Editor: Annette B. Smith, CPA
When negotiating the purchase price of a partnership interest from an existing partner, the buyer often takes into account the anticipated federal tax depreciation and amortization deductions from the partnership that will be associated with the purchasing partner's Sec. 743(b) step-up in the basis of partnership assets as a result of the acquisition. Due to time constraints during deal negotiations, purchasers may incorrectly assume that the amount of the Sec. 743(b) adjustment arising from the purchase will equal the seller's federal tax gain realized on the sale of the partnership interest. However, in many instances the selling partner's tax gain realized on the sale of the interest is not a reliable proxy for the amount of a purchasing partner's Sec. 743(b) adjustment.
Another common misconception is that the purchaser's Sec. 743(b) adjustment will be allocated among the partnership assets in proportion to the purchasing partner's share of the built-in gain or loss in each partnership asset, but often this is not the case. This discussion considers reasons the purchaser of a partnership may want to rethink the use of such shortcuts when estimating the federal income tax consequences associated with a Sec. 743(b) adjustment in an acquired partnership interest.
Assumptions about a purchaser's Sec. 743(b) adjustment amount
Specific transactions are known to create an inside/outside basis disparity, or a difference between a partner's adjusted tax basis in the partnership interest (outside basis) and that partner's share of the partnership's adjusted tax basis in partnership property (inside basis). Misalignment of inside basis and outside basis creates distortions in the amount and timing of income. The Sec. 754 election allows a partnership to adjust its inside basis to alleviate the inside/outside basis disparity created in connection with these known events. These adjustments are made pursuant to Sec. 734(b) in connection with a distribution of partnership property or pursuant to Sec. 743(b) in connection with a partner's sale or exchange of a partnership interest.
Example 1: X, an equal one-third partner in partnership XYZ, sells its entire XYZ interest to A for $50. XYZ holds only one asset — land with a tax basis of $60 and a value of $150. No partner is allocated a disproportionate amount of gain in the land under Sec. 704(c). Following the purchase, A has an outside basis of $50 in XYZ, a $20 share of inside basis, and, therefore, a disparity of $30 between inside basis and outside basis. XYZ does not have an election in effect under Sec. 754 with respect to the sale.
If XYZ later sells the land for $150, XYZ would recognize $90 of capital gain that would be allocated equally among A, Y, and Z. A would have taxable gain of $30 as a result of the sale, even though the gain economically accrued during the time that X held the XYZ interest that was sold to A. X was already taxed on this gain when X sold its interest to A. A eventually will have an offsetting loss of $30, but A will not recognize this loss until A disposes of its partnership interest.
Example 2: XYZ had a Sec. 754 election in effect when X sold its interest to A. In that case, A would have a $30 Sec. 743(b) basis adjustment in the land (equal to the difference between A's $50 outside basis and A's $20 share of XYZ's inside basis) as a result of its acquisition from X. A's Sec. 743(b) adjustment would offset A's allocable share of the gain recognized by XYZ on a subsequent sale of the land for $150.
Example 3: XYZ had a Sec. 754 election in effect when X sold its interest to A (and, thus, A has a $30 Sec. 743(b) basis adjustment in the land), but XYZ did not sell the land following A's acquisition. Later, when the land had appreciated in value to $180, A sold its interest in XYZ to B for $60. B would be mistaken in assuming that its Sec. 743(b) adjustment in XYZ would equal A's $10 gain realized on the sale of its interest to B. B's Sec. 743(b) basis adjustment in XYZ would instead equal the difference between B's $60 outside basis and B's $20 share of XYZ's inside basis, for a total Sec. 743(b) basis adjustment of $40.
Similarly, a purchaser unknowingly might acquire a partnership interest with a disparity between inside basis and outside basis if the partnership's property has been subject to limitation under the "ceiling rule" pursuant to Sec. 704(c). Assume that a partner contributes depreciable property with built-in gain to the partnership and that the partnership adopts the traditional method under Sec. 704(c). A ceiling rule limitation will apply if the tax depreciation generated by the contributed property is less than the amount of depreciation allocated under Sec. 704(b) to the noncontributing partners.
If the ceiling rule limitation applies to the partnership's allocations of depreciation deductions on the built-in gain property, a subsequent purchaser of either the contributing partner's or the noncontributing partner's interest would have an outside tax basis that does not align with the partner's share of the partnership's inside basis. In such a case, the purchaser's Sec. 743(b) basis adjustment would not equal the amount of the selling partner's gain realized on the sale of its partnership interest.
