Partnership and LLC Interests in a Trust: The § 754 Election, Transfer Restrictions, and Trustee Duties

Your parent's revocable living trust holds a membership interest in a family LLC or a limited partnership interest in a family limited partnership (FLP). You are the successor trustee. This page explains the most commonly missed tax opportunity in trust administration — the IRC § 754 inside-basis election — plus the operating agreement issues, UPIA diversification duties, and Form 1041 reporting that apply to trust-held partnership interests.

Why partnership and LLC interests require special attention

Family limited partnerships (FLPs) and family LLCs treated as partnerships for tax purposes are among the most common estate planning tools for transferable family wealth. A parent who owned business interests, rental real estate, or a diversified investment portfolio may have transferred those assets into an FLP or LLC decades ago for asset protection and estate planning purposes.

From the successor trustee's perspective, these interests look like a single line item on the trust inventory — a percentage ownership interest in an entity. In reality, they involve a multi-layered set of legal, tax, and fiduciary decisions that are entirely distinct from the rules governing publicly traded securities, S-corporation stock, or real estate held directly in the trust.

The two-tier basis problem: outside vs. inside basis

Understanding the § 754 election requires understanding why partnership taxation involves two separate basis concepts:

Outside basis is the partner's (or trust's) basis in its partnership interest — what the trust "paid" for the interest, adjusted for subsequent income, contributions, and distributions. Under IRC § 1014, the trust receives a new outside basis equal to the fair market value of the partnership interest on the date of death.¹ If the deceased parent's FLP interest was worth $1.2 million on the date of death, the trust's outside basis is $1.2 million — regardless of what the parent originally paid.

Inside basis is the partnership's own basis in the assets it holds — the value at which the partnership records its real estate, securities, equipment, or other assets on its internal books. The partnership's inside basis does not automatically change when a partner dies. If the FLP holds real estate the parent bought in 1990 for $200,000 that is now worth $900,000, the FLP's inside basis in that property remains $200,000 even though the trust's outside basis now reflects a $1.2 million interest.

The mismatch creates a double-taxation trap. When the FLP eventually sells the appreciated real estate, the gain at the FLP level ($900,000 − $200,000 inside basis = $700,000) flows through to the trust's Schedule K-1. The trust will pay capital gains tax on its allocable share of that $700,000 — even though the outside basis step-up at death was supposed to eliminate that embedded gain. Without a mechanism to conform inside basis to outside basis, the trust pays tax on appreciation that predated its ownership.

The § 754 election: aligning inside basis with outside basis

IRC § 754 allows the partnership to elect to adjust the inside basis of its assets when a partner dies (or when a partnership interest is transferred), using the mechanics of IRC § 743(b).² When a § 754 election is in effect:

• The partnership allocates an inside-basis "step-up" to the specific assets held by the partnership — in proportion to the unrealized appreciation in each asset at the time of the transfer
• This § 743(b) adjustment reduces the trust's allocable share of future gain when those assets are sold
• The step-up is specific to the trust as the transferee partner — it does not affect other partners' tax positions

Using the example above: the FLP holds real estate with $700,000 of unrealized appreciation. With a § 754 election and § 743(b) adjustment, the trust's share of the inside basis in that real estate increases by the allocable portion of that $700,000. When the FLP sells the property later, the trust's K-1 shows a reduced gain (or no gain, depending on the exact amounts) because the trust has already "paid" for that appreciation via the estate.

Who makes the § 754 election — and when

The § 754 election is made by the partnership or LLC, not by the successor trustee. This is a critical distinction that surprises many trustees: the tax benefit belongs to the trust, but the action required is by a separate entity that the trust does not necessarily control.

How the election is made: The partnership files a written statement with its Form 1065 (the partnership's annual tax return) for the year in which the triggering transfer occurs — the year of the partner's death.⁴ The statement must include a declaration that the partnership elects to apply IRC § 754 and the name and address of the partnership. Once made, the § 754 election is binding on the partnership in all future years (unless the IRS grants permission to revoke it).

The deadline: The election must be made on or before the due date for the partnership's Form 1065, including extensions, for the year of the partner's death. The Form 1065 due date is March 15 of the year following the partnership's tax year (September 15 with extension).

