Expertise Beyond the Numbers

Investing Insights Part 2: Are You Utilizing Valuable Tax Planning Opportunities?

As an investor it is important to not overlook important tax incentives. Thoughtful investment planning requires working with a tax advisor to review how you can be managing your portfolio. Taking the time to fully understand the tax consequences through investments in specific funds will help you produce efficient tax results. The following is a deep dive into the potential advantages you can obtain for your investment funds through Section 1045.

Overview

Code Section 1045 of the Internal Revenue Code promotes investment in small businesses by allowing taxpayers to defer the recognition of gain on the sale of qualified small business stock (QSBS), if the proceeds from the sale are reinvested in another QSBS.

Certain requirements must be met in order to make the §1045 election. The taxpayer must:

  • Be a non-corporate taxpayer,
  • Have held the stock for at least six months prior to the sale (for purposes of determining if the six-month requirement is met, the holding period begins with each purchase of QSBS–it does not carry over from previous rollovers made under §1045), and
  • Make the election on or before the due date (including extensions) of their tax return for the tax year in which the QSBS was sold, by attaching a statement to the return.

Additionally, the following criteria must be met:

  • The gain that would be recognized, if no §1045 election were made, cannot be an ordinary gain,
  • The replacement QSBS must be purchased within 60 days of the sale of the QSBS, and
  • The replacement QSBS must meet the active business requirement, as described in §1202(e), for the six month period following the purchase.

Gain may be deferred only to the extent that the amount realized upon the sale of QSBS does not exceed the cost of the replacement QSBS, reduced by the portion of cost already used to defer gain under §1045 with other reinvestments. The amount of deferred gain then reduces the basis in the replacement QSBS.

Rollover by Partnership vs. Rollover by Partner

Both partnerships and the underlying investors of those partnerships can make a §1045 election.

If a partnership makes the §1045 election, eligible partners can defer the recognition of gain on the sale of QSBS. To be an eligible partner, an investor cannot be a corporation and must hold an interest in the partnership at the time of acquisition of the QSBS and at all times until the QSBS is sold. Partners also have the option to opt out of the §1045 election at the individual level, when the election is made at the partnership level.

If a partnership makes the election, it must notify the partners of the election, the purchase of replacement QSBS, and their share of deferred gain. If a partner is not eligible, or opts out of the election, and recognizes the gain, the partner must notify the partnership of the amount of gain recognized by the partner.

If the partnership chooses not to make the §1045 election upon the sale of QSBS, the partners may make the §1045 election at the partner level by purchasing new QSBS directly or through a “purchasing partnership,” a partnership in which they hold an interest.

Tax Planning Considerations

Section 1045 is an often overlooked option for those taxpayers that have held QSBS for more than six months but less than five years, and are not eligible for §1202. Taxpayers can also utilize §1045 in conjunction with §1202 so that any remaining gain not deferred under §1045 may be excluded under §1202. Lastly, if a taxpayer has more than one sale of QSBS during a taxable year, the taxpayer can choose the specific sales for which they would like to elect §1045 treatment.

 

If you plan to invest in small businesses, contact your tax advisor to make sure you are taking advantage of any potential tax saving opportunities.

Robin Boyd and Ashley Caudle co-authored this piece. They are both members of the SC&H Group Investment Funds Tax Team.