Td 9353

Part I. Rulings and Decisions Under the Internal Revenue Code
of 1986
Section 805.—General
Deductions
A revenue procedure to provide a safe harbor under which companies taxable under Subchapter L do
not have to include any portion of the increase for the
taxable year in policy cash values of life insurance
contracts described in section 264(f)(4)(A) (“ICOLI
Contracts”) for purposes of applying the insurance company proration rules in sections 807(a)(2),
807(b)(1), 805(a)(4), 812, or 832(b)(5). See Rev.
Proc. 2007-61, page 747.

Section 807.—Rules for
Certain Reserves
A revenue procedure to provide a safe harbor under which companies taxable under Subchapter L do
not have to include any portion of the increase for the
taxable year in policy cash values of life insurance
contracts described in section 264(f)(4)(A) (“ICOLI
Contracts”) for purposes of applying the insurance company proration rules in sections 807(a)(2),
807(b)(1), 805(a)(4), 812, or 832(b)(5). See Rev.
Proc. 2007-61, page 747.

Section 812.—Definition
of Company’s Share and
Policyholders’ Share
A revenue procedure to provide a safe harbor under which companies taxable under Subchapter L do
not have to include any portion of the increase for the
taxable year in policy cash values of life insurance
contracts described in section 264(f)(4)(A) (“ICOLI
Contracts”) for purposes of applying the insurance company proration rules in sections 807(a)(2),
807(b)(1), 805(a)(4), 812, or 832(b)(5). See Rev.
Proc. 2007-61, page 747.

Section 832.—Insurance
Company Taxable Income
A revenue procedure to provide a safe harbor under which companies taxable under Subchapter L do
not have to include any portion of the increase for the
taxable year in policy cash values of life insurance
contracts described in section 264(f)(4)(A) (“ICOLI
Contracts”) for purposes of applying the insurance company proration rules in sections 807(a)(2),
807(b)(1), 805(a)(4), 812, or 832(b)(5). See Rev.
Proc. 2007-61, page 747.

Section 1045.—Rollover
of Gain From Qualified
Small Business Stock to
Another Qualified Small
Business Stock
26 CFR 1.1045–1: Application to partnerships.

T.D. 9353
DEPARTMENT OF
THE TREASURY
Internal Revenue Service
26 CFR Parts 1 and 602
Section 1045 Application to
Partnerships
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Final regulations.
SUMMARY: This document contains final 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 (QSB stock) and a partner’s sale of
QSB stock distributed by a partnership.
These regulations also provide rules for a
taxpayer (other than a C corporation) who
sells QSB stock and purchases replacement QSB stock through a partnership.
The regulations affect partnerships that
invest in QSB stock and their partners.
DATES: Effective Date: These regulations
are effective August 14, 2007.
Applicability Dates: For dates of
applicability of these regulations, see
§1.1045–1(j).
FOR
FURTHER
INFORMATION
CONTACT: Jian H. Grant at (202)
622–3050 (not a toll-free number).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collections of information contained in these final regulations have been
reviewed and approved by the Office of

2007–40 I.R.B.

721

Management and Budget in accordance
with the Paperwork Reduction Act of
1995 (44 U.S.C. 3507(d)) under control
number 1545–1893. Responses to these
collections of information are mandatory
and are required to obtain a benefit. The
collections of information in these final
regulations are in §1.1045–1(b)(3)(ii)(C),
(b)(5)(ii), and (c)(4)(ii). The information collected in §1.1045–1(b)(5)(ii) is
required to ensure that gain from the sale
of QSB stock by a partnership is reported
correctly. The information collected in
§1.1045–1(b)(3)(ii)(C) and (c)(4)(ii) will
be used by the partnership and the partner
to make the basis adjustments upon the
sale of QSB stock and the purchase of
replacement QSB stock when necessary.
The likely respondents are businesses or
other for-profit institutions and small businesses or organizations.
An agency may not conduct or sponsor,
and a person is not required to respond to, a
collection of information unless it displays
a valid control number assigned by the Office of Management and Budget.
Estimated total annual reporting burden: 1,500 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:
1,500.
Estimated annual frequency of responses: On occasion.
Comments concerning the accuracy
of this burden estimate and suggestions for reducing this burden should
be sent to the Internal Revenue Service,
Attn: IRS Reports Clearance Officer,
SE:W:CAR:MP:T:T:SP, Washington, DC
20224, and 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.
Books or records relating to these collections 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
return information are confidential, as required by 26 U.S.C. 6103.

October 1, 2007

Background
This document amends 26 CFR Part 1
under section 1045 of the Code by adding
§1.1045–1 regarding the application of
section 1045 to partnerships and their
partners.
Section 1045 permits a non-corporate
taxpayer that holds QSB stock for more
than six months and sells it after August
5, 1997, to elect to defer recognizing gain
(other than gain treated as ordinary income) 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 QSB stock. Any gain not recognized reduces the cost basis of the replacement QSB stock. The taxpayer recognizes
gain to the extent the amount realized on
the sale of the QSB stock exceeds the cost
basis of the replacement QSB stock. The
benefits of section 1045 with respect to a
sale of QSB stock by a partnership flow
through to a non-corporate partner that
held an interest in the partnership at all
times the partnership held the QSB stock.
See section 1045(b)(5) and the legislative
history accompanying 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. In response to inquiries, the
IRS issued Rev. Proc. 98–48, 1998–2
C.B. 367, which provides procedures for
taxpayers (including passthrough entities and individuals holding interests in
a passthrough entity) to elect to apply
section 1045. Since Rev. Proc. 98–48
was published, the IRS and the Treasury
Department received further inquiries regarding the application of section 1045
to partnerships and their partners. See
§601.601(d)(2)(ii)(b) of this chapter.
On July 15, 2004, in response to those
inquiries, a notice of proposed rulemaking and a notice of public hearing
(REG–150562–03, 2004–2 C.B. 175)
were published in the Federal Register
(69 FR 42370) regarding the application
of section 1045 to partnerships and their
partners. No one requested to speak at
the public hearing. Accordingly, the public hearing scheduled for November 9,
2004, was cancelled in the Federal Register (69 FR 62631) on October 27, 2004.
Comments responding to the proposed
regulations were received. After consid-

October 1, 2007

eration of the comments, the proposed
regulations are adopted as revised by this
Treasury decision.
Summary of Comments and
Explanation of Revisions
1. QSB Stock — Replacement QSB Stock
Requirement
The proposed regulations provided that
the term “QSB stock” had the same meaning given such term by section 1202(c)
and did not include an interest in a partnership that held QSB stock. Thus, under
the proposed regulations, an investment
in a partnership that held QSB stock was
not treated as an investment in QSB stock.
Consequently, a partner that sold an interest in a partnership that held QSB stock
was not treated as selling QSB stock, and
could not elect to apply section 1045 with
respect to gain realized on the sale of the
partnership interest. Similarly, under the
proposed regulations, a partner that made a
section 1045 election with respect to QSB
stock sold by the partnership could not
treat as replacement QSB stock an interest in a second partnership that held QSB
stock.
Commentators agreed that an interest in
a partnership that owns QSB stock should
not be treated as an investment in QSB
stock. Some commentators, however, argued that the final regulations should permit a partner that makes a section 1045
election with respect to QSB stock sold by
one partnership to satisfy the replacement
QSB stock requirement of section 1045 by
holding an interest in a partnership, which
acquires QSB stock within the statutory
period. Commentators believed that the
suggested rule is consistent with the intent
of Congress to encourage investments in
QSB stock.
The final regulations adopt this comment. A taxpayer (other than a C corporation) that sells QSB stock and elects to
apply section 1045 may satisfy the replacement QSB stock requirement with QSB
stock that is purchased within the statutory
period by a partnership in which the taxpayer is a partner on the date the QSB stock
is purchased (purchasing partnership). In
addition, the final regulations provide that
an eligible partner of a partnership that
sells QSB stock (selling partnership) and
elects to apply section 1045 may satisfy

722

the replacement QSB stock requirement
with QSB stock purchased by a purchasing partnership during the statutory period.
The IRS and the Treasury Department believe that these rules are appropriate because they are consistent with the underlying continuous economic interest requirement of section 1045. Although the final
regulations permit the replacement QSB
stock requirement to be satisfied in this
manner, for the reasons stated, a partner
that sells its interest in the purchasing partnership is not treated as selling replacement QSB stock.
The final regulations contain rules for
calculating a partner’s distributive share of
partnership gain that is not recognized as a
result of an election under section 1045 by
the partner. These rules are necessary for
determining how much gain a partner can
defer upon a sale of QSB stock under section 1045. These rules address instances
in which the eligible partner continues to
defer gain under section 1045 from a prior
sale or sales of QSB stock.
2. Basis Adjustments
The proposed regulations provided
rules regarding adjustments to an eligible
partner’s basis in a partnership interest and
a partnership’s basis in replacement QSB
stock. One rule required a partnership
to make a basis adjustment to the partnership’s replacement QSB stock by the
amount of gain from the partnership’s sale
of QSB stock that is deferred by an eligible
partner, the effect of which is determined
under the principles of §1.743–1(g), (h),
and (j). Under this rule, the basis adjustments constitute an adjustment to the basis
of the partnership’s replacement QSB
stock with respect to that eligible partner
only. To allow the partnership to make
the appropriate basis adjustments, the proposed regulations required any partner
that must recognize all or a 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.
One commentator argued that many
partnerships that invest in QSB stock are
thinly staffed, and that they would incur additional administrative expenses to
comply with the notification and basis
adjustment requirements. Therefore, the
commentator suggested that the partner

2007–40 I.R.B.

