United States Tax Court, Nos. 930–07, 1384–07, 13303–07, 29011–08, 29090–08, January 19, 2012
KEY QSBS TAKEAWAY(S): In Owen v. Commissioner, the taxpayer met the 60–day requirement of section 1045(a)(1) because the stock purchase agreement transaction was signed on June 17, 2002, and the sold Family First Companies shares–amounting to $1,916,827.07–were placed into a J & L Gems corporate account on August 14, 2002. However, the taxpayer failed to provide sufficient evidence that J&L Gems met the “active business” requirement under section 1202(e)(1)(A) requiring a qualified business has to have “at least 80 percent (by value) of the assets of such corporation are used by such corporation in the active conduct of 1 or more qualified trades or businesses.” See §1202(e).
QUESTION PRESENTED: How does the “active business” requirement under §1202(c)(2) apply when there is a §1045 rollover?
These are the rules that were at issue within the case: (1) For section 1045 to qualify, the amount realized has to exceed: “(a) The cost of any qualified small business stock purchased by the taxpayer during the 60–day period beginning on the date of such sale, reduced by (b) any portion of such cost previously taken into account under this section.” Section 1045(a). (2) For a business to satisfy an “active business” requirement, section 1202(e)(1)(A) states that the qualified business has to assure that “at least 80 percent (by value) of the assets of such corporation are used by such corporation in the active conduct of 1 or more qualified trades or businesses.” (3) There is an exception under section 1202(e)(6) that spells out that any assets which: “(a) are held as part of the reasonably required working capital needs of a qualified trade or business of the corporation shall be treated as used in the active conduct of a qualified trade or business. For periods after the corporation has been in existence for at least 2 years, in no event may more than 50 percent of the assets of the corporation qualify as used in the active conduct of a qualified trade or business by reason of this paragraph.” (4) Under section 1202(e)(3)(A) defines a “qualified trade or business” as any trade or business other than: “(A) any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees…”
MAIN QSBS ISSUES ADDRESSED:
(1) What qualifies as an “active business” under §1202(e) and the issues revolving around (2) the §1045 “rollover”
The taxpayer failed to provide sufficient evidence that shows their “rollover” from Family First Companies to J&L Gems met the “active business” requirement under §1202(e). The Tax Court found that J&L Gems was not a qualified business because 92% of its assets were in cash not being actively used in the trade of that business (selling jewelry). Only 8% of the used assets happened within the first 2 years of the initial investment; seen in §1202(e)(6), the Owens tried to claim the Research and Development provision as an argument for the 92% excess cash in J&L Gems. However, §1202(e)(6) states that no more than 50% of the total assets should be used after the second year of the initial investment, therefore J&L Gems does not qualify as an “active business” and the Owens are not entitled to defer $1,867,500 of capital gain.
In 1989, Mr. and Mrs. Owen met each other and, in 1995, they organized and owned their own corporation called J&L Owen, Inc. Being the only shareholders of the corporation they did not necessarily need any employees because the business ran out of their house. Mr. Owen then entered the insurance business, where he sold tax-deferred annuities, life insurance, long-term care insurance, and whole life insurance. In 1997, Mr. Owen and an old colleague split 50-50 and formed the corporation called Family First Advanced Estate Planning (which distributed prepaid legal services) and Family First Insurance Services. Mr. Owen during these years worked as both an executive and sales representative for Family First Companies.
On June 17, 2002, Mr. Owen sold his 50% ownership interests in both founded corporations (Family First Companies) to Amerus Annuity Group Co. (Amerus). The stock sale was closed on June 18, 2002 with Mr. Owen acquiring $1,916,827.07 from his shares.
Mr. Owen elected to structure the sale with Amerus in a manner that would defer recognition of the income received from the sale of Family First Advanced Estate Planning (FFAEP) under section 1045. Hence, Mr. Owens believed that the $1.9 million could be invested into a retail jewelry business (J&L Gems), qualifying him for the income tax deferral. Subsequently, Mr. Owen on August 12, 2002, formed J&L Gems and 2 days later deposited $1,916,827.07 of the Amerus transaction into J&L Gems financial bank account. Some time later, Mr. Owen purchased a total of 16 pieces of jewelry at $147,026.20. Between the dates of August 2002 and July 31, 2003, there were only 6 pieces of jewelry sold, and evidence points to one piece being sold to the Family First Companies and two pieces were sold to Mr. Owen’s former business partner.
