Sale Or Exchange

March 13, 2024

7537 / How is the sale or disposition of stock or securities in a wash sale taxed?

<div class="Section1">No special tax rules apply if an investor realizes a gain in a wash sale of stock or other securities; rather, the sale will be taxed under the rules peculiar to both the type of disposition and to the particular stock or security sold. For the taxation of gain on treasury bills, bonds and notes, and municipal bonds, see respectively Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7626">7626</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7632">7632</a>, and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7663">7663</a>. For taxation of gain on corporate obligations, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7628">7628</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7635">7635</a>. For taxation of stock, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7517">7517</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7522">7522</a>.<div class="Section1"> On the other hand, to the extent that shares of stock or securities sold are replaced in a wash sale (as defined in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7536">7536</a>), any loss realized on the stock or securities sold may not be recognized for income tax purposes and, therefore, may not be used to offset capital gains or otherwise deducted. However, if the quantity of the stock or securities sold at a loss exceeds the quantity replaced, the loss realized on the excess shares or securities may be recognized as a capital loss for income tax purposes.<a href="#_ftn1" name="_ftnref1">1</a> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC § 1091(b); Treas. Reg. § 1.1091-1(c); Rev. Rul. 70-231, 1970-1 CB 171. </div></div>

March 13, 2024

7518 / What is a demutualization? What is the tax treatment of stock sold by a taxpayer following a demutualization?

<div class="Section1">A “demutualization” occurs when a mutually-owned life insurance company (i.e., a company owned by its policyholders, or “members”) converts into a publicly-owned company (i.e., a company owned by its shareholders). Essentially, the members exchange their rights in the mutual life insurance company (i.e., voting and dividend rights) for shares of stock in the “demutualized” company. Where a taxpayer (trust) was a former policy holder in a mutual life insurance company and received shares of stock when that company “demutualized,” and the taxpayer sold its shares and then reported gain—based on the then prevalent belief that the “basis” of such stock was zero—the U.S. Court of Federal Claims held that the taxpayer was entitled to a refund of tax paid. The court analyzed the application of the “open transaction doctrine” to the transaction, and then determined that because the amount received by the trustee was less than the trust’s cost basis in the policy as a whole, the taxpayer, in fact, did not realize any income on the sale of the shares.<a href="#_ftn1" name="_ftnref1">1</a></div> <div class="Section1"> For guidance on determining the (1) holding period and (2) capital gain treatment of stock received by a policyholder in a demutualization transaction that does (or does not) qualify as a tax-free reorganization, see CCA 200131028. </div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. Fisher v. U.S., 333 Fed. Appx. 572, 2008-2 USTC ¶ 50,481 (Ct. Cl. 2008), aff’d per curiam, 2010-1 USTC ¶ 50,289 (Fed. Cir. 2009). </div>

March 13, 2024

7528 / What is “substantially identical property”?

<div class="Section1">In the case of stock and securities, “substantially identical property,” for purposes of the short sale rules, has the meaning given to “substantially identical stock or securities” for purposes of the wash sale rule.<a href="#_ftn1" name="_ftnref1">1</a> See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7539">7539</a> for details. It would appear that the same definition should apply for purposes of constructive sales of appreciated financial positions under IRC Section 1259.<div class="Section1"> A securities futures contract (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7586">7586</a>) to acquire substantially identical property will be treated as substantially identical property.<a href="#_ftn2" name="_ftnref2">2</a> In addition, for purposes of short sales entered into as part of an arbitrage operation (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7533">7533</a>), a taxpayer will be deemed to hold substantially identical property for arbitrage operations at the close of any business day if he or she owns any other property acquired for arbitrage operations (whether or not substantially identical) or has entered any contract in an arbitrage operation which in either case, at the close of that day, gives the taxpayer the right to receive or acquire substantially identical property.<a href="#_ftn3" name="_ftnref3">3</a> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   Treas. Reg. § 1.1233-1(d). <a href="#_ftnref2" name="_ftn2">2</a>.   IRC § 1233(e)(2)(D). <a href="#_ftnref3" name="_ftn3">3</a>.   IRC § 1233(f)(3); Treas. Reg. § 1.1233-1(f)(2). </div></div>

March 13, 2024

7532 / May an investor deduct expenses incurred in reimbursing the lender of stock in a short sale for stock dividends and liquidating dividends paid on the borrowed stock?