Example 4: L contributes depreciable property with a basis of $200, a value of $1,000, and a remaining useful life of five years to partnership LM in exchange for a 50% partnership interest. LM elects the traditional method under Sec. 704(c) with respect to the contributed property. M contributes $1,000 cash. LM has annual tax depreciation deductions of $40 and Sec. 704(b) depreciation of $200 with respect to the property contributed by L. M is allocated $100 of Sec. 704(b) depreciation but only $40 of tax depreciation per year.
At the end of five years, LM has allocated total tax depreciation of $200 to M, reducing M's tax basis in its interest to $800, and has allocated total Sec. 704(b) depreciation of $500 to M, reducing M's book capital account to $500. Thus, M's tax basis exceeds its book capital account by $300. The ceiling rule has, in effect, shifted $300 of ordinary income from L to M. If M sold its interest in LM to N for $750, N would have an outside basis of $750, and N's share of inside basis would be $500. Thus, N's Sec. 743(b) adjustment of $250 would not equal the $50 loss that M would realize on its sale of the interest.
Assumptions about allocations of Sec. 743(b) basis adjustments under Sec. 755
Once the amount of a Sec. 743(b) adjustment is calculated, it must be allocated among the partnership's assets under Sec. 755. While the intricacies of Sec. 755 generally are beyond the scope of this discussion, surprises may await purchasers of partnership interests who assume that the amount of their Sec. 743(b) adjustments will be allocated among the partnership assets in a manner that eliminates the purchaser's proportionate share of the built-in gain or loss in each partnership asset.
Allocations of the Sec. 743(b) basis adjustment under Sec. 755 are intended to reduce the difference between the fair market value (FMV) and the adjusted tax basis of the partnership's assets on a property-by-property basis. Four steps are generally involved in making the Sec. 755 allocation: (1) determine the FMVs of all partnership assets; (2) divide the assets into two classes consisting of capital gain property (which includes Sec. 1231 property) and ordinary income property; (3) allocate the Sec. 743(b) basis adjustment to the class of ordinary income property first and then to the class of capital gain property; and (4) allocate the portion of the Sec. 743(b) basis adjustment allocated to each class among the assets in each such class.
The amount paid by the purchaser (including assumed liabilities) sometimes equals the partner's share of the sum of the FMVs of the partnership's assets. The Sec. 743(b) basis adjustment, allocated pursuant to Sec. 755, would equalize the purchaser's share of the basis of each of the partnership's assets with the purchaser's share of its FMV in such a case. However, when a purchaser receives a discounted purchase price for its partnership interest and the partnership has Sec. 197 intangible assets, the application of Sec. 755 can lead to unexpected results. Often in those cases, none of the purchaser's Sec. 743(b) basis adjustment is allocable to any of the partnership's Sec. 197 intangibles.
Example 5: AB partnership has the following assets on its balance sheet: cash of $200, investment in subsidiaries with a tax basis of $200 and an FMV of $400, and intangible assets with a tax basis of zero and an FMV of $400. No partner is allocated a disproportionate amount of gain in any property under Sec. 704(c). If A, an equal 50% partner, sells its entire interest at a discount to Z for $300, Z would have an outside basis of $300, a $200 share of inside basis, and a Sec. 743(b) adjustment of $100. Z may incorrectly assume that a portion of its basis adjustment would be allocated to the investment in subsidiaries and a portion to the intangible asset to reduce the respective differences between FMV and adjusted tax basis. However, that is not the case.
Applying the regulations under Sec. 755, AB first determines the aggregate value of the partnership assets other than Sec. 197 intangibles to be $600. Next, AB determines the partnership gross value under Regs. Sec. 1.755-1(a)(4) to be $600, based on the $300 price for a 50% interest. Because the aggregate value of partnership property other than Sec. 197 intangibles (as determined under Regs. Sec. 1.755-1(a)(3)) is equal to or greater than partnership gross value (as determined under Regs. Sec. 1.755-1(a)(4)), AB's Sec. 197 intangible asset is deemed to have a value of zero for purposes of Sec. 755. Thus, none of X's $100 of Sec. 743(b) basis adjustment would be allocated to AB's intangible asset under Sec. 755.
Never assume when it comes to Sec. 743(b) basis adjustments
Although deal negotiations can progress quickly, purchasers of partnership interests should be wary of applying shortcuts and assumptions relating to a Sec. 743(b) basis adjustment when negotiating the purchase of an interest.
Annette B. Smith, CPA, is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington, D.C.
For additional information about these items, contact Ms. Smith at 202-414-1048 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.