February 20, 2009

The Internal Revenue Service (“IRS”) recently issued final Regulations (the “Regulations”) regarding the application of Internal Revenue Code (the “Code”) Section 1045 to partnerships and partners.  The final Regulations became effective on August 14, 2007. Section 1045 permits the deferral of gain upon the sale of qualified small business stock (“QSBS”). As a general matter, in order to defer gain on the sale of QSBS the seller is required to purchase different QSBS within a sixty (60) day period.  
 
In a departure from the proposed Regulations, the final regulations permit a partner that makes a Section 1045 election with respect to QSBS sold by the partnership to satisfy the replacement stock requirement by holding an interest in a partnership which acquires QSBS within the requisite sixty day period. In order to qualify the taxpayer must be a partner on the date QSBS is purchased by the partnership.  However, the Regulations clarify that the disposition of an interest in a partnership which owns QSBS by a partner will not qualify for deferral. The Regulations also set forth rules for determining a partner’s distributive share that is not recognized as a result of the Section 1045 election. The final Regulations retain the rules set forth in the proposed Regulations regarding basis adjustment; partnerships must adjust the basis in their replacement QSBS by the amount of gain from the partnership’s sale of QSBS that is deferred by a partner.
 
The final Regulations also contain rules requiring the recognition of gain with respect to certain types of distributions. For instance, a partner must recognize gain upon a distribution of a replacement QSBS to another partner that reduces the partner’s share of the replacement QSBS stock held by the partnership. The amount of gain subject to recognition is based on the amount of gain the partner would have recognized if he had sold the replacement QSBS at its fair market value on the date of the distribution; any such gain is limited to the amount of gain previously deferred. Additionally, gain recognition will also impact the adjusted basis of the partner’s interest in the partnership as well as the partnership’s basis in the QSBS that was distributed to another partner.
 
Finally, the new Regulations retained the deferral limitation contained in the proposed Regulations, although the IRS sought to simplify the calculation methodology. Moving forward, a taxpayer’s 1045 deferral may not exceed (i) the partner’s smallest percentage interest in the partnership capital from the time the QSBS stock is acquired until the time it is sold, multiplied by (ii) the partnership’s realized gain from the sale of such stock.  
 
CIRCULAR 230 DISCLOSURE
THE DISCUSSION OF TAX CONSIDERATIONS WAS NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED BY ANY TAXPAYER, FOR THE PURPOSE OF AVOIDING TAX PENALTIES THAT MAY BE IMPOSED BY THE INTERNAL REVENUE SERVICE.  ANY TAX ADVICE CONTAINED HEREIN WAS WRITTEN TO SUPPORT THE PROMOTION OR MARKETING OF THE TRANSACTIONS OR MATTERS ADDRESSED BY THE WRITTEN ADVICE. EACH PARTY SHOULD SEEK ADVICE BASED ON THE PARTY’S PARTICULAR CIRCUMSTANCES FROM AN INDEPENDENT TAX ADVISOR.