make the basis adjustments with respect to
the partnership’s replacement QSB stock,
unless the partnership makes an election
to make the basis adjustments.
The IRS and the Treasury Department
believe that, if the partnership makes an
election under section 1045 and purchases
replacement QSB stock, the partnership
is the proper party to make the appropriate basis adjustments with respect to that
stock. Accordingly, this comment is not
adopted. As noted below, a partnership
is not required to maintain these basis adjustments for eligible partners that separately make the election under section
1045. The final regulations also clarify
that if a partnership makes an election under section 1045, the partnership must attach a statement to the partnership return
for the taxable year in which the partnership purchases replacement QSB stock setting forth the computation of the adjustment, the replacement QSB stock to which
the adjustment has been made, the date(s)
on which such stock was acquired by the
partnership, and each partner’s distributive
share of deferred partnership section 1045
gain.
If a taxpayer or an eligible partner
makes an election under section 1045
and treats its interest in QSB stock purchased by a purchasing partnership as
its replacement QSB stock, the final regulations provide specific rules for the
determination of the partner’s basis in the
replacement QSB stock and interest in the
purchasing partnership. In these cases, the
partner’s adjusted basis in the partnership
interest is reduced by the partner’s gain
that is deferred under section 1045, and
the electing partner must reduce its share
of the partnership’s adjusted basis of the
replacement QSB stock by the amount of
gain deferred. When the basis reduction
results from a partner-level election, the
final regulations require the partner, rather
than the partnership, to retain records setting forth the computation of this basis
adjustment, the replacement QSB stock
to which the adjustment has been made,
and the date(s) on which such stock was
acquired by the purchasing partnership.
3. Gain Recognition Upon Certain
Distributions
The final regulations provide rules requiring a partner to recognize gain upon a

2007–40 I.R.B.

distribution of replacement QSB stock to
another partner that reduces the partner’s
share of the replacement QSB stock held
by a partnership. The amount of gain that
the partner must recognize is determined
based on the amount of gain that the partner would have recognized upon a sale
of the distributed replacement QSB stock
for its fair market value on the date of the
distribution (not to exceed the amount of
gain previously deferred by the partner
with respect to the distributed replacement
QSB stock). Any gain recognized by a
partner whose interest is reduced must be
taken into account in determining the adjusted basis of the partner’s interest in the
partnership and also taken into account in
determining the partnership’s adjusted basis in the QSB stock distributed to another
partner under §1.1045–1(e)(4). These
rules apply in the case of a partner election
or a partnership election under section
1045.
4. Nonrecognition Limitation
The proposed regulations provided that
the amount of gain that an eligible partner
may defer under section 1045 may not exceed: (A) the partner’s smallest percentage interest in the partnership’s income,
gain, or loss with respect to the QSB stock
that was sold, multiplied by (B) the partnership’s realized gain from the sale of
such stock. This nonrecognition 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 QSB
stock that was sold.
Commentators agreed with the underlying “continuous ownership” requirement
in the proposed regulations, but raised
concerns that the nonrecognition limitation rule may be difficult to administer
when a partnership does not have a simple
“pro rata” partnership arrangement. One
commentator suggested that the nonrecognition limitation rule only apply in certain
situations.
The IRS and the Treasury Department
continue to believe that a nonrecognition
limitation rule is consistent with section
1045 and the underlying continuous economic interest requirement in section
1202(g)(2) and (3). The continuous economic interest requirement as applied
under section 1202(c)(1)(B) requires that

723

QSB stock must be acquired by the taxpayer at its original issuance in exchange
for money or other property or as compensation for services provided to such
corporation. Taxpayers that invest through
a partnership acquire the requisite interest
for purposes of the continuous economic
interest requirement by an investment of
capital in the partnership. Accordingly, to
address the commentator’s concerns, the
nonrecognition rule has been modified to
provide that the amount of gain that an
eligible partner may defer under section
1045 may not exceed: (A) the partner’s
smallest percentage interest in partnership
capital from the time the QSB stock is acquired until the time the QSB stock is sold,
multiplied by (B) the partnership’s realized gain from the sale of such stock. The
IRS and the Treasury Department believe
that this nonrecognition rule in the final
regulations will be easier to administer, is
consistent with each partner’s economic
interest in the partnership, and will not
inappropriately limit the amount of gain
that can be deferred.
5. Opt Out of Partnership Election by
Partner
The proposed regulations allowed an eligible partner to make a section 1045 election with respect to all or part of the partner’s share of gain from the partnership’s
sale of QSB stock only if the partnership
did not make a section 1045 election, or the
partnership did make a section 1045 election, but failed to purchase any (or enough)
replacement QSB stock within the statutory time period. If a partnership elected
to apply section 1045 and purchased replacement QSB stock, all eligible partners
of the partnership were required to defer
their distributive shares of the partnership
section 1045 gain. One commentator suggested that an eligible partner should be
allowed to opt out of a partnership section 1045 election and either purchase separate replacement QSB stock directly, and
elect to apply section 1045 at the partner
level, or recognize the partner’s distributive share of the partnership section 1045
gain. The IRS and the Treasury Department believe that allowing a partner to opt
out of a partnership section 1045 election
is consistent with providing the intended
and desired flexibility for investments in
QSB stock. Accordingly, this comment is

October 1, 2007

adopted. The final regulations provide that
a partner that elects out of a partnership’s
section 1045 election must notify the partnership in writing. If an eligible partner
opts out of a partnership section 1045 election, such action does not constitute a revocation of the partnership section 1045 election and the partnership section 1045 election continues to apply to the other partners.
The final regulations do not impose a
deadline for when a partner must notify
the partnership that the partner is opting
out of a partnership section 1045 election. The IRS and the Treasury Department believe partnerships are responsible
for obtaining the required information to
report gain properly, and that the partnership agreement should require that partners supply this notice to the partnership
in a timely manner.
6. Tiered-partnership Rules
Under the proposed regulations, only an
eligible partner was entitled to defer gain
under section 1045. The proposed regulations provided special rules for determining whether a partner was an eligible partner if a partnership (upper-tier partnership)
held an interest in a partnership (lower-tier
partnership) that held QSB stock. The proposed regulations disregarded the uppertier partnership’s ownership of the lowertier partnership and treated each partner of
the upper-tier partnership as owning an interest in the lower-tier partnership directly.
The preamble to the proposed regulations
explained that, although this rule provided
a simple approach, it limited the availability of section 1045 in situations involving tiered partnerships. The IRS and the
Treasury Department requested comments
specifically on the application of section
1045 in tiered-partnership situations.
Commentators suggested that an upper-tier partnership should be an “eligible
partner” of a lower-tier partnership and
allowed to make an election to defer
gain under section 1045 with respect to
the distributive share of the gain from the
lower-tier partnership’s sale of QSB stock.
After careful consideration, the IRS and
the Treasury Department have concluded
that treating an upper-tier partnership as
an “eligible partner” of a lower-tier partnership would create an unacceptable
administrative burden and increased com-

October 1, 2007

plexity to the rules. Therefore, the final
regulations retain the rule in the proposed
regulations relating to tiered-partnership
structures. The final regulations, however,
clarify that the rule does not preclude a
partner in an upper-tier partnership from
treating its interest in QSB stock that
was purchased by either the upper-tier
partnership or a lower-tier partnership as
replacement QSB stock. The final regulations contain an example illustrating this
rule.
7. Disregarded Entity Rules
One commentator suggested that the final regulations set forth rules that are specific to disregarded entities. It has been determined that this suggestion is beyond the
scope of the regulations and, therefore, is
not included in the final regulations.
8. Election Procedures and Reporting
Rules
The proposed regulations provided that
a partnership making a section 1045 election must do so on the partnership’s timely
filed return (including extensions) for the
taxable year during which the partnership
sells the QSB stock. The proposed regulations also provided 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. The final regulations retain
these rules. However, in both cases, the
proposed regulations stated that the electing partnership or partner also must follow the procedures of Rev. Proc. 98–48.
In contrast, the final regulations provide
that a partnership making an election under section 1045 or a partner making an
election under section 1045 must do so in
accordance with the applicable forms and
instructions. It is anticipated that the applicable forms and instructions will be revised to take into account the rules in the
final regulations.
Effective/Applicability Date
The final regulations apply to sales of
QSB stock on or after August 14, 2007.

724

Effect on Other Documents
Rev. Proc. 98–48, 1998–2 C.B. 367,
is modified to include the following sentence at the end of the PURPOSE section:
“This revenue procedure does not apply in situations described in §1.1045–1
of the Income Tax regulations.” See
§601.601(d)(2)(ii)(b) of this chapter.
Special Analyses
It has been determined that this Treasury decision 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, the notice of proposed rulemaking
that preceded these regulations was submitted to the Chief Counsel for Advocacy
of the Small Business Administration for
comment on its impact on small business.
Drafting Information
The principal author of these regulations is Jian H. Grant, Office of the
Associate Chief Counsel (Passthroughs
and Special Industries). However, other
personnel from the IRS and the Treasury
Department participated in their development.
*****
Adoption of Amendments to the
Regulations
Accordingly, 26 CFR parts 1 and 602
are amended as follows:
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:

2007–40 I.R.B.

