The importance of making an effective Section 754 election
Limited partners (LPs) of family limited partnerships (FLPs) have long been a powerful estate-planning tool. LPs of FLPs can take a discount of as much as 75 percent for both estate and gift tax purposes, attributed to a lack of marketability and control and a fractional interest in an FLP.1 But someone who inherits a partnership share in an FLP can face a huge disparity between his inside and outside basis in the partnership's assets. This disparity could result in increased capital gains and other types of taxes. Fortunately, the inheriting partner can maximize his tax benefits by making an Internal Revenue Code Section 754 election at the FLP level and funding the FLP with highly appreciated properties. The inheriting partner can get even more benefits if the FLP funding properties are depreciable ones.
IRC Section 742 states that the outside cost basis of an interest in a partnership that's acquired in a manner other than by contribution is determined by the following IRC sections: if the partnership interest is acquired by a purchase, the cost basis is the purchase cost (IRC Section 1012); if the partnership interest is inherited, the cost basis is normally equal to its fair market value (FMV) at the decedent's date of death or an alternative valuation date (IRC Section 1014); and if the partnership interest is a gift, the cost basis should be adjusted according to the gift tax and the generation-skipping transfer (GST) tax paid (IRC Sections 1015 and Section 2654).
Nevertheless, IRC Section 743(a) provides the general rule that the partner's share of the basis of the partnership assets (the inside basis) isn't adjusted as a result of a sale, exchange, inheritance or gift. This means that the cost basis adjustment under Sections 1012, 1014, 1015 and 2654 is reflected only in the respective partner's outside basis. If a partnership property is highly appreciated or depreciated, this general rule can result in a huge disparity between the successor partner's inside and outside basis.
This disparity is problematic from both a theoretical and a practical viewpoint. First, it's contradictory to the rules of aggregate theory. Under the IRC rules, an inheriting partner is, in effect, becoming heir to a part of each separate property held in the partnership. As a result, the heir should have a cost basis factored into the share of each of its property items (that is to say, the inside and outside basis that's allocated to a certain property should be consistent). Second, such a disparity could distort the partner's tax consequences with respect to the associated property when the partnership disposes of it in the future. Let's take a look at the FLP of “Henry”:
Example 1: Henry had a daughter (Susan), a son (Michael) and a grandson (Ethan). His family set up an FLP in 2001. As the LP, Henry funded the FLP with a property worth $9.8 million that he had bought a long time ago at a cost of $4 million, in exchange for a 98 percent interest in the partnership. Michael and Susan, the general partners, each contributed $100,000 in cash in exchange for the remaining 2 percent partnership interest. When Henry passed away in 2005, Michael and Susan each inherited half of his interest in the partnership. At the date of Henry's death, his tax basis in the partnership property was still $4 million, but, based on a qualified appraisal, his partnership interest FMV was worth $20 million. The executor of Henry's estate made a date-of-death cost basis step-up election, pursuant to IRC Section 1014.
Now, let's examine the situation that Susan faces. Due to the cost basis step-up, Susan's outside basis for the inherited partnership interest would be $10 million, which is half of the date-of-death FMV. However, under Section 743(a), her share of the property's basis (the inside basis) is only $2 million (50 percent of the $4 million inside basis). Assuming that the partnership sold the property for $28 million in 2009 (each partner's share of the proceeds being $14 million), Susan would then receive a K-1 with $12 million in capital gains (the $14 million proceeds less the $2 million basis in the property). Meanwhile, Susan's partnership interest has an $8 million built-in loss, which is equal to the $10 million outside basis minus the $2 million inside basis. Susan would thus have to sell her interest in the partnership or wait until the liquidation of the partnership to realize the losses. Here, the artificial capital gains that Susan had to recognize for 2009 and the deferred built-in loss are clearly undesirable. Michael faces the same situation as Susan.
To avoid such a potential discord between the inside and outside basis, Congress enacted Section 743(b), which provides an exception to the general rules under Section 743(a) — that of a Section 754 election.
Section 743(b) provides that if a partnership has a Section 754 election in effect, the partnership can either: (1) increase the inheriting partner's share of the inside basis of the partnership property if the partner's outside basis in its partnership interest exceeds its share of the inside basis of the partnership property (a favorable positive adjustment), or (2) decrease the inheriting partner's inside basis of the partnership property if the partner's share of the inside basis of the partnership property exceeds its outside basis in its partnership interest (an unfavorable negative adjustment).
