Section 754 Election When a Partner Dies: Basis Step-Up and Filing

When a partner dies, a Section 754 election lets the partnership step up the heir’s share of the partnership’s inside asset basis to match the fair market value of the interest at the date of death. Without it, the heir will eventually pay tax on gains that accrued before they inherited anything. The election is made by the partnership, not the heir, and it has to be attached to the partnership’s Form 1065 for the tax year the partner died. Miss that filing and the heir can lose tens or hundreds of thousands of dollars in avoidable tax.

Why a Partner’s Death Creates a Basis Problem

Every partner has an outside basis in their partnership interest, which reflects contributions, allocated income, and share of partnership debt. The partnership separately tracks an inside basis in each asset it owns, based on what it originally paid. Over time these two figures move roughly together.

Death breaks the alignment. Under Section 1014, property inherited from a decedent takes a new basis equal to fair market value at the date of death.¹ The heir’s outside basis in the partnership interest jumps to that date-of-death value, typically established by appraisal and reported on Form 706 if an estate tax return is required. The partnership’s inside basis in its assets does not move at all. Nobody adjusts the partnership books just because a partner died.

So the heir may hold an interest worth $800,000 while their proportionate share of the partnership’s inside basis is $300,000. That $500,000 gap is where phantom income comes from. If the partnership later sells its assets, it will calculate gain on the heir’s share using the old inside basis, and the heir will owe tax on appreciation that happened entirely before they inherited the interest.

Community Property Doubles the Gap

If the deceased partner and a surviving spouse held the interest as community property, Section 1014(b)(6) steps up both halves at the first death, not just the decedent’s share.¹ The outside-to-inside basis gap is larger in these situations, and so is the value of a 754 election.

What the Election Does for the Heir

A Section 754 election authorizes the partnership to adjust the basis of its assets to match the heir’s new stepped-up outside basis. The adjustment applies only to the heir. Continuing partners keep depreciating and calculating gain on the partnership’s original cost basis. The heir gets a separate set of numbers reported on their Schedule K-1.²

Two benefits follow. First, phantom income disappears. Gain on the heir’s share of any later asset sale is measured from the date-of-death value, not the partnership’s historical cost. Second, depreciation resets. Where the stepped-up basis is allocated to depreciable buildings or equipment, the heir gets fresh depreciation deductions against their partnership income. Where it lands on goodwill or other Section 197 intangibles, the heir amortizes that portion over 15 years.³

How the Adjustment Is Calculated

Section 743(b) supplies the formula. Take the heir’s outside basis (date-of-death fair market value, plus the heir’s share of partnership liabilities under Section 752) and subtract the heir’s proportionate share of the partnership’s inside basis in its assets.⁴⁵ After a death, this figure is usually positive because most partnership assets appreciate. An outside basis of $750,000 and a proportionate inside basis of $400,000 produces a positive adjustment of $350,000, added to the basis of the partnership’s assets for the heir alone.

Section 755 then controls how that $350,000 gets spread across specific assets. The regulations split assets into capital gain property (capital assets, Section 1231 property, goodwill) and ordinary income property (inventory, receivables, unrealized receivables), allocate the total between the two groups by their net appreciation, and then push the adjustment onto individual assets in proportion to how much each has appreciated.⁶⁷ Assets that haven’t appreciated get nothing. In service businesses and professional practices, goodwill often absorbs most of the positive adjustment, and valuing it usually requires a specialized appraisal.

How the Partnership Makes the Election

The election is a partnership-level act. The heir cannot make it, and the estate cannot make it. The partnership attaches a written statement to its timely filed Form 1065 for the tax year in which the partner died.⁸ The statement must:

Give the partnership’s name and address.
Be signed by a partner.
Declare that the partnership elects under Section 754 to apply Sections 734(b) and 743(b).
Identify the specific transfer that triggered the election.

The filing deadline is the due date of the Form 1065 for the year of death, including extensions. If a partnership has had multiple ownership changes in the same year, the statement needs to name the death that prompted the election; a vague statement risks the IRS treating the election as invalid.

If the Deadline Was Missed

A late filing is not necessarily fatal. Within 12 months of the original due date (including extensions), the partnership can use the automatic extension under Treasury Regulation 301.9100-2. It files an amended or late return with the election statement attached and writes “FILED PURSUANT TO § 301.9100-2” at the top.⁸ No IRS approval is required, but the partnership and every affected partner must file consistently with the election for the year it should have been made.