<div class="Section1">The cost of purchasing additional shares of stock to reimburse the lender for nontaxable stock dividends and any amount paid to reimburse the lender for a liquidating dividend are always capital expenditures and not tax deductible.<a href="#_ftn1" name="_ftnref1">1</a> As such, these amounts should be added to the investor’s basis in the stock used to close the short sale.</div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. Rev. Rul. 72-521, 1972-2 CB 128. </div>

March 13, 2024

7517 / How is a shareholder taxed on the sale or exchange of stock?

<div class="Section1">Generally, a shareholder who sells or exchanges stock (other than IRC Section 1202 stock, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7522">7522</a>) for other property realizes a capital gain or loss.<a href="#_ftn1" name="_ftnref1">1</a> Whether such gain or loss is short-term or long-term usually depends on how long the shareholder held the stock before selling (or exchanging) it.<a href="#_ftn2" name="_ftnref2">2</a> For an explanation of how the holding period is calculated, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="699">699</a>; for the treatment of capital gains and losses, including the lower rates for capital gains, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="702">702</a>.<div class="Section1">Specific circumstances may result in the conversion of what appears to be a long-term capital gain to short-term, short-term capital loss to long-term, capital gain to ordinary income, or the disallowance of a loss. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7507">7507</a> concerning stripped preferred stock, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7616">7616</a> concerning conversion transactions, and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="701">701</a> concerning sales between related individuals. Also, certain derivative securities transactions may result in a constructive sale (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7617">7617</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7621">7621</a>) with respect to an appreciated stock position, which may result in immediate recognition of gain, and the start of a new holding period. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7525">7525</a> concerning short sales and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7588">7588</a> concerning futures and forward contracts.</div><div class="Section1"> For an explanation of the rollover of gain into specialized small business investment company stock for tax years prior to 2018, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7520">7520</a>.For an explanation of the 50 percent (or 75 percent or 100 percent) exclusion for gain from the sale of qualified small business stock, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7522">7522</a>. Assuming none of the special rules described above applies, when shares of stock are sold, the amount of gain (or loss) is the difference between the selling price and the shareholder’s tax basis in the shares at the time of sale. If the shares are exchanged for property, or for property and cash, the amount of gain (or loss) is the difference between the fair market value of the property plus the cash received in the exchange and the shareholder’s tax basis.<a href="#_ftn3" name="_ftnref3">3</a> But if common stock in a corporation is exchanged for common stock in the same corporation, or if preferred stock is exchanged for preferred stock in the same corporation, gain or loss is generally not recognized unless cash or other property is also received; that is, the exchange is taxed in substantially the same manner as a “like-kind” exchange (noting that these Section 1036 exchanges are different from the generally applicable Section 1031 exchange rules, which now only apply to real estate exchanges post-reform). The exchange of shares of different corporations and exchanges of common for preferred do not qualify for the general “like-kind” exchange rules, even if the shares are similar in all respects.<a href="#_ftn4" name="_ftnref4">4</a> The nonrecognition rules of IRC Section 1036 apply to exchanges of common stock for common stock in the same corporation, even though the shares are of a different class and have different voting, preemptive, or dividend rights.<a href="#_ftn5" name="_ftnref5">5</a> For an explanation of “like-kind” exchanges, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="710">710</a>. Special rules apply to exchanges of stock made pursuant to a plan of corporate reorganization.<a href="#_ftn6" name="_ftnref6">6</a> The IRS has released regulations under IRC Section 358 providing guidance regarding the determination of the basis of stock or securities received in exchange for, or with respect to, stock or securities in certain transactions (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="692">692</a>).<a href="#_ftn7" name="_ftnref7">7</a> If a shareholder’s holdings in a company’s stock were all acquired on the same day and at the same price, the shareholder will have little difficulty in establishing the tax basis and holding period for the shares sold or exchanged. But where the shares were acquired at different times or prices and the shareholder sells less than all of the holdings in the stock, the process becomes more difficult while also becoming more significant. Unless the shareholder can “adequately identify” the lot from which the shares being sold originated, the shares sold will be deemed to have come from the earliest of such lots purchased or acquired (i.e., under a first-in, first-out (FIFO) method).<a href="#_ftn8" name="_ftnref8">8</a> For an explanation of how lots can be “adequately identified,” see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="700">700</a> and Treasury Regulation Section 1.1012-1. If the stock sold was acquired on the conversion of a market discount bond, a portion of the sales proceeds may have to be treated as interest income (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7648">7648</a>). </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC §§ 1221, 1222. <a href="#_ftnref2" name="_ftn2">2</a>.   IRC §§ 1222, 1223. <a href="#_ftnref3" name="_ftn3">3</a>.   IRC § 1001. <a href="#_ftnref4" name="_ftn4">4</a>.   IRC § 1036; Treas. Reg. § 1.1036-1. See IRC § 1031(a). <a href="#_ftnref5" name="_ftn5">5</a>.   Rev. Rul. 72-199, 1972-1 CB 228. See Treas. Reg. § 1.1036-1. <a href="#_ftnref6" name="_ftn6">6</a>.   IRC § 354. <a href="#_ftnref7" name="_ftn7">7</a>.   Treas. Reg. §§ 1.358-1, 1.358-2. <a href="#_ftnref8" name="_ftn8">8</a>.   Treas. Reg. § 1.1012-1(c). </div></div>

