Rollover of gains on certain property dispositions

BY JOHN W. MCKINLEY, CPA, CGMA, J.D., LL.M. AND CRAIG J. WRIGHT

A little-known provision of the Code is Sec. 1044, which allows certain taxpayers to defer recognition of gain on the sale of publicly traded securities that is reinvested into specialized small business investment companies (SSBICs). When taxpayers later dispose of interests in SSBICs, important tax implications can arise from the interrelationship of Sec. 1044 with Sec. 1202, which allows exclusion of gain from certain small business stock.

An SSBIC is any partnership or corporation that is licensed by the Small Business Administration (SBA) under Section 301(d) of the Small Business Investment Act of 1958, P.L. 85-699. SSBICs were created in 1970 to invest in small businesses owned by individuals who are socially or economically disadvantaged, especially minorities.

Although Section 301(d) was repealed by the Omnibus Consolidated Appropriations Act of 1997, P.L. 104-208, any SSBICs that were licensed before Oct. 1, 1996, were grandfathered. According to the SBA website directory of SSBICs and similar SBICs (small business investment companies) (available at tinyurl.com/l76loyz), as of this year, 10 SSBICs are still licensed. Despite their loss of prominence, SSBICs may still provide an attractive investment and tax strategy. 

DEFERRAL OF GAIN

Under Sec. 1044(a), individuals and C corporations can elect to roll over any realized gain on the sale of publicly traded securities if the proceeds are reinvested into an SSBIC within 60 days from the date of the sale. Therefore, any portion of the realized gain that meets the nonrecognition requirements of Sec. 1044 will be deferred until the SSBIC shares or interests are later sold.

LIMITATIONS

Sec. 1044 applies to capital gain property held by an individual or C corporation. It does not apply to ordinary income property or capital gain property held by an S corporation, partnership, estate, or trust. 

Individuals can exclude the lesser of $50,000 per year or $500,000 during their lifetime (Sec. 1044(b)(1)). If a married couple file separate returns, the limitations are $25,000 and $250,000 each (Sec. 1044(b)(3)(A)).

For a C corporation, the limitation amount is the lesser of $250,000 for any tax year or a lifetime cap (including for any predecessor corporation) of $1 million (Sec. 1044(b)(2)). A controlled group is considered one taxpayer for purposes of these limitations.

TIMING OF ELECTION

Taxpayers must make a timely election by the due date of their income tax return, including any extensions. The election must be a statement attached to Form 1040, U.S. Individual Income Tax Return, or 1120, U.S. Corporation Income Tax Return, containing information specified in  Regs. Sec. 1.1044(a)-1. In addition, if the original return was filed on time, the taxpayer can make the choice on an amended return filed no later than six months after the due date of the return (excluding extensions). The taxpayer should write “Filed pursuant to section 301.9100-2” at the top of the amended return and file it at the same address used for the original return. The election can be revoked only with the IRS’s consent.

TAX CONSEQUENCES WHEN SSBIC SHARES OR INTERESTS ARE SOLD

When a taxpayer later sells the SSBIC shares or interests, the tax rules governing capital assets apply. In calculating the gain on the sale, the basis in the shares or interests is reduced by the gain previously deferred under Sec. 1044.

Individual taxpayers who sell shares in an SSBIC may qualify for the 50% gain exclusion under Sec. 1202. However, when calculating the Sec. 1202 gain exclusion, the basis of the stock is not reduced by the amount of gain deferred under Sec. 1044.

Example: Andrew and Beth Smith are married and file jointly. In 2006, Andrew purchases stock in a publicly traded corporation for $300,000. In 2008, he sells back the stock for $350,000 and realizes a $50,000 gain. Five days later, Andrew pays $350,000 for stock in an SSBIC. He elects to defer the entire $50,000 gain, which is the annual limit for married taxpayers filing jointly, assuming no portion of the $500,000 lifetime cap has been used. As a result, his new basis in the stock is $300,000.

In 2014, after holding the SSBIC stock for more than five years, Andrew decides to sell it for $400,000. Andrew and Beth’s realized gain is $100,000 ($400,000 − $300,000). Under Sec. 1202(a)(1), they can exclude $25,000, which is 50% of the amount realized ($400,000) minus the $350,000 he paid for the SSBIC stock. Thus, their recognized gain is $75,000 ($400,000 − $325,000). However, a 28% capital gain rate may apply to gain recognized under Sec. 1202, as well as an alternative minimum tax (AMT) preference of 7% of the amount excluded.

Even though Sec. 1044 applies only in limited circumstances, taxpayers may wish to consult their adviser about taking advantage of this deferral provision, especially in connection with the Sec. 1202 exclusion of gain. At the same time, SSBICs can play a role in encouraging business activity of entrepreneurs to whom capital markets may otherwise be inaccessible.

100% Exclusion of Sec. 1202 Gain
For qualified small business stock acquired after Sept. 27, 2010, and before Jan. 1, 2014, the 50% exclusion under Sec. 1202(a) is increased to 100% (75% for stock acquired between Feb. 17, 2009, and Sept. 27, 2010), and the Sec. 57(a)(7) AMT preference of 7% of excluded gain does not apply. As this column went to press, proposed legislation to extend these provisions was pending. The EXPIRE Act of 2014, S. 2260, would extend their sunset date to Jan. 1, 2016.

By John W. McKinley, CPA, CGMA, J.D., LL.M. ( jwm336@cornell.edu ), senior lecturer of accounting and taxation at Cornell University and adjunct lecturer of auditing and taxation at Ithaca College, both in Ithaca, N.Y., and Craig J. Wright ( cjw236@cornell.edu ), a student at Cornell University.

To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at pbonner@aicpa.org or 919-402-4434.

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