Invalid Sec. 754 Elections: Some Observations

Editor: Greg A. Fairbanks, J.D., LL.M.

Partners & Partnerships

Taxpayers often make an election to adjust the basis of partnership property under Sec. 754 whenever a positive basis adjustment would result from such election upon the occurrence of a triggering distribution from a partnership or transfer of a partnership interest. Almost weekly, however, we see IRS letter rulings in which taxpayers are seeking Regs. Sec. 301.9100 relief for a late or missed election. This item discusses the requirements for a valid Sec. 754 election and then highlights some of the reasons for those late or missed elections.

General Requirements for a Valid Sec. 754 Election

No particular form is required for a Sec. 754 election. Regs. Sec. 1.754-1(b) requires that the election be in writing and (1) include the name and address of the partnership making the election, (2) be signed by any one of the partners, and (3) contain a declaration that the partnership elects, under Sec. 754, to apply the provisions of Secs. 734(b) and 743(b). To be valid, the Sec. 754 election must be filed with the partnership return for the tax year during which a triggering distribution or transfer occurs. Moreover, the election must be filed no later than the due date of the partnership return, for the year in which the triggering distribution or transfer occurred, as set forth in Regs. Sec. 1.6031-1(e) (including extensions thereof).

Although the above requirements are relatively straightforward, taxpayers continue to encounter difficulty when applying them.

Signed by Any Partner

Many invalid Sec. 754 elections arise because the wrong person signs the election. The regulations make clear that only a partner may sign a valid Sec. 754 election (Regs. Sec. 1.754-1(b)). It is relatively easy to determine who is a partner in a state law general or limited partnership. But, with the advent of limited liability companies, it has become increasingly more difficult to determine who is and who is not a partner.

For example, is a person who holds a nominal interest in an LLC (that is otherwise classified as a partnership for U.S. federal tax purposes) a partner for purposes of making a valid Sec. 754 election? In certain instances, the IRS has not treated a person as an owner of a domestic eligible entity (and concluded that the entity was a disregarded entity rather than a partnership) where such person did not have economic rights related to the entity (e.g., rights to capital, profits, losses, liquidation proceeds, etc.) and, but for certain limited rights, did not have management rights related to the entity (see, e.g., Letter Rulings 200201024 (1/4/02), 199914006 (4/12/99), and 199911033 (3/22/99)). The same analysis would apply where an LLC has two or more owners, in addition to the nominal owner, and is, thus, clearly a partnership for federal tax purposes. A person holding solely a nominal interest in a partnership and who is not considered an owner of the LLC would likely not be a partner for purposes of making a valid Sec. 754 election. Because the regulations mandate that a valid Sec. 754 election be signed by a partner, an election signed by a nominal interest holder who is not an owner of the LLC is likely invalid.

What about a person who is named as the manager of an LLC, but who holds no ownership interest in the LLC? Again, the regulations are clear that only a partner is empowered to sign a valid Sec. 754 election. So a person who is a manager, even if the LLC operating agreement empowers such person to enter into contracts and generally conduct business on behalf of the LLC, is still not empowered by tax law to sign a valid Sec. 754 election.

What if a U.S. corporation holding an indirect ownership interest in a foreign partnership files a U.S. partnership return with a Sec. 754 election (as part of its U.S. consolidated tax return) on behalf of the foreign partnership, because the foreign partnership is not otherwise required to file a U.S. partnership tax return? The IRS addressed this issue in Field Service Advice 200025017, issued on June 23, 2000. Although the election would have been advantageous because, in the following year, a lower-tier foreign subsidiary increased its interest and other subsidiaries acquired interests in the foreign partnership, the IRS ruled that a Sec. 754 election made in this manner is ineffective. In so ruling, the IRS noted that:

Where a United States citizen is a partner in a partnership which is not required to file a United States return because it does no business in the United States, and the citizen desires an election in accordance with the provisions of section 703 to be made by or for the partnership, a return must be filed by the partnership. Treas. Reg. § 1.6031-1(d)(2). The filing of a return for a taxable year of the partnership by a citizen or resident partner constitutes a filing for the partnership of such partnership return. Treas. Reg. § 1.6031-1(d)(2).