§1.1045–1 Application to partnerships.
(a) Overview of section. A partnership that holds qualified small business
stock (QSB stock) (as defined in paragraph (g)(1) of this section) for more than
6 months, sells such QSB stock, and purchases replacement QSB stock (as defined
in paragraph (g)(2) of this section) may
elect to apply section 1045. An eligible
partner (as defined in paragraph (g)(3) of
this section) of a partnership that sells QSB
stock, may elect to apply section 1045
if the eligible partner purchases replacement QSB stock directly or through a purchasing partnership (as defined in paragraph (c)(1)(i) of this section). A taxpayer (other than a C corporation) that
holds QSB stock for more than 6 months,
sells such QSB stock and purchases replacement QSB stock through a purchasing partnership may elect to apply section
1045. A section 1045 election is revocable only with the prior written consent of
the Commissioner. To obtain the Commissioner’s prior written consent, the person
who made the section 1045 election must
submit a request for a private letter ruling. (For further guidance, see Rev. Proc.
2007–1, 2007–1 C.B. 1 (or any applicable successor) and §601.601(d)(2)(ii)(b) of
this chapter.) Paragraph (b) of this section
provides rules for partnerships that elect to
apply section 1045. Paragraph (c) of this
section provides rules for certain taxpayers
other than C corporations and for eligible
partners that elect to apply section 1045.
Paragraph (d) of this section provides a
limitation on the amount of gain that an
eligible partner does not recognize under
section 1045. Paragraph (e) of this section
provides rules for partnership distributions
of QSB stock to an eligible partner. Paragraph (f) of this section provides rules for
contributions of QSB stock or replacement
QSB stock to a partnership. Paragraph (g)
of this section provides definitions of certain terms used in section 1045 and this
section. Paragraph (h) of this section provides reporting rules for partnerships and
partners that elect to apply section 1045.
Paragraph (i) of this section provides examples illustrating the provisions of this
section. Paragraph (j) of this section contains the effective date.
(b) Partnership election—(1) Partnership purchase of replacement QSB stock.
A partnership that holds QSB stock for

2007–40 I.R.B.

more than 6 months, sells such QSB stock,
and purchases replacement QSB stock
may elect in accordance with paragraph
(h) of this section to apply section 1045.
If the partnership elects to apply section
1045, then, subject to the provisions of
paragraphs (b)(4) and (d) of this section,
each eligible partner shall not recognize
its distributive share of any partnership
section 1045 gain (as determined under
paragraph (b)(2) of this section). 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 total cost of all replacement QSB stock purchased by the partnership (excluding the
cost of any replacement QSB stock purchased by the partnership that is otherwise
taken into account under section 1045).
(2) Partner’s distributive share of partnership section 1045 gain. A partner’s distributive share of partnership section 1045
gain shall be in the same proportion as
the partner’s distributive share of the partnership’s gain from the sale of the QSB
stock. 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. The adjusted basis
of an eligible partner’s interest in a partnership shall not be increased under section
705(a)(1) by gain from a partnership’s sale
of QSB stock that is not recognized by the
partner as the result of a partnership election under paragraph (b)(1) of this section.
(ii) Partnership’s replacement QSB
stock—(A) Rule. 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 as a result of the partnership’s
election under section 1045. 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

725

such a basis adjustment is determined under the principles of §1.743–1(g), (h), and
(j) except as modified in this paragraph
(b)(3)(ii)(A). If a partnership sells QSB
stock with respect to which a basis adjustment has been made under this paragraph
(b)(3)(ii), and the partnership makes an
election under paragraph (b)(1) of this section with respect to the sale and purchases
replacement QSB stock, the basis adjustment shall carry over to the replacement
QSB stock except to the extent otherwise
provided in this paragraph (b)(3)(ii). The
basis adjustment that carries over to the
replacement QSB stock shall be reduced
(but not below zero) by the eligible partner’s distributive share of the excess, if
any, of the greater of the amount determined under paragraph (b)(1)(i) or (ii)
of this section from the sale of the QSB
stock, over the partnership’s gain from the
sale of the QSB stock (determined without
regard to basis adjustments under section
743 or paragraph (b)(3)(ii) of this section).
The excess amount that reduces the basis
adjustment shall be accounted for as gain
in accordance with §1.743–1(j)(3). See
Example 5 of paragraph (i) of this section.
For purposes of this paragraph (b)(3)(ii),
a partnership must presume that a partner did not recognize that partner’s distributive share of the partnership section
1045 gain as a result of the partnership’s
section 1045 election unless the partner
notifies the partnership to the contrary as
described in paragraph (b)(5)(ii) of this
section. However, if a partnership knows
that a particular partner is classified, for
Federal tax purposes, as a C corporation,
then the partnership may presume that the
partner did not defer recognition of its
distributive share of the partnership section 1045 gain, even in the absence of a
notification by the partner. If a partnership
makes an election under section 1045, but
an eligible partner opts out of the election
under paragraph (b)(4) of this section and
provides to the partnership the notification required under paragraph (b)(5)(ii) of
this section, no basis adjustments under
this paragraph (b)(3)(ii) are required with
respect to that partner as a result of the
section 1045 election by the partnership.
(B) Tiered-partnership rule. If a partnership (upper-tier partnership) holds an
interest in another partnership (lower-tier
partnership) that makes an election under
section 1045, the portion of the lower-tier

October 1, 2007

partnership’s basis adjustment as provided
in paragraph (b)(3)(ii)(A) of this section
in the replacement QSB stock must be
segregated and allocated to the upper-tier
partnership and any eligible partner as defined in paragraph (g)(3)(iii) of this section. Similarly, that portion of the basis of the upper-tier partnership’s interest in the lower-tier partnership attributable to the basis adjustment as provided
in paragraph (b)(3)(ii)(A) of this section
in the lower-tier partnership’s replacement
QSB stock must be segregated and allocated solely to any eligible partner as defined in paragraph (g)(2)(iii) of this section.
(C) Statement of adjustments. A partnership that must adjust the basis of replacement QSB stock under this paragraph
(b) must attach a statement to the partnership return for the taxable year in which
the partnership purchases replacement
QSB stock setting forth the computation
of the adjustment, the replacement QSB
stock to which the adjustment has been
made, the date(s) on which such QSB
stock was acquired by the partnership,
and the amount of the adjustment that is
allocated to each partner.
(4) Eligible partners may opt out of
partnership’s section 1045 election. An
eligible partner may opt out of the partnership’s section 1045 election with respect to
QSB stock either by recognizing the partner’s distributive share of the partnership
section 1045 gain, or by making a partner
section 1045 election under paragraph (c)
of this section with respect to the partner’s
distributive share of the partnership section 1045 gain. See paragraph (b)(5)(ii) of
this section for applicable notification requirements. Opting out of a partnership’s
section 1045 election under this paragraph
(b)(4) does not constitute a revocation of
the partnership’s election, and such election shall continue to apply to other partners of the partnership.
(5) Notice requirements—(i) Partnership notification to partners. A partnership that makes an election under paragraph (b)(1) of this section must notify all
of its partners of the election and the purchase of replacement QSB stock, in accordance with the applicable forms and instructions, and separately state each partner’s distributive share of partnership section 1045 gain from the sale of QSB stock
under section 702. Each partner shall de-

October 1, 2007

termine whether the partner is an eligible
partner within the meaning of paragraph
(g)(3) of this section and report the partner’s distributive share of partnership section 1045 gain from the partnership’s sale
of QSB stock, including gain not recognized, in accordance with the applicable
forms and instructions.
(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. Similarly, an eligible
partner that opts out of a partnership’s section 1045 election under paragraph (b)(4)
of this section must notify the partnership,
in writing, that the partner is opting out of
the partnership’s section 1045 election.
(c) Partner election—(1) In general—(i) Rule. An eligible partner of
a partnership that sells QSB stock (selling partnership) may elect in accordance
with paragraph (h) of this section to apply
section 1045 if replacement QSB stock
is purchased by the eligible partner. An
eligible partner of a selling partnership
may elect in accordance with paragraph
(h) of this section to apply section 1045
if replacement QSB stock is purchased by
a partnership in which the taxpayer is a
partner (directly or through an upper-tier
partnership) on the date on which the
partnership acquires the replacement QSB
stock (purchasing partnership). A taxpayer other that a C corporation that sells
QSB stock held for more than 6 months
at the time of the sale may elect in accordance with paragraph (h) of this section
to apply section 1045 if replacement QSB
stock is purchased by a purchasing partnership (including a selling partnership).
(ii) Partner purchase of replacement
QSB stock. Subject to paragraph (d) of
this section, an eligible partner of a selling
partnership that elects to apply section
1045 with respect to the eligible partner’s
purchase of replacement QSB stock must
recognize its distributive share of gain
from the sale of QSB stock by the selling
partnership only to the extent of the greater
of—
(A) The amount of the eligible partner’s
distributive share of the selling partnership’s gain from the sale of the QSB stock
that is treated as ordinary income; or

726

(B) The excess of the eligible partner’s
share of the selling partnership’s amount
realized (as determined under paragraph
(c)(2) of this section) on the sale by the
selling partnership of the QSB stock (excluding the cost of any replacement QSB
stock purchased by the selling partnership) over the cost of any replacement
QSB stock purchased by the eligible partner (excluding the cost of any replacement
QSB stock that is otherwise taken into
account under section 1045).
(iii) Partnership purchase of replacement QSB stock—(A) Partner of a selling
partnership. Subject to paragraph (d) of
this section, an eligible partner that treats
its interest in QSB stock purchased by a
purchasing partnership as a purchase of replacement QSB stock by the eligible partner and that elects to apply section 1045
with respect to such purchase must recognize its total gain (the eligible partner’s
distributive share of gain from the selling
partnership’s sale of QSB stock and any
gain taken into account under paragraph
(c)(5) of this section from the sale of replacement QSB stock) only to the extent
of the greater of—
(1) The amount of the eligible partner’s
distributive share of the selling partnership’s gain from the sale of the QSB stock
that is treated as ordinary income; or
(2) The excess of the eligible partner’s
share of the selling partnership’s amount
realized (as determined under paragraph
(c)(2) of this section) on the sale by the
selling partnership of the QSB stock (excluding the cost of any replacement QSB
stock purchased by the selling partnership) over the eligible partner’s share of
the purchasing partnership’s cost of the
replacement QSB stock, as determined
under paragraph (c)(3) of this section (excluding the cost of any QSB stock that is
otherwise taken into account under section
1045).
(B) Taxpayer other than a C corporation. Subject to paragraph (d) of this section, a taxpayer other than a C corporation
that treats its interest in QSB stock purchased by a purchasing partnership with
respect to which the taxpayer is a partner
as a purchase of replacement QSB stock by
the taxpayer must recognize its gain from
the sale of the QSB stock only to the extent
of the greater of—

2007–40 I.R.B.

