Sec. 743(b) adjustment complications in multitier partnerships

By Thomas A. Orr, CPA, Anchorage, Alaska, and Jeffrey N. Bilsky, CPA, Atlanta

Editor: Kevin D. Anderson, CPA, J.D.

Sec. 743(b) provides that in the case of a sale or exchange of a partnership interest for which a Sec. 754 election is in place, a partnership shall adjust the basis of partnership property. The purpose of the adjustment is to eliminate the difference between inside basis of the partnership property and the outside basis of the partnership interest for the transferee partner. The basis adjustment is allocated among the partnership's assets in a manner that has the effect of reducing the difference between the property's fair market value (FMV) and its tax basis.

To illustrate these concepts, suppose A is a member of partnership PRS in which the partners have equal interests in capital and profits. The partnership has made an election under Sec. 754, relating to the optional adjustment to the basis of partnership property. A sells its interest to T for $22,000. The tax basis and FMV of PRS's assets attributable to A's interest are summarized in the table "A's Share of PRS's Assets."

A's share of PRS's assets

Following the rules above, T's total basis step-up is $7,000, the difference between T's purchase price of $22,000 and A's share of the tax basis of PRS's assets of $15,000. The $7,000 step-up is then assigned to the assets based on their relative appreciation. Depreciable assets have total appreciation of $2,000, and the interest in partnership DEF has appreciation of $5,000. The $2,000 appreciation would be assigned to each depreciable asset based on relative appreciation and then depreciated under the applicable rules. The $5,000 applicable to DEF raises two questions:

1. How is a basis adjustment allocated when an upper-tier partnership (UTP) owns an interest in a lower-tier partnership (LTP)? (PRS is the UTP and DEF is the LTP in this example.)

2. What are the implications of the UTP and/or the LTP either making or failing to make a Sec. 754 election?

Sec. 743(b) adjustments in a multitier partnership structure

Rev. Rul. 87-115 (which clarifies and amplifies Rev. Rul. 78-2) provides guidance on the allocation of Sec. 743(b) adjustments in the context of a tiered-partnership structure. Specifically, Rev. Rul. 87-115 addresses the impact of a sale of an interest in a UTP that owns an interest in an LTP in three distinct situations:

1. Both the UTP and the LTP have made an election under Sec. 754;

2. Only the UTP has made an election under Sec. 754; and

3. Only the LTP has made an election under Sec. 754.

Situation 1: Both the UTP and the LTP have made valid Sec. 754 elections: Rev. Rul. 87-115 provides that the making of a Sec. 754 election by the UTP manifests an intent to be treated as an aggregate for purposes of Secs. 754 and 743. Consequently, the sale of an interest in the UTP should be viewed as a sale of interests in all assets held by the UTP, including the LTP. The deemed sale of an interest in the LTP triggers the application of Sec. 743(b) to the LTP. Since the LTP has a Sec. 754 election in place, it must adjust the basis in its assets by following the rules outlined above. Within the LTP the deemed sales price is equal to the new partner's share of the UTP's basis in the LTP, including the new basis adjustment. The LTP must then also follow the rules of Regs. Sec. 1.755-1(b) to allocate its basis adjustment among its property. This adjustment must be segregated and allocated only to the UTP and the new partner within the UTP.

Situation 2: Only the UTP has made a valid Sec. 754 election: Rev. Rul. 87-115 provides that when the UTP has made a valid Sec. 754 election but the LTP has not, only the UTP will be able to make the basis adjustment under Sec. 743(b). The UTP would calculate a basis adjustment for its interest in the LTP, but the lack of a Sec. 754 election by the LTP precludes making Sec. 743(b) adjustments at the LTP level.

Situation 3: Only the LTP has made a valid Sec. 754 election: Rev. Rul. 87-115 provides that by not making a Sec. 754 election, the UTP manifests an intent to be treated as an entity for purposes of Secs. 754 and 743. Thus, the sale of an interest in the UTP will not trigger a Sec. 743(b) adjustment within either the UTP or the LTP.

