Requesting a Revocation of a Partnership Election under Sec. 754 when It Becomes Disadvantageous to the Partners and the Partnership

Editor:

Albert B. Ellentuck, Esq.
Of Counsel
King and Nordlinger, L.L.P.
Arlington, VA

Editor's note: This case study has been adapted from "PPC Tax Planning Guide—Partnerships," 14th edition, by Grover A. Cleveland, James A. Keller, William D. Klein, Terry W. Lovelace, Sara McMurrian and Linda A. Markwood, published by Practitioners Publishing Company, Fort Worth, Tex., 2000 ((800) 323-8241; www.ppcnet.com ).

Facts: In early 1998, Harry Edsel and Kenny Corvair formed a calendar-year general partnership to acquire a 50-acre tract of land on the outskirts of Houston, Texas. Harry, a brilliant architect (with a poorly developed business sense), had drawn plans for Space City Park, a state-of-the-art office, retail and residential development. Kenny, a heart surgeon with more money and surgical technique than financial acumen, agreed to invest $1 million in the project. • In May 1998, Space City Partners started construction of the Space City Inn, a futuristic hotel they hoped would be the drawing card to make Space City Park a reality. During construction, Harry fell from the 15th floor and was killed. The partnership made an election under Sec. 754 to step up the basis of the partnership assets on behalf of his widow, Annie Edsel. In 1999, the hotel was completed at a cost of $40 million. The additional $39 million needed to complete the hotel was loaned to the partnership by a savings and loan owned by Kenny's brother-in-law. • After occupancy of the hotel had averaged 12% for the first 18 months of operations, Kenny and Annie agreed the timing had not been right for Space City. After consulting with their financial advisers, they decide to retain a joint 67% interest in the partnership and try to sell 33% to outside investors (to provide additional funding). The new partnership plans to abandon the idea of developing Space City Park. Instead, they will operate the hotel and hold the additional land for eventual sale to other developers. • The tax adviser for the potential investors has indicated that, because the value of the partnership assets is only 50% of its basis, the basis of the partnership assets attributable to their partnership interest will be stepped down, and thus his clients will not become partners unless Space City Partners revokes its Sec. 754 election. The partnership's tax adviser warns Kenny and Annie that the sale of the building would be financially disastrous, and a partnership termination would result in extending the hotel's depreciable life. Issue: Can Space City Partners revoke its previous election under Sec. 754?

Analysis

Regs. Sec. 1.754-1(c) provides for the revocation of a Sec. 754 election under certain circumstances. A request for revoking the election must be filed with the District Director for the district in which the partnership files its return. The request must be filed no later than 30 days after the close of the partnership tax year for which the revocation is intended to take effect. The request may be signed by any of the partners.

If Space City Partners is granted a revocation of its Sec. 754 election, the new partners will not have to step down their basis in partnership assets. Assuming they satisfy the other partnership rules on the allocation of losses to the partners (i.e., at-risk rules, substantial economic effect rule, passive loss rules, etc.), the new partners will be allocated their share of hotel depreciation based on the full partnership basis in the hotel. Additionally, because the parcels of land will maintain a tax basis equal to their purchase price, the new partners will be able to defer gain until cash distributions exceed the basis of their partnership interests.

Under these facts, IRS approval of the request for revocation is questionable. The Service will not approve a request for revocation of the election if the purpose of the revocation is to avoid stepping down the basis of the partnership's assets on a distribution or a transfer of a partnership interest. This is an extremely hard prohibition to overcome, as it would seem the only reason (with the possible exception of administrative burden) to revoke a Sec. 754 election would be to avoid a step-down. Examples in Regs. Sec. 1.754-1(c) of situations that may be considered sufficient reason for an approval of a request for revocation include:

1. A change in the nature of the partnership business.

2. A substantial increase in the partnership's assets.

3. A change in the character of partnership assets.

4. Increased frequency of retirements or transfers of partnership interests that cause an administrative burden.

Under the planned restructuring of Space City Partners, there will be a change in the nature of the partnership business, a change in the character of partnership assets and (depending on how many new partners are admitted) there could be an administrative burden created by continuing to be required to make Sec. 754 basis adjustments.

While it is possible Space City Partners might be granted a revocation of its Sec. 754 election, the tax adviser would probably advise the partners that they need to structure the transaction to ensure a backup plan is available. This is especially true in this situation. Because a Sec. 754 revocation is granted after the fact, if the revocation is denied, there is no opportunity to correct the problem.

In the case of Space City Partners, if the new partners form a partnership (that does not make a Sec. 754 election), the new partnership could acquire a 33% partnership interest in Space City Partners by a contribution of cash. The issuance of the partnership interest will not be treated as a transfer of a partnership interest and will, therefore, not trigger the optional basis adjustment. (Caution: The fact that Kenny's and Annie's interests in Space City Partners would in effect be reduced, and if Kenny and Annie have already taken formal steps for the sale of the partnership interest, the IRS could argue that the reduction of their interests may actually be a disguised sale. Thus, no formal agreements should be entered into unless the Service approves the revocation.) The admission of the new partnership also will not trigger gain recognition to the existing partners, nor will it cause the partnership to change its depreciation methods or depreciable lives.

Conclusion

Space City Partners may apply to have its election under Sec. 754 revoked; however, it is likely the application will be denied. Although the revocation of the election is available under the regulations, it is difficult to obtain. One should consider the Sec. 754 election irrevocable when making the original decision to adjust the basis of partnership assets. Additionally, it is always better to have a backup plan in the event the request for revocation is denied.