March 13, 2024

7519 / What are the basis reporting rules that became effective in 2011? To which types of securities do the new rules apply?

<div class="Section1">Under current law, brokers are required to file annual information returns with the IRS showing the gross proceeds realized by customers from various sales transactions.<a href="#_ftn1" name="_ftnref1">1</a> Under EIEA 2008, new requirements were enacted with respect to the reporting of a customer’s basis in securities,<a href="#_ftn2" name="_ftnref2">2</a> and rules were put in place for determining the basis of certain securities subject to the new reporting requirements.<a href="#_ftn3" name="_ftnref3">3</a> The reporting requirements and basis rules generally took effect on January 1, 2011.<a href="#_ftn4" name="_ftnref4">4</a> Final regulations were released in October 2010.<a href="#_ftn5" name="_ftnref5">5</a></div> <div class="Section1"> Under Section 6045(g), every broker that is required to file a return from the sale of a “covered security” must now include in the return (1) the customer’s adjusted basis, and (2) whether any gain or loss with respect to the security is long-term or short-term.<a href="#_ftn6" name="_ftnref6">6</a> A “covered security” is any “specified security” acquired on or after the “applicable date” if the security was (1) acquired through a transaction in the account of which the security was held, or (2) transferred to that account from an account in which the security was a covered security (but only if the transferee broker received a statement under Section 6045A).<a href="#_ftn7" name="_ftnref7">7</a> A “specified security” is: (1) any share of stock in a corporation (including stock of a mutual fund); (2) any note, bond, debenture, or other evidence of indebtedness; (3) any commodity, or a contract or a derivative with respect to the commodity (if the Treasury Secretary determines that adjusted basis reporting is appropriate); or (4) any other financial instrument with respect to which the Treasury Secretary determines that adjusted basis reporting is appropriate.<a href="#_ftn8" name="_ftnref8">8</a> The “applicable dates” are as follows: stock in a corporation – January 1, 2011; stock in a mutual fund, or stock acquired in connection with a dividend reinvestment plan – January 1, 2012; any other specified security – January 1, 2013.<a href="#_ftn9" name="_ftnref9">9</a> The Service announced, however, that the basis reporting requirement for debt instruments and options was not effective until January 1, 2014.<a href="#_ftn10" name="_ftnref10">10</a> Form 1099-B. Effective after December 31, 2008, EIEA extended the deadline for furnishing information statements to customers from January 31 to February 15.<a href="#_ftn11" name="_ftnref11">11</a> EIEA 2008 also provided new rules for determining the basis of certain securities subject to the new reporting requirements.<a href="#_ftn12" name="_ftnref12">12</a> The adjusted basis of any security (other than stock in a mutual fund, or stock acquired in connection with a dividend reinvestment plan) is determined under the first-in-first-out method unless the customer notifies the broker by making an adequate identification of the stock sold at the time of sale.<a href="#_ftn13" name="_ftnref13">13</a> For any sale, exchange, or other disposition of a specified security on or after the applicable date, the conventions prescribed by the Treasury regulations for determining adjusted basis (i.e., the first-in-first-out, specific identification, and average basis conventions) must be applied on an account-by-account basis.<a href="#_ftn14" name="_ftnref14">14</a> An exception for uncorrected, de minimis errors now applies.<a href="#_ftn15" name="_ftnref15">15</a> </div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 6045(a). <a href="#_ftnref2" name="_ftn2">2</a>. IRC §§ 6045(g), 6045(h), 6045A, 6045B, as added by EIEA 2008. <a href="#_ftnref3" name="_ftn3">3</a>. IRC § 1012, as amended by EIEA 2008. <a href="#_ftnref4" name="_ftn4">4</a>. Notice 2009-17, 2009-1 CB 575. <a href="#_ftnref5" name="_ftn5">5</a>. TD 9504, 75 Fed. Reg. 64072 (Oct. 18, 2010). <a href="#_ftnref6" name="_ftn6">6</a>. IRC § 6045(g)(3)(A), as added by EIEA 2008; Notice 2009-17, 2009-1 CB 575. <a href="#_ftnref7" name="_ftn7">7</a>. IRC § 6045(g)(3)(A), as added EIEA 2008; Notice 2009-17, 2009-1 CB 575. <a href="#_ftnref8" name="_ftn8">8</a>. IRC § 6045(g)(3)(B), as added by EIEA 2008; Notice 2009-17, 2009-1 CB 575. <a href="#_ftnref9" name="_ftn9">9</a>. IRC § 6045(g)(3)(C)(iii), as added by EIEA 2008; Notice 2009-17, 2009-1 CB 575. <a href="#_ftnref10" name="_ftn10">10</a>. Notice 2012-34, 2012-1 CB 937. <a href="#_ftnref11" name="_ftn11">11</a>. IRC § 6045(b), as amended by EIEA 2008; Notice 2009-17, 2009-1 CB 575. <a href="#_ftnref12" name="_ftn12">12</a>. IRC § 1012, as amended by EIEA 2008; IRC section 6045(g), as added by EIEA 2008; Notice 2009-17, 2009-1 CB 575. <a href="#_ftnref13" name="_ftn13">13</a>. IRC § 6045(g)(2)(B)(i)(I), as added by EIEA 2008; Notice 2009-17, 2009-1 CB 575. <a href="#_ftnref14" name="_ftn14">14</a>. IRC § 1012(c)(1), as added by EIEA 2008; Notice 2009-17, 2009-1 CB 575. <a href="#_ftnref15" name="_ftn15">15</a>. IRC § 6045(g)(2)(B)(iii). </div>