Important considerations

Sec. 743(b) adjustments are complex calculations, and multitier partnership structures only exacerbate that complexity. Rev. Rul. 87-115 does not provide a de minimis threshold, so if both the UTP and the LTP have valid Sec. 754 elections, the basis adjustments are mandatory at both levels. Generally, making the election at both levels is favorable since it maximizes the ability to recover basis more quickly than in the absence of the election. Inasmuch as Sec. 743(d) requires negative basis adjustments even without a Sec. 754 election, in certain circumstances, the downside risk of the election is limited. While the revenue ruling only explicitly addresses a two-partnership structure, the rules should presumably still apply if an LTP also owned another LTP. It is conceivable to have a near-infinite chain of Sec. 743(b) adjustments if every partnership in the chain has made a Sec. 754 election.

A UTP that is a minority owner or a nonmanagement member of the LTP may have difficulty determining whether the LTP has made a Sec. 754 election. If the UTP can get the LTP to make the Sec. 754 election, it may still be difficult to cause the LTP to properly allocate and track the pushed-down basis adjustment. How does a basis adjustment get pushed down if there is insufficient information to track it to the LTP's assets? Unfortunately, the adjustment would only be booked down to the lowest level for which balance sheet detail is available.

Even if the UTP is a majority owner of the LTP, getting the LTP to dedicate the time and resources necessary may be a struggle. While the adjustment is included in the LTP's return, it is triggered by a transaction between the UTP's owners. Thus, it may be challenging to get the LTP to perform the complex and detailed analysis necessary to properly allocate the basis adjustment when it benefits only one owner of the UTP.

The timing of preparing the returns is another administrative complexity. Since the LTP needs information on the deemed sale to complete its return and the UTP needs the Schedule K-1 (Form 1065) from the LTP to complete its own return, communication between the entities is crucial. If the LTP is not informed of the triggering transaction in a timely manner, it may prepare an inaccurate tax return.

When the LTP does have all the information necessary to prepare an accurate return, the reporting is still more involved than would be the case for a single-level Sec. 743(b) adjustment. Absent a multitier structure, deductions or income items attributable to a basis adjustment on the LTP would generally require an allocation to the UTP, reported via Schedule K-1. In a multitier structure, the adjustment on the LTP requires not only an allocation to the UTP but to a specific partner of the UTP. Additional footnote disclosure will be necessary on the UTP's Schedule K-1 to ensure allocation to the correct partner within the UTP. If the LTP has multiple Sec. 743(b) adjustments allocable to the UTP, this disclosure can become even more complex. Consequently, it is important to maintain a continual segregation of the amounts attributable to each individual transaction related to the UTP.

Planning opportunities

When Situation 1 applies, two planning options are available, given that the adjustments are mandatory. The first option is to revoke the Sec. 754 election with the IRS's consent, but presumably the IRS will require a compelling justification, which will likely be difficult to establish. The second option would be to trigger a technical termination of the partnership (Sec. 708(b)(1)(B)). This may or may not be feasible depending on the nature of the transaction. Furthermore, the technical termination would cause a number of ancillary complications that could very well outweigh the benefits of terminating an unwanted Sec. 754 election.

When Situation 2 applies (Sec. 754 election on the UTP but not on the LTP), Rev. Rul. 87-115 explicitly provides that the UTP's Sec. 754 election makes it appropriate for purposes of Secs. 754 and 743 to treat the sale of an interest in the UTP as a sale of the UTP's interest in the LTP. This means that even if the LTP has not made a Sec. 754 election, a qualifying transaction in the UTP creates the option to make the election. If the LTP makes the election, the two partnerships would be governed by Situation 1 for that tax year and all subsequent tax years.

When Situation 3 applies, there is a qualifying transaction in the UTP, and the Sec. 754 election is available. If the UTP makes the election, the partnerships would be governed by Situation 1 for that tax year and all subsequent years.

Before making the Sec. 754 election at either entity, it is vital to consider the relationship between the entities, the benefit of the basis adjustments at each level, and the administrative costs of maintaining and tracking the adjustments.


Kevin Anderson is a partner, National Tax Office, with BDO USA LLP in Washington.

For additional information about these items, contact Mr. Anderson at 202-644-5413 or

Unless otherwise noted, contributors are members of or associated with BDO USA LLP.

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