[Federal Register Volume 69, Number 135 (Thursday, July 15, 2004)]
[Proposed Rules]
[Pages 42370-42379]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-15964]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-150562-03]
RIN 1545-BC67


Section 1045 Application to Partnerships

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations relating to the 
application of section 1045 of the Internal Revenue Code (Code) to 
partnerships and their partners. These regulations provide rules 
regarding the deferral of gain on a partnership's sale of qualified 
small business stock and deferral of gain on a partner's sale of 
qualified small business stock distributed by a partnership. The 
proposed regulations affect partnerships that invest in qualified small 
business stock and their partners. This document also provides notice 
of a public hearing on the proposed regulations.

DATES: Written or electronic comments and requests to speak and 
outlines of topics to be discussed at the public hearing scheduled for 
Tuesday, November 2, 2004, at 10 a.m. must be received by October 11, 
2004.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-150562-03), Room 
5203, Internal Revenue Service, PO Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
150562-03), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC, or sent electronically, via the IRS 
Internet site at: www.irs.gov/regs or via the Federal eRulemaking 
Portal at www.regulations.gov (IRS and REG-150562-03). The public 
hearing will be held in the IRS Auditorium, Internal Revenue Building, 
1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Charlotte Chyr, (202) 622-3070, or Jian H. Grant, (202) 622-3050; 
concerning submissions, the hearing, and/or placement on the building 
access list to attend the hearing, Sonya Cruse, (202) 622-4693 (not 
toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in this notice of proposed 
rulemaking has been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507(d)). Comments on the collection of information should be 
sent to the Office of Management and Budget, Attn: Desk Officer for the 
Department of the Treasury, Office of Information and Regulatory 
Affairs, Washington, DC 20503, with copies to the Internal Revenue 
Service, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP 
Washington, DC 20224. Comments on the collection of information should 
be received no later than September 13, 2004. Comments are specifically 
requested concerning:
    Whether the proposed collection of information is necessary for the 
proper performance of the functions of the Internal Revenue Service, 
including whether the information will have practical utility;
    The accuracy of the estimated burden associated with the proposed 
collection of information (see below);
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
    How the burden of complying with the proposed collection of 
information can be minimized, including through the application of 
automated collection techniques or other forms of information 
technology; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of services to provide information.
    The collection of information in this proposed regulation is in 
Sec.  1.1045-

[[Page 42371]]

1(b)(4)(ii). This information is required to inform the IRS of 
partnerships and partners making the section 1045 election. The 
collection of information is required to obtain a benefit, that is, to 
elect to apply section 1045 treatment for qualified small business 
stock that is sold by the partnership. This information will be used by 
the partner to permit the partner to defer its allocable share of gain 
on the partnership's sale of qualified small business stock and by 
partnerships to make necessary adjustments to the basis of replacement 
qualified small business stock. The likely respondents are individuals, 
businesses or other for-profit institutions, and small businesses or 
organizations.
    The estimated burden for the collection of information in Sec.  
1.1045-1(b)(4)(ii) is as follows:
    Estimated total annual reporting burden: 1,000 hours.
    The estimated annual burden per respondent varies from 45 to 75 
minutes, depending on individual circumstances, with an estimated 
average of 1 hour.
    Estimated number of respondents: 1000.
    Estimated annual frequency of responses: On occasion.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless the collection of 
information displays a valid OMB control number assigned by the Office 
of Management and Budget.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    Section 1045 and section 1202 both provide for special treatment of 
gain on the sale of QSB stock held by non-corporate taxpayers. Under 
section 1202 of the Internal Revenue Code (Code), a taxpayer other than 
a corporation (a non-corporate taxpayer) excludes 50 percent of gain on 
the sale of qualified small business (QSB) stock (as defined in section 
1202(c)) from gross income if the taxpayer holds the stock for more 
than five years. Section 1045 permits a non-corporate taxpayer that 
holds QSB stock (relinquished QSB stock) for more than six months and 
sells it after August 5, 1997, to elect to defer recognizing gain on 
the sale. To qualify for such deferral, the taxpayer must purchase QSB 
stock (replacement QSB stock) within a 60-day period beginning on the 
date of the sale of the relinquished QSB stock. Any gain not recognized 
reduces the cost basis of the replacement QSB stock. Section 
1045(b)(3). The taxpayer recognizes gain to the extent the amount 
realized on the sale of the relinquished QSB stock exceeds the cost 
basis of the replacement QSB stock. Section 1045(a). Section 1045 does 
not apply to any gain treated as ordinary income. Id.
    Section 6005(f)(2) of the Internal Revenue Service Restructuring 
and Reform Act of 1998, Public Law 105-206 (112 Stat. 6005(f)(2)), July 
22, 1998, (the 1998 Act) added section 1045(b)(5). That section 
provides that rules similar to the rules in section 1202 (f), (g), (h), 
(i), (j), and (k) apply for purposes of section 1045. The legislative 
history accompanying the 1998 Act provides that the benefit of deferred 
recognition of gain with respect to the sale of QSB stock by a 
partnership will flow through to a partner who is not a corporation if 
the partner held the partnership interest at all times the partnership 
held the QSB stock. See H.R. Conf. Rep. 105-599, 105th Cong., 2d Sess. 
339 (1998). The legislative history further provides that there are no 
limitations on the types of partners that a partnership may have in 
order for the benefits of section 1045 to apply. Id. at 340.
    Under section 1202(g), a non-corporate taxpayer applies section 
1202 to the taxpayer's share of a passthrough entity's gain from the 
sale of QSB stock if two requirements are met. First, the passthrough 
entity must have held the QSB stock for more than five years. Second, 
the taxpayer must have held an interest in the passthrough entity on 
the date the passthrough entity acquired the QSB stock and at all times 
thereafter before the disposition of the stock. For purposes of section 
1202, passthrough entities include partnerships, S corporations, 
regulated investment companies (RICs), and common trust funds. Section 
1202(g)(4).
    QSB stock must generally be acquired by the taxpayer at its 
original issue. However, section 1202(h) provides that, in the case of 
certain transfers of QSB stock, the transferee is treated as having 
acquired such stock in the same manner as the transferor and as having 
held such stock during any continuous period immediately preceding the 
transfer during which it was held by the transferor. Section 1202(h) 
applies to transfers from a partnership to a partner of stock with 
respect to which requirements similar to the requirements of section 
1202(g) are met at the time of the transfer (without regard to the 5-
year holding period requirement) as well as to transfers by gift or at 
death.
    The committee reports underlying the enactment of section 1202 
explain that, under section 1202(h),

[q]ualified small business stock * * * may be distributed by a 
partnership to one or more of its partners, as long as (1) all 
eligibility requirements with respect to qualified small business 
stock are met, and (2) the partner held its interest in the 
partnership on the date the partnership acquired the stock and at 
all times thereafter and before the disposition of the stock. In 
addition, a partner cannot treat stock distributed by a partnership 
as qualified small business stock to the extent that the partner's 
share of the stock distributed by the partnership exceeded the 
partner's interest in the partnership at the time the partnership 
acquired the stock.

H.R. Rep. No. 103-111, 103d Cong., lst Sess. 602 (1993).