(1) The amount of gain from the sale of
the QSB stock that is treated as ordinary
income; or
(2) The excess of the amount realized by the taxpayer on the sale of the
QSB stock over the partner’s share of
the purchasing partnership’s cost of the
replacement QSB stock, as determined
under paragraph (c)(3) of this section (excluding the cost of any QSB stock that is
otherwise taken into account under section
1045).
(2) Eligible partner’s share of amount
realized by partnership—(i)—General
rule. The eligible partner’s share of the
amount realized by the selling partnership
is the amount realized by the partnership
on the sale of the QSB stock (excluding
the cost of any replacement QSB stock
otherwise taken into account under section
1045) multiplied by the following fraction—
(A) The numerator of which is the eligible partner’s distributive share of the partnership’s realized gain from the sale of the
QSB stock; and
(B) The denominator of which is the
partnership’s realized gain on the sale of
the QSB stock.
(ii) General rule modified for determining eligible partner’s share of amount realized by purchasing partnership upon a sale
of replacement QSB stock in certain situations—(A) No gain realized or loss realized on sale of replacement QSB stock. If
a purchasing partnership does not realize
a gain or realizes a loss from the sale of
replacement QSB stock for which an election under this section was made for purposes of applying paragraph (c)(1)(iii)(A)
of this section, the eligible partner’s share
of the amount realized is—
(1) The greater of—
(i) The amount determined in paragraph
(c)(2)(i) of this section from a prior sale
of QSB stock (that is not otherwise taken
into account under paragraph (c)(2) of this
section) in which the eligible partner had a
distributive share of gain allocated to the
eligible partner that was not recognized
under paragraph (c)(1)(iii)(A) of this section; or
(ii) The amount realized by a taxpayer
other than a C corporation from a prior
sale of QSB stock (that is not otherwise
taken into account under paragraph (c)(2)
of this section) in which the taxpayer re-

2007–40 I.R.B.

alized gain that was not recognized under
paragraph (c)(1)(iii)(B) of this section; less
(2) The eligible partner’s distributive
share of any loss recognized on the sale of
replacement QSB stock, if applicable.
(B) Eligible partner’s interest in purchasing partnership is reduced and gain
realized on sale of replacement QSB stock.
If an eligible partner’s interest in a purchasing partnership is reduced subsequent
to the sale of QSB stock and the purchasing partnership realizes a gain from the
sale of the replacement QSB stock, the eligible partner’s share of the amount realized upon a sale of replacement QSB
stock must be determined under paragraph
(c)(2)(i) of this section based on the distributive share of the partnership’s realized
gain that would have been allocated to the
eligible partner if the eligible partner’s interest in the partnership had not been reduced.
(iii) Eligible partner’s share of the
amount realized. For purposes of determining the eligible partner’s share of
the amount realized by the partnership, the
partnership’s realized gain from the sale of
QSB stock and the eligible partner’s distributive share of that gain are determined
without regard to basis adjustments under
section 743(b) and paragraphs (b)(3)(ii)
and (c) of this section.
(3) Partner’s share of the cost of QSB
stock purchased by a purchasing partnership. The partner’s share of the cost (adjusted basis) of replacement QSB stock
purchased by a purchasing partnership is
the percentage of the partnership’s future
income and gain, if any, that is reasonably
expected to be allocated to the partner (determined without regard to any adjustment
under section 1045) with respect to the replacement QSB stock that was purchased
by the partnership, multiplied by the cost
of that replacement QSB stock. The assumptions made by a partnership in determining the reasonably expected allocation
of income and gain must be consistent for
each partner. For example, a partnership
may not treat the same item of income or
gain as being reasonably expected to be allocated to more than one partner.
(4) Basis adjustments—(i) Eligible
partner’s interest in selling partnership.
Under section 705(a)(1), the adjusted basis of an eligible partner’s interest in a
selling partnership that sells QSB stock
is increased by the partner’s distributive

727

share of gain without regard to paragraph
(c)(1) of this section. However, if the
selling partnership is also a purchasing
partnership, the adjusted basis of an eligible partner’s interest in a partnership that
sells QSB stock may be reduced under
paragraph (c)(4)(iii) of this section.
(ii) Replacement QSB stock. A partner’s basis in any replacement QSB stock
that is purchased by the partner, as well as
the adjusted basis of any replacement QSB
stock that is purchased by a purchasing
partnership and that is treated as the partner’s replacement QSB stock must be reduced (in the order replacement QSB stock
is acquired by the partner and purchasing
partnership, as applicable) by the partner’s
distributive share of the gain on the sale of
the selling partnership’s QSB stock that is
not recognized by the partner under paragraph (c)(1) of this section, or by the gain
on a sale of QSB stock by the partner that is
not recognized by the partner under section
1045, as applicable. If replacement QSB
stock is purchased by the purchasing partnership, the purchasing partnership shall
maintain its adjusted basis in the replacement QSB stock without regard to any basis adjustments required by this paragraph
(c)(4)(ii). The eligible partner, however,
shall in computing its distributive share
of income, gain, loss and deduction from
the purchasing partnership with respect to
the replacement QSB stock take into account the variation between the adjusted
basis in the QSB stock as determined under this paragraph (c)(4)(ii) and the adjusted basis determined without regard to
this paragraph (c)(4)(ii). A partner must
retain records setting forth the computation of this basis adjustment, the replacement QSB stock to which the adjustment
has been made, and the date(s) on which
such stock was acquired. See Examples 7
and 8 of paragraph (i) of this section.
(iii) Partner’s basis in purchasing partnership interest. A partner that treats the
partner’s interest in QSB stock purchased
by a purchasing partnership as the partner’s replacement QSB stock must reduce
(in the order replacement QSB stock is acquired) the adjusted basis of the partner’s
interest in the purchasing partnership by
the partner’s distributive share of the gain
on the sale of the selling partnership’s QSB
stock that is not recognized by the partner pursuant to paragraph (c)(1) of this section, or by the gain on a sale of QSB stock

October 1, 2007

by the partner that is not recognized by
the partner under section 1045, as applicable. Similarly, a partner of an upper-tier
partnership that treats the partner’s interest in QSB stock purchased by a lower-tier
purchasing partnership as the partner’s replacement QSB stock must reduce (in the
order replacement QSB stock is acquired)
the adjusted basis of the partner’s interest
in the upper-tier partnership by the partner’s distributive share of the gain on the
sale of the selling partnership’s QSB stock
that is not recognized by the partner pursuant to paragraph (c)(1) of this section, or
by the gain on a sale of QSB stock by the
partner that is not recognized by the partner under section 1045, as applicable.
(iv) Increase in basis on sale of QSB
stock by purchasing partnership. A partner that recognizes gain under paragraph
(c)(5) of this section must increase the
adjusted basis of the partner’s interest in
the purchasing partnership under section
705(a)(1) by the amount of the gain recognized by that partner. Similarly, a partner
in an upper-tier partnership that recognizes
gain under paragraph (c)(5) of this section must increase the adjusted basis of the
partner’s interest in the upper-tier partnership under section 705(a)(1) by the amount
of the gain recognized by that partner.
(5) Partner recognition of gain. At the
time that either the partner or the purchasing partnership (whichever applies) sells
or exchanges replacement QSB stock, the
amount recognized by the partner is determined by taking into account the basis adjustments described in paragraph (c)(4)(ii)
of this section. Similarly, a partner of an
upper-tier partnership that owns an interest in a lower-tier partnership that holds
replacement QSB stock must take into account the basis adjustments described in
paragraph (c)(4)(ii) of this section in determining the amount recognized by the partner on a sale of the interest in the lower-tier
partnership by the upper-tier partnership
or the partner’s distributive share of gain
from the upper-tier partnership. See paragraph (e)(4) of this section for rules applicable to certain distributions of replacement QSB stock.
(d) Nonrecognition limitation—(1) 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. Except as oth-

October 1, 2007

erwise provided in paragraph (d)(2) of this
section, the nonrecognition limitation is
equal to the product of—
(i) The partnership’s realized gain from
the sale of the QSB stock, determined
without regard to any basis adjustment
under section 734(b) or section 743(b)
(other than basis adjustments described in
paragraph (b)(3)(ii) of this section); and
(ii) The eligible partner’s smallest percentage interest in partnership capital as
determined in paragraph (d)(2) of this section. See Example 9 of paragraph (i) of this
section.
(2) Eligible partner’s smallest percentage interest in partnership capital. An
eligible partner’s smallest percentage interest in partnership capital is the eligible
partner’s percentage share of capital determined at the time of the acquisition of the
QSB stock as adjusted prior to the time the
QSB stock is sold to reflect any reduction
in the capital of the eligible partner including a reduction as a result of a disproportionate capital contribution by other partners, a disproportionate capital distribution
to the eligible partner or the transfer of an
interest by the eligible partner, but excluding income and loss allocations.
(3) Special rule for tiered partnerships.
For purposes of paragraph (d)(1)(ii) of this
section, if an eligible partner is treated as
owning an interest in a lower-tier purchasing partnership through an upper-tier partnership, the eligible partner’s percentage
interest in the purchasing partnership shall
be proportionately adjusted to reflect the
eligible partner’s percentage interest in the
upper-tier partnership.
(e) Partnership distribution of QSB
stock to a partner—(1) In general. Subject to paragraphs (e)(2) and (3) of this
section, in the case of a partnership distribution of QSB stock to a partner, the
partner shall be treated for purposes of this
section 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. See Examples 10 and
11 of paragraph (i) of this section.
(2) Eligibility under section 1202(c).
Paragraph (e)(1) of this section does not
apply unless all eligibility requirements
with respect to QSB stock as defined in
section 1202(c) are met by the distributing