If the election was not made: A late § 754 election requires IRS consent under Revenue Procedure 2011-34, which provides an automatic 12-month extension from the original return due date for partnerships that failed to make the election and meet certain requirements.⁵ Beyond that window, relief requires a private letter ruling, which is time-consuming and not guaranteed.

What the trustee should do immediately: Contact the partnership's accountant or general partner and ask two questions:

1. Does the partnership currently have a § 754 election in effect?
2. If not, has the Form 1065 for the year of the settlor's death been filed? If not, can the partnership make the election on that return?

If the partnership already has a standing § 754 election (made in a prior year for a different transfer), the election is already in effect and applies automatically to the step-up triggered by the settlor's death. Many FLPs established years ago already have this election in place. If not, the trustee has a narrow window to get one made.

The § 743(b) basis adjustment: how the step-up is allocated to assets

Once a § 754 election is in effect, the partnership computes the § 743(b) adjustment and allocates it among the partnership's assets following the rules of IRC § 755.⁶

The total § 743(b) adjustment equals the difference between:

• The trust's new outside basis in the partnership interest (fair market value at date of death, per IRC § 1014); and
• The trust's proportionate share of the partnership's existing inside basis in all of its assets

The adjustment is then allocated among two asset classes: ordinary income property (inventory, receivables, depreciation recapture) and capital gain property (real estate, securities, goodwill). Within each class, the adjustment is allocated to specific assets in proportion to the unrealized appreciation or depreciation in each asset.

Practical implication: A large § 743(b) adjustment allocated to depreciable property — rental real estate, equipment, improvements — may be eligible for bonus depreciation under OBBBA (which permanently restored 100% bonus depreciation for qualifying property placed in service after January 19, 2025). If the partnership elects bonus depreciation on the § 743(b) adjustment, the trust may be able to deduct the entire step-up in the first year rather than depreciating it over 27.5 years (residential real estate) or 39 years (commercial). This can generate a significant first-year deduction that offsets other trust income — an opportunity most trustees never consider.⁷

Operating agreement transfer restrictions

Before the trust can exercise any rights as a partner or member, the successor trustee must review the operating agreement (for an LLC) or limited partnership agreement (for an FLP) carefully for transfer restrictions.

Most family LLC and FLP agreements contain transfer restriction provisions that:

• Require the consent of the existing members or partners before a transferee can be admitted as a "substituted member" or "substituted limited partner" with full voting and management rights
• Grant existing members a right of first refusal if the trust proposes to sell its interest to a third party
• Limit transfers to certain permitted transferees (which typically include revocable trusts of the transferring member, but may not clearly include the trust after the settlor's death)

A trust that acquires an interest without proper admission may be an "assignee" only — entitled to its economic share of distributions and allocations but with no right to vote, inspect books, or participate in management decisions. For most successor trustees, this creates an awkward situation where you receive K-1 income from an entity you have no formal voice in.

Practical steps: Present the Certificate of Trust (or a Certification of Trust under UTC § 1013) and the death certificate to the partnership's general partner or LLC manager, and request formal admission as a substituted partner or member. Most governing agreements permit this for successor trustees without requiring a consent vote of all members. If the agreement is ambiguous, the estate attorney handling the trust administration can address it with a brief amendment or written consent of the existing members.

UPIA diversification duty for illiquid business interests

A family FLP or LLC interest is typically an illiquid, undiversified position — the opposite of what a prudent investor would hold in a well-constructed portfolio. The Uniform Prudent Investor Act requires the trustee to consider diversification as a key element of the trust's investment policy, and to take reasonable steps to diversify a concentrated position unless the trust document authorizes retention.⁸

Several factors complicate the diversification analysis for FLP/LLC interests:

• No public market. There is no ready market for a minority interest in a family limited partnership. A sale, if possible, would typically require valuation and negotiation with other family members or a third party. The illiquidity itself is a reason the UPIA analysis matters — the trustee cannot simply "sell" the position if circumstances change.
• Transfer restrictions may limit sale options. Right-of-first-refusal provisions and transfer restrictions in the governing agreement can narrow or effectively eliminate the ability to sell to a third party.
• Retention power clauses. Many trust documents explicitly authorize the trustee to retain closely-held business interests that the settlor contributed to the trust, recognizing that the settlor intended to pass those interests to beneficiaries intact. If such a clause exists, the trustee's diversification obligation is modified — but not eliminated. The trustee must still periodically review whether retention continues to serve the trust's objectives.
• The step-up basis window. In the early months of administration, the trust's outside basis (and potentially § 743(b) inside-basis adjustment) is at its highest. A sale shortly after death may generate minimal capital gain. As the underlying assets appreciate further, the tax cost of sale increases — which can create a lock-in effect that makes the retention decision harder each year.

