IRS Grants A “Do Over” To A Taxpayer Engaging In A Qualified Rollover

The IRS not too long ago launched a personal letter ruling (PLR 202244004 (August 9, 2022)) that grants extra time to a taxpayer that didn’t well timed elect to defer the achieve from a rollover of certified small enterprise inventory (QSBS). The IRS’s choice to grant late-filing reduction on this context isn’t that stunning or ground-breaking, nevertheless it does spotlight an necessary tax technique that we’re beginning to see with growing frequency.

QSBS Usually

Section 1202 usually gives for the total or partial exclusion of capital achieve realized on the sale of QSBS. If the necessities are met, then taxpayers can exclude from gross earnings capital achieve in an quantity equal to the higher of (i) $10 million, or (ii) an annual exclusion of 10 occasions their foundation within the inventory bought (for an exclusion quantity as much as $500 million). Each of those limitations apply on a per-issuer and per-taxpayer foundation, and whereas the exclusion is restricted to the higher of the 2 guidelines, in observe, the $10 million rule is most frequently the limiting consider start-up ventures.

Certified Rollovers

Section 1045 is a companion to part 1202. It permits taxpayers that promote QSBS earlier than the 5-year holding interval is met to defer capital achieve on the sale to the extent the sale proceeds are reinvested into one other certified small enterprise (QSB) inside 60 days of the sale. It additionally permits the substitute inventory to represent QSBS in order that future achieve on a sale of the substitute inventory might be excluded below part 1202.

The good factor about part 1045 is that six months after the reinvestment, the deferral facet of the prior achieve operates independently of the QSBS facet of the substitute inventory. Thus, deferral of the prior achieve is not going to be affected if the brand new enterprise fails to satisfy the QSB necessities greater than 6 months after the rollover transactions.

The primary necessities for a professional rollover are —

1. The taxpayer should personal the unique QSBS for greater than 6 months earlier than its sale, with out contemplating any carryover (or tacked) holding durations that will apply.
2. The deferral of achieve recognition applies solely to the extent the taxpayer reinvests the sale proceeds (not simply achieve) in substitute QSBS inside 60 days of the sale.
3. The entity issuing the substitute QSBS should meet the QSB necessities for no less than 6 months after the taxpayer’s acquisition of the inventory.
4. The taxpayer correctly elects deferral by making an election on or earlier than the due date (together with extensions) for submitting the tax return for the 12 months during which the QSBS is bought.

If the certified rollover guidelines apply, then the taxpayer takes a foundation and holding interval within the substitute QSBS that’s decided by reference to the QSBS bought, thus preserving the built-in achieve and the relevant exclusion proportion of the unique QSBS.

If a taxpayer well timed reinvests QSBS sale proceeds into multiple entity that may be a QSB, as did the taxpayer within the ruling mentioned under, then he/she will take the place that every substitute entity is a separate issuer for functions of the $10M/10x foundation limitation. For instance, this could convert one $10 million exclusion into a number of $10 million exclusions.

The Ruling

Within the current personal letter ruling, the taxpayer failed the fourth requirement above. The taxpayer not directly, by way of a partnership, bought QSBS and reinvested the proceeds into two completely different QSBs (more likely to double up the long run part 1202 exclusion) inside 60 days, however didn’t file his/her tax return containing the part 1045 election by the prolonged due date. The taxpayer represented to the IRS that the tax return was filed late as a result of “the preparation of [the] federal particular person earnings tax return is complicated on account of quite a few pursuits in partnerships” and there was a delay in receiving a number of the Schedule Ok-1s, which was past the taxpayer’s management. The taxpayer thus didn’t correctly elect deferral below part 1045 on his/her well timed filed tax return (together with extensions). Though unspoken, the taxpayer presumably didn’t meet the 5-year holding interval on the time of sale; in any other case, part 1202 would have utilized.

The IRS routinely grants extensions of sure elections (e.g., late subchapter S company elections) below rules that had been written for that goal. That is the primary time, nonetheless, that the IRS prolonged late-filing reduction to an election below part 1045.

In a nutshell, late-filing reduction is granted to taxpayers that act fairly and in good religion, and granting reduction is not going to prejudice the pursuits of the federal government.

A taxpayer is deemed to have acted fairly and in good religion if it —

1. Requests reduction earlier than the failure to make the regulatory election is found by the IRS;
2. Did not make the election due to intervening occasions past the taxpayer’s management;
3. Did not make the election as a result of, after exercising due diligence, the taxpayer was unaware of the need for the election;
4. Fairly relied on the written recommendation of the IRS; or
5. Fairly relied on a professional tax skilled, together with a tax skilled employed by the taxpayer, and the tax skilled didn’t make, or advise the taxpayer to make the election.

One frequent cause the IRS makes use of to conclude a taxpayer didn’t act fairly and in good religion is that the taxpayer acted with hindsight, i.e., it decided after the due date of the election that it might have been advantageous to have filed the election.

The pursuits of the federal government usually are thought of prejudiced if granting reduction would consequence within the taxpayer having a decrease tax legal responsibility for all taxable years affected by the election than the taxpayer would have had if the election had been well timed made, e.g., the statute of limitations is closed for the tax 12 months during which the election ought to have been filed.

Beneath these standards, the IRS concluded that the taxpayer was entitled to late-filing reduction and it granted the taxpayer an extra 60 days to file the part 1045 election – the “do over.”

The taxpayer’s receipt of this ruling signifies that he/she will defer the achieve realized on the sale of QSBS and qualify for a bit 1202 exclusion on a later sale of the substitute inventory in every of the 2 entities (assuming the QSBS necessities for every entity are met at the moment). It additionally signifies that the taxpayer (and presumably his/her preparer that missed the submitting deadline) breathed an enormous sigh of reduction {that a} easy mistake is not going to price his/her/them doubtlessly thousands and thousands of {dollars} in future part 1202 advantages.

The M&A increase of the previous couple of years has sparked renewed curiosity in part 1045. I wrote about this subject a number of months again when addressing taxpayers that promote inventory earlier than reaching the 5-year holding interval. In that article, I concluded that in my expertise, one’s willingness to entertain a professional rollover of QSBS is inversely associated to the period of time wanted to achieve the 5-year mark. This current personal letter ruling is useful as a result of errors occur, and the extra taxpayers interact in certified rollovers, the extra they’ll miss the submitting deadlines. Fortunately for them, and for all of us, the IRS is keen to entertain requests for a “do over” on this context.