728

partnership with respect to its investment
in QSB stock.
(3) Distribution nonrecognition limitation—(i) Generally. The amount of gain
that an eligible partner does not recognize
under this section on the sale of QSB stock
that was distributed by the partnership to
the partner cannot exceed the distribution
nonrecognition limitation. For this purpose, the distribution nonrecognition limitation is—
(A) The partner’s section 1045 amount
realized (determined under paragraph
(e)(3)(ii) of this section); reduced by
(B) The partner’s section 1045 adjusted basis (determined under paragraph
(e)(3)(iii) of this section).
(ii) Section 1045 amount realized—(A)
QSB stock received in liquidation of partner’s interest and in certain nonliquidating distributions. If a partner receives 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 distributed QSB
stock, multiplied by a fraction—
(1) The numerator of which is the
partner’s smallest percentage interest in
partnership capital determined under paragraph (e)(3)(ii)(B) of this section; and
(2) The denominator of which is the
partner’s percentage interest in that type
of QSB stock immediately after the distribution (determined under paragraph
(e)(3)(iv) of this section).
(B) Partner’s smallest percentage interest in partnership capital. A partner’s
smallest percentage interest in partnership
capital is the partner’s percentage share of
capital determined at the time of the acquisition of the QSB stock as adjusted prior to
the time the QSB stock is distributed to the
partner to reflect any reduction in the capital of the partner including a reduction as a
result of a disproportionate capital contribution by other partners, a disproportionate capital distribution to the partner, or the
transfer of a capital interest by the partner,
but excluding income and loss allocations.
(C) QSB stock received in other distributions. If a partner receives QSB stock
in a distribution from the partnership that
is not described in paragraph (e)(3)(ii)(A)

2007–40 I.R.B.

of this section, the partner’s section 1045
amount realized is the partner’s amount realized from the sale of the distributed QSB
stock multiplied by the partner’s smallest
percentage interest in partnership capital
determined under paragraph (e)(3)(ii)(B)
of this section.
(iii) Section 1045 adjusted basis—(A)
QSB stock received in liquidation of partner’s interest and in certain nonliquidating distributions. If a partner receives 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 section 743(b), other than
basis adjustments described in paragraphs
(b)(3)(ii) and (c)(4)(ii) of this section);
(2) The partner’s smallest percentage
interest in partnership capital determined
under paragraph (e)(3)(ii)(B) of this section; 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 QSB stock
in a distribution from the partnership that
is not described in paragraph (e)(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 section 743(b), other than basis adjustments described in paragraphs (b)(3)(ii)
and (c)(4)(ii) of this section); and
(2) The partner’s smallest percentage
interest in partnership capital determined
under paragraph (e)(3)(ii)(B) of this section.
(iv) Partner’s percentage interest in distributed QSB stock. For purposes of this
paragraph (e)(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.

2007–40 I.R.B.

(v) QSB stock of the same type. For purposes of this paragraph (e)(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 original issue.
(4) Distribution of replacement QSB
stock to a partner that reduces another
partner’s interest in the replacement QSB
stock. For purposes of this section, a
partner must recognize gain upon a distribution of replacement QSB stock to
another partner that reduces the partner’s
share of the replacement QSB stock held
by a partnership. The amount of gain
that the partner must recognize is determined based on the amount of gain that
the partner would recognize upon a sale
of the distributed replacement QSB stock
for its fair market value on the date of the
distribution but not to exceed the amount
that was previously not recognized by the
partner under section 1045 with respect
to the distributed replacement QSB stock.
Any gain recognized by a partner whose
interest is reduced must be taken into account in determining the adjusted basis of
the partner’s interest in the partnership and
also taken into account in determining the
partnership’s adjusted basis in the QSB
stock distributed to another partner under
paragraph (e)(3) of this section.
(f) Contribution of QSB stock or replacement QSB stock to a partnership.
Section 721 applies to a contribution of
QSB stock to a partnership. 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. Stock that is contributed to a
partnership is not QSB stock in the hands
of the partnership. See Example 12 of
paragraph (i) of this section.
(g) Definitions. For purposes of section
1045 and this section, the following terms
are defined as follows:
(1) Qualified small business stock. The
term qualified small business stock (QSB
stock) has the meaning provided in section
1202(c). The term “QSB stock” does not
include an interest in a partnership that purchases or holds QSB stock. See Example
1 of paragraph (i) of this section.
(2) Replacement QSB stock. The term
replacement QSB stock is any QSB stock

729

purchased within 60 days beginning on the
date of a sale of QSB stock.
(3) Eligible partner—(i) In general.
Except as provided in paragraphs (e)(1),
(g)(3)(ii), (iii) and (iv) of this section, an
eligible partner with respect to QSB stock
is a taxpayer other than a C corporation
that holds an interest in a partnership on
the date the partnership acquires the QSB
stock and at all times thereafter for more
than 6 months until the partnership sells or
distributes the QSB stock.
(ii) Acquisition by gift or at death. For
purposes of paragraph (g)(3)(i) of this section, a taxpayer who acquires from a partner (other than a C corporation) 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 partner (other than a
C corporation) held the interest in the partnership.
(iii) Tiered partnership. For purposes
of paragraph (g)(3)(i) of this section, if a
partnership (upper-tier partnership) holds
an interest in another partnership (lowertier partnership) that holds QSB stock, then
the upper-tier partnership’s ownership of
the lower-tier partnership is disregarded
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—
(A) The partner of the upper-tier partnership held an interest in the upper-tier
partnership; and
(B) The upper-tier partnership held an
interest in the lower-tier partnership. See
Examples 3 and 4 of paragraph (i) of this
section.
(iv) Multiple tiers of partnerships.
Principles similar to those described in
paragraph (g)(3)(iii) of this section apply
where a taxpayer holds an interest in a
lower-tier partnership through multiple
tiers of partnerships.
(4) Month(s). For purposes of this section, the term month(s) means a period
commencing on the same numerical day of
any calendar month as the day on which
the QSB stock is sold and ending with the
close of the day preceding the numerically
corresponding day of the succeeding calendar month or, if there is no corresponding day, with the last day of the succeeding
calendar month.

October 1, 2007

(h) Reporting and election rules—(1)
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) Federal income tax 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 by such partner under
section 706. In addition, a partnership or
partner making an election under section
1045 must make such election in accordance with the applicable forms and instructions.
(2) Purchases, distributions, and sales
of QSB stock or replacement QSB stock
by partnerships. A partnership that purchases, distributes to a partner, or sells
or exchanges QSB stock or replacement
QSB stock must provide information to
the Commissioner and to the partnership’s
partners to the extent provided by the applicable forms and instructions.
(3) Nonrecognition of gain by eligible
partners. An eligible partner that does not
recognize gain under section 1045 must
provide information to the Commissioner
to the extent provided by the applicable
forms and instructions.
(i) Examples. The provisions of this
section are illustrated by the following examples:
Example 1. Sale of a partnership interest. On
January 1, 2008, A, an individual, X, a C corporation, and Y, a C corporation, form PRS, a partnership.
A, X, and Y each contribute $250 to PRS and agree
to share all partnership items equally. PRS purchases
QSB stock for $750 on February 1, 2008. On November 4, 2008, A sells A’s interest in PRS for $500, realizing $250 of capital gain. Under paragraph (g)(1)
of this section, an interest in a partnership that holds
QSB stock is not treated as QSB stock. Therefore,
the sale of an interest in a partnership that holds QSB
stock is not treated as a sale of QSB stock, and A
may not elect to apply section 1045 with respect to
A’s $250 gain from the sale of A’s interest in PRS.
Example 2. Election by partner; replacement by
partnership. (i) Assume the same facts as in Example 1, except that A does not sell A’s interest in PRS.
Instead, PRS sells the QSB stock (QSB1 stock) for
$1,500 on November 3, 2008. PRS realizes $750 of
gain from the sale of the QSB1 stock (none of which
is treated as ordinary income) and allocates $250 of

October 1, 2007

gain to each of A, X, and Y. PRS does not make a section 1045 election. On November 30, 2008, A contributes $500 to ABC, a partnership, in exchange for
a 10 percent interest in ABC. ABC then purchases
QSB stock (QSB2 stock) for $5,000 on December 1,
2008. ABC has no other assets. A makes an election under paragraph (c)(1) of this section and treats
A’s percentage interest in ABC’s QSB2 stock as replacement QSB stock under paragraph (c)(1)(iii) of
this section with respect to the $250 gain PRS allocated to A. Under paragraph (c)(3) of this section,
A’s share of the cost of QSB2 stock purchased by
ABC is $500 (A’s reasonably expected income and
gain with respect to QSB2 stock, or 10 percent multiplied by the cost of the QSB2 stock, $5,000). Under
paragraph (c)(1)(iii) of this section, A will not recognize the $250 gain PRS allocated to A, because A’s
share of the amount realized by PRS, $500 (the total
amount realized by the partnership on the sale of the
QSB1 stock ($1,500) multiplied by A’s share of the
gain from the sale of the QSB1 stock ($250) over the
total gain realized by the partnership on the sale of
the QSB1 stock ($750)), does not exceed A’s share
of ABC’s cost of the QSB2 stock acquired by ABC,
$500. Under paragraph (c)(4)(ii) of this section, A
must reduce A’s share of ABC’s basis in the QSB2
stock by $250. Under paragraph (c)(4)(iii) of this section, A must reduce A’s basis in A’s interest in ABC
by $250. Under paragraph (c)(4)(i) of this section,
A’s basis in A’s interest in PRS is increased by $250.
(ii) Assume the same facts as in paragraph (i) of
this Example 2, except that A does not contribute
$500 to ABC in exchange for a partnership interest.
Instead, on November 30, 2008, EFG, a partnership
in which A has an existing 10 percent partnership interest, purchases QSB stock for $5,000. Under paragraph (c)(1) of this section, A may treat A’s 10 percent interest in EFG’s QSB stock as replacement QSB
stock with respect to the $250 of gain PRS allocated
to A.
(iii) Assume the same facts as in paragraph (i) of
this Example 2, except that ABC owns QSB stock that
ABC purchased on November 10, 2008, and ABC
does not purchase QSB stock on December 1, 2008.
Under paragraph (c)(1) of this section, ABC is not a
purchasing partnership with respect to A for the QSB
stock ABC purchased on November 10, 2008. A may
not treat A’s percentage interest in ABC’s QSB stock
as replacement QSB stock to defer the $250 gain PRS
allocated to A, because A acquired its interest in ABC
after ABC acquired the QSB stock.
(iv) Assume the same facts as in paragraph (i) of
this Example 2, except that ABC sells QSB2 stock
on July 30, 2009, for $5,000. ABC realizes no gain
or loss on the sale of QSB2 stock. A desires to continue to rollover the $250 gain from the sale of QSB1
stock. Under paragraph (c)(2)(ii)(A) of this section,
A’s share of the amount realized is $500, which was
A’s share of the amount realized on the prior sale of
QSB1 stock. Accordingly, A must elect to apply section 1045 and purchase $500 of replacement QSB
stock either directly or through a purchasing partnership to continue to defer the $250 gain from the sale
of QSB1 stock.
Example 3. Tiered partnerships; partnership
election. (i) On January 1, 2008, A, an individual,
and B, an individual, each contribute $500 to UTP,
(upper-tier partnership) for equal partnership interests. On February 1, 2008, UTP and C, an individual,

