Section 1045 QSBS Rollovers: Deferring Capital Gains on Qualified Small Business Stock

Section 1045 provides taxpayers with a valuable opportunity to defer recognition of capital gains from the sale of Qualified Small Business Stock (QSBS) by rolling the proceeds into replacement QSBS within a 60-day window. This rollover provision allows investors to maintain their investment in small businesses while deferring tax on gains, creating significant tax planning opportunities.

This page explains the mechanics of Section 1045 rollovers, eligibility requirements, partnership-specific rules, and important limitations.

What is a Section 1045 Rollover?

Section 1045 allows taxpayers (other than corporations) to defer recognition of gain from the sale of QSBS if they reinvest the proceeds into replacement QSBS within 60 days. [IRC §1045(a)]

Key Concept: This is a deferral mechanism, not an exclusion. The deferred gain reduces the basis of the replacement QSBS and will be recognized when the replacement stock is sold (unless another rollover occurs).

Basic Rollover Requirements

1. Original QSBS Holding Period

The original QSBS must have been held for more than 6 months before sale. [IRC §1045(a)]

This is different from Section 1202's 5-year holding period requirement. Section 1045 allows rollovers even if the stock hasn't been held long enough to qualify for Section 1202 exclusion.

2. 60-Day Replacement Window

Replacement QSBS must be purchased within 60 days beginning on the date of the sale. [IRC §1045(a)(1)]

Important Timing Rules:

• The 60-day period begins on the date of sale
• Replacement stock must be purchased (not merely contracted for) within this window
• Partial rollovers are permitted—gain is recognized only to the extent proceeds are not reinvested

3. Replacement QSBS Qualification

The replacement stock must meet the definition of "qualified small business stock" under Section 1202(c). [IRC §1045(b)(1)]

This means the replacement stock must:

• Be stock in a qualified small business (C corporation with assets ≤$75 million)
• Be acquired at original issue
• Meet all other Section 1202(c) requirements

4. Taxpayer Eligibility

Section 1045 applies only to taxpayers other than corporations. [IRC §1045(a)]

Eligible taxpayers include:

• Individuals
• Trusts and estates
• Partnerships (subject to special rules, discussed below)
• S corporations and other pass-through entities

C corporations cannot use Section 1045 rollovers.

How the Rollover Works

Recognition of Gain

Gain is recognized only to the extent that the amount realized on the sale exceeds the cost of replacement QSBS purchased within the 60-day period. [IRC §1045(a)]

Formula:

Recognized Gain = Amount Realized - Cost of Replacement QSBS (purchased within 60 days)

Basis Adjustment

If gain is deferred, it reduces the basis of the replacement QSBS in the order acquired (first-in, first-out). [IRC §1045(b)(3)]

Example:

• Taxpayer sells QSBS for $1,000,000 (basis: $100,000), realizing $900,000 gain
• Within 60 days, taxpayer purchases replacement QSBS for $800,000
• Recognized gain: $100,000 ($1,000,000 - $800,000)
• Deferred gain: $800,000
• Basis in replacement QSBS: $0 ($800,000 cost - $800,000 deferred gain)

Holding Period Rules

For purposes of Section 1045:

• The holding period for the original stock and replacement stock is determined without regard to Section 1223 (which would otherwise allow tacking) [IRC §1045(b)(4)(A)]
• Only the first 6 months of the taxpayer's holding period for the original stock is taken into account for purposes of applying Section 1202(c)(2) (the active business requirement) [IRC §1045(b)(4)(B)]

This means the replacement stock must independently satisfy the active business requirement, and the holding periods don't "tack" for rollover purposes.

Section 1045 Election

Section 1045 applies only if the taxpayer elects its application. [IRC §1045(a)]

The election is made by:

• Reporting the sale and purchase on the tax return
• Following applicable forms and instructions

Important: The election is revocable only with the prior written consent of the Commissioner, which requires a private letter ruling. [Reg. 1.1045-1(a)]

Partnership Rollovers: Special Rules

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

Partnership-Level Rollover

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 limitations, discussed below). [Reg. 1.1045-1(b)(1)]

Partner-Level Rollover

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)]

The partner recognizes gain only to the extent of the excess of the partner's share of amount realized over the cost of replacement stock purchased. [Reg. 1.1045-1(c)(1)(ii)]

Capital Interest Limitation for Partners

Critical Limitation: Regulation 1.1045-1(d) limits the amount of gain that 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 holding only profits interests (carried interest) with zero or minimal capital interests:

• Smallest percentage interest in partnership capital = 0% (or very small)
• Nonrecognition limitation = Partnership gain × 0% = $0

Result: Partners with only profits interests cannot defer gain through Section 1045 rollovers, even if the partnership makes the rollover election.

