When a purchaser buys an existing partner's partnership interest, or the interest of a member of a limited liability corporation (LLC) taxed as a partnership, for its fair market value, the amount paid becomes the basis for the purchaser's partnership interest (outside basis). The new partner assumes the seller's pro rata share of the partnership's adjusted basis in its property (inside basis). If the partnership's assets have appreciated sufficiently, the difference between the new partner's inside and outside basis can be substantial. This disparity can deprive the new partner of depreciation deductions and inflate his share of the gain from subsequent property dispositions. A knowledgeable buyer who is aware of these negative tax consequences can negotiate a discounted purchase price to minimize the negative tax result. Alternatively, the partnership can make an IRC Section 754 election to equalize a new partner's outside and inside basis. This election can enhance the value of a partnership interest and make it more marketable. Section 754 elections are a complex area of the IRC, and this article is intended as an introduction to the basic concept. Because of potentially conflicting interests, advising the purchasers, partnerships, and continuing partners requires care and caution.

Federal regulation
Partnership interest
Internal Revenue Code -- Section 754