If the funding assets are appreciated ones, the inside cost basis adjustment would be a favorable positive adjustment. When the funding assets are non-depreciable, the inheriting partner is able to harvest the benefits gained from the Section 754 election when the partnership sells assets by realizing fewer capital gains due to the increased inside basis.
Example 2: In Example 1, the Section 754 election clearly leads to a favorable positive adjustment. If the FLP made an effective Section 754 election, Susan's inside basis would be stepped up by $8 million to $10 million. When the partnership sells the property in 2009, Susan will receive a K-1 with $4 million in capital gains, instead of $12 million, and there will be no built-in capital loss.
Furthermore, if the properties are depreciable, Susan and Michael, the inheriting partners, can immediately benefit from this election. This election will reduce their current ordinary income other than capital gains by taking an additional depreciation.
Example 3: Let's continue with our example. Assume now that the partnership property is a residential rental property and that the partnership generated $1 million in rental income during 2009 (Susan's share here is equal to $500,000). Residential rental properties are depreciable for 27.5 years under the General Depreciation System. If Susan continued to hold the partnership interest, without the Section 754 election, given a $2 million inside cost basis, the depreciation that Susan is entitled to take would be just $72,727 ($2 million divided by 27.5). Hence, if no other deductions exist, then Susan would have to report the $427,273 on the Schedule E of her individual 2009 tax return. However, by making the Section 754 election, Susan will be able to take an additional corresponding adjustment of depreciation in the amount of $290,909 ($8 million divided by 27.5) due to the $8 million inside cost basis step-up, which typically can be reported as a Section 754 depreciation adjustment in Box 13 of the partnership K-1. This will result in Susan only having to report $136,364 of the rental income for the year 2009. Even more favorably, Susan will see this depreciation adjustment in her partnership K-1 every year going forward until the adjustment of the inside basis is fully depreciated or the partnership sells the rental properties. Of course, the recapture provisions may come into play if the property is eventually sold with capital gains. As a result, part of the capital gains (up to the total depreciation) would be recaptured as ordinary income.
Based on the above analysis, we conclude that the Section 754 elections make a significant difference in determining when the inheriting partners can realize the benefits of the Section 1014 basis adjustment. If there were no Section 754 election at all, the inheriting partners would have to wait until they redeem the partnership interest to reap the potential benefits that Section 1014 brings them; if the partnership has an effective Section 754 election in place, the inheriting partners can realize the benefits when the partnership sells the properties. Moreover, if an FLP is funded by depreciable properties, successor partners can immediately take advantage of the income tax benefits by claiming an additional depreciation attributed to the step-up inside cost basis.
Nevertheless, our analysis doesn't work in the same manner for 2010 since the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) repealed the estate tax and the date-of-death step-up provision Section 1014 by adding a new subsection (f). In addition, EGTRRA introduces a modified carryover basis system by inserting after Section 1021 a new Section 1022 to substitute Section 1014 for decedents dying after Dec. 31, 2009. However, there's a sunset provision to this repeal in Section 901(a)-(b) of P.L. 107-16, meaning that, if no one pursues litigation, it's likely that the sunset provision will revalidate Section 1014 after Dec. 31, 2010.
Property Acquired As Gift
Under Sections 742 and 1015(a), when a partnership interest is acquired as a gift, the transferee partner's basis generally carries over the donor's basis. An exception exists if such a basis is greater than the FMV of the property at the time of the gift. In this case, the cost basis should be the FMV for the purpose of determining loss.
Section 1015(d) provides another exception: The basis of a property acquired as a gift is increased by the amount of the gift tax attributable to the net appreciation of the value of the gift. If the gift is an interest in an FLP, this adjustment causes the discrepancy between the transferee's outside basis and that of the inside basis in the FLP properties. In this situation, the Section 754 election will work in the same manner as noted in the previous section. The following example illustrates the mechanics of the adjusted cost basis calculation.
Example 4: Let's now assume that instead of doing nothing before passing away, in 2003 Henry transferred 25 percent of his interest in the FLP to his son Michael as a gift. The FMV of that gift was $4 million. To simplify the calculation, let's assume that Henry didn't claim any value discount for this gift. Prior to 2003, Henry had exhausted his gift tax unified credit and the adjusted basis of the interest in the partnership is $1 million. Henry filed a gift tax return (Form 709) for 2003 on time and paid gift tax in the amount of $1,464,610 at the highest gift tax rate for 2003 (49 percent). The following is the cost basis calculation using these numbers. (You can find a similar calculation in Treasury Regulations Section 1.1015-(b).)