Whatever the trustee decides, the decision must be documented. The trustee's written record should include: the nature of the partnership interest, the UPIA diversification analysis, the retention power clause (if any), and the rationale for retaining or pursuing sale. This documentation is the trustee's primary defense against a surcharge claim if the interest later declines in value.

Tax reporting: Form 1065 K-1 to Form 1041

Partnership interests are pass-through interests: the partnership files Form 1065 and issues a Schedule K-1 to the trust each year. The trust then reports the allocated income, deductions, and credits on Form 1041 and its own Schedule K-1s to beneficiaries.

Key reporting considerations:

Character matters

The income from a partnership retains its character as it flows through to Form 1041. Ordinary business income from an active partnership is ordinary income; net capital gains from asset sales are capital gain income. This matters because the trust's compressed tax brackets apply to ordinary income at 37% above approximately $16,550 (2026), while long-term capital gains are taxed at 0%, 15%, or 20% depending on the amount, with the 3.8% Net Investment Income Tax applying above $16,250 (2026).³ A K-1 reporting substantial ordinary income (e.g., from an operating FLP) is taxed more harshly inside the trust than LTCG.

The distribution deduction

If the trust distributes partnership K-1 income to beneficiaries during the year, it may take a distribution deduction (limited to Distributable Net Income), shifting the tax to beneficiaries who are likely in lower brackets. However, the 65-day election under IRC § 663(b) allows distributions made within 65 days after year-end to be treated as made on December 31 of the prior year — giving the trustee time to quantify the K-1 income before deciding how much to distribute.⁹

Passive activity rules

If the trust holds a limited partnership interest in an FLP and the FLP has passive losses (e.g., from rental real estate with accelerated depreciation), those losses are passive activity losses at the trust level. Passive losses can only offset passive income unless the trust materially participates in the partnership activity — which is rare for a trust holding a limited interest. Suspended passive losses can be used in the year the trust disposes of the entire passive activity interest.¹⁰

Self-employment tax

Limited partners are generally excluded from self-employment tax under IRC § 1402(a)(13) — their distributive share of partnership income is not subject to SE tax.¹¹ Most trust-held FLP interests are limited partnership interests or non-managing LLC member interests, which qualify for this exclusion. However, if the trust holds a general partnership interest or a managing-member LLC interest, the income may be subject to SE tax at the trust level — an unusual situation worth confirming with the CPA.

When to distribute the partnership interest in kind to beneficiaries

Rather than selling the partnership interest, the trustee may have authority to distribute it in kind to beneficiaries as part of the final distribution. Several tax and practical considerations apply:

• Nonrecognition on distribution: Under IRC § 731, distributions of partnership interests from a trust to beneficiaries are generally nonrecognition events — no immediate gain or loss at the trust level, and the beneficiary takes the trust's adjusted basis in the interest.¹²
• Impartiality duty: If the trust has multiple beneficiaries and only one receives the partnership interest while others receive cash, the trustee must ensure the distribution is equitable in value — which requires a current appraisal of the partnership interest.
• Operating agreement admission: The incoming beneficiary will face the same admission-as-substituted-member process the trust faced. Confirm in advance that the governing agreement permits the proposed transfer.
• Basis tracking passes to the beneficiary: After an in-kind distribution, the responsibility for tracking the § 743(b) inside-basis adjustment and filing positions shifts to the individual beneficiary. They should receive a detailed basis schedule from the trust's CPA.

