According to the Internal Revenue Service, the 2019 tax year saw more than 25 million partners comprising nearly four million tax returns filed by partnerships 2019. With many concerns necessary for navigating the U.S. tax code, including filing annual returns, one important consideration for partnerships and their partners is how to calculate tax liability. To determine how much they profit or lose on their investment, there must be an accurate calculation of adjusted cost basis via outside cost and inside cost basis.
According to the Internal Revenue Code (IRC), one aspect of Section 754 details how the tax basis of partnership assets is handled. When partnerships change, or when there are changes in partnership interest, it helps to rebalance the basis of the business entity's property. This entails defining and calculating both the outside cost basis and the inside cost basis. 
Understanding Outside Cost Basis
Outside cost basis refers to the percentage of interest each partner owns in a partnership. For example, if three partners own a partnership and each partner contributes $200,000, this establishes their outside cost basis. Recording what each initial partner contributes to the partnership is essential to determine their tax basis, including whether they’ve established a loss or gain, and therefore their tax obligations.
Understanding Inside Cost Basis
As the IRC explains it, “Inside basis refers to a partnership's basis in its assets.” One way to look at it is if three partners bought an asset for $600,000, each contributing $200,000 (symbolizing their inside cost basis), their respective inside basis in that particular asset would be $200,000.
When to Consider a Section 754 Election
It’s important to distinguish that partnerships adding or selling partnership interests must consider how such changes impact owners’ tax basis. By making a Section 754 election, partnerships can adjust the cost basis for new partners to provide an accurate accounting of profits (or losses). Assume five partners contributed $200,000 to a partnership and bought an asset for $1 million. A year later, the asset appreciated to $1.3 million. The outside basis is $200,000 (per partner) and the inside basis is $1 million.
Assume the asset appreciates to $1.3 million and one of the original five partners wants to cash out and sell their portion to a new, independent partner for $260,000. The original partner must pay taxes on the appreciation of $60,000 when exiting the partnership. Assume three months later, the asset is sold at the same price of $1.3 million with no Section 754 election. The four original partners are faced with a taxable gain of $60,000 each ($1.3 million selling price Р$1 million inside basis) / 5 partners = $300,000 profit / 5 partners). However, despite the new partner’s outside basis of $260,000, they would face the same $60,000 tax liability.
However, if a partnership chose to elect its partnership to Section 754, the new partner’s tax basis is “stepped up” to $260,000 instead of remaining at the original partner's basis of $200,000. The new partner’s inside cost basis will remain at $200,000, requiring no adjustment. However, the new partner now has an outside basis of $260,000 – the amount the partnership interest was sold for from the original partner to the new partner.
While each business arrangement is unique, for partnerships that see their assets regularly increase in value and experience frequent changes in partners, it could make sense to go with a Section 754 election.