March 13, 2024

7521 / What is qualified small business stock?

<div class="Section1">IRC Section 1202 provides for special treatment of qualified small business stock, which generally means stock (a) in a C corporation that is a “qualified small business; (b) that meets the active business requirement (explained below); (c) that was originally issued after August 10, 1993; and (d) (except as otherwise provided) was acquired by the taxpayer at its original issue in exchange for money or other property (not including stock), or as compensation for services to the corporation.<a href="#_ftn1" name="_ftnref1">1</a> For the tax treatment of qualified small business stock, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7522">7522</a>.<div class="Section1"> An issuing corporation is a qualified small business if it is a domestic corporation with aggregate gross assets of $50,000,000 or less at all times after August 10, 1993. Generally, “aggregate gross assets” means the amount of cash and the aggregate adjusted bases of other property held by the corporation. Under certain circumstances, a parent corporation and its subsidiary corporations may be treated as one corporation for purposes of determining a corporation’s aggregate gross assets.<a href="#_ftn2" name="_ftnref2">2</a> As a general rule, stock acquired by the taxpayer will not be treated as “qualified small business stock” if the issuing corporation has directly or indirectly purchased any of its stock from the taxpayer (or a related person) within two years before or after the date of issuance.<a href="#_ftn3" name="_ftnref3">3</a> But an issuing corporation may redeem de minimis amounts of stock without the loss of qualified small business stock treatment. Stock redeemed from a taxpayer (or related person) exceeds a de minimis amount of stock only if the aggregate amount paid for the stock exceeds $10,000 and more than 2 percent of the stock held by the taxpayer and related persons is acquired.<a href="#_ftn4" name="_ftnref4">4</a> Similarly, stock issued by a corporation will generally not be treated as qualified small business stock if the issuing corporation makes a significant redemption of stock or, in other words, redeems stock with an aggregate value of more than 5 percent of the value of all of its stock within one year before or after the date of issuance.<a href="#_ftn5" name="_ftnref5">5</a> But an issuing corporation may redeem de minimis amounts of stock without the loss of qualified small business stock treatment. Stock redeemed by an issuing corporation exceeds a de minimis amount only if the aggregate amount paid exceeds $10,000 and more than 2 percent of all outstanding stock is purchased.<a href="#_ftn6" name="_ftnref6">6</a> In addition, the following stock redemptions are disregarded in determining whether redemptions exceed de minimis amounts and will not result in the loss of qualified small business stock treatment: (1) a redemption of stock acquired in connection with the performance of services as an employee or director (or an option to acquire such stock) incident to the seller’s retirement or other bona fide termination of such services; (2) a purchase from a deceased shareholder’s estate, beneficiary, heir, surviving joint tenant, surviving spouse, or a trust established by the decedent or decedent’s spouse, and the purchase is within three years and nine months of the decedent’s death, provided that prior to the decedent’s death, the stock (or an