Adjusting Inside Basis on the Death of a Limited Partner
When a limited partner in a partnership dies, tax and estate planning considerations become crucial for both the deceased partner’s estate and the remaining partners. One of the key tax implications is the adjustment of the inside basis—the partnership’s basis in its assets. This article explores how the inside basis may be adjusted upon the death of a limited partner, the implications for the deceased partner’s estate and the partnership, and planning strategies to optimize tax outcomes.
Understanding Inside Basis and Outside Basis
To grasp the adjustment process, it is important to distinguish between “inside basis” and “outside basis”:
• Inside Basis: The partnership’s tax basis in its assets. This is determined by the cost basis of the assets when acquired, plus or minus adjustments for depreciation, amortization, or other transactions.
• Outside Basis: The individual partner’s tax basis in their partnership interest. This reflects the partner’s contributions, income allocations, distributions, and other adjustments.
Upon a partner’s death, their outside basis is typically adjusted to fair market value (FMV) due to the step-up in basis under Code §1014. However, the inside basis of the partnership’s assets remains unchanged unless a specific election is made.
Adjusting Inside Basis: IRC § 754 Election
The most common mechanism for adjusting inside basis upon the death of a limited partner is the Code § 754 election. This election allows the partnership to adjust the inside basis of its assets to reflect the step-up (or step-down) in basis of the deceased partner’s outside interest.
How the § 754 Election Works
When a limited partner dies, their partnership interest is valued at FMV for estate tax purposes.
If the partnership has a § 754 election in place (or chooses to make the election in the year of the partner’s death), it can adjust the inside basis of the partnership assets under Code § 743(b).
This adjustment benefits the successor (heir or estate) by ensuring that their share of future depreciation deductions and gain recognition aligns with the FMV basis rather than the partnership’s historic basis.
Impact of the § 743(b) Adjustment
If the FMV of the deceased partner’s interest is higher than their previous outside basis, an inside basis step-up is allocated to their share of the partnership’s assets. This increases depreciation deductions and reduces capital gains upon disposition.
If the FMV is lower than their prior basis, a step-down occurs, potentially reducing future depreciation and increasing taxable gains.
Practical Considerations and Tax Planning
1. Should the Partnership Make a § 754 Election?
The election is optional, but it must be considered carefully because:
It is binding for future transactions, meaning the partnership must apply it for all future partner transfers, which could create administrative complexity.
It can create disparities between continuing partners and new successors, as the adjustment applies only to the incoming partner’s share.
If the partnership has highly appreciated assets, a step-up can yield significant tax benefits for the deceased partner’s heirs.
2. Timing and Filing Requirements
The § 754 election must be made with a timely filed partnership tax return (Form 1065) for the year in which the partner’s death occurs.
If not already in place, the partnership must affirmatively elect § 754 treatment.
Conclusion
Adjusting inside basis upon the death of a limited partner through a Code § 754 election can be a powerful tax planning tool, allowing the successor partner to benefit from a step-up in basis and reducing future tax burdens. However, the election carries long-term administrative and tax consequences that must be weighed carefully. Partnerships and estate planners should work closely to ensure that elections and reporting obligations are handled properly to optimize tax efficiency.
For more information on estate planning for owners of limited partnership interests, structuring limited partnerships, or the administration of the estate of a limited partnership owner contact the legal professionals at North Carolina Estate Planning and Fiduciary Law.