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By Liliana Dimitrova, LL.B., LL.M.
Published on 08 SEP 2023 8:00 am ET.
A Partner Sold, Now What? A Guide to Calculating and Recording Section 743(b) Adjustments.
Partnerships should consider Section 743(b) adjustments when structuring future transactions involving the sale or exchange of partnership interests. Section 743(b) of the Internal Revenue Code allows partnerships to adjust the tax basis of partnership assets when a partnership interest is sold or exchanged. These adjustments are intended to ensure that the purchasing partner's share of the partnership's inside basis aligns with their purchase price, thus preventing unintended tax consequences.
5 Min Read
It is the dream of most partnership to begin a business nurture it to an increased value ad and cash in by selling their ownership percent and living the life of adventurer. However, the owners dream can become the tax professional's nightmare. The complexity of the sale of a partnership interest frequently means it is inappropriately recorded leading to inaccurate taxation among the partners.
When client informs an accountant that they wish to sell their interest in the partnership there begins the process of removing the original partners equity from the books and adding the new partner. Frequently senior accountants will use Section 754 step up adjustment to describe the generic reference for partnership base adjustment.
Section 754 permits partnerships to make base adjustments however, section 754 is limited to such an authorization. 754 authorizes the partnership. Example, hen a 754 election is made, the partnership steps up the inside cost basis — but only for the new partner. This balances the inside cost basis and outside cost basis and reduces capital gains tax when a property that has appreciated is sold.
Consider the following scenario. Five partners contributed $100,000 each to purchase a property for $500,000. The property now has a market value of $1,000,000. Each partner’s inside cost basis is still $100,000, and their outside cost basis is still $100,000 each. Now, one of the partners sells their ownership interest for $200,000 and is taxed on the $100,000 gain.
Without making a 754 election, the asset’s inside cost basis would be transferred to the new partner with no adjustment. The new partner would have an inside cost basis of $100,000 and outside cost basis of $200,000. If the partnership decided to sell the property for $1,000,000, each partner would have a taxable gain of $100,000 — including the new partner. By making a 754 election at the time of ownership transfer, the new partner’s inside basis would be increased to $200,000. With an inside basis of $200,000, if the partnership decided to sell the property, the new partner wouldn’t experience a taxable event.
However, Section 734(b) provides the partnership to an adjustment that when the partner leaves partnership through distribution the leaving partner's interest is re-distributed to the remaining partners. Sectio 743(b) directs on calculating an existing partner's sell their ownership interest aka the leaving partner's is assumed by a new partner.
Partnerships Financials: Books and Taxes
Partnerships keep at least two set of financial statements, books and tax records. Books are for the IRC a set of financial statements, maintained under Section 704(b) rules. 704(b) financial serves as a guideline for determining sustainable economic efforts. Required for the allocation of income and expenses.
In public accounting many practitioners refer to books as the client's internal method of accounting such as financials presented on GAAP basis.
The goal of the 704(b) is to demonstrate the partners' ownership in the entity. If the partnership was to convert every asset on the balance sheet to cash by selling the assets at fair market value, and then distribute the cash to the partners how much cash would each partner receive? Or what percent of the value of the business are the partners entitled to? The 704(b) books asset in answering these questions.
The complexity surrounding the sale of a partnership interest frequently means it is inappropriately recorded, resulting in accurate taxation among the partners.
EXHIBIT 1
Emma and David's Book Post Contribution of Assets
Books
Tax
Assests
Cash
Assests
Total
50,000.00
50,000.00
100,000.00
50,000.00
15,000.00
65,000.00
Liabilities & Equity
Liabilities:
Equity:
Emma
David
50,000.00
50,000.00
100,000.00
50,000.00
15,000.00
65,000.00
EXHIBIT 2
Emma and David's After Mary buys Emma's Ownership
Books
Tax
Assests
Cash
Assests
Total
50,000.00
50,000.00
100,000.00
50,000.00
15,000.00
65,000.00
Liabilities & Equity
Liabilities:
Equity:
Mary
David
50,000.00
50,000.00
100,000.00
75,000.00
50,000.00
65,000.00
Consider Emma and David. Emma has held land for a few years and decides to put it into the partnership. Emma contributes raw land worth $50,000. Her cost basis was $15,000. Since they intended share into the partnership 50/50, David contends to share in the partnership.
In Emma ad David's case, the books or 704(b) financials the partnership will record the assets at fair market value $50,000 for the land $50,000 for the cash. Emma and David are 50/50 partners because they each contributed an asset worth $50,000.
If the partnership liquidated immediately, the land would sell for $50,000. Therefore, the cash would increase to $100,000 ad would be distributed 50/50 giving each partner back $50,000 worth of investment.
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The second set of financial statements are tax records and are designed to record the tax implications for each partner if the business was to sell the assets at fair value. Many accountants understand that the sale of an asset could produce a gain, that is sale price minus the purchases price (cost basis) and is subject to taxation. The tax set of financial statements track cost basis so that as asset are sold, gain for tax purposes can be calculated and distributed to the partners on a schedule K1 who the claim the gain on their personal 1040 income taxes.
EXHIBIT 3
Mary's Eventual Loss on Disposition Emma's Ownership
Liquidation
Price
Tax Basis
Gain
100,000.00
15,000.00
85,000.00
Land Sale
BIG
Mary
35,000.00
Daivd
Liabilities & Equity
1/2 each
Total Gain
Original
Gain
Net
25,000.00
50,000.00
100,000.00
50,000.00
50,000.00
100,000.00
Liquidation Cash
Assests
75,000.00
Net Loss on DispositioDisposition
80,000.00
25,000.00
15,000.00
65,000.00
75,000.00
50,000.00
65,000.00
150,000.00
75,000.00
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