QSBS and Partnerships: Pass-Through Entity Treatment of Qualified Small Business Stock

Qualified Small Business Stock (QSBS) offers significant tax advantages, which can be extended to individual taxpayers when the stock is held through partnerships or other pass-through entities. This nuanced area of tax law, particularly Section 1202(g) and Regulation 1.1045-1, allows for the benefits of QSBS to flow through to partners, subject to specific conditions and limitations. This page delves deeply into how these rules apply when QSBS is held through partnerships, highlighting the essential requirements for pass-through treatment and important constraints.

Section 1202(g): Pass-Through Entity Treatment

Basic Rule

At its core, Section 1202(g) enables the exclusion of gain from the sale of QSBS at the partner level, rather than at the partnership level itself. This provision ensures that any gain recognized on the sale of QSBS by a partnership is not taxed at the partnership level but instead flows through to the partners. Each partner may then potentially exclude the gain under Section 1202, provided they meet certain conditions. This treatment aligns with the pass-through nature of partnerships, where income and gains are typically taxed at the individual level.

Requirements for Pass-Through Treatment

The ability to exclude gain at the partner level under Section 1202(g) hinges on meeting several critical criteria:

1. Entity-Level Qualification: The stock must qualify as QSBS in the hands of the partnership, which is assessed as if the partnership were an individual. This requirement ensures that only genuine small business investments benefit from the provision.

2. Holding Period: The partnership must have held the stock for at least three years. This duration underscores the policy goal of encouraging long-term investment in small businesses.

3. Partner's Interest Requirement: The partner must have held an interest in the partnership from the time the partnership acquired the QSBS and continuously thereafter until its disposition. This continuous holding requirement is pivotal and emphasizes the intention to benefit long-term, committed investors within the partnership.

Limitation Based on Original Interest

A critical limitation under Section 1202(g)(3) restricts the exclusion to the amount that would apply based on the interest the partner held at the time the QSBS was acquired. If a partner's interest in the partnership increases post-acquisition, the exclusion remains capped at the level calculated based on the original, smaller interest. This rule prevents manipulation of partnership interests to maximize tax benefits unfairly.

Pass-Through Entities Covered

The definition of "pass-thru entity" under Section 1202(g)(4) is broad, encompassing:

• Partnerships
• S corporations
• Regulated investment companies (RICs)
• Common trust funds

This inclusivity ensures that various organizational structures can benefit from QSBS provisions, promoting investment across a diverse range of business entities.

Partnership Basis and Gain Allocation

When a partnership disposes of QSBS, the gain recognized is treated as a capital gain assuming QSBS conditions are met and is allocated to the partners according to the partnership agreement. This allocation must adhere to the substantial economic effect rules, ensuring that allocations reflect economic reality. Each partner then includes their share of the gain in their gross income and, if eligible, applies the Section 1202 exclusion to their portion. The partner’s share of the partnership’s adjusted basis in the QSBS is crucial for determining the per-issuer limitation under Section 1202(b), which is the greater of $10 million or 10 times the adjusted basis of the QSBS.

Section 1045 Partnership Rollovers

Regulation 1.1045-1 provides a framework for Section 1045 rollovers involving partnerships, allowing deferral of gain on QSBS if replacement stock is purchased within 60 days. This provision can be elected at either the partnership or partner level but is subject to a capital interest limitation, which significantly affects partners with minimal or no capital interest, such as those holding only profits interests. This limitation reflects a concern about the potential for abuse through the allocation of profits interests that do not reflect an underlying economic investment in the partnership.

Reporting Requirements and Planning Considerations

Partnerships must meticulously report any Section 1045 elections and the distributive share of gains to all partners. Partners, in turn, must report their shares and apply relevant exclusions and deferrals, maintaining detailed records of their basis in the QSBS and any adjustments resulting from rollovers.

Strategically, partnerships should be structured to consider potential QSBS benefits from inception, documenting capital interest percentages and ensuring continuous interest holdings to maximize eligible gains.

Key Takeaways

1. Section 1202(g) allows pass-through treatment: Partners can claim exclusions when partnerships hold QSBS.
2. Continuous interest required: Partners must maintain their interest from the time of QSBS acquisition through disposition.
3. Capital interest limitation for Section 1045: Limits benefits for partners with only profits interests.
4. Basis tracking is critical: Accurate tracking of basis adjustments is essential for applying QSBS benefits.
5. Tiered partnerships add complexity: Requires careful management in multi-tier structures.
6. Reporting is partner-level: Partnerships report on K-1s, but partners apply exclusion rules.

Sources and Citations

• IRC Section 1202(g): Pass-through entity treatment
• Reg. 1.1045-1: Application to partnerships (comprehensive partnership rollover rules)
• IRC Section 1202(g)(2)(B): Partner interest requirement

Verification Date: January 2025

Note: This page reflects the law as of January 2025. Tax law changes frequently, and partnership QSBS rules are complex. This information should not be construed as legal or tax advice. Consult with qualified tax counsel regarding partnership structures and QSBS benefits.