Estate Planning Opportunities with IRC Section 754 Election
Estate planning can be a complex process, especially when closely held partnerships or businesses are involved.
However, if you operate a business using a partnership or Limited Liability Company, one valuable tool in the estate planner’s toolkit is the Internal Revenue Code (IRC) Section 754 election. This election can offer significant tax benefits when properly applied, particularly for estates or trusts involving partnership interests.
Let’s explore how this provision works and its potential estate planning advantages.
What is an IRC Section 754 Election?
IRC Section 754 allows a partnership to adjust the tax basis of its assets (inside basis) when certain triggering events occur, such as a partner’s death or the sale of a partnership interest. Typically, when a partner dies, the partnership interest receives a step-up in basis to its fair market value at the time of death. However, this step-up generally only applies to the deceased partner’s share of the partnership (outside basis), not the partnership’s actual assets.
By making a Section 754 election, the partnership can align the inside basis of its assets with the stepped-up outside basis, ensuring that both the deceased partner’s interest and the underlying partnership assets reflect their current market value. This adjustment can reduce the tax burden for the successor in interest, often by providing larger depreciation deductions and lowering capital gains taxes upon future sales of partnership property.
Estate Planning Advantages of a Section 754 Election
- Tax Savings Through Basis Adjustment: When a partner dies, the estate or heirs inherit the partnership interest with a stepped-up basis. Without a Section 754 election, the inside basis of the partnership assets remains unchanged. A Section 754 election ensures that the heirs benefit from the higher tax basis in the partnership’s assets, which can reduce future taxable income from the partnership.
- Increased Depreciation Deductions: For partnerships holding depreciable assets like real estate, a Section 754 election can be especially beneficial. When the inside basis is adjusted, the heirs or successors can claim higher depreciation deductions, reducing taxable income from the partnership over time. This can be particularly useful in lowering the tax burden for estate beneficiaries who inherit partnership interests.
- Deferral of Capital Gains Taxes: The election allows for a deferral of capital gains taxes on the sale of partnership assets. By adjusting the inside basis, the taxable gain upon the sale of these assets is reduced, resulting in lower tax liabilities. This can be a crucial benefit for estates or trusts that need to liquidate partnership interests as part of the estate settlement process.
- Avoiding Tax Traps in Trust Administration: When a trust inherits partnership interests, the timing of distributions and sales of partnership assets can have significant tax implications. A Section 754 election can mitigate these issues by ensuring that the trust beneficiaries are not hit with unexpected capital gains taxes when the partnership assets are sold. This can preserve more of the estate’s value for the beneficiaries.
Example of a Section 754 Election in Action
Consider a partnership valued at $1,000,000 at the time of Partner A’s death. Partner A and Partner B each own a 50% interest in the partnership. Before A’s death, his outside basis in the partnership was $100,000, and the inside basis of the partnership’s assets was fully depreciated to zero. Without a Section 754 election, the heirs would inherit A’s partnership interest with a step-up in outside basis to $500,000, but the inside basis of the assets would remain at zero. This discrepancy could lead to higher taxes for the heirs.
By making a Section 754 election, the partnership adjusts the inside basis of its assets to $500,000. This allows the heirs to benefit from greater depreciation deductions and reduces future capital gains taxes, ultimately providing more tax-efficient management of the inherited partnership interest.
Practical Considerations
- Filing Requirements: To make a Section 754 election, the partnership must file a written statement with its tax return (Form 1065) in the year of the triggering event, such as the death of a partner. The election is binding for the year it is made and all future years unless revoked with IRS approval.
- Strategic Use in Estate Planning: Advisors should carefully consider whether a Section 754 election aligns with the overall estate plan. In some cases, the election may not provide a significant benefit, particularly if the partnership assets are not expected to be sold or depreciated significantly. However, for estates involving real estate partnerships or other depreciable property, the election can provide valuable tax savings.
The IRC Section 754 election is a powerful estate planning tool for families with partnership interests. By allowing for the adjustment of the inside basis of partnership assets, the election can reduce taxes and enhance the financial legacy passed on to heirs.
For those involved in trust administration or estate settlement, understanding when and how to leverage this election is key to optimizing tax outcomes and preserving wealth for future generations.
