Section 1045 Application to Partnerships

This document contains final regulations relating to the application of section 1045 of the Internal Revenue Code (Code) to partnerships and their partners. These regulations provide rules regarding the deferral of gain on a partnership’s sale of qualified small business stock (QSB stock) and a partner’s sale of QSB stock distributed by a partnership. These regulations also provide rules for a taxpayer (other than a C corporation) who sells QSB stock and purchases replacement QSB stock through a partnership. The regulations affect partnerships that invest in QSB stock and their partners.

Summary of Comments and Explanation of Revisions

1. QSB Stock — Replacement QSB Stock Requirement

The proposed regulations provided that the term “QSB stock” had the same meaning given such term by section 1202(c) and did not include an interest in a partnership that held QSB stock. Thus, under the proposed regulations, an investment in a partnership that held QSB stock was not treated as an investment in QSB stock. Consequently, a partner that sold an interest in a partnership that held QSB stock was not treated as selling QSB stock, and could not elect to apply section 1045 with respect to gain realized on the sale of the partnership interest. Similarly, under the proposed regulations, a partner that made a section 1045 election with respect to QSB stock sold by the partnership could not treat as replacement QSB stock an interest in a second partnership that held QSB stock.

Commentators agreed that an interest in a partnership that owns QSB stock should not be treated as an investment in QSB stock. Some commentators, however, argued that the final regulations should permit a partner that makes a section 1045 election with respect to QSB stock sold by one partnership to satisfy the replacement QSB stock requirement of section 1045 by holding an interest in a partnership, which acquires QSB stock within the statutory period. Commentators believed that the suggested rule is consistent with the intent of Congress to encourage investments in QSB stock.

The final regulations adopt this comment. A taxpayer (other than a C corporation) that sells QSB stock and elects to apply section 1045 may satisfy the replacement QSB stock requirement with QSB stock that is purchased within the statutory period by a partnership in which the taxpayer is a partner on the date the QSB stock is purchased (purchasing partnership). In addition, the final regulations provide that an eligible partner of a partnership that sells QSB stock (selling partnership) and elects to apply section 1045 may satisfy the replacement QSB stock requirement with QSB stock purchased by a purchasing partnership during the statutory period. The IRS and the Treasury Department believe that these rules are appropriate because they are consistent with the underlying continuous economic interest requirement of section 1045. Although the final regulations permit the replacement QSB stock requirement to be satisfied in this manner, for the reasons stated, a partner that sells its interest in the purchasing partnership is not treated as selling replacement QSB stock.

The final regulations contain rules for calculating a partner’s distributive share of partnership gain that is not recognized as a result of an election under section 1045 by the partner. These rules are necessary for determining how much gain a partner can defer upon a sale of QSB stock under section 1045. These rules address instances in which the eligible partner continues to defer gain under section 1045 from a prior sale or sales of QSB stock.

2. Basis Adjustments

The proposed regulations provided rules regarding adjustments to an eligible partner’s basis in a partnership interest and a partnership’s basis in replacement QSB stock. One rule required a partnership to make a basis adjustment to the partnership’s replacement QSB stock by the amount of gain from the partnership’s sale of QSB stock that is deferred by an eligible partner, the effect of which is determined under the principles of §1.743-1(g), (h), and (j). Under this rule, the basis adjustments constitute an adjustment to the basis of the partnership’s replacement QSB stock with respect to that eligible partner only. To allow the partnership to make the appropriate basis adjustments, the proposed regulations required any partner that must recognize all or a part of the partner’s distributive share of partnership section 1045 gain to notify the partnership of the amount of the partnership section 1045 gain that was recognized.

One commentator argued that many partnerships that invest in QSB stock are thinly staffed, and that they would incur additional administrative expenses to comply with the notification and basis adjustment requirements. Therefore, the commentator suggested that the partner make the basis adjustments with respect to the partnership’s replacement QSB stock, unless the partnership makes an election to make the basis adjustments.

