The Internal Revenue Service - Research Paper Example

Running Head: SUMMARY OF SECTION 754 Summary of Section 754 of the of the Section 754 Top of Form A vast majority of businesses were planned and organized as partnerships, more than a decade ago. A large number of these businesses were in the real estate sector and many were professional service firms. The taxation of these businesses, organized in partnerships, was not a major issue, hence gained lesser attention from the lawmakers and tax managers alike. Not very recently, but due to the beginning of the widespread acceptability of the limited liability companies and the spread of "check-the-box" policy (Orbach, 2004), partnerships and especially partnership taxation gained a lot of attention. Many complex issues, that relate to partnership taxation have been addressed and re-addressed through the introduction and amendments in the taxation laws for the partnerships. Hence, now the owners and managers who pay tax and their advisers now advance towards the transactions with the same concern, as those stated in the historic decrees of subchapter K that the partnerships concerned with tax have been asking for years: why incorporate The substantial increase in the use of partnerships has led to increasing frustration with the obsolete subchapter K regulations (most of which were spread in 1955). Among the most troublesome laws are those which govern the basis for adjustments on the sale or swap (exchange) of a partnership stake (Orbach, 2004). In fact, the laws --which allow the purchaser of a partnership stake to reflect the purchaser's acquiring cost in partnership resources, are among the most perplexed and highly defective aspects of partnership taxation. At the start of the year 1998, to address these problems, the Internal Revenue Service in collaboration with the Treasury issued proposed laws and policies u/s734(b) (basis adjustments on some distributions), section743(b) (basis adjustments on transfers of partnership interests),section 751(a) (the "collapsible partnership rule" requiring recognition of ordinary income on the disposition of certain partnership interests), andsection754 (Depreciation Adjustment). (Internal Revenue Code) The origin of partnership property is usually not affected when a partner sells or exchanges its interest in the business. As a result, if a person buys or ventures into a partnership stake or interest by sale or exchange for a sum that exceeds the transferee's allocation of the adjusted basis of partnership property, the purchase price in excess, is not reflected in the partnership's asset basis, i.e., the purchaser is not able to "push down" its purchase price to the partnership's assets When the business (partnership) makes a an election u/s754 within the stipulated time, however, a transferee partner's share of the partnership's adjusted basis in its assets ("inside basis") is stepped up or stepped down to reflect the partner's basis in the acquired business interest ("outside basis"). Bottom of Form We would proceed by considering an example, in relation to the partnership business, the various transactions that take place in the form of sale and exchange. More importantly, we would focus on the implications of Section 754 of the IRS, which has a major impact with respect to taxation in shaping up these transactions (Orbach, 2004). When an interested party, buys a stake or share of an existing partner's partnership interest, or the interest of a member of a limited liability corporation (LLC) taxed as a partnership, at a value which is said to be its fair value in the market the amount that the purchaser of the interest pays becomes the base for the purchaser's business interest (outside basis). In this transaction at fair market value, the buyer (new partner) assumes the seller's pro rata share of the business partnership's adjusted basis in its assets (inside basis). If the partnership's property or asset value has appreciated sufficiently, the variation between the new partner's inside and outside basis can be substantial, from the lower to the higher end. This difference can deny the new partner of depreciation deductions and substantially increase his share of the profit or gain from subsequent asset dispositions. A buyer who is well aware of this increased complexity in the form of negative tax consequences can negotiate a discounted purchase price to lessen the negative tax result. Alternatively, the partnership business can make an Internal Revenue Codesection754elections to bring the new partner's outside and inside basis at about the same level. This election at the crucial time of transaction can augment the value of a partnership concern and make it more saleable. There are no immediate positive impacts on the continuing partner's interests of making an early election. Asection754election from the IRC does impose some burdensome recordkeeping requirements for the administration which can negatively influence the basis of partnership assets in the future (Osofsky, 2007). It is however, a general consensus among the tax experts and managers alike, that section 754 of the Internal Revenue Code is a complex area and its implications can be far reaching for the partnership and the owners and potential owners who have a controlling stake in the business (Cuff, 2000). Hence, we would proceed by examining a case where by a section 754 of the IRC are applied and observe its implications. Assume that a potential buyer Mr. A is negotiating to buy a one-third partnership interest in the GRIM Partnership from Partner X. The partnership has the following condensed balance sheet; Legend