option to acquire the stock) was held by the decedent or decedent’s spouse (or by both), by the decedent and joint tenant, or by a trust revocable by the decedent or decedent’s spouse (or by both); (3) a purchase incident to the disability or mental incompetence of the selling shareholder; or (4) a purchase incident to the divorce (within the meaning of IRC Section 1041(c)) of the selling shareholder (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="789">789</a>). Also, transfers by shareholders to an employee or independent contractor (or beneficiary thereof) in connection with the performance of services are generally not treated as redemptions.<a href="#_ftn7" name="_ftnref7">7</a> Stock acquired through the conversion of qualified small business stock of the same corporation will be considered qualified small business stock held for the same period that the converted stock was held by the taxpayer.<a href="#_ftn8" name="_ftnref8">8</a> In order to satisfy the active business requirement, at least 80 percent of the issuing corporation’s assets must be committed to the active conduct of one or more “qualified trades or businesses,” and the corporation must be an “eligible corporation.”<a href="#_ftn9" name="_ftnref9">9</a> (A specialized small business investment company is not subject to this requirement,<a href="#_ftn10" name="_ftnref10">10</a> see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7520">7520</a>.) A “qualified trade or business” is a trade or business other than one that involves (a) the performance of services in a field where the principal asset of the trade or business is the reputation or skill of one or more employees, such as the fields of law, accounting, performing arts, or athletics; (b) any insurance, banking, financing, leasing, investing, or similar business; (c) any farming business; (d) any mining business for which a percentage depletion deduction is allowed under the IRC; or (e) any business operating a hotel, motel, restaurant, or similar business.<a href="#_ftn11" name="_ftnref11">11</a> Regardless of whether the active business requirement is met, stock will not be treated as qualified small business stock unless the issuing corporation is an eligible corporation. An “eligible corporation” is a domestic corporation other than (a) a domestic international sales corporation (“DISC”) or former DISC; (b) a regulated investment company (“RIC”), a real estate investment trust (“REIT”), or a real estate mortgage investment conduit (“REMIC”); (c) a cooperative; or (d) a corporation that has made an election under IRC Section 936 (relating to the U.S. possession tax credit).<a href="#_ftn12" name="_ftnref12">12</a> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC § 1202(c)(1). <a href="#_ftnref2" name="_ftn2">2</a>.   IRC § 1202(d). <a href="#_ftnref3" name="_ftn3">3</a>.   IRC § 1202(c)(3)(A). <a href="#_ftnref4" name="_ftn4">4</a>.   Treas. Reg. § 1.1202-2(a)(2). <a href="#_ftnref5" name="_ftn5">5</a>.   IRC § 1202(c)(3)(B). <a href="#_ftnref6" name="_ftn6">6</a>.   Treas. Reg. § 1.1202-2(b)(2). <a href="#_ftnref7" name="_ftn7">7</a>.   Treas. Reg. §§ 1.1202-2(c), 1.1202-2(d). <a href="#_ftnref8" name="_ftn8">8</a>.   IRC § 1202(f). <a href="#_ftnref9" name="_ftn9">9</a>.   IRC § 1202(e)(1). <a href="#_ftnref10" name="_ftn10">10</a>.   IRC § 1202(c)(2)(B). <a href="#_ftnref11" name="_ftn11">11</a>.   IRC § 1202(e)(3). <a href="#_ftnref12" name="_ftn12">12</a>.   IRC § 1202(e)(4). </div></div>