    The committee report goes on to explain that transferees in cases 
not described in section 1202(h) are not eligible for partial exclusion 
of gain under section 1202(a). Thus, for example, if qualified small 
business stock is transferred to a partnership and the partnership 
disposes of the stock, any gain from the disposition will not be 
eligible for the exclusion. Id.
    Rev. Proc. 98-48 (1998-2 C.B. 367) generally provides procedures 
for taxpayers (including passthrough entities and individuals holding 
interests in a passthrough entity) to elect to apply section 1045. The 
background section of the revenue procedure explains that, under 
section 1045(b)(5), a passthrough entity that sells QSB stock held for 
more than 6 months may make a section 1045 election if the entity 
purchases replacement QSB stock during the 60-day period beginning on 
the date of the sale. Section 2.03, Rev. Proc. 98-48. The benefit of 
the section 1045 election flows through to a non-corporate taxpayer 
that held an interest in the passthrough entity for as long as the 
entity held the QSB stock. The background section of the revenue 
procedure also explains that, under section 1045(b)(5), if a 
passthrough entity sells QSB stock held for more than six months, a 
non-corporate taxpayer who has held an interest in the entity during 
the period in which the entity held the QSB stock and who purchases 
replacement QSB stock during the 60-day statutory period may elect to 
apply section 1045 to the non-corporate taxpayer's share of any gain on 
the sale that the entity does not defer under section 1045. Section 
2.03, Rev. Proc. 98-48.
    Since Rev. Proc. 98-48 was published, the IRS and Treasury

[[Page 42372]]

Department have received inquiries regarding the application of section 
1045 to partnerships and their partners. In response to these 
inquiries, the proposed regulations provide rules relating to sales and 
purchases of interests in a partnership that owns QSB stock, 
partnership dispositions of QSB stock, partnership distributions of QSB 
stock, and contributions of QSB stock to a partnership. Partners and 
partnerships wishing to elect section 1045 must continue to follow the 
procedures of Rev. Proc. 98-48 for rules regarding the time and manner 
for making the election, the scope of the election, and revocation of 
the election.

Explanation of Provisions

A. General Rules and Definitions

1. QSB Stock
    Section 1045(b)(1) provides that the term QSB stock has the same 
meaning given such term by section 1202(c). Section 1202(c) provides 
that the term QSB stock is any stock in a C corporation that is 
originally issued after the date of the enactment of the Revenue 
Reconciliation Act of 1993, if (A) as of the date of issuance, the 
corporation is a qualified small business, and (B) except as provided 
in section 1202(f) and (h), the stock is acquired by the taxpayer at 
its original issue in exchange for money or other property (not 
including stock), or as compensation for services provided to the 
corporation.
    Some taxpayers have asked if a partner may treat a sale of a 
partnership interest as a sale of QSB stock or an acquisition of a 
partnership interest as an acquisition of QSB stock. Sections 1045 and 
1202 do not adopt a look-though approach to the sale and acquisition of 
partnership interests. Under the plain language of section 1202(c), an 
investment in a partnership that holds or purchases QSB stock is not 
treated as an investment in QSB stock. This plain language 
interpretation is further supported by the structure of sections 1045 
and 1202. Congress clearly contemplated partnership transactions when 
enacting section 1202, as several of its provisions address such 
transactions. In light of this, Congress's failure to provide for 
section 1202(a) treatment for acquisitions and dispositions of 
partnership interests appears to have been intentional. Such a decision 
by Congress would be consistent with the approach taken by section 
1202(g). That section allows partners to qualify for section 1202(a) 
treatment with respect to gain recognized by reason of holding a 
partnership interest only if the partner held the interest in the 
partnership on the date of the partnership's acquisition of QSB stock 
and at all times thereafter before the disposition of the stock by the 
partnership. If a partner were to sell its partnership interest while 
the partnership still held QSB stock, then the partner would not have 
held the partnership interest from the date of the acquisition of that 
stock until the date of the disposition of the stock by the 
partnership. For these reasons, the proposed regulations provide that 
the term QSB stock does not include an interest in a partnership that 
holds or purchases QSB stock.
2. Eligible Partner
    Under the proposed regulations, only an eligible partner may defer 
gain recognized by a partnership on the sale of QSB stock. Consistent 
with section 1202(g) and (h), the proposed regulations define an 
eligible partner as a non-corporate partner who held an interest in the 
partnership at all times that the partnership held the QSB stock or a 
non-corporate partner who acquired an interest in a partnership from an 
existing eligible partner by gift or death.
    The proposed regulations provide special rules for determining 
eligible partners if a partnership (upper-tier partnership) holds an 
interest in a partnership (lower-tier partnership) that holds QSB 
stock. The proposed rules disregard the upper-tier partnership's 
ownership of the lower-tier partnership and treat each partner of the 
upper-tier partnership as owning the interest in the lower-tier 
partnership directly. A partner of the upper-tier partnership is 
treated as owning an interest in the lower-tier partnership during the 
period in which both the partner of the upper-tier partnership held an 
interest in the upper-tier partnership and the upper-tier partnership 
held an interest in the lower-tier partnership.
    The IRS and the Treasury Department are concerned that, although 
the current look-through treatment for tiered partnerships may be the 
simplest approach, the application of the proposed rules presents the 
following potential problems: (1) The proposed rules prohibit an upper-
tier partnership from making a section 1045 election at the partnership 
level; (2) the eligible partners of the upper-tier partnership may not 
have the necessary information to benefit from the proposed rules; and 
(3) notification from the lower-tier partnership to the upper-tier 
partnerships and their partners and vice versa may be difficult if 
multiple tiers of partnerships are involved. Accordingly, the IRS and 
Treasury Department request comments specifically on the application of 
the proposed rules with respect to tiered partnerships.
3. Nonrecognition Limitation
    Under the proposed regulations, the amount of gain that an eligible 
partner may defer under section 1045 (whether the election to apply 
section 1045 is made at the partnership or the partner level) may not 
exceed: (A) The partner's smallest percentage interest in the 
partnership's income, gain, or loss with respect to the relinquished 
QSB stock, multiplied by (B) the partnership's realized gain from the 
sale of such stock. For this purpose, the partnership's realized gain 
from the sale of the QSB stock is determined without regard to any 
basis adjustment under section 734(b) or 743(b). This rule follows 
section 1202(g)(2) and (3) by ensuring that the partner can defer 
recognition of only the gain that relates to the partner's continuous 
economic interest in the relinquished QSB stock.

B. Partnership Election Under Section 1045

1. General Rule
    Consistent with Rev. Proc. 98-48, the proposed regulations allow a 
partnership to elect to apply section 1045 if the partnership held QSB 
stock for more than six months, sold such QSB stock, and purchased 
other QSB stock (replacement QSB stock) within 60 days of the sale. If 
the partnership makes an election under section 1045, all eligible 
partners of the partnership must defer their distributive shares of the 
partnership section 1045 gain from the partnership's sale of the QSB 
stock. No separate election is required of the partners. Partnership 
section 1045 gain equals the partnership's gain from the sale of the 
QSB stock reduced by the greater of: (A) The gain from the sale of the 
QSB stock that is treated as ordinary income, or (B) the excess of the 
amount realized by the partnership on the sale over the cost of any 
replacement QSB stock purchased by the partnership during the 60-day 
period beginning on the date of the sale.
2. Election Procedures and Notification
    The proposed regulations require the partnership to make the 
section 1045 election on the partnership's timely filed return 
(including extensions) for the taxable year during which the 
partnership sells the QSB stock. In addition, the partnership must 
follow the procedures of Rev. Proc. 98-48.
    When a partnership makes the election, the proposed regulations 
require the partnership to notify all

[[Page 42373]]

partners that it has made the election, and separately state each 
partner's distributive share of the partnership section 1045 gain under 
section 702. Each partner must determine if it is an eligible partner 
and report the partner's distributive share of gain, including gain not 
recognized, on Schedule D of the partner's Federal income tax return.