730

each contribute $1,000 to LTP, (lower-tier partnership) for equal partnership interests. On March 1,
2008, LTP purchases QSB stock for $500. On April
1, 2008, D, an individual, joins UTP by contributing
$500 to UTP for a 1/3 interest in UTP. On December
1, 2008, LTP sells the QSB stock for $2000. Under
paragraph (g)(3)(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 paragraphs (g)(3)(i) and (iii) of this section, A
and B are eligible partners, and D and UTP are not
eligible partners with respect to the QSB stock sold
by LTP. Under paragraph (g)(3)(i) of this section, C
is also an eligible partner with respect to the QSB
stock sold by LTP.
(ii) Assume the same facts as in paragraph (i) of
this Example 3. LTP realizes a gain of $1,500 on the
December 1, 2008, sale of QSB stock. LTP allocates
$750 of gain to each of UTP and C. UTP, in turn, allocates $250 (of the $750 of gain allocated to UTP) to
each of A, B, and D. LTP makes a section 1045 election. On January 1, 2009, LTP purchases replacement
QSB stock for $2,000. Under paragraph (b)(5)(ii) of
this section, D notifies UTP that it recognizes $250 of
gain and UTP notifies LTP. Because A, B, and C are
eligible partners with respect to the QSB stock sold
by LTP, A and B may each defer $250 of LTP’s section 1045 gain and C may defer $750 of LTP’s section
1045 gain. LTP must decrease its basis in the replacement QSB stock by the $750 of partnership section
1045 gain that was allocated to C and by $500 of the
partnership section 1045 gain that was allocated to
UTP. These basis reductions are with respect to UTP
(A and B) and C only. Under paragraph (b)(3)(ii)(B)
of this section, the basis of UTP’s interest in LTP attributable to the LTP’s replacement QSB stock must
be segregated and allocated to A and B. In addition,
A and B each have a $250 negative basis adjustment
in their respective interests in UTP. If UTP sells its
interest in LTP for $1,250, A and B would each recognize $250 of gain from the sale of the LTP interest.
D would not recognize any gain or loss from the sale.
Example 4. Tiered partnerships; partner election.
(i) On January 1, 2008, A, an individual, and X, a
C corporation, form UTP, a partnership. A and X
each contribute $250 to UTP and agree to share all
partnership items equally. Also, on January 1, 2008,
UTP and Y, a C corporation, form LTP, a partnership.
UTP and Y contribute $500 and $250, respectively, to
LTP. UTP and Y agree to share all partnership items
equally. LTP purchases QSB stock for $750 on February 1, 2008. On November 3, 2008, LTP sells the
QSB stock for $1,500. LTP realizes $750 of gain
from the sale of the QSB stock (none of which is
treated as ordinary income) and allocates $250 gain
to Y and $500 gain to UTP. Of the $500 gain allocated
to UTP from the sale of QSB stock, $250 is allocated
to A and $250 is allocated to X. LTP purchases replacement QSB stock (replacement QSB1 stock) for
$1,350 on December 15, 2008. LTP does not make
an election under section 1045. Under the rules provided in paragraph (c) of this section, A makes an
election under section 1045 on its timely filed return
for the taxable year for which the distributive share of
gain from the sale of QSB stock is taken into account
by A under section 706. Under paragraph (c)(1)(iii)
of this section, A treats A’s interest in replacement
QSB1 stock as replacement stock with respect to A’s

2007–40 I.R.B.

distributive share of LTP’s section 1045 gain. On
March 30, 2009, LTP sells replacement QSB1 stock
for $1,650. LTP realizes $300 of gain from the sale of
replacement QSB1 stock (none of which is treated as
ordinary income) and allocates $100 to Y and $200
to UTP.
(ii) Under paragraph (c)(1)(iii) of this section,
A must recognize its distributive share of gain from
LTP’s sale of QSB stock ($250) only to the extent
of the greater of A’s distributive share of LTP’s gain
from the sale of QSB stock that is treated as ordinary
income ($0) or the amount by which A’s share of
the amount realized by LTP’s sale of QSB stock
exceeds A’s share of LTP’s cost of the replacement
rd
QSB1 stock, $50 (1/3 of $1,500, or $500, minus
1/3rd of $1,350, or $450). Because Y is not an eligible partner of LTP under paragraph (g)(3) of this
section, Y must recognize its $250 distributive share
of partnership gain from the sale of the QSB stock.
Also, X is not an eligible partner under paragraph
(g)(3) of this section, and it must recognize its $250
distributive share of gain from UTP attributable to
UTP’s distributive share of $500 of LTP’s gain from
the sale of QSB stock.
(iii) Under section 705(a)(1), the adjusted basis
of Y’s interest in LTP is increased by $250, and the
adjusted basis of UTP’s interest in LTP is increased
by $500. Under section 705(a)(1), the adjusted basis
of X’s interest in UTP is increased by $250, and the
adjusted basis of A’s interest in UTP is increased by
$250. However, under paragraph (c)(4)(iii) of this
section, the adjusted basis of A’s interest in UTP is
reduced by the $200 of partnership section 1045 gain
that was not recognized by A.
(iv) Under paragraph (c)(4)(ii) of this section, the
LTP’s adjusted basis in replacement QSB1 stock is
reduced by the $200 of gain from the sale of QSB
stock that is not recognized by A, as a result of A’s
election under section 1045. A must retain records
setting forth the computation of this basis adjustment,
the replacement QSB stock to which the adjustment
is made, and dates the stock was acquired. LTP’s adjusted basis in the replacement QSB1 stock is maintained without regard to the eligible partner’s adjustment provided in paragraph (c)(4)(ii) of this section.
(v) On the sale of replacement QSB1 stock, LTP
realizes a gain of $300, $100 of which is allocated to
Y and $200 of which is allocated to UTP. UTP allocates $100 of this gain to A. Under paragraph (c)(5)
of this section, in determining A’s amount recognized
upon the sale of replacement QSB1 stock by LTP, A
must take into account A’s basis adjustment of $200.
Accordingly, A recognizes a total gain of $300 upon
the sale of replacement QSB1 stock, absent an additional section 1045 election by A or LTP. Under paragraph (c)(4)(iv) of this section, the adjusted basis of
A’s interest in UTP is increased by $300 under section 705(a)(1).
(vi) Assume the same facts as in paragraph (i) of
this Example 4, except that UTP sells its entire interest in LTP on March 30, 2009, for $1,200. UTP
realizes a gain of $200 on the sale of its interest in
LTP ($1,200 amount realized less $1,000 adjusted
basis) and allocates $100 of this gain to A. Under
paragraph (c)(5) of this section, in determining A’s
amount recognized upon the sale of UTP’s interest in
LTP, A must take into account A’s basis adjustment
of $200. Accordingly, A recognizes a total gain of
$300 upon the sale of the interest in LTP. Under para-

2007–40 I.R.B.

graph (c)(4)(iv) of this section, the adjusted basis in
A’s interest in UTP is increased by $300 under section 705(a)(1).
Example 5. Partnership sale of QSB stock and
purchase and sale of replacement QSB stock. (i) On
January 1, 2008, A, an individual, X, a C corporation,
and Y, a C corporation, form PRS, a partnership. A,
X, and Y each contribute $250 to PRS and agree to
share all partnership items equally. PRS purchases
QSB stock for $750 on February 1, 2008. On November 3, 2008, PRS sells the QSB stock for $1,500. PRS
realizes $750 of gain from the sale of the QSB stock
(none of which is treated as ordinary income) and allocates $250 of gain to each of A, X, and Y. PRS purchases replacement QSB stock (replacement QSB1
stock) for $1,350 on December 15, 2008. On its
timely filed return for the taxable year during which
the sale of the QSB stock occurs, PRS makes an election to apply section 1045. A does not make an election to apply section 1045 with respect to the November 3, 2008, sale of QSB stock. PRS knows that X
and Y are C corporations. On March 30, 2009, PRS
sells replacement QSB1 stock for $1,650. PRS realizes $300 of gain from the sale of replacement QSB1
stock (none of which is treated as ordinary income)
and allocates $100 of gain to each of A, X, and Y. A
does not make an election to apply section 1045 with
respect to the March 30, 2009, sale of replacement
QSB1 stock.
(ii) Under paragraph (b)(1) of this section, the
partnership section 1045 gain from the November 3,
2008, sale of QSB stock is $600 ($750 gain less $150
($1,500 amount realized on the sale of QSB stock
less $1,350 cost of replacement QSB1 stock)). This
amount must be allocated among the partners in the
same proportions as the entire gain from the sale of
QSB stock is allocated to the partners, 1/3 ($200) to
A, 1/3 ($200) to X, and 1/3 ($200) to Y.
(iii) Because neither X nor Y is an eligible partner
under paragraph (g)(3) of this section, X and Y must
each recognize its $250 distributive share of partnership gain from the sale of QSB stock. Because A is
an eligible partner under paragraph (g)(3) of this section, A may defer recognition of A’s $200 distributive share of partnership section 1045 gain. A is not
required to separately elect to apply section 1045. A
must recognize A’s remaining $50 distributive share
of the partnership’s gain from the sale of QSB stock.
(iv) Under section 705(a)(1), the adjusted bases
of X’s and Y’s interests in PRS are each increased
by $250. Under section 705(a)(1) and paragraph
(b)(3)(i) of this section, the adjusted basis of A’s
interest in PRS is not increased by the $200 of partnership section 1045 gain that was not recognized by
A, but is increased by A’s remaining $50 distributive
share of gain.
(v) PRS must decrease its basis in the replacement
QSB1 stock by the $200 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 replacement QSB1 stock to reflect the effect of A’s basis adjustment under paragraph (b)(3)(ii) of this section. In
accordance with the principles of §1.743–1(j)(3), the
amount of A’s gain from the March 30, 2009, sale
of replacement QSB1 stock in which A has a $200
negative basis adjustment equals $300 (A’s share of
PRS’s gain from the sale of replacement QSB1 stock
($100), increased by the amount of A’s negative basis