March 13, 2024

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

<div class="Section1">Generally, a noncorporate taxpayer, including certain partnerships and S corporations, may elect to roll over gain from the sale or exchange of qualified small business stock held more than six months to the extent that the taxpayer purchases other qualifying small business stock within 60 days of the sale of the original stock.<a href="#_ftn1" name="_ftnref1">1</a><div class="Section1"> 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.<a href="#_ftn2" name="_ftnref2">2</a> Rules similar to those applicable to rollovers of gain by an individual from certain small business stock<a href="#_ftn3" name="_ftnref3">3</a> will apply to the rollover of such gain by a partnership or S corporation.<a href="#_ftn4" name="_ftnref4">4</a> 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.<a href="#_ftn5" name="_ftnref5">5</a> (A similar rule applies to S corporations.)<a href="#_ftn6" name="_ftnref6">6</a> 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.<a href="#_ftn7" name="_ftnref7">7</a> 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.<a href="#_ftn8" name="_ftnref8">8</a> 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="7521">7521</a>).<a href="#_ftn9" name="_ftnref9">9</a> 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.<a href="#_ftn10" name="_ftnref10">10</a> 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.<a href="#_ftn11" name="_ftnref11">11</a> 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.<a href="#_ftn12" name="_ftnref12">12</a> 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.<a href="#_ftn13" name="_ftnref13">13</a> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC § 1045(a). <a href="#_ftnref2" name="_ftn2">2</a>.   IRC § 1045(a). <a href="#_ftnref3" name="_ftn3">3</a>.   IRC § 1202. <a href="#_ftnref4" name="_ftn4">4</a>.   IRC § 1045(b)(5). <a href="#_ftnref5" name="_ftn5">5</a>.   Treas. Reg. §§ 1.1045-1(b)(1), 1.1045-1(g)(3)(i). <a href="#_ftnref6" name="_ftn6">6</a>.   General Explanation of Tax Legislation Enacted in 1998 (JCS-6-98), p. 167 (the 1998 Blue Book). <a href="#_ftnref7" name="_ftn7">7</a>.   TD 9353, 2007-2 CB 721. <a href="#_ftnref8" name="_ftn8">8</a>.   IRC § 1045(b)(3). <a href="#_ftnref9" name="_ftn9">9</a>.   IRC §§ 1045(b)(4), 1223(15). <a href="#_ftnref10" name="_ftn10">10</a>.   Rev. Proc. 98-48, 1998-2 CB 367. <a href="#_ftnref11" name="_ftn11">11</a>.   Rev. Proc. 98-48, 1998-2 CB 367. <a href="#_ftnref12" name="_ftn12">12</a>.   Rev. Proc. 98-48, 1998-2 CB 367. <a href="#_ftnref13" name="_ftn13">13</a>.   Let. Rul. 200604004. </div></div>

March 13, 2024

7527 / How is a short sale taxed when the property sold becomes substantially worthless?