C. Partner Election Under Section 1045

1. General Rule
    Also consistent with Rev. Proc. 98-48, the proposed regulations 
allow an eligible partner to make a section 1045 election with respect 
to the partner's share of gain from the partnership's sale of QSB stock 
if the partnership does not make a section 1045 election or purchase 
replacement QSB stock within the statutory time period. The election 
may be made if the partnership either replaces none of the relinquished 
QSB stock or replaces some but not all of the relinquished QSB stock. 
For example, relinquished QSB stock can be partially replaced by the 
partnership and partially replaced by the partner if section 1045 
elections are made by both the partnership and the partner. If a 
partner makes a section 1045 election, the partner recognizes its 
distributive share of the gain from the sale of the relinquished QSB 
stock only to the extent of the greater of: (1) The gain that is 
treated as ordinary income, or (2) the excess of the partner's share of 
the amount realized by the partnership on the sale of the QSB stock 
over the cost of any replacement QSB stock purchased by the partner 
during the 60-day statutory period.
    A partnership that has sold QSB stock should promptly notify its 
partners when it does not intend to make a section 1045 election with 
respect to the sale. Prompt notification will allow partners who intend 
to make separate section 1045 elections time to purchase replacement 
QSB stock within 60 days of the sale of the relinquished QSB stock and 
to make timely section 1045 elections. However, the proposed 
regulations do not impose a requirement on partnerships to provide such 
notification. The IRS and Treasury Department believe that it is more 
appropriate for the partners to decide (for example, in the partnership 
agreement) whether, and to what extent, the partnership must provide 
such notification.
2. Election Procedures
    The proposed regulations provide that a partner making an election 
under section 1045 with respect to its distributive share of gain on 
the partnership's sale of QSB stock must do so on the partner's timely 
filed federal income tax return (including extensions) for the taxable 
year in which such gain is taken into account. In addition, the partner 
must follow the procedures of Rev. Proc. 98-48.

D. Basis Adjustments

    The proposed regulations provide rules regarding adjustments to the 
eligible partner's basis in the partnership interest and the 
partnership's basis in the replacement QSB stock. Under these rules, if 
the partnership makes a section 1045 election, then the eligible 
partner may not increase its outside basis by the amount of gain that 
is not recognized under section 1045. In addition, the partnership is 
required to reduce its basis in the replacement QSB stock by the amount 
of gain that is not recognized by its partners. The adjustment to the 
partnership's inside basis in the replacement QSB stock is similar to a 
basis adjustment under section 743(b). These rules are necessary to 
preserve (in the replacement QSB stock and the partnership interest) 
the deferred gain on the sale of the relinquished QSB stock.
    As explained above, a partner's basis in a partnership interest is 
not increased by any gain that is deferred by reason of a partnership 
section 1045 election. In contrast, a partner's basis in a partnership 
interest is increased by any gain that is deferred by reason of a 
partner section 1045 election. A partner must reduce the basis of any 
replacement QSB stock the partner purchases by the amount of gain that 
is not recognized by reason of a partner section 1045 election.
    To allow the partnership to make the appropriate adjustments to the 
basis of the replacement QSB stock, the proposed regulations require 
any partner who recognizes all or part of the partner's distributive 
share of partnership section 1045 gain to notify the partnership of the 
amount of the partnership section 1045 gain that was recognized. In the 
absence of notification, the partnership must presume that the partner 
deferred recognition of the partnership section 1045 gain and decrease 
its basis in the replacement QSB stock by the partner's distributive 
share of partnership section 1045 gain until such time as the partner 
provides notification of the amount recognized by the partner. However, 
if the partnership knows that one of its partners was, during any 
period in which the partnership held the QSB stock, classified as a 
corporation for federal tax purposes, then the partnership may presume 
that the partner did not defer recognition of the partnership section 
1045 gain even in the absence of a notification by the partner.

E. Distribution of QSB Stock

    Consistent with section 1202(h) and the legislative history 
underlying that section, the proposed regulations provide that, if a 
partnership distributes QSB stock to an eligible partner, then the 
eligible partner is treated as having acquired such stock in the same 
manner as the partnership and having held such stock during any 
continuous period immediately preceding the distribution during which 
it was held by the partnership. However, the amount of gain on the sale 
of such distributed QSB stock that the partner can defer cannot exceed 
the distribution nonrecognition limitation. For this purpose, the 
distribution nonrecognition limitation is equal to the partner's 
section 1045 amount realized, reduced by the partner's section 1045 
adjusted basis. The proposed regulations provide rules for determining 
the partner's section 1045 amount realized and the partner's section 
1045 adjusted basis in the case of a liquidating distribution, a 
nonliquidating distribution of all of the QSB stock (of the same type), 
and other nonliquidating distributions.
    These rules follow the legislative history's directive that a 
partner may not treat stock distributed by a partnership as QSB stock 
to the extent that the partner's share of the distributed stock exceeds 
the partner's interest in the partnership at the time the partnership 
acquired the stock. Under the proposed regulations, the amount of gain 
that a distributee partner may defer on the sale of distributed QSB 
stock will be no more than (but in the case of QSB stock received in 
certain nonliquidating distributions may be less than) the amount of 
gain that the partner would have been able to defer in the absence of 
the distribution.
    The IRS and Treasury Department considered an alternative approach 
for determining the distribution nonrecognition limitation for sales of 
QSB stock following a nonliquidating distribution to a partner. Under 
this alternative approach, the distribution nonrecognition limitation 
would be determined by reference to the maximum amount of gain that the 
partner would have been able to defer if the partnership had not 
distributed any QSB stock of the type sold, but instead had sold all of 
that QSB stock for a per share price equal to the per share price 
received on the actual sale of the distributed QSB stock by the

[[Page 42374]]

partner. Due to the complexity of this alternative approach, it was 
rejected and is not included in the proposed regulations. The IRS and 
Treasury Department request comments on the extent to which refinements 
of the distribution nonrecognition limitation applicable to sales of 
distributed QSB stock are appropriate.

F. Contribution of QSB Stock

    The proposed regulations provide that a contribution of QSB stock 
to a partnership in a transaction to which section 721(a) applies does 
not cause the contributing partner to recognize any gain that was 
previously deferred under section 1045. However, the QSB stock, once 
contributed, is no longer QSB stock in the hands of the partnership 
because the partnership has not acquired the stock at original issue 
within the meaning of section 1202(c)(1)(B). See also H.R. Rep. No. 
103-111, 103d Cong., 1st Sess. 602 (1993).

G. Proposed Effective Date

    The regulations are proposed to apply to sales of QSB stock on or 
after the date final regulations are published in the Federal Register.

Effect on Other Documents

    The following publication will be amplified for partners and 
partnerships beginning on or after the date these regulations are 
published as final regulations in the Federal Register:
    Rev. Proc. 98-48 (1998-2 C.B. 367).

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It also has 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations. It is hereby 
certified that the collection of information in these regulations will 
not have a significant economic impact on a substantial number of small 
entities. This certification is based upon the fact that QSB stock is 
not held by a substantial number of small entities and that the time 
required to make the election is estimated to average 1 hour. 
Therefore, a Regulatory Flexibility Analysis under the Regulatory 
Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to 
section 7805(f) of the Code, this notice of proposed rulemaking will be 
submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written (a signed original and eight 
(8) copies) or electronic comments that are submitted timely to the 
IRS. The IRS and Treasury Department request comments on the clarity of 
the proposed rules and how they can be made easier to understand. All 
comments will be available for public inspection and copying.
    A public hearing has been scheduled for Tuesday, November 2, 2004, 
at 10 a.m. in the IRS Auditorium, Internal Revenue Building, 1111 
Constitution Avenue, NW., Washington, DC. Due to building security 
procedures, visitors must enter at the Constitution Avenue entrance. In 
addition, all visitors must present photo identification to enter the 
building. Because of access restrictions, visitors will not be admitted 
beyond the immediate entrance area more than 15 minutes before the 
hearing starts. For information about having your name placed on the 
building access list to attend the hearing, see the FOR FURTHER 
INFORMATION CONTACT section of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit written or 
electronic comments and an outline of the topics to be discussed and 
the time to be devoted to each topic (signed original and eight (8) 
copies) by October 11, 2004. A period of 10 minutes will be allotted to 
each person for making comments. An agenda showing the scheduling of 
the speakers will be prepared after the deadline for receiving outlines 
has passed. Copies of the agenda will be available free of charge at 
the hearing.

