7523 / Can a taxpayer elect to roll over gain from the sale or exchange of qualified small business stock?

If the rollover election is made, gain will be recognized only to the extent that the amount realized on the sale exceeds (1) the cost of any qualified small business stock purchased by the taxpayer during the 60-day period beginning on the date of the sale, reduced by (2) any portion of such cost previously taken into account under this rollover provision. The rollover provisions of IRC Section 1045 will not apply to any gain that is treated as ordinary income.²

Rules similar to those applicable to rollovers of gain by an individual from certain small business stock³ will apply to the rollover of such gain by a partnership or S corporation.⁴ Thus, for example, the benefit of a tax-free rollover with respect to the sale of small business stock by a partnership will flow through to an “eligible partner”—i.e., a partner who is not a corporation and who held a partnership interest at all times during which the partnership held the small business stock.⁵ (A similar rule applies to S corporations.)⁶ For the rules regarding, among other things, (1) the deferral of gain on a partnership’s sale of qualified small business stock followed by an eligible partner’s acquisition of qualified replacement stock, and (2) the deferral of gain on a partner’s sale of qualified small business stock distributed by a partnership, see Treasury Regulation Section 1.1045-1, finalized in 2007.⁷

The amount of gain not recognized because of a rollover of qualified small business stock will be applied to reduce (in the order acquired) the basis for determining gain or loss of any qualified small business stock purchased by the taxpayer during the 60-day rollover period.⁸

Ordinarily, the holding period of qualified small business stock purchased in a rollover transaction will include the holding period of the stock sold; but for purposes of determining whether the nonrecognition of gain applies to the stock that is sold, the holding period for the replacement stock begins on the date of purchase. In addition, only the first six months of the taxpayer’s holding period for the replacement stock will be taken into account for purposes of determining whether the active business requirement is met (see Q 7521).⁹

An IRC Section 1045 election must be made by the due date (including extensions) for filing the income tax return for the taxable year in which the qualified small business stock is sold.¹⁰ The election is made by (1) reporting the entire gain from the sale of qualified small business stock on Schedule D; (2) writing “IRC Section 1045 rollover” directly below the line on which the gain is reported; and (3) entering the amount of the gain deferred under IRC Section 1045 on the same line as (2), above, as a loss, in accordance with the instructions for Schedule D.¹¹ If a taxpayer has more than one sale of qualified small business stock in a taxable year that qualifies for the IRC Section 1045 election, the election can be made for any one or more of those sales. An IRC Section 1045 election is revocable only with the Commissioner’s consent.¹²

The Service has stated that in order to be granted approval to make a late Section 1045 election (when the requirements for an automatic extension are not met), the requesting taxpayer must provide evidence to establish that he or she acted reasonably and in good faith and that granting the relief would not prejudice the interests of the government. A taxpayer is deemed to have not acted reasonably and in good faith if the taxpayer either uses hindsight in requesting relief, or was informed in all material respects of the required election and related tax consequences but chose not to file the election. Furthermore, the taxpayer must provide a detailed affidavit from the individuals having knowledge or information about the events leading to the failure to make a valid regulatory election. The affidavit must describe the engagement and responsibilities of the individual as well as the advice that the individual provided to the taxpayer.¹³