The IRS and the Treasury Department believe that, if the partnership makes an election under section 1045 and purchases replacement QSB stock, the partnership is the proper party to make the appropriate basis adjustments with respect to that stock. Accordingly, this comment is not adopted. As noted below, a partnership is not required to maintain these basis adjustments for eligible partners that separately make the election under section 1045. The final regulations also clarify that if a partnership makes an election under section 1045, the partnership must attach a statement to the partnership return for the taxable year in which the partnership purchases replacement QSB stock setting forth the computation of the adjustment, the replacement QSB stock to which the adjustment has been made, the date(s) on which such stock was acquired by the partnership, and each partner’s distributive share of deferred partnership section 1045 gain.

If a taxpayer or an eligible partner makes an election under section 1045 and treats its interest in QSB stock purchased by a purchasing partnership as its replacement QSB stock, the final regulations provide specific rules for the determination of the partner’s basis in the replacement QSB stock and interest in the purchasing partnership. In these cases, the partner’s adjusted basis in the partnership interest is reduced by the partner’s gain that is deferred under section 1045, and the electing partner must reduce its share of the partnership’s adjusted basis of the replacement QSB stock by the amount of gain deferred. When the basis reduction results from a partner-level election, the final regulations require the partner, rather than the partnership, to retain records setting forth the computation of this basis adjustment, the replacement QSB stock to which the adjustment has been made, and the date(s) on which such stock was acquired by the purchasing partnership.

3. Gain Recognition Upon Certain Distributions

The final regulations provide rules requiring a partner to recognize gain upon a distribution of replacement QSB stock to another partner that reduces the partner’s share of the replacement QSB stock held by a partnership. The amount of gain that the partner must recognize is determined based on the amount of gain that the partner would have recognized upon a sale of the distributed replacement QSB stock for its fair market value on the date of the distribution (not to exceed the amount of gain previously deferred by the partner with respect to the distributed replacement QSB stock). Any gain recognized by a partner whose interest is reduced must be taken into account in determining the adjusted basis of the partner’s interest in the partnership and also taken into account in determining the partnership’s adjusted basis in the QSB stock distributed to another partner under §1.1045-1(e)(4). These rules apply in the case of a partner election or a partnership election under section 1045.

4. Nonrecognition Limitation

The proposed regulations provided that the amount of gain that an eligible partner may defer under section 1045 may not exceed: (A) the partner’s smallest percentage interest in the partnership’s income, gain, or loss with respect to the QSB stock that was sold, multiplied by (B) the partnership’s realized gain from the sale of such stock. This nonrecognition rule follows section 1202(g)(2) and (3) by ensuring that the partner can defer recognition of only the gain that relates to the partner’s continuous economic interest in the QSB stock that was sold.

Commentators agreed with the underlying “continuous ownership” requirement in the proposed regulations, but raised concerns that the nonrecognition limitation rule may be difficult to administer when a partnership does not have a simple “pro rata” partnership arrangement. One commentator suggested that the nonrecognition limitation rule only apply in certain situations.

The IRS and the Treasury Department continue to believe that a nonrecognition limitation rule is consistent with section 1045 and the underlying continuous economic interest requirement in section 1202(g)(2) and (3). The continuous economic interest requirement as applied under section 1202(c)(1)(B) requires that QSB stock must be acquired by the taxpayer at its original issuance in exchange for money or other property or as compensation for services provided to such corporation. Taxpayers that invest through a partnership acquire the requisite interest for purposes of the continuous economic interest requirement by an investment of capital in the partnership. Accordingly, to address the commentator’s concerns, the nonrecognition rule has been modified to provide that the amount of gain that an eligible partner may defer under section 1045 may not exceed: (A) the partner’s smallest percentage interest in partnership capital from the time the QSB stock is acquired until the time the QSB stock is sold, multiplied by (B) the partnership’s realized gain from the sale of such stock. The IRS and the Treasury Department believe that this nonrecognition rule in the final regulations will be easier to administer, is consistent with each partner’s economic interest in the partnership, and will not inappropriately limit the amount of gain that can be deferred.