How a fee-only advisor helps

A partnership or LLC interest in a trust concentrates multiple technical disciplines — partnership tax, trust tax, fiduciary duty, and business valuation — in a single asset. A fee-only financial advisor who works with trustees brings several practical contributions:

• § 754 election identification: Reviewing the trust's asset inventory against the partnership's most recent Form 1065 to determine whether a § 754 election is in effect, and coordinating with the partnership's accountant or general partner to make the election on a timely basis if not
• § 743(b) adjustment analysis: Quantifying the inside-basis step-up, allocating it to the partnership's underlying assets, and evaluating whether bonus depreciation on depreciable assets could accelerate the tax benefit into the current year
• UPIA documentation: Drafting the written Investment Policy Statement that addresses the FLP/LLC concentration, the retention power clause analysis, and the trustee's documented rationale for the hold or sell decision — which is the trustee's primary protection against surcharge claims
• Distribution modeling: Using the trust distribution calculator to compare the after-tax cost of retaining K-1 ordinary income inside the trust (at 37%) versus distributing it to beneficiaries (at their personal rates), incorporating the 65-day election window
• Sale structuring: If selling the interest is the right outcome — to existing partners, in a redemption, or to a third party — modeling installment sale treatment, the UPIA documentation required to support the sale price, and the coordination between the trust's Form 1041 and the partnership's Form 1065

Sources

1. IRC § 1014 — Basis of Property Acquired from a Decedent. Outside basis step-up to fair market value on date of death; applies to partnership interests held in a revocable living trust. LII / Cornell Law School.
2. IRC § 754 — Manner of Electing Optional Adjustment to Basis of Partnership Property. Election by partnership to adjust inside basis of partnership assets when a partnership interest is transferred by death or sale. LII / Cornell Law School.
3. IRS Rev. Proc. 2025-32. 2026 inflation adjustments: trust ordinary income top bracket (37%) begins at approximately $16,550; trust LTCG rate of 20% begins at $16,250; NIIT of 3.8% applies above $16,250. Used to compute after-tax cost of partnership income inside a trust.
4. 26 CFR § 1.754-1 — Time and Manner of Making Election to Adjust Basis of Partnership Property. Election made by partnership with timely-filed Form 1065 for the year of the triggering transfer (partner's death); binding on partnership in all future years. LII / Cornell Law School.
5. Rev. Proc. 2011-34 — Automatic 12-Month Extension for § 754 Elections. Procedure for obtaining an automatic 12-month extension from the return due date to make a § 754 election that was inadvertently omitted. IRS.gov.
6. IRC § 755 — Rules for Allocation of Basis. How the § 743(b) adjustment is allocated among the partnership's assets in two classes (ordinary income property vs. capital gain property) and within each class to specific assets in proportion to unrealized appreciation. LII / Cornell Law School.
7. IRC § 168(k) — Additional First Year Depreciation (Bonus Depreciation). OBBBA (July 2025) permanently restored 100% bonus depreciation for qualifying property placed in service after January 19, 2025. § 743(b) adjustments allocated to depreciable assets may qualify for bonus depreciation, accelerating the deduction to the year of the step-up. LII / Cornell Law School.
8. Uniform Law Commission — Uniform Prudent Investor Act (1994). § 3 diversification duty; § 8 reasonable time to comply at inception of trusteeship; trustee personal liability for undocumented concentration in illiquid positions. Enacted in all 50 states.
9. IRC § 663(b) — 65-Day Election. Distributions made within 65 days after the close of the trust's tax year may be treated as made on the last day of that year, allowing the trustee to time distributions after receiving K-1 income information from the partnership. LII / Cornell Law School.
10. IRC § 469 — Passive Activity Losses and Credits. Passive losses from limited partnership interests suspended at trust level; released in full in year of complete disposition of the passive activity. LII / Cornell Law School.
11. IRC § 1402(a)(13) — Self-Employment Tax Exclusion for Limited Partners. Limited partners' distributive share generally excluded from net earnings from self-employment; applies to most trust-held FLP and non-managing LLC interests. LII / Cornell Law School.
12. IRC § 731 — Extent of Recognition of Gain or Loss on Distribution. Nonrecognition of gain at trust level on in-kind distribution of partnership interest to beneficiary (subject to § 731(a) hot-asset rules); beneficiary takes trust's adjusted basis in the interest. LII / Cornell Law School.

This guide covers federal tax rules. State income tax treatment of partnership income, state partnership law governing transfer restrictions, and state trust law affecting trustee duties vary by state. The tax rates described are for the 2026 tax year per IRS Rev. Proc. 2025-32. The OBBBA bonus depreciation restoration applies to property placed in service after January 19, 2025. Consult a CPA experienced in trust and partnership taxation and a fee-only financial advisor before making decisions about a trust-held partnership or LLC interest.