United States Tax Court, No. 3769-10, August 30, 2012
KEY QSBS TAKEAWAY(S): In Holmes v Commissioner, the taxpayer provided no evidence to demonstrate that they received the shares at original issuance (required as per IRC §1202(c)(1)(B)), and therefore failed to substantiate that their stock holdings qualified as QSBS. The taxpayer testified he purchased shares from the company president rather than directly from the company.
QUESTION PRESENTED: Can one omit capital gains on the sales of Qualified Small Business Stock (QSBS) if the shares were rolled into a second, non-QSBS, investment, under the QSBS rollover provision per IRC §1045?
These are the rules that were at issue within the case: (1) As per IRC §1045, the QSBS rollover provision, a taxpayer must use the gains from the original QSBS to purchase another QSBS within 60 days of the original sale for a “rollover” to be able to qualify. (2) A “Qualified Business” under §1202(c)-(e) occurs when the stock purchased by the taxpayer is acquired at original issuance and not from secondary sources (i.e. from a previous shareholder) in exchange for money or other property or as compensation for services rendered to the corporation. The corporation issuing the stock needs to meet the criteria of a Qualified Small Business at the time of the QSBS clock for each issued security starts, such as having no more than $50 million in aggregate gross assets, being a C-Corp, satisfying the qualifying trade or business requirement, satisfying the Active Business Requirement whereby the corporation utilizes at least 80% of their assets towards company’s business, etc.. See §1045(a) and §1202(c)-(e).
MAIN QSBS ISSUES ADDRESSED:
The petitioner sold MacroPore (QSBS) stocks between June 2000 and 2004 totaling 972,500 shares ($3,055,680) and did not claim the gain on their Income Tax Return because the petitioner assumed they qualified for §1045 rollover when purchasing shares in LeonardoMD (Non-QSBS) in 36 separate transactions through January 2002 and July 2004.
In May 1997, petitioner co-founded MacroPore, Inc, incorporated in Delaware as a C- corporation. The corporation dealt in surgical implants and later evolved into developing regenerative therapies. Petitioner, as of May 1997, acquired 1 million shares in MacroPore for $0.01 per share. Later in 2000, petitioner co-founded LeonardoMD, Inc., also a C-corporation incorporated in Delaware, which provides a physician practice management software. Petitioner purchased shares of LeonardoMD stock in 36 separate transactions through the dates of January 2002 and July 2004. In late 2000, the petitioner was engaged in a conversation with a friend that involved a tax provision that allowed the petitioner to rollover any capital gain from a startup into another startup which allows the petitioner to defer the tax. Before the court reviewed the statement of facts, they allowed both parties to express their argument(s):
Commissioner of Internal Revenue argued: “… [T]hat petitioner was required to report on his 2000, 2001-, 2002-, 2003-, and 2004-income tax returns gain from sales of MacroPore stock in the amounts of $498,000, $408,662, $1,097,166, $1,012,702, and $29,425, respectively”(quoting T.C. Memo. 2012-251 at *15)
Petitioner argued: “…[T]hat he is entitled to defer recognition of that gain because (1) a substantial portion of the gain from those sales would have qualified for deferral under section 1045 had he properly made the election to do so on his tax returns…”(quoting T.C. Memo. 2012-251 at *15)
The Tax Court looked to see if the second investment (LeonardoMD) was a Qualified Small Business, so the §1045 rollover occurred between the sale of a QSBS and then a purchase of another QSBS within 60 days of the original sale. IRC §1045 allows a taxpayer to defer gains from the sale of QSBS that was held for a minimum of 6 months. Gain from the sale is recognized to “the extent that the amount realized exceeds: “(1) 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 (2) any portion of such cost previously taken into account under this section.” §1045(a). The leftover gain not recognized will then be applied “to reduce (in the order acquired) the basis for determining gain or loss of any qualified small business stock which is purchased by the taxpayer during the 60–day period”. Sec. 1045(b)(3)
In order for a “rollover” to qualify the taxpayer must make an election by the taxpayers income tax return due date for the taxable year the sale of the stocks occurred. The 1045 election is made by: “(a) reporting the entire gain from the sale of …[qualified small business stock] on Schedule D, Capital Gains and Losses…(b) writing “section 1045 rollover” directly below the line on which the gain is reported; and (c) entering the amount of the gain deferred under § 1045 on the same line as (b) above, as a loss….” Sec. 3.02(1); Rev. Proc. 98–48, 1998–2 C.B. 367.
As with many QSBS situations, at issue in this case was whether the petitioner’s LeonardoMD and MacroPore stock are qualified QSBS as defined under §1202(c) and whether the petitioner satisfied the 60-day period requirement under §1045(a)(1). Key to this case was that the petitioner provided no evidence that showed the purchase of LeonardoMD was at Original Issuance. “Original issue” is defined as the “first issue of securities of a particular type or series.” Black’s Law Dictionary 908 (9th ed.2009). Statements from trial reflect that the petitioner has bought LeonardoMD stocks from the President and the Accountant of the company.
Petitioner provided no financial statements indicating the amount of cash and/or property held by LeonardoMD before and immediately after each and all of the 36 transactions of buying LeonardoMD. This is an issue when discussing whether LeonardoMD satisfies the Qualified Small Business criteria given the $50 million in aggregated gross assets threshold per IRC §1202(d). Since the petitioner was unable to demonstrate that the rolled over entity, LeonardoMD, met the criteria as a Qualified Small Business, the subsequent questions surrounding the petitioner satisfying the 60-day period rollover requirement under §1045(a)(1) was not further analyzed. Although, the petitioner has testified that some of the transactions—out of the 36—buying LeonardoMD occurred after 60-days of selling MacroPore stock.
The court decided in this case that:
- Petitioner failed to buy LeonardoMD stock at its original issue (provided under §1202(c)) and failed to carry their burden on proving otherwise
- Petitioner failed to provide evidence that showed LeonardoMD was a Qualified Business on the days purchased between 2002 and 2004 because there was no documentation that showed the corporations assets did not exceed $50 million before the issuance and immediately after provided under §1202(d)(1)(A)-(B).
- Petitioner failed to provide any evidence that showed LeonardoMD met the active business requirements under §1202(e) stating that during majority of the petitioners holding period for LeonardoMD stock, the corporation used at least 80% of its assets in the active conduct to further the business’s trade and/or business (in this case, provide physician practice management software)
United States Tax Court, No. 3769-10, August 30, 2012
Holmes v. Comm’r, T.C. Memo. 2012-251, aff’d (9th Cir 2015) 593 Fed Appx 693.
This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.