Past 12 months, relief still exists but gets expensive. Under Treasury Regulation 301.9100-3, the partnership must request the Commissioner’s approval through a private letter ruling, showing it acted reasonably and in good faith and that the government won’t be prejudiced. Expect professional fees and a wait of several months, and expect the case to get harder the further you are from the original deadline.

What the Step-Up Does Not Cover

Section 1014(c) excludes income in respect of a decedent (IRD) from the step-up.¹ IRD is income the deceased partner earned during life but hadn’t received by death: unpaid fees for services already performed, installment payments not yet collected, and the decedent’s share of accrued but unreceived partnership income. Those items keep their original basis and pass through to the heir as ordinary income when collected. The 754 election and the 743(b) adjustment do not override this. In service partnerships, professional practices, and any partnership with meaningful receivables, the heir should identify the IRD portion of the inherited interest with a tax advisor, because it will be taxed at ordinary rates regardless of any election.

What the Partnership Is Signing Up For

A Section 754 election is irrevocable without IRS approval, and it applies to every future transfer of a partnership interest and every partnership distribution going forward.⁹ The partnership can’t pick and choose which events it applies to.

The election also activates Section 734(b), which requires the partnership to adjust the basis of its remaining assets whenever it distributes property to any partner in a way that creates a loss to the distributee.¹⁰ For partnerships with frequent distributions or high partner turnover, that ongoing tracking is real work.

Revocation is possible but limited. The partnership files Form 15254 within 30 days after the close of the tax year for which revocation is sought. The IRS will consider revocation for administrative burden reasons, such as a substantial increase in partnership assets or frequent ownership changes. It will not approve a revocation whose primary purpose is to avoid a downward basis adjustment.⁸

Traps That Cost Heirs the Benefit

The biggest risk is inaction at the partnership. The heir has no unilateral remedy if the managing partner or the partnership’s tax preparer fails to file the election statement with the Form 1065 for the year of death. Partnership agreements can close this gap by requiring the managing partner to make a 754 election on any partner’s death. Without that contractual duty, the heir’s leverage is limited to whatever the other partners agree to.

Valuation is the other soft spot. The Section 743(b) adjustment is only as strong as the date-of-death fair market value that drives it. Understating value means a smaller step-up and more taxable gain later; overstating it can draw an IRS challenge. For partnerships holding real estate, closely held business interests, or significant intangibles, a qualified independent appraisal is worth the cost.

Tiered partnership structures introduce their own trap. If an upper-tier partnership owns an interest in a lower-tier partnership, both entities need active 754 elections for the basis adjustment to reach the underlying assets where it affects depreciation and gain. An election only at the upper tier adjusts the upper tier’s interest in the lower tier but leaves the lower tier’s assets untouched. An election only at the lower tier does nothing when a partner in the upper tier dies, because the transfer happens one level up. In multi-entity structures, this coordination is easy to miss and expensive to fix.

Finally, expect the compliance workload to be real. Once the election is in place, the partnership tracks the basis adjustment separately for each transferee partner across every affected asset, and reports it on the heir’s Schedule K-1 using specific codes.² That parallel bookkeeping is the most common reason partnerships eventually seek revocation, and it’s a good reason to have the conversation about who will do the work before the election gets filed rather than after.

1
Office of the Law Revision Counsel. 26 U.S. Code 1014 – Basis of Property Acquired From a Decedent
2
Internal Revenue Service. Partner’s Instructions for Schedule K-1 (Form 1065)
3
Office of the Law Revision Counsel. 26 U.S. Code 197 – Amortization of Goodwill and Certain Other Intangibles
4
Office of the Law Revision Counsel. 26 U.S. Code 743 – Special Rules Where Section 754 Election or Substantial Built-In Loss
5
Office of the Law Revision Counsel. 26 U.S. Code 752 – Treatment of Certain Liabilities
6
Office of the Law Revision Counsel. 26 U.S. Code 755 – Rules for Allocation of Basis
7
eCFR. 26 CFR 1.755-1 – Rules for Allocation of Basis
8
Internal Revenue Service. FAQs for Internal Revenue Code (IRC) Sec. 754 Election and Revocation
9
Office of the Law Revision Counsel. 26 USC 754 – Manner of Electing Optional Adjustment to Basis of Partnership Property
10
Office of the Law Revision Counsel. 26 USC 734 – Adjustment to Basis of Undistributed Partnership Property Where Section 754 Election or Substantial Basis Reduction