Drafting Information

    The principal authors of these regulations are Charlotte Chyr and 
Jian H. Grant, Office of the Associate Chief Counsel (Passthroughs and 
Special Industries). However, other personnel from the IRS and Treasury 
Department participated in their development.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 301

    Employment taxes, Estate taxes, Excise taxes, Gift taxes, Income 
taxes, Penalties, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read, 
in part, as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 2. Section 1.1045-1 is added to read as follows:


Sec.  1.1045-1  Application to partnerships.

    (a) General rules--(1) Definition of QSB stock--In general. For 
purposes of section 1045 and this section, qualified small business 
stock (QSB stock) has the meaning provided in section 1202(c). For 
purposes of section 1045 and this section, the term QSB stock does not 
include an interest in a partnership that purchases or holds QSB stock. 
(For further guidance, see Example 1 and Example 2 of paragraph (g) of 
this section.)
    (2) Eligible partner--(i) In general. For purposes of this section, 
an eligible partner with respect to QSB stock is a taxpayer other than 
a corporation who holds an interest in a partnership on the date the 
partnership acquires the QSB stock and at all times thereafter before 
the partnership sells or distributes the QSB stock.
    (ii) Acquisition by gift or at death. For purposes of this section, 
a taxpayer who acquires from an eligible partner by gift or at death an 
interest in a partnership that holds QSB stock is treated as having 
held the acquired interest in the partnership during the period the 
eligible partner held the interest in the partnership. (For further 
guidance, see Example 6 of paragraph (g) of this section.)
    (iii) Tiered partnership--(A) Generally. If a partnership (upper-
tier partnership), holds an interest in another partnership (lower-tier 
partnership) that holds QSB stock, then, for purposes of this paragraph 
(a)(2), the upper-tier partnership's ownership of the lower-tier 
partnership is ignored and each partner of the upper-tier partnership 
is treated as owning the interest in the lower-tier partnership 
directly. The partner of the upper-tier partnership is treated as 
owning the interest in the lower-tier partnership during the period in 
which both--
    (1) The partner of the upper-tier partnership held an interest in 
the upper-tier partnership; and
    (2) The upper-tier partnership held an interest in the lower-tier 
partnership. (For further guidance, see Example 3 of paragraph (g) of 
this section.)

[[Page 42375]]

    (B) Multiple tiers of partnership. Principles similar to those 
described in paragraph (a)(2)(iii)(A) of this section apply where a 
taxpayer holds the interest in the lower-tier partnership through 
multiple tiers of partnerships.
    (3) Nonrecognition limitation--(i) In general. For purposes of this 
section, the amount of gain that an eligible partner does not recognize 
under paragraphs (b)(1) and (c)(1) of this section cannot exceed the 
nonrecognition limitation. For this purpose, the nonrecognition 
limitation is equal to the product of--
    (A) The partnership's realized gain from the sale of the QSB stock, 
determined without regard to any basis adjustment under section 734(b) 
or 743(b) (other than basis adjustments described in paragraph 
(b)(3)(ii) of this section); and
    (B) The eligible partner's smallest percentage interest in the 
partnership's income, gain, or loss with respect to the QSB stock that 
was sold. (For further guidance, see Example 4 of paragraph (g) of this 
section.)
    (ii) Eligible partner's smallest percentage interest. In 
determining an eligible partner's smallest percentage interest in the 
partnership's income, gain, or loss with respect to QSB stock, 
reductions in the partner's interest that occur solely as a result of a 
distribution of QSB stock to the partner are not taken into account.
    (b) Partnership election--(1) General rule. A partnership that 
holds QSB stock for more than six months, sells such QSB stock, and 
purchases other QSB stock (replacement QSB stock), within 60 days 
beginning on the date of the sale may elect to apply section 1045. For 
purposes of this paragraph (b)(1), a purchase of replacement QSB stock 
by a partner is not treated as a purchase of replacement QSB stock by 
the partnership. If the partnership elects to apply section 1045, then, 
subject to the provisions of paragraph (a)(3) of this section, each 
eligible partner does not recognize the partner's distributive share of 
any partnership section 1045 gain. For this purpose, partnership 
section 1045 gain equals the partnership's gain from the sale of the 
QSB stock reduced by the greater of--
    (i) The amount of the gain from the sale of the QSB stock that is 
treated as ordinary income; or
    (ii) The excess of the amount realized by the partnership on the 
sale over the cost of any replacement QSB stock purchased by the 
partnership during the 60-day period beginning on the date of the sale 
(excluding the cost of any replacement QSB stock that is otherwise 
taken into account under section 1045).
    (2) Partner's share of partnership section 1045 gain. A partnership 
must allocate partnership section 1045 gain to the partners in the same 
proportion as the partnership's entire gain from the sale of the QSB 
stock is allocated to the partners. For this purpose, the partnership's 
gain from the sale of QSB stock and the partner's distributive share of 
that gain are determined without regard to basis adjustments under 
section 743(b) and paragraph (b)(3)(ii) of this section.
    (3) Basis adjustments--(i) Partner's interest in a partnership. 
Notwithstanding section 705(a)(1), the adjusted basis of a partner's 
interest in a partnership is not increased by gain from a partnership's 
sale of QSB stock that is not recognized by the partner under paragraph 
(b)(1) of this section.
    (ii) Partnership's replacement QSB stock. The basis of a 
partnership's replacement QSB stock is reduced (in the order acquired) 
by the amount of gain from the partnership's sale of QSB stock that is 
not recognized by an eligible partner. The basis adjustment with 
respect to any amount described in this paragraph (b)(3)(ii) 
constitutes an adjustment to the basis of the partnership's replacement 
QSB stock with respect to that partner only. The effect of such a basis 
adjustment is determined under the principles of Sec.  1.743-1(g), (h), 
and (j). For purposes of this paragraph (b)(3)(ii), the partnership 
must presume that a partner did not recognize that partner's 
distributive share of QSB gain until such time as the partner provides 
to the partnership the notification described in paragraph (b)(4)(ii) 
of this section. However, if the partnership knows that a particular 
partner is classified, for Federal tax purposes, as a corporation 
during any period in which the partnership held the QSB stock, then the 
partnership may presume that the partner did not defer recognition of 
the partnership section 1045 gain, even in the absence of a 
notification by the partner.
    (4) Notice requirements--(i) Partnership notification to partners. 
A partnership that makes the election described in paragraph (b)(1) of 
this section must notify all of its partners of the election in 
accordance with the applicable forms and instructions and separately 
state each partner's distributive share of gain from the sale of QSB 
stock under section 702. Each partner shall determine whether the 
partner is an eligible partner within the meaning of paragraph (b)(1) 
of this section and report the partner's distributive share of gain 
from the partnership's sale of QSB stock, including gain not 
recognized, on Schedule D of the partner's federal income tax return.
    (ii) Partner notification to partnership. Any partner that must 
recognize all or part of the partner's distributive share of 
partnership section 1045 gain must notify the partnership, in writing, 
of the amount of partnership section 1045 gain that is recognized by 
the partner. (For further guidance concerning paragraph (b) of this 
section, see Example 4 through Example 7 of paragraph (g) of this 
section.)
    (c) Partner election--(1) In general. If an eligible partner of a 
partnership that sells QSB stock purchases replacement QSB stock during 
the 60-day period beginning on the date of the partnership's sale of 
the QSB stock, then the partner may elect to apply section 1045. For 
purposes of this paragraph (c)(1), a purchase of replacement QSB stock 
by the partnership is not treated as a purchase of replacement QSB 
stock by a partner. An eligible partner that elects to apply section 
1045 must recognize its distributive share of gain from the 
partnership's sale of QSB stock only to the extent of the greater of--
    (i) The amount of the partner's distributive share of the gain from 
the sale of the QSB stock that is treated as ordinary income; or
    (ii) The excess of the partner's share of the amount realized by 
the partnership on the sale of the QSB stock (excluding any QSB stock 
that was replaced by the partnership) over the cost of any replacement 
QSB stock purchased by the partner during the 60-day period beginning 
on the date of the partnership's sale of the QSB stock (excluding the 
cost of any replacement QSB stock that is otherwise taken into account 
under section 1045).
    (2) Partner's share of amount realized by partnership. The 
partner's share of the amount realized by the partnership shall bear 
the same proportion to the amount realized by the partnership on the 
sale of the QSB stock (excluding the cost of any replacement QSB stock) 
as the partner's distributive share of the partnership's realized gain 
from the sale of the QSB stock bears to the partnership's realized gain 
on the sale of the QSB stock. For this purpose, the partnership's 
realized gain from the sale of QSB stock and the partner's distributive 
share of that gain are determined without regard to basis adjustments 
under section 743(b) and paragraph (b)(3)(ii) of this section.
    (3) Basis adjustments--(i) Partner's interest in a partnership. 
Under section 705(a)(1), the adjusted basis of a partner's interest in 
a partnership is increased by the amount of gain that is not recognized 
by an eligible partner

