The Step-Up Most Family Business Owners Miss: Why a Trust Holding Partnership Interests Needs One Overlooked Election

The family business was a multi-member LLC taxed as a partnership. It owned a distribution warehouse and a fleet of trucks, and the founder held his interest through a revocable living trust. When he died, the trust became irrevocable and his two adult children became its beneficiaries.

The estate attorney told them the step-up in basis had eliminated the built-in gain. Later, the LLC sold the warehouse. The trust’s Schedule K-1 then showed a large capital gain allocated to it, the same gain the family thought had disappeared at their father’s death.

One written statement could have prevented it. Nobody attached it to the partnership’s return for the year he died.

Two Kinds of Basis, and Only One Steps Up on Its Own

A partner who dies leaves two separate basis numbers behind. Outside basis is the owner’s basis in the partnership interest itself. Under 26 U.S.C. § 1014(b)(9), property that must be included in the decedent’s gross estate takes a basis equal to its value at death. The heirs’ outside basis resets.

Inside basis is the partnership’s own basis in the warehouse, the trucks and everything else it owns. That number stays where it was. Under 26 U.S.C. § 743(a), the basis of partnership property “shall not be adjusted” on the death of a partner unless a Section 754 election is in effect or the partnership has a substantial built-in loss.

That gap is where the money leaks out. The partnership figures its gain on the sale using its old, depreciated basis, then passes the heir’s share of that gain through to the trust. The heir also keeps carrying over the old depreciation schedule and gets no fresh deductions on the stepped-up value. Generally, the extra outside basis comes back only when the interest itself is sold or wound up, often decades later.

What a Section 754 Election Fixes

The statute is short. If the partnership files the election, “the basis of partnership property shall be adjusted” on a transfer of a partnership interest in the manner provided in Section 743. The election covers that taxable year and all later years, and it “may be revoked by the partnership, subject to such limitations as may be provided by regulations.”

Once the election is in place, Section 743(b) adjusts the basis of partnership property “with respect to the transferee partner only.” The heir or the trust gets the higher inside basis, and the other partners’ numbers stay the same. 26 U.S.C. § 755(a) then spreads the adjustment across assets in a way that narrows the gap between fair market value and adjusted basis.

Partnership Files It, Not the Heirs

The heirs and the trust have no power to make this election. Treasury regulations require a written statement filed with the partnership return for the taxable year during which the transfer occurs, and that return must be filed on time, including extensions. If a valid election from an earlier year was never revoked, a new election is not required. When the deadline is missed, the only path left is a relief request under § 1.9100-1.

That puts the managing partner and the other owners in control. A trustee who holds a minority interest has to rely on the operating agreement or on good will. The trustee should raise the election with the partnership’s tax accountant as soon as possible after the death, well before that year’s return is prepared.

Election Applies to Every Future Transfer

The election stays in place. It applies to all property distributions and transfers of partnership interests in that year and every later year. When asset values fall, the same mechanism adjusts basis down. Revoking it requires IRS approval, and the regulations say no revocation will be approved when the purpose is primarily to avoid stepping down the basis of partnership assets.

The partnership also has to track a separate adjustment for each transferee, asset by asset. Some partnerships are covered regardless: an adjustment is mandatory when partnership basis exceeds asset value by more than $250,000. When a family business holds appreciated real estate, the upward adjustment usually outweighs the added paperwork.

Trust Type Decides Whether There Is Anything to Adjust

The election only passes through a step-up that already exists. An interest held in a revocable trust is generally included in the gross estate under 26 U.S.C. § 2038(a)(1), which reaches transfers the decedent kept the power to “alter, amend, revoke, or terminate.” An interest gave into an irrevocable trust during life generally stays out of the estate and keeps the donor’s basis under the gift rules in IRS Publication 551. In that case, Section 754 has little to adjust.

Plenty of families hold wealth this way. Estate tax returns filed in 2024 reported real estate partnerships on 2,056 returns worth $14,027,312,000, plus other limited partnerships on 1,899 returns.

Four Moves to Make Before the Next K-1

• Confirm the trust type. Read the trust instrument and note whether the grantor kept the power to revoke.
• Check for an existing election. Ask the partnership’s accountant whether a Section 754 statement was ever filed and never revoked.
• Amend the operating agreement. Add language that requires the partnership to make the election when a partner dies, at the request of the heir or trustee.
• Coordinate after a death. The trustee, the estate’s CPA and the partnership’s accountant should agree on the election before that year’s partnership return is filed.

Missed beneficiary forms, outdated ownership and overlooked elections like this one are the quiet reasons family money ends up with the IRS instead of the next generation (we put the full estate checklist in a free guide, here).

Here is the key figure: one written statement, filed with the partnership return for the year of death, decides whether the step-up reaches the partnership’s assets.

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