for Chart: A - Assets B - Adjusted Basis C - Fair Market Value A B C Cash $50,000 $50,000 Land 200,000 400,000 Equipment 70,000 140,000 Total Assets $320,000 $590,000 Liabilities $140,000 $140,000 Capital Accounts Partner A 60,000 150,000 Partner B 60,000 150,000 Partner C 60,000 150,000 Total $320,000 $590,000 Partner X agrees to sell his one-third interest for $197,000 which is one-third of the partnership's Fair Market Value. X expects Partner A to pay $150,000 in cash and assume X's 1/3rd share of business partnership liabilities. Accordingly, if the sale transaction occurs, X will have an outside basis for his partnership stake of $197,000 ($150,000 + $47,000). However, his share of the partnership's basis for its assets (his inside basis) is only $107,000 (one-third of $320,000). This $90,000 basis disparity ($197,000 - $107,000) will deprive him of depreciation deductions on the assets that come under the equipment category. Additionally, if the land is sold, X's share of the assessable for tax gain will be synthetically inflated. If the land is immediately sold for its FMV of $400,000, X's share of the partnership profit recognized will be $67,000 [1/3 x ($400,000 - $200,000)], even though X has no economic gain because his outside basis of $197,000 (the amount he paid for his partnership interest) includes his one-third stake of the land's fair price which is assessed to be $133,000. Including the $67,000 gain in X's share of partnership income (losses) will benefit him by escalating his outside basis as a result [IRCsection705(a)(1)(A)], but this will not offer a tax advantage in the form of a minor recognized gain or a bigger recognized loss until he sells of his partnership interest in the future at some specified date. If the time sphere for selling off the assets or partnership stake is substantial, the present value of this future benefit to Mr. A will be nominal. On the other hand, if the partnership makes asection754election. X's inside basis will equal his outside basis of $197,000 [IRCsection743(b); X's optional basis adjustment is $90,000 (i.e., $197,000 - $107,000); the technical establishment of the adjustment basis is more intricate. Partner X will have an inside basis for his share of the land of $133,000. This consists of his $66,667 one-third share of the common partnership basis plus his $66,667section743(b) optional basis adjustment The election as per the IRCsection754would trigger the application of IRCsection743 as well (Osofsky, 2007), which provides the incoming partner with an optional basis adjustment--here, the $90,000 variation between X's inside and outside basis. IRCsection755 specifies the rules for allocating the incoming partner's basis adjustment to particular assets. Moving forward, we try to understand the complex implications of the IRC Section 754 on a stand-alone basis. Additionally, we observe its implications in conjunction with the rules of related sections and their subsection as they may impact the sale and purchase transactions in partnership businesses. Continuing with the same example of the GRIM Partnership, we will assume that the election in the partnership takes place under the Internal Revenue Codesection754. Application of Section 754 election calls for the application of both IRC sections 743(b) & 734(b). The Section743(b) of the Internal Revenue Code calls for the optional basis adjustment that does not affect the existing partners but directly affects the new partner (Osofsky, 2007). Accordingly, it requires the partnership business for the allocation of the basis for adjustment to its property and separate calculation of the new partner's yearly share of decrease in value (depreciation) and profit or loss from the transaction of sale or purchase of the various assets and properties. For instance, A's share of yearly depreciation is computed using a $47,000 adjusted basis. New Partner A's adjusted basis is computed using his $24,000 one-third share of the partnership's basis in equipment in addition to his $24,000 stake of thesection743(b) optional basis adjustment which is allocable to the equipment referred in Internal Revenue CodeSection755(a). (Cuff, 2000) In the election as per section754the IRCsection734(b) also comes into play.Section734(b) will cause an adjustment towards the higher end or the lower end to a partnership's basis for its remaining assets following an inconsistent allocation of cash or other asset to one or more associates. These adjustments directly affect all the other partners, but it is fairly difficult to ascertain precisely, whether these adjustments would create a beneficial or detrimental affects in the future course of the partnership business. After the section 754 election have been conducted after the appropriate announcement and decision, it can only be revoked with the consent of the Internal Revenue Service. However, the filing of the application for revocation should take place within thirty days of the closing of the partnership tax year for which the revocation of section 754 election is intended to take effect and it shall set forth the basis for which the revocation is preferred under the Treasury regulationssection1.754-1(c). In cases where failure to meet the closing date was not deliberate or intended, the Internal Revenue Service has granted an extension of the deadline within which the filing of application for revocation of election should be sent according to the IRS Letter Ruling 200112023. Moreover, the application for revocation of the section 754 election to the IRS is not automatically approved. For example, the potential reduction in the basis of partnership assets