[[Page 42376]]

pursuant to paragraph (c)(1) of this section.
    (ii) Partner's replacement QSB stock. A partner's basis in any 
replacement QSB stock that is purchased by the partner during the 60-
day period described in paragraph (c)(1) of this section must be 
reduced (in the order acquired) by the partner's distributive share of 
the gain on the sale of the partnership's QSB stock that is not 
recognized by the partner pursuant to paragraph (c)(1) of this section. 
(For further guidance concerning this paragraph (c), see Example 8 
through Example 10 of paragraph (g) of this section.)
    (d) Partnership distribution of QSB stock to an eligible partner--
(1) In general. Subject to paragraphs (d)(2) and (3) of this section, 
in the case of a partnership distribution of QSB stock to an eligible 
partner within the meaning of paragraph (a)(2) of this section, the 
eligible partner shall be treated as--
    (i) Having acquired such stock in the same manner as the 
partnership; and
    (ii) Having held such stock during any continuous period 
immediately preceding the distribution during which it was held by the 
partnership. (For further guidance concerning this paragraph (d), see 
Example 11 and Example 12 of paragraph (g) of this section.)
    (2) Eligibility under section 1202(c). Paragraph (d)(1) of this 
section does not apply unless all eligibility requirements with respect 
to the QSB stock as defined in section 1202(c) are met by the 
distributing partnership with respect to its investment in the QSB 
stock.
    (3) Distribution nonrecognition limitation--(i) Generally. The 
amount of gain that an eligible partner does not recognize on the sale 
of QSB stock (the relinquished QSB stock) that was distributed by the 
partnership to the partner cannot exceed the distribution 
nonrecognition limitation. For this purpose, the nonrecognition 
limitation is--
    (A) The partner's section 1045 amount realized; reduced by
    (B) The partner's section 1045 adjusted basis.
    (ii) Section 1045 amount realized--(A) QSB stock received in 
liquidation of partner's interest and in certain nonliquidating 
distributions. If a partner receives relinquished QSB stock from the 
partnership in a distribution in liquidation of the partner's interest 
in the partnership or as part of a series of related distributions by 
the partnership in which the partnership distributes all of the 
partnership's QSB stock of a particular type, then the partner's 
section 1045 amount realized is the partner's amount realized from the 
sale of the relinquished QSB stock, multiplied by a fraction--
    (1) The numerator of which is the partner's smallest percentage 
interest (prior to the distribution) in the partnership's income, gain, 
or loss with respect to the type of QSB stock sold by the partner; and
    (2) The denominator of which is the partner's percentage interest 
in that type of partnership QSB stock immediately after the 
distribution (determined under paragraph (d)(3)(iv) of this section).
    (B) QSB stock received in other distributions. If a partner 
receives relinquished QSB stock in a distribution from the partnership 
that is not described in paragraph (d)(3)(ii)(A) of this section, the 
partner's section 1045 amount realized is the partner's amount realized 
from the sale of the relinquished QSB stock multiplied by the partner's 
smallest interest (prior to the distribution) in the partnership's 
income, gain, or loss with respect to such stock.
    (iii) Section 1045 adjusted basis--(A) QSB stock received in 
liquidation of partner's interest and in certain nonliquidating 
distributions. If a partner receives relinquished QSB stock from the 
partnership in a distribution in liquidation of the partner's interest 
in the partnership or as part of a series of related distributions by 
the partnership in which the partnership distributes all of the 
partnership's QSB stock of a particular type, then the partner's 
section 1045 adjusted basis is the product of--
    (1) The partnership's basis in all of the QSB stock of the type 
distributed (without regard to basis adjustments under section 734(b) 
or 743(b), other than basis adjustments described in paragraph 
(b)(3)(ii) of this section);
    (2) The partner's smallest interest (prior to the distribution) in 
the partnership's income, gain, or loss with respect to such stock; and
    (3) The proportion of the distributed QSB stock that was sold by 
the partner.
    (B) QSB stock received in other distributions. If a partner 
receives relinquished QSB stock in a distribution from the partnership 
that is not described in paragraph (d)(3)(iii)(A) of this section, the 
partner's section 1045 adjusted basis is the product of--
    (1) The partnership's basis in the QSB stock sold by the partner 
(without regard to basis adjustments under section 734(b) or 743(b), 
other than basis adjustments described in paragraph (b)(3)(ii) of this 
section); and
    (2) The partner's smallest interest (prior to the distribution) in 
the partnership's income, gain, or loss with respect to such stock.
    (iv) Partner's percentage interest in distributed QSB stock. For 
purposes of this paragraph (d)(3), a partner's percentage interest in a 
type of QSB stock immediately after a partnership distribution is the 
value (as of the date of the distribution) of the QSB stock distributed 
to the partner divided by the value (as of the date of the 
distribution) of all of that type of QSB stock that was acquired by the 
partnership.
    (v) QSB stock of the same type. For purposes of this paragraph 
(d)(3), QSB stock will be of the same type as the distributed QSB stock 
if it has the same issuer and the same rights and preferences as the 
distributed QSB stock and was acquired by the partnership at its 
original issue.
    (e) Contribution of QSB stock or replacement QSB stock to a 
partnership. Section 721 applies to a contribution of QSB stock to a 
partnership by a taxpayer other than a corporation. Except as provided 
in section 721(b), any gain that was not recognized by the taxpayer 
under section 1045 is not recognized when the taxpayer contributes QSB 
stock to a partnership in exchange for a partnership interest in the 
hands of the taxpayer. Stock that is contributed to a partnership is 
not QSB stock in the hands of the partnership because the partnership 
did not acquire the stock at original issue. (For further guidance, see 
Example 13 of paragraph (g) of this section.)
    (f) Time and manner of making election. A partnership making an 
election under section 1045 (as described under paragraph (b)(1) of 
this section) must do so on the partnership's timely filed (including 
extensions) return for the taxable year during which the sale of QSB 
stock occurs. A partner making an election under section 1045 (as 
described under paragraph (c)(1) of this section) must do so on the 
partner's timely filed (including extensions) Federal income tax return 
for the taxable year during which the partner's distributive share of 
the partnership's gain from the sale of the QSB stock is taken into 
account under section 706. In addition, a partnership or partner making 
an election under section 1045 must follow the administrative 
procedures issued for making such elections. (For further guidance, see 
Rev. Proc. 98-48 (1998-2 C.B. 367) and Sec.  601.601(d)(2)(ii)(b) of 
this chapter.)
    (g) Examples. The provisions of this section are illustrated by the 
following examples:

