QSBS and Partnerships: Pass-Through Entity Treatment of Qualified Small Business Stock

Qualified Small Business Stock (QSBS) can be held directly by individual taxpayers or through partnerships and other pass-through entities. Section 1202(g) provides special rules allowing QSBS benefits to flow through to partners when QSBS is held by a partnership, while Regulation 1.1045-1 governs partnership rollovers under Section 1045.

This page explains how QSBS benefits apply when stock is held through partnerships, including the requirements for pass-through treatment and important limitations.

Section 1202(g): Pass-Through Entity Treatment

Basic Rule

Section 1202(g) allows gain from the sale of QSBS by a partnership to be treated as excludable gain at the partner level, provided certain requirements are met. [IRC §1202(g)(1)]

Key Concept: The exclusion applies at the partner level, not the partnership level. The partnership's gain flows through to partners, who then apply the Section 1202 exclusion rules.

Requirements for Pass-Through Treatment

Under Section 1202(g)(2), gain qualifies for exclusion at the partner level if:

1. Entity-Level Qualification: The stock is qualified small business stock in the hands of the partnership (determined by treating the partnership as an individual) [IRC §1202(g)(2)(A)]

2. Holding Period: The partnership held the stock for at least 3 years (or more than 5 years for stock acquired on or before the applicable date) [IRC §1202(g)(2)(A)]

3. Partner's Interest Requirement: The gain is includible in the partner's gross income "by reason of the holding of an interest in such entity which was held by the taxpayer on the date on which such pass-thru entity acquired such stock and at all times thereafter before the disposition of such stock by such pass-thru entity" [IRC §1202(g)(2)(B)]

Key Language: The statute requires that the partner hold "an interest" in the entity continuously from acquisition through disposition. This broader language (not specifically "capital interest") is relevant to carried interest discussions.

Limitation Based on Original Interest

Section 1202(g)(3) provides that the exclusion does not apply to any amount to the extent it exceeds what would have applied if determined by reference to the interest the partner held when the QSBS was acquired.

Example: If a partner's interest increases after QSBS acquisition, the exclusion is limited to what would apply based on the original, smaller interest.

Pass-Through Entities Covered

Section 1202(g)(4) defines "pass-thru entity" to include:

• Partnerships
• S corporations
• Regulated investment companies (RICs)
• Common trust funds

Partnership Basis and Gain Allocation

Gain Flow-Through

When a partnership sells QSBS:

• The partnership recognizes gain (capital gain, assuming QSBS treatment)
• The gain is allocated to partners according to the partnership agreement (subject to substantial economic effect rules)
• Each partner includes their distributive share in gross income
• Each partner applies Section 1202 exclusion rules to their share

Basis Considerations

For purposes of the per-issuer limitation under Section 1202(b), the partner's proportionate share of the partnership's adjusted basis in the QSBS is taken into account. [IRC §1202(g)(1)(B)]

Example:

• Partnership has $1 million basis in QSBS
• Partner has 10% interest
• Partner's share of basis for limitation purposes: $100,000
• Partner's per-issuer limit: Greater of $10 million (or $15 million for post-applicable date stock) or 10 × $100,000 = $1 million

Section 1045 Partnership Rollovers

Regulation 1.1045-1 provides comprehensive rules for Section 1045 rollovers involving partnerships.

Partnership-Level Rollover Election

A partnership may elect Section 1045 if it:

• Holds QSB stock for more than 6 months
• Sells such QSB stock
• Purchases replacement QSB stock within 60 days [Reg. 1.1045-1(b)(1)]

If the partnership elects, eligible partners do not recognize their distributive share of partnership section 1045 gain (subject to the capital interest limitation, discussed below). [Reg. 1.1045-1(b)(1)]

Partner-Level Rollover Election

An eligible partner may elect Section 1045 if:

• The partnership sells QSB stock, and
• The partner purchases replacement QSB stock directly or through a purchasing partnership [Reg. 1.1045-1(c)(1)]

Capital Interest Limitation

Critical Limitation: Regulation 1.1045-1(d) limits the amount of gain an eligible partner can defer through a Section 1045 rollover.