731

adjustment for replacement QSB1 stock ($200)). Accordingly, upon the sale of replacement QSB1 stock,
A recognizes $300 of gain, and X and Y each recognize $100 of gain.
(vi) Assume the same facts as in paragraph (i) of
this Example 5, except that PRS purchases replacement QSB stock (replacement QSB2 stock) on April
15, 2009, for $1,150 and PRS makes an election to
apply section 1045 with respect to the March 30,
2009, sale of replacement QSB1 stock. Under paragraph (b)(3)(ii)(A) of this section, PRS’ $200 basis
adjustment in QSB1 stock relating to the November
3, 2008, sale of QSB stock carries over to the basis
adjustment for QSB2 stock. This basis adjustment
is an adjustment with respect to A only. The $200
basis adjustment is reduced by A’s distributive share
of the excess of $500 (the greater of the amount determined under paragraph (b)(1)(i), $0, or (ii) of this
section, $500 ($1,650 amount realized on the sale of
QSB1 stock less $1,150 cost of replacement QSB2
stock)) over $300 (PRS’ gain from the sale of QSB1
stock), or $67 ($200 ($500 minus $300) divided by
3). Under paragraph (b)(3)(ii)(A), A must account
for the $67 excess amount that reduces PRS’ basis
adjustment in QSB2 stock as gain in accordance with
§1.743–1(j)(3). Therefore, A now has a $133 negative basis adjustment with respect to replacement
QSB2 stock (($200) negative basis adjustment from
the November 3, 2008, sale of QSB stock plus $67
positive basis adjustment from the March 30, 2009,
sale of QSB1 stock). A also recognizes the $100 of
gain allocated by PRS to A from the March 30, 2009,
sale of replacement QSB1 stock for total gain recognition of $167 ($100 plus $67).
Example 6. Partnership sale of QSB stock; election by eligible partner; replacement QSB stock purchased by purchasing partnership. (i) Assume the
same facts as in Example 5 except that PRS does not
make an election under section 1045 with respect to
the sale of either the QSB stock on November 3, 2008,
or the QSB1 stock on March 30, 2009. However, A
makes an election under section 1045 with respect to
the sale of QSB stock and treats the purchase of QSB1
stock on December 15, 2008, by PRS, as the purchase
of replacement QSB stock. Additionally, A makes an
election under section 1045 with respect to the sale of
QSB1 stock and treats the purchase of QSB2 stock on
April 15, 2009, by PRS, as the purchase of replacement QSB stock.
(ii) A’s distributive share of gain from the November 3, 2008, sale of QSB stock is $250 (A’s 1/3 interest in $750 of total PRS gain). Under paragraph
(c)(1)(iii) of this section, A must recognize only $50
of A’s distributive share of PRS’ gain of $250, that is
the excess of A’s share of the amount realized on the
sale of QSB stock, or $500 (the total amount realized
by PRS on the sale of QSB stock ($1,500) multiplied
by A’s share of the gain from the sale of QSB stock
($250) over the total gain realized by PRS on the sale
of QSB stock ($750)), minus A’s share of PRS’ cost
of QSB1 stock, or $450 (1/3 of $1,350). Under section 705(a)(1) and paragraph (c)(4)(i) of this section,
A’s adjusted basis in its interest in PRS is increased
by $250. However, under paragraph (c)(4)(iii) of this
section, because PRS is a purchasing partnership, A’s
adjusted basis of its interest in PRS is then reduced
by the deferred gain of $200. Also under paragraph
(c)(4)(ii) of this section, PRS’ adjusted basis in QSB1
stock is reduced by the gain not recognized of $200

October 1, 2007

and A must take into account such adjusted basis in
computing A’s income, gain, loss or deduction with
respect to QSB1 stock. A must retain records setting forth the computation of this basis adjustment,
the replacement QSB stock to which the adjustment
is made, and dates the stock was acquired.
(iii) A’s distributive share of gain from the March
30, 2009, sale of QSB1 stock is $100 (A’s 1/3 interest
in $300 of total PRS gain) and under paragraph (c)(5)
of this section, A must take into account A’s $200
basis adjustment with respect to the QSB1 stock that
was sold. Accordingly, A’s total gain from the sale of
QSB1 stock is $300. Under paragraph (c)(1)(iii) of
this section, A must recognize only $167 of A’s total gain of $300, that is, the excess of A’s share of
the amount realized on the sale of QSB1 stock, or
$550 (the total amount realized by PRS on the sale
of QSB1 stock ($1,650) multiplied by A’s share of
the gain from the sale of QSB1 stock ($100) over the
total gain realized by PRS on the sale of QSB1 stock
($300)) minus A’s share of PRS’ cost of QSB2 stock,
or $383 (1/3 of $1,150). Under section 705(a)(1), A’s
adjusted basis in A’s interest in PRS is increased by
A’s $100 distributive share of gain from the sale of
QSB1 stock. Under paragraph (c)(4)(iv) of this section, A’s adjusted basis of A’s interest in PRS is increased by the additional $67 of gain recognized under paragraph (c)(5) of this section. Also, under paragraph (c)(4)(ii) of this section, PRS’ adjusted basis
in QSB2 stock is reduced by the gain not recognized
of $133 ($300 minus $167) and A must take into account such adjusted basis in computing A’s income,
gain, loss or deduction with respect to QSB2 stock.
A must retain records setting forth the computation
of this basis adjustment, the replacement QSB stock
to which the adjustment is made, and dates the stock
was acquired.
Example 7. Partnership sale of QSB stock and
partner purchase of replacement QSB stock. (i) Assume the same facts as in paragraph (i) of Example
5, except that PRS does not make an election under section 1045 with respect to the sale of the QSB
stock and does not purchase replacement QSB stock.
On November 30, 2008, A, an eligible partner under
paragraph (g)(3) of this section, purchases replacement QSB stock for $500. A elects pursuant to paragraph (c) of this section 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’ gain
from the sale of the QSB stock.
(ii) Under paragraph (c)(2) of this section, A’s
share of the amount realized from PRS’ sale of the
QSB stock is $500 (the total amount realized by the
partnership on the sale of the QSB stock ($1,500)
multiplied by A’s share of the gain from the sale of
the QSB stock ($250) over the total gain realized by
the partnership on the sale of the QSB stock ($750)).
Because A purchased, within 60 days of PRS’ 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 an election pursuant to paragraph (c) of this section to apply section 1045, A defers recognition of A’s
$250 distributive share of gain from PRS’ sale of the
QSB stock. Under section 705(a)(1) and paragraph
(c)(4)(i) of this section, the adjusted basis of A’s interest in PRS is increased by $250. Under paragraph
(c)(4)(ii) of this section, A’s adjusted basis in the re-

October 1, 2007

placement QSB stock is $250 ($500 cost minus $250
nonrecognition amount).
Example 8. Partial replacement by partnership;
partial replacement by partner. (i) On January 1,
2008, A, an individual, and X, a C corporation, form
PRS, a partnership. A and X each contribute $500 to
PRS and agree to share all partnership items equally.
PRS purchases QSB stock on February 1, 2008, for
$1,000 and subsequently sells the QSB stock on January 31, 2010, for $3,000. PRS realizes $2,000 of
gain from the sale of the QSB stock (none of which
is treated as ordinary income) and allocates $1,000
of gain to each of A and X. On February 10, 2010,
PRS purchases replacement QSB stock for $2,200.
On March 20, 2010, A purchases replacement QSB
stock for $400. PRS makes an election to apply section 1045 under paragraph (b)(1) of this section with
respect to the partnership section 1045 gain from the
sale of QSB stock and A does not opt out of PRS’
section 1045 election under paragraph (b)(4) of this
section. Also, A makes an election under paragraph
(c)(1) of this section with respect to the remaining
gain from the sale of the QSB stock.
(ii) Under paragraph (b)(1) of this section, partnership section 1045 gain is $1,200 ($2,000 less $800
($3,000 amount realized on the sale of the QSB stock
minus $2,200 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
($600), and 1/2 to X ($600). Because A is an eligible
partner, A defers recognition of A’s $600 distributive
share of partnership section 1045 gain.
(iii) A also made an election under section 1045
and purchased, within 60 days of PRS’ sale of the
QSB stock, replacement QSB stock for $400. 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 to the extent
that A’s share of the amount realized by PRS on the
sale of the QSB stock (excluding the cost of 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 cost of the QSB stock that was
replaced by PRS) is $800 ($3,000 minus $2,200). Under paragraph (c)(2) of this section, A’s share of that
amount realized is $400 ($1,000 (A’s share of the realized gain from the sale of the QSB stock) / $2,000
(PRS total realized gain from the sale of the QSB
stock) multiplied by $800). Because the replacement
QSB stock purchased by A cost $400, 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 $600 gain that was not recognized pursuant to paragraph (b)(1) of this section, but
is increased by the $400 gain that was not recognized
pursuant to paragraph (c)(1) of this section. See paragraphs (b)(3)(i) and (c)(4)(i) of this section. PRS
must decrease its basis in the replacement QSB stock
by the $600 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 $400 not recognized pursuant to paragraph (c)(1) of this section. See
paragraph (c)(4)(ii) of this section.