An overview of section 1045 allows a taxpayer, not a corporation, to defer their gains on the sale of qualified small business stock held by the taxpayer for more than 6 months. With that being said, if there is an election to apply section 1045, the “rollover” into another qualified business has to occur within the 60-day requirement after the original sale of QSBS. See 1045(a)(1).
One of the major issues found in this case falls under the section 1202(c)(2) “active business” requirement and defined under section 1202(e). Section 1202(e)(1)(A) requires that the qualified business has to assure that “at least 80 percent (by value) of the assets of such corporation are used by such corporation in the active conduct of 1 or more qualified trades or businesses”.
The Tax Court agreed that the Owens met the 60-day period under section 1045(a)(1) when they “rolled” their $1,916,827.07 worth (from purchase agreement on June 17, 2002) of Family First Companies stock into J&L Gems account on August 14, 2002. However, the court found that the Owens did not qualify for section 1045 because J&L Gems never satisfied the “active business” requirement under 1202(c)(2). More importantly, during the first 6 months, J&L Gem purchased 16 pieces of jewelry totaling $147,026.20. The initial investment was $1,916,827.07 from the Owens “rollover”; meanwhile, the Owens only used 8% of the assets into the active trade of J&L Gems. The court found that the evidence failed to satisfy the provision under 1202(e)(1)(A) requiring at least 80 percent of assets in the new business to be used in an active trade or business. Furthermore, the only evidence of the 6 jewelry sale transactions from August 2002 to July 2003, 3 of the sold pieces were from previous business partners of the Owens.
Mr. Owen testified that: “My view of active business is just that. I went out and I purchased some. I took the stock of this company and put it into the stock of this other company. I put the money from the sale of the company within the 60–day period he told me to put it in, and I started buying up gems. So in my opinion, I thought I was doing everything correctly.”(quoting T.C. Memo. 2012-21 at *17)
During the trial, Mr. Owen explained that he tried to establish the J&L Gems business between 2002 and 2004, but the Tax Court noticed that only 16 pieces of jewelry were purchased (only 8% of the total asset of the business). J&L Gems appeared to not use anymore of the initial money that was invested by the Owens from the sale transaction of their Family First Companies shares. If the Owens tried to use the section 1202(e)(6) exception to the “80% of assets to the active business” requirement, the Owens still had 92 percent of their assets in the J&L Gems and still did not meet the 50 percent requirement under section 1202(e)(6) for the first 2 years. The Tax Court found that J&L Gems was not an “active business” therefore J&L Gems cannot be defined as a qualified business for a section 1045 “rollover” to successfully apply.
The court decided in this case that:
- Married taxpayers’ retail jewelry corporation did not meet active business requirement during requisite period, and thus taxpayers were not entitled to defer $1,867,500 of capital gain they received from sale of their stock in company and with which they formed jewelry corporation, where corporation made 16 purchases totaling $147,026.20 in its first six months, representing only eight percent of money deposited into corporation’s account from taxpayers’ stock sale, and six sales, three of which were to insurance company or husband’s former business partner, with gross receipts of only $12,069. 26 U.S.C.A. §§ 1045, 1202. See T.C. Memo. 2012-21, (T.C. 2012)
- The Tax Court agreed that the Family First Advanced Estate Planning corporation met the “qualified business” standard under section 1045. The IRS tried arguing that the corporation did not qualify because one of the principal assets relies on the skill of Mr. Owen, the court disagreed.
- The Tax Court agrees that the Owens met the 60-day requirement under section 1045(a)(1) because the stock purchase agreement transaction with Amerus was completed on June 17, 2002, and then the initial deposit into J&L Gems occurred on August 14, 2002.
For more information on Qualified Business, look at the IRS Rulings under Case Law Section.
United States Tax Court, Nos. 930–07, 1384–07, 13303–07, 29011–08, 29090–08, January 19, 2012.
Owen v. Comm’r, T.C. Memo. 2012-21, (T.C. 2012).
This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.