QSBS Tax-Deferred Rollover

TW Langevin

Today, many business owners are aware of qualified small business stock (“QSBS”) and the exclusion from gain on certain sales of QSBS under §^[1] 1202, but it is still common to encounter business owners who are either unaware of QSBS or who hold QSBS and have an opportunity to sell their company prior to satisfying the five-year holding requirement necessary to claim the exclusion. In either case, planning opportunities exist to obtain the benefits of QSBS.

Background

Recall, that § 1202 permits a taxpayer who sells QSBS to exclude from income the greater of $10 million or 10 times the aggregate adjusted bases of QSBS issued by such corporation and disposed of by the taxpayer during the taxable year.^[2] However, to claim that exclusion, the taxpayer must have held the QSBS for at least five years prior to the sale.^[3] Now, imagine a scenario where the taxpayer has held the QSBS for four years and obtains a significant offer to acquire his shares. Many taxpayers might incorrectly believe that their two options are to either: (1) sell their company and forego the QSBS benefit or (2) refuse to sell the company for at least another year, at which point a similar or better offer might not be available. But, there is, in fact, a third option.

Deferral Under Section 1045

The planning opportunity centers around § 1045. Section 1045 permits a shareholder to defer otherwise taxable gain on the sale of QSBS (“Original QSBS”) by reinvesting their sale proceeds into shares of a different qualified small businesses (“Replacement QSBS”), so long as the taxpayer has held the Original QSBS for at least six months.^[4] If a shareholder reinvests sales proceeds under § 1045, some or all of the gain that would otherwise be recognized on the sale of the Original QSBS will be deferred until the Replacement QSBS is sold.^[5] In order to timely take advantage of the reinvestment option under § 1045, a taxpayer must make the reinvestment within sixty days from the date the Original QSBS is sold.^[6]

Example 1: Michael founded a company on January 1, 2024, and the corporation’s stock he owns is considered QSBS. The company grew faster than expected and on June 30, 2027, Michael receives a generous offer to acquire his company for $5MM. Since Michael has only held the QSBS for three and one-half years, he cannot exclude any gain from the sale under § 1202. So, Michael’s options are to either: (1) forego the deal until he has held the stock for at least five years, (2) sell the company and pay tax on all $5MM, or (3) sell the company and reinvest some or all of the $5MM into another QSBS.

Based on the above example, assume Michael exercises option three and reinvests $4MM of his proceeds into new QSBS and keeps $1MM. In that scenario, Michael will only pay tax on the $1MM of proceeds retained. Additionally, his holding period in the Original QSBS (3.5 years) will carry over to the Replacement QSBS.^[7]

In the above example, Michael founded his company as a C corporation and obtained QSBS at the outset. But what about someone who has operated a company for years, is considering selling the company in the near future, but just learned of the benefits of QSBS? Proper planning can help that taxpayer as well.

Example 2: Ryan has been operating a manufacturing company for a number of years as a single-member LLC (disregarded for federal income tax purposes). Recently, he has started searching for buyers to acquire his company when he learned of the tax benefits of QSBS. After consulting with his tax adviser, Ryan’s company is incorporated as a C corporation, the stock of which qualifies as QSBS. Six months after incorporation, Ryan sells the stock of his company for $5MM.

Here, similar to Example 1, even though Ryan only very recently obtained QSBS status upon the incorporation of his single-member LLC, Ryan can still utilize § 1045 to defer gain from the sale by reinvesting the proceeds into Replacement QSBS since he held his Original QSBS for at least six months.

Reinvestment Into New Corporation

While people can reinvest their § 1045 deferral proceeds into an already existing corporation that qualifies under § 1202, many people that elect to utilize § 1045 may not desire to find another QSBS-qualified company that is suitable for investment, nor may they have the time since they must reinvest their proceeds within 60 days after the sale of their Original QSBS. One easy solution is for the seller to reinvest the proceeds into a newly-formed corporation that is controlled by the seller. The new seller-controlled corporation can use those proceeds to start a new business or acquire an already existing business that would qualify under § 1202.

If the seller goes the route of forming a new corporation, the seller should be aware that § 1045 requires that the corporation issuing Replacement QSBS must meet § 1202’s active business requirement for at least six months after issuance of Replacement QSBS.^[8] The primary issue is ensuring that the new corporation meets the 80% active business requirement under § 1202(e)(1), which requires that during “substantially all” of that six-month period, 80% (by value) of the corporation’s assets must be used in the active conduct of a trade or business.^[9] In short, a seller that intends to obtain Replacement QSBS through a newly-formed corporation should be prepared to develop and execute on a comprehensive budget and business plan and not sit idly by, otherwise the deferral may be lost.

Election

One final note: utilizing the gain deferral under § 1045 requires the taxpayer to make an election. The taxpayer must attach a statement to their timely filed tax return that they are making an election under § 1045.^[10]

Conclusion

Advanced Sections 1202 and 1045 planning are not commonly understood. Those engaging in advanced planning should consider seeking the advice of tax professionals who regularly handle QSBS issues.

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[1] All references to “Section” or “§” refer to sections of the Internal Revenue Code of 1986, as amended, and applicable Treasury Regulations.

[2] § 1202(b).

[3] § 1202(a)(1).

[4] § 1045(a).

[5] Id.

[6] § 1045(a)(1).

[7] § 1045(b)(4)(A).

[8] § 1045(b)(4)(B).

[9] § 1202(c)(2)(A), 1202(e)(1)(A).

[10] § 1045(a); Rev. Proc. 98-48.