Understanding the qualified small business stock tax-free rollover

RC section 1045 allows a shareholder to defer gain realized on the sale of qualified small business (QSB) stock held for more than 6 months where the shareholder uses the sale proceeds to purchase other QSB stock (replacement QSB stock) within 60 days following the date of the sale. If the section 1045 requirements are satisfied, the shareholder can elect to defer the gain realized on the sale of the old QSB stock to the extent the sale proceeds do not exceed the purchase price of the replacement QSB stock. The gain deferred instead reduces the basis of the replacement QSB stock.

Section 1045 differs from section 1202 insofar as it provides a tax deferral rather than a tax exclusion. Section 1045 provides a benefit to QSB shareholders who are unable to benefit from section 1202 (either completely or partially). For example, a shareholder who hasn’t held his QSB stock for the section 1202 five-year-holding period might benefit from the section 1045 deferral, and a shareholder whose gain exceeds her section 1202 per-issuer gain limitation might benefit from the section 1045 deferral on the excess portion.

Qualified small business stock

The section 1045 deferral only applies if both the old stock and the replacement stock are “qualified small business stock” (QSBS) as defined in section 1202.¹ Section 1202’s requirements include, among others:

• The domestic C corporation requirement
• The original issuance requirement
• The $50 million gross assets test
• The qualified trade or business requirement
• The active business requirement
• The no redemption rule.

For a summary of the key section 1202 rules, please see our article: Understanding the qualified small business stock gain exclusion.

Unlike under section 1202, however, for purposes of section 1045, the shareholder only must have held the old QSBS for more than six months (unlike the section 1212 holding period of five years).² Additionally, for purposes of section 1045, the replacement QSB must satisfy the active business requirement for only the first six months of the shareholder’s holding period.³

Note also that the section 1045 deferral does not apply to any gain treated as ordinary income.⁴It also does not apply where the shareholder seeking to defer tax is a C corporation.⁵

So how does the deferral actually work?

Section 1045 states that gain from the sale of the old QSBS is recognized only to the extent that the amount realized on the sale exceeds the cost of any replacement QSBS purchased by the taxpayer within the 60-day period, reduced by any portion of that cost previously taken into account under section 1045.⁶ A taxpayer should, therefore:

1. compute the gain realized on the sale of the old QSBS, then
2. of the realized gain, recognize as taxable income the amount realized from the sale of the old QSBS less the cost of the replacement QSBS, and
3. reduce his basis in the replacement QSBS by the amount of gain computed in step 1 less the amount recognized in step 2.

Example 1: In 2019, Jane purchases stock in ABC Corp, a QSB, for $1M. In 2021, she sells the stock for $6M. Within 60 days she purchases stock of XYZ Corp, also a QSB, for $4M, and she makes a section 1045 election. Jane:

1. realized $5M of gain ($6M amount realized on old QSBS, less $1M basis),
2. must recognize $2 million of that gain ($6M amount realized on old QSBS, less $4M cost of the replacement QSBS), and
3. must reduce the basis of the replacement QSBS by $3 million ($5M realized gain less $2M recognized gain). She, therefore, reduces her replacement QSBS basis from $4M (cost basis) to $1M.

The shareholder does not need to physically trace the proceeds from the sale of the old QSBS to the purchase price payment for the new QSBS. Rather, once she elects section 1045 treatment on the sale of the old QSBS, she is treated as (i) rolling the old QSBS proceeds into the first replacement QSBS she purchases within 60 days thereafter and (ii) rolling the remaining proceeds into the next replacement QSBS she purchases within 60 days after the old QSBS sale (where the purchase price for the first replacement QSBS is less than the proceeds from the old QSBS sale). This continues until all the proceeds from the old QSBS are used up or 60 days has expired, whichever comes first.

Interaction between the section 1202 gain exclusion and section 1045 deferral

Section 1045 primarily serves as a deferral mechanism. However, it also can serve to enable the replacement QSB to meet the five-year holding period requirement.

• Deferral (primary function): As noted above, it works separately from section 1202 to defer gain on the sale of the old QSBS. This gain deferral applies even where the sale of the old stock does not qualify for the section 1202 gain exclusion (because, for example, the taxpayer did not hold the stock for five years), or where the sale of the replacement QSBS does not qualify for the section 1202 gain exclusion (because, for example, the replacement QSB did not satisfy the active business requirement after the first six months of the shareholder’s holding period).

• Exclusion of rollover gain upon subsequent sale (secondary function): Where section 1045 works to defer gain on the old QSBS, for purposes of the section 1202 five-year holding period requirement, the holding period of the replacement QSBS includes the holding period of the old QSBS.⁷

Example 2: In 2015, John purchases stock in ABC Corp, a QSB, for $1M. In 2018, he sells the stock for $3M. Within 60 days he purchases stock of XYZ Corp, also a QSB, for $3M, and makes a section 1045 election. In 2022, he sells the XYZ Corp stock for $6M. John's $2M gain on the sale of the ABC Corp stock qualifies for deferral under section 1045. Additionally, John's holding period for the XYZ Corp stock includes the 3-year period during which John held the ABC Corp. stock; John is therefore deemed to have held the XYZ Corp stock for more than five years (2015 to 2022). 

