Section 754 election

A Section 754 election is a tax tool that partnerships can use to adjust the tax basis of their assets under specific circumstances. The election can provide significant tax benefits to partners and helps ensure more accurate tax reporting. This election can be particularly valuable for hedge fund partnerships that own assets that have increased in value over time. However, many hedge funds choose not to make Section 754 elections because the accounting requirements are extremely complex.

A Section 754 election can reduce tax burden in two main situations. When partnership property is distributed, remaining partners may benefit from reduced taxes. When a partnership interest is transferred, new partners may also benefit from reduced taxes.

Many hedge funds still avoid making this election because the accounting work is extremely complicated. The election provides these benefits by ensuring that new partners do not inherit tax consequences from gains that happened before they invested. This can reduce their future tax liability when assets are sold and makes the fund more attractive to new investors.

The election achieves this by aligning two different types of tax basis. "Inside basis" refers to the partnership's total basis in its assets. "Outside basis" refers to each partner's basis in their partnership interest. When these two measures are not aligned, new partners could end up paying taxes on gains that occurred before they joined the partnership. This creates an unfair distribution of tax consequences and can complicate fund economics.

Section 754 allows a partnership to elect to adjust the basis of its property when two key events happen: when the partnership distributes property to partners, and when partnership interests change hands through sales, exchanges, redemptions, or when a partner dies.

When a Section 754 election is active, the partnership must adjust the basis of its assets whenever partnership interests are transferred or when a partner dies. The election works through two separate mechanisms in the Internal Revenue Code.

First, when someone sells their partnership interest or dies, Section 743(b) governs the basis adjustments. This provision allows the partnership to increase or decrease its asset basis specifically for the benefit of the new partner. Second, when the partnership distributes property to a partner, Section 734(b) adjustments allow the partnership to increase or decrease the basis of the property it keeps.

Some basis adjustments are required regardless of whether a Section 754 election is in place. A partnership must adjust the tax basis of its remaining assets when a distribution results in a "substantial basis reduction." This means a reduction exceeding $250,000. This typically happens when an investor withdraws from a partnership and recognizes a loss greater than $250,000.

Similarly, a partnership must adjust its basis in its assets with respect to a new partner when a partnership interest is sold, exchanged, or transferred when a partner dies, if the partnership has a "substantial built-in loss" immediately after the transfer. This occurs when the partnership's basis in its property exceeds fair market value by more than $250,000.

These mandatory adjustments reflect Congressional intent to prevent the same losses from being claimed twice and to ensure consistent tax treatment across different partner situations, regardless of whether the partnership made the election.

To make a Section 754 election, a partnership must attach a written statement to its tax return for the tax year in which a qualifying distribution or transfer occurs. The return must be filed on time, including any extensions. The statement must include the partnership's name and address, along with a declaration that the partnership elects under Section 754.

Once filed, the election applies to all qualifying transactions in that tax year and all subsequent years.

The Section 754 election becomes particularly relevant when buying out seed investors. From a fund manager's or fund general partner's perspective, using the partnership's after-tax capital to buy out a seed investor is typically not efficient.

If a Section 754 election has been made, the fund manager's partners might recover the buyout cost through deductions over approximately fifteen years. However, the actual ability to use these deductions may be limited by timing and other tax restrictions.

Regulations that became final in January 2025 created additional compliance requirements for certain partnership basis adjustment transactions. Specifically, distributions and transfers involving related parties that result in basis increases may be classified as "transactions of interest." This classification triggers disclosure obligations and enhanced reporting requirements.

Partnerships and their advisors should evaluate whether transactions involving related parties—such as continuation fundsAn investment fund established by existing investment managers to continue managing capital from the same or similar investor base, often created to extend a fund's strategy or address regulatory succession issues., fund restructurings, or in-kind distributionsDistributions where investors receive actual securities instead of cash when withdrawing from a fund.—fall under these new reporting rules. Failure to comply can result in significant penalties.

The Section 754 election, once made, generally applies to all subsequent qualifying transactions unless the IRS grants permission to revoke it. Revocation requires filing Form 15254IRS filing form that partnerships must submit to request revocation of a Section 754 election, subject to IRS approval. with the IRS, and approval is not guaranteed. Partnerships should carefully consider the administrative burden of maintaining the required basis adjustments and calculations, as well as the potential benefits to partners before making this election.

The complexity of the required accounting often prevents hedge funds from making the election despite its potential tax benefits. The election requires several complex tasks. These include allocating basis to individual assets using hypothetical liquidation methodsAn accounting methodology that allocates basis adjustments to partnership assets by calculating fair market values as if the partnership were liquidated at current market conditions., ongoing tracking of adjustments across multiple transactions, and potential cost segregation studiesSpecialized tax accounting studies that segregate property into components with different useful lives to maximize depreciation deductions by assigning accelerated recovery periods to eligible assets. to optimize depreciation.

For funds with frequent partner changes, the administrative cost can substantially reduce the tax benefits realized. Additionally, because the election is effectively permanent, a partnership that makes it during a period when assets are increasing in value could face unfavorable downward adjustments if market values decline in future years. This makes the Section 754 election an important strategic decision with long-term consequences.