732

Example 9. Change in partner’s interest in partnership while partnership holds QSB stock. (i) On
January 1, 2008, A, an individual, and X, a C corporation, form PRS, a partnership. A and X each contribute $500 to PRS and agree to share all partnership
items equally. PRS purchases QSB stock on February 1, 2008, for $1,000. On August 2, 2008, A sells a
25 percent interest in PRS to Z. On July 10, 2009, A
repurchases the 25 percent interest from Z for $500.
PRS makes a timely election under section 754 for
the 2008 taxable year. Under section 743(b), A has
a positive basis adjustment of $250. On January 31,
2011, PRS sells the QSB stock for $3,000. PRS realizes $2,000 of gain from the sale of the QSB stock
(none of which is treated as ordinary income) and allocates $1,000 of gain to each of A and X. On February 10, 2010, PRS purchases replacement QSB stock
for $3,000. PRS makes an election to apply section
1045 under paragraph (b)(1) of this section with respect to the partnership section 1045 gain from the
sale of QSB stock.
(ii) Of the $2,000 of realized gain from the sale of
the QSB stock, PRS allocates $1,000 to A and $1,000
to X. However, A has a positive basis adjustment of
$250 under section 743(b) as a result of the purchase
of the 25 percent interest in PRS from Z; therefore,
A’s share of the gain is reduced to $750. Because A is
an eligible partner under paragraph (g)(3) 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 (d)
of this section. The smallest percentage interest that
A held in PRS capital 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 $2,000, A may defer recognition of $500 (25 percent of $2,000) of the
gain from the sale of the QSB stock. A must recognize the remaining $250 of that gain.
Example 10. Sale by partner of QSB stock received in a liquidating distribution. (i) On January
1, 2008, A, an individual, and X, a C corporation,
form PRS, a partnership. A and X each contribute
$1,500 to PRS and agree to share all partnership
items equally. PRS purchases QSB stock on February 1, 2008, for $3,000. On May 1, 2008, when
the QSB stock has appreciated in value to $4,000, A
contributes $1,000 to PRS, increasing A’s interest in
PRS capital to 60 percent. On June 1, 2011, when
the QSB stock is still worth $4,000, PRS makes
a liquidating distribution of $3,000 worth of QSB
stock to A. Under section 732, A’s basis in the distributed QSB stock is $2,500. A sells the QSB stock
on August 4, 2011, for $6,000, realizing a gain of
$3,500 (none of which is treated as ordinary income).
A purchases replacement QSB stock on August 30,
2011, for $5,500, and makes an election under section 1045 with respect to the August 4, 2011, sale of
QSB stock.
(ii) A is an eligible partner under paragraph (g)(3)
of this section. Therefore, under paragraph (e)(1) of
this section, A is treated as having acquired the distributed QSB stock in the same manner as PRS and as

2007–40 I.R.B.

having held the QSB stock since February 1, 2008, 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, $6,000, 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
QSB stock, $5,500. Accordingly, A must recognize
$500 of the gain from the sale of the QSB stock. A
defers recognition of the remaining $3,000 of gain to
the extent that such gain does not exceed the distribution nonrecognition limitation under paragraph (e)(3)
of this section.
(iii) Under paragraph (e)(3)(i) 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, $6,000; and a fraction—
(1) The numerator of which is A’s smallest percentage interest in PRS capital with respect to such
stock, 50 percent; and
(2) The denominator of which is A’s percentage
interest in that type of partnership QSB stock immediately after the distribution, 75 percent (the value of the
stock distributed to A, $3,000, divided by the value of
all QSB stock of that type acquired by PRS, $4,000).
(iv) Therefore, A’s section 1045 amount realized
is $4,000 ($6,000 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’ basis in all of the QSB stock of the
type distributed, $3,000; A’s smallest percentage interest in PRS capital with respect to QSB stock of the
type distributed, 50 percent; and the percentage of the
distributed QSB stock that was sold by A, 100 percent. Therefore, A’s section 1045 adjusted basis is
$1,500 (the product of $3,000, 50 percent, and 100
percent)) and A’s nonrecognition limitation amount
on the sale of the QSB stock is $2,500 ($4,000 section 1045 amount realized minus $1,500 section 1045
adjusted basis). Accordingly, A defers recognition of
$2,500 of the remaining $3,000 gain from the sale of
the QSB stock and must recognize $500 of the remaining $3,000 gain. Accordingly, A’s total gain recognized from the sale of the QSB stock is $1,000.
(v) A’s basis in the replacement QSB stock is
$3,000 (cost of the replacement QSB stock, $5,500,
reduced by the gain not recognized under section
1045, $2,500).
Example 11. Sale by partner of QSB stock received in a nonliquidating distribution. (i) The facts
are the same as in Example 10, except that, on June 1,
2011, PRS distributes only $2,000 of the QSB stock

to A, reducing A’s interest in PRS capital from 60 percent to 33 percent. PRS’ basis in the distributed QSB
stock is $1,500. On November 1, 2011, A sells for
$2,500 the QSB stock distributed by PRS to A and
purchases, within 60 days of the date of sale of the
QSB stock, replacement QSB stock for $2,500. A
makes a timely election to apply section 1045 with
respect to A’s sale of the distributed QSB stock.
(ii) Under section 732, A’s basis in the distributed
QSB stock is $1,500. Therefore, A realizes a gain on
the sale of the distributed QSB stock of $1,000. Because A made an 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 (e)(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 the particular type of
QSB stock and the distribution of the QSB stock to
A was not in liquidation of A’s interest in PRS, under paragraph (e)(3)(ii)(C) of this section A’s section
1045 amount realized is $1,250 (A’s amount realized
from the sale of the distributed QSB stock, $2,500,
multiplied by A’s smallest percentage interest in PRS
capital with respect to such stock, 50 percent). Under paragraph (e)(3)(iii)(B) of this section, A’s section 1045 adjusted basis is the product of the partnership’s basis in the QSB stock sold by the partner, $1,500, and A’s smallest percentage interest in
the partnership capital with respect to such stock, 50
percent. Therefore, A’s section 1045 adjusted basis
is $750 (50 percent of $1,500), and A’s nonrecognition limitation amount on the sale of the QSB stock
is $500 ($1,250 section 1045 amount realized minus
$750 section 1045 adjusted basis). As this amount is
less than the amount of gain that A is eligible to defer
under section 1045, $1,000, A defers recognition of
only $500 of the gain from the sale of the QSB stock.
A must recognize the remaining $500 of that gain.
(iv) A’s basis in the replacement QSB stock is
$2,000 (cost of the replacement QSB stock, $2,500,
reduced by the gain not recognized under section
1045, $500).
Example 12. Contribution of replacement QSB
stock to a partnership. (i) On January 1, 2008, A,
an individual, B, an individual, and X, a C corporation, form PRS, a partnership. A, B, and X each contribute $250 to PRS and agree to share all partnership items equally. On February 1, 2008, PRS purchases QSB stock for $750. PRS sells the QSB stock
on November 3, 2008, for $1,050. PRS realizes $300

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 its partners. PRS informs the partners that it does not intend to make an election under section 1045 with respect to the sale of the QSB
stock. Each partner’s share of the amount realized
from the sale of the QSB stock is $350. On November 30, 2008, A, an eligible partner within the meaning of paragraph (g)(3) of this section, purchases replacement QSB stock for $350 and makes a section
1045 election under paragraph (c)(1) of this section.
Subsequently, A transfers the replacement QSB stock
to ABC, a partnership, in exchange for an interest in
ABC.
(ii) 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 with
respect to A’s share of the gain from PRS’s sale of
the QSB stock, A does not recognize A’s $100 distributive share of the gain from PRS’s sale of the
QSB stock. Before the contribution of the replacement QSB stock to ABC, A’s adjusted basis in the replacement QSB stock is $250 ($350 cost minus $100
nonrecognition amount). A does not recognize gain
upon the contribution of QSB stock to ABC under
section 721(a). Upon the contribution of the replacement QSB stock to ABC, A’s basis in the ABC partnership interest is $250, and ABC’s basis in the replacement QSB stock is $250. However, the replacement QSB stock does not qualify as QSB stock in
ABC’s hands. Neither A nor ABC will be eligible
to defer gain under section 1045 on a subsequent sale
of the replacement QSB stock.

(j) Effective/applicability date—In general. This section applies to sales of QSB
stock on or after August 14, 2007.
PART 602—OMB CONTROL
NUMBERS UNDER THE PAPERWORK
REDUCTION ACT
Par. 3. The authority citation for part
602 continues to read, in part, as follows:
Authority: 26 U.S.C. 7805.
Par. 4. In §602.101 paragraph (b) is
amended by adding in numerical order,
§1.1045–1, to read as follows:
§602.101 OMB Control numbers.
*****
(b) * * *

CFR part or section where
identified and described
*****
1.1045–1
*****

2007–40 I.R.B.

Current OMB
control No.
...........................................................

733

1545–1893

October 1, 2007

Kevin M. Brown,
Deputy Commissioner for
Services and Enforcement.

Eric Solomon,
Assistant Secretary of
the Treasury (Tax Policy).

(Filed by the Office of the Federal Register on August 13,
2007, 8:45 a.m., and published in the issue of the Federal
Register for August 14, 2007, 72 F.R. 45346)

Approved August 2, 2007.

October 1, 2007

734

2007–40 I.R.B.