    Example 1. Acquisition of a partnership interest as replacement 
property. On January

[[Page 42377]]

1, 2006, A, an individual, X, a corporation, and Y, a corporation, 
form PRS, a partnership. A, X, and Y each contribute $25 to PRS and 
agree to share all partnership items equally. PRS purchases QSB 
stock on February 1, 2006, and subsequently sells the QSB stock on 
November 4, 2006, for $150. PRS realizes $75 of gain from the sale 
of the QSB stock (none of which is treated as ordinary income) and 
allocates $25 of gain to each of A, X, and Y. On November 30, 2006, 
A contributes $50 to ABC, a partnership, in exchange for an interest 
in ABC (instead of purchasing QSB stock). ABC then purchases QSB 
stock for $50 on December 1, 2006. A's acquisition of the additional 
partnership interest is not treated as a purchase of replacement QSB 
stock for purposes of section 1045.
    Example 2. Sale of a partnership interest. The facts are the 
same as in Example 1, except that PRS does not sell its QSB stock. 
Instead, on November 4, 2006, A sells the PRS interest for $50x, 
realizing $25 of capital gain. On November 30, 2006, A purchases $50 
of new QSB stock. Under paragraph (a)(1) of this section, the sale 
of an interest in a partnership that holds QSB stock is not treated 
as a sale of QSB stock. Therefore, A may not elect to apply section 
1045 with respect to A's $25 of gain from the sale of the PRS 
interest.
    Example 3. Eligible and non-eligible partners of tiered 
partnership. On January 1, 2006, A, an individual, and B, an 
individual, contribute cash to UTP, (upper-tier partnership) for 
equal partnership interests. On February 1, 2006, UTP and C, an 
individual, contribute cash to LTP, (lower-tier partnership) for 
equal partnership interests. On March 1, 2006, LTP purchases QSB 
stock. On April 1, 2006, D, an individual, joins UTP by contributing 
cash to UTP for a 1/3 interest in UTP. On December 1, 2006, LTP 
sells the QSB stock. Under paragraph (a)(2)(iii) of this section, A, 
B, and D are treated as owning an interest in LTP during the period 
in which each of the partners held an interest in UTP and UTP held 
an interest in LTP. Therefore, under paragraph (a)(2)(i) of this 
section, A and B are eligible partners, and D is not an eligible 
partner.
    Example 4. Partnership sale of QSB stock and purchase and sale 
of replacement QSB stock. (i) Assume the same facts as in Example 1, 
except that PRS purchases replacement QSB stock for $135 on December 
15, 2006. On its timely filed return for the taxable year during 
which the sale of the relinquished QSB stock occurs, PRS makes an 
election to apply section 1045. PRS knows that X and Y are 
corporations. On March 30, 2007, PRS sells the replacement QSB stock 
for $165. PRS realizes $30 of capital gain from the sale of the 
replacement QSB stock and allocates $10 of gain to each of A, X, and 
Y.
    (ii) Under paragraph (b)(1) of this section, the partnership 
section 1045 gain is $60 ($75 gain less $15 ($150 amount realized on 
the sale of the relinquished QSB stock less $135 cost of the 
replacement QSB stock)). This amount must be allocated among the 
partners in the same proportions as the entire gain from the sale of 
the QSB stock is allocated to the partners, \1/3\ ($20) to A, \1/3\ 
($20) to X, and \1/3\ ($20) to Y.
    (iii) Because neither X nor Y are eligible partners under 
paragraph (a)(2) of this section, X and Y must each recognize its 
$25 distributive share of partnership gain from the sale of the QSB 
stock. Because A is an eligible partner under paragraph (a)(2) of 
this section, and because A is bound by the election by PRS to apply 
section 1045, A defers recognition of A's $20 distributive share of 
partnership section 1045 gain. A is not required to separately elect 
to apply section 1045. A must recognize A's remaining $5 
distributive share of the partnership's gain from the sale of the 
QSB stock.
    (iv) Under section 705(a)(1)(A), the adjusted bases of X's and 
Y's interests in PRS are each increased by $25. Under section 
705(a)(1)(A) and paragraph (b)(3)(i) of this section, the adjusted 
basis of A's interest in PRS is not increased by the $20 of 
partnership section 1045 gain that was not recognized by A, but is 
increased by A's remaining $5 distributive share of gain.
    (v) PRS must decrease its basis in the replacement QSB stock by 
the $20 of partnership section 1045 gain that was allocated to A. 
This basis reduction is a reduction with respect to A only. PRS then 
adjusts A's distributive share of gain from the sale of the 
replacement QSB stock to reflect the effect of A's basis adjustment 
under paragraph (b)(3)(ii) of this section. In accordance with the 
principles of Sec.  1.743-1(j)(3), the amount of A's gain from the 
sale of the replacement QSB stock in which A has a $20 negative 
basis adjustment equals $30 (A's share of PRS's gain from the sale 
of the replacement QSB stock ($10), increased by the amount of A's 
negative basis adjustment for the replacement stock ($20)). 
Accordingly, upon the sale of the replacement QSB stock, A 
recognizes $30 of gain, and X and Y each recognize $10 of gain.
    Example 5. Sale of partnership interest while partnership holds 
QSB stock. Assume the same facts as in Example 4, except that A 
sells A's interest in PRS to B, an individual, on March 1, 2006. B 
is not an eligible partner under paragraph (a)(2)(i) of this 
section, because B did not hold an interest in PRS on the date PRS 
originally acquired the QSB stock. Therefore, B must recognize B's 
distributive share of partnership section 1045 gain.
    Example 6. Death of partner while partnership holds QSB stock. 
Assume the same facts as in Example 4, except that A dies on March 
1, 2006, and B inherits A's interest in PRS. Under paragraph 
(a)(2)(ii) of this section, B is treated as holding the interest in 
PRS during the period that A held the interest in PRS. Therefore, B 
is an eligible partner under paragraph (a)(2)(i) of this section. 
Accordingly, B defers recognition of B's distributive share of the 
partnership section 1045 gain on the sale of the QSB stock.
    Example 7. Partnership sale of QSB stock and partner purchase of 
replacement QSB stock. (i) Assume the same facts as in Example 4, 
except that PRS does not make an election under section 1045 with 
respect to the sale of the QSB stock. On November 30, 2006, A, an 
eligible partner under paragraph (a)(2) of this section, purchases 
replacement QSB stock for $50. A elects to apply section 1045 on A's 
timely filed return for the taxable year that A is required to 
include A's distributive share of PRS's gain from the sale of the 
relinquished QSB stock.
    (ii) Under paragraph (c)(2) of this section, A's share of the 
amount realized from PRS's sale of the QSB stock is $50 (the amount 
which bears the same proportion to the total amount realized by the 
partnership on the sale of the QSB stock ($150) as A's share of the 
gain from the sale of the QSB stock ($25) bears to the total gain 
realized by the partnership on the sale of the QSB stock ($75)). 
Because A purchased, within 60 days of PRS's sale of the QSB stock, 
replacement QSB stock for a cost equal to A's share of the 
partnership's amount realized on the sale of the QSB stock, and 
because A made a valid election to apply section 1045, A defers 
recognition of A's $25 distributive share of gain from PRS's sale of 
the QSB stock. Under section 705(a)(1) and paragraph (c)(3)(i) of 
this section, the adjusted basis of A's interest in PRS is increased 
by $25. Under paragraph (c)(3)(ii) of this section, A's basis in the 
replacement QSB stock is $25 ($50 cost minus $25 nonrecognition 
amount).
    Example 8. Election by partner; replacement by partnership. 
Assume the same facts as in Example 7, except that PRS purchases 
replacement QSB stock on December 31, 2006, but does not make an 
election to apply section 1045. A makes an election to apply section 
1045, but does not purchase any replacement QSB stock during the 60-
day period beginning on the date of PRS's sale of the QSB stock. 
Because the requirements of neither paragraph (b)(1) nor paragraph 
(c)(1) of this section has been satisfied, A must recognize all of 
A's distributive share of the gain from PRS's sale of the QSB stock.
    Example 9. Partial replacement by partnership; partial 
replacement by partner. (i) On January 1, 2006, A, an individual, 
and X, a corporation, form PRS, a partnership. A and X each 
contribute $50 to PRS and agree to share all partnership items 
equally. PRS purchases QSB stock on February 1, 2006, for $100 and 
subsequently sells the QSB stock on January 31, 2008, for $300. PRS 
realizes $200 of gain from the sale of the QSB stock (none of which 
is treated as ordinary income) and allocates $100 of gain to each of 
A and X. On February 10, 2008, PRS purchases replacement QSB stock 
for $220. On March 20, 2008, A purchases replacement QSB stock for 
$40. Both A and PRS make valid elections to apply section 1045.
    (ii) Under paragraph (b)(1) of this section, partnership section 
1045 gain is $120 ($200 less $80 ($300 amount realized on the sale 
of the relinquished QSB stock minus $220 cost of the replacement QSB 
stock)). This amount is allocated among the partners in the same 
proportions as the entire gain from the sale of the QSB stock is 
allocated to the partners, \1/2\ to A ($60), and \1/2\ to X ($60). 
Because A is an eligible partner, A defers recognition of A's $60 
distributive share of partnership section 1045 gain.
    (iii) A also made a valid section 1045 election and purchased, 
within 60 days of