<div class="Section1">Ordinarily, whether capital gain or loss on a short sale is long-term or short-term will be determined by how long the seller held the stock used to close the sale.<a href="#_ftn1" name="_ftnref1">1</a> For most purposes, the holding period requirement for claiming long-term capital gain tax treatment is “more than one year.” (See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="702">702</a> for the treatment of capital gains and losses.)<div class="Section1"> Under provisions predating the constructive sale rules (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7617">7617</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7621">7621</a>) to prevent individuals from using short sales to convert short-term gains to long-term gains or long-term losses to short-term losses, and to prevent the creation of artificial losses, the IRC and regulations provide special rules as follows: (1) If on the date the short sale is closed, any “substantially identical property” (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7528">7528</a>) has been held by the seller for a period of one year or less, any gain realized on property used to close the sale will, to the extent of the quantity of such substantially identical property, be short-term capital gain.<a href="#_ftn2" name="_ftnref2">2</a> This is true even though the stock actually used to close the short sale has been held by the seller for more than one year. This rule does not apply to losses realized on the property used to close the sale. (2) If any substantially identical property is acquired by the seller after the short sale and on or before the date the sale is closed, any gain realized on property used to close the sale will, to the extent of the quantity of such substantially identical property, be short-term capital gain.<a href="#_ftn3" name="_ftnref3">3</a> This is true regardless of how long the substantially identical property has been held, how long the stock used to close the short sale has been held, and how much time has elapsed between the short sale and the date the sale is closed. This rule does not apply to losses realized on the property used to close the sale. (3) The holding period of any substantially identical property held one year or less, or acquired after the short sale and on or before the date the short sale is closed will, to the extent of the quantity of stock sold short, be deemed to have begun on the date the sale is closed or the date such property is sold or otherwise disposed of, whichever is earlier. If the quantity of such substantially identical property held for one year or less or so acquired exceeds the quantity of stock sold short, the “renewed” holding period will normally be applied to individual units of such property in the order in which they were acquired (beginning with earliest acquisition), but only to so much of the property as does not exceed the quantity sold short. Any excess retains its original holding period.<a href="#_ftn4" name="_ftnref4">4</a> However, where the short sale is entered into as part of an arbitrage operation in stocks or securities (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7533">7533</a>), this order of application is altered so that the “renewed” holding period will be applied first to substantially identical property acquired for arbitrage operations and held at the close of business on the day of the short sale and then in the order of acquisition as described in the previous sentence. The holding period of substantially identical property not acquired for arbitrage operations will be affected only to the extent that the quantity sold short exceeds the amount of substantially identical property acquired for arbitrage operations.<a href="#_ftn5" name="_ftnref5">5</a> If substantially identical property acquired for arbitrage operations is disposed of without closing the short sale, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7534">7534</a>. (4) If on the date of a short sale any substantially identical property has been held by the seller for more than one year, any loss realized on property used to close the sale will, to the extent of the quantity of such substantially identical property, be long-term capital loss.<a href="#_ftn6" name="_ftnref6">6</a> This is true even though the stock actually used to close the short sale has been held by the seller for a year or less. This rule does not apply to gains realized on the property used to close the sale. Capital gain or loss from the sale or exchange of a securities futures contract—see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7586">7586</a>—to sell property (i.e., the short side of a futures contract) will generally be short-term capital gain or loss unless the position is part of a straddle, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7599">7599</a>. In other words, a securities futures contract to sell property is treated as equivalent to a short sale of the underlying property.<a href="#_ftn7" name="_ftnref7">7</a> See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7528">7528</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7539">7539</a> for a discussion of what constitutes substantially identical property for purposes of these rules. </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   Treas. Reg. § 1.1233-1(a)(3). See Bingham, 27 BTA 186 (1932), acq. 1933-1 CB 2. <a href="#_ftnref2" name="_ftn2">2</a>.   IRC § 1233(b)(1); Treas. Reg. § 1.1233-1(c). <a href="#_ftnref3" name="_ftn3">3</a>.   IRC § 1233(b)(1); Treas. Reg. § 1.1233-1(c). <a href="#_ftnref4" name="_ftn4">4</a>.   IRC § 1233(b)(2); Treas. Reg. § 1.1233-1(c)(2). <a href="#_ftnref5" name="_ftn5">5</a>.   IRC § 1233(f); Treas. Reg. § 1.1233-1(f). <a href="#_ftnref6" name="_ftn6">6</a>.   IRC § 1233(d); Treas. Reg. § 1.1233-1(c)(4). <a href="#_ftnref7" name="_ftn7">7</a>.   H.R. Conf. Rep. No. 106-1033 (CRTRA 2000). See IRC § 1234B(b). </div></div>

March 13, 2024

7525 / When and how is a short sale taxed?

