Recently proposed IRS regulations would limit the rollover of gain on "qualified small business stock" (QSB stock). Gain realized by a non-corporate investor on the sale of QSB stock held for at least six months may be rolled over into replacement QSB stock purchased within 60 days of the sale. Rollover effectively defers the tax until the replacement QSB stock is sold. Applying this simple rule to partnership purchases and sales, however, left ample gray area, now partially clarified by proposed regulations.

For example, some fund investors have taken the position that if a sale of QSB stock and purchase of replacement QSB stock occurred at the fund level but the fund declined to elect rollover treatment, the investor could make the election. The proposed regulations prohibit this. Similarly, some investors elected rollover treatment for a sale by one of their funds and a purchase of replacement QSB stock by another fund. Others elected rollover for a sale by the investor and a purchase of replacement QSB stock by a fund in which the investor held an interest. The proposed regulations deny rollover treatment in both cases.

The proposed regulations clarify that rollover elections may be made in three circumstances:

  • by a fund if it has a match (i.e., a sale and purchase of QSB stock within 60 days);
  • by an investor if the fund sells QSB stock and the investor purchases replacement QSB stock within 60 days; and
  • by an investor if the fund distributes QSB stock to the investor, who sells it and replaces it with QSB stock within 60 days.

A fund that makes a rollover election must notify its investors of the election and must adjust the tax basis of the fund’s replacement QSB stock separately for each investor. For those investors who qualify for rollover treatment (e.g., non-corporate investors), the tax basis of the fund’s replacement QSB stock is reduced by the amount of gain rolled over. If adopted, the new regulations would be effective on the date of publication of final regulations in the Federal Register.

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