|(2)||Less the adjusted basis||$1 million|
|(3)||Equal to net appreciation||$3 million|
|(4)||FMV less $11,000 annual exclusion2||$3.989 million|
|(5)||Inclusion ratio: (3) divided by (4)||75.20 percent|
|(6)||Gift tax paid||$1,954,610|
|(7)||Tax attributable to net appreciation: |
(6) multiplied by (5)
|(8)||Michael's cost basis: (2) plus (7)||$2,469,867|
Based on this calculation, Michael's outside basis is $2,469,867, but his inside basis with respect to FLP properties is still $1 million. The partnership should thus make an effective Section 754 election to increase Michael's inside basis to the same level as his outside basis. If the partnership property is depreciable, Michael will receive the immediate income tax benefits, as discussed in the above section.
IRC Section 2654(a) provides that if property is transferred as a GST, the basis of such property shall be increased by an amount attributable to the excess of the FMV of such property over its adjusted basis immediately before the transfer. Since the litigious language in this section is plain and unambiguous, the Treasury has issued no interpretation regulations about cost basis calculation in regard to a GST tax paid. A tentative calculation is presented here to better illustrate this situation.
Example 5: In addition to making a gift to Michael, Henry gave another gift to his grandson Ethan (a skip person), which was the same amount of the FLP interest in 2003. Prior to 2003, Henry had never used a GST tax exemption and all $1.12 million of the GST tax exemption was automatically allocated to this gift. He paid $1.412 million GST tax under the highest GST tax rate of 49 percent in 2003.
|(2)||Less the adjusted basis||$1 million|
|(3)||Equal to net appreciation||$3 million|
|(4)||Inclusion ratio: (3) divided by (1)||75 percent|
|(5)||Gift tax paid||$1.412 million|
|(6)||Tax attributable to net appreciation: |
(4) multiplied by (5)
Because of the GST tax paid, Ethan's cost basis on the partnership interest should increase by $1.059 million. Further, Section 2654(a)(1) also states that this increase “shall be applied after any basis adjustment under Section 1015 with respect to the transfer,” meaning that the gift tax and the GST tax paid can be combined to increase the cost basis, as long as the adjusted basis isn't over the FMV of the partnership interest.
Again, if there's an effective Section 754 election in place, the transferee partner will be entitled to receive the same benefits as discussed in the previous two sections.
Closing the Loophole
The motivation for clients to establish FLPs is the large discount that FLPs may be entitled to claim. However, there's uncertainty about this. Congress has long been aware of the huge economic benefits that come along with this discount and has been trying to close the loophole. On Jan. 25, 2005, the Joint Committee of Taxation issued a proposal that included limiting the discount rate for a minority interest, lack of marketability and fractional interest.3 Although we haven't seen any legislation yet, it's likely that the lawmakers will work on this sooner or later if there's no action taken during 2010 to repeal the estate tax. In particular, in looking at the examples and the three proposed rules, Congress clearly intended to limit the benefits of FLPs that are funded by liquid assets. Tax advisors should anticipate that it may well become increasingly difficult for a case like Estate of Kelly v. Commissioner4 to succeed. In this case, the only issue was the FMV of the decedent's one-third interest in a limited liability company and 94.83 percent interest in an FLP funded solely with cash and certificates of deposit.
Nevertheless, the income tax benefits to the successor partner as a result of a Section 754 election always works as long as the successor partner's adjusted outside basis is higher than that of his inside basis.
— This article is solely the author's opinion and does not in any way represent the views of PricewaterhouseCoopers LLP.
- In Estate of Folks v. Commissioner, T.C. Memo 1982-43, the Tax Court granted the taxpayer a total discount of 75 percent, including a 50 percent marketability discount.
- The Internal Revenue Service has taken the position that the transfers of family limited partnership (FLP) interests are gifts of a future interest and are thus not eligible for the gift tax annual exclusion. The Tax Court agreed with the IRS in quite a few cases and provided certain requirements for a gift of FLP interests to be satisfied as a present value, such as it did in Hackl v. Comm'r, 118 T.C. No. 114 (2002).
- Options to Improve Tax Compliance and Reform Tax Expenditures, JCS-02-05.
- Estate of Kelly v. Comm'r, T.C. Memo 2005-235. In this case, the Tax Court allowed a total 35 percent discount for an FLP funded with cash and certificates of deposits, including a 12 percent lack of control discount and a 23 percent lack of marketability discount.
Yong Shuai is a senior associate at the Philadelphia office of PricewaterhouseCoopers LLP