds the basis of the assets received. In these cases, the partnership adjusts the basis of its remaining property by the amount of the gain or loss the distributee partner recognized. This prevents that gain or loss from being duplicated by the remaining partners when the partnership later sells its assets.

A second scenario arises from basis differences in property distributions, most commonly in a liquidating distribution. When a partner receives property in liquidation, their basis in that property is determined by their outside basis in the partnership. If the partnership’s inside basis in the distributed asset is higher than the partner’s outside basis, the asset’s basis is stepped down in the partner’s hands. A Section 734(b) adjustment allows the partnership to increase the basis of its remaining assets by the amount of this step-down.

Conversely, if a partner’s outside basis is higher than the partnership’s inside basis in the distributed property, the asset’s basis may be stepped up. For example, if a liquidating partner with an outside basis of $90,000 receives property with a partnership basis of $60,000, the partner takes a $90,000 basis in the property. The partnership must then make a negative $30,000 adjustment to its remaining assets. This adjustment is mandatory if a Section 754 election is active and prevents the partnership’s total asset basis from being artificially inflated.

Key Distinctions in Application and Effect

The primary difference between Section 743(b) and Section 734(b) adjustments is their triggering event. A 743(b) adjustment is a consequence of a transfer of a partnership interest, like a sale or inheritance. In contrast, a 734(b) adjustment is prompted only by a distribution of property from the partnership to a partner.

Their application and effect are also distinct. The Section 743(b) adjustment is personal to the transferee partner, creating a special basis adjustment that only the new partner can use for calculating future depreciation or gain and loss. This leaves the other partners’ tax situations unaffected.

The Section 734(b) adjustment is a common adjustment made to the basis of the partnership’s remaining property. Its benefits or detriments are shared among all partners who remain in the partnership after the distribution, impacting their collective future tax liabilities.