The Sale of Interest: How to Calculate the Step-Up Without Blowing the Budget
A § 743(b) basis adjustment is one of the most commonly misunderstood mechanics in partnership taxation, particularly in transactions involving the sale or exchange of a partnership or LLC membership interest. While conceptually tied to the buyer’s purchase price, the § 743(b) adjustment is not simply the selling partner’s gain (or loss) passed through to the buyer. Instead, it is a partner-specific adjustment designed to align the transferee partner’s outside basis with their share of the partnership’s inside basis, but only if a § 754 election is in effect (or mandatory under § 743(d)). Getting this right requires a disciplined, step-by-step approach grounded in §§ 743(b), 742, and 755, as well as the capital and liability allocation rules under § 752.
The starting point is determining the transferee partner’s outside basis under IRC § 742. This generally equals the amount paid for the interest, plus the buyer’s share of partnership liabilities under § 752, less any liabilities the buyer is treated as relieved of in the transaction. This outside basis is purely partner-level and says nothing, by itself, about the partnership’s asset bases. In parallel, the partnership must determine the buyer’s share of the partnership’s adjusted inside basis in its assets immediately after the transfer, based on the buyer’s post-transfer profit, loss, and capital percentages and the partnership’s existing tax bases. The difference between these two amounts—outside basis versus share of inside basis—is the preliminary § 743(b) adjustment.
Once the net § 743(b) adjustment is computed, the next critical step is allocating that adjustment among the partnership’s assets under IRC § 755 and the accompanying regulations. This is where fair market value (FMV) analysis becomes essential. The partnership must first group assets into the two statutory classes: § 1245/1250 and other ordinary-income property versus capital assets and § 1231 property. Within each class, the adjustment is allocated based on the relative FMV differences between each asset’s FMV and its adjusted tax basis as of the transfer date. Importantly, this is not a book-up exercise for all partners; it is a transferee-only adjustment tracked separately and applied solely in computing the buyer’s depreciation, amortization, and gain or loss.
A practical step-by-step framework looks like this: (1) Confirm that a § 754 election is in effect (or required). (2) Compute the buyer’s outside basis under § 742, including post-transfer liability allocations under § 752. (3) Determine the buyer’s share of inside basis immediately after the transfer. (4) Calculate the net § 743(b) adjustment as the difference between the two. (5) Determine the FMV of partnership assets as of the transfer date and classify them under § 755 asset classes. (6) Allocate the adjustment among assets based on relative FMV-to-basis differentials. (7) Apply the resulting asset-level adjustments to the buyer’s depreciation, amortization, and disposition calculations going forward, while maintaining separate tracking schedules.
One of the most common—and dangerous—pitfalls is assuming that the selling partner’s gain equals the buyer’s § 743(b) adjustment. This is often incorrect because the seller’s gain reflects their outside basis, historic allocations, and tax attributes, while the buyer’s adjustment depends on their purchase price and post-transfer liability share. Differences in debt allocation, hot asset exposure under § 751, prior special allocations, or preexisting § 704(c) layers can cause these amounts to diverge significantly. Treating them as interchangeable can result in overstated depreciation deductions, understated gain on exit, or both.
Additional errors frequently arise from skipping or shortcutting the FMV allocation step, particularly when partnerships lack contemporaneous valuation support. Over-allocating the adjustment to depreciable assets, ignoring § 755 asset classes, or failing to separately track multiple § 743(b) layers for different transferees can all lead to reporting failures that compound over time. Equally problematic is failing to properly report the adjustment on Form 1065, Schedule K-1 (footnotes), and supporting workpapers, leaving the transferee without adequate substantiation in an exam. A properly calculated and documented § 743(b) adjustment is not merely a compliance exercise—it is essential to preserving the intended tax economics of the transaction and avoiding silent basis distortions that surface years later.