[[Page 42378]]

PRS's sale of the QSB stock, replacement QSB stock. Therefore, under 
paragraph (c)(1) of this section, A may defer a portion of A's 
distributive share of the remaining gain from the partnership's sale 
of the QSB stock. A must recognize that remaining gain, however, to 
the extent that A's share of the amount realized by PRS on the sale 
of the QSB stock (excluding the QSB stock that was replaced by PRS) 
exceeds the cost of the replacement QSB stock purchased by A during 
the 60-day period following the sale of the QSB stock. The amount 
realized by PRS on the sale of the QSB stock (excluding the QSB 
stock that was replaced by PRS) is $80 ($300 minus $220). Under 
paragraph (c)(2) of this section, A's share of that amount realized 
is $40 (50/100 (A's share of the gain from the sale of the QSB 
stock) multiplied by $80). Because the replacement QSB stock 
purchased by A cost $40, A defers recognition of all of the 
remaining gain from the sale of the QSB stock.
    (iv) The adjusted basis of A's interest in PRS is not increased 
by the gain that was not recognized pursuant to paragraph (b)(1) of 
this section, $60, but is increased by the gain that was not 
recognized pursuant to paragraph (c)(1) of this section, $40. See 
paragraphs (b)(3)(i) and (c)(3)(i) of this section. PRS must 
decrease its basis in the replacement QSB stock by the $60 of 
partnership section 1045 gain that was allocated to A. See paragraph 
(b)(3)(ii) of this section. A must decrease A's basis in the 
replacement QSB stock purchased by A by the $40 not recognized 
pursuant to paragraph (c)(1) of this section. See paragraph 
(c)(3)(ii) of this section.
    Example 10. Change in partner's interest in partnership while 
partnership holds QSB stock. (i) Assume the same facts as in Example 
9, except that, on August 2, 2006, A sells a 25 percent interest in 
PRS to Z. On July 10, 2007, A repurchases the 25 percent interest 
from Z for $50. Assume that PRS makes a timely election under 
section 754 for the taxable year during which A purchases Z's PRS 
interest and that, under section 743(b), A has a positive basis 
adjustment of $25.
    (ii) PRS allocates the $200 of realized gain from the sale of 
the QSB stock $100 to A and $100 to X. However, A has a positive 
basis adjustment of $25; therefore, A's share of the gain is reduced 
to $75. Because A is an eligible partner under paragraph (a)(2) of 
this section, A may defer recognition of A's distributive share of 
gain from the sale of the QSB stock subject to the nonrecognition 
limitation described in paragraph (a)(3) of this section. The 
smallest interest that A held in PRS during the time that PRS held 
the QSB stock is 25 percent. Under the nonrecognition limitation, A 
may not defer more than 25 percent of the partnership gain realized 
from the sale of the QSB stock (determined without regard to any 
basis adjustment under section 734(b) or section 743(b), other than 
a basis adjustment described in paragraph (b)(3)(ii) of this 
section). Because the partnership's realized gain determined without 
regard to A's basis adjustment under section 743(b) is $200, A may 
defer recognition of $50 (25% of $200) of the gain from the sale of 
the QSB stock. A must recognize the remaining $25 of that gain.
    Example 11. Sale by partner of QSB stock received in a 
liquidating distribution. (i) On January 1, 2006, A, an individual, 
and X, a corporation, form PRS, a partnership. A and X each 
contribute $150 to PRS and agree to share all partnership items 
equally. PRS purchases QSB stock on February 1, 2006, for $300. On 
May 1, 2006, when the QSB stock has appreciated in value to $400, A 
contributes $100 to PRS, increasing A's interest in PRS's income, 
gains, losses, deductions, and credits to 60 percent. On June 1, 
2009, when the QSB stock is still worth $400, PRS makes a 
liquidating distribution of $300 worth of QSB stock to A. Under 
section 732, A's basis in the distributed QSB stock is $250. A sells 
the QSB stock on August 4, 2009, for $600, realizing a gain of $350 
(none of which is treated as ordinary income). A purchases 
replacement QSB stock on August 30, 2009, for $550, and makes a 
valid election under section 1045 with respect to the QSB stock.
    (ii) A is an eligible partner under paragraph (a)(2)(i) of this 
section. Therefore, under paragraph (d)(1) of this section, A is 
treated as having acquired the distributed QSB stock in the same 
manner as PRS and as having held the QSB stock since February 1, 
2006, its original issue date. Because A purchased, within 60 days 
of A's sale of the QSB stock, replacement QSB stock, A is eligible 
to defer a portion of A's gain from the sale of the QSB stock. A 
must recognize gain, however, to the extent that A's amount realized 
on the sale of the QSB stock, $600, exceeds the cost of the 
replacement QSB stock purchased by A during the 60-day period 
beginning on the date of the sale of the relinquished QSB stock, 
$550. Accordingly, A must recognize $50 of the gain from the sale of 
the QSB stock. A defers recognition of the remaining $300 of gain to 
the extent that such gain does not exceed the distribution 
nonrecognition limitation.
    (iii) Under paragraph (d)(3)(ii) of this section, A's 
nonrecognition limitation with respect to the sale of the QSB stock 
is A's section 1045 amount realized with respect to the stock, 
reduced by A's section 1045 adjusted basis with respect to the 
stock. A's amount realized from the sale is the product of A's 
amount realized from the sale, $600; and a fraction:
    (1) the numerator of which is A's smallest percentage interest 
in PRS's income, gain, or loss with respect to such stock, 50%; and
    (2) the denominator of which is A's percentage interest in that 
type of partnership QSB stock immediately after the distribution, 
75% (the value of the stock distributed to A, $300, divided by the 
value of all QSB stock of that type acquired by PRS, $400).
    Therefore, A's section 1045 amount realized is $400 ($600 
multiplied by 50/75). Because PRS distributed the QSB stock to A in 
liquidation of A's interest in PRS, A's section 1045 adjusted basis 
is the product of PRS's basis in all of the QSB stock of the type 
distributed, $300; A's smallest interest (prior to the distribution) 
in PRS's income, gain, or loss with respect to QSB stock of the type 
distributed, 50%; and the percentage of the distributed QSB stock 
that was sold by A, 100%. Therefore, A's section 1045 adjusted basis 
is $150 (the product of $300, 50%, and 100%)) and A's nonrecognition 
limitation amount on the sale of the QSB stock is $250 ($400 section 
1045 amount realized minus $150 section 1045 adjusted basis). 
Accordingly, A defers recognition of $250 of the remaining $300 gain 
from the sale of the QSB stock.
    (iv) A's basis in the replacement QSB stock is $300 (cost of the 
replacement stock, $550, reduced by the gain not recognized under 
section 1045, $250).
    Example 12. Sale by partner of QSB stock received in a 
nonliquidating distribution. (i) The facts are the same as in 
Example 11, except that, on June 1, 2009, PRS distributes only $200 
of the QSB stock to A, reducing A's interest in PRS from 60% to 33%. 
PRS's basis in the distributed QSB stock is $150. On November 1, 
2009, A sells for $250 the QSB stock distributed by PRS to A and 
purchases, within 60 days of the date of sale of the relinquished 
QSB stock, replacement QSB stock for $250. On December 1, 2009, PRS 
sells all of its QSB stock for $250 and purchases, within 60 days of 
the date of the sale of the relinquished QSB stock, replacement QSB 
stock for $250. A makes a timely election to apply section 1045 with 
respect to its sale of the distributed QSB stock and PRS makes a 
timely election to apply section 1045 with respect to its sale of 
the QSB stock.
    (ii) Under section 732, A's basis in the distributed QSB stock 
is $150. Therefore, A realizes a gain on the sale of the distributed 
QSB stock of $100. Because A made a valid election to apply section 
1045 to the sale, and because A purchased, within 60 days of A's 
sale of the QSB stock, replacement QSB stock at a cost equal to the 
amount realized on the sale of the distributed QSB stock, A defers 
recognition of the gain from the sale of the QSB stock to the extent 
that such gain does not exceed the distribution nonrecognition 
limitation.
    (iii) Under paragraph (d)(3) of this section, the nonrecognition 
limitation with respect to A's sale of the QSB stock is A's section 
1045 amount realized reduced by A's section 1045 adjusted basis. 
Because PRS did not distribute all of a particular type of QSB stock 
and the distribution of the QSB stock to A was not in liquidation of 
A's interest in PRS, A's section 1045 amount realized is $125 (A's 
amount realized from the sale of the distributed QSB stock, $250, 
multiplied by A's smallest percentage interest (prior to the 
distribution) in PRS's income, gain, or loss with respect to such 
stock, 50%). A's section 1045 adjusted basis is the product of the 
partnership's basis in the QSB stock sold by the partner, $150, and 
A's smallest percentage interest (prior to the distribution) in the 
partnership's income, gain, or loss with respect to such stock, 50%. 
Therefore, A's section 1045 adjusted basis is $75 (50% of $150), and 
A's nonrecognition limitation amount on the sale of the QSB stock is 
$50 ($125 section 1045 amount realized minus $75 section 1045 
adjusted basis). As this amount is less than the amount of gain that 
A is eligible to defer under section 1045, $100, A defers 
recognition of only $50 of the gain from the sale of the QSB stock. 
A must recognize the remaining $50 of that gain.