Thus, for a foreign partnership to make a valid Sec. 754 election, the foreign partnership must file its own U.S. partnership tax return even though it is not otherwise required to file a U.S. return (i.e., even though it has no U.S.-source income or deductions, etc.).

Filed with the Right Return

Many Sec. 754 elections are invalid because they are filed with the wrong partnership tax return. According to Regs. Sec. 1.754-1(b), a Sec. 754 election is valid only if it is filed with the partnership return for the tax year during which a triggering distribution or transfer occurs. Once a valid Sec. 754 election is filed for a year in which a triggering distribution or transfer occurs, however, the election continues indefinitely until permission is sought and granted to revoke the election or until the partnership undergoes a technical termination (Sec. 754 and Regs. Sec. 1.708-1(b)(5)). If no triggering distribution or transfer occurs during the tax year in which the purported Sec. 754 election is filed, then the purported election is inoperative.

Particular care must be taken in the case of a partnership that technically terminates under Sec. 708(b)(1)(B), to ensure that the Sec. 754 election is made in the proper tax year (i.e., the tax year in which the transfer or distribution occurs). Sec. 706(c)(1) provides that the tax year of a partnership ends on the date of its termination under Sec. 708(b)(1)(B). Therefore, a midyear technical termination generally will result in the filing of two short-period partnership tax returns: one by the terminated partnership for the period beginning on the first day of the partnership’s tax year and ending on the date of the technical termination, and one for the new partnership for the period beginning immediately thereafter and ending on the last day of the partnership’s tax year. (Many also believe a third one-day short-period return is required whenever a partnership technically terminates.)

The technical termination purges any existing Sec. 754 election that may have been made in prior years. However, a Sec. 754 election (including a Sec. 754 election made by the terminated partnership on its final return) that is in effect for the tax year of the terminated partnership in which the sale occurs, applies with respect to the incoming partner. Therefore, the bases of partnership assets are adjusted pursuant to Secs. 743 and 755 prior to their deemed contribution to the new partnership (Regs. Sec. 1.708-1(b)(5)).

If the transfer or distribution for which a basis step-up is sought occurs during the first short period, then the Sec. 754 election generally should be filed with the first short-period partnership tax return. The advantage of filing the Sec. 754 election with the first short-period return is that the technical termination itself operates to purge the election so that the Sec. 754 election does not carry forward into future years.

Alternatively, for technical terminations of partnerships under Sec. 708(b)(1)(B), a Sec. 754 election may be made by the new partnership by filing the election with the partnership’s second short-period partnership return even if no other triggering distribution or transfer occurs during the second short period. Regs. Sec. 1.708-1(b)(4) provides that, when a partnership terminates under Sec. 708(b)(1)(B), the following is deemed to occur:

The partnership contributes all of its assets and liabilities to a new partnership in exchange for an interest in the new partnership; and, immediately thereafter, the terminated partnership distributes interests in the new partnership to the purchasing partner and the other remaining partners in proportion to their respective interests in the terminated partnership in liquidation of the terminated partnership, either for the continuation of the business by the new partnership or for its dissolution and winding up. [Emphasis added.]

Furthermore, Regs. Sec. 1.761-1(e) provides, for purposes of Sec. 708(b)(1)(B), that the deemed distribution of an interest in a new partnership that terminates under Sec. 708(b)(1)(B) is treated as an exchange of the interest in the new partnership for purposes of Sec. 743. Thus, a Sec. 754 election filed with the second short-period partnership return in the year of a Sec. 708(b)(1)(B) technical termination will be effective because a “transfer” occurs during the tax year in which the Sec. 754 election is filed (i.e., the deemed transfer of an interest in the new partnership pursuant to Regs. Sec. 1.761-1(e)).

Conclusion

On its face, making a valid Sec. 754 return should be a simple matter; however, every year, many taxpayers file for letter rulings requesting that the IRS grant relief for filing an invalid election. Taxpayers and practitioners should exercise care in deciding who signs a Sec. 754 election and in which tax year the taxpayer files the election.

EditorNotes

Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington, DC.

For additional information about these items, contact Mr. Fairbanks at (202) 521-1503 or greg.fairbanks@us.gt.com.

Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.