Take-Away: The tax benefits from holding and selling qualified small business stock are extraordinary. The Tax Code even provides an opportunity to retain those tax benefits if the small business stock is sold.

Background: I have previously covered the incredible income tax benefits associated with qualified small business stock (QSBS), so those benefits will not be repeated here. As a quick refresher, IRC 1202 provides for the full or partial exclusion of capital gain realized on the sale of qualified small business stock, or QSBS, [C corporate stock]  equal to the larger  of ten times the seller’s basis in the QSBS or $10 million of gain!

Gain Rollover Option: There is a companion Tax Code section to IRC 1202 that is sometimes overlooked. The other code section, IRC 1045, allows the owner of QSBS that sells the stock before the 5-year QSBS holding period to defer the capital gain on the sale of that stock to the extent the sales proceeds are reinvested in another qualified small business (QSB) within 60 days of the sale. IRC 1045 also allows the replacement stock to be classified as QSBS so that the future gain on the sale of the replacement stock can be excluded under IRC 1202.

What is important to keep in mind is that six months after the reinvestment of the QSBS sales proceeds, the deferral aspect of the prior gain operates independently of the QSBS aspect of the replacement stock that is acquired. Consequently, the deferral of the prior QSBS capital gain will not be affected  if the new business in which those sales proceeds are reinvested fails to meet the QSB requirements more than 6 months after the rollover transaction is complete.

The four requirements for the rollover of the QSBS sales proceeds are:

  1. The seller must own the original QSBS for more than 6 months before its sale, without considering any carryover (or tacked) holding periods that may otherwise apply;
  2. The deferral of QSBS gain recognition applies only to the extent the seller reinvests the sales proceeds (not just the gain) in replacement QSBS within 60 days of the sale;
  3. The entity that issues the replacement stock must meet the QSB requirements for at least 6 months after the seller’s acquisition of the stock; and
  4. The seller properly elects the deferral by making an election on or before the due date (including extensions) for filing the income tax return for the year in which the QSBS was sold.

If these qualified rollover rules apply, then the seller takes an income  tax basis and holding period in the replacement QSBS that is determined by reference to the QSBS sold, thus preserving the built-in gain and the applicable exclusion percentage of the original QSBS.

If the seller timely reinvests the QSBS sales proceeds into more than one entity that is a QSB, then the seller can take the position that each replacement entity is a separate issuer for purposes of the $10 million gain exclusion/ 10x basis exclusion limitation. Restated, a rollover of the QSBS gain to multiple entities converts one $10 million of IRC 1202 gain exclusion into multiple $10 million exclusions.

PLR 202244004, August 9, 2022

In this recent PLR the seller screwed up with the 4th qualified rollover requirement. The seller had failed to file his tax return that contained the IRC 1045 election by its extended due date. A partnership was involved as the seller of the QSBS and there had been a delay in the individual partner receiving some K-1’s from the partnership, which was beyond the partner’s control. The QSBS sales proceeds were reinvested by the partner in two separate entities. [Unstated in the PLR was that the seller presumably did not meet the 5-year holding period at the time of sale- otherwise IRC 1202 would have applied.] The IRS held that the partner was entitled to late-filing relief, and it granted the partner an additional 60 days to file his IRC 1045 election. With this ruling the partner can defer the capital gain realized on the sale of QSBS and qualify for an IRC 1202 exclusion on a later sale of the replacement stock in each of the two entities in which the QSBS sales proceeds were reinvested (assuming the QSBS requirements for each entity are met at that time.)  The merger and acquisition activity of the past few years has brought renewed interest to IRC 1045.

Estate Planning: This PLR result is consistent with an earlier missive written a few years back where it was pointed out that a gift of QSBS stock by the donor-shareholder to multiple irrevocable trusts established for that shareholder’s children would also multiply the $10 million maximum gain exclusion by each of the trusts that held the QSBS stock when the stock was ultimately sold. The same would apply if each of those trusts that held the QSBS stock later sold the stock and timely reinvested the QSBS sales proceeds in multiple replacement entities.

Conclusion: Planning for and preserving QSBS, can provide incredible tax breaks. While there are a lot of rules to follow and conditions to be met to meet the QSBS definition, the tax benefits derived from such a classification are extraordinary.