IRS Grants a “Do Over” to a Taxpayer Engaging in a Qualified Rollover

The IRS recently released a private letter ruling (PLR 202244004 (August 9, 2022)) that grants additional time to a taxpayer that failed to timely elect to defer the gain from a rolloverof qualified small business stock (QSBS). The IRS’s decision to grant late-filing relief in this context is not that surprising or ground-breaking, but it does highlight an important tax strategy that we are starting to see with increasing frequency.

QSBS Generally

Section 1202 generally provides for the full or partial exclusion of capital gain realized on the sale of QSBS. If the requirements are met, then taxpayers can exclude from gross income capital gain in an amount equal to the greater of (i) $10 million, or (ii) an annual exclusion of 10 times their basis in the stock sold (for an exclusion amount up to $500 million). Both of these limitations apply on a per-issuer and per-taxpayer basis, and while the exclusion is limited to the greater of the two rules, in practice, the $10 million rule is most often the limiting factor in start-up ventures.

Qualified Rollovers

Section 1045 is a companion to section 1202. It allows taxpayers that sell QSBS before the 5-year holding period is met to defer capital gain on the sale to the extent the sale proceeds are reinvested into another qualified small business (QSB) within 60 days of the sale. It also allows the replacement stock to constitute QSBS so that future gain on a sale of the replacement stock can be excluded under section 1202.

The nice thing about section 1045 is that six months after the reinvestment, the deferral aspect of the prior gain operates independently of the QSBS aspect of the replacement stock. Thus, deferral of the prior gain will not be affected if the new business fails to meet the QSB requirements more than 6 months after the rollover transactions.

The main requirements for a qualified rollover are —

  1. The taxpayer must own the original QSBS for more than 6 months before its sale, without considering any carryover (or tacked) holding periods that may apply.
  2. The deferral of gain recognition applies only to the extent the taxpayer reinvests the sale proceeds (not just gain) in replacement QSBS within 60 days of the sale.
  3. The entity issuing the replacement QSBS must meet the QSB requirements for at least 6 months after the taxpayer’s acquisition of the stock.
  4. The taxpayer properly elects deferral by making an election on or before the due date (including extensions) for filing the tax return for the year in which the QSBS is sold.

If the qualified rollover rules apply, then the taxpayer takes a basis and holding period in the replacement QSBS that is determined by reference to the QSBS sold, thus preserving the built-in gain and the applicable exclusion percentage of the original QSBS.

If a taxpayer timely reinvests QSBS sale proceeds into more than one entity that is a QSB, as did the taxpayer in the ruling discussed below, then he/she can take the position that each replacement entity is a separate issuer for purposes of the $10M/10x basis limitation. For example, this can convert one $10 million exclusion into multiple $10 million exclusions.

The Ruling

In the recent private letter ruling, the taxpayer failed the fourth requirement above. The taxpayer indirectly, through a partnership, sold QSBS and reinvested the proceeds into two different QSBs (likely to double up the future section 1202 exclusion) within 60 days but failed to file his/her tax return containing the section 1045 election by the extended due date. The taxpayer represented to the IRS that the tax return was filed late because “the preparation of [the] federal individual income tax return is complex due to numerous interests in partnerships,” and there was a delay in receiving some of the Schedule K-1s, which was beyond the taxpayer’s control. The taxpayer thus failed to properly elect deferral under section 1045 on his/her timely filed tax return (including extensions). Although unstated, the taxpayer presumably did not meet the 5-year holding period at the time of sale; otherwise, section 1202 would have applied.

The IRS routinely grants extensions of certain elections (e.g., late subchapter S corporation elections) under regulations written for that purpose. This is the first time, however, that the IRS extended late-filing relief to an election under section 1045.

In a nutshell, late-filing relief is granted to taxpayers who act reasonably and in good faith, and granting relief will not prejudice the interests of the government.

A taxpayer is deemed to have acted reasonably and in good faith if it —

  1. Requests relief before the failure to make the regulatory election is discovered by the IRS;
  2. Failed to make the election because of intervening events beyond the taxpayer's control;
  3. Failed to make the election because, after exercising due diligence, the taxpayer was unaware of the necessity for the election;
  4. Reasonably relied on the written advice of the IRS; or
  5. Reasonably relied on a qualified tax professional, including a tax professional employed by the taxpayer, and the tax professional failed to make, or advise the taxpayer to make the election.

One common reason the IRS uses to conclude a taxpayer did not act reasonably and in good faith is that the taxpayer acted with hindsight,i.e., it determined after the due date of the election that it would have been advantageous to have filed the election.

The interests of the government generally are considered prejudiced if granting relief would result in the taxpayer having a lower tax liability for all taxable years affected by the election than the taxpayer would have had if the election had been timely made,e.g., the statute of limitations is closed for the tax year in which the election should have been filed.

Under these criteria, the IRS concluded that the taxpayer was entitled to late-filing relief, and it granted the taxpayer an additional 60 days to file the section 1045 election – the “do over.”

The taxpayer’s receipt of this ruling means that he/she can defer the gain realized on the sale of QSBS and qualify for a section 1202 exclusion on a later sale of the replacement stock in each of the two entities (assuming the QSBS requirements for each entity are met at that time). It also means that the taxpayer (and possibly his/her preparer that missed the filing deadline) breathed a huge sigh of relief that a simple mistake will not cost his/her/them potentially millions of dollars in future section 1202 benefits.

The M&A boom of the past couple of years has sparked renewed interest in section 1045. I wrote about this topic a few months back when addressing taxpayers that sell stock before reaching the 5-year holding period. In that article, I concluded that in my experience, one’s willingness to entertain a qualified rollover of QSBS is inversely related to the amount of time needed to reach the 5-year mark. This recent private letter ruling is helpful because mistakes happen, and the more taxpayers engage in qualified rollovers, the more they are going to miss the filing deadlines. Luckily for them and all of us, the IRS is willing to entertain requests for a “do over” in this context.

This article was originally published by Daniel Mayo in Forbes on November 5, 2022.

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For more information on this topic, please contact a member of Withum’s Business Tax Services Team.