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

Multiple Rollovers

Section 1045 can be used in succession—taxpayers can roll over gains from replacement QSBS into new replacement QSBS, continuing to defer gain indefinitely (subject to basis adjustments).

Cumulative Basis Adjustment: Each rollover reduces the basis of the replacement stock by the deferred gain. If multiple rollovers occur, the deferred gains accumulate, reducing basis accordingly.

Ordinary Income Exception

Section 1045 does not apply to gain treated as ordinary income. [IRC §1045(a)]

If any portion of the gain from the sale of QSBS is ordinary income (rather than capital gain), that portion cannot be deferred through Section 1045.

Relationship to Section 1202

Cross-Reference

Section 1045 uses the same definition of "qualified small business stock" as Section 1202(c). [IRC §1045(b)(1)]

Similar Rules Apply

Section 1045(b)(5) provides that "rules similar to" subsections (f), (g), (h), (i), (j), and (k) of Section 1202 apply. This includes:

• Section 1202(g): Pass-through entity treatment rules
• Section 1202(h): Tax-free transfers (gifts, death, reorganizations)
• Section 1202(i): Basis rules
• Section 1202(j): Short positions
• Section 1202(k): Anti-abuse regulations

Coordination with Section 1202 Exclusion

Taxpayers can potentially benefit from both provisions:

1. First, use Section 1045 to defer gain by rolling into replacement QSBS
2. Later, when replacement QSBS is sold after the required holding period, claim Section 1202 exclusion

However, the Section 1202 exclusion applies only to gain that would otherwise be recognized, so deferred gain under Section 1045 reduces the amount eligible for exclusion.

Key Limitations and Considerations

1. Active Business Requirement

The replacement QSBS must meet the active business requirement under Section 1202(e) during the taxpayer's holding period. Only the first 6 months of holding the original stock counts toward this requirement. [IRC §1045(b)(4)(B)]

2. 60-Day Window is Strict

The 60-day replacement window is strict. Stock purchased on day 61 does not qualify, even by one day.

3. Partial Rollovers

If replacement stock costs less than the sale proceeds, only partial deferral occurs. The excess gain is recognized in the year of sale.

4. Basis Reduction

Deferred gain permanently reduces basis in replacement stock, meaning it will eventually be recognized when the replacement stock is sold (unless rolled over again).

5. Partnership Capital Interest Limitation

For partners, the capital interest limitation severely restricts (or eliminates) rollover benefits for carried interest holders.

Planning Strategies

Timing Considerations

• Plan sales and purchases to maximize the 60-day window
• Identify replacement QSBS opportunities before selling
• Consider market conditions affecting availability of replacement stock

Successive Rollovers

• Can be used to defer gain indefinitely through multiple rollovers
• Track cumulative basis adjustments carefully
• Consider eventual recognition when planning

Coordination with Section 1202

• Plan holding periods to eventually qualify for Section 1202 exclusion
• Balance immediate deferral (Section 1045) with long-term exclusion (Section 1202)

Partnership Planning

• Partners should understand capital interest limitations
• Consider structuring to include capital interests if rollover benefits are desired
• Document partnership capital percentages for Section 1045 purposes

Key Takeaways

1. Section 1045 allows deferral, not exclusion: Gain is deferred by reducing basis in replacement stock

2. 60-day window is critical: Replacement QSBS must be purchased within 60 days of sale

3. 6-month holding period required: Original QSBS must be held more than 6 months (not 5 years)

4. Partnership rules are complex: Capital interest limitations apply to partner-level rollovers

5. Election is required: Taxpayers must elect Section 1045 treatment

6. Basis adjustments are permanent: Deferred gain reduces basis and will eventually be recognized

7. Multiple rollovers are possible: Can defer gain indefinitely through successive rollovers

Sources and Citations

• IRC Section 1045: Rollover of gain from qualified small business stock
• Reg. 1.1045-1: Application to partnerships
• IRC Section 1202(c): Definition of qualified small business stock (cross-referenced by Section 1045)

Verification Date: January 2025

Note: This page reflects the law as of January 2025. Tax law changes frequently, and this information should not be construed as legal or tax advice. Consult with a qualified tax professional regarding your specific situation.