<div class="Section1">The timing of the taxable event depends on when the short sale occurs and whether it constitutes a constructive sale of an appreciated financial position (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7617">7617</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7621">7621</a>). Special rules also govern the determination of the holding period of property subject to a short sale (and thus its tax treatment) as explained below.<div class="Section1"> Generally, if a taxpayer holds an appreciated financial position (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7617">7617</a>) that is the same as or substantially identical to the property sold short, the short sale will be treated as a constructive sale of that position, unless certain requirements are met for closing out the short position.<a href="#_ftn1" name="_ftnref1">1</a> Furthermore, if a taxpayer holds a short sale position that has appreciated, the acquisition of the same or substantially identical property (e.g., to cover the short sale) constitutes a constructive sale of the short sale position, which is subject to the same rules.<a href="#_ftn2" name="_ftnref2">2</a> Unless certain exceptions apply, a constructive sale results in immediate recognition of gain as if the position were sold, assigned, or otherwise terminated at its fair market value on the date of the constructive sale.<a href="#_ftn3" name="_ftnref3">3</a> For an explanation of the constructive sale rules for appreciated financial positions under IRC Section 1259, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7617">7617</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7621">7621</a>. A sale of appreciated stock “short against the box” constitutes a constructive sale of an appreciated financial position (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7617">7617</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7621">7621</a>).<a href="#_ftn4" name="_ftnref4">4</a> (Under earlier law, short sales against the box were taxed as a short sale.)<a href="#_ftn5" name="_ftnref5">5</a> The nature of capital gain recognized as a result of a constructive sale of an appreciated financial position may be subject to the rules of IRC Section 1233 and regulations thereunder, which generally govern the determination of a taxpayer’s holding period for gain or loss on short sale transactions. (Those rules are described in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7526">7526</a>.) The treatment of capital gains and losses is explained in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="702">702</a>. In the case of a short sale that, if terminated, would result in a loss, the taxable event following a short sale does not occur until the seller delivers stock to the lender to “close” the sale, not when the sales agreement was made, nor when the borrowed stock was delivered to the purchaser (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7524">7524</a>).<a href="#_ftn6" name="_ftnref6">6</a> If the seller’s tax basis exceeds the sale proceeds, the seller will realize a capital loss.<a href="#_ftn7" name="_ftnref7">7</a> If the seller does not hold the same or substantially identical property, a short sale alone will not result in constructive sale treatment; but at such time as the seller acquires the same or substantially identical property to close the sale, a constructive sale takes place, under the rules described above, if the short position has appreciated.<a href="#_ftn8" name="_ftnref8">8</a> For the tax treatment of the “premium” paid by the short seller to borrow the stock for delivery to the buyer, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7529">7529</a>. The treatment of capital gain or loss on sales is subject to the rules set forth in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="702">702</a>. Special rules are provided where a taxpayer holds an offsetting short position with respect to qualified small business stock, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7522">7522</a>. If a short sale is deemed to be part of a conversion transaction, a portion of the gain recognized upon the sale of stock sold short may be treated as ordinary income.<a href="#_ftn9" name="_ftnref9">9</a> See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7615">7615</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7616">7616</a> for an explanation of conversion transactions and the tax treatment of them. No deduction is allowed for a loss incurred in a short sale if, within the 61-day period that begins 30 days before the date the short sale was closed and ends 30 days after such date, the short seller entered into a wash sale.<a href="#_ftn10" name="_ftnref10">10</a> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC §§ 1259(c)(1)(A), 1259(c)(3). <a href="#_ftnref2" name="_ftn2">2</a>.   IRC § 1259(c)(1)(D). <a href="#_ftnref3" name="_ftn3">3</a>.   IRC § 1259(a). <a href="#_ftnref4" name="_ftn4">4</a>.   IRC §§ 1259(b)(1), 1259(c)(1)(A). <a href="#_ftnref5" name="_ftn5">5</a>.   DuPont v. Comm., 110 F.2d 641 (3d Cir.), cert. den., 311 U.S. 657 (1940). <a href="#_ftnref6" name="_ftn6">6</a>.   Rev. Rul. 2002-44, 2002-2 CB 84. <a href="#_ftnref7" name="_ftn7">7</a>.   Treas. Reg. § 1.1233-1(a). <a href="#_ftnref8" name="_ftn8">8</a>.   IRC § 1259(c)(1)(D). <a href="#_ftnref9" name="_ftn9">9</a>.   IRC § 1258(a). <a href="#_ftnref10" name="_ftn10">10</a>.   IRC § 1091(e); AOD 1985-019. </div></div>