A taxpayer who sells his QSBS after holding it for more than five years can benefit from both section 1202 and section 1045.

Example 3: In 2015, John purchases stock in ABC Corp, a QSB, for $1M. In 2021, he sells the stock for $15M. Per section 1202, he may exclude $10M (which is the upper limit on the section 1202 exclusion in this case). He may also defer the remaining $4M of gain through a section 1045 rollover.

Example 3(a): Assume the above facts and John purchases replacement QSBS for $13M. John:

1. realized gain (the portion not excludable under section 1202) of $4M,
2. must recognize $2 million of gain ($15M amount realized on old QSBS, less $13M cost of the replacement QSBS), and
3. must reduce the basis of the replacement QSBS by $2 million ($4M realized gain, less $2M recognized gain). He, therefore, reduces his replacement QSBS basis from $13M to $11M.

Example 3(b): Assume the above facts and John purchases replacement QSBS for $9M. In this case, John:

1. realized gain (the portion not excludable under section 1202) of $4M, and
2. must recognize the entire $4 million of gain. This is because the $15M amount realized on the old QSBS, less the $9M cost of the replacement QSBS is $6M, which is more than the $4M realized gain not excluded by section 1202.
3. he, therefore, does not reduce the basis of the replacement QSBS.

What about when the QSBS is held through a flow-through entity?

Section 1045 rollover treatment applies to the sale and purchase of QSBS by an individual, and also applies to the sale and purchase by a flow-through entity (an entity taxed as a partnership or S corporation). Where a flow-through entity sells QSBS, an individual owner of the flow-through entity can take into account her proportionate share of any gain realized by the flow-through entity. Where a flow-through entity buys replacement QSBS, an individual owner of the flow-through entity can take into account her share of any such purchase of replacement QSBS. Section 1045 rollover treatment, therefore, applies whether:

• The old QSBS was held by a flow-through entity (to the extent of the individual’s portion) and the replacement QSBS is held by the individual.
• The old QSBS was held by the individual and the replacement QSBS is held by a flow-through entity (to the extent of the individual’s portion).
• The old QSBS was held by a flow-through entity (to the extent of the individual’s portion) and the replacement QSBS is held by a flow-through entity (to the extent of the individual’s portion).

Although a partner can defer tax when the partnership sells its QSBS, the partner cannot defer tax when the partner sells his partnership interest itself (even if the partnership owned nothing but QSBS).⁸

How does the shareholder make the election?

To obtain the rollover benefit, the shareholder must make an election on or before the due date (including extensions) for filing the income tax return for the tax year in which the QSBS is sold.⁹ The shareholder must report the sale on Form 8949, “Sales and Other Dispositions of Capital Assets,” and file Schedule D, on which the election must be made. A taxpayer who has more than one sale of QSBS in a tax year may make a rollover election for any or all of the sales.¹⁰ The election is revocable only with the prior written consent of the IRS, which a taxpayer must obtain by submitting a request for a private letter ruling.¹¹

Where a flow-through entity holds the QSBS, the flow-through entity itself can make an entity-level section 1045 election on its tax return for the year in which it sold the old QSBS.¹² If the flow-through entity did not make the election, any individual who would therefore recognize tax and who purchases replacement QSBS can instead make the election on her tax return.¹³

Conclusion

The section 1045 gain deferral on the sale of QSBS, like the section 1202 gain exclusion, is a provision intended to incentivize investors to invest in small businesses. Section 1045 may be of significant benefit to many investors, but its requirements must be followed carefully to ensure eligibility for the gain deferral. As illustrated above through some of its key requirements and mechanics, the nuances of the section 1045 rules are complex. Taxpayers should consult with their tax advisors when considering deferring gain under section 1045.

_{^{1. Section 1045(a) and (b)(1).}}

_{^{2. Section 1045(a).}}

_{^{3. Section 1045(b)(4)(B).}}

_{^{4. Section 1045(a).}}

_{^{5. Reg. section 1.1045-1(a).}}

_{^{6. Section 1045(a).}}

_{^{7. Section 1223(13).}}

_{^{8. Reg. section 1.1045-1(g)(1); Reg. section 1.1045-1(i), Ex. 1.}}

_{^{9. Rev. Proc. 98-48, 1998-2 C.B. 367, section 3.01.}}

_{^{10. Rev. Proc. 98-48, section 3.03.}}

_{^{11. Rev. Proc. 98-48, section 3.04.}}

_{^{12. Reg. section 1.1045-1(b).}}