Section 754: What You Need to Know About Depreciation, Amortization Benefits

Beware: Once this benefit is in place, it’s difficult to remove

Making the Section 754 election is a big deal if your client is in the midst of handling partners, partnerships, and property distributions to partners. And accurately calculating the 743(b) basis adjustment—and then reporting it on Partnership Form 1065—is no walk in the park.

As tax expert Vicki L. Mulak explains in her Eli Financial webinar, “Section 754 Elections: Theory and Practice,” proper reporting requires knowing you way around Form 1065 and then choosing appropriate Section 754 elections. In the presentation, Mulak walks you through in-depth explanations, such as how to equalize a buyer’s basis when property is distributed or when partnership interest is transferred.

Section 754: Why It’s Worth Your Time

Section 754 allows a partnership to elect to adjust the basis of partnership property when that property is distributed or when a partnership interest is transferred, explains Section 754 reconciles a new partner’s outside and inside basis in the partnership and allows the new partner to receive the benefits of depreciation or amortization that may have slipped away had the election not been made.

The benefits: “A Section 754 election is an off-balance sheet adjustment; therefore, there should never be a change in how the net tax effect is reported. The Section 754 election should be favorable for the buyer of a partnership interest, because it allows him to avoid waiting until a partnership liquidates to make his interest whole,” explains Michael Galloway from accounting firm JPMS Cox.

Galloway adds that the election is not automatic: The partnership needs to decide and report it before income taxes are due.

Important: Once the Section 754 is in place, it can only be revoked by IRS consent. Reasons for withdrawal include:

  • A change in the nature of the partnership’s business.
  • A substantial increase in partnership assets.
  • A change in the character of partnership assets.
  • An increased frequency of retirements and shifts in partnership interests that increase the administrative burden placed on the partnership by the election.

“Avoidance of potential decreases in bases of assets is not an acceptable purpose,” adds Galloway.

Form 1065: A Snapshot of Financial Standing

Form 1065, U.S. Return of Partnership Income, is a five-page statement that declares profits, losses, deductions, and credits for a business partnership. If you file it, you also need to submit a Schedule K-1 for each partner.

The Internal Revenue Service’s 52-page instruction sheet runs down the basics for filers.

“Form 1065 does not determine how much tax a partnership owes” explains Investopedia. “Instead, it shows the IRS a snapshot of the company’s financial status for the year. The partners must report and pay taxes on their share of income from the partnership on their tax returns. Partners must pay income tax on their earnings regardless of whether the earnings were distributed.”

Investopedia notes that:

  • A partnership, per the IRS, is two or more people who carry on a trade or business together.
  • Foreign partnerships with income in the U.S. must also report Form 1065; exemptions include those with earnings of less than $20,000 in the U.S. or those who receive less than 1% of their income in the U.S.
  • Non-profit religious organizations must also report their income and losses on the form.

Form 1065 May Be the Tip of the Form-Filing Iceberg

Ready to complete Form 1065? Not so fast. To file Form 1065, you’ll need information from a host of other forms, including:

  • Form 4562, Depreciation and Amortization
  • Form 1125-A, Cost of Goods Sold
  • Form 4797, Sale of Business Property
  • Copies of any Form 1099 issued by the partnership
  • Form 8893, Election of Partnership Level Tax Treatment
  • Form 8918, Material Advisor Disclosure Statement

There’s obviously a lot of work that goes into making the Section 754 election, says Mulak, host of the webinar, “Section 754 Elections: Theory and Practice.” Make sure you understand its requirements before attempting to secure this valuable benefit.

To join the conference or see a replay, order a DVD or transcript, or read more

Jeff Schmerker

Jeff has extensive professional experience writing on a variety of topics, from pharmaceutical research to environmental history. He has published more than a half-dozen books, and he has worked as a newspaper reporter, magazine editor and restaurant reviewer. He lives in Missoula, Montana with his wife and son.

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