5. Opt Out of Partnership Election by Partner

The proposed regulations allowed an eligible partner to make a section 1045 election with respect to all or part of the partner’s share of gain from the partnership’s sale of QSB stock only if the partnership did not make a section 1045 election, or the partnership did make a section 1045 election, but failed to purchase any (or enough) replacement QSB stock within the statutory time period. If a partnership elected to apply section 1045 and purchased replacement QSB stock, all eligible partners of the partnership were required to defer their distributive shares of the partnership section 1045 gain. One commentator suggested that an eligible partner should be allowed to opt out of a partnership section 1045 election and either purchase separate replacement QSB stock directly, and elect to apply section 1045 at the partner level, or recognize the partner’s distributive share of the partnership section 1045 gain. The IRS and the Treasury Department believe that allowing a partner to opt out of a partnership section 1045 election is consistent with providing the intended and desired flexibility for investments in QSB stock. Accordingly, this comment is adopted. The final regulations provide that a partner that elects out of a partnership’s section 1045 election must notify the partnership in writing. If an eligible partner opts out of a partnership section 1045 election, such action does not constitute a revocation of the partnership section 1045 election and the partnership section 1045 election continues to apply to the other partners.

The final regulations do not impose a deadline for when a partner must notify the partnership that the partner is opting out of a partnership section 1045 election. The IRS and the Treasury Department believe partnerships are responsible for obtaining the required information to report gain properly, and that the partnership agreement should require that partners supply this notice to the partnership in a timely manner.

6. Tiered-partnership Rules

Under the proposed regulations, only an eligible partner was entitled to defer gain under section 1045. The proposed regulations provided special rules for determining whether a partner was an eligible partner if a partnership (upper-tier partnership) held an interest in a partnership (lower-tier partnership) that held QSB stock. The proposed regulations disregarded the upper-tier partnership’s ownership of the lower-tier partnership and treated each partner of the upper-tier partnership as owning an interest in the lower-tier partnership directly. The preamble to the proposed regulations explained that, although this rule provided a simple approach, it limited the availability of section 1045 in situations involving tiered partnerships. The IRS and the Treasury Department requested comments specifically on the application of section 1045 in tiered-partnership situations.

Commentators suggested that an upper-tier partnership should be an “eligible partner” of a lower-tier partnership and allowed to make an election to defer gain under section 1045 with respect to the distributive share of the gain from the lower-tier partnership’s sale of QSB stock. After careful consideration, the IRS and the Treasury Department have concluded that treating an upper-tier partnership as an “eligible partner” of a lower-tier partnership would create an unacceptable administrative burden and increased complexity to the rules. Therefore, the final regulations retain the rule in the proposed regulations relating to tiered-partnership structures. The final regulations, however, clarify that the rule does not preclude a partner in an upper-tier partnership from treating its interest in QSB stock that was purchased by either the upper-tier partnership or a lower-tier partnership as replacement QSB stock. The final regulations contain an example illustrating this rule.

7. Disregarded Entity Rules

One commentator suggested that the final regulations set forth rules that are specific to disregarded entities. It has been determined that this suggestion is beyond the scope of the regulations and, therefore, is not included in the final regulations.

8. Election Procedures and Reporting Rules

The proposed regulations provided that a partnership making a section 1045 election must do so on the partnership’s timely filed return (including extensions) for the taxable year during which the partnership sells the QSB stock. The proposed regulations also provided that a partner making an election under section 1045 with respect to its distributive share of gain on the partnership’s sale of QSB stock must do so on the partner’s timely filed Federal income tax return (including extensions) for the taxable year in which such gain is taken into account. The final regulations retain these rules. However, in both cases, the proposed regulations stated that the electing partnership or partner also must follow the procedures of Rev. Proc. 98-48. In contrast, the final regulations provide that a partnership making an election under section 1045 or a partner making an election under section 1045 must do so in accordance with the applicable forms and instructions. It is anticipated that the applicable forms and instructions will be revised to take into account the rules in the final regulations.