Page 16 - BusinessWest February 17, 2021
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Entering a Partnership?
Avoid Costly Tax Issues by Considering the Section 754 Election
TBy Brenden Cawley and Gabriel Jacobson
he COVID-19 pandemic has caused sev- Like anything worthwhile, this election takes eral partnerships local to Western Mass. work. It is perhaps especially laborious if the
to either consider or actually effect a partner or partnership have not been actively
change in ownership. When navigating the tracking the inside and outside basis disparity.
Alternatively, Carl recognizes a $50,000 loss outside of the partnership since his total outside basis is $200,000. At this point Carl is kicking himself because he paid taxes on a $50,000 gain in year three only to recognize a loss of $50,000 one year later. If Carl does not have any capital gains in year four, he can only utilize $3,000 of the capital losses on his tax return. The remain- ing losses are carried forward indefinitely.
Now let’s imagine the partnership made the
“Partnerships may be relatively easy to form, but the tax implications can be very complex.
754 election when Carl purchased his 50% inter- est in year two. At that time, his inside basis would have been increased by $50,000 to match his outside basis. The partnership would have adjusted Carl’s inside basis in the building to $150,000, matching his outside basis. Then in year three, when Ann and Carl sell the building, Carl would not recognize any gain because his inside basis matches his share of the sales pro- ceeds ($150,0000).
In year four, when the partnership dissolved, Carl would not recognize a loss on the distri- bution of cash from the partnership because his portion of the partnership’s cash balance ($150,000) equals his outside basis ($150,000). Carl avoided the timing issue regarding any tax- able gain on the building sale and any loss on dissolution by making the 754 election.
On an Income-tax Return
If Carl and Ann decided to hold onto the building instead of selling in year three, Carl could deduct from his Schedule K-1 the basis adjustments related to the Section 754 election. The total Section 754 adjustment of $50,000
is reduced to zero over time using the same mechanics as the depreciation on the building. The 754 adjustment reduces both Carl’s inside and outside basis equally. The benefit is that
he will receive deductions on line 13 of his K-1 against income on his tax return each year until the $50,000 is fully deducted.
Partnerships may be relatively easy to form, but the tax implications can be very com-
plex. Section 754 is important for a partner purchasing an interest and for existing partners looking to secure a new partner to help their business. Accurate tracking of inside and outside basis is of the utmost importance to reduce neg- ative tax consequences down the line. u
Brenden Cawley is a senior associate at the Holyoke-based accounting firm Meyers Brothers Kalicka P.C., and Gabriel Jacobson is an associate with the firm; (413) 536-8510.
complexities of these changes in ownership, partnership basis is a vital component.
For tax advisors and taxpayers alike, basis would be better as a four-letter word. However, understanding the basics of cost basis can pre- vent future headaches.
Understanding the Basics of Basis
It stands to reason that the cash spent or provided to acquire an asset would be the cost (basis) of that asset. However, when analyzing partnerships, understand the concepts of ‘inside’ and ‘outside’ basis. The difference is a shift in perspective. The outside basis is established when the partner joins or forms the partnership through the contribution of cash (or property, which adds additional complexity). The partner- ship then uses that cash to purchase assets.
The cash outlay to acquire those assets estab- lishes the total inside basis of the partnership. Based on each partner’s ownership, a share of the inside basis of the individual assets is assigned accordingly. This inside basis does not fluctu-
ate with changes in market value of the assets. When a tax year closes, the partners each receive a Schedule K-1 and adjust their outside basis by the income, expense, gain, or loss disclosed on the Schedule K-1.
Over the life of the partnership, cash or prop- erty will be distributed to the partners, which will decrease their outside basis. The inside basis of the partnership will similarly be reduced as the
The partners’ Schedule K-1s could offer a lifeline. Prior to 2020, each partner’s capital account in itemLcouldbepreparedonabook,GAAP,Sec- tion 704(b), or tax basis. It is possible that the partner’s capital account prepared using book, GAAP, or Section 704(b) is a reasonable approxi- mation for the inside basis of the partner.
This is a highly simplified approach that needs to be vetted with the partnership’s tax advisor. Starting in 2020, the IRS has mandated that Item L of Schedule K-1 must be prepared on a tax basis. The partner’s tax capital account is a good starting point for both outside and inside tax basis. Again, this simplified assumption needs to be discussed with a tax advisor. Please note that tax capital reported on the Schedule K-1 is not equivalent to outside tax basis. Instead, outside tax basis considers liabilities of the part- nership for which the partner is individually responsible and partner-specific adjustments.
Everyday Example
In year one, Ann and Bob purchase a build- ing for $200,000 and split the cost evenly, giving them each 50% ownership in ABC Partnership. Initially, they each had outside basis equal to their inside basis of $100,000. In year two, as a result of COVID-19, Bob wants to exit the part- nership. The building has appreciated in value to $300,000, so he sells his interest in ABC Partner- ship to Carl for $150,000. Bob will recognize a $50,000 gain in year two as a result of the excess
       “For tax advisors and
taxpayers alike, basis would be
better as a four-letter word.
However, understanding the
basics of cost basis can prevent
BRENDEN CAWLEY ” future headaches.
cash received compared to his cost basis.
First, let’s imagine the partnership does not make a 754 election at this point. Carl steps into Bob’s inside basis of $100,000. However, his outside basis equals the total amount he paid, or $150,000. In year three, Ann and Carl decide to
sell the building (for sim- plicity’s sake, let’s assume no depreciation has been expensed), which is still valued at $300,000 and
      cost of assets is removed from the books through sale or distribution. When the partnership is in need, the partners may contribute additional cash or property. Additional contributions have the same positive impact on outside basis as the initial contribution that formed the partnership or acquired an interest.
As time goes by, differences can arise between the inside and outside basis of the partner(s). As the inside and outside basis of the partnership fall out of alignment, the partners can experi- ence negative tax consequences. Each taxpayer is responsible for maintaining their own out- side basis, so consult your tax advisor if ques- tions arise. Through a Section 754 election, the partnership has an opportunity to avoid these consequences.
therefore results in a gain of $100,000. Both Ann and Carl receive Schedule K-1s with a $50,000 gain for the year because they both had an inside basis of $100,000 prior to the sale.
After recording the gain, their inside basis increases to $150,000. Ann’s inside and outside basis remain aligned, but Carl’s basis disparity persists as the $50,000 of gain impacts his inside and outside basis in the same manner. In year four, Carl and Ann decide to dissolve the part- nership. At this point, the $300,000 cash they received from the sale of the building is distribut- ed to both partners evenly. Ann receives $150,000 in cash, which equals her outside basis. For this reason, she recognizes no gain or loss on the dis- solution of the partnership.
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