[[Page 42379]]

    (iv) The partnership realizes gain of $100 ($250 amount realized 
minus $150 remaining basis in QSB stock) on the sale of its QSB 
stock. Because the partnership reinvested its entire amount realized 
in new QSB stock and because the partnership made a timely election 
to apply section 1045, the partnership may treat all of this gain as 
section 1045 gain. A's share of the partnership section 1045 gain is 
$50 (50% of $100). Because A is an eligible partner under paragraph 
(a)(2) of this section, A can defer recognition of this gain subject 
to the nonrecognition limitation described in paragraph (a)(3) of 
this section. The smallest percentage interest that A held in PRS 
during the time that PRS held the QSB stock (determined without 
regard to the reduction that occurred as a result of PRS's 
distribution of QSB stock to A) is 50%. See paragraph (a)(3)(ii) of 
this section. Therefore, under the nonrecognition limitation, A can 
defer recognition of all $50 (50% of $100) of the gain allocated to 
A.
    Example 13. Contribution of replacement QSB stock to a 
partnership. (i) On January 1, 2006, A, an individual, B, an 
individual, and X, a corporation, form PRS, a partnership. A, B, and 
X each contribute $25 to PRS and agree to share all partnership 
items equally. On February 1, 2006, PRS purchases Stock 1, which is 
QSB stock in the hands of the partnership. PRS sells Stock 1 on 
November 4, 2006, for $150. PRS realizes $75 of gain from the sale 
of Stock 1 (none of which is treated as ordinary income) and 
allocates $25 of gain to each of its partners. PRS informs the 
partners that it does not intend to make an election under section 
1045 with respect to the sale of Stock 1. Each partner's share of 
the amount realized from the sale of Stock 1 is $50. On November 30, 
2006, A, an eligible partner within the meaning of paragraph (a)(2) 
of this section, purchases Stock 2, which is also QSB stock, for $50 
and makes a valid section 1045 election under paragraph (c)(1) of 
this section. Subsequently, A transfers Stock 2 to ABC, a 
partnership.
    (ii) Because A purchased, within 60 days of PRS's sale of Stock 
1, replacement QSB stock for a cost equal to A's share of the 
partnership's amount realized on the sale of Stock 1, and because A 
made a valid election to apply section 1045 with respect to A's 
share of the gain from PRS's sale of Stock 1, A does not recognize 
A's $25 distributive share of the gain from PRS's sale of Stock 1. 
Before the contribution of Stock 2 to ABC, A's adjusted basis in 
Stock 2 is $25 ($50 cost minus $25 nonrecognition amount). Upon the 
contribution of Stock 2 to ABC, A's basis in the ABC partnership 
interest is $25, and ABC's basis in Stock 2 is $25. However, Stock 2 
does not qualify as QSB stock in ABC's hands because it was not 
acquired at original issue. Neither A nor ABC will be eligible for 
section 1045 treatment on a subsequent sale of Stock 2.

    (h) Effective date. This section applies to sales of QSB stock on 
or after the date final regulations are published in the Federal 
Register.

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 04-15964 Filed 7-14-04; 8:45 am]
BILLING CODE 4830-01-P