Build a Tax Wall and Make the IRS Pay for It

Nobody likes to talk about taxes, unless it is a conversation about how to avoid paying taxes, and somehow sticking it to the IRS. If only it were that simple. Sticking it to the IRS, generally speaking, is more difficult than it sounds at first glance, but it is vital to be aware of your tax situation so that you can take advantage of the regulations when the opportune moment arises.

With that as a backdrop, today we are going to venture into one of the most thorny, tangled, and just basically messiest areas of tax law: Subchapter K and Partnership taxation. Not to worry, we will not be getting into the extreme of tax nerdiness today, but do be aware that this may still feel like:

Partnership taxation is vital for various reasons, but two that come to mind right away are: 1- Most LLCs are taxed as partnerships, even if they are technically called LLCs, and 2- Goof ups in partnership taxation can have serious consequences.

First, some partnership tax basics. The primary term that we will use repeatedly today is “basis.” In tax, the basis, at its very core, is the amount of money you pay for an asset. It is important to keep track of the basis, because if you sell the asset, then you will only be taxed for the amount of money you receive that is over the basis. And, your intuition is correct, the opposite is also true: if you sell the asset for the same or lower price than what you paid for it (the basis), then you are not taxed at all for selling the asset.

Next step gets a touch more complicated: in a partnership (or an LLC taxed as a partnership), basis is a funny concept. Each member of the partnership will have basis in their partnership interest itself, which is either the value of any assets that they have contributed to the partnership, or the amount of money that they paid to purchase that partnership interest. That makes intuitive sense. However, the partnership will ALSO have its own basis in the assets that are contributed to the partnership. These two types of bases have different terms: a partner’s basis in the partnership interest itself is called “outside basis”, and the basis that the partnership holds in the assets that are owned by the partnership is called “inside basis.”[1], [2]

Something vital about inside and outside basis is that when a partner contributes an asset to the partnership, the partner’s outside basis is the basis that they had in the asset. However, the partnership will have an inside basis in that very same asset of the fair market value, and not necessarily the partner’s basis.[3] That means, if an asset as appreciated (or depreciated) while owned by the partner, then the partner’s outside basis may be different than the partnership’s inside basis in the very same asset. By way of example, if A contributes a piece of real estate to the partnership with a basis of $5,000, but a FMV of $10,000, then A’s outside basis in the partnership will be $5,000, but the partnership’s inside basis in the asset will be $10,000.

Are we good so far? Awesome! Now let’s take it a step further. Some of you may be wondering, ‘then what happens when somebody else purchases a partnership interest?’ That is a great question. When a partner sells their partnership interest, the new partner takes an outside basis in her new partnership interest of the amount that she paid for the interest itself. That makes sense! BUT, the partnership does not change its inside basis in the partnership assets. As you can imagine, this creates a problem in that the new partner and the partnership itself have different bases. If not remedied, there is a scenario in which the IRS gets to double tax the partnership interest. Not cool! The IRS, however, has allowed a way to avoid that double taxation. It is called the 754 election.

When a partnership makes a 754 election, it allows for the partnership to adjust its inside basis in the assets it owns to match the basis of a partner, if certain big events happen.[4], [5] This is great! The easiest example of this happening is if X purchases A’s interest in a partnership, and A recognizes a gain (meaning that A sold the interest for more than her outside basis), then X gets an outside basis that is greater than what A’s was, by definition. A Section 754 election then allows the partnership to increase the inside basis of assets in the partnership (meaning less taxes, hooray!!) by the amount of gain A recognizes, in order to match X’s new outside basis in the partnership interest.

That was a mouthful! I hope it made sense. Of course, as with all things IRS, there are some caveats. I will just touch on two caveats for a 754 election briefly: 1- This increase in inside basis only applies to the new partner. Remaining members of a partnership cannot perpetually increase their basis in partnership assets by just having other partners sell their interests, escalator style. 2- This is exclusively a tax function. This increase in basis will not show up on a balance sheet or a P&L report, or anything like that. It is extremely tedious and time consuming to keep track of.

Now I can hear you asking me: Jeff, why would I care that a new partner in my partnership gets a tax benefit when they buy in, if I cannot enjoy it? Another great question! This can come up when you buy an old partner out of a partnership, because then there is a way to increase your basis in partnership property, and then obtain some sweet sweet depreciation on that new basis.[6] It can also be an effective-if-rarely-needed estate planning tool.

A 754 election is not for everyone, though. As mentioned, it is extremely time consuming and difficult to track, and it is exceedingly difficult to undo a 754 election, meaning that you can be stuck with decreases in basis as well if you are not careful.

At Irvine Legal, we have the tax experience and know-how to be able to help you navigate the nightmare of partnership taxation. Please feel free to reach out to us if you have any questions, and we would be happy to help.

[1] Though it is long and gets into various different issues, this article has a nice section explaining inside vs outside basis in the beginning, with examples: https://thismatter.com/money/tax/partnership-distributions.htm#:~:text=The%20inside%20basis%20is%20the,fair%20market%20value%20(%20FMV%20).

[2] This is governed broadly by §754 of the Internal Revenue Code

[3] https://corporatefinanceinstitute.com/resources/knowledge/accounting/754-inside-basis-vs-outside-basis/

[4] These events are generally encapsulated in making a distribution or a transfer of a partnership interest, which are governed by §734(b) and §743(b), respectively.

[5] Good explanation of these events found here: https://tax.thomsonreuters.com/blog/consequences-of-a-section-754-election/

[6] As described here: https://www.dsb-cpa.com/could-the-754-election-benefit-your-partnership/