Step-Up in Basis Rules: What Really Happens When a Partner Dies and Why Valuation Matters
Part of Redwood Valuation’s 59th Heckerling Institute Coverage
The step-up in basis remains one of the most powerful tools in estate tax planning. When a partner or business owner dies, the tax basis of their ownership interest is typically adjusted, or “stepped up,” to fair market value as of the date of death. This adjustment can eliminate unrealized capital gains and significantly reduce future tax exposure for heirs.
But as the Heckerling session, “The Great Unknown: What Really Happens When Partners Die?” made clear, applying the step-up in basis is far from straightforward, especially in partnerships and LLCs. Between conflicting tax guidance, incomplete operating agreements, and heightened audit scrutiny, what actually unfolds after a partner’s death often falls into a legal and valuation gray area.
What the Step-Up Is Supposed to Do
In theory, the step-up gives heirs a clean slate by resetting the value of inherited assets to fair market value at the time of death. This can eliminate or reduce capital gains tax when those assets are eventually sold.
But when the inherited asset is an interest in a privately held business, things get more complicated. The tax outcome hinges on a mix of entity-level elections, partnership agreement provisions, and valuation methodology.
Where Things Get Complicated
When a partner passes away, the step-up in basis can occur at two levels: the outside basis (the deceased partner’s interest in the partnership) and the inside basis (the partnership’s underlying assets). Applying the step-up to the inside basis requires the partnership to make a timely election under IRC §754. Without it, heirs may receive a stepped-up outside basis, but still face capital gains on underlying assets within the entity. That mismatch can result in unexpected tax exposure.
Beyond elections, valuation plays a critical role. While fair market value typically accounts for discounts for lack of control and marketability, those discounts may face IRS scrutiny in an estate context, particularly when they’re perceived as aggressive or poorly supported. A defensible valuation must be carefully documented, grounded in accepted methodology, and aligned with the partnership’s governing documents.
Another challenge arises when the deceased partner had a negative capital account or the partnership holds negative basis assets. In these situations, liabilities may exceed asset basis, leading to gain recognition or diminished effectiveness of the step-up. These complexities require a nuanced understanding of both partnership economics and tax law.
In short, basis adjustments in partnership structures demand close coordination among tax, legal, and valuation professionals. Technical missteps can carry serious consequences, while thoughtful planning can unlock significant tax efficiencies.
The Legislative Landscape Is Still in Flux
Although no changes have been enacted, the step-up in basis has been a target for reform over the past decade. Some proposals have included:
Eliminating the step-up for high-net-worth estates
Replacing it with carryover basis
Triggering capital gains recognition at death
Even without legislative change, enforcement pressure has been rising. The IRS has increased its scrutiny around basis calculations, valuation discounts, and the mechanics of §754 elections. Estate planners and advisors must prepare for greater complexity and a shift toward more rigorous examination of this particular area.
This increased scrutiny is part of a broader push to close what policymakers often describe as “loopholes” in the tax code, especially those perceived to benefit high-net-worth estates. The step-up in basis is frequently cited in this context, as it allows significant unrealized gains to escape capital gains tax entirely when assets transfer at death.
In recent years, new funding and marching orders to enhance enforcement have led the IRS to actively target complex estate structures, valuation discounts, and partnership transactions. For estate planners and valuation professionals, this led to expectations of more audits, tougher questions, and a higher burden of proof. The results of the 2024 election and subsequent policy shifts have generated a form of regulatory “whiplash” with the potential of a different Congressional structure every two years and recent Presidential changes every four years, leading to significant differences in approach affecting IRS staffing and priorities.
How Redwood Can Help
When a partner dies, a valuation becomes the foundation of a critical tax position. Given the complexity of basis adjustments in partnership settings, valuations require careful coordination and must reflect economic reality, align with partnership documents, and withstand IRS scrutiny.
Redwood Valuation delivers audit-ready, technically sound valuations grounded in independent analysis and deep professional expertise. With a focus on credibility and economic reality, our experts:
Determine fair market value at date of death, including appropriate discounts
Document valuation assumptions and methodologies for defensibility
Navigate §754 elections and evaluate transfer provisions with respect to valuation impacts
Help identify gaps in partnership agreements and resulting valuation methodology that could affect the step-up or trigger audit exposure
Whether you’re planning proactively for succession or evaluating your partnership structure, Redwood brings clarity and credibility to complex valuation matters.