The nonrecognition limitation equals:

Partnership's realized gain × Partner's smallest percentage interest in partnership capital

The Carried Interest Problem: For partners with only profits interests (zero or minimal capital interests), this limitation results in zero (or minimal) deferral, even if the partnership makes a rollover election.

Note: This limitation applies specifically to Section 1045 rollovers. Whether it applies by analogy to Section 1202 exclusions is uncertain (see QSBS and Carried Interest).

Basis Adjustments

When a partnership makes a Section 1045 election:

• The partner's basis in the partnership interest is not increased by the deferred gain [Reg. 1.1045-1(b)(3)(i)]
• The partnership's basis in replacement QSB stock is reduced by the deferred gain [Reg. 1.1045-1(b)(3)(ii)]
• The basis adjustment is partner-specific (tracked per partner)

Partner Opt-Out Rights

Eligible partners may opt out of a partnership's Section 1045 election by:

• Recognizing their distributive share of partnership section 1045 gain, or
• Making their own partner-level Section 1045 election [Reg. 1.1045-1(b)(4)]

Partners must notify the partnership in writing if opting out. [Reg. 1.1045-1(b)(5)(ii)]

Tiered Partnerships

Upper-Tier and Lower-Tier Partnerships

Regulation 1.1045-1 addresses tiered partnership structures:

• Upper-tier partnerships holding interests in lower-tier partnerships
• Basis adjustments must be tracked through the tiers
• Capital interest limitations apply at each tier

Complexity: Tiered partnerships require careful tracking of basis adjustments and capital interests through multiple entity levels.

Partnership Distributions of QSBS

Regulation 1.1045-1(e) provides rules for when a partnership distributes QSBS to a partner.

General Rule

A partner receiving QSBS in a distribution is treated as:

• Having acquired the stock in the same manner as the partnership
• Having held the stock during the continuous period it was held by the partnership [Reg. 1.1045-1(e)(1)]

Distribution Limitations

The amount of gain that can be deferred on subsequent sale of distributed QSBS cannot exceed the "distribution nonrecognition limitation," which is based on the partner's capital interest in the partnership. [Reg. 1.1045-1(e)(3)]

This limitation mirrors the capital interest limitation for rollovers and affects carried interest holders similarly.

Reporting Requirements

Partnership Reporting

Partnerships making Section 1045 elections must:

• Notify all partners of the election
• Separately state each partner's distributive share of partnership section 1045 gain on Schedule K-1 [Reg. 1.1045-1(h)(1)]
• Provide information necessary for partners to report properly

Partner Reporting

Partners must:

• Report their distributive share of partnership section 1045 gain
• Determine eligibility and apply limitations
• Report excluded amounts under Section 1202
• Maintain records of basis adjustments

Planning Considerations

Structuring Partnership Interests

• Partners seeking QSBS benefits should understand capital interest requirements for Section 1045
• Consider structuring to include capital interests if rollover benefits are desired
• Document capital percentages carefully

Documentation

• Maintain clear partnership agreements showing interests held continuously
• Document partnership's QSBS acquisition dates
• Track partnership's holding periods
• Keep records of capital interest percentages for Section 1045 purposes

Coordination of Elections

• Partnerships and partners must coordinate Section 1045 elections
• Partners can opt out if partnership elects
• Consider timing and coordination issues

Key Takeaways

1. Section 1202(g) allows pass-through treatment: Partners can claim exclusions when partnerships hold QSBS

2. Continuous interest required: Partners must hold interests from QSBS acquisition through disposition

3. Capital interest limitation for Section 1045: Partners with only profits interests face significant limitations on rollovers

4. Basis tracking is critical: Partnership basis adjustments must be carefully tracked

5. Tiered partnerships add complexity: Multi-tier structures require additional tracking

6. Reporting is partner-level: Partnerships report on K-1s, but partners apply exclusion rules

Sources and Citations

• IRC Section 1202(g): Pass-through entity treatment
• Reg. 1.1045-1: Application to partnerships (comprehensive partnership rollover rules)
• IRC Section 1202(g)(2)(B): Partner interest requirement

Verification Date: January 2025

Note: This page reflects the law as of January 2025. Tax law changes frequently, and partnership QSBS rules are complex. This information should not be construed as legal or tax advice. Consult with qualified tax counsel regarding partnership structures and QSBS benefits.