upon either the transfer through sale and purchase of a partnership interest or the allocation (distribution) of partnership assets would not be sufficient for the approval of revocation application. Applicable reasons for a positive consent from the IRS include: an alteration in the nature of the partnership organization and business; a significant increase in the number of assets, in the form of property, equipment or other asset classes, in the partnership; a change in the character of business assets; or an augmented frequency of retirements or ownership transfers (Internal Revenue Code). Any of the situations mentioned can compel the partnership towards more administrative burdens of record keeping and other measures, as a result of having the election in place under the Treasury Regulationssection1.754-1(c). Because there is no guarantee that asection754election will not be unfavorable or even harmful to the existing and continuing partners or may not be revoked in the near future, there is no assurance that the partnership managers will make the election to accommodate exiting or new partners who become a part through a purchase of the interest in the business. Another important case, where the section 754 election is considered to make an impact is current-year reallocation, transfer or distribution; a partnership is required to file asection754election with the current-year tax return by its deadline (including all the extensions granted). The partnership business must also attach a statement with its tax return showing the calculation and the allocation of the optional basis adjustment as per IRC regulations 1.734-1(d) and 1.743-1(k)(l) (Blair, 2002). The IRS has adopted a liberal extension strategy that usually allows a business or organizers additional time, even after the general deadline, within which to proceed, as per the guidelines provided by the Internal Revenue Service. For instance, an incorrect belief that asection754election had previously been made & an unforeseen failure to make the election have both been held by the regime to be sufficient reasons for compromising a deadline request according to the IRS Letter Rulings 200229028 & 200202053 (Blair, 2002) . If a validsection754election made in a preceding tax year has not been revoked with the consent of the IRS, a new election is not mandatory, because both sections 743 and 734 will continue with its mandatory application as per the Treasury Regulationssection1.754-1(b). If the partners in the business are not willing to make asection754election, a choice exists under the IRCsection732(d). It applies to a partnership share shifted by sale, exchange, or demise of a partner where an election under thesection754has not been conducted. The Internal Revenue Codesection732(d) allows the new partner to elect to attribute, to any partnership asset or assets actually distributed to him within 2 years of acquiring his interest, the same tax basis he would have had if asection743(b) optional basis adjustment had applied. The IRCsection732(d) election affects only the new incoming associate. While the election conducted under this section can provide some relief, it does not have a similar effect as asection754 election (Blair, 2000). Assets allocated outside the range of the 2-year time horizon remains largely unaffected. The vote has no effect until an allocation is made. Both the base of assets or property sold by the partnership and the partnership's anticipated amounts for depreciation or amortization remain unaffected. Additionally, there is no guarantee that a minority partner can persuade the partnership to make the allocations in a timely mode. In some cases, the Internal Revenue Service may force the application of IRCsection732(d) when assets are distributed by the partnership without deliberation over the two-year regulation. This rule can be invoked only if the fair market value of the partnership's assets, other than cash, exceeds 110 percent of its adjusted basis to the partnership at the time of purchase by the incoming partner. The rules limit the application of this binding alterations to situations where the absence of the IRCsection732(d) election would cause a shift in basis from non depreciable assets (land) to depreciable assets (property) as per the Treasury Regulationssection1.732-1(d)(4)(ii). (Cuff, 2000) Furthermore, an IRCsection754election can in some cases be disadvantageous. If the incoming partner's share of a business' basis for its assets (inside basis) exceeds his outside basis, he will be burdened with a negative optional basis adjustment. As a result, he will be deprived of additional depreciation deductions and report more asset disposition gains or less loss. He will lose the entire existing benefit from the positive difference between his inside & outside basis had the election not been made. Hence, before its application the cases need to be examined thoroughly after calculations and then a decision should be made on implementing a Section 754 election. References Blair, Larry S. Pennsylvania, Partnerships May Revoke Section 754 Election. CPA Journal, Summer2002, Vol. 71 Issue 2, Internal Revenue Code, 1986, as amended Osofsky, Leigh. Tax Lawyer, Winter2007, SOLVING SECTION 734(b). Vol. 60 Issue 2, p473-502, (AN 26712371) Orbach, Kenneth N. The Application of Sections 704(c)(1)(B) and 754 after an Assets-Over Partnership Merger: An Analysis of Revenue Ruling 2004-43. ATA Journal of Legal Tax Research, 2004, Vol. 2, p40-48 Cuff, Terence Floyd., New Section 743/754/755, Regulations for Adjusting 'Inside' Basis, Journal of Taxation, May2000, Vol. 92 Issue 5, p281-300, Read More