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Tennessee Letter Ruling addresses partnership basis step-up and push-down treatment

July 2021

In brief

In Letter Ruling 21-06 (6/10/21), the Tennessee Department of Revenue addressed the franchise and excise tax implications when a partnership makes an IRC Sec. 754 election to step up the adjusted basis of its assets for federal income tax purposes,  and the partnership elects to “push down” the purchase accounting adjustments resulting from the purchase that gave rise to the IRC Sec. 754 election.  

The Department opined that for franchise tax purposes, the taxpayer must calculate its taxable net worth using the fair market value adjustments that resulted from the push-down election.  

For excise tax purposes, the Department opined that the taxpayer must exclude from its net earnings the basis adjustments and associated amortization and depreciation deductions that resulted from the IRC Sec. 754 election.

The takeaway: The ruling discusses the excise tax ramifications of the IRC Sec. 754 election.  Because Tennessee taxes the partnership itself, the question frequently arises whether the partnership can claim the benefit of the stepped-up basis when reporting its net earnings.  As the ruling opines, for federal income tax purposes, the election does not affect the taxable income of the partnership itself, but rather is only taken into consideration when determining the partner’s taxable income from the partnership.

[Letter Ruling 21-06 (6/10/21, posted on 7/14/21)]

In detail

Facts

Taxpayer is a single-member limited liability that is disregarded for federal income tax purposes, but is taxed as a separate entity in Tennessee because its owner is an LLC (hereinafter referred to as ‘Partnership’) that is treated for federal tax purposes as a partnership.  Partnership’s owners sold a portion of their Partnership interest to Purchasers.  Partnership made a IRC Sec. 754 election such that Purchasers’ adjusted basis in Partnership’s property (which is an SMLLC) was stepped up to fair market value under IRC Sec. 743(b).  

As part of a letter ruling request, Partnership represents that it desires to “push down” to Taxpayer’s separate entity books the purchase accounting adjustments that resulted from the Purchasers’ acquisition of Partnership, and further that this election is permitted under GAAP.

Franchise tax net worth is calculated by including step-up basis in assets

Tennessee net worth tax

Tennessee imposes a franchise tax at the rate of $0.25 per $100 on a taxpayer’s net worth.  “Net worth” is defined as the difference between a taxpayer’s total assets less its total liabilities computed in accordance with GAAP.

Although Taxpayer is disregarded as a separate entity for federal tax purposes, for Tennessee franchise tax purposes. Taxpayer is classified as a separate entity because the only person that can be disregarded for Tennessee franchise and excise tax purposes is a federally disregarded LLC whose single member is a person taxed as a corporation for federal income tax purposes.  In the immediate case, the single member is a person taxed as a partnership.

GAAP “pushdown” accounting

“Pushdown accounting” is the use of the acquirer’s basis in the preparation of the acquiree’s separate financial statements and may be elected following a change-in-control event.  

In this case, the “acquiree” is Partnership and the “acquirer” is Purchasers.  The acquiree also has the option to apply pushdown accounting to its subsidiaries.  Because Taxpayer is a subsidiary of Partnership, Partnership can make the election to use pushdown accounting in the preparation of Taxpayer’s GAAP financials, and that is what Partnership represented that it intended to do.  

Pushdown accounting followed for net worth purposes

Tennessee “net worth” is expressly defined as being computed in accordance with GAAP, which permits the use of pushdown accounting. Therefore, if pushdown accounting is elected, the step-up in basis of its assets will be reflected in its balance sheet, and Taxpayer must compute its taxable net worth by including the step-up in basis.

IRC Sec. 743(b) basis adjustments and depreciation/amortization deductions not included for income tax purposes

Tennessee excise tax

Tennessee imposes an excise tax at the rate of 6.5% on net earnings.  Although Taxpayer is disregarded as a separate entity for federal tax purposes, for Tennessee excise tax purposes Taxpayer is classified as a separate entity.

Federal income tax IRC Sec. 754 election

Under IRC Sec. 754, a partnership may elect to adjust the basis of its property following the transfer of a partnership interest, in the manner provided in IRC Sec. 743.  

IRC Sec. 743(b) generally provides that when a partnership interest is transferred, the basis of the partnership property is stepped up (or stepped down) to fair market value.  IRC Sec. 743(b) and regulations provide that the basis adjustment is made with respect to the transferee partner only. No adjustment is made to the common basis of partnership property.  Accordingly, the transferee partner will have a special basis for those partnership properties that were adjusted under IRC Sec. 743(b).  

Federal principles applied to taxpayer

For purposes of the IRC Sec. 754 election described above, Purchasers are the transferees and Taxpayer, which is a disregarded entity for federal income tax purposes, constitutes a component of the partnership property. The Letter Ruling describes the federal implications as follows:

  • The basis step-up is attributable to Purchasers rather than partnership property.
  • Nothing changes with respect to Partnership’s “inside basis” in the partnership property as a result of the IRC Sec. 754 election.
  • The IRC Sec. 743(b) basis adjustment is only determinative of the Purchasers’ distributive share of the Partnership’s items of income, deduction, gain, or loss. 
  • Partnership adjusts the Purchasers’ distributive share of the items of partnership income, deduction, gain, or loss to reflect the effects of the Purchasers’ basis adjustment under IRC Sec.  743(b).

Tennessee excise tax does not adjust for IRC Sec. 743

As noted above, the basis step-up applies only to Purchasers for federal income tax purposes. No adjustment is made to the common basis of partnership property. 

For Tennessee excise tax purposes, partnerships are taxed directly at the partnership level, rather than the partner level. Accordingly, the Letter Ruling concludes, for Tennessee excise tax purposes, Taxpayer’s net earnings or net loss will be determined without making any addition or subtraction relating to the IRC Sec. 743(b) basis adjustment pursuant to the IRC Sec.  754 election because those adjustments apply only to Purchasers, not to the partnership or, in the immediate case, a federally disregarded entity owned by the partnership.

Observation: Until recently, the mechanics of the excise tax return allowed for recognition of the IRC Sec. 754 election at the partnership level, and the definition of “net earnings” for purposes of the excise tax on partnerships would seem to allow for the IRC Sec. 754 adjustment.  For purposes of the excise tax, the net earnings of a partnership are defined by reference to the ordinary income of the partnership for federal income tax purposes, but it also includes (but is not limited to) guaranteed payments and capital gains, but which, like the IRC Sec. 754 adjustment, are separately stated to the partner.  Accordingly, the Department's ultimate conclusion may be subject to subsequent scrutiny if Taxpayer litigates the issue or other taxpayers challenge the Department's conclusion.

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Peter Michalowski

Peter Michalowski

Partner, State